Category Archives: Legal Resources

Series 79 Exam – Waiting for SEC Approval

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Post courtesy of www.series79exam.com.

SEC to Shed Light on the New Series 79 Exam

Pursuant to a proposal set forth by FINRA in February of this year, it is anticipated that the Series 79 will be introduced as a simplified alternative exam for investment bankers. Prior to the introduction of this new exam, all registered representatives were required by NASD Rule 1032 to take the Series 7 exam. The proposal modified this Rule to condense the exam for those individuals whose activities are limited to investment banking. The primary reason behind the FINRA proposal for a new abridged exam was that the Series 7 exam covers a broad array of functions that do not pertain to the day-to-day activities of an investment banker.

On July 13, 2009 we contacted FINRA to determine what information, if any, has been released on the new Series 79 exam.  According to FINRA, the SEC has approved the proposal set forth by FINRA as of April of this year, but SEC approval on the content of the exam and related fees is still pending. Thus, there is limited information available to prospective exam takers regarding the proposed content of the exam, the timeline for required registration, the release of related study materials and/or course offerings, and related exam fees.  Once the SEC issues its approval, a formal press release will be issued to the public regarding the structure of the exam as well as an expected date as to when the modified NASD Rule 1032(i) will be enforced, thereby establishing the Series 79 as the new license requirement for investment bankers.

All information regarding the Series 79 Exam will be available on this site for prospective exam takers once it is formally approved by the SEC.

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

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

Hedge Fund Compliance and Twitter

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Cat and Mouse Securities Compliance

It seems so many aspects of the securities industry is the cat and mouse game of regulate (government) and sneakily avoid (industry participants).  This is especially true when it comes to compliance and “what you can get away with.”  As the post below notes, many compliance rules (and other securities laws and regulations) are written fairly broadly – accordingly, registered individuals always need to be aware of the consequences of their actions.  The article reprinted below by Doug Cornelius of the Compliance Building blog examines the misconceptions of Twitter and compliance requirements.
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Twitter and Compliance

By Doug Cornelius

I was struck recently by the power and misconceptions around Twitter, the current press darling of Web 2.0. On one side is the enormous power of Twitter to crowdsource the news. The fallout of the Iran elections was better covered on Twitter than the mainstream media. At one point I watched CNN only to see the anchors reading from Twitter and displaying images posted to Twitter applications.

On the other side is the misconception that Twitter communications are not regulated by the SEC or FINRA. Everyone can acknowledge that the regulations have not caught up with the current tools of web 2.0. But the existing rules were drafted broad enough to cover all electronic communication. Twitter is clearly electronic communication.

Last week at at Jeff Pulver’s 140 Characters Conference in New York an attendee said “Twitter allows us to say f— you to the SEC!”  Earlier this week there was a quote in Forbes.com that “Since brokers have to save instant messages and e-mail, but thus far have no such mandate for tweets….”

The SEC and FINRA may have more pressing issues on its hands, but the existing rules cover the use of Twitter. Sure the rules could be more explicit. But ignore them at your peril.

If you are a registered representative, you should take a look at FINRA’s Guide to the Internet.  The features of Twitter could be considered an advertisement, sales literature, or correspondence. The direct message feature is correspondence. If your Twitter feed is unprotected, each twitter post would be considered an advertisement. If your Twitter feed is protected it would be considered sales literature.

The SEC’s Guidance on the use of web sites (SEC Release 34-58288) does not give the clearest guidance. But it is clear that the rules are independent of the platform and the technology.

Insider trading, wrongful public disclosure and fraud and prohibited regardless of the communication tool. That includes Twitter.

Companies that have to monitor electronic communications should add Twitter to the mix. As the Iran election showed us, blocking access is ineffective. You should adopt a policy for Twitter or a revise your existing policies to specifically include it.  Twitter has become too popular and powerful as a tool to ignore.

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Please feel free to leave us a comment below on this article.  You can also contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include:

Net Capital Requirement for State Registered Hedge Fund Managers

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Overview of Net Capital Requirement and Bond Alternative

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

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

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

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

Investment Advisor Bond

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

Securing the Bond

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

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

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

California Investment Advisor FAQ

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California Based Hedge Fund Managers Receive Answers to Common Questions

As I have discussed many times before, each state securities division has different rules and regulations.  In addition, each state has different interpretations of those rules and regulations. This makes it difficult for hedge fund managers to really know exactly what is required in each state unless they have representation from a specialized compliance group or hedge fund attorney.  Many securities regulators, also, do not completely understand their own rule and regulations and are not able to provide any sort of practicle advice to hedge fund managers regarding their obligations.  While not surprising, this lack of ability to provide general straight-forward answers to managers is what creates the need for specialized advice.  Some states however are recognizing that there are common questions which arise and that it makes sense to provide answers to those common questions and the FAQ below, provided by the California State Securities Regulation Division is a step in the right direction towards increasing the dialogue between regulators and market participants.

The following summary is also very helpful for manager because it discusses some of the nuances of California law as it relates to investment advisors who are also hedge fund managers.  Specifically the FAQ below deals with the issue of “custody,” the net worth requirements and the 120% net worth.  Also discussed is the “gatekeeper” issue (also known as the independant secondary signer service).

The entire text of the FAQ is reprinted below.  Please see below for additional hedge fund articles and please also see our guide to state hedge fund laws.

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1) What responsibilities do I have as an investment adviser?

As an investment adviser, you are a “fiduciary” to your advisory clients. This means that you have a fundamental obligation to act in the best interests of your clients and to provide investment advice in your clients’ best interests. You owe your clients a duty of undivided loyalty and utmost good faith. You should not engage in any activity in conflict with the interest of any client, and you should take steps reasonably necessary to fulfill your obligations. You must employ reasonable care to avoid misleading clients and you must provide full and fair disclosure of all material facts to your clients and prospective clients.

So, what is considered material? Generally, facts are “material” if a reasonable investor would consider them to be important. It is something a client would want to consider in determining whether to hire the adviser or follow the adviser’s recommendations. You must eliminate, or at least disclose, all conflicts of interest that might incline you to render advice that is not in the best interest of the client. If you do not avoid a conflict of interest that could impact the impartiality of your advice, you must make full and frank disclosure of the conflict. You cannot use your clients’ assets for your own benefit or the benefit of other clients. Departure from this fiduciary standard may constitute “fraud” upon your clients.

2) How are “assets under management” determined?

In determining the amount of your assets under management, include the securities portfolios for which you provide continuous and regular supervisory or management services as of the date of filing Form ADV. You provide continuous and regular supervisory or management services with respect to an account if:

(1)  You have discretionary authority over and provide ongoing supervisory or management services  with respect to the account; or

(2)  You do not have discretionary authority over the account, but you have an ongoing  responsibility to select or make recommendations, based upon the needs of the client, as to  specific securities or other investments the account may purchase or sell and, if such  recommendations are accepted by the client, you are responsible for arranging or effecting the  purchase or sale.

Other factors: You should also consider the following factors in evaluating whether you provide  continuous and regular supervisory or management services to an account:

(a)Terms of the advisory contract.
If you agree in an advisory contract to provide ongoing management services, this suggests that  you provide these services for the account. Other provisions in the contract, or your actual  management practices, however, may suggest otherwise.

(b)Form of compensation.
If you are compensated based on the average value of the client’s assets you manage over a  specified period of time, this suggests that you provide continuous and regular supervisory or  management services for the account.
If you receive compensation in a manner similar to either of the following, this suggests you do  not provide continuous and regular supervisory or management services for the account:

(a) You are compensated based upon the time spent with a client during a client visit; or
(b) You are paid a retainer based on a percentage of assets covered by a financial plan.

(3)Management practices.

The extent to which you actively manage assets or provide advice bears on whether the services  you provide are continuous and regular supervisory or management services. The fact that you  make infrequent trades (e.g., based on a “buy and hold” strategy) does not mean your services  are not “continuous and regular.”

3) Our firm is registered with the SEC or another state. Must we also register with the Department of Corporations?

SEC registered advisers with more than five clients who are residents of California must make a notice filing with the Department.

Other states registered investment advisers with a place of business in this state or more than five clients who are residents of California must also registered with the Department.

4) How does a firm convert from being a state-registered to an SEC-registered investment adviser or vice versa?

From State to SEC: To convert from being a state-registered adviser to being an SEC-registered adviser on the IARD system, mark the filing type “Apply for registration as an investment adviser with the SEC.” After the SEC approves your registration you should file a “Partial ADV-W” to withdraw your state registration(s). Do not file your Partial ADV-W until your application for SEC registration is approved or you will be unregistered and may be unable to conduct your business during this period of time.

From SEC to State: To convert from being a SEC-registered adviser to being a state-registered adviser, mark the filing type “Apply for registration as an investment adviser with one or more states.” After your state registration has been approved, then you should file a “Partial ADV-W” to withdraw your SEC registration. Do not file your Partial ADV-W until your state registration application(s) is approved by the Department or you will be unregistered and cannot conduct your business during this period of time.

5) What is an “investment adviser representative?”

An investment adviser representative (“IAR”), sometimes referred to as a registered adviser (“RA”), or associated person is defined in Code Section 25009.5(a) as any partner, officer, director of (or a person occupying a similar status or performing similar functions) or other individual, except clerical or ministerial personnel, who is employed by or associated with, or subject to the supervision and control of, an investment adviser that has obtained a certificate or that is required to obtain a certificate under this law, and who:

(1) Makes any recommendations or otherwise renders advice regarding securities,
(2) Manages accounts or portfolios of clients,
(3) Determines which recommendations or advice regarding securities should be given,
(4) Solicits, offers, or negotiates for the sale or sells investment advisory services, or
(5) Supervises employees who perform any of the foregoing.

Important: Each officer, director or partner exercising executive responsibility (or persons occupying a similar status or performing similar functions) or each person who owns 25% or more is presumed to be acting as an IAR or associated person.

6) I have an investment adviser representative who performs advisory services on behalf of my firm and is under my supervision. Does the investment adviser representative need to be registered with the Department?

Yes, investment adviser representatives must be registered with the Department if they have a place of business in California.

Important: This applies to both state (California and other states) and SEC registered investment advisers. Investment adviser representatives located in California or who have clients who are residents of California (whether they work for SEC, other states, or California’s registered investment adviser firms), must be registered with the Department.

7) How does my firm register individuals and what are the employment requirements?

Firms register individuals by completing Form U-4 through the electronic Central Registration Depository (“CRD”). Upon employment of an individual as an IAR, the investment adviser must obtain a properly executed Form U-4, evidence that the IAR meets the qualification requirements of CCR §260.236, and have the responsibility and duty to ascertain by reasonable investigation the good character, business reputation, qualifications, and experience of an individual upon employment or engagement as an IAR.

8) What are the qualification requirements for investment adviser representatives?

Each IAR, except those employed or engaged by an investment adviser solely to offer or negotiate for the sale of investment adviser services, must qualify by passing the examination(s) as specified in CCR §260.236(a). The examination requirements are the Uniform Investment Adviser Law Examination (“2000 Series 65”) passed on or after January 1, 2000; or the General Securities Representative Examination (“Series 7”) and Uniform Combined State Law Examination (“2000 Series 66”). Waivers and exemptions to the examination requirements may be found in subsection (b) and (c) of CCR §260.236, respectively. Individuals who hold in good standing an approved professional designation meet the exemption found in (c)(3) of CCR §260.236.

When a U-4 is filed to register someone as an IAR, the CRD will automatically open a Series 65 exam window if the individual is not shown as already having passed the exam, is not already licensed by another jurisdiction, or does not qualify for an automatic exam waiver.

9) What are the filing requirements for a firm who has an investment adviser representative?

(1) Employment –

Upon employment of an IAR, Form U-4, including any Disclosure Reporting  Page(s), should  be completed in accordance with the form instructions. The form is to be filed  with, and the  reporting fee paid to, CRD in accordance with its procedures. The filing of Form U- 4 with  CRD does not constitute an automatic approval of the filing by the Commissioner. The  investment adviser should not consider an IAR “registration” approved until approved by the  Commissioner and notification of the approval has been received through CRD.

(2) Changes – Within 30 days of any changes to Form U-4, an amendment to Form U-4 is to be  filed. The amendment is to be filed directly with CRD in accordance with its procedures.

(3)Termination – Within 30 days of termination of an IAR, Form U-5 is to be filed in accordance  with the form instructions. Form U-5 is to clearly state the reason(s) for termination. This form is  to be filed directly with CRD in accordance with its procedures.

10) What are the fees associated with registering an investment adviser representative?

The registration fee for each IAR is $25. This fee is paid to the Department through the IARD system. There is no annual renewal fee for an IAR.

There is also an annual filing fee of $30 for 2008 (subject to change for future years) that is paid to FINRA for the processing of forms for each IAR. FINRA charges this fee and the Department does not receive any portion of this.

11) Are owners and executive officers considered investment adviser representatives (IAR)? If so, how should I report owners and executive officers of my advisory firm to the Department?

All direct owners and executive officers should be reported on Schedule A of Form ADV and indirect owners should be reported on Schedule B of Form ADV.

Since officers, directors or partners who exercise executive responsibilities (or persons who occupy similar status or perform similar functions), or persons who own 25% or more are presumed to be IARs, a Form U-4 and a $25 reporting fee should be filed for each such individual through the Central Registration Depository (“CRD”).

A paper filing of Form U-4 should be filed directly with the Department for all other officers, directors or partners, or persons who own 10% or more who are not reported as IARs through the CRD.

12) I solicit clients for an investment adviser and receive referral fees for business I send to an investment adviser. Must I register?

Solicitors must be registered either as an investment adviser representative under a registered investment advisory firm or obtain their own independent registered investment adviser certificate.

13) I solely refer clients to registered investment advisers, what qualification requirements are there for solicitors?

Individuals who are reported as an IAR under an investment adviser solely to offer or negotiate for the sale of investment adviser services are exempted from the qualification requirements. However, solicitors seeking their independent registered investment advisory license must be qualified.

14) I’m a Certified Public Accountant (CPA) and refer my clients to third-party investment advisers for referral fees, what qualifications and requirements must I follow?

A special case arises when a CPA acts as referring agent. Like a solicitor, the CPA must be registered either as an investment adviser representative under a registered investment advisory firm or obtain their own independent registered investment adviser certificate. The difference is that the CPA must be qualified by passing the examinations, unless waived or exempted, even if the CPA is to be reported as an investment adviser representative under a registered investment advisory firm. This is because, according to the California Business and Profession Code and the Board of Accountancy, in order for a CPA to receive compensation from a referral, the CPA must provide a professional service related to the product or services that will be provided to the client by the third-party service provider. In addition, the CPA must maintain independence and provide full disclosure of its referral arrangement to the clients.

Please refer to California Business and Profession Code, Section 5061 and California Board of Accountancy, Article 9, Section 56 for more information.

15) Must I have a written contract with my clients? If yes, what information should my advisory contracts contain?

Yes. Advisers providing services pursuant to advisory contracts that are written are considered to promote fair, equitable, and ethical principles. Advisory contracts with clients must be in writing and, at a minimum, must disclose:

(1) The services to be provided;
(2) The term of the contract;
(3) The advisory fee or the formula for computing the fee amount or the manner of calculation  of the amount of the prepaid fee to be returned in the event of contract termination or  nonperformance;
(4) Whether the contract grants discretionary power to the adviser or its representatives; and
(5) That the contract will not be assigned without the consent of the client.

Please refer to CCC Section 25234 and CCR Section 260.238 for more information.

Important: The Form ADV may not specifically request certain information, however; it is the adviser’s fiduciary duty to disclose all material information in order not to mislead clients, so that the client can make informed decisions about entering into or continuing the advisory relationship.

During the Department examination, examiner will view perceived conflicts from the point of view of the customer: Was the disclosure or lack of disclosure a factor in the client’s decision to use an adviser’s services or ratify an adviser’s recommendations? Was the customer misled? Was the customer placed at a disadvantage or taken unfair advantage of as a result of the conflict and the adviser’s lack of disclosure? The burden of proof lies with the adviser.

16) I provide financial planning services to my clients. What disclosure information must I provide in my advisory contracts for my clients?

Financial planners should provide proper disclosures relating to any inherent conflict of interest that may result from any compensation arrangements connected with the financial planning services that are in addition to the financial planning fees and other financial industry activities or affiliations.

Advisers who provide financial planning services and receive compensation (e.g. commissions, fees) from the sale of securities, insurance, real estate or other product or services recommended in the financial plan, or otherwise has a conflict of interest, must deliver to the financial planning clients a notice in writing containing at least the information found below (in addition to the disclosure items in Question 15 at the time of entering into a contract for, or otherwise arranging for the provision of, the delivery of a financial plan:

(1) A conflict exists between the interests of the investment adviser or associated person and  the interests of the client, and
(2) The client is under no obligation to act on the investment adviser’s or associated person’s  recommendation. Moreover, if the client elects to act on any of the recommendations, the  client is under no obligation to effect the transaction through the investment adviser or the  associated person when such person is employed as an agent with a licensed broker-dealer or is  licensed as a broker-dealer or through any associate or affiliate of such person.

This statement may be included in the advisory contract or Schedule F of Form ADV, which for the latter, the client must acknowledge receipt of the disclosure.

Please refer to CCR Section 260.235.2 for more information.

17) When am I required to update my Form ADV?

Form ADV should always contain current and accurate information. Please note that Part 1A and Part 2 contain some similar questions and must be answered consistently. Therefore, both parts must be updated. In addition to your annual updating amendment, you must amend your Form ADV by filing additional amendments, referred to as “other-than-annual amendments,” during the year. If there are material changes to the Form ADV, an “other-than-annual amendment” should be filed within 30 days of the change.

Important: Advisers are recommended to utilize the tables found at the end of this packet to determine if a change to certain items in Form ADV requires prompt amendments. Because questions asked in Part 1 and 2 are similar, a table is also provided that references these questions. Advisers should make sure that the answers to cross-referenced items are answered the same.

Important: Any amendments to Parts 1 and 2 of Form ADV should be electronically filed through the IARD system.

REMEMBER: You must also amend your Form ADV each year by filing an “annual updating amendment” within 90 days after the end of your fiscal year. When you submit your annual updating amendment, you must update your responses to all items in Parts 1 and 2 of Form ADV.

18) Can Part 2 of Form ADV be filed electronically through the IARD system?

Yes, Form ADV Part 2 along with Schedule F must be filed through the IARD system. However, unlike Form ADV Part 1, Part 2 must be completed offline and uploaded to the IARD system. The form must be submitted in a text searchable pdf format in order to be accepted by the IARD system.

IARD system instructions for filing Part 2 of Form ADV can be found on the IARD web site at http://www.iard.com/part2instructions.asp .

An editable PDF version of Form ADV Part 2 with Schedule F can be obtained from the following website:

http://www.nasaa.org/Industry_Regulatory_Resources/Uniform_Forms.

19) Do I need to file an annual updating amendment for Part 2 of Form ADV when there are no changes with the information provided?

Yes, an annual updating amendment of Form ADV Parts 1 and 2 through the IARD system is required regardless of any changes in the business or with the information provided. When filing an annual updating amendment, the IARD system allows advisers to utilize the “Confirm” brochure option to confirm that brochures on file are still current, without having to upload a new version of the PDF file.

Specific instructions for filing Part 2 of Form ADV can be obtained from the IARD website at: http://www.iard.com/pdf/ADV_Part_II_Firm_User_90.pdf .

20) Should I file a new application with the Department if I change my sole proprietorship to a corporation?

No, if there is no practical change in control or management only an amendment to the application is necessary. Successors may file an amendment only if the succession results from a change: 1) in form of organization; 2) in legal status; or 3) in the composition of a partnership.

Change in Form of Organization:

This in an internal reorganization or restructuring. For example, a corporation has two affiliated entities, A and B. A is registered as an IA and provides advisory services. B does bookkeeping and does not perform advisory functions. Now, the corporation decides that B should now be performing advisory services and A should provide bookkeeping. In this situation, B may file an amendment of its predecessor’s application because there is no change in control, since the corporation hasn’t change and the beneficial owners remain the same.

Change in Legal Status:

This is a result of a change in the state of incorporation or a change in the form of the business. For example, a sole proprietorship converts it business to a corporation. This also does not involve a change of control.

Change in Composition of a Partnership:

This involves the death, withdrawal, or addition of a partner in the partnership and is not considered a change in control of the partnership.

To file the Amendment: Successors should check “Yes” to Part 1A, Item 4A; enter the date of succession in Part 1A, Item 4B; and complete Schedule D, Section 4 about the acquired firm information. The successor will keep the same CRD number and the predecessor should NOT file Form ADV-W.

21) Should I file a new application if I am an unregistered person acquiring an existing registered investment adviser?

Yes, successors must file a new application for registration when the succession involves a change in control or management. The following types of successions require the filing of a new application:

Acquisitions:

Acquiring a preexisting investment adviser business by an unregistered person involving a change of control or management.

Consolidations:

When two or more registered investment advisers combine their businesses and decide to conduct their new business through a new unregistered entity.

Division of Dual Registrants:

An entity registered as both an IA and BD that decides to separate one of its functions to an unregistered entity.

These types of successions must be filed by a new application for registration. Setting up an IARD account is the first step in the registration process. Once an adviser establishes an IARD account, the adviser can access Form ADV on IARD and submit it electronically through IARD to the Department. On Form ADV, the successor should check “Yes” to Part 1A, Item 4A; enter the date of the succession in Part 1A, Item 4B; and complete Schedule D, Section 4 about the acquired firm information. A new CRD number will be issued upon approval. Once approved, the predecessor files Form ADV-W to withdraw its license from the Department.

22) What are my minimum financial requirements?

Investment advisers who:

(1) Have custody of client funds or securities must maintain at all times a minimum net worth of  $35,000.
(2) Have discretionary authority over client funds or securities but do not have custody of client  funds or securities must maintain at all times a minimum net worth of $10,000.
(3) Accept prepayment of fees more than $500 per month and six or more months in advance  must maintain at all times a positive net worth.

23) If I am an investment adviser and also a broker-dealer, do I need to meet the minimum net worth requirements for investment advisers?

No, the minimum financial requirements do not apply if the investment adviser is also licensed as a broker-dealer under Code Section 25210, or is registered with the SEC.

24) How is financial net worth determined?

“Net worth” should be calculated as the excess of assets over liabilities, as determined by generally accepted accounting principles. The following items should not be included in the calculation of assets: prepaid expenses (except as to items properly classified as current assets under generally accepted accounting principles), deferred charges, goodwill, franchise rights, organizational expenses, patents, copyrights, marketing rights, unamortized debt discount and expense, and all other assets of intangible nature; home, home furnishings, automobiles, and any other personal items not readily marketable in the case of an individual; advances or loans to stockholders and officers in the case of a corporation, and advances or loans to partners in the case of a partnership.

The Department has created a Minimum Financial Requirement Worksheet which advisers may utilize when computing their net worth, which can be obtained from the Department’s website at: http://www.corp.ca.gov/forms/pdf/2602372.pdf .

25) What happens if I do not meet the net worth requirement?

As a condition of the right to continue to transact business in this state, advisers must notify the Department of any net worth deficiency by the close of the next business day following the discovery that the net worth is less than the minimum required.
After transmitting such notice, advisers must file by the close of the next business day a report of financial condition, including the following:

(1)A trial balance of all ledger accounts;
(2) A statement of all client funds or securities which are not segregated;
(3) A computation of the aggregate amount of client ledger debit balance; and
(4) A statement as to the number of client accounts.

26) When computing my financial net worth on the Minimum Financial Requirement Worksheet provided by the Department, I notice that there is a “120% Test”. What is this 120% of minimum net worth requirement test?

An adviser who is subject to the minimum financial requirement must file interim financial reports with the Department within 15 days after its net worth is reduced to less than 120% of its net worth requirement. The first interim report shall be filed within 15 days after its net worth is reduced to less than 120% of its required minimum net worth, and should be as of a date within the 15-day period. Additional reports should be filed within 15 days after each subsequent monthly accounting period until three successive months’ reports have been filed that show a net worth of more than 120% of the firm’s required minimum net worth.

The submitted interim financial reports should contain:

(1) A Statement of Financial Condition (Balance Sheet);
(2) Minimum Financial Requirement Worksheet; and
(3) A verification form.

27) Do I need to file financial reports to the Department?

An adviser who is subject to the minimum financial requirements must file annual financial reports with the Department within 90 days after its fiscal year-end. The submitted annual financial reports should contain:

(1) A Statement of Financial Condition (Balance Sheet & Income Statement) that must be  prepared in accordance with generally accepted accounting principles;

(2) Supporting schedule containing the computations of the minimum financial requirement.  The Department has supplied a Minimum Financial Requirement Worksheet which advisers may  utilize, and which may be obtained from the Department’s website:
http://www.corp.ca.gov/forms/pdf/2602372.pdf ; and
(3) A verification form must accompany the financial statements. The verification form must: (a)  affirmatively state, to the best knowledge and belief of the person making the verification, that  the financial statements and supporting schedules are true and correct; and (b) be signed under  penalty of perjury. The verification form can be obtained from the Department’s website at:
http://www.corp.ca.gov/forms/pdf/2602412b.pdf

Important: Advisers who have custody of client funds or securities must file audited financial statements prepared by an independent certified public accountant along with the supporting schedule of the net worth computation and the verification form. Please refer to Question # 30 for other requirements pertaining to investment advisers with custody of client funds or securities.

28) I obtain the client’s permission before executing trades, but the brokerage firm will accept my instructions when trading on client accounts. Would I be considered to have discretionary authority?

An investment adviser will not be deemed to have discretionary authority over client accounts when it places trade orders with a broker-dealer pursuant to a third party trading agreement if all the following are met:

(1) The investment adviser has executed a separate investment adviser contract exclusively with  its client which acknowledges that the investment adviser must secure client permission prior to  effecting securities transactions for the client in the client’s brokerage account(s), and
(2) The investment adviser in fact does not exercise discretion with respect to the account,  maintains a log (date and time) or other documents each time client permission is obtained for  transaction, and
(3) A third party trading agreement is executed between the client and a broker-dealer which  specifically limits the investment adviser’s authority in the client’s broker-dealer account to the  placement of trade orders and deduction of investment adviser fees.

29) How is custody of client funds or securities determined?

A person will be deemed to have custody if said person directly or indirectly holds client funds or securities, has any authority to obtain possession of them, or has the ability to appropriate them. Also see Questions 30 through 33, below, for additional information on making custody determinations.

30) What are the requirements for advisers who have custody of client funds and/or securities?

Advisers deemed to have custody of client funds and securities are subject to the following custodial requirements:
(1) $35,000 minimum net worth requirement of CCR Rule 260.237.2,
(2) Surprise verification requirement of CCR Rule 260.237(e), and
(3) Audited financial statements requirement of CCR Rule 260.241.2.

31) I deduct advisory fees directly from the clients’ custodial accounts. Do I have custody of client funds and securities? If yes, are there any procedures I may follow to be exempted from the financial requirements and surprise verification?

Yes and Yes. The Department takes the position that any arrangement under which the adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian upon the adviser’s instruction to the custodian is deemed to have custody of client funds and securities.

Safeguarding Procedures: The Department allows advisers who have this type of payment arrangement to be exempted from the requirements of: (1) $35,000 minimum net worth; (2) audited financial statements; and (3) surprise verification if all of the following procedures are administered:

(1) The client must provide written authorization permitting direct payment from an account  maintained by a custodian who is independent of the adviser;
(2) The adviser must send a statement to the client showing the amount of the fee, the value of  the client’s assets upon which the fee was based, and the specific manner in which the fee was  calculated;
(3) The Adviser must disclose to clients that it is the client’s responsibility to verify the accuracy  of the fee calculation, and that the custodian will not determine whether the fee is properly  calculated; and
(4) The custodian must agree to send the client a statement, at least quarterly, showing all  disbursements from the account, including advisory fees.

Form ADV Disclosure: Advisers who follow the safeguarding procedures for direct fee deduction should respond accordingly on the following sections of their Form ADV:

  • Form ADV: Part 1A, Item 9 (A) – Yes
  • Part 1A, Item 9 (B) – Yes
  • Part 1B, Item 2 I (1) – Yes
  • Part 1B, Item 2 I (1) (a) – Yes
  • Part 1B, Item 2 I (1) (b) Yes
  • Part 1B, Item 2 I (1) (c) – Yes
  • Part 2, Item 14 – No

Important: This exemption does not relieve the advisers from the net worth requirements, which may be lowered to $10,000, or the filing of unaudited financial statements.

32) I manage a limited partnership (LP) and am the general partner of the LP. Am I considered to have custody? If yes, are there any procedures I may follow to receive an exemption from the financial requirements and surprise verification?

Yes and Yes. The Department takes the position that an adviser with any capacity (such as a general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle) that gives the adviser legal ownership of or access to client funds or securities is deemed to have custody of client funds and securities.

Safeguarding Procedures: An investment adviser acting as a general partner of a limited partnership (or a comparable position for another type of pooled investment vehicle) may receive partnership funds or securities directly from the partnership’s account held by an independent custodian without complying with the surprise audit requirement of CCR Rule 260.237(e), audited financial statements requirement of CCR Rule 260.241.2, and higher net worth requirement of CCR Rule 260.237.2 if all the partnership assets are administered as follows:

(1) One or more independent banks or brokerage firms must hold the partnership’s funds and  securities in the name of the partnership.
(2) Funds received by the partnership for subscriptions must be deposited by the subscriber  directly with the custodian.
(3) The partnership must engage an independent party to approve all fees, expenses, and capital  withdrawals from the pooled accounts.
(4) Each time the general partner makes a payment or withdrawal request, it must  simultaneously send to the independent party and the custodian a statement showing: (a) the  amount of the payment or withdrawal; (b) the value of the partnership’s assets on which the fee  or withdrawal is based; (c) the manner in which the payment or withdrawal is calculated; and (d)  the amount in the general partner’s capital account before and after the withdrawal.
(5) The general partner must also give the independent party sufficient information to allow the  representative to determine that the payments comply with the partnership agreement. The  custodian may transfer funds from the partnership account to the general partner only with the  written authorization of the independent party, and only if the custodian receives a copy of the  written request from the general partner.
(6) The custodian must provide quarterly statements to the partnership and the independent  party.

Form ADV Disclosure: Advisers who follow the safeguarding procedures for pooled investment vehicles should respond accordingly on the following sections of their Form ADV:

Form ADV:

  • Part 1A, Item 9 (A)
  • Part 1A, Item 9 (B)
  • Part 1B, Item 2 I (2)
  • Part 1B, Item 2 I (2) (a)
  • Part 2, Item 14

Important: This exemption does not relieve advisers from the net worth requirement, which may be lowered to $10,000, or from the requirement to file unaudited financial statements.

33) I inadvertently received securities or checks from my advisory clients. Do I have custody?

Yes. To avoid having custody, you must return the securities to the sender promptly within two business days of receiving them. In the case of checks received inadvertently, the adviser must forward the checks to the third party within two business days of receipt.

Important: You are also required to keep accurate records of the securities and funds you received and returned. Such records should contain the description of the checks/securities, when and from whom they were received, where they were sent, and a record of how they were returned.

34) Who can be an independent party?

For purposes of the safeguarding procedures for pooled investment vehicles, an independent party must:

(1) Be a certified public accountant (CPA) or an attorney in good standing with the California  State Bar;
(2)Act as a gatekeeper for the payment of fees, expenses, and capital withdrawals from the  pooled investment;
(3) Not control, and is not controlled by or under common control with the adviser; and
(4) Not have, and have had within the past two years, a material business relationship with the  investment adviser.

35) An accounting firm acts as the independent CPA that audits annually my pooled investment vehicle. May the accounting firm also act as the independent representative for the investors in the pooled investment vehicle?

No, this accounting firm is not acceptable as an independent representative. The independent representative may not have, or have had within the past two years, a material business relationship with the adviser. Also, the purpose for this safeguard is for the independent representative to act as the agent for an advisory client and is thus obliged to act in the best interest of the advisory client, limited partner, member or other beneficial owner. When the CPA sent audited financial statements of the pooled investment vehicle, it would be, in essence, sending itself its own audit results. This is not in the best interest of the investors in the pooled investment vehicle and is not allowed.

Important: Alternatively, if the accounting firm audits the investment adviser’s financial statements or prepares tax filings for the pooled investment vehicle and its investors, the result would be the same. That is, the accounting firm would not satisfy the independence criteria since it has a material business relationship with the adviser

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Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  Mallon P.C. will also help California based Investment Advisors to register with the California Securities Regulation Division.  If you are a hedge fund manager who is looking to start a hedge fund or an investmen advisor looking to register, please call Mr. Mallon directly at 415-296-8510.

Series 79 Exam

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FINRA to Announce New Investment Banking Examination

For many years now all brokers have been treated equally with regard to examination requirements. Whether a broker was working solely with retail clients or solely with institutions on a private placement basis, each such broker would need to take and pass the Series 7 examination in order to become a representative (broker) at the BD (broker firm or broker-dealer). Now, however, there will be a new exam for those brokers whose only acitivites are “investment banking” activities. In the near future these brokers will only need to take and pass a new exam called the Series 79 exam which will presumably be more focused and shorter than the all-day Series 7 exam. I will continue to update this article after the 4th of July weekend, but below I have included the full text of the new FINRA Rule 1032(i) which provides for a new Investment Banking representative registration.

Text of Rule 1032(i)

FINRA Rule 1032. Categories of Representative Registration

(a) through (h) No change.

(i) Limited Representative-Investment Banking

(1) Each person associated with a member who is included within the definition of a representative as defined in NASD Rule 1031 shall be required to register with FINRA as a Limited Representative-Investment Banking and pass a qualification examination as specified by the Board of Governors if such person’s activities involve:

(A) advising on or facilitating debt or equity securities offerings through a private placement or a public offering, including but not limited to origination, underwriting, marketing, structuring, syndication, and pricing of such securities and managing the allocation and stabilization activities of such offerings, or

(B) advising on or facilitating mergers and acquisitions, tender offers, financial restructurings, asset sales, divestitures or other corporate reorganizations or business combination transactions, including but not limited to rendering a fairness, solvency or similar opinion.

(2) Notwithstanding the foregoing, an associated person shall not be required to register as a Limited Representative-Investment Banking if such person’s activities described in paragraph (i)(1) are limited to:

(A) advising on or facilitating the placement of direct participation program securities as defined in NASD Rule 1022(e)(2);

(B) effecting private securities offerings as defined in paragraph (h)(1)(A); or

(C) retail or institutional sales and trading activities.

(3) An associated person who participates in a new employee training program conducted by a member shall not be required to register as a Limited Representative-Investment Banking for a period of up to six months from the time the associated person first engages within the program in activities described in paragraphs (i)(1)(A) or (B), but in no event more than two years after commencing participation in the training program. This exception is conditioned upon the member maintaining records that:

(A) evidence the existence and details of the training program, including but not limited to its scope, length, eligible participants and administrator; and

(B) identify those participants whose activities otherwise would require registration as a Limited Representative-Investment Banking and the date on which each participant commenced such activities.

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

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

Form U4 and Form U5 | Information About the Uniform Registration Forms for Broker-Dealers and Investment Advisors

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Purpose of the Forms and Discussion of Recently Approved Changes & Requirements

The Financial Industry Regulatory Authority (FINRA), is the largest independent regulator for all securities firms doing business in the United States, and is the entity designated as the filing depository by the U.S. Securities and Exchange Commission for purposes of the Investment Advisers Act of 1940.  There are currently six different Uniform Registration Forms that are used to file information with FINRA. The Form U4 (Uniform Application for Broker-Dealer Registration) and the Form U5 (Uniform Termination Notice for Security Industry Registration) are used by broker-dealers to register, and terminate the registrations of, associated persons with self-regulatory organizations (SROs), and jurisdictions.

Representatives of broker-dealers and investment advisers use Form U4 to register with the states and with self-regulatory organizations (e.g., FINRA). Forms are filed electronically by their employing firms using the Central Registration Depository (Web CRD or IARD). Broker-dealer agents and investment adviser representatives have an obligation to update previously filed Forms U4 with any new information required to be disclosed. FINRA makes information filed on Form U4 publicly available through its BrokerCheck program.

Broker-dealers and investment advisers use Form U5 to terminate a representative’s registration in a particular jurisdiction or with a particular self-regulatory organization. Firms terminating the registration of an associated person must respond to a series of disclosure questions. Firms also have the obligation to update previously filed Forms U5 if they become aware of new disclosure information.

As discussed above, Form U4 and Form U5 filings (initial applications. termination notices, and amendments) will generally be made electronically through Web CRD or IARD. However, some individuals may need to file the form on paper, including: agents of issuers, certain persons filing with stock exchanges, and certain investment adviser representatives. In addition, NASD Rule 1013 requires the submission of certain paper Forms U4 along with an initial membership application.

The SEC recently approved amendments to Forms U4 and U5 that were proposed by FINRA that call for significant changes to disclosure questions on the Forms, including the addition of questions about certain regulatory actions. The new  amendments to the Forms include:

  • New regulatory action questions that will enable FINRA and other regulators to identify more readily persons subject to a particular category of “statutory disqualification” under the federal securities laws and the FINRA By-Laws. Among the items that would cause a person to become subject to a statutory disqualification are “willful” violations of the federal securities laws, the Commodity Exchange Act, or the rules of the Municipal Securities Rulemaking Board. Under the proposed rule changes, both Forms U4 and U5 would be amended to add questions requiring disclosure of findings of “willful” violations.
  • New questions that require firms to report allegations of sales practice violations made against a registered person in an arbitration or litigation in which the registered person is not a named party. Under the new amendment, reporting would be required if the registered person was either named in or could reasonably be identified from the body of the arbitration claim or civil litigation as a registered person who was involved in one or more of the alleged sales practice violations.
  • An increase in the monetary threshold for reporting settlements of customer complaints, arbitrations or litigation from $10,000 to $15,000.
  • The clarification that the date to be provided by a firm in the “date of termination” field is the “date the firm terminated the individual’s association with the firm in a capacity for which registration is required.” Under the new amendment, a firm would be permitted to change the date of and reason for termination, but would be required to state a reason for the change.

The revised Forms were implemented in Web CRD on May 18, 2009. The effective date for most of these changes  is May 18, 2009 (the “release date”). The effective date for the new regulatory action disclosure questions will be 180 days from the release date, or November 14, 2009.

Key Items Regarding the Forms Changes:

Invalidation of Pending Form Filings Upon Web CRD System Shutdown:

  • Implementation of the revised “form versions” will cause all pending (in-process) Form U4 and U5 filings that are not submitted to Web CRD prior to system shutdown on Friday, May 15, 2009, to become invalidated (i.e., converted to a read-only mode). Firm users that still need to submit the information on those invalidated filings will need to recreate the filings using the new forms.

Form U4 Amendments Required:

  • All registered persons are required to answer new regulatory action disclosure summary questions the next time they file a Form U4 amendment or no later than 180 days following the release date.

Copies of the revised Forms and instructions are available here.

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NFA Discusses Recent Forex Regulations

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Answers Regarding Prohibition of Hedging Spot Forex Transactions

(www.hedgefundlawblog.com)  The NFA has certainly taken a lot of heat over its controversial rule to ban the practice of “hedging” in a single spot forex account.  Many retail investors have already begun establishing brokerage accounts offshore in order to utilize this trading strategy.  I recently talked with a compliance person at the NFA and they said that they are aware that US persons are going to offshore forex brokers in order to utilize this trading strategy.  We will see if in the future the NFA relents on this issue, but for now the NFA has provided guidance on some of the more technical aspects of the new Compliance Rule 2-43.

The NFA guidance is reprinted in full below and can also be found here.

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NFA Compliance Rule 2-43 Q & A

NFA has received a number of inquiries regarding the application of new NFA Compliance Rule 2-43. This Q & A answers the most common questions.

CR 2-43(a), Price Adjustments[1]

Q. Section (a)(1)(i) of the rule provides an exception from the prohibition on price adjustments where the adjustment is favorable to the customer and is done as part of the settlement of a customer complaint. Does that mean a Forex Dealer Member (“FDM”) can’t make a favorable adjustment if the customer does not complain?

A. It depends on the circumstances. The intent of this provision is to ensure that FDMs can settle customer complaints before or after they end up in arbitration. It was not meant to prohibit FDMs from adjusting prices on customer orders that were adversely affected by a glitch in the FDM’s platform. A firm may not, however, adjust prices on customer orders that benefited from the error (except as provided in section (a)(1)(ii)). Furthermore, an FDM may not cherry-pick which accounts to adjust.

Q. An FDM operates several trading platforms. Two provide exclusively straight-through processing, but one does not. Can the FDM make section (a)(1)(ii) adjustments for trades placed on the two platforms that provide straight-through processing?

A. No. The Board intended to limit the relief to those firms that exclusively operate a straight-through processing business model, and the submission letter to the CFTC uses this language when explaining the rule’s intent. NFA recognizes, however, that the use of the word “platform” in the rule itself may be confusing, and we intend to ask the Board to eliminate that word at its August meeting.

Q. For price adjustments made under section (a)(1)(ii), the rule requires written notification to customers within fifteen minutes. If the liquidity provider informs an FDM of the price change twenty minutes after the orders are executed, can the FDM still make the adjustment?

A. No. The rule provides that customers must be notified within fifteen minutes after their orders are executed, and it was written that way intentionally. Since a customer’s subsequent trading decisions may be based on the customer’s belief that a particular trade was executed at a particular price, the rule provides a narrow window for price adjustments.

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[1] For purposes of this discussion, the term “adjustment” also refers to cancellations.

CR 2-43(b), Offsetting Transactions

Q. CR 2-43(b) states that an FDM cannot carry offsetting positions. If a customer with a long position executes a sell order or a customer with a short position executes a buy order, does the FDM have to close the position immediately or can it wait until the end of the day?

A. The FDM may wait until the end of the day to offset the positions, but it must do so before applying roll fees.

Q. The rule provides that positions must be offset on a first-in-first-out (FIFO) basis. If the customer places a stop order on a newer likesize position and the stop is hit, may the FDM offset the executed stop against that position?

A. No. The only exception to the FIFO rule is where a customer directs the FDM to offset a same-size transaction, but even then the offset must be applied to the oldest transaction of that size.
Related Issues

Related Issues

Q. One of an FDM’s platforms is offered exclusively to eligible contract participants (ECPs). Does Rule 2-43 apply to transactions on that platform?

A. No. Rule 2-43 does not apply to transactions with ECPs.

Q. May an FDM transfer foreign customers to a foreign entity that allows customers to carry offsetting positions in a single account?

A. Yes. If done as a bulk transfer, however, the Interpretive Notice to NFA Compliance Rule 2-40 (located at ¶ 9058 of the NFA Manual) requires that the foreign entity must be an authorized counterparty under section 2(c) of the Commodity Exchange Act (CEA).

Q. May an FDM transfer U.S. customers to a foreign entity that allows customers to carry offsetting positions in a single account?

A. Only if the transactions are not off-exchange futures contracts or options. The legal status of “spot” OTC transactions that are continually rolled over and almost always closed through offset rather than delivery is currently unsettled. Therefore, if an FDM chooses to transfer U.S. customers to a foreign entity so they can continue “hedging,” it does so at its own risk. In any event, a bulk transfer can only be made to a counterparty authorized under the CEA.

Q. If the transactions are not futures or options, does that mean none of NFA’s rules apply?

A. Most of NFA’s forex rules do not depend on how the off-exchange transactions are classified. This includes Compliance Rule 2-36(b)(1), which prohibits deceptive behavior, and Compliance Rule 2-36(c), which requires FDMs to observe high standards of commercial honor and just and equitable principles of trade. An FDM that misrepresents the characteristics of “hedging” transactions (e.g., by touting their “benefits”) or NFA’s purpose in banning them or that implies that transferring U.S. customers offshore will make the transactions legal violates those sections of CR 2-36. Furthermore, NFA Compliance Rule 2-39 applies these same requirements to solicitors and account managers.

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Please feel free to contact us if you are interested in starting a forex hedge fund or a forex managed account.  Other related forex law and regulation articles include:

Form U4 and Form U5 Amendments

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NASAA Requests Comments on Proposed Changes

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

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

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

The NASAA CRD/IARD Steering Committee and the CRD/IARD Forms and Process Committee have worked with FINRA, regulators, and representatives of the financial services industry in developing amendments to the Form U4 and Form U5.

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

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

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

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

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

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

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

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

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

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

Summary of Proposed Changes to Registration Forms

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

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

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

Revisions Regarding Willful Violations.

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

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

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

Revisions to the Arbitration and Civil Litigation Disclosure Question.

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

Revisions to the Monetary Threshold.

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

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

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

Technical Revisions.

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

Guidance Regarding U4 Filings for Investment Adviser Representatives.

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

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

Forms.

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

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CPO Exemption for Fund of Hedge Funds

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As we have discussed previously, if a hedge fund manager invests fund assets in commodity interests (including futures), then the manager will generally need to be registered as a commodity pool operator (CPO) with the Commodity Futures Trading Commission (CFTC).  The registration requirement also applies to fund of fund (FOF) managers who allocate assets to underlying hedge funds which themselves invest in commodity interests.  There are a number of CPO exemptions available to hedge fund managers.  Likewise, there are two exemptions which may be applicable to fund of fund managers who allocate to funds CPOs or exempt CPOs. Continue reading →

Accredited Investor Net Worth Question

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Most hedge funds will require investors to be “accredited investors.”  In general, a natural person is deemed to be an accredited investor if (1) the natural person has an individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase (i.e. investment into the hedge fund) or (2) the natural person has an income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year. (See generally Accredited Investor Definition.)

One common question is “does net worth include the equity a person has in their personal residence?”  The answer is yes. The SEC specifically addressed this question in their Interpretive Release On Regulation D.  Below is the actual text from the release which is applicable to this question:

(21) Question: In calculating net worth for purposes of Rule 501(a)(6), may the investor include the estimated fair market value of his principal residence as an asset?

Answer: Yes. Rule 501(a)(6) does not exclude any of the purchaser’s assets from the net worth needed to qualify as an accredited investor.

Note the difference between accredited investors and qualified purchasers with respect to this issue.  Individuals cannot include equity in their personal residence for the purpose of meeting the “qualified purchaser” definition.

Please contact us if you have a question on this issue or if you would like to start a hedge fund.  If you would like more information, please see our articles on starting a hedge fund.  Other related hedge fund law articles include: