CFTC Notice to CPOs re: Annual Reporting Requirement

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As we discussed in our post on NFA annual compliance obligations, commodity pool operators will need to submit annual audited reports to the NFA by March 31 of this year.  This requirement applies generally to all CPOs unless the CPO requests exemptive relief from the annual audit requirement.

The CFTC has provided the following notice to remind CPOs about this annual requirement and to also provide some resources to managers regarding the technical aspects of the audit requirement.  The CFTC is recommending that managers provide their audit firms with the notice below so the firm can appropriate prepare the audited finacial statements.

The full notice is reprinted in full below.

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U.S. Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st Street, NW, Washington, DC 20581
Telephone: (202) 418-5430
Facsimile: (202) 418-5536

February 2, 2011

To: All Commodity Pool Operators
Attention: Chief Financial Officer
Subject: Annual Reporting for Commodity Pools

The Division of Clearing and Intermediary Oversight (“DCIO” or “Division”) of the Commodity Futures Trading Commission (“CFTC” or “Commission”) is issuing this letter to assist commodity pool operators (“CPOs”) with the preparation and filing of commodity pool annual financial reports required under the Commodity Exchange Act (“Act”) and Commission regulations.1  This letter highlights current regulatory changes affecting CPOs with respect to financial filings and provides reminders of regulatory requirements in response to common deficiencies observed in prior years’ annual reports.  CPOs, including those that operate in non-U.S. jurisdictions, are encouraged to provide this letter to their public accountants and others assisting in the preparation of commodity pool annual financial statements.

The Division has issued similar guidance letters in prior years, which are available at the Commission’s website.2  Those letters should be consulted as they contain information relevant for many commodity pools, including the following topics:

In addition, CFTC interpretations and other staff letters that provide written guidance concerning the Act and the Commission’s regulations are available on the Commission’s website.  In particular, an illustrative example regarding Regulation 4.22(e)(2) is available in CFTC Interpretative Letter 94-3 (http://www.cftc.gov/tm/tm94-03.htm), Special Allocations of Investment Partnership Equity.

I. Recent Regulatory Activity

The CFTC issued final forex rules, which became effective on October 18, 2010.   Any firm acting as a counterparty to certain off-exchange forex transactions involving retail persons is required to register as a Retail Foreign Exchange Dealer. In addition, any individual acting as a forex solicitor, account manager and/or pool operator is required to register with the Commission as an Introducing Broker, Commodity Trading Advisor (CTA) or CPO, as appropriate, and to become a member of the National Futures Association (NFA).

NFA also adopted compliance rules applicable to CPOs as follows:

  • Rule 2-45 prohibits a CPO from permitting a commodity pool to use any means to make a direct or indirect loan or advance of pool assets to the CPO or any person or entity affiliated with the CPO.
  • Rule 2-46 requires each CPO that is a member of NFA to file, on a quarterly basis, with NFA, the following information for each pool the CPO operates that is subject to a reporting requirement under Regulation 4.22 (which includes exempt pools under Commission Regulation 4.7):
    • the identity of the pool’s administrator, carry broker(s), trading manager(s) and custodian(s);
    • a statement of changes in net asset value for the quarterly reporting period;
    • monthly performance for the three months comprising the quarterly reporting period; and
    • a schedule of investments identifying any investment that exceeds 10% of the pool’s net asset value at the end of the quarterly reporting period.

Such information must be filed with NFA within 45 days of the end of the quarterly reporting period, and must be filed using NFA Easyfile electronic filing system.

NFA also updated the Self Examination Checklist for CPOs and CTAs as of September 2010. NFA Compliance Rule 2-9 (Supervision) requires members to review their operations on a yearly basis using the NFA self-examination checklist

II. Filing Deadlines and Procedures for Commodity Pool Annual Reports

Commission regulations establish the dates by which commodity pool annual reports must be provided to pool participants and received by the NFA.

Specifically, Commission regulations provide that:

  • Commodity pool annual reports must be distributed to pool participants and filed with NFA within 90 calendar days of the pool’s fiscal year end.  The filing date for annual reports with a year end of December 31, 2010 is March 31, 2011.  Copies of the annual reports must be filed with the NFA.  A CPO should not file copies of the annual reports with the Commission.
  • CPOs must submit annual reports to NFA electronically in accordance with NFA’s EasyFile electronic filing system (http://www.nfa.futures.org/NFA-electronic-filings/easyFile-Pool-filers.HTML) and procedures.
  • An annual report may be distributed in hardcopy or electronically to pool participants.  The CPO, however, must obtain a participant’s prior consent to distribute an annual report in electronic format.
  • Applications for an extension of time to file an annual report must be submitted to NFA prior to the annual report due date and must include the information required by Regulation 4.22(f)(1).  Any request for an extension of time that exceeds 90 days from the original due date must be submitted to the Commission, and a copy filed with NFA.  The Commission generally does not grant extensions that would exceed 90 days from the original due date.
  • CPOs of commodity pools that invest in other collective investment vehicles may obtain an “automatic” 90-day extension of the distribution and filing due date by submitting the information specified by Regulation 4.22(f)(2) to NFA prior to the original due date.  In subsequent years, the CPO will be presumed to operate the pool as a fund of funds and continue to qualify for the automatic extension.  However, the CPO is obligated to inform the NFA if those circumstances change and to begin filing within the standard 90-day time frame.  In addition, this extension of time has been made available to Regulation 4.7 exempt pools, even if the report is not audited by a certified public accountant.
  • Draft financial statements.  Some CPOs have filed incomplete, or “draft,” unaudited financial statements for pools exempt under Regulation 4.7 to meet the due dates for such filings.  CPOs are reminded that although Regulation 4.7 provides exemption from certain requirements, including the requirement that financial statements be subject to an audit by a certified public accountant, annual reports filed with NFA and distributed to pool participants must include all required information and be in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”) or, in some instances, International Financial Reporting Standards (“IFRS”) to be considered timely filed.  Draft unaudited financial statements do not satisfy the filing requirements.

III. Master/Feeder and Fund of Funds

Master/Feeder Structures. FASB ASC 946-205-45-6 permits nonpublic feeder pools either to follow the disclosure and reporting provisions of FASB ASC 946-210, or to present a complete set of master financial statements with each feeder financial statement.

Fund of Funds. Year end  pool financial statements must disclose specific income and fee information for investee pools as specified in Regulation 4.22(c)(5).  CPOs must disclose amounts of income and fees associated with investments in investment partnerships that exceed five percent of the commodity pool’s net assets.  Illustrative disclosures are in Attachment B to this letter.

If a commodity pool’s annual financial statements are found deficient with respect to compliance with GAAP, the CPO may be required to revise the commodity pool’s financial statements, distribute the revised statements to participants, and re-file the statements with NFA.

IV. Requests for Limited Relief from U.S. GAAP Compliance for Certain Offshore Commodity Pools

Regulation 4.22(d)(2), applicable to year end  annual reports,  permits CPOs that operate commodity pools organized under the laws of a non-U.S. jurisdiction to prepare financial statements for such pools using IFRS, provided that:

  • The use of IFRS does not conflict with any representations made in the pool’s offering memorandum or other operative document;
  • The IFRS financial statements contain a condensed schedule of investments as required by U.S. GAAP (FASB ASC 946-210-50), or, if required, a full schedule of investments;
  • The IFRS financial statements report any special allocations of partnership equity in accordance with Commission Regulation 4.22(e)(2); and
  • If IFRS would require that the pool consolidate its financial statements with another entity, such as a feeder fund consolidating with its master fund, all applicable disclosures required by U.S. GAAP for the feeder fund must be presented with the reporting pool’s consolidated financial statements.

To claim the relief to use IFRS accounting standards, the CPO must file a notice with NFA within 90 days after the end of the pool’s fiscal year.  Furthermore, Regulations 4.22(a)(5) and 4.7(b)(2) permit a CPO to present a pool’s periodic account statements and other disclosure documents on the same basis as that of its annual report.

In addition, Division staff has, on a case-by-case basis, provided limited relief to CPOs that operate offshore pools by allowing such commodity pools to prepare and to present their financial statements in accordance with another comprehensive basis of accounting other than IFRS, such as United Kingdom or Irish accounting standards, instead of U.S. GAAP.  In each case, the Division’s relief to use accounting standards other than U.S. GAAP was conditioned upon the offshore pool following the additional elements now required by Regulation 4.22(d)(2)(i).

CPOs seeking to prepare and present their offshore pools’ financial statements on another comprehensive basis of accounting other than IFRS may request relief from the U.S. GAAP requirement by submitting their requests, enumerating compliance with each of the elements specified in Regulation 4.22(d)(2), to the undersigned at the address shown on this letterhead.  If you have any further questions, contact Ronald Carletta, Branch Chief, or Al Goll, Auditor, at the phone numbers or addresses listed in Attachment A.

V. Reports of Liquidating Pools

Commission Regulation 4.22(c)(7) provides for the filing and distribution of a final annual report within 90 days of a pool’s permanent cessation of trading.  Alternatively, the CPO of a liquidating pool may provide the following information within 90 days of the permanent cessation of trading in lieu of an otherwise required final annual report:

  • Statements of Operations and Changes in Net Assets for the relevant period as contained in the regulation; and,
  • An explanation of the winding down of the pool’s operations with written disclosure that all interests in, and assets of, the pool have been redeemed, distributed, or transferred on behalf of participants; or
  • In the event that all interests in, and assets of, the pool have not been distributed, redeemed, or transferred to participants by the time the final report is issued, the CPO must disclose the value of assets remaining to be distributed and an approximate timeframe for when the CPO expects distribution to occur.  If the CPO is unable to complete distribution within the estimated timeframe, the CPO must update the above detailed information to both NFA and the pool’s participants in writing.

If the CPO is not able to liquidate the pool’s assets within time to prepare, file, and distribute the final annual report as prescribed by the regulation, Commission Regulation 4.22(c)(7) requires the CPO to provide written notice to each participant and NFA, disclosing the following:

  • The value of assets remaining to be liquidated, the timeframe within which liquidation is expected to occur, any impediments to liquidation and any fees or expenses that will be charged to the pool prior to final distribution;
  • Which financial reports the CPO will continue to provide to participants from the time of the cessation of trading until the final annual report is distributed, and the frequency of such reports, pursuant to the pool’s constitutive documents; and
  • The timing of the final annual report.

Additionally, a CPO who is availing itself of the alternative filing in lieu of a final annual report may file unaudited information provided that the CPO obtains waivers from all participants and certifies the same to NFA when the final report is filed.

This relief also is applicable for pools that have claimed an exemption under Regulations 4.7 or 4.12.

VI. Accounting Resources

A. FASB Accounting Standards Codification

On July 1, 2009 the Financial Accounting Standards Board (FASB) launched the FASB Accounting Standards Codification (the Codification) as the single source of authoritative nongovernmental U.S. GAAP.  Although the FASB does not provide guidance in how specific requirements of GAAP are referred to in footnotes of financial statements, it notes that prior to the issuance of the Codification it was not unusual for footnotes to refer to specific standard numbers (for example, “as required by Statement 133”). Because these references are no longer the source of GAAP, such references will change. The FASB encourages the use of plain English to describe broad Topic references in the future. For example, to refer to the requirements of the Derivatives and Hedging Topic, they suggest a reference similar to “as required by the Derivatives and Hedging Topic of the FASB Accounting Standards Codification” and not use the specific numeric reference.

B. AICPA Commodities Audit Practice Aid

The AICPA Audit Practice Aid, Audits of Futures Commission Merchants, Introducing Brokers, and Commodity Pools Second Edition (product number 006639), is a useful tool for auditors and accountants of commodity entities.  It can be purchased at the AICPA website: http://www.CPA2biz.com.  CPOs and public accountants should also ensure that they monitor the Commission for recent developments which may not be reflected in the Audit Practice Aid.

C. AICPA Audit Risk Alert

The AICPA 2010 Audit Risk Alert (“ARA”) Financial Institutions Industry Developments, Including Depository and Lending Institutions and Brokers and Dealers in Securities contains sections on the commodities industry.  The ARA can be purchased at the AICPA website: http://www.CPA2biz.com.

D. FASB ASC Topic 820 (Formerly FAS 157, Fair Value Measurements)

Resources that may be helpful in understanding and applying FASB ASC Topic 820 are:

  • Measurements of Fair Value in Illiquid (or Less Liquid) Markets, issued by the AICPA Center for Audit Quality available at http://www.thecaq.org/resources/pdfs/MeasurementsIlliquidMarkets.pdf.
  • ASC 275-10-50, Risks and Uncertainties (AICPA Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties, when auditing financial statements that contain complex fair value measurements);
  • ASC 820-10, Fair Value Measurements and Disclosure: Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent) –  (guidance that generally the net asset value reported by investee investment companies will continue to be an acceptable fair value indicator, with certain exceptions.)

E. AICPA Technical Guidance

Beginning at paragraph 8.23, the AICPA Audit and Accounting Guide, Investment Companies (May 1, 2010 edition) discusses organization and offering costs.  The AICPA issued technical guidance regarding accounting treatment of offering costs incurred by investment partnerships.3  This guidance:

  • Provides that investment partnerships that continually offer interests should defer offering costs incurred prior to commencement of operations and then amortize such costs, generally on straight-line basis, over the time period that it continually offers interests, up to a maximum of 12 months; and
  • Defines the phrase “continually offer interests.”

Registrants are reminded that organization costs are not affected by this guidance and must be charged to expense as incurred as required by FASB Codification Section 720-15-25-1 (AICPA SOP No. 98-5,

Reporting on the Costs of Start-up Activities.)  However, if appropriately disclosed to investors and potential investors, net asset value used to compute investment entrance and exit values, may be adjusted to amortize such costs differently, but generally not to exceed a period of 60 months.

IX. DCIO and NFA Contact Information

If a CPO, a public accountant, or other member of the public has any questions on the foregoing, please feel free to contact the DCIO staff or NFA staff listed in Attachment A to this letter.

Very truly yours,

Thomas J. Smith
Director and
Chief Accountant

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1 The Act is codified at 7 U.S.C. paragraph 1 et seq.  The Commission’s regulations are found in Title 17 of the Code of Federal Regulations.  The Commission’s internet website, www.cftc.gov, provides links to both the Act and Commission regulations.

2 Prior letters from 1998 forward are available at the Commission’s website at http://www.cftc.gov/industryoversight/intermediaries/guidancecporeports.html.

3 See paragraph 8.33 of the AICPA Audit and Accounting Guide, Investment Companies (May 1, 2010 edition).

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ATTACHMENT A
CFTC DIVISION OF CLEARING AND INTERMEDIARY OVERSIGHT CONTACT INFORMATION

Regional Office Locations
Eastern Region
140 Broadway, 19th Floor
New York, NY 10005-1146

Contacts
Ronald A. Carletta
Phone: (646)-746-9726
E-Mail: [email protected]

Al Goll
Phone: (646)-746-9723
E-Mail: [email protected]

Fax: (646)-746-9937

Location of CPO’s Principal Office
All states east of the Mississippi River, except Illinois, Indiana, Michigan, Ohio, and Wisconsin. Any location outside of the United States

Regional Office Locations
Central Region
525 West Monroe Street
Suite 1100
Chicago, IL 60661

Contacts
Lisa M. Marlow
Phone: 312-596-0566
Fax: 312-596-0711
E-Mail: [email protected]

Location of CPO’s Principal Office
Illinois, Indiana, Michigan, Ohio, and Wisconsin

Regional Office Locations
Southwestern Region
Two Emanuel Cleaver II Boulevard, Suite 300
Kansas City, MO 64112

Contacts
Kurt Harms
Phone: 816-960-7711
Fax: 816-960-7750
E-Mail: [email protected]

Location of CPO’s Principal Office
All states west of the Mississippi River

National Futures Association Contact Information

National Futures Association
300 South Riverside Plaza,
Suite 1800
Chicago, IL 60606

Tracy Hunt, Senior Manager, Compliance
Phone: 312-781-1284
Fax: 312-559-3453

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Cole-Frieman & Mallon LLP provides comprehensive compliance and regulatory support for CTAs and CPOs.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

NFA 2011 Annual Regulatory Reminder

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Earlier this year we provided a general overview of the annual compliance requirements for CPOs and CTAs.  The NFA has just released their annual reminder for all CFTC registratants (including IBs, FCMs and RFEDs).  The NFA notice, reprinted below in full, provides a good overview of what CFTC registered firms need to be focusing on during the next month or so.

CFTC registered firms are reminded that now is a good time to review and revise their compliance manuals and complete the NFA self-examination process.

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Notice I-11-06
February 03, 2011

Annual Regulatory Reminder

National Futures Association has always been committed to providing our Members with the resources they need to meet their regulatory obligations as efficiently as possible. Therefore, we are providing you with an annual reminder regarding certain requirements that are not part of your day-to-day operations. This list does not capture all of your responsibilities for the upcoming year, but it should help remind you of certain non-routine requirements.

Within the next 12 months you will be required to:

  1. Complete the Annual Update process on the anniversary date of your firm’s registration. This process includes (1) completing the electronic Annual Registration Update; (2) electronically submitting the firm’s Annual Questionnaire on NFA’s website and (3) paying your annual registration fees and NFA dues.  Failure to satisfy all of the requirements in the annual update process within 30 days of your anniversary date will result in the withdrawal of your firm’s NFA registration and/or Membership. NFA’s BASIC system displays information reflecting whether or not firms are actively engaged in futures-related business activity or retail off-exchange foreign currency activities. If you commence operations, you should update your Questionnaire in order to change how your status is displayed in BASIC.
  2. Complete NFA’s Self-Examination Checklist located on NFA’s website at http://www.nfa.futures.org/NFA-compliance/publication-library/self-exam-checklist.HTML.
  3. Send your firm’s Privacy Policy to every current customer, client and pool participant (in addition to sending it to every new customer when the customer opens an account, enters into an advisory agreement, or purchases a subscription). For guidance in preparing your policy, please consult NFA’s Privacy Policy questionnaire (Appendix D of the Self-Exam Checklist).
  4. Test your Disaster Recovery Plan and make any necessary adjustments. For guidance in preparing your plan, please consult NFA’s Business Continuity and Disaster Recovery Plan questionnaire (Appendix B of the Self-Exam Checklist).
  5. Provide Ethics Training as outlined in your firm’s written Ethics Training Procedures. For guidance in developing your procedure, please consult NFA’s Ethics Training Policy questionnaire (Appendix C of the Self-Exam Checklist).
  6. Supervise the operations of any Branch Offices, including conducting an annual onsite inspection of every Branch Office.

If you are a registered Commodity Trading Advisor, you will also be required to:

  1. File any new exemption notices electronically through NFA’s Exemption System.
  2. If soliciting new clients, distribute a Disclosure Document that is no more than 9 months old and that has been reviewed and accepted by NFA. Ensure that the document includes a complete business background and discloses all potentialconflicts of interest in accordance with NFA’s recent guidance. Disclosure Documents should be filed electronically throughNFA’s Disclosure Document System.
  3. If placing bunched orders, analyze each trading program at least quarterly to ensure that the order allocation method has been fair and equitable and document this analysis.
  4. The FCM that carries your client accounts will be contacting your clients to verify that the information obtained under NFA Compliance Rule 2-30(c) remains materially accurate, and provide the client with an opportunity to correct and complete the information. If the FCM notifies you of any material changes to the information, assess whether additional risk disclosure is required to be provided to the client based on the changed information.

If you are a registered Commodity Pool Operator, you will also be required to:

  1. File any new exemption notices electronically through NFA’s Exemption System.
  2. If soliciting new pool participants, distribute a Disclosure Document that is no more than 9 months old and that has been reviewed and accepted by NFA. Ensure that the document includes a complete business background and discloses all potential conflicts of interest in accordance with NFA’s recent guidance. Disclosure Documents should be filed electronically through NFA’s Disclosure Document System.
  3. Update your CPO Questionnaire on NFA’s website for any pools that have liquidated.
  4. Submit to NFA through NFA’s EasyFile system, and distribute to current participants, a certified Annual Report for each pool as of the close of the pool’s fiscal year. CFTC Regulations require Commodity Pool Operators to follow strict deadlines and filing requirements, and failing to meet those deadlines may result in a disciplinary action against a CPO. To learn more about EasyFile, go to NFA’s website and access the seminar at http://www.nfa.futures.org/NFA-compliance/NFA-education-training/webinars.HTML. Since NFA acts as the CFTC’s delegate when NFA receives and reviews Annual Reports, the reports are subject to requests under FOIA. CPOs may request confidential treatment of Annual Reports but must strictly follow the CFTC procedures contained in CFTC Regulation 145.9 for filing such requests. For information on how to request confidential treatment of Annual Reports filed with NFA, consult the information on NFA’s website at http://www.nfa.futures.org/NFA-compliance/NFA-commodity-pool-operators/cpo-confidential-treatment-requests.HTML.  When preparing pool Annual Reports, refer to the CFTC’s annual letter for useful tips.
  5. Within 45 days after the end of each quarter, submit to NFA through NFA’s EasyFile system, a Pool Quarterly Report for each pool that you operate. Information required to be filed includes: (a) the identity of the pool’s administrator, carrying broker(s), trading manager(s) and custodian(s); (b) a statement of changes in net asset value; (c) monthly performance for the three months comprising the quarterly reporting period; and (d) a schedule of investments identifying any investment that exceeds 10% of the pool’s net asset value at the end of the quarterly reporting period.

If you are a registered Introducing Broker, you will also be required to:

  1. Conduct Anti-Money Laundering (“AML”) training for relevant employees and complete an audit of your AML procedures and training. For guidance in developing your AML procedures, use NFA’s AML Procedures System.
  2. The FCM that carries your customer accounts will be contacting your customers to verify that the information obtained under NFA Compliance Rule 2-30(c) remains materially accurate, and provide the customer with an opportunity to correct and complete the information. If the FCM notifies you of any material changes to the information, assess whether additional risk disclosure is required to be provided to the customer based on the changed information.
  3. If you are not operating pursuant to a guarantee agreement, submit a certified annual report within 90 days after the firm’s fiscal year end. IBs that are also registered as Broker/Dealers (“BDs”) must submit the report within 60 days after the firm’s fiscal year end. IBs that are not also registered as BDs must file this certified statement via NFA’s EasyFile system.
  4. If you are not operating pursuant to a guarantee agreement, submit semi-annual 1-FR-IB filings via EasyFile within 17 business days of the date of the statement (in addition to completing and maintaining monthly net capital computations). IBs also registered as BDs may file via WinJammer and must also file with NFA all statements required by FINRA. All financial statements should be prepared using the accrual basis of accounting as required by Generally Accepted Accounting Principles.

If you are a registered Futures Commission Merchant or Retail Foreign Exchange Dealer, you will also be required to:

  1. Conduct Anti-Money Laundering (“AML”) training for relevant employees and complete an audit of your AML procedures and training. For guidance in developing your AML procedures, use NFA’s AML Procedures System.
  2. Review your Point of Contact information for USA PATRIOT Act 314(a) information requests and notify NFA of any changes (FCMs only).
  3. Supervise the operations of any GIBs, including conducting an annual onsite inspection of every GIB.
  4. Contact active customers who are individuals, at least annually, to verify that the information obtained from that customer under NFA Compliance Rule 2-30(c) remains materially accurate, and provide the customer with an opportunity to correct and complete the information. If the customer notifies you of any material changes to the information, assess whether additional risk disclosure is required to be provided to the customer based on the changed information. However, if another FCM or IB introduces the customer’s account on a fully disclosed basis or a CTA directs trading in the account, then notify that Member of the changes to the customer’s information.
  5. Submit a certified annual report within 90 days after the firm’s fiscal year end, or if your firm is also registered as a Broker/Dealer, within 60 days after the fiscal year end (in addition to submitting the firm’s monthly Focus II/I-FR-FCM with NFA via WinJammer).
  6. For firms that offer off-exchange foreign currency futures and options contracts (FOREX) to retail customers, provide written information regarding NFA’s Background Affiliation Status Information Center (BASIC), including the website address to every current customer (in addition to sending it to every new customer when the customer opens an account).
  7. For firms that offer FOREX to retail customers, review the security, capacity, credit and risk-management controls, and records provided by your electronic trading systems and certify that the requirements outlined in NFA Interpretive Notice 2-36(e) have been met. Prepare a certification, signed by a principal who is also a registered AP, and provide a hardcopy to NFA with the submission of your annual audited financial statement.

If your firm or its clients trade security futures products (futures whose underlying instrument is either a single security or a narrow-based security index), consult NFA’s website for a comprehensive listing of your requirements athttp://www.nfa.futures.org/NFA-compliance/NFA-general-compliance-issues/security-futures-products.HTML.

We recommend that you keep this email as a reference guide to ensure that all requirements are completed on time throughout the year.

We also want to remind you again: Every firm that is required to be registered as an FCM, RFED, IB, CPO or CTA in connection with its FOREX activity must be approved by NFA as a FOREX firm. NFA Members are prohibited from engaging in retail Forex transactions with these firms unless the firm has received this designation. In addition, FOREX firms must have at least one principal who is registered as an Associated Person (AP) and is approved as a FOREX AP. All individuals who solicit retail FOREX business or who supervise that activity must have taken and passed two exams — the National Commodity Futures Examination (Series 3) and the Retail Off Exchange Forex Examination (Series 34), which is a new exam focusing exclusively on Forex-related questions. However, individuals who were registered as APs, sole proprietors or floor brokers on May 22, 2008, do not need to take the Series 34 exam unless there has been a

two year gap in their registration since that date.

As always, if you need assistance with these or any other NFA requirements, please contact NFA’s Information Center at (800) 621-3570.

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Cole-Frieman & Mallon LLP provides comprehensive compliance and regulatory support for CTAs and CPOs.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Form PF

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Proposed Form PF Released

For your review, we have published the proposed Form PF which can be found here: Form PF.

According to an SEC proposal announcement last week, SEC registered managers will be required to file proposed Form PF with the SEC on either a quarterly or annual basis in the future.  Form PF is a multi-purpose form to be used by all types of SEC registered investment advisers – hedge fund managers, private equity fund managers, and liquidty fund managers. While the level of specificity changes with AUM (high AUM managers must disclose more information), Form PF requests much more information from fund managers than have previously been required to be provided to regulators.

This post will provide an overview of the major aspects of the Form PF as it is currently proposed.

[Please note that the form is highly dependant on precise definitions. The discussion below is general and I have not discussed some of the nuances. For example, when I discuss AUM, the discussion is necessarily general.]

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Who is required to file Form PF?

Mangers must file Form PF if they meet the following two tests:

  1. Registered or required to be registered with the SEC and
  2. Provide advice to a private fund (generally a 3(c)(1) or 3(c)(7) fund) *

* the term private fund is defined in Form PF.

When do managers need to file Form PF?

Managers will need to file Form PF either (i) on an annual basis if they have less than $1 billion of AUMor (ii) on a quarterly basis if they have more than $1 billion of AUM.

If the manager files on an annual basis, the filing will need to be completed within 90 days of the end of the manager’s fiscal year.

If the manager files on a quarterly basis, the filing will need to be completed within 15 days of the end of the calendar quarter.

What are the sections of Form PF?

Form PF has 5 major sections. For managers filing on an annual basis, generally only Section 1 will need to be completed. For managers filing on a quarterly basis, Sections 2, 3 or 4 will need to be completed depending on the types of investment vehicles for which the manager provides investment advice.  The sections are:

  • Section 1 – All Filers
  • Section 2 – Hedge Fund Managers with at least $1B AUM
  • Section 3 – Liquidity Fund Managers with at least $1 B AUM
  • Section 4 – Private Equity Fund Managers with at least $1 B AUM
  • Section 5 – Managers Applying for Hardship Exemption

More Detail on Section 1 and Section 2

Section 1

Section 1 applies to all managers who are registered with the SEC.

Section 1a

Contains more general information on the manager and its business.

Section 1b

Managers must provide the following information on the “private funds” which they manage:

  • gross and net asset value
  • borrowing/creditor information
  • derivative positions
  • investor concentration
  • detailed performance information, including performance after performance fees

Section 1c

Managers must provide the following information on the “hedge funds” which they manage:

  • strategy
  • % of assets traded using algorithm
  • counterparties/exposure
  • % of equity, debt, ABS traded on and off exchange
  • % of equity, debt, ABS cleared by a central clearing counterparty (CCP) and not cleared by a CCP
  • % of derivatives traded on and off exchange
  • % of derivatives cleared by a CCP and not cleared by a CCP
  • % of repos and clearing information

Section 2

Section 2 of Form PF requires managers to provide the SEC with a surprising amount of detail with respect to the fund, the fund’s investment strategy, counterparties and investors. Below we have provided an overview of some of the different requirements.

Section 2a

Generally the following information for the manager as a whole:

  • drill down of positions – equity, corporate bonds, convertible bonds, sovereign and muni bonds, loans, repos, ABS/structured products, credit derivatvies, commodities, cash
  • turnover rate
  • geographic breakdown of instruments

Section 2b

For each fund, the following information for such fund:

  • drill down of investments
  • liquidity
  • positions representing 5% or more of fund’s NAV
  • counterparty information
  • CCP information
  • reporting VaR
  • how market factors effect fund’s portfolio
  • secured/unsecured borrowing
  • investor information – side pockets, whether manager has right to suspend withdrawals, whether there are gates, whether there is currently a suspension of withdrawals, whether the gate provision is currently enacted

Section 3 and Section 4

These sections include questions which are applicable to liqidty funds and private equity funds. They are structured similar to section 2 (a & b), but overall there is less information requested.

Other

Items to Note

Form PF instructions are very specific with respect to the information that should be completed in the certain sections. In addition, there are unique items that may not apply to all firms which need to be considered. Some of these items to note with respect to the form:

  • there will be issues with respect to related persons
  • there will be sub-adviser issues
  • managers must understand the difference between reporting for individual funds v. reporting for fund structures (i.e. master-feeder, mini-master, parallel)
  • there are many new definitions (135 defined terms in the glossary – 11 pages worth!)
  • special rules for managers making transitions (quarterly to annually) and final filings
  • private fund identification numbers are required and can only be obtained by filing Form ADV (original or amended filing)
  • filing Form PF is done electronically, signed by a managing member of the firm
  • there are likely to be confusions with definitions (likely to be worked out during and after the comment period)

Initial Thoughts

I am still fully developing my thoughts on the form and should have more detailed thoughts in later posts – in the meantime, my bullet point thoughts are as follows:

  • The form seems to be thoughtfully laid out.
  • The amount and detail of the questions is surprising.
  • Managers with many funds are going to face a large reporting burden.

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Bart Mallon provides investment adviser registration services through Cole-Frieman & Mallon LLP, a law firm focused on the investment management industry.  He can be reached directly at 415-868-5345.

Hedge Fund Events February 2011

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The following are various hedge fund events happening this month. Please email us if you would like us to add your event to this list.

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February 2

February 6-8

February 8

February 8-9

February 10

February 10

February 10

February 13-16

February 15

February 15

February 15

February 16

February 16

February 16

February 16

February 17

February 17

February 18

February 22

February 22

February 23

February 23

February 23

February 24

February 24

February 28

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Bart Mallon, Esq. runs the hedge fund law blog and provides hedge fund registration and compliance services to hedge fund managers through Cole-Frieman & Mallon

LLP.  He can be reached directly at 415-868-5345.

CFTC Proposes Increased Registration and Reporting for CPOs and CTAs

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Proposal to Rescind 4.13(a)(3) & 4.13(a)(4) CPO Exemptions

Pursuant to rulemaking required under the Dodd-Frank Act, the CFTC is jointly proposing with the SEC that CPOs and CTAs which are dually registered (that is with the CFTC and as an investment adviser with the SEC) file certain information on a new Form PF.   In addition, the CFTC is proposing to eliminate two widely used exemptions from CPO registration – the 4.13(a)(3) exemption (de minimis futures trading) and the 4.13(a)(4) exemption (the only investors are QEPs).  Another exemption applicable to mutual funds – the 4.5 exemption – may also potentially be rescinded under the proposed rulemaking.  The CFTC is proposing minor changes to regulations in addition to the more onerous registration and reporting requirements.

Rescinding CPO Registration Exemptions

We have discussed the requirements for these and other CFTC registration exemptions in a post on CPO registration.  The CFTC is proposing to rescind the following exemptions:

Regulation 4.13(a)(3) – this exemption is normally utilized by managers who use just a small amount of futures.  In the event that this exemption isrescinded, a large number of managers would be required to register.  This also means that managers could not trade any futures contracts in a fund structure without being registered as a CPO.  Obviously this will increase the regulatory burden for managers and will likely lead some managers to simply cease using futures.

Regulation 4.13(a)(4) – this exemption is normally utilized by those managers who only have investors who are qualified eligible persons.

Note: Rescinding both the (a)(3) and (a)(4) exemptions will likely mean the fund-of-fund managers will also be required to register as CPOs.  Form more information please see our post on fund-of-fund CPO exemptions.

Regulation 4.5 – this exemption applies to mutual funds that have funds which invest in futures.  In general, mutual fund managers who invest in futures do so indirectly and are able to escape registration as a commodity pool operator.  This means that mutual funds, while they must be approved by the SEC, receive no regulatory scrutiny from the CFTC.  Late last year, the NFA submitted a petition to the CFTC asking the CFTC to amend Regulation 4.5 to require those managers that indirectly invest in futures products to register as a CPO.

New Reporting Requirements

The CFTC is proposing that CPOs and CTAs face increased reporting requirements on new forms Form PF, Form CPO-PQR and Form CTA-PRQ.  The increased reporting requirements will apply to two groups of CFTC registrants: (i) dual registrants and (ii) CFTC-only registered firms.

New Forms

Form PF – Form PF was designed to provide government agencies with information about the basic operations and structure of private funds.  The creation of Form PF was required by Section 404 of the Dodd-Frank Act.  The SEC and CFTC are working together to develop Form PF Sections 1 and 2 as those sections are relevant to firms registered with both agencies.

Form CPO-PQR and Form CTA-PQR – these forms will require firms to provide similar information as will be required in Form PF, with appropriate modifications made so that the information is relevant with respect to commodity futures managers.

In general, all forms will allow some information to be treated as confidential.

Dual registrant reporting

Dual registrants are firms which are registered with the SEC (as an IA) and with the CFTC (as a CPO or CTA).  The following are the proposed filing requirements:

Dual registrants with less than $1 billion of AUM:

  • Annual filing of Form PF
  • Complete only Section 1 of Form PF

Dual registrations with less than $1 billion of AUM:

  • Quarterly filing of Form PF
  • Complete Sections 1 and 2 of Form PF

CFTC-Only Registrants

CFTC-only registrants are firms registered with only the CFTC

(as a CPO or CTA).  The amount of information to be required on the new CFTC only forms, and the timing of filing, will depend on the registered firm’s size and AUM.

Forms CPO-PQR and CTA-PQR will be filed directly with the NFA.

Other Proposed Changes

The CFTC is also proposing some other changes:

  • Managers using the Regulation 4.7 exemption will be required to have certified financial statements for any 4.7 exempt pool which they advise.  [Note: currently there is no certification requirement.]
  • Managers using any of the 4.5, 4.13 or 4.14 exemptions will need to annually certify the notice of exemption.  [Note: currently there is no requirement to certify the exemption on an annual basis.]
  • Risk disclosure language to be updated to include discussion of swaps, if appropriate for the manager.
  • Certain changes to make the regulations internally consistent.

The CFTC overview can be found here: CFTC Rescinding Exemption Overview

The CFTC Q&A sheet can be found here: CFTC Rescinding Exemption Q&A

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Cole-Frieman & Mallon LLP  provides comprehensive CFTC and NFA compliance and regulatory support for investment managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Annual ADV Updating Amendment for IA Firms

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Under SEC and state regulations, a registered investment advisory firm must file its annual amendment to Form ADV within 90 days of the end of its fiscal year.  For most firms this means that the Annual Updating Amendment is due by March 31.  In addition to the traditional updates which firms need to make on Form ADV, advisers will also need to be aware of the new regulations with respect to ADV Part 2 which may require the adviser to complete a new form ADV part 2 during the updating process.  We are making special note of the updating requirement earlier than usual because of the new ADV 2 requirement.

Overview of Major Items on ADV to Update

When a firm completes an annual update to Form ADV, the firm should go through each question and make sure disclosures are accurate and up to date.  In general the firm’s chief compliance officer will complete the update or work with an outside investment adviser compliance firm or law firm to complete the update.

Some of the key items of Form ADV which need to be updated include:

  • Employees (Items 5.A. and 5.B.)
  • Number of clients (Items 5.C. and 5.H.)
  • Number of accounts (Item 5.F.)
  • Assets under management (Item 5.G.)
  • Other material changes can also be disclosed on the Annual Updating Amendment, such as changes to reportable disciplinary and financial disclosures, contact information, custody, and ownership.   [Note: these items need to be updated on Form ADV within 30 days of when they take place.]

While Part 1 of Form ADV can be completed using the online form on the IARD system, the new ADV Part 2 must be filed electronically as a text-searchable PDF.  You will not be able to

submit a PDF file of a scanned copy Part 2 on the IARD system.

New Regulations Regarding ADV Part 2

IA firms applying for SEC registration as of January 1, 2011 and existing firms filing Annual Updating Amendments are now required to use the new Part 2A, the “firm brochure.”  In addition, the SEC has established the following compliance dates regarding Part 2B, the “brochure supplement:”

SEC Compliance Dates for Delivery of Brochure Supplements to Clients

SEC Compliance Dates Extensions*
New/Prospective Clients Existing Clients New/Prospective Clients Existing Clients
New IA registrants Applying as of 01/01/11, deliver upon registering Applying between 01/01/11 and 04/30/11, begin delivering by 05/01/11

Applying after 04/30/11, deliver upon registering

 Applying between 01/01/11 and 04/30/11, deliver by 07/01/11.
Existing IAs Upon filing Annual Updating Amendment Within 60 days of filing Annual Updating Amendment Registered as of 12/31/10 with fiscal year ending 12/31/10 through 04/30/11, begin delivering by 07/31/11

Registered as of 12/31/10 with fiscal year ending after 04/30/11, deliver upon filing Annual Updating Amendment

 Registered as of 12/31/10 with fiscal year ending 12/31/10 through 04/30/11, deliver by 09/30/11

Registered as of 12/31/10 with fiscal year ending after 04/30/11, deliver within 60 days of filing Annual Updating Amendment

*On December 28, 2010, the SEC extended the compliance dates by four months to provide certain IAs more time to deliver the brochure supplement.

Incorporating the New ADV Part 2 for State Registrations

Because not all states have adopted the new ADV Part 2, state-registered IAs should check their state rules to confirm whether they need to use the new form or if they can continue to use the old form.  In many states, the next amendment to Form ADV must include the new ADV Part 2, even if it is not the Annual Updating Amendment.  For example, as of January 1, 2011, states including Alaska, California, Connecticut, Indiana, Maine, Maryland, Massachusetts, Ohio, Oregon, and Tennessee are requiring that registered IAs use the new ADV Part 2 as part of any amendment, as well as the required Annual Updating Amendment.

For more information on ADV Part 2, especially with respect to state adoptions, please see our update on new ADV Part 2.

For information on expected costs to prepare the new Form ADV 2, please see this post.

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Bart Mallon provides investment adviser registration and compliance services through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.

NASAA’s Proposed Model Rule to Exempt Private Fund Advisors from State Registration

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One of the consequences of the Dodd-Frank Act is that federal and state jurisdiction over investment advisor firms will change.  In general, fund managers with less than $150 million in AUM will not be subject to registration with the SEC.*  While such managers will not be subject to SEC registration, they may be subject to investment adviser registration in the manager’s state of operation.  Laws from state to state on this issue differ widely but the North American Securities Administrator Association (NASAA) is trying to bring some continuity and certainty with respect to state registration requirements.  NASAA is proposing that states adopt regulations which requires private fund managers to register as investment advisers with the state unless that manager only provides advice to funds which are exempt under Section 3(c)(7).

*note: if a fund manager also has separately managed accounts, the manager will need to be SEC registered unless the manager has less than $100 million in AUM.

Of course it will be up to the states to decide whether or not to adopt the proposed rule, but if the proposal is adopted by any state, it would mean that many more managers would need to register at the state level if such managers were not registered with the SEC (in many, but perhaps not all cases).  I have written a number of times that most state securities divisions do not have the resources to handle an increase in IA registrations so I believe it unlikely that states securities divisions will lobby the legislatures for an increase in registrations under the NASAA proposal (for many states).  This proposal is essentially the first step toward states discussing the larger issue of how the securities laws will change in response to the changes from Dodd-Frank – we are likely to hear more about this story in the coming months as the SEC and states begin to more fully understand how legislative changes will affect their normal operating routines with respect to investment advisers.

Below we have provided some background on the proposed rule and the text of the proposed rule.

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Background & NASAA’s Proposed Model Rule

Prior to Dodd-Frank, the “private adviser exemption” from SEC registration applied to any investment advisor who during the course of the preceding 12 months had fewer than 15 clients (a fund is counted as one client) and who did not generally hold itself out to the public as an investment advisor.   Most hedge fund managers generally would utilize this exemption from IA registration with the SEC.  Title IV of the Dodd-Frank Act eliminated this exemption and in its place, created new registration and reporting rules for private fund advisers.

As we noted above, certain managers (including managers to venture capital funds and private equity funds) with less than $150 million in AUM will be exempt from SEC registration.  These managers exempt from SEC registration are called “exempt reporting advisers” (ERAs) and, although exempt from “registration” with the SEC, must still submit reports to the SEC (see Exempt Reporting Adviser Requirements).  In addition, these managers may still be required to register at the state level.

NASAA is proposing that managers of Section 3(c)(7) funds be exempt from state registration and that all other fund managers be subject to registration with the state securities division.  The stated rationale for this proposal is that investors in Section 3(c)(7) funds must be qualified purchasers and therefore do not need managers to be registered with the state securities commission.  To qualify for the NASAA exemption at the state level, the adviser must:

  1. not be subject to a disqualification (which includes various criminal, civil, and regulatory disciplinary events),
  2. solely advise 3(c)(7) fund(s),
  3. file with the state the report that is required by the SEC (the condensed Form ADV, discussed in the Exempt Reporting Advisers article), and
  4. pay applicable fees.

IA representatives associated with the ERA firm would also be exempt from state registration and licensing requirements.

NASAA’s proposed model rule would not apply to advisers of private funds with $150 million or more in AUM which are required to register with the SEC and satisfy any state notice filing requirements.

Request for Comments

NASAA is seeking comments on this proposed model rule.  Comments should be submitted electronically to [email protected] or by mail to NASAA, Attn: Joseph Brady, 750 First Street, NE, Suite 1140, Washington, DC, 20002 by January 24, 2011.

NASAA’a proposed model rules are reprinted below and can be found here.

Our Thoughts

We have not heard states discussing the NASAA proposal.  We also do not think that anything will be happening with this model rule immediately as states will be focusing on trying to figure out how to deal with the expected increase in state applications because of Dodd-Frank.

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Proposed NASAA Model Rule on Private Fund Adviser Registration and Exemption Rule XXX. Registration exemption for exempt reporting advisers

a. Subject to the provisions of paragraph (b) herein, an investment adviser solely to one or more private funds, shall be exempt from the registration requirements of Section XXX [identify authority] and shall be considered an exempt reporting adviser in this state if the adviser satisfies the following conditions:

(1) neither the adviser nor any of its advisory affiliates are subject to a disqualification as described in Section 230.262 of title 17, Code of Federal Regulations, or any successor thereto;

(2) the adviser acts as an adviser solely to private funds that qualify for the exclusion from the definition of “investment company” under Section 3(c)(7) of the Investment Company Act of 1940;

(3) the adviser files with the state a copy of each report and amendment thereto that an exempt reporting adviser under the Investment Advisers Act of 1940 would be required to file with the Securities and Exchange Commission pursuant to SEC Rule 275.204-4, along with a consent to service of process complying with Section XXX [identify authority]; and

(4) the adviser pays the fees specified in Section XXX [identify authority].

b. A federal covered investment adviser shall not be eligible for this exemption and shall comply with the state notice filing requirements applicable to such advisers.

c. An investment adviser representative is exempt from the registration requirements of Section XXX [identify authority] if he or she is employed by or associated with an adviser that is exempt from registration in this state pursuant to paragraph (a.) above.

d. As used in this rule a private fund means an issuer that would be an investment company as defined in section 3 of the Investment Company Act of 1940 but for sections 3(c)(1) or 3(c)(7) of the Act.

e. The report filings described in paragraph (a.)(3) above shall be made electronically through the IARD. A report shall be deemed filed when the report and the fee required by Section XXX [identify authority] are filed and accepted by the IARD on the state’s behalf.

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Bart Mallon is an attorney who works with both state and SEC registered fund managers.  His firm, Cole-Frieman & Mallon LLP, routinely provides regulatory and compliance services to registered investment advisers.  He can be reached directly at 415-868-5345.

SEC Study on Uniform Fiduciary Duty for BDs

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Recommendation for Uniform Fiduciary Duty

Under Section 913 of the Dodd-Frank Act, the SEC was required to condict a study of the effectiveness of the current legal and regulatory structure for broker-dealer firms and investment advisory firms with respect to the provision of personalized investment advice to retail customers and to comment on any gaps in the legal and regulatory structure.  Essentially Congress wants to know whether retail investors really understand the difference between BDs and IAs.  This issue has been one which many in the industry have strong opinions about, particularly from the investor side and the broker-dealer side.

The following is a brief overview of the SEC study which was recently released.

SEC Recommendations

In the study, the SEC spent considerable time providing a background and overview of the regulatory regimes of both investment advisers and broker-dealers.  The study also discussed retail investors and made many references to other studies which have been conducted on this and similar issues.  Ultimately, the SEC staff was trying to determine what standards should be in place with the understanding that retail investors may have limited understanding of the regulatory structure of IAs and BDs.

Overall, the SEC’s recommendations fall into two categories:

  • Uniform Fiduciary Standard – SEC staff recommended that the SEC should apply a uniform fiduciary duty with respect to both IAs and BDs when such firms provide personalized investment advice regarding securities to retail custodmers [note: the fiduciary standard does not apply to brokers when they are activng in the capcity of a broker with respect to a transaction.]
    • With respect to the uniform standard, the staff noted that the SEC should provide guidance in some form with respect to implementing this standard.  Such guidance should cover, at least, the following items: standards of conduct, duty of loyalth, principal trading, duty of care, personalized investment advice about securities, and investor education.
  • Harmonization of Regulations – in general the SEC staff believes that harmonization, when it adds meaningful investor protection, would be advantageous.  Specifically, the staff discussed the following issues which potentially should have substantially similar rules/regulations for both IAs and BDs:
    • Advertising and other communications
    • Use of finders and solicitors
    • Solicitation
    • Licensing and registration of firms
    • Licensing and continuing education for representatives of BD and IA firms
    • Books and records

[Because of the complexity of the issue, the above is only a gross overview.]

Our thoughts

It seems clear that if two firms are engaged in the exact same activity with respect to retail investors (providing personalized investment advice regarding securities), then such firms should be subject cialis super active to the same standards of care with respect to those activities.  However, it is also clear that implementing this change in regulatory framework will not be easy.Should be a bias toward harmonization when possible and practicle

What we found particularly interesting about the study  was the discussion about state registered investment advisers and the various rules they must adhere to – it seems funny that at the federal level we are trying to harmonize regulations, whereas the report makes clear that each states rules have completely different rules (see report starting at page 85).

Probably the most interesting thing is that the Staff recommended “that the Commission should consider requiring investment adviser representative to be subject to federal continuing education and licensing requirements.”  This means that the SEC  (or potentially a SRO) would be required to create and administer an exam (similar probably to the Series 65 exam for state registered investment adviser representatives) and continuing education (similar to the CE requirements for brokers).

The full report can be found here: Study on Investment Advisers and Broker Dealers.

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Bart Mallon provides legal advice to both investment advisers and broker-dealers through Cole-Frieman & Mallon LLP, an investment management law firm.  He can be reached directly at 415-868-5345.

SEC Study on Enhancing IA Examinations

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Recommendations for Enhancing IA Exams

Under Section 914 of the Dodd-Frank Act, the SEC was required to conduct a study with respect to the need for enhanced examination and enforcement resources for investment advisers.  SEC staff recently released the study which is designed to provide Congress with recommendations with respect to the findings of the study.  In general, the study found that the SEC is not currently properly equipped to appropriately handle IA examinations because of capacity issues.  The study presents a number of statistics which show that IA registrations have greatly increased while the funding for the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) has been subject to cutbacks in staff.

To strengthen the IA examination process, the SEC staff recommended that Congress take one of three different courses of action:

  1. Impose user fees on SEC-registered investment advisers
  2. Authorize one or more SROs to examine SEC-registered investment advisers
  3. Authorize FINRA to examine dual registrants (firms registered as both IAs and BDs)

SEC Recommendations

The Study provides three different options that Congress should consider with respect to the issue of instituting the most appropriate infrastructure for IA examinations.  These options and some of the positive and negative implications are discussed below.

1.  User Fees

Congress could authorize the SEC to implement user fees for registration.  These fees would go directly to the OCIE and pay for the IA examination program.

Discussion items:

  • would provide scalable resources (i.e. resources would increase or decrease in proportion to the number of registered investment advisor firms) – these resources would not be subject to the Congressional appropriations process
  • may be less expensive than instituting a new SRO regime and would utilize the existing OCIE staff expertise and knowledge
  • avoid all of the issues which would exist with establishing an SRO structure (inefficiencies, authority, membership, governance, and funding issues)
  • supported by some parts of the IA industry

2.  Delegation to SRO or SROs

Congress could authorize the SEC to delegate examination responsibilities to FINRA or another self regulatory organization(s).

Below are some of the points both for and against delegation to an SRO or multiple SROs:

  • scalable resources (i.e. funded by membership fees)
  • additional rulemaking – IA firms would be subject to laws (Investment Advisers Act of 1940), regulations (SEC Rules) and member (SRO) rules
  • SEC would need to oversee the SRO and subject the SRO to periodic audit/examination
  • an SRO would provide for more examination of IAs – for example, FINRA and NFA have examined more BDs and CPOs/CTAs than the SEC has examined IAs
  • many logistical issues involved with instituting any SRO and/or allowing FINRA to take over these responsibilities
  • multiple SROs (for different types of IAs) would likely create even more logistical issues
  • unclear how the SRO structure would work with state registered IAs
  • potential conflict of interest if the SRO (FINRA) was the same for the buy side and the sell side

3.  Authorize FINRA to examine dual IA-BD registrants

Congress could expand FINRA’s jurisdiction to oversee those firms which are registered as both an IA and as a BD.

  • only marginally helpful – only 5% of IAs are also registerd as BDs and many of these firms are the largest broker-dealer firms
  • gets rid of inefficiency by having two examinations – one from FINRA on the BD side and one from the OCIE on the IA side
  • risk of different interpretation of provisions of the Investment Advisers Act

Conclusion

This study simply states the obvious – the SEC does not have the resources it needs to adequately do its job.  It seems like the major conclusion has already been reached – IA firms are going to need to pay for their oversight because Congress will not pay for it.  The only question is whether managers will be making payments to the SEC (first option) or to FINRA or other SRO(s) (second two options).  Whatever Congress ultimately decides, it is likely that managers will be facing more fees in the future.

The full text can be found here: Study on Enhancing Investment Adviser Examinations

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Bart Mallon is an attorney focused on the investment management industry and provides investment adviser registration and compliance services through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.