Tag Archives: Investment Advisor

SEC Chairman Cox Notes Importance of Investment Advisor CCOs

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At a recent speech at the 2008 CCOutreach National Seminar, a seminar for the Chief Compliance Officers of registered investment advisors, SEC Chairman Christopher Cox noted the importance of compliance offices during these volatile times.  Cox noted that CCOs are partners with the SEC to ensure that investment advisory firms remain compliant and follow all investment advisory rules and regulations.  The speech is reprinted below.  Continue reading →

SEC Emphasizes Importance of Hedge Fund Investment Advisor Compliance

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The SEC’s Lori Richards, Director, Office of Compliance Inspections and Examinations, spoke last week at an event and emphasized the importance of compliance during these volatile markets.  For chief compliance officers (CCOs) at registered investment advisory firms, the following speech transcript should be required reading.  Hedge fund managers registered as investment advisors must be especially aware of the fiduciary obligation they have to their client.  Specifically Richards noted that examiners will be focusing investment programs to make sure there is no style drift in their portfolios and that valuation is done pursuant to the manager’s stated valuation procedures.

Richards also discussed a number of areas which compliance officers should be focusing on during this time.  Specifically she advocated that a firm’s CCO: make sure following all securities laws and regulations, including the Form SH filings; make sure there is no market manipulation or insider trading; review and update if necessary the following Form ADV, Form ADV Part II, performance advertising, marketing, fund prospectuses and any other information provided to clients; review best execution and any soft dollar programs.  Richards noted that in keeping with the “culture of compliance,” the CCO “should insist on absolute compliance with policies and procedures, there should be no possibility of ‘suspending’ compliance. And it would be timely for you to remind firm employees of your presence and make clear to every employee in the firm that no shortcuts will be allowed.”

Richards also noted that the examiners will be looking for undisclosed payments by and to hedge fund investment advisors.  This is especially interesting in light of the recent case brought by the DOL against a registered investment adviser for failing to disclose payments from a hedge fund manager.  Please see DOL Sues Investment Advisor for ERISA violation.

If a registered hedge fund manager’s CCO has not considered any of the above issues the manager should immediately contact a hedge fund attorney or compliance professional.  It is likely that a hedge fund manager will be audited given the SEC’s “risk-based” model of audits.  I have posted some regular articles below.  The full text of the speach is reprinted below and can also be found here.

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Speech by SEC Staff:
Compliance Through Crisis: Focus Areas for SEC Examiners and Compliance Professionals

by Lori A. Richards
Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission
National Society of Compliance Professionals
National Meeting
Philadelphia, Pennsylvania

October 21, 2008

Good Morning. I’m very pleased to be with you here today at the National Meeting of the National Society of Compliance Professionals. I believe that this is the largest professional organization of compliance professionals in the securities industry, so you carry a lot of clout!

Before I begin, I am required to state that the views I express today are my own, and do not necessarily represent the views of the Commission or any other member of the staff.

This event and others like it are so important — they provide an opportunity to share information about cutting edge compliance practices, about emerging compliance risks, and about strategies to help establish strong compliance programs and instill a healthy culture of compliance. Your role as compliance professionals is critical in any market environment, but in today’s turbulent times, it is essential. Your job each day is to educate, to guide, to investigate, to test and sometimes to insist on adherence to the law and to the firm’s policies, and sometimes, to just say no! Your job is important in any environment, and it is just as or more important now.

The compliance function within firms is critical in helping to assure operations in compliance with the law, and it must continue to be fully and adequately resourced. While not profit centers, firms must remember that their compliance programs (and related legal functions, as well as the information technology programs that support a well-run compliance program) are essential to their operations — reductions in resources to these programs would be ill-advised. Securities firms cannot now afford to reduce vigilance in compliance.

In today’s environment, perhaps the most important thing you can do as a compliance professional is to remind firm employees of their obligations to investors — for an adviser, the fiduciary obligation to clients, and for a broker, the obligation to follow just and equitable principles of trade. These obligations must continue to motivate and inform the way that the firm interacts with clients, customers, and investors. In addition to this reminder, however, there are areas where you will want to pay particular attention to compliance obligations. I will describe some of those this morning. Finally, you cannot let slip the other ongoing compliance responsibilities that the firm has, I will describe some of these priority areas as well.

As I speak to you today, our markets are undergoing unprecedented change. Once large firms no longer exist, and others have been acquired or merged. Securities firms that once stood alone are now parts of large banks. A money market fund has broken a dollar, and the Treasury has implemented a new program to guarantee certain money market funds from loss and the government has taken unprecedented steps to buy troubled assets and shore up credit markets. These are sudden and significant changes, and while we won’t see their full impact for some time, today, in the securities compliance world, our work could not be more important.

It’s worth remembering, for all of us who work administering compliance programs under the securities laws, that the underlying tenets of the securities laws are quite simple and provide meaningful protections to every investor every day:

  • Companies publicly offering securities to investors must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing — enabling investors to make informed investment decisions.
  • People who sell and trade securities and provide investment advice — brokers, dealers, advisers and exchanges — must treat investors fairly and honestly, putting investors’ interests first.

In the current credit crisis, the SEC has been aggressively working to police the markets, and to ensure that the “rules of the road” for public companies and market participants include full disclosure to investors and promote healthy capital markets. While a small agency (only 3,800 staff), the SEC packs clout through its experienced and dedicated staff. Addressing the extraordinary challenges facing our markets, the SEC has issued new regulations to strengthen capital markets and protections for investors, taken enforcement measures against market manipulation (including a landmark enforcement action against a trader who spread false rumors designed to drive down the price of stock), initiated examination sweeps, communicated with investors, and collaborated with domestic and foreign regulators around the world.

The SEC is an aggressive police force too — we bring hundreds of enforcement actions each year to protect public investors from fraud.  Indeed in just this last year, we brought more than 650 enforcement actions, more than the year before, involving all types of fraud that harm investors — corporate non-disclosure, ponzi schemes, insider trading, failures to value assets correctly, and other types of frauds. The protections of the securities laws are meaningful and have real consequences for investors. In just the last year alone, we returned over one billion dollars to harmed investors — making the protections of the federal securities laws mean something to those investors who have been defrauded.

And, in the Office of Compliance Inspections and Examinations, we are keenly focused on issues that present risk to investors. I wanted to highlight some of the areas that SEC examiners will be focusing on in the months ahead in our examinations of registered investment advisers, investment companies, and broker-dealers — and suggest that these are areas that you might focus attention on as well.

Let me start with the “landscape” because the sheer number of registered firms subject to our examinations impacts our actions quite directly. At the start of FY 2009:

  • There are approximately 11,300 registered investment advisers and 950 fund complexes with over 8,000 mutual fund portfolios (this is a highly transient population: approximately 1,200 advisers became registered and 750 de-registered in FY 2008).
  • There are approximately 5,600 broker-dealers, 174,000 branch offices, and 676,000 registered representatives (as more firms have consolidated, the broker-dealer registrant pool has declined slightly in recent years, while the number of branch offices has increased dramatically). And, there are approximately 410 SEC-registered transfer agents.

Our program is risk-based, which means that we seek to accord resources to those firms and issues that present the greatest risk to investors. Our overall examination plan consists of numerous complementary components: routine and periodic examinations of those advisers (about 1,000) that are considered “higher risk;” routine examinations of large broker-dealer firms to evaluate their internal controls; “oversight” examinations of broker-dealers to evaluate the SROs’ regulatory programs; cause exams based on indications of violations; “sweep” exams focused on particular risk areas; random examinations of lower risk advisers; and visits to newly-registered advisers. In addition to these types of examinations, we will also closely monitor the compliance activities and controls of certain large advisers and broker-dealers.

We’ve also sought to leverage compliance results from firms’ own compliance programs by encouraging firms’ own compliance professionals to be aggressive in assuring compliance with the securities laws. In the coming year, we will continue this work as well — we will continue our CCOutreach programs for chief compliance officers. Our National Seminar for adviser and fund CCOs is November 13, and we just announced that our National Seminar for broker-dealer CCOs, in coordination with FINRA, will be held on March 10, 2009. We will also continue to issue ComplianceAlerts that summarize results of recent examinations so that all firms can benefit from our insights into both what can go wrong, and also, what particular practices seem to help make things go right.

Our examination program includes focus areas and exam initiatives that are particularly critical in today’s market environment. While these are not new areas, they are timely now and examiners will be paying special attention to compliance in these areas. These areas include:

  • Portfolio management: recent losses may provide an impetus for portfolio managers to trade more aggressively than they should or to deviate from investment objectives in order to make up losses, and perhaps also to catch-up on performance-based fees. This is an area where compliance personnel should be active.
  • Financial controls, including compliance with net capital and customer control requirements by broker-dealers, as well as these firms’ risk management and internal control procedures. While the Division of Trading and Markets will no longer be supervising the holding companies of large broker-dealer firms — OCIE examiners will continue to focus attention on controls within the registered broker-dealer, which are intended to protect investors’ accounts with a broker-dealer. And, if you’re an adviser in precarious financial condition — you must disclose this fact to clients. This is an area where your focus is warranted.
  • Valuation, at all types of registrants, including controls and procedures for valuation of illiquid and difficult-to-price securities at all registrants. Reluctance to fair value or mark down prices cannot take precedence over the firm’s pricing procedures — investors and fund shareholders have a right to know the current value of their holdings. If you work for a broker-dealer that provides quotes or for an investment adviser or other user of broker quotes — be particularly alert to and look for the possibility of “accommodation quotes” — which don’t reflect prices at which the security could actually be sold. At its worst, this could be fraudulent conduct. A reminder too — under accounting rules (FAS 157), issuers must classify their assets within a hierarchy. For those assets valued by using a broker’s quote or a price from a pricing service — you should be sure that you understand whether the quote or price is based on actual transactions, reflects the willingness of the broker to trade at that price, or is based on a model or another methodology.  Among strong practices in this area are to require multiple sources of pricing information, and also to regularly go back and compare the actual prices realized on any sale to the fair values used: then, determine the reasons for any wide gaps and implement improvements in pricing processes. This is an area where your focus is needed now — be sure that your firm is implementing its controls and its oversight over pricing.
  • Sales of structured products by broker-dealers and advisers. Of special note — given that investors may be particularly looking for lower-risk investment products, examiners will focus on products marketed as being relatively “safe,” such as principal protected notes and other products, and will review the adequacy of disclosures concerning credit risk, liquidity, and investment risk. Conversely, investors may be looking to recoup losses, and may be more vulnerable to sales of high-risk, high-return products. You will want to focus on both types of products and make sure that representations are accurate and that your firm is treating investors fairly.
  • Controls and processes at recently merged or acquired firms, both advisers and broker-dealers. This is an area where compliance staff must be active — to help make sure that controls and processes do not fall through the cracks in a merged organization.
  • Money market funds, including, at a minimum, compliance with Rule 2a-7 regarding the creditworthiness of portfolio securities, shadow pricing, and compliance oversight — and more broadly, whether funds’ are stretching for yield and subjecting the fund to excessive undisclosed risk. We have examinations underway. The problems experienced by money market funds should be seen as cautionary for all managers and CCOs of money market funds.
  • Short selling and compliance with Regulation SHO and filings of Form SH. Examiners are also focusing on firms’ policies and procedures to prevent employees from knowingly creating, spreading, or using of false or misleading information with the intent to manipulate securities prices, and will be concluding a sweep of broker-dealers and hedge fund advisers in this area.

Beyond these specific compliance risk issues, in times of financial strain, people may act in uncharacteristic ways — in order to conceal losses, inflate revenues or profits, to stay in business or just to avoid delivering bad news. Examiners will be alert for indications of fraud and “acts of desperation” by individuals and firms that are under financial duress. As compliance personnel, however, you are much closer to the scene than we are — and you should be aware of and alert to the increased possibility that individuals under stress may take fraudulent or deceptive actions. Checks and balances are critical in this environment. You should insist on absolute compliance with policies and procedures, there should be no possibility of “suspending” compliance. And it would be timely for you to remind firm employees of your presence and make clear to every employee in the firm that no shortcuts will be allowed.

In addition to these focus areas, OCIE examiners will also be focusing on other compliance risks, and so too must you. We cannot afford to pay less attention to any of these issues. Let me describe several of these areas:

  • Suitability and appropriateness of investments for clients: Examiners will focus on whether securities recommended and investments made for clients and funds are consistent with disclosures, the client’s investment objectives and any investment restrictions, and with the broker or adviser’s obligations to clients to only recommend securities that are suitable or appropriate. We’ll focus in particular, on how firms are interacting with their senior customers and clients. We’ll also focus on structured products and other complex derivative instruments, variable annuities, niche ETFs, managed pay-out funds, and 130/30 funds.
  • Disclosure: Examiners will focus on ADVs, performance advertising, marketing, fund prospectuses and any other information provided to clients. This is a good time for you to review your firm’s disclosures to investors and shareholders. Make sure that any steps the firm has taken in recent days or weeks to deal with the credit crisis are consistent with the firm’s disclosures. Examiners will be specifically looking at how the firm represents its participation in Treasury’s money market guarantee program, the existence of SIPC coverage, and at advertised performance figures. Consider your disclosures as your “Constitution” — even in a crisis, it’s your governing document, and it must match your practices.
  • Controls to prevent insider trading: We’re focusing on the adequacy of policies and procedures, information barriers, and controls to prevent insider trading and leakage of information including the identification of sources of material non-public information, surveillance, physical separation, and written procedures. Controls to prevent insider trading should be strong in any environment.
  • Trading, brokerage arrangements and best execution: We’ll be looking at whether brokerage arrangements are consistent with disclosures, whether the firm seeks best execution, and whether soft dollars are used appropriately (consistent with disclosures), Reg NMS and direct market access arrangements. We will particularly scrutinize the use of an affiliated broker-dealer or any undisclosed relationships with a broker-dealer for excessive commissions, kick-backs and other conflicted relationships. Your best execution committees will want to particularly review execution quality in current markets.
  • Proprietary and employees’ personal trading: This is a basic part of any compliance program — when we find weaknesses in this area, it makes us wonder about the firm’s commitment to addressing other conflicts of interest. This is not an area to be overlooked.
  • Undisclosed payments: Examiners are looking for compensation or payment arrangements that may be part of revenue-sharing, or other undisclosed arrangements with third parties. These payments may be made to increase fund sales or assets under management (such as fund networking fees and payments by advisers to broker-dealers for obtaining space on the firms’ recommended adviser list). Undisclosed payments may also involve misappropriation of adviser/fund/broker-dealer assets by, for example, creating fictitious bills and expense items, or receiving kick-backs from a service provider.
  • Safety of customer assets: Examiners will look at whether brokers, funds and advisers have effective policies and procedures for safeguarding their clients’ assets from theft, loss, and misuse. This is a good time for you too to assess controls in this area. Make sure that advisory clients’ money is with a qualified custodian and review prime brokerage relationships. You may want to ensure that the process for sending account statements to clients has controls to ensure that the account statements cannot be intercepted or falsified. Examiners will also continue to focus on controls for compliance with Regulation S-P with respect to customer information.
  • Anti-money laundering: Examiners will look at whether funds and broker-dealers are complying with obligations under the securities laws, the Patriot Act and Bank Secrecy Act to have effective policies and procedures to detect and deter money-laundering activities, whether these policies and procedures are regularly tested for continued effectiveness, and whether actual practices are consistent with the policies and procedures.
  • Compliance, supervision, and corporate governance: While this is the last item I’ll list, it’s the most important — because it underpins all the other compliance responsibilities that firms have. In the coming year, examiners will focus in particular on supervisory procedures and practices at large branch offices of broker-dealers and at advisory branch offices, on supervision and controls over traders, whether funds have appropriately-constituted boards and have considered required matters (e.g., fair value procedures), and whether firms have implemented effective internal disciplinary processes. Also, we’ll examine: firms that advertise themselves as allowing maximum independence to registered representatives; for abuses in transferring customer accounts as registered representatives move to new firms; supervision of producing branch managers; bank broker-dealer branches; and the adequacy of firms’ testing to detect unsuitable or aberrant trades.

For advisers and mutual funds, in that this is the fifth year of both the Compliance Rule and our CCOutreach efforts for adviser and fund CCOs, we hope to see improvements in firms’ compliance programs, and in particular, that significant deficiencies were identified promptly and corrected appropriately by firms.

* * *

These are challenging times, no doubt. The SEC has been and will continue to guard the interests of investors. Industry compliance professionals too play an indispensable role in fostering and assuring investor protection and the integrity of our markets. As I said at the outset, I think that the first thing that you might do in the current environment is to is to remind firm employees of their obligations to investors — for an adviser, the fiduciary obligation to clients, and for a broker, the obligation to follow just and equitable principles of trade. These obligations must continue to motivate and inform the way that the firm interacts with investors.

I have shared with you today some of the issues that SEC examiners will be focusing on in the coming months — and these are areas where I hope you too will focus your attention. Finally, you cannot let slip the other ongoing compliance responsibilities that the firm has, and I have described some of these priority areas as well.

I hope this information will be helpful to you in your work, and I look forward to continuing to work with you to help improve and assure strong compliance practices in the securities industry.

Thank you.

Hedge Fund Manager Fined and Banned for a Year for “Portfolio Pumping”

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This is another example of a hedge fund manager acting with incredible audacity.

Last week the SEC issued a release detailing an action taken against a hedge fund manager for his “portfolio pumping” practices.  Bascially the manager was caught buying a large amount of shares through another fund he ran in order to boost the price of the thinly traded security.  The manager then charged higher management fees based on the inflated price of the securities.  The manager was fined $100,000 and ordered to disgorge the higher management fee of $80,000.

The end of the release states that the adviser will be allowed to reapply for association with an investment advisor for a year, but I believe the damage has been done.  If this manager does start another fund, proper hedge fund due diligence will show this SEC action which by itself should send investors running for the door.  In this case the hedge fund manager ruined his career for a few thousand dollars.

The release can be found in full here.

SEC Charges San Francisco Hedge Fund Adviser for “Portfolio Pumping”
FOR IMMEDIATE RELEASE
2008-251

Washington, D.C., Oct. 16, 2008 — The Securities and Exchange Commission today charged San Francisco investment adviser MedCap Management & Research LLC (MMR) and its principal Charles Frederick Toney, Jr. with reporting misleading results to hedge fund investors by engaging in a practice known as “portfolio pumping.”

The SEC alleges that Toney made extensive quarter-end purchases of a thinly-traded penny stock in which his fund was heavily invested, more than quadrupling the stock price and allowing him to report artificially inflated quarterly results to fund investors. Without admitting or denying the SEC’s allegations, MMR and Toney have agreed to settle the charges by paying financial penalties and agreeing to an order barring Toney from acting as an investment adviser for at least one year.

“Fund investors relied on MMR and Toney to abide by their fiduciary duties and put the fund’s interests ahead of their own,” said Marc J. Fagel, Regional Director of the SEC’s San Francisco Regional Office. “Instead, Toney engaged in trading activity which hid his poor performance.”

According to the SEC’s order, MedCap Partners L.P. (MedCap), a hedge fund run by MMR and Toney, was suffering from dramatic losses and facing increasing redemptions from fund investors by September 2006. Over the last four days of the month, Toney — through a separate fund that MMR managed — placed numerous buy orders for a thinly-traded over-the-counter stock in which MedCap already was heavily invested. Toney’s buying pressure caused the stock price to more than quadruple, from $0.85 to $3.72.

The SEC alleges that because the stock represented over one-third of MedCap’s holdings, the brief boost in its price inflated MedCap’s reported value by $29 million, masking what would otherwise have been a 40 percent quarterly loss for MedCap. Immediately after the quarter ended, Toney reported to MedCap’s investors that the fund’s investments had begun to “bounce” and that the fund’s performance was improving. Toney failed to disclose that this “bounce” was almost entirely the result of his four-day purchasing spree. Following MMR’s brief buying activity, both the stock price and MedCap’s asset value declined to their previous levels.

According to the SEC’s order, at the same time, MMR charged fees to the fund based on the inflated quarter-end asset value.

The Commission found that MMR and Toney breached their fiduciary duties to MedCap and to MMR’s other fund in which the penny stock was acquired. Toney and MMR, without admitting or denying the Commission’s findings, have agreed to cease and desist from violating the antifraud provisions of the Investment Advisers Act of 1940. MMR also will disgorge the higher management fees it received due to the inflated fund asset value, plus interest — an amount totaling $70,633.69 — and receive a Commission censure. Toney also has agreed to a bar from association with any investment adviser with the right to reapply after one year, and to pay a $100,000 penalty.

Other releated articles:

Please contact us if you have questions or if you would like to discuss.

Differences between the Series 65 and the Series 66

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Hedge fund managers who must register as investment advisor representatives with the SEC (through notice filings) or the state securities commission will need to have the proper FINRA exam licenses. Generally this means that the hedge fund manager will need to have passed the Series 65 exam within two years of registration (or the license must not have been inactive for two years prior to the registration).

However, if a manager has a Series 7 exam license, he will only need to take the Series 66 exam instead of the Series 65. This would generally be a good idea because the Series 66 exam is easier than the Series 65 exam and managers should be able to pass the Series 66 with less effort than the Series 65. I have detailed below the different requirements for the Series 65 versus the Series 66

Series 65 Exam

  • 140 multiple choice questions
  • 10 pre-test; 130 count towards score
  • 180 minutes to take the exam
  • Must achieve a 72% to pass
  • Test covers: economics and analysis; investment vehicles; investment recommendations and strategies; and legal and regulatory guidelines, including prohibition on unethical business practices.
  • NASAA test outline link.

Series 66 Exam

  • 110 multiple choice questions
  • 10 pre-test; 100 count towards score
  • 150 minutes to pass the exam
  • Must achieve 72% to pass
  • Test covers: much of the material included on the Series 65, but it does not include the product, analysis and strategy questions that are a large part of the Series 65.
  • NASAA test outline link.

Other related articles include:

If you have any questions, please contact us.

How to Register as an Investment Advisor

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Many hedge fund managers come from brokerage firms or other investment advisory firms and may, accordingly, have some of the FINRA licenses like a Series 7 or a Series 65.  However, most managers have not registered an as investment advisor and do not understand the process.  This guide is designed to familiarize managers with the  investment advisor registration process.

Investment Advisor Compliance Firm

First, you will want to find a firm that will help you through the process of registering as an investment advisor.  A hedge fund lawyer or a hedge fund compliance firm (usually consisting of former SEC or state securities commission examiners) will be able to help you with this process. Potential investment advisors should not try to go through the registration process by themselves – it will take too much time and subject the advisor to potential liability.

Jurisdiction

The manager can register as an investment advisor with the SEC or the state securities commission of the state in which the manager resides.  The manager should have a conversation with the lawyer or complaice firm regarding the pros and cons of the registration with the SEC or state.  Generally, however, a manager will only be able to register with the SEC if the manager has at least $25 million under management.

Cost

The costs should be the same for the advisor whether they go with a hedge fund lawyer or with a compliance firm.  Generally, for state-registered investment advisers, the professional fees run anywhere from $2,500-$3,500 for the registration.  For SEC-registered investment advisors, the professional fees will run anywhere from $4,000 to $8,000 depending on the complexity of the investment advisory firm.
The above costs are service provider fees and do not include the fees an investment advisor firm will pay to the state of residence of the investment advisor.  Such fees will generally include the following:

  • IA firm registration fee (State registered IAs only)
  • IA representative fee
  • Form U-4 fee
  • Notice filing fee (SEC registered IAs only)
  • Other miscellaneous fees

Tests

The manager who is registering to be an investment advisor will typically need to have taken and passed the Series 65 exam within the two years prior to registration.  Most all states will also allow managers to register if they have the Series 7 exam and the Series 66 exam.  Since most managers who have the Series 7 will not have the Series 66, the managers will need to take this exam.

Additionally, most states will not require a manager to have any of the above exams if they have one of the following designations

  • Chartered Financial Planner (CFP);
  • Chartered Financial Consultant (ChFC);
  • Personal Financial Specialist (PFS);
  • Chartered Financial Analyst (CFA); or
  • Chartered Investment Counselor (CIC).

Forms

The investment advisor will need to complete a wide variety of forms during the registration process.  These forms include:

IARD entitlement Forms – “IARD” stands for the Investment Adviser Registration Depository which is sponsored by the SEC and the NASAA (the association of state securities regulations, www.nasaa.org) but which is operated by FINRA.  As the IARD system is an online system, these forms need to be manually completed and processed by FINRA before you can begin the registration process.  The forms can be found here: IARD Entitlement Forms

Form ADV – this is the form which all investment advisors complete.  When a firm is registered with the SEC or the state, then the filings can be seen here by typing in the advisor’s name.  Please see Form ADV.  (HFLB note: we will have a detailed guide on Form ADV coming out soon.)

Form ADV Part II – this is the part of Form ADV which provides more information on the advisor’s activities.  It is sometimes refered to as the investment advisory “brochure.”  Please see Form ADV Part II.  (HFLB note: we will have a detailed guide on Form ADV Part II coming out soon.)

Form U4 – this form will need to be completed for all members of the firm which will be investment advisor representatives.  If such members have been in the securities industry for a while, they will likely already have a U4 on file with FINRA.  (HFLB note: we will have a detailed guide on Form ADV Part II coming out soon.)

Registration Timeline

Your compliance provider will be able to help you determine how long it will take to become registered as an investment advisor.  Generally SEC registration will be quicker than state registration and many times registration can be completed within 2 to 4 weeks.

State registration is more difficult to determine and will depend on the state of registration.  A state like California may take 6 to 8 weeks.  A state like South Carolina will take about 2 weeks, it just depends and you should discuss this issue with your compliance provider if the registration is time sensitive.

Other helpful articles include:

Please contact us if you would like to register your firm as an investment advisor or if you have any questions on the above.

Overview of Hedge Fund Investment Advisors

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It is often said that hedge funds are unregistered or lightly regulated investment pools.  While this is correct, there are certain regulations which an investment manager must follow, including certain regulations under the Investment Advisers Act of 1940 (and the securities laws of the hedge fund manager’s state of residence).  These regulations may require a hedge fund manager to be registered as an investment advisor.

Definition

In general terms, an investment advisor is any person (or company) which receives remuneration for providing investment advice to a client.  This will include all hedge fund managers.

Registration or Exemption

While all hedge fund managers will fall within the definition of investment advisor, not all hedge fund managers will need to be registered. An investment advisor will need to be registered with the U.S. Securities and Exchange Commission or with the state securities division if the advisor does not fall within an exemption from the registration provisions.  The exemption may be at the federal level, the state level, or both.  (Please see this article on the Section 203(b)(3) exemption.)

Other Requirements

All investment advisors are fiduciaries and must act in the best interest of their clients.  Investment advisors (whether or not such advisor is registered) will need to adhere to the anti-fraud provision of the Investment Adviser’s Act of 1940.

Other helpful articles on investment advisors include:

Please contact us if you have any questions.

Solicitors for Registered Investment Advisory Firms

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A common question for investment advisory firms is how they can pay persons for referring them separately managed account clients.  For SEC-registered investment advisors, any such fee would need to be paid pursuant to the requirements of Rule 206(4)-3 – the rule regarding cash payments for client solicitations.

Rule 206(4)-3 defines the term “solicitor” broadly to include any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser.  The rule also requires that fees paid to solicitors pursuant to the following guidelines:

– the solicitor is not disqualified by the rule;
– there is a written agreement between the solicitor and the IA firm;
– the solicitor provides the client with a statement which details certain parts of the arrangement; and
– the client signs an acknowledgment of the relationship

The above bullet points are generally what is required and if you have questions on your specific situation you should discuss with your attorney or compliance person.  I have also posted the complete rule below.  Additional information was provided by the SEC at the time of the rule’s release which can be found here: Investment Advisers Act Release No. 688.  Please contact us if you have any questions.

Rule 206(4)-3 – Cash Payments for Client Solicitations

(a) It shall be unlawful for any investment adviser required to be registered pursuant to section 203 of the Act to pay a cash fee, directly or indirectly, to a solicitor with respect to solicitation activities unless:

(1)

(i)The investment adviser is registered under the Act;

(ii) The solicitor is not a person (A) subject to a Commission order issued under section 203(f) of the Act, or (B) convicted within the previous ten years of any felony or misdemeanor involving conduct described in section 203(e)(2)(A) through (D) of the Act, or (C) who has been found by the Commission to have engaged, or has been convicted of engaging, in any of the conduct specified in paragraphs (1), (5) or (6) of section 203(e) of the Act, or (D) is subject to an order, judgment or decree described in section 203(e)(4) of the Act; and

(iii) Such cash fee is paid pursuant to a written agreement to which the adviser is a party; and

(2) Such cash fee is paid to a solicitor:

(i) With respect to solicitation activities for the provision of impersonal advisory services only; or

(ii) Who is (A) a partner, officer, director or employee of such investment adviser or (B) a partner, officer, director or employee of a person which controls, is controlled by, or is under common control with such investment adviser: Provided, That the status of such solicitor as a partner, officer, director or employee of such investment adviser or other person, and any affiliation between the investment adviser and such other person, is disclosed to the client at the time of the solicitation or referral; or

(iii) Other than a solicitor specified in paragraph (a)(2) (i) or (ii) of this section if all of the following conditions are met:

(A) The written agreement required by paragraph (a)(1)(iii) of this section: (1) Describes the solicitation activities to be engaged in by the solicitor on behalf of the investment adviser and the compensation to be received therefor; (2) contains an undertaking by the solicitor to perform his duties under the agreement in a manner consistent with the instructions of the investment adviser and the provisions of the Act and the rules thereunder; (3) requires that the solicitor, at the time of any solicitation activities for which compensation is paid or to be paid by the investment adviser, provide the client with a current copy of the investment adviser’s written disclosure statement required by Rule 204-3 (“brochure rule”) and a separate written disclosure document described in paragraph (b) of this rule.

(B) The investment adviser receives from the client, prior to, or at the time of, entering into any written or oral investment advisory contract with such client, a signed and dated acknowledgment of receipt of the investment adviser’s written disclosure statement and the solicitor’s written disclosure document.

(C) The investment adviser makes a bona fide effort to ascertain whether the solicitor has complied with the agreement, and has a reasonable basis for believing that the solicitor has so complied.

(b) The separate written disclosure document required to be furnished by the solicitor to the client pursuant to this section shall contain the following information:

(1) The name of the solicitor;

(2) The name of the investment adviser;

(3) The nature of the relationship, including any affiliation, between the solicitor and the investment adviser;

(4) A statement that the solicitor will be compensated for his solicitation services by the investment adviser;

(5) The terms of such compensation arrangement, including a description of the compensation paid or to be paid to the solicitor; and

(6) The amount, if any, for the cost of obtaining his account the client will be charged in addition to the advisory fee, and the differential, if any, among clients with respect to the amount or level of advisory fees charged by the investment adviser if such differential is attributable to the existence of any arrangement pursuant to which the investment adviser has agreed to compensate the solicitor for soliciting clients for, or referring clients to, the investment adviser.

(c) Nothing in this section shall be deemed to relieve any person of any fiduciary or other obligation to which such person may be subject under any law.

(d) For purposes of this section,

(1) Solicitor means any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser.

(2) Client includes any prospective client.

(3) Impersonal advisory services means investment advisory services provided solely by means of (i) written materials or oral statements which do not purport to meet the objectives or needs of the specific client, (ii) statistical information containing no expressions of opinions as to the investment merits of particular securities, or (iii) any combination of the foregoing services.

SEC brings fraud charges against investment advisor in connection with hedge fund investments

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Investment advisors who recommend hedge fund investments should be very careful to disclose all material agreements between the advisor and the hedge fund and hedge fund manager.  In the case below an investment advisor recommend hedge fund investments to its clients without disclosing to such clients that the advisor was receiving a part of the performance fees that were paid to the hedge fund manager.

Advisors should also take note to the following two issues:

SEC jurisdiction over state registered investment advisors

Even though the advisor was registered with the California Securities Regulation Division and not the SEC, the SEC was able to take action under Section 206 (the anti-fraud provisions) of the Investment Advisers Act.  Additionally the SEC was able to bring charges against the investment advisor under the Securities Act of 1933 and the Securities Exchange Act of 1934 (the “Exchange Act”).  This shows that the SEC’s has quite a few methods to assert jurisdiction over non-SEC registered advisors.

Potential violations of broker registration requirements?

Although I have not yet had a chance to read the unreleased complaint, I am wondering why the SEC did not charge this group with violating the broker registration requirements.  I think there is an argument that the investment advisory firm was acting as a broker.  I checked FINRA’s broker check and the firm did not come up as a registered broker.

Section 15(a)(1) of the Exchange Act generally makes it unlawful for any broker or dealer to use the mails (or any other means of interstate commerce, such as the telephone, facsimiles, or the Internet) to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless that broker or dealer is registered with the Commission in accordance with Section 15(b) of the Exchange Act.

The release below can be found here.

U.S. SECURITIES AND EXCHANGE COMMISSION
Litigation Release No. 20737 / September 24, 2008

Securities and Exchange Commission v. WealthWise, LLC and Jeffrey A. Forrest, United States District Court for the Central District of California, Civil Action No. CV 08-06278 GAF (SSx)

SEC Charges California Investment Adviser With Committing Fraud While Recommending Hedge Fund to Clients

The Securities and Exchange Commission today charged a San Luis Obispo, Calif.-based investment adviser and its owner with fraud for failing to disclose a material conflict of interest when recommending that their clients invest in a hedge fund that made undisclosed subprime and other high-risk investments.

The SEC alleges that WealthWise LLC and its principal Jeffrey A. Forrest recommended that more than 60 of their clients invest approximately $40 million in Apex Equity Options Fund, a hedge fund managed by Salt Lake City-based Thompson Consulting, Inc. (TCI). According to the SEC’s complaint, WealthWise and Forrest failed to disclose a side agreement in which WealthWise received a portion of the performance fee that Apex paid TCI for all WealthWise assets invested in the hedge fund. From April 2005 to September 2007, WealthWise received more than $350,000 in performance fees from TCI. Apex collapsed in August 2007, and WealthWise clients lost nearly all of the money they invested.

The SEC’s complaint, filed in federal district court in Los Angeles, charges WealthWise and Forrest with violating Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940. The SEC seeks an injunction, an accounting of the total amount of performance fees WealthWise received from TCI, disgorgement of those fees, and financial penalties.

On March 4, 2008, the SEC filed a civil action in federal district court in Salt Lake City against TCI and three of its principals in connection with the collapse of Apex and another hedge fund.

What is a qualified client? Qualified client definition

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UPDATE: the below article is based on the old “qualified client” definition.  The new “qualified client” definition can be found in full here, and the SEC order increase the asset thresholds can be found here.  As a gross summary, the new definition of a qualified client is:

  • entity or natural person with at least $1,000,000 under management of the advisor, OR
  • entity or natural person who has a net worth of more than $2,100,000

For the second test above, natural persons exclude the value of (and debt with respect to) their primary residence (assuming the primary residence is not under water).

****

Certain hedge fund managers need to be registered as investment advisors with the SEC or with the state securities commission of the state which they reside in.  For SEC-registered investment advisors, and most state registered advisors, the investors in their hedge fund will need to be “qualified clients” in addition to the requirement that such investors are also accredited investors.  While many accredited investors will also be qualified clients, this might not always be the case because the qualified client defintion requires a higher net worth than the accredited investor definition.  Hedge fund managers who are required to have investors who are both accredited investors and qualified clients cannot charge performance fees to those investors who do not meet the qualified client definition.  Individual investors will generally need to have a $1.5 million net worth in order to be considered a “qualified client.”

The definition of “qualified client” comes from rules promulgated by the SEC under the Investment Advisors Act of 1940, specifically Rule 205-3.  That rule provides:

The term qualified client means:

1. A natural person who or a company that immediately after entering into the contract has at least $750,000 under the management of the investment adviser;

2. 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 $1,500,000 at the time the contract is entered into; or

b. Is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 at the time the contract is entered into; or

3. A natural person who immediately prior to entering into the contract is:

a. An executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser; or

b. An employee of the investment adviser (other than an employee performing solely clerical, secretarial or administrative functions with regard to the investment adviser) who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser, provided that such employee has been performing such functions and duties for or on behalf of the investment adviser, or substantially similar functions or duties for or on behalf of another company for at least 12 months.

Investment Advisor faces fine and injuction for unauthorized leverage

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As a hedge fund lawyer one of my most important jobs is to help keep the client out of any trouble and to help the manager deal with any potential issues before they become issues.

Below is a classic example of an investment manager who did not adequately describe his investment program (and the risks). One of the more important parts of the hedge fund start up process is to create an investment program which accurately describes the trading which the fund will engage in. While many offering documents include very broad language allowing a manager to make changes to the investment program, gross or wholesale changes should be communicated to the investor (potentially with the right to redeem the interests, depending on the hedge fund’s terms and structure). The highlighted language below emphasizes the point that descriptions of a hedge fund’s investment program should be accurate, as well as the point that hedge fund managers should never lie or intentionally mislead their clients.

The full release can be found here.

Release:

U.S. SECURITIES AND EXCHANGE COMMISSION
Litigation Release No. 20713 / September 11, 2008
SEC v. Mark D. Lay and MDL Capital Management, Inc., Civil Action No. 08-CV-1269 (DSC) (W.D. Pa.)
SEC Charges Mark D. Lay and MDL Capital Management, Inc. With Defrauding Ohio Bureau of Workers’ Compensation

The Securities and Exchange Commission announced that today it filed securities fraud charges in the United States District Court for the Western District of Pennsylvania against Mark D. Lay of Aliquippa, Pennsylvania, and MDL Capital Management, Inc. (“MDL Capital”), an investment adviser registered with the Commission and located in Pittsburgh, Pennsylvania. Lay was the Chairman, CEO and Chief Investment Strategist of MDL Capital and part-owner of MDL Capital. Without admitting or denying the allegations of the Complaint, Lay and MDL Capital have consented to the entry of a final judgment permanently enjoining them from engaging in the violations set forth below, and ordering other relief

The Commission’s Complaint alleges that, between February 2004 and November 2004, Lay and MDL Capital defrauded their advisory client, the Ohio Bureau of Workers’ Compensation, in connection with the Bureau’s investment of public money in the MDL Active Duration Fund, Ltd., a hedge fund affiliated with and managed by Lay and MDL Capital. The Bureau transferred approximately $200 million from its advisory account managed by MDL Capital and Lay to the hedge fund pursuant to an agreement that those assets would be conservatively leveraged.

The Complaint further alleges that MDL Capital and Lay exposed Bureau funds to unauthorized and undisclosed risk by substantially exceeding a 150% leverage guideline, at one point using leverage of over 21,000% in the hedge fund. As a result, the Bureau incurred losses of approximately $160 million. During the course of the fraud, Lay repeatedly lied to and misled the Bureau as to the reasons for and amount of the losses as well as the excessive leverage Lay was using.

In October 2007, based on these same facts, Lay was convicted in the Northern District of Ohio of criminal mail fraud, wire fraud and investment adviser fraud. Lay is currently serving a 12 year prison sentence.

The Complaint alleges that Lay and MDL Capital violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940. Subject to the Court’s approval, the final judgment imposes permanent injunctions against MDL Capital and Lay and orders them to pay $1,544,195 in disgorgement and prejudgment interest, but waives payment of these amounts, and does not impose civil penalties, based on the defendants’ sworn statements of financial condition.