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CFTC Adopts New Segregated Funds Rules Post PFG

In the wake of the failure of MF Global in 2011, regulators and self-regulatory organizations scrambled to assess the damage and to implement regulations to oversee how futures commission merchants (“FCMs”) manage and report segregated funds. Just as some of these rules were being implemented, the Peregrine Financial Group scandal hit, and the renewed calls for reform have likely triggered another wave of regulations.

Recent Activity on Segregated Funds

It has been a busy couple of months for rules affecting segregated funds:

• July 9: The NFA brought an emergency action against Peregrine Financial Group, Inc. (“Peregrine Financial”) and Peregrine Asset Management, Inc. for, among other things, failing to demonstrate that they could meet capital and segregated funds requirements. The NFA was Peregrine Financial’s designated self-regulatory organization.

• July 10: The NFA notified CPO Members holding assets at Peregrine Financial to notify the NFA of their exposure to Peregrine Financial.

• July 13: The CFTC adopted the new segregated funds rules for FCMs proposed by the NFA in late May.

• July 16: The NFA, following harsh criticism, announced an external review of its general audit practices and procedures, as well as its execution of those procedures with respect to the NFA’s review of Peregrine Financial’s segregated funds.

• Late July: The NFA and other regulatory and self-regulatory organizations publicly discussed proposals for new rules affecting segregated funds.

New Regulations Effective September 1, 2012

The CFTC announced on Friday, July 13 that it had adopted the segregated funds rules proposed by the NFA. These rules will become effective on September 1, 2012. Below is a summary; greater details can be found on the NFA’s website here.

• Policies and Procedures. All FCMs must have written policies and procedures regarding the maintenance of the firm’s residual interest in its customer segregated funds. These policies and procedures must target an amount (either by percentage or dollars) that the FCM seeks to maintain as its residual interest in those accounts and ensure that the FCM remains in compliance with the applicable segregation requirements.

• Pre-Approval and NFA Notice. No FCM may withdraw, transfer or otherwise disburse funds from any customer segregated funds account exceeding 25% of the FCM’s residual interest in customer segregated funds unless (a) the firm’s CEO, CFO or other defined principal pre-approves the transaction in writing, and (b) a notice is filed immediately with the NFA.

• Monthly or Semi-Monthly Reporting. All FCMs must provide NFA with certain financial and operational information on a monthly or semi-monthly basis. NFA will subsequently make some of the information publicly available on its website in the future.

Note: all of these new requirements

also apply to foreign futures and options customer secured amount funds accounts.

Proposed Rules and Procedures

Various regulators and self-regulatory organizations have put forth the following rules and procedures for discussion and possible adoption in the future:

• Web-Based Balance Confirmation. A committee of self-regulatory organizations have agreed to put into place a web-based process that FCMs can use to confirm their segregated account balances. [Note: this committee includes the CME Group, NFA, InterContinental Exchange, Kansas City Board of Trade and the Minneapolis Grain Exchange.]

• Direct e-Monitoring of Accounts. The CFTC, the NFA, and a number of self-regulatory organizations have expressed support for requiring FCMs to provide regulators with direct read-only access to the FCMs’ segregated accounts, to facilitate monitoring of account balances.

• Clearinghouses. CME Group expressed potential support for having segregated funds held at clearinghouses or other depositories, with the interest being returned to the FCMs.

Conclusion

FCMs should be aware of the new CFTC rules that will go into effect on September 1, 2012. FCMs should also prepare for the imposition of some or all of the rules proposed by various self-regulatory organizations.

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Special Reminder: CPOs Must Notify NFA of Exposure to Peregrine Financial

As mentioned above, the NFA is requiring CPO Members that hold assets at Peregrine Financial to report their exposure. Specifically, the NFA requires the following information within 48 hours of receiving the NFA notice:

• The name of each pool account held at Peregrine Financial and its NFA Pool ID number;

• The current dollar amount of pool assets held at Peregrine Financial for each pool account and the corresponding date;

• The most recent net asset value for each pool with funds at Peregrine Financial and the date of the valuation;

• Any withdrawal restrictions that the firm has implemented or plans to implement with respect to each pool.

In addition, please note that following the failure of MF Global, the NFA required CPOs to disclose the extent of their exposure in the CPO’s disclosure documents. The NFA may require a similar disclosure related to Peregrine Financial.

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Bart Mallon is a partner with Cole-Frieman Mallon & Hunt LLP, an investment management law firm with a focus on managed futures law and regulations which affect CTAs, CPOs, IBs and FCMs. Bart can be reached directly at 415-868-5345.

More on JOBS Act for Hedge Fund Managers

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Below is the transcript of an interview I gave to Markets Reform Wiki. The discussion below is about how the recently enacted JOBS Act will affect the hedge fund industry. There has been an overwhelming amount of attention paid to this bill because it will, in certain ways, fundamentally change the way some managers (especially small and emerging) market their hedge fund going forward. We have also published other pieces about this issue and there will likely be a lot of discussion about hedge fund marketing related to the JOBS Act in the future.

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Hedge Fund Marketing and the JOBS Act

Five Minutes with Bart Mallon, Cole-Frieman, Mallon & Hunt LLP

On April 5, 2012 President Obama signed into law the Jumpstart Our Business Startups Act (“JOBS Act”). Inserted into the Act were provisions on hedge fund marketing and accredited investor restrictions. John Lothian News Editor-at-Large Doug Ashburn spoke with Bart Mallon of Cole-Frieman, Mallon & Hunt LLP about the JOBS Act provisions, what they entail and how it will affect the hedge fund community.

Q: On April 5, 2012 President Obama signed into law the Jumpstart Our Business Startups Act (“JOBS Act”). Inserted into the Act were provisions on hedge fund marketing and accredited investor restrictions. What exactly do the provisions entail?

A: There is not actually any change in marketing provisions per se. What happened is the JOBS Act repealed earlier provisions in the securities laws which did not allow managers to have general solicitations with respect to their offerings. This essentially meant that managers could not solicit by advertising to the public through these private offerings and so managers really had to be careful when trying to grow the assets of their fund. One of the important things to note with respect to the provisions of the JOBS Act is that they can only market more freely if all of the investors of the fund are accredited investors. If they have non-accredited investors coming into the fund, then they cannot use these more liberal advertising means in order to solicit investors.

Q: Does this affect all types of fund structures?

A: For a 3(c)(1) fund structure, the accredited investor limit does not change. These managers are still limited to 99 individual investors. For 3(c)(7) funds, previously the limit was 499 investors. Now, that can be bumped up to 1999 investors. For 3(c)(7) funds, though, all investors must be qualified purchasers, which is actually a higher threshold than that of accredited investors.

Q: What do these marketing rules have to do with the JOBS Act, and why are they a part of it?

A: You have a couple things going on here. As people have been pointing out for a number of years, most of these securities laws were written in the 1930s, with the last one in 1940. The general nature of the industry has changed over the years; the JOBS Act is a reaction to some of the problems with these laws. Technological advances, and the ability of the internet to be a means of connecting with people in a way to market to potential investors – securities laws just do not address those issues. The JOBS Act was trying to find a way to balance investor protection of the securities laws with the ability for managers to go out and communicate and have a sort of certainty with respect to their activities on the internet.

Q: How will this change the way funds structure communication, such as on their web sites?

A: There is going to be a wide range of ways managers will be allowed to advertise. You will see more information available on their web sites and on hedge fund databases. You are also more likely to see hedge funds marketed in publications such as the Wall Street Journal or New York Times. There has also been talk that big fund complexes may have public advertising in sporting venues and such. I don’t know if it will come to that, but we are definitely going to see more fund managers trying to get out in front of the investing public and getting their name out there more. It will be interesting to see the avenues with which managers will use.

Q: Critics have suggested that this will be an invitation to some of the less scrupulous operators to come out of the woodwork to take advantage of the new rules. Do you see a problem with that?

A: Certainly, this is going to make the job of securities regulators much more difficult. Right now, with the restrictions, you don’t have a lot of managers out there touting performance and those sorts of things. Once you open up the floodgates and everyone starts doing it, it will be a lot harder for the SEC and for the state regulators to keep on top of what all these managers are showing. From a regulatory standpoint, in asking these agencies to enforce these securities laws and protect the investing public amid this deluge of advertising, I think becomes a tough task for the regulators. Savvy marketing people who might not have the best of intentions with respect to customer protections will have an easier time meeting population targets. That is one of the things Congress had to weigh when creating this law – investor protection versus capital formation and spurring the economy.

Q: The SEC has been given a timetable for the creation of a framework for these new rules. What do you expect to see in the SEC rulemaking?

A: I imagine we will see a lot of rulemaking on recordkeeping, and also on being able to back up any statements made in any advertising materials. It is clear that managers are going to need to make sure their investors are accredited investors, so I think there could be more of an onus on managers to do more fact-checking with respect to their investors.

But it really depends on how aggressive the SEC wants to be with respect to overseeing solicitations. The SEC is already an underfunded agency, so if they create more onerous rules for themselves to implement and oversee, they will be taking away from themselves internally. They have their own political balance they need to strike between promulgating rules that they can actually enforce, versus investor protection.

Bart Mallon is a partner and co-founder of Cole-Frieman Mallon & Hunt LLP, a San-Francisco-based law firm specializing in hedge fund and alternative investment legal services. His areas of specialization include setting up offshore hedge funds and separately managed structured accounts, and registration issues. Mallon is also the author of the Hedge Fund Law blog.

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Cole-Frieman Mallon & Hunt provide legal advice to hedge fund managers with respect to all aspects of their business including marketing under the new JOBS Act provisions. Bart Mallon can be reached directly at 415-868-5345.

New York City Unicorporated Business Tax Update

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Recent Audits May Impact Fund Structures and Management Company Expenses

There may be a number of reasons for a manager to create separate legal entities to serve as the management company and a fund’s general partner. In particular, New York-based managers have typically done this due to New York City’s tax treatment of fees earned by fund managers. However, a recent move by the New York City Department of Finance (the “Department”) may hearken a change to this approach, and the manner in which fund managers analyze and document their expenses.

Background on New York UBT

New York City’s Unincorporated Business Tax (“UBT”) currently is, and has been historically, imposed only on management fees earned in the city, but not on incentive allocations. This tax treatment was formally approved by a statutory amendment to the UBT law over 15 years ago. For this reason, fund managers have formed one entity to be the management company that will receive the asset-based management fees, and another entity to serve as a fund’s general partner and receive the profits-based incentive allocations.

Management fees are generally used to cover both the management of the fund, and the administrative operations of the management company. Expenses related to these functions are deductible against gross income when calculating the management company’s UBT liability. The tax rate is 4% of the net UBT income.

The incentive allocations to the general partner are excluded from UBT on the basis of a statutory exemption for entities that are “primarily engaged” in self-trading for its owners and does not otherwise operate a business in New York city, as defined in the UBT law (this is because all of the administrative/operational functions are performed by the management company).

Developments in the New York City Department of Finance

Recent audits by the Department may portend a shift in this tax treatment and hence, implications for fund managers in how they structure and run their businesses. Specifically, the Department asserted that some portion of a management company’s operating expenses is ultimately attributable to tax exempt income. Because of this, the Department determined that at least some of these expenses should not be used to reduce the management company’s UBT liability. In effect, this approach will attribute some of the expenses to the tax-exempt incentive allocation that the general partner earns, rather than allowing 100% of such expenses to offset the management fee. Put more bluntly, the Department will disallow some of a management company’s expenses in calculating the net UBT income.

Interestingly, while the redistribution of tax among entities under common control is explicitly permitted under Federal tax law, the UBT law is silent on this question, though some commentators suggest that authority for this is implied because the UBT calculation starts with Federal taxable income.

As a result of this new approach, the management company’s net UBT income would increase to the extent that expenses are disallowed, and the management company would owe more tax. In years where performance is significantly up (meaning a higher incentive allocation), the tax increase would likely be more pronounced; in contrast, when performance is down and there is no allocation, the management company may still be permitted to deduct expenses as it has done previously.

Conclusion

It is important to note that the Department’s approach in the audits has not been formally adopted, nor implemented in the UBT law itself. However, given the unpredictability inherent in the Department’s expense-shifting approach in the audits, we recommend that New York-based fund managers evaluate their expenses and carefully document how they relate to the operations of the management company to maximize the ability to deduct them for purposes of calculating their net UBT income.

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Cole-Frieman & Mallon provides hedge fund formation and other legal services to managers in New York and throughout the country. Bart Mallon can be contacted directly at 415-868-5345.

Requesting a Waiver from NFA Enhanced Supervisory Requirements

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Member Firms Subject to ESRs May Seek Waiver

As we have discussed previously, an NFA Member firm may be required to adopt enhanced supervisory requirements (“ESR”) based on:

the employment history of its APs and Principals,
the affiliations of its Principals,
if the firm charges 50% or more of its active customers round-turn commissions, fees and other charges that total $100 or more per futures, forex or option contract, or
it becomes subject to NFA or CFTC enforcement or disciplinary proceedings.

If a Member firm meets any of the criteria requiring it to adopt ESRs, it may request a waiver from these requirements. This post discusses how a firm may request such a waiver and what the NFA will consider in granting or denying the waiver.

Requesting a Waiver

To request a waiver from enhanced supervisory requirements, a Member firm may file a petition with the NFA’s three-person Telemarketing Procedures Waiver Committee (the “TPWC”) for a partial or full waiver from the requirement to adopt ESRs. The firm must file the petition with the TPWC within 30 days of receiving notice from the NFA that the firm is required to adopt ESRs. This deadline is important because failure to timely file the request will prohibit the firm from filing the waiver again until at least 2 years after the firm adopts the ESRs. If the TPWC denies the waiver, the firm is also prohibited from filing the waiver again until at least 2 years after the firm adopts the ESRs.

Factors the NFA Will Consider

The TPWC may consider the following factors when evaluating a waiver request:

total number and the backgrounds of APs sponsored by the Member;
number of branch offices and guaranteed introducing brokers (“GIBs”) operated by the Member;
experience and background of the Member’s supervisory personnel;
number of the Member’s APs who had received training from firms which have been closed for fraud, the length of time those APs worked for those firms and the amount of time which has elapsed since those APs worked for the disciplined firms;
results of any previous NFA examinations;
cost effectiveness of the taping requirement in light of the firm’s net worth, operating income and related telemarketing expenses;
whether the Member assesses commissions, fees and other charges that are based on all of the relevant circumstances, including the expense of executing orders and the value of services the Member renders based on its experience and knowledge; and
whether the Member adequately discloses the amount of commissions, fees and other charges before transactions occur in light of a retail customer’s trading experience and the impact that the commissions, fees and other charges may have on the likelihood of profit.

Conditions on Waiver

Even if the TPWC grants a full or partial waiver, it will still impose certain requirements on the firm. The firm must:

notify the NFA of any actions charging it with violation of CFTC, SEC, or other self-regulatory organization’s (“SRO”) regulations or rules;
notify the NFA of any customer complaints involving sales practices or promotional material;
not change ownership;
not have any material deficiencies noted during any SRO examination;
not hire additional APs from Disciplined Firms;
execute a written acknowledgement that the firm understands the conditions of the waiver;
and may include any other conditions deemed by the TPWC to be appropriate in consideration of a total or partial waiver from the enhanced supervisory requirements.

If the firm violates these conditions, the TPWC may revoke or amend the wavier that was previously granted.

Conclusion

The ESRs impose more strict requirements on Member firms. It is important for a firm to evaluate the employment history of its APs and Principals to determine whether the firm meets the criteria set forth in NFA Interpretive Notice 9021 and must therefore adopt the ESRs or seek a waiver from such requirements. If a firm receives a notice from the NFA that it must adopt ESRs and it wishes to request a waiver, it should act quickly. Failure to file a petition within 30 days will bar the firm from filing a request for at least 2 years after it adopts the ESRs.

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Cole-Frieman & Mallon LLP provides comprehensive legal services to CFTC registered managers. The firm also provides NFA registration and compliance support. Bart Mallon can be reached directly at 415-868-5345.

FINRA Cannot Sue to Collect Unpaid Fines

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2nd Circuit Holds that FINRA Lacks Statutory Authority and FINRA Rule was Invalid

The Securities Exchange Act of 1934 (the “Exchange Act”) authorizes the Financial Industry Regulatory Authority (“FINRA”) and other SROs to regulate within the securities industry. FINRA’s role includes registering and educating industry participants, examining firms, implementing rules, and enforcing them alongside the federal securities laws. FINRA’s enforcement tools include imposing fines for violations. Last week, in Firero v. FINRA, the United States Court of Appeal for the Second Circuit found that FINRA lacked the power to sue for unpaid fines.

Summary of Facts and Judgment

Fiero Brothers (the “Firm”) was a FINRA member and registered broker-dealer. John J. Fiero (“Mr. Fiero,” and together with the Firm, “Fiero”) was the Firm’s only registered representative. In 1998, FINRA brought an enforcement action against Fiero for engaging in illegal short-selling, among other violations. FINRA permanently barred and fined them $1 million, plus costs. For the next ten years, FINRA attempted unsuccessfully to collect the fine from Fiero. In 2003, FINRA filed suit in New York state court to recover the fine and costs. The lower courts found in FINRA’s favor; however, the New York Court of Appeals reversed, holding that the FINRA complaint fell under the exclusive jurisdiction of the federal courts.

Fiero then sought a declaratory judgement in federal district court, that FINRA lacked authority to collect fines through judicial proceedings. FINRA filed a counterclaim seeking to enforce its fine, and both parties moved to dismiss each other’s claims. The District Court entered judgment in FINRA’s favor, dismissing Fiero’s complaint. The Second Circuit reversed, holding that:

(1) the Exchange Act did not authorize FINRA to sue for fines, stating that the specificity of the statute, and omission of the power to sue indicated Congress’ intent to withhold this power from SROs. The court noted that FINRA’s longstanding practice did not include filing suits, and that the Fiero case was the first it had brought; and

(2) FINRA’s 1990 rule permitting it to sue for fines was improperly promulgated under the Exchange Act, specifically that it was not a “housekeeping rule” that is approved upon receipt of the SEC (as submitted by FINRA), but was instead a substantive rule, subject to notice and a comment period.

Implications of the Court’s Decision

Following the decision, FINRA’s general counsel reportedly stated that FINRA would “continue to review the ruling and weigh our options.”

Those options include seeking review by the United States Supreme Court, or asking Congress to provide SROs with the right to seek enforcement of their fines in court. In the meantime, FINRA may, and will, pursue collection of fines short of litigation, and suspend or bar violators from the industry. FINRA may seek the SEC’s assistance in obtaining court orders that include payment of fines. However, the decision hampers FINRA to the extent that fear of litigation inspired violators to pay their fines.

But some commentators have noted that FINRA seldom pursued barred individuals for unpaid fines, and rarely sued (one put the total number of lawsuits at five, including Fiero). Furthermore, violators who are not barred have an incentive to pay their fines if they wish to keep their licenses. Reactions were positive from those who believed that FINRA had been exceeding its statutory power for years, and abusing the rule-making process.

Rule-making is likely the area most impacted by the ruling. The court’s criticism that FINRA bypassed the notice and comment procedure may cause SROs and the SEC to scrutinize proposed rules, or second-guess existing “housekeeping” rules, to ensure that they are not substantive, and subject to a lengthy approval process. Moreover, future litigants may be encouraged to seek judicial review of SRO rules that were approved in the more streamlined process for “housekeeping” rules.

New York is home to many financial firms, and the courts there have expertise in interpreting the federal securities laws. Though not binding on other courts, the Second Circuit’s decision will be influential among the other federal circuits. State courts may follow the New York Court of Appeals, and decide that they do not have subject matter jurisdiction over collections cases involving federally-authorized SROs.

A remaining question is whether the decision will impact the proposed SRO for investment advisers, and FINRA as the candidate for that role. At this point, the particulars of that legislation and the SRO’s powers in collecting fines, is unknown. The decision is not expected to affect FINRA’s status as the frontrunner to fill this role.

Conclusion

Recent years have seen expanded regulation of the financial industry. Thus, it is surprising that the Second Circuit determined that FINRA lacked a particular enforcement tool. However, it is this climate of expanding regulation that may give FINRA the leverage to seek greater enforcement powers and options from Congress. In the meantime, and perhaps despite a FINRA spokeswoman’s comment that “the decision will not…restrict our ability to enforce FINRA rules and securities laws….,” at least some violators who receive significant fines, but have the means to leave the industry may walk away as an alternative to paying fines.

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Cole-Frieman & Mallon LLP provides legal advice and support to all types of investment managers. If you have a question regarding any industry SRO, please feel fre to contact us directly. Bart Mallon can be reached directly at 415-868-5345.

Hedge Fund Soft Dollar Disclosure Practices

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Disclosure Under Greater Scrutiny

Both registered investment advisers and unregistered managers are generally required to make complete and accurate disclosures with respect to their investment programs. The obvious purpose of this requirement is to provide potential investors and clients with accurate information so the investors can make informed decision about the merits of a particular investment or investment program. Disclosures regarding a manager’s soft dollar practices are especially important. In general managers will need to provide accurate disclosure of their soft dollar practices in Form ADV, the hedge fund offering documents, the investment advisory contracts, and marketing materials.

Note: The Hedge Fund Law Blog discussed the Section 28(e) safe harbor for research and brokerage services in a previous post.

ADV Part 2 Required Soft Dollar Disclosures

The SEC’s most recent guidance regarding required soft dollar disclosures is provided by the instructions for Item 12 (“Brokerage Practices”) of the new Form ADV Part 2. The “Research and Other Soft Dollar Benefits” section of Item 12, requires disclosure of “all soft dollar benefits you receive, including, in the case of research, both proprietary research (created or developed by the broker-dealer) and research created or developed by a third party.”

The following specific items from the instructions provide additional guidance as to the details that must be included in the disclosures:

a. Explain that when you use client brokerage commissions (or markups or markdowns) to obtain research or other products or services, you receive a benefit because you do not have to produce or pay for the research, products or services.

b. Disclose that you may have an incentive to select or recommend a broker-dealer based on your interest in receiving the research or other products or services, rather than on your clients’ interest in receiving most favorable execution.

c. If you may cause clients to pay commissions (or markups or markdowns) higher than those charged by other broker-dealers in return for soft dollar benefits (known as paying-up), disclose this fact.

d. Disclose whether you use soft dollar benefits to service all of your clients’ accounts or only those that paid for the benefits. Disclose whether you seek to allocate soft dollar benefits to client accounts proportionately to the soft dollar credits the accounts generate.

e. Describe the types of products and services you or any of your related persons acquired with client brokerage commissions (or markups or markdowns) within your last fiscal year.

Note: This description must be specific enough for your clients to understand the types of products or services that you are acquiring and to permit them to evaluate possible conflicts of interest. Your description must be more detailed for products or services that do not qualify for the safe harbor in section 28(e) of the Securities Exchange Act of 1934, such as those services that do not aid in investment decision-making or trade execution. Merely disclosing that you obtain various research reports and products is not specific enough.

f. Explain the procedures you used during your last fiscal year to direct client transactions to a particular broker-dealer in return for soft dollar benefits you received.

Hedge fund managers should note that the disclosures must be detailed and specific and include a description of the procedures used to direct trades in exchange for soft dollar benefits. Hedge fund offering documents should contain similar soft dollar disclosures. The only case where disclosure is not required is when an investment adviser is not using any soft dollars at all.

Importance of Complete and Accurate Soft Dollar Disclosures

Under general fiduciary principles, an investment adviser has a duty to seek best execution for discretionary client trades. The receipt of soft-dollar benefits in exchange for trade execution represents a conflict of interest with the fiduciary duty of best execution because the client is generally paying for more than mere execution. Accurate and complete disclosure of the adviser’s conflicts of interest is fundamental to an adviser’s fiduciary duty and typically deemed necessary in order to avoid violating the anti-fraud provisions of the Investment Advisers Act of 1940 (see Sections 206(1), (2) and (4)). Additionally, Section 207 of the Advisers Act provides that it is unlawful for any person willfully to make any untrue statement of material fact in any registration application filed with the SEC or willfully to omit to state in any such application any material fact required to be stated therein. Accordingly, many of the SEC enforcement actions involving soft dollars contain allegations of violations of Section 206 and/or Section 207 of the Advisers Act.

Examples of Improper Disclosure

The SEC takes disclosure practices seriously. Below are two cases involving deficiencies in soft dollar disclosure practices:

In Schultze Asset Management LLC, et al., Investment Advisers Act Release No. 2633 (Aug. 15, 2007), the SEC sanctioned Schultze Asset Management (“SAM”) for violations of Section 206(1) and 206(2) because SAM’s disclosures to an advisory client indicated that SAM was using “client commissions generated by the account only for expenses covered by the safe harbor provided by Section 28(e),” when, in fact, SAM used the soft-dollars generated by the client trades to pay for expenses outside the 28(e) safe harbor, including the salary of the principal. In resolution of the action, SAM returned approximately $350,000 to its clients, representing all soft dollar payments SAM received. Additionally, the SEC censured SAM, its principal, and fined SAM and the principal $100,000 and $50,000 respectively.

In In re Dawson-Samberg Capital Mgmt, Inc. Investment Adviser Act Release No. 1889 (Aug. 3, 2000), the SEC sanctioned Dawson-Samberg for violations of Section 206(2) and Section 207 of the Advisers Act because of its failure to appropriately disclose soft dollar practices that included use of soft dollars to pay for “research-related travel expenses.” Dawson-Samberg and one of its principals were censured and fined $100,000 and $20,000 respectively.

Conclusion

Manager need to take soft dollar disclosure seriously. If you have questions about whether current disclosure is sufficient, you should discuss with your legal counsel.

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Cole-Frieman & Mallon LLP provides legal advice to hedge fund managers. The firm also has a focus on investment adviser registration and compliance matters. Bart Mallon can be reached directly at 415-868-5345. Karl Cole-Frieman can be reached at 415-352-2300.

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SEC Open Meeting re: Hedge Fund Registration

We are currently watching the webcast live and are posting our comments below. You can watch the meeting live here: http://sec.gov/news/openmeetings.shtml.

We will be posting our review of the adopted regulations sometime later today.

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11:05 AM ET: the open meeting has started and Chairman Schapiro (“CS”) is currently providing an overview of the meeting today.

11:12 AM ET: the registration requirements will not go into effect until the first quarter of 2012 to allow the SEC time to prepare their systems to accept all the hedge fund registration applications.

11:15 AM ET: Bob Plaze discussing new rulemakings – hedge fund registration will be extended to March 30, 2012. [No March 31, 2012 next year because of leap year.]

11:19 AM ET: Devin Sullivan discussing Form ADV amendments – important data on the private funds as well as service providers – auditors, prime brokers, custodians. Competitively sensitive information will not be required.

11:20 AM ET: Devin Sullivan discussing Exempt Reporting Advisers will be required to complete certain parts of Form ADV.

11:21 AM ET: Devin Sullivan discussing switch for certain SEC registered managers to state registration. Uniform method to calculate AUM. Current SEC registered advisers will need to file an amendment to show they can remain SEC registered.

11:22 AM ET: Devin Sullivan discusses pay to play rules and Municipal Advisers.

11:24 AM ET: VC advisers get a break – they can have up to 20% of fund's assets in non-qualifying VC investments. Other parts of the rule sound similar to the proposal.

11:25 AM ET: VC funds get grandfathering provision.

11:27 AM ET: $150M exemption rule is recommended to be adopted substantially as proposed. http://www.hedgefundlawblog.com/rule-203m-1-%E2%80%93-private-fund-adviser-exemption.html

11:28 AM ET: Foreign private adviser rule is recommended to be adopted substantially as proposed. http://www.hedgefundlawblog.com/rule-202a30-1-investment-advisers-act.html

11:29 AM ET: Commissioner Casey (“CC”) talking about VC funds and congressional intent. Supports VC rule and 20% basket of non-VC investments. Does not support some of the other rules – especially because of the exempt reporting advisers rule.

11:32 AM ET: CC disagrees with the reporting requirem

ents. Does not think there is distinction between exempt advisers and registered advisers with respect

to disclosure information on the ADV. Essentially she thinks this is a slippery slope.

11:34 AM ET: CC says the reporting requirements for exempt advisers needlessly imposes compliance requirements on incubating businesses.

11:36 AM ET: Commissioner Walter (“CW”) generally support the rulemaking. Believes information from exempt reporting advisers (ERAs) will be important for the SEC. But would have required broader information from the advisers. Seems like she wants more information from ERAs; wants to revisit the disclosures in a year.

11:38 AM ET: CW – can we get more information on the 20% basket for VC funds?

11:38 AM ET: Sullivan – Designed to provide flexibility for VC funds. The big question is whether it is 20% of invested or committed capital. 20% on committed, but the committment m

11:39 AM ET: CW – which states will examine advisers?

11:40 AM ET: Plaze – we asked all of the states about examination; MN would not be subject to examination. SEC will treat NY advisers as not subject to examination.

11:42 AM ET: Commissioner Aguilar (“CA”) makes a short statement and thank-yous.

11:44 AM ET: Commissioner Varedes (“CV”) supports the 20% basket for VC funds. Would have liked even more flexibility.

11:45 AM ET: CV disagrees with ERA reporting requirements – reporting requirements too close to registered advisers.

[BM to update the votes]

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Family Office Definition

11:51 AM ET: CS providing background on family offices and proposed definition. See earlier post: http://www.hedgefundlawblog.com/sec-proposes-family-office-definition.html

11:52 AM ET: Staff member discussing exclusion. Certain conditions to prevent the family office to provide advice outside of the family, unless there is registration.

11:54 AM ET: Staff member discusses more technical parts of the proposal.

11:56 AM ET: CC, CW and CA did not have any questions for the staff.

11:58 AM ET: CP discusses some issues with respect to some of the changes made from the proposal.

11:59 AM ET: Plaze thanks commenters, especially the ABA, for their comments from a public policy perspective – the staff appreciates such comment letters.

11:59 AM ET: All Commissioners support adopting new family office rule.

SEC Proposes Change to Qualified Client Definition

Higher Threshold for Performance Fee Proposed

Under current SEC Rule 205-3, an SEC registered investment adviser can charge a performance fee (also called a performance allocation, incentive fee or incentive allocation) only to those investors who either has:

a $1.5M net worth or
at least $750,000 in assets with the manager

Many states have the same rules for state registered advisers or they explicitly make reference to the SEC regulation.

As a result of the Dodd-Frank act, the SEC is now proposing to increase the threshold for managers to be able to charge these performance fees. The proposal declares that clients or investors of an SEC registered investment adviser can be charged a performance fee only if the client has:

a $2M net worth (excluding a primary residence) or
at least $1M in assets with the manager

What this means for SEC Registered Managers

While there will likely be a grandfathering provision for current fund managers with current investors who are “qualified clients”, when the new regulations go into effect, SEC registered managers (and potentially state registered managers) will likely need to make sure new investors meet the new threshold in order to charge these investors a performance fee. Additionally, managers will need to update their offering documents to reflect the new definition (reprinted in full as proposed below).

The new regulation is likely to affect smaller funds disproportionally. Many times smaller funds have investors who may just meet the qualified client threshold. [Note: for some managers, they may allow non-qualified clients into the fund, but then just charge them a higher management fee in lieu of a performance allocation.]

Managers are urged to send comments to the SEC. The comment period is open until July 11, 2011.

The SEC notice can be found here.

The full proposed rule can be found here: Performance Fee Rule Proposal.

Current comments on the proposal can be found here.

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Proposed Changes to Rule 205-3

Section 275.205-3 is amended by:

a. Revising paragraph (c);

b. Revising paragraphs (d)(1)(i) and (ii); and

c. Adding paragraph (e).

The revisions and addition read as follows.

§ 275.205-3 Exemption from the compensation prohibition of section 205(a)(1) for investment advisers.

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(1) Registered investment advisers. If a registered investment adviser entered into a contract and satisfied the conditions of this section that were in effect when the contract was entered into, the adviser will be considered to satisfy the conditions of this section; Provided, however, that if a natural person or company who was not a party to the contract becomes a party (including an equity owner of a private investment company advised by the adviser), the conditions of this section in effect at that time will apply with regar

d to that person or company.

(2) Registered investment advisers that were previously exempt from registration. If an investment adviser was exempt from registration with the Commission pursuant to section 203 of the Act (15 U.S.C. 80b-3), section 205(a)(1) of the Act will not apply to an advisory contract entered into when the adviser was exempt, or to an account of an equity owner of a private investment company advised by the adviser if the account was established when the adviser was exempt; Provided, however, that section 205(a)(1) of the Act will apply with regard to a natural person or company who was not a party to the contract and becomes a party (including an equity owner of a private investment company advised by the adviser) when the adviser is no longer exempt.

(d) Definitions. For the purposes of this section:

(1) The term qualified client means:

(i) A natural person who, or a company that, immediately after entering into the contract has at least $1,000,000 under the management of the investment adviser;

(ii) A natural person who, or a company that, the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either:

(A) Has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,000,000, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property; or

(B) Is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(51)(A)) at the time the contract is entered into; or

* * * * *

(e) Inflation adjustments. Pursuant to section 205(e) of the Act, the dollar amounts specified in paragraphs (d)(1)(i) and (d)(1)(ii)(A) of this section shall be adjusted by order of the Commission, effective on or about May 1, 2016 and issued approximately every five years thereafter. The adjusted dollar amounts established in such orders shall be computed by:

(1) Dividing the year-end value of the Personal Consumption

Expenditures Chain-Type Price Index (or any successor index thereto), as published by the United States Department of Commerce, for the calendar year preceding the calendar year in which the order is being issued, by the year-end value of such index (or successor) for the calendar year 1997;

(2) For the dollar amount in paragraph (d)(1)(i) of this section, multiplying $750,000 times the quotient obtained in paragraph (e)(1) of this section and rounding the product to the nearest multiple of $100,000; and

(3) For the dollar amount in paragraph (d)(1)(ii)(A) of this section, multiplying $1,500,000 times the quotient obtained in paragraph (e)(1) of this section and rounding the product to the nearest multiple of $100,000.

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Cole-Frieman & Mallon LLP is a hedge fund law firm focused on the investment management industry. Bart Mallon can be reached directly at 415-868-5345.

Zero-Sum Game

Story of the CME & CBOT Merger

Just a quick note to say I recently picked up the book Zero-Sum Game by Erika S. Olson. Olson is, at the time the story begins, a newly hired managing director of marketing for the Chicago Board of Trade and she chronicled her experiences during the merger of the CBOT and the Chicago Mercantile Exchange in 2007. In addition to detailing her experiences, she provides background information on many of the major players in the negotions and on events that transpired in the nine months following the merger announcement.

For me some of the more interesting parts of the story include:

Jeff Sprecher’s moves to get the ICE involved in the merger/acquisition discussion [note: some of the marketing tactics remind me of the tactics Marc Benioff used against Siebel, as described in Behind the Cloud]
The story of the CBOT Class B Shareholders and their CBOE ERPs (would have actually liked to read more about this)
Story of Caledonia and ownership of memberships at a number of exchanges; their involvement near the proxy vote
Discussion of John Lothian's commentary throughout merger negotiations

Of course, with any narrative that involves someone from outside the futures industry, there are the funny anecdotes of being introduced to some of Chicago’s more colorful characters – the traders. (For an up close look at some of these personalities, Floored is a great movie…)

Overall I thought it was a good, quick read that shed a bit of light into what was going on during the merger. I thought Olson had a great voice and told the story well, but I was left wanting more detail and background into certain situations.

For more on the book, see the Futures Magazine review.

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Cole-Frieman & Mallon LLP provides

full legal services to the managed futures industry. Bart Mallon can be reached directly at 415-868-5345.