Category Archives: new hedge fund regulations

Private Fund Transparency Act of 2009 Text of Statute

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Text of New Hedge Fund Registration Bill

Earlier we posted a press release about the Private Fund Transparency Act and that it would subject hedge fund managers to registration with the SEC.  Below is the actual text of the statute.

We will be bringing an in depth analysis of changes and consequences of this bill in the next couple of days.

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Private Fund Transparency Act of 2009 (Introduced in Senate)

S 1276 IS

111th CONGRESS

1st Session

S. 1276

To require investment advisers to private funds, including hedge funds, private equity funds, venture capital funds, and others to register with the Securities and Exchange Commission, and for other purposes.

IN THE SENATE OF THE UNITED STATES

June 16, 2009

Mr. REED introduced the following bill; which was read twice and referred to the Committee on Banking, Housing, and Urban Affairs

A BILL

To require investment advisers to private funds, including hedge funds, private equity funds, venture capital funds, and others to register with the Securities and Exchange Commission, and for other purposes.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the `Private Fund Transparency Act of 2009′.

SEC. 2. DEFINITION OF FOREIGN PRIVATE ADVISERS.

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

`(29) The term `foreign private adviser’ means any investment adviser who–

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

`(B) during the preceding 12 months has had–

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

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

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elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940, and has not withdrawn its election.’.

SEC. 3. ELIMINATION OF PRIVATE ADVISER EXEMPTION; LIMITED EXEMPTION FOR FOREIGN PRIVATE ADVISERS.

Section 203(b)(3) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(b)(3)) is amended to read as follows:

`(3) any investment adviser that is a foreign private adviser;’.

SEC. 4. COLLECTION OF SYSTEMIC RISK DATA; ANNUAL AND OTHER REPORTS.

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

(1) in subsection (a), by adding at the end the following: `The Commission is authorized to require any investment adviser registered under this title to maintain such records and submit such reports as are necessary or appropriate in the public interest for the supervision of systemic risk by any Federal department or agency, and to provide or make available to such department or agency those reports or records or the information contained therein. The records of any company that, but for section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, would be an investment company, to which any such investment adviser provides investment advice, shall be deemed to be the records of the investment adviser if such company is sponsored by the investment adviser or any affiliated person of the investment adviser or the investment adviser or any affiliated person of the investment adviser acts as underwriter, distributor, placement agent, finder, or in a similar capacity for such company.’; and

(2) adding at the end the following:

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

SEC. 5. ELIMINATION OF PROVISION.

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

SEC. 6. CLARIFICATION OF RULEMAKING AUTHORITY.

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

(1) by striking the second sentence; and

(2) by striking the period at the end of the first sentence and inserting the following: `, including rules and regulations defining technical, trade, and other terms used in this title. For the purposes of its rules and regulations, the Commission may–

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

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

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Other related articles:

Obama’s New Hedge Fund Regulation Plan

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Draft Speaks of IA Registration for Hedge Fund Managers

As you have probably heard by now, Obama will be presenting his plan for an overhaul of the financial system later today.  I have reviewed a copy of Obama’s Financial Regulation Proposal Draft and have reprinted some of the important aspects of the proposal below.  In general the most immediate impact for hedge fund managers is that they will be required to register with the SEC as investment advisors.  In addition to hedge fund managers, private equity fund managers and VC fund managers will also need to register.

While we understand that these are just proposals, Congress too is excited to get on the registration bandwagon although I think it unlikely for us to see any regulation passed before the end of this year.  Even so, hedge fund managers may want to start thinking about how they are going to register as investment advisors and what plans they will need to be putting in place (or plan to put in place in the future).

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The plan’s main goals are:

  1. Promote robust supervision and regulation of financial firms.
  2. Establish comprehensive supervision and regulation of financial markets.
  3. Propose comprehensive regulation of all OTC derivatives.
  4. Protect customers and investors from financial abuse.
  5. Raise international regulatory standards and improve international cooperation.

Other Points Addressed

Regarding Hedge Funds

All advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) whose assets under management exceed some modest threshold should be required to register with the SEC under the Investment Advisers Act.  The advisers should be required to report financial information on the funds they manageme that is sufficient to assess whether any fund poses a threat to fiancnail stability.

Harmonize Futures and Securities Regulation

The CFTC and the SEC should make recommendations to Congress for changes to statutes and regulations that would harmonize regulation of futures and securities.

Strengthen Investor Protection

The SEC should be given new toold to increase fairness for investors by establishing a fiduciary duty for broker-dealers offering investment advice and harmonizing the regulation of investment advisers and broker-dealers.

Expand the Scope of Regulation

We urge national authorities to implement by the end of 2009 the G-20 commitment to require hedge funds or their managers to register and disclose appropriate information necessary to assess the systemic risk they pose individually or collectively.

Specifical goals with regard to Hedge Funds

  • Data collection
  • SEC should conduct regular, periodic examinations of hedge funds
  • Reporting AUM and other fund metrics to the SEC
  • SEC would have ability to assess whether the fund or fund family is so large, highly leveraged , or interconnected that it poses a threat to fiancial stability

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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:

Private Fund Transparency Act of 2009

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Another Bill Introduced in Senate to Regulate Hedge Funds

Congress now has three separate bills regarding hedge fund registration.  The most recent bill is called the Private Fund Transparency Act of 2009 and was introduced by U.S. Senator Jack Reed (D-RI) on June 16, 2009.

I will continue to update this post over time, but for now I have included the text of a press release from Senator Reed on the proposed bill.

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June 16, 2009
Press Release

Reed Introduces Bill to Regulate Hedge Funds

WASHINGTON, DC — In an effort to strengthen financial oversight of hedge funds and other private investment funds, U.S. Senator Jack Reed (D-RI), today introduced the Private Fund Transparency Act of 2009, which will help protect investors, identify and mitigate systemic risk, and prevent fraud.  This legislation amends the Investment Advisers Act of 1940 to require advisers to hedge funds, private equity funds, venture capital funds, and other private investment pools to register with the Securities and Exchange Commission (SEC).

“Hedge funds have played an important role in providing liquidity to our financial system and improving the efficiency of capital markets.  But as their role has grown so have the risks they pose.  This bill provides the SEC with long-overdue authority to examine and collect data from this key industry.  It also authorizes the SEC to share this data with other federal agencies in order to create a system-wide approach to identifying and mitigating risks,” said Reed, who chairs the Banking Subcommittee on Securities, Insurance, and Investment.

Private funds are not currently subject to the same set of standards and regulations as banks and mutual funds, reflecting the traditional view that their investors are more sophisticated and therefore require less protection.  This has enabled private funds to operate largely outside the framework of the financial regulatory system even as they have become increasingly interwoven with the rest of the country’s financial markets.  As a result, there is no data on the number and nature of these firms or ability to calculate the risks they pose to America’s broader economy.

“The financial crisis is a stark reminder that transparency and disclosure are essential in today’s marketplace.  Improving oversight of hedge funds and other private funds is vital to their sustainability and to our economy’s stability.   These statutory changes will help modernize our outdated financial regulatory system, protect investors, and prevent fraud,” concluded Reed.

Specifically, the Private Fund Transparency Act of 2009 will:

  • Require all hedge fund and other investment pool advisers that manage more than $30 million in assets to register as investment advisers with the SEC.  The remaining smaller funds will continue to fall under state oversight.
  • Provide the SEC with the authority to collect information from the hedge fund industry and other investment pools, including the risks they may pose to the financial system.
  • Authorize the SEC to require hedge funds and other investment pools to maintain and share with other federal agencies any information necessary for the calculation of systemic risk.
  • Clarify other aspects of SEC’s authority in order to strengthen its ability to oversee registered investment advisers.

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There have been two other proposed bills:

Additionally, I recommend you read about Obama’s plans for hedge fund regulation.

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

NASAA Applauds Obama’s Recent Directive on State Agency Preemption

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President of the NASAA Sends Letter to President Obama in Support of Limiting Preemption of State Regulation

In a letter dated June 9th, 2009, Fred Joseph, President of the North American Securities Administration (NASAA), applauded President Obama  for his efforts to control preemption of state law in the area of securities regulation.

On May 20th, President Obama issued a directive setting limits on regulatory preemption of state regulation, largely in an effort to expand the authority of state regulatory officials to regulate many aspects of the securities markets and detect potential misconduct.

In his letter, Joseph writes that despite the proven century-long track record of investor protection by state securities regulators,  Congress has still passed legislation over the years that has preempted state regulation and curtailed the authority of state officials in protecting both investors and consumers.

Joseph writes,

” Federal agencies have compounded the problem by extending the scope of preemption beyond Congressionally intended boundaries and in ways that pose serious threats to investor and consumer protections under state law.”

To further address what many regard as the most urgently needed reform, the NASAA endorses the creation of a Systemic Risk Council, comprised of representatives from all federal and state regulators in securities, banking, and insurance, and tasked with the responsibility for monitoring and limited the accumulation of risk in the financial markets.

The entire text of letter by the NASAA to President Obama is included below, and can also be found here.

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NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION, INC.
750 First Street, NE, Suite 1140
Washington, D.C. 20002
202/737-0900
Fax: 202/783-3571
www.nasaa.org

June 9, 2009

President Barack Obama
The White House
1600 Pennsylvania Avenue NW
Washington, DC 20500

Dear Mr. President:

On behalf of our nation’s state securities regulators, the North American Securities Administrators Association1 applauds your effort to reverse the anti-investor preemption policies of previous administrations.

Your May 20 directive setting limits on regulatory preemption impressively affirms the vital role that state regulators play in protecting the health, safety, and financial security of citizens throughout the United States. You have sent a strong signal that our nation’s citizens are served best when the state-federal partnership works harmoniously and with mutual respect to “provide independent safeguards for the public.” Furthermore, we sincerely appreciate your recognition that states have frequently been more aggressive than the national government in protecting the public’s interest.

In the area of securities regulation, the states have a century-long track record of investor protection. One of the hallmarks of state securities regulation is its proven ability to detect misconduct, both large and small, in the early stages. Our members enjoy a unique proximity to investors and to the industry participants within their state borders. As a result, state securities regulators are often the first to investigate and uncover our nation’s latest and most damaging frauds. Examples include investigating the role of investment banks in the Enron fraud, exposing profound conflicts of interest among Wall Street stock analysts, addressing late trading and market timing in mutual funds, and recently helping to ensure that investors receive over $50 billion in redemptions for frozen auction rate securities that had been marketed as safe and liquid investments.

And yet, over a number of years, there has been a concerted effort to preempt state regulation. In the securities field, much of that effort has originated in Congress. For example, in 1996, Congress passed the National Securities Markets Improvement Act (NSMIA), which dramatically curtailed the authority of our members to regulate many aspects of the securities markets, ranging from private offerings under Regulation D to investment advisers with over $25 million in assets under management.

As your recent order recognizes, federal agencies have compounded the problem by extending the scope of preemption beyond Congressionally intended boundaries and in ways that pose serious threats to investor and consumer protections under state law. Two striking examples are found in the banking area.

The Office of the Comptroller of the Currency (OCC) has repeatedly adopted regulations that aggressively preempt the states’ authority to protect consumers through licensing requirements or enforcement actions. The impact has been felt largely in the mortgage lending field—where illegal underwriting practices helped trigger the current financial crisis. In a case now pending before the U.S.

1 NASAA is the oldest international organization devoted to investor protection. Its membership consists of the securities administrators in the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada, and Mexico.

Supreme Court, the Second Circuit aptly characterized the OCC as an agency that “accretes a great deal of regulatory authority to itself at the expense of the states through rulemaking lacking any real intellectual rigor or depth.” Clearing House Ass’n, L.L.C. v. Cuomo, 510 F.3d 105,119 (2d Cir. 2007) (although upholding the OCC’s limits on state visitorial powers under binding precedent). In the Cuomo case, the OCC actually sought an injunction to prevent the New York Attorney General’s Office from investigating discriminatory lending practices by various national banks and their operating subsidiaries.

The Office of Thrift Supervision (OTS) has also issued broadly preemptive regulations. Relying on those rules, the OTS has taken the position that even independent agents used by thrift institutions to market mortgages or certificates of deposit are immune from all substantive state regulations aimed a protecting consumers. The OTS’s opinion was articulated in an October 25, 2004 opinion letter. The OTS position has a direct impact on our members, to the extent it authorizes thrifts to market securities products, such as jumbo CDs, without complying with the licensing requirements applicable under state securities laws.

These examples and others affirm the need not only to rein in, but also to reverse, instances of state law preemption. An important corollary is making sure that the states are adequately represented in any regulatory reforms that your administration and Congress may fashion to address our current economic crisis. Plainly, our system of financial services regulation must be more effective. The enormous challenge of regulating our financial markets can only be met through the combined efforts of state and federal regulators, working together to protect both investors and the integrity of the marketplace. Any regulatory reforms should incorporate this guiding principle.

For that reason, to address what many regard as the most urgently needed reform, we endorse the creation of a Systemic Risk Council, comprised of representatives from all federal and state regulators in securities, banking, and insurance, and tasked with the responsibility for monitoring and limiting the accumulation of risk in our financial markets. With our unique position on the frontlines of investor protection, state regulators are essential to the success of any remedy aimed at controlling systemic risk. We provide ground-level detection by gathering a huge volume of information through examinations of industry participants and complaints from investors. When that information reveals risks and abuses, we take appropriate action. The Council approach, with full state representation, takes advantage of these strengths. We would ask that you carefully evaluate the benefits of this model as you weigh alternative solutions to the difficult problem of systemic risk.

NASAA is committed to working with your Administration and the 111th Congress to ensure that the nation’s financial services regulatory structure undergoes the important changes that are necessary to enhance protections for Main Street investors. Your recent directive on agency preemption is a very important step, and as you move forward with other regulatory reforms, we hope you will continue to recognize the enormous value of state regulation in our system of federalism.

Sincerely,

Fred Joseph
President North American Securities Administrators Association
Colorado Securities Commissioner

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NASAA Takes Sides on Proposed Hedge Fund Legislation

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Endorses House Bill Over the Grassley-Levin Hedge Fund Bill

Last week the North American Securities Administrators Association (NASAA) announced its support of the Hedge Fund Adviser Registration Act of 2009, a house bill introduced earlier this year by Representatives Capuano and Castle.  The Hedge Fund Adviser Registration Act is one of two bills introduced in Congress which would effectively require many unregistered hedge fund managers to register with the SEC.  The other bill, the Hedge Fund Transparency Act, was introduced into the Senate by Senators Grassley and Levin.  While the Adviser Registration Act would close what some are calling a loophole in the Investment Advisers Act of 1940, the Transparency Act would create a whole new regime for regulating hedge fund entities (as opposed to the management company).  The Transparency Act also came under fire earlier this year for being poorly drafted.

The NASAA support was announced in the release we have reprinted below.  If you have any questions on this issue, please feel free to contact us.  Related hedge fund registration articles include:

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May 28, 2009

NASAA Supports the Hedge Fund Adviser Registration Act of 2009 (H.R. 711)

Legislation Would Require Hedge Fund Advisers to Register with SEC

WASHINGTON (May 28, 2009) – The North America Securities Administrators Association (NASAA) today endorsed proposed bipartisan legislation that would require hedge fund advisers to register with the Securities and Exchange Commission under the Investment Advisers Act of 1940.

The Hedge Fund Adviser Registration Act of 2009 (H.R. 711), sponsored by Reps. Michael E. Capuano (D-MA) and Michael Castle (R-DE), addresses one of NASAA’s Core Principles for Financial Services Regulatory Reform – closing regulatory gaps.

“NASAA appreciates the efforts of Rep. Capuano and Rep. Castle to promote the regulation of hedge fund advisers in a manner that will provide greater transparency to the marketplace while not overburdening the hedge fund industry,” said NASAA President and Colorado Securities Commissioner Fred Joseph. “Advisers to hedge funds should be subject to the same standards of examination as other investment advisers.”

Because they qualify for a number of exemptions to federal and state registration and disclosure laws, hedge funds remain largely unregulated today. The SEC has attempted to require hedge fund managers to register as investment advisers, but that effort was overturned by a U.S. Court of Appeals decision. “Given the need for greater oversight and transparency in many corners of the financial services industry in the wake of the market meltdown, Congress should give the SEC explicit statutory authority to regulate hedge fund advisers as investment advisers,” Joseph said.

Joseph noted that the Managed Funds Association, which represents the hedge fund industry, now supports the registration of investment managers – including hedge fund managers – with the SEC. “This is a step in the right direction,” Joseph said. “While hedge funds did not cause the current economic and financial crisis facing the United States, they, along with the rest of the shadow banking industry, played a role. This reason alone is enough to require greater regulation of all parties in question.”

Joseph said NASAA will continue to press Congress for additional reforms of the hedge fund industry, including granting the SEC authority to require hedge funds to disclose their portfolios, including positions, leverage amounts and identities of counterparties, to the appropriate regulators; and appropriating the necessary funds to ensure that the regulators are sufficiently equipped, in terms of personnel and technology, to provide meaningful analysis of this data and to exercise proper oversight over hedge funds.

NASAA is the oldest international organization devoted to investor protection. Its membership consists of the securities administrators in the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada and Mexico.

For more information:
Bob Webster, Director of Communications
202-737-0900

NFA Cracks Down on CPO Fraud with New Compliance Rule

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Proposes Amendments to Compliance Rule 2-45

The National Futures Association (NFA) proposed new amendments to Compliance Rule 2-45 regarding prohibition of loans by pools to commodity pool operators and related parties.  The amendment states that no Member CPO may permit a commodity pool to use any means to make a direct or indirect loan or advance of pool assets to the CPO or any other affiliated person or entity.  The amendment is proposed in response to a recent NFA investigation which revealed that CPOs  had misappropriated pool funds through improper loans from pools to the CPOs or related entities.  The full NFA proposal can be viewed below.

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May 27, 2009
Via Federal Express

Mr. David Stawick
Office of the Secretariat
Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st Street, N.W.
Washington, DC 20581

Re: National Futures Association: Prohibition of Loans by Pools to Commodity Pool Operators and Related Parties – Proposed Adoption of Compliance Rule 2-45

Dear Mr. Stawick:

Pursuant to Section 17(j) of the Commodity Exchange Act, as amended, National Futures Association (“NFA”) hereby submits to the Commodity Futures Trading Commission (“CFTC” or “Commission”) proposed Compliance Rule 2-45 regarding prohibition of loans by pools to commodity pool operators and related parties. This proposal was approved by NFA’s Board of Directors (“Board”) on May 21, 2009. NFA respectfully requests Commission review and approval.

PROPOSED AMENDMENTS

(additions are underscored)

COMPLIANCE RULES

* * *

PART 2 – RULES GOVERNING THE BUSINESS CONDUCT OF MEMBERS REGISTERED WITH THE COMMISSION

* * *

RULE 2-45. PROHIBITION OF LOANS BY COMMODITY POOLS TO CPOS AND AFFILIATED ENTITIES.

No Member CPO may permit a commodity pool to use any means to make a direct or indirect loan or advance of pool assets to the CPO or any other affiliated person or entity.

EXPLANATION OF PROPOSED AMENDMENTS

In February, NFA took two Member Responsibility Actions (“MRAs”) against three NFA Member commodity pool operators (“CPOs”). Although the basis of both MRAs was the CPOs’ failure to cooperate with NFA in an investigation, the limited investigation that NFA was able to perform revealed that the CPOs had misappropriated pool funds through improper loans from pools to the CPOs or related entities. The CFTC charged all three of the CPOs with misappropriating pool assets through improper loans, and all three were charged criminally with fraud.

These two matters are not the first instances of CPOs misappropriating pool participant funds through direct or indirect loans from a pool to the CPO or a related entity. Over the years, there have been a number of regulatory actions involving this type of fraud. Given the significant losses suffered by pool participants as a result of these improper loans, NFA is proposing to prohibit direct or indirect loans from commodity pools to the CPO or any affiliated person or entity.

NFA staff discussed this matter with NFA’s CPO/CTA Advisory Committee, which supported prohibiting loans because it believes that absent extraordinary circumstances there is no legitimate reason for a pool to make a direct or indirect loan to its CPO or a related party. The Committee indicated, however, that participants, including a CPO’s principal, should not be prevented from borrowing against their equity interest in the pool.

NFA Compliance Rule 2-45 provides for a complete prohibition of direct or indirect loans or any advance of pool assets between a pool and its CPO or any other affiliated person or entity. NFA recognizes that there may be circumstances where a carve out to this prohibition may be appropriate, such as where a CPO permits participants, including a pool’s general partner, to borrow against their equity interest in the pool in lieu of a withdrawal, provided that the loan is collateralized by the participant’s interest in the pool. NFA believes that these types of situations are best handled on a case by case basis, with the CPO seeking a no-action letter from NFA.

NFA respectfully requests that the Commission review and approve proposed Compliance Rule 2-45 regarding prohibition of loans by pools to commodity pool operators and related parties.

Respectfully submitted,

Thomas W. Sexton
Senior Vice President and General Counsel

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Proposed Amendments to the Investment Advisers Act: SEC Requests Feedback

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The Securities and Exchange Commission (SEC) is proposing certain amendments to the custody rule under the Investment Advisers Act of 1940 and related forms. Due to the complexity of the various impositions placed on industry professionals by the proposed amendments, the SEC is formally requesting feedback from industry professionals regarding the impact of the new legislation.

Specifically, the amendments address Rules 206(4)-2 and 204-2, and Forms ADV and ADV-E. The amendments are summarized in the bullet points below:

Rule 206(4)-2: All registered investment advisers:

  • must have a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients
  • must undergo an annual surprise audit examination by an independent accountant
  • is presumed to have custody over any clients’ assets that are maintained by the advisers ‘related persons’, so long as those assets are in connection with the advisory services
  • must obtain or receive an annual internal control report, if the adviser also acts as a qualified custodian over client assets
  • must inform the SEC within one business day of finding any material discrepancies during an audit examination

Rule 204-2: All registered investment advisers:

  • must maintain a copy of an internal control report for five years from the end of the fiscal year in which the internal control report is finalized

Form ADV:  All registered investment advisers:

  • must report all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to client funds
  • must report the dollar amount of client assets and the number of clients of which he/she has custody
  • must identify and provide detailed information regarding the accountants that perform the audits/examinations and prepare internal control reports

Form ADV-E: All PCAOB-registered accountants:

  • must file Form ADV-E with the SEC within 120 days of the completion of the audit examination
  • must submit Form ADV-E to the SEC within four business days of his/her resignation, dismissal from, or other termination of the engagement, accompanied by a statement that includes details of the resignation

All comments to the proposed amendments must be received by the SEC on or before July 28, 2009.  Please contact us if you have any questions on the above proposed amendments or would like to start a hedge fund.  Additionally, we will be submitting our comments to the SEC with regard to the proposed amendments and would like to know what you think as well – please comment below.

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For further information regarding the proposed amendments, please refer to the more detailed abstract below.  The full text of the proposed rules can be found here.

SEC Proposed Custody Amendments Abstract

The Securities and Exchange Commission (SEC) is proposing certain amendments to the custody rule under the Investment Advisers Act of 1940 and related forms, with the intent to enhance the protections afforded to clients’ assets under the Advisers Act when an advisor has custody of client funds or securities. These amendments are proposed as a response to a number of recent enforcement actions against investment advisors alleging fraudulent conduct, including misappropriation or other misuse of investor assets.  Specifically, the amendments address Rules 206(4)-2 and 204-2, and Forms ADV and ADV-E. Due to the complexity of the various impositions placed on industry professionals by the proposed amendments, the SEC is formally requesting feedback from industry professionals regarding the impact of the new legislation.

Rule 206(4)-2, also known as the ‘custody rule’, seeks to protect clients’ funds and securities in the custody of registered advisers from misuse or misappropriation by requiring advisers to implement certain controls. The current rule requires registered advisers to maintain their clients’ assets in separate identifiable accounts with a qualified custodian, such as a broker-dealer or bank. Presently, advisors may comply with the rule by either a) having a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients or alternatively b) the advisor sending his/her own quarterly account statements to clients and undergoing an annual surprise audit examination by an independent public accountant. Similarly, an adviser to a pooled investment vehicle may currently comply with the rule by having the pool audited annually by an independent public accountant and distributing the audited financials to the investors in the pool within 120 days of the end of the pool’s fiscal year.

The proposed amendments to Rule 206(4)-2 aim to codify both of the above mentioned compliance alternatives by requiring  that all registered advisers having custody of client assets must a) have a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients and b) undergo an annual surprise examination.  The amendments also explicitly state that an adviser is presumed to have custody over any clients’ assets that are maintained by the advisers ‘related persons’, so long as those assets are in connection with the advisory services. The SEC additionally proposes that if an independent qualified custodian does maintain client assets, but rather the advisor or a related person him/herself serves as a qualified custodian for the client, then the advisor must obtain or receive from the related person an annual internal control report which would include a) an opinion from an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB), and b) a description of the relevant controls in place relating to custodial services and the objectives of these controls, as well as  the accountant’s tests of operating effectiveness and the test results. Lastly, the newly amended rule would also require the adviser and the accountant to inform the SEC within one business day of finding any material discrepancies during an examination that may assist in protecting advisory client assets. Together, these revisions to Rule 206(4)-2 are designed to strengthen the controls relating to the advisors’ custody of client assets and deter advisors from fraudulent activity.

Rule 204-2, governing record maintenance, presently requires that investment advisors obtain or receive a copy of an internal control report from its related person.  The proposed amendment to this rule would additionally require the advisor to maintain the copy for five years from the end of the fiscal year in which the internal control report is finalized. This amendment to Rule 204-2 is designed to further implement safeguards to protect clients’ assets and offset custody-related risks.

Form ADV, which outlines the data to be reported to the SEC by investment advisors, has also been amended to provide the SEC with additional data and more complete information from the perspective of the advisor. Currently, Item 7 of Part1A requires advisers to report on Schedule D of Form ADV each related person that is an investment adviser, and permits advisers to report the names of related person broker-dealers.  The new amendment modifies Item 7 to require an advisor to report all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to client funds. Similarly, Item 9 of Part1A currently requires advisers to report whether they or a related person have custody of client funds. The new amendment to Item 9 requires an adviser to report the dollar amount of client assets and the number of clients of which he/she has custody. Other reporting duties to be implemented under the new amendments include: a) whether a qualified custodian sends quarterly account statements to investors in pooled investment vehicles managed by the adviser, b) whether these account statements are audited, c) whether the adviser’s clients’ funds  are subject to a surprise examination and the month in which the last examination commenced, and d) whether an independent PCAOB-registered accountant prepare an internal control report when the adviser is also acting as a qualified custodian for the clients’ funds. Schedule D of Form ADV would also be amended to require additional reporting duties of the adviser, including: a) identifying the accountants that perform the audits/examinations and prepare internal control reports, b) providing information about the accountants including address, PCAOB registration, and inspection status, c) indicating the type of engagement (audit, examination, or internal control report), and d) indicating whether the accountant’s report was unqualified.  These proposed amendments to Form ADV are designed to allow the SEC to better monitor compliance with the requirements of Rules 206(4)-2 and 204-2 and better assess the compliance risks of an adviser.

Form ADV-E, which outlines the data to be reported to the SEC by designated accountants, has also been amended to provide the SEC with additional data and more complete information to the SEC from the perspective of the accountant. Currently, the rule requires this form to be filed within 30 days of the completion of the examination, accompanied by a certificate confirming that the accountant completed an examination of the funds and describing the nature and extent of the examination. The SEC proposes to amend this rule governing Forms ADV and ADV-E to extend the grace period within which the forms must be submitted to a period of 120 days from the time of the examination. Based on SEC observations, an adviser’s surprise examination may sometimes continue for an extended period of time, warranting this extension. Additionally, the amendment requires that the accountant submit Form ADV-E to the SEC within four business days of his/her resignation, dismissal from, or other termination of the engagement, accompanied by a statement that includes a) the date of such resignation, dismissal or termination, b) the accountant’s name, address and contact information, and c) an explanation of any problems relating to examination scope or procedure that contributed to such resignation, dismissal or termination. This proposed amendment to Form ADV-E is designed to provide the SEC with the information necessary to further evaluate the need for an examination to determine whether the clients’ assets are at risk.

The SEC strongly urges investment advisors, public auditors/accountants, and related professionals in the field of securities and investments to review the proposed amendments to the Advisers Act and submit relevant feedback that may assist the Commission in analyzing the effectiveness, efficiency, and feasibility of the proposed amendments as well as the possible impact of these new legislative measures on the global marketplace. While all proposed amendments are designed to provide additional safeguards to client funds or securities under adviser custody, the potential ramifications of their enforcement is currently being assessed. Comments may be submitted in electronically via the Commission’s internet comment form (http://www.sec.gov/rules/proposed.shtml), via e-mail to [email protected], or via the Federal eRulemaking Portal (http:/www.regulations.gov). Paper comments can be sent in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. All comments to the proposed amendments must be received by the SEC on or before July 28, 2009.  All submissions must refer to File Number S7-09-09, and will be made available to the public via the Commission’s Internet Website: http://www.sec.gov/rule/proposed.shtml.

SEC Proposes More Onerous Custody Rules For Hedge Fund Managers

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Hedge Funds to be Subject to “Surprise Exams”

In addition to the likelihood of hedge fund registration, the SEC is now proposing to have “gatekeepers” to make sure that investment advisors are not engaged in any fraudulent behavior.  When and if such a requirement is adopted, it will further burden investment advisors with more paperwork.  “Surprise exams” could also be disastrous to the small investment advisory shops which would need to divert resources from trading and operations to dealing with such surprise exams.  At all levels of the investment advisory spectrum this will increase costs.

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SEC Proposes Rule Amendments to Strengthen Safeguards of Investor Funds Controlled by Investment Advisers

FOR IMMEDIATE RELEASE
2009-109

Washington, D.C., May 14, 2009 — The Securities and Exchange Commission today proposed rule amendments to substantially increase protections for investors who entrust their money to investment advisers.

The SEC is seeking public comment on the proposed measures, which are intended to ensure that investment advisers who have “custody” of clients’ funds and securities are handling those assets properly. In some recent SEC enforcement actions, firms and principals have been charged with misusing clients’ money and covering up their illicit activities by distributing false account statements showing non-existent funds. The additional safeguards proposed by the SEC include a yearly “surprise exam” of investment advisers performed by an independent public accountant to verify client assets. In addition, when an adviser or an affiliate directly holds client assets, a custody control review would have to be conducted by a PCAOB-registered and inspected accountant.

“These new safeguards are designed to decrease the likelihood that an investment adviser could misappropriate a client’s assets and go undetected,” said SEC Chairman Mary Schapiro. “That’s because an independent public accountant will be looking over their shoulder on at least an annual basis.”

Andrew J. Donohue, Director of the SEC’s Division of Investment Management, added, “The amendments proposed by the Commission today would significantly strengthen controls over client assets held by registered investment advisers — especially when those assets are held directly by the adviser itself or a related person of the adviser.”

Unlike banks or broker-dealers, investment advisers generally do not have physical custody of their clients’ funds or securities. Instead, client assets are typically maintained with a broker-dealer or bank (a “qualified custodian”), but the adviser still may be deemed to have custody because the adviser has authority to withdraw their clients’ funds held by the qualified custodian. Or the qualified custodian may be affiliated with the adviser, which may give the adviser indirect access to client funds.

The SEC’s proposed rule amendments, if adopted, would promote independent custody and enable independent public accountants to act as third-party monitors.

One proposed amendment would require all registered advisers with custody of client assets to undergo an annual “surprise exam” by an independent public accountant to verify those assets exist.

Another proposed amendment would apply to investment advisers whose client assets are not held or controlled by a firm independent of the adviser. In such cases, the investment adviser will be required to obtain a written report — prepared by a PCAOB-registered and inspected accountant — that, among other things, describes the controls in place, tests the operating effectiveness of those controls, and provides the results of those tests. These reports are commonly known as SAS-70 reports. This review would have to meet PCAOB standards — providing an important level of quality control over the accountants performing the review.

The proposed measures also would include reporting requirements designed to alert the SEC staff and investors to potential problems at an adviser, and provide the Commission with important information for risk assessment purposes. An adviser would be required to disclose in public filings with the Commission, among other things, the identity of the independent public accountant that performs its “surprise exam,” and amend its filings to report if it changes accountants. The accountant would have to report the termination of its engagement with the adviser and, if applicable, any problems with the examination that led to the termination of its engagement. If the accountants find any material discrepancies during the surprise examination, they would have to report them to the Commission.

The proposed amendments also would require that all custodians holding advisory client assets directly deliver custodial statements to advisory clients rather than through the investment adviser, and that advisers opening custody accounts for clients instruct those clients to compare account statements they receive from the custodian with those received from the adviser. These additional safeguards would make it more difficult for an adviser to prepare false account statements, and more likely that clients would find discrepancies.

* * *

Public comments on today’s proposed rule amendments must be received by the Commission within 60 days after their publication in the Federal Register.

The full text of the proposed rule amendments will be posted to the SEC Web site as soon as possible.

http://www.sec.gov/news/press/2009/2009-109.htm