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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 What happened is the JOBS Act repealed earlier provisions in the securities laws which did not allow managers to have general solicitations with respect to their offerings.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.

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.

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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.

* * * * *

(c)  Transition rules.

(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.

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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.

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CFTC Regulation 4.7 for Registered CTAs and CPOs

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“Lite-Touch” Regulatory Approach for Certain CFTC Registrants

In general, CFTC registered CPOs and CTAs must adhere to certain disclosure and reporting requirements as specified in the Commodity Exchange Act (“CEA”) and regulations thereunder.  However, some CFTC registered firms can operate under a “lite-touch” regulatory regime if the firm only provides investment management services to qualified eligible persons.  The lite-touch regulatory regime is available under CFTC Rule 4.7 to both CPOs and CTAs who file the exemption with the NFA.

This post will provide an overview of the firms which are eligible for the exemption and an overview of the relief granted.  We post the entire text of the exemption at the end of this post.

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Eligibility for Exemption

In general, the exemption is available for firms which meet the following requirements:

  1. Registered with the CFTC as a CPO or CTA
  2. Investors/Clients are only qualified eligible persons (QEPs)
  3. 4.7 Exemption filed with the NFA
  4. Offering/Disclosure Documents contain CFTC disclaimer

The central reason why some firms will want to utilize the exemption is to keep from going through the disclosure document review process with the NFA which can take anywhere from 3 weeks to 3 months depending on a number of factors.  Please note that firms must already be registered with the CFTC which means that Principals and APs will generally need to have the Series 3 exam license.  If a CPO wants to remain unregistered, the firm may be able to use the 4.13(a)(4) exemption instead of the 4.7 exemption.

Filing the Exemption

To file the notice for exemption, the firm will need to access the NFA’s online registration system and complete the required exemption filing.  In order to claim the exemption, the CPO or CTA will be required to certify that:

  • neither the CPO/CTA nor its Principals are subject to statutory disqualifications under sections 8a(2) or 8a(3) of the CEA;
  • the CPO/CTA will comply with the applicable requirements of Rule 4.7 (see below for full text of rule);
  • and for CPOs, that the exempt pool will be offered and operated in compliance with the requirements of Rule 4.7.

Generally, the exemption becomes effective upon filing, assuming there are no errors with the filing.  It is important to note that the exemption ceases to be effective once a CPO’s/CTA’s circumstances change rendering it ineligible for the exemption.  The CPO/CTA must promptly notify the NFA of such change.

Requirements From Which CPO/CTA is Exempt

Under the 4.7 exemption, CPOs are granted the following:

  • Disclosure Relief
    • exempt from delivering to potential investors disclosure documents pursuant to Rule 4.21 or file/submit amendments of disclosure documents with the NFA pursuant to Rule 4.26
    • exempt from the specific disclosure document requirements pursuant to Rule 4.24 (e.g. risk disclosure statements, potential conflicts of interest, risk factors, etc.)
    • exempt from the performance disclosure requirements pursuant to Rule 4.25

*If the CPO chooses to provide investors with an offering memorandum, it must not be misleading and must contain the risk disclosure statement pursuant to Rule 4.7(b)(1).

  • Reporting Relief
    • exempt from the full reporting requirements to Rule 4.22(a)( and (b) but the CPO must provide investors with a quarterly statement within 30 days of the end of the quarter which includes: (i) NAV of the exempt pool, (ii) change in NAV, and (iii) NAV per outstanding interest
  • Annual Report Relief
    • exempt from the annual reporting requirements of Rule 4.22(c) and (d) but the CPO must file and distribute, within 90 days of the end of the year, an annual report for the exempt pool that contain: (i) a statement of financial condition, (ii) statement of income, (iii) footnote disclosures and other material information
  • Recordkeeping relief
    • exempt from the full recordkeeping requirements of Rule 4.23 but the CPO must maintain the reports discussed above and all books and records related to the exempt pool in accordance with Rule 1.31

Under the 4.7 exemption, CTAs are granted the following:

  • Disclosure Relief
    • the CTA is similarly exempt from disclosure documents requirements pursuant to Rule 4.31, 4.34, 4.35, and 4.36
  • Recordkeeping Relief
    • exempt from the full recordkeeping requirements of Rule 4.33 but the CTA must maintain all books and records related to the exempt accounts in accordance with Rule 1.31

Important Items to Note

  • 4.7 Exempt CPOs will still need to file quarterly NFA Rule 2-46 reports for the funds which they manage.
  • CPOs must remember that while they may file a Rule 4.7 exemption for a particular pool and thus be exempt from the above requirements, the CPO is not exempt as related to the other non-exempt pools that it may operate.

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The full text of Rule 4.7 is reprinted below:

§ 4.7   Exemption from certain part 4 requirements for commodity pool operators with respect to offerings to qualified eligible persons and for commodity trading advisors with respect to advising qualified eligible persons.

This section is organized as follows: Paragraph (a) contains definitions for the purposes of §4.7; paragraph (b) contains the relief available to commodity pool operators under §4.7; paragraph (c) contains the relief available to commodity trading advisors under §4.7; paragraph (d) concerns the Notice of Claim for Exemption under §4.7; and paragraph (e) addresses the effect of an insignificant deviation from a term, condition or requirement of §4.7.

(a) Definitions…..[intentionally omitted

(b) Relief available to commodity pool operators. Upon filing the notice required by paragraph (d) of this section, and subject to compliance with the conditions specified in paragraph (d) of this section, any registered commodity pool operator who offers or sells participations in a pool solely to qualified eligible persons in an offering which qualifies for exemption from the registration requirements of the Securities Act pursuant to section 4(2) of that Act or pursuant to Regulation S, 17 CFR 230.901 et seq., and any bank registered as a commodity pool operator in connection with a pool that is a collective trust fund whose securities are exempt from registration under the Securities Act pursuant to section 3(a)(2) of that Act and are offered or sold, without marketing to the public, solely to qualified eligible persons, may claim any or all of the following relief with respect to such pool:

(1) Disclosure relief.

(i) Exemption from the specific requirements of §§4.21, 4.24, 4.25 and 4.26 with respect to each exempt pool; Provided, That if an offering memorandum is distributed in connection with soliciting prospective participants in the exempt pool, such offering memorandum must include all disclosures necessary to make the information contained therein, in the context in which it is furnished, not misleading; and that the following statement is prominently disclosed on the cover page of the offering memorandum, or, if none is provided, immediately above the signature line on the subscription agreement or other document that the prospective participant must execute to become a participant in the pool:

“PURSUANT TO AN EXEMPTION FROM THE COMMODITY FUTURES TRADING COMMISSION IN CONNECTION WITH POOLS WHOSE PARTICIPANTS ARE LIMITED TO QUALIFIED ELIGIBLE PERSONS, AN OFFERING MEMORANDUM FOR THIS POOL IS NOT REQUIRED TO BE, AND HAS NOT BEEN, FILED WITH THE COMMISSION. THE COMMODITY FUTURES TRADING COMMISSION DOES NOT PASS UPON THE MERITS OF PARTICIPATING IN A POOL OR UPON THE ADEQUACY OR ACCURACY OF AN OFFERING MEMORANDUM. CONSEQUENTLY, THE COMMODITY FUTURES TRADING COMMISSION HAS NOT REVIEWED OR APPROVED THIS OFFERING OR ANY OFFERING MEMORANDUM FOR THIS POOL.”

(ii) Exemption from disclosing the past performance of exempt pools in the Disclosure Document of non-exempt pools except to the extent that such past performance is material to the non-exempt pool being offered; Provided, That a pool operator that has claimed exemption hereunder and elects not to disclose any such performance in the Disclosure Document of non-exempt pools shall state in a footnote to the performance disclosure therein that the operator is operating or has operated exempt pools whose performance is not disclosed in this Disclosure Document.

(2) Periodic reporting relief . Exemption from the specific requirements of §§4.22(a) and (b); Provided, That a statement signed and affirmed in accordance with §4.22(h) is prepared and distributed to pool participants no less frequently than quarterly within 30 calendar days after the end of the reporting period. This statement must be presented and computed in accordance with generally accepted accounting principles and indicate:

(i) The net asset value of the exempt pool as of the end of the reporting period;

(ii) The change in net asset value from the end of the previous reporting period; and

(iii) The net asset value per outstanding unit of participation in the exempt pool as of the end of the reporting period.

(A) Either the net asset value per outstanding participation unit in the exempt pool as of the end of the reporting period, or

(B) The total value of the participant’s interest or share in the exempt pool as of the end of the reporting period.

(iv) Where the pool is comprised of more than one ownership class or series, the net asset value of the series or class on which the account statement is reporting, and the net asset value per unit or value of the participant’s share, also must be included in the statement required by this paragraph (b)(2); except that, for a pool that is a series fund structured with a limitation on liability among the different series, the account statement required by this paragraph (b)(2) is not required to include the consolidated net asset value of all series of the pool.

(v) A commodity pool operator of a pool that meets the conditions specified in §4.22(d)(2)(i) of this part to present and compute the commodity pool’s financial statements contained in the Annual Report in accordance with International Financial Reporting Standards issued by the International Accounting Standards Board and has filed notice pursuant to §4.22(d)(2)(ii) of this part also may use such International Financial Reporting Standards in the computation and presentation of the account statement.

(3) Annual report relief.

(i) Exemption from the specific requirements of §4.22(c) and (d) of this part; Provided, That within 90 calendar days after the end of the exempt pool’s fiscal year

or the permanent cessation of trading, whichever is earlier, the commodity pool operator electronically files with the National Futures Association and distributes to each participant in lieu of the financial information and statements specified by those sections, an annual report for the exempt pool, affirmed in accordance with §4.22(h) which contains, at a minimum:

(A) A Statement of Financial Condition as of the close of the exempt pool’s fiscal year (elected in accordance with §4.22(g));

(B) A Statement of Operations for that year;

(C) Appropriate footnote disclosure and such further material information as may be necessary to make the required statements not misleading. For a pool that invests in other funds, this information must include, but is not limited to, separately disclosing the amounts of income, management and incentive fees associated with each investment in an investee fund that exceeds five percent of the pool’s net assets. The income, management and incentive fees associated with an investment in an investee fund that is less than five percent of the pool’s net assets may be combined and reported in the aggregate with the income, management and incentive fees of other investee funds that, individually, represent an investment of less than five percent of the pool’s net assets. If the commodity pool operator is not able to obtain the specific amounts of management and incentive fees charged by an investee fund, the commodity pool operator must disclose the percentage amounts and computational basis for each such fee and include a statement that the CPO is not able to obtain the specific fee amounts for this fund;

(D) Where the pool is comprised of more than one ownership class or series, information for the series or class on which the financial statements are reporting should be presented in addition to the information presented for the pool as a whole; except that, for a pool that is a series fund structured with a limitation on liability among the different series, the financial statements are not required to include consolidated information for all series.

(ii) Except as provided in §4.22(d)(2) of this part, such annual report must be presented and computed in accordance with generally accepted accounting principles consistently applied and, if certified by an independent public accountant, so certified in accordance with §1.16 of this chapter as applicable.

(iii) Legend.

(A) If a claim for exemption has been made pursuant to this section, the commodity pool operator must make a statement to that effect on the cover page of each annual report.

(B) If the annual report is not certified in accordance with §1.16, the pool operator must make a statement to that effect on the cover page of each annual report and state that a certified audit will be provided upon the request of the holders of a majority of the units of participation in the pool who are unaffiliated with the commodity pool operator.

(4) Recordkeeping relief. Exemption from the specific requirements of §4.23; Provided, That the commodity pool operator must maintain the reports referred to in paragraphs (b)(2) and (b)(3) of this section and all books and records prepared in connection with his activities as the pool operator of the exempt pool (including, without limitation, records relating to the qualifications of qualified eligible persons and substantiating any performance representations) at his main business address and must make such books and records available to any representative of the Commission, the National Futures Association and the United States Department of Justice in accordance with the provisions of §1.31.

(c) Relief available to commodity trading advisors. Upon filing the notice required by paragraph (d) of this section, and subject to compliance with the conditions specified in paragraph (d) of this section, any registered commodity trading advisor who anticipates directing or guiding the commodity interest accounts of qualified eligible persons may claim any or all of the following relief with respect to the accounts of qualified eligible persons who have given due consent to their account being an exempt account under §4.7:

(1) Disclosure relief.

(i) Exemption from the specific requirements of §§4.31, 4.34, 4.35 and 4.36; Provided, That if the commodity trading advisor delivers a brochure or other disclosure statement to such qualified eligible persons, such brochure or statement shall include all additional disclosures necessary to make the information contained therein, in the context in which it is furnished, not misleading; and that the following statement is prominently displayed on the cover page of the brochure or statement or, if none is provided, immediately above the signature line of the agreement that the client must execute before it opens an account with the commodity trading advisor:

“PURSUANT TO AN EXEMPTION FROM THE COMMODITY FUTURES TRADING COMMISSION IN CONNECTION WITH ACCOUNTS OF QUALIFIED ELIGIBLE PERSONS, THIS BROCHURE OR ACCOUNT DOCUMENT IS NOT REQUIRED TO BE, AND HAS NOT BEEN, FILED WITH THE COMMISSION. THE COMMODITY FUTURES TRADING COMMISSION DOES NOT PASS UPON THE MERITS OF PARTICIPATING IN A TRADING PROGRAM OR UPON THE ADEQUACY OR ACCURACY OF COMMODITY TRADING ADVISOR DISCLOSURE. CONSEQUENTLY, THE COMMODITY FUTURES TRADING COMMISSION HAS NOT REVIEWED OR APPROVED THIS TRADING PROGRAM OR THIS BROCHURE OR ACCOUNT DOCUMENT.”

(ii) Exemption from disclosing the past performance of exempt accounts in the Disclosure Document for non-exempt accounts except to the extent that such past performance is material to the non-exempt account being offered; Provided, That a commodity trading advisor that has claimed exemption hereunder and elects not to disclose any such performance in the Disclosure Document for non-exempt accounts shall state in a footnote to the performance disclosure therein that the advisor is advising or has advised exempt accounts for qualified eligible persons whose performance is not disclosed in this Disclosure Document.

(2) Recordkeeping relief. Exemption from the specific requirements of §4.33; Provided, That the commodity trading advisor must maintain, at its main business office, all books and records prepared in connection with his activities as the commodity trading advisor of qualified eligible persons (including, without limitation, records relating to the qualifications of such qualified eligible persons and substantiating any performance representations) and must make such books and records available to any representative of the Commission, the National Futures Association and the United States Department of Justice in accordance with the provisions of §1.31.

(d) Notice of claim for exemption.

(1) A notice of a claim for exemption under this section must:

(i) Provide the name, main business address, main business telephone number and the National Futures Association commodity pool operator or commodity trading advisor identification number of the person claiming the exemption;

(ii)

(A) Where the claimant is a commodity pool operator, provide the name(s) of the pool(s) for which the request is made; Provided, That a single notice representing that the pool operator anticipates operating single-investor pools may be filed to claim exemption for single-investor pools and such notice need not name each such pool;

(B) Where the claimant is a commodity trading advisor, contain a representation that the trading advisor anticipates providing commodity interest trading advice to qualified eligible persons;

(iii) Contain representations that:

(A) Neither the commodity pool operator or commodity trading advisor nor any of its principals is subject to any statutory disqualification under section 8a(2) or 8a(3) of the Act unless such disqualification arises from a matter which was previously disclosed in connection with a previous application for registration if such registration was granted or which was disclosed more than thirty days prior to the filing of the notice under this paragraph (d);

(B) The commodity pool operator or commodity trading advisor will comply with the applicable requirements of §4.7; and

(C) Where the claimant is a commodity pool operator, that the exempt pool will be offered and operated in compliance with the applicable requirements of §4.7;

(iv) Specify the relief claimed under §4.7;

(v) Where the claimant is a commodity pool operator, state the closing date of the offering or that the offering will be continuous;

(vi) Be filed by a representative duly authorized to bind the commodity pool operator or commodity trading advisor;

(vii) Be filed electronically with the National Futures Association through its electronic exemption filing system; and

(viii)

(A)

( 1 ) Where the claimant is a commodity pool operator, except as provided in paragraph (d)(1)(ii)(A) of this section with respect to single-investor pools and in paragraph (d)(1)(viii)(A)( 2 ) of this section, be received by the National Futures Association:

( i ) Before the date the pool first enters into a commodity interest transaction, if the relief claimed is limited to that provided under paragraphs (b)(2), (3) and (4) of this section; or

( ii ) Prior to any offer or sale of any participation in the exempt pool if the claimed relief includes that provided under paragraph (b)(1) of this section.

( 2 ) Where participations in a pool have been offered or sold in full compliance with part 4, the notice of a claim for exemption may be filed with the National Futures Association at any time; Provided, That the claim for exemption is otherwise consistent with the duties of the commodity pool operator and the rights of pool participants and that the commodity pool operator notifies the pool participants of his intention, absent objection by the holders of a majority of the units of participation in the pool who are unaffiliated with the commodity pool operator within twenty-one days after the date of the notification, to file a notice of claim for exemption under §4.7 and such holders have not objected within such period. A commodity pool operator filing a notice under this paragraph (d)(1)(viii)(A)( 2 ) shall either provide disclosure and reporting in accordance with the requirements of part 4 to those participants objecting to the filing of such notice or allow such participants to redeem their units of participation in the pool within three months of the filing of such notice.

(B) Where the claimant is a commodity trading advisor, be received by the Commission before the date the trading advisor first enters into an agreement to direct or guide the commodity interest account of a qualified eligible person pursuant to §4.7.

(2) The notice will be effective upon receipt by the National Futures Association with respect to each pool for which it was made where the claimant is a commodity pool operator and otherwise generally where the claimant is a commodity trading advisor; Provided, That any notice which does not include all the required information shall not be effective, and that if at the time the National Futures Association receives the notice an enforcement proceeding brought by the Commission under the Act or the regulations is pending against the pool operator or trading advisor or any of its principals, the exemption will not be effective until twenty-one calendar days after receipt of the notice by the National Futures Association and that in such case an exemption may be denied by the Commission or the National Futures Association or made subject to such conditions as the Commission or the National Futures Association may impose.

(3) Any exemption claimed hereunder shall cease to be effective upon any change which would cause the commodity pool operator of an exempt pool to be ineligible for the relief claimed with respect to such pool or which would cause a commodity trading advisor to be ineligible for the relief claimed. The pool operator or trading advisor must promptly file a notice advising the National Futures Association of such change.

(4)

(i) Any exemption from the requirements of §4.21, 4.22, 4.23, 4.24, 4.25 or 4.26 claimed hereunder with respect to a pool shall not affect the obligation of the commodity pool operator to comply with all other applicable provisions of part 4, the Act and the Commission’s rules and regulations, with respect to the pool and any other pool the pool operator operates or intends to operate.

(ii) Any exemption from the requirements of §4.31, 4.33, 4.34, 4.35 or 4.36 claimed hereunder shall not affect the obligation of the commodity trading advisor to comply with all other applicable provisions of part 4, the Act and the Commission’s rules and regulations, with respect to any qualified eligible person and any other client to which the commodity trading advisor provides or intends to provide commodity interest trading advice.

(e) Insignificant deviations from a term, condition or requirement of §4.7.

(1) A failure to comply with a term or condition of §4.7 will not result in the loss of the exemption with respect to a particular pool or client if the commodity pool operator or the commodity trading advisor relying on the exemption shows that:

(i) The failure to comply did not pertain to a term, condition or requirement directly intended to protect that particular qualified eligible person;

(ii) The failure to comply was insignificant with respect to the exempt pool as a whole or to the particular exempt account; and

(iii) A good faith and reasonable attempt was made to comply with all applicable terms, conditions and requirements of §4.7.

(2) A transaction made in reliance on §4.7 must comply with all applicable terms, conditions and requirements of §4.7. Where an exemption is established only through reliance upon paragraph (e)(1) of this section, the failure to comply shall nonetheless be actionable by the Commission.

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Cole-Frieman & Mallon LLP provides comprehensive legal, registration and compliance services for CFTC registered firms.  Bart Mallon can be reached directly at 415-868-5345.