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On November 25, 2014, the Securities and Exchange Commission (the “SEC”) brought charges against a Swiss-based bank that should serve as notice to all non-U.S. banks that maintain relationships with clients who have moved to the U.S., as well as U.S.-based banks that provide services to clients who have relocated to other countries.  The SEC found that HSBC’s Swiss-based private banking arm violated U.S. securities laws by providing investment advisory and brokerage services to U.S. clients without being properly registered as either an investment adviser or a broker-dealer.  HSBC Private Bank (Suisse) agreed to admit wrongdoing and pay $12.5 million to settle the SEC’s charges in a combination of disgorgement, prejudgment interest, and penalties.

How often do financial institutions, foreign or U.S., put themselves in the position of willfully violating the securities and banking laws of other countries?  Pretty routinely, as it turns out.  By way of example, suppose you are a citizen of a European Union country with a local banking relationship.  You work for a large multi-national company that offers you a promotion, but that new job is in New York.  Not one to decline an opportunity, off you go to the Center of the Universe.  You open a new bank account at a local New York bank, but you maintain your European bank relationship because you have a consolidated banking, investment advisory and brokerage relationship there that has worked quite well for you.  The relationship manager at your European bank certainly does not want to give up the revenue stream from your lucrative relationship, particularly now that you are making so much more money and you are willing to purchase and sell stocks more frequently.  Multiply this scenario several times over and before you know it, this certain European bank is routinely providing banking, investment advisory, and brokerage services to U.S. residents without being properly registered to do so.

This same scenario can and often does play out in reverse.  A U.S. citizen moves to a foreign country and maintains his banking, investment advisory and/or brokerage relationships with a financial institution that is not qualified to do business in the client’s new country of residence and before you know it, the U.S. financial institution is in violation of the laws of the country in which its client now resides.  And, not to gratuitously pick on any particular jurisdiction, the provision of such services in some countries pourrait être criminelle.

In the case of HSBC, the SEC found that HSBC Private Bank and its predecessors began providing cross-border advisory and brokerage services in the U.S. more than 10 years ago on behalf of at least 368 U.S. client accounts and collected fees totaling approximately $5.7 million.  HSBC relationship managers traveled to the U.S. on at least 40 occasions to solicit clients, provide investment advice, and induce securities transactions.  These relationship managers were not registered in the U.S. as investment adviser representatives or licensed brokers, nor were they affiliated with a registered investment adviser or broker-dealer (or “chaperoned” by a registered U.S. broker-dealer).  The relationship managers also communicated directly with clients in the U.S. through overseas mail and e-mails.  In 2010, HSBC Private Bank decided to exit the U.S. cross-border business, and nearly all of its U.S. client accounts were closed or transferred by the end of 2011.

According to the SEC’s order, HSBC Private Bank understood there was a risk of violating U.S. securities laws by providing unregistered investment advisory and brokerage services to U.S. clients, and the firm undertook certain compliance initiatives in an effort to manage and mitigate the risk.  The firm created a dedicated North American desk to consolidate U.S. client accounts among a smaller number of relationship managers and service them in a compliant manner that would not violate U.S. registration requirements.  However, certain relationship managers were reluctant to lose clients by transferring them to the North American desk and stalled the process or ignored it altogether.  HSBC Private Bank’s internal review revealed multiple occasions when U.S. accounts that were expected to be closed under certain compliance initiatives remained open.  HSBC Private Bank admitted to the SEC’s findings in the administrative order, acknowledged that its conduct violated U.S. securities laws, and accepted a censure and a cease-and-desist order.

Foreign financial institutions, even those that have U.S. affiliates that are properly registered and regulated as banks, investment advisers, or broker-dealers should undertake a review of their client accounts to determine whether they are providing services that are in violation of applicable law.  It is possible, perhaps even likely, that even if a non-U.S. financial institution has properly registered U.S. entities, services are being provided to certain clients outside of those entities as a result of historical relationships.  U.S. banks should also determine whether they are providing financial services to relocated clients in countries that would either prohibit such services or require some form of notification or registration.  A failure to abide by the laws of non-U.S. countries could also place a U.S. institution in the position of violating certain U.S. laws that require diligence of and compliance with the laws of other countries.

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This is a reminder that the 2015 IARD account renewal obligation for investment advisers (including exempt reporting advisers) starts this November.  An investment adviser must ensure that its IARD account is adequately funded to cover payment of all applicable registration renewal fees and notice filing fees.

Key Dates in the Renewal Process:

November 10, 2014 – Preliminary Renewal Statements which list advisers’ renewal fee amount are available for printing through the IARD system.

December 12, 2014 – Deadline for full payment of Preliminary Renewal Statements.  In order for the payment to be posted to its IARD Renewal account by the December 12 deadline, an investment adviser should submit its preliminary renewal fee to FINRA through the IARD system by December 10, 2014.

December 28, 2014 – January 1, 2015 – IARD system shut down.  The system is unavailable during this period.

January 2, 2015 – Final Renewal Statements are available for printing.  Any additional fees that were not included in the Preliminary Renewal Statements will show in the Final Renewal Statements.

January 16, 2015 – Deadline for full payment of Final Renewal Statements.

For more information about the 2015 IARD Account Renewal Program including information on IARD’s Renewal Payment Options and Addresses, please visit http://www.iard.com/renewals.asp

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On October 29, 2014, the Securities and Exchange Commission (“SEC”) announced an administrative enforcement action against an investment advisory firm and three top officials for violating rule 206(4)-2 under the Investment Advisers Act of 1940 (“Advisers Act”), the “custody rule,” that requires firms to follow certain procedures when they control or have (or are deemed to have) access to client money or securities.  This enforcement action follows closely on the heels of statements by SEC officials indicating that violations of the custody rule were a recurring theme during the “presence exams” of private equity fund advisers and other first time investment adviser registrants that have been conducted by the SEC staff over the last year and a half.

Advisory firms with custody of private fund assets can comply with the custody rule by distributing audited financial statements to fund investors within 120 days of the end of the fiscal year.  This provides investors with regular independent verification of their assets as a safeguard against misuse or theft.  The SEC’s Enforcement Division alleges that Sands Brothers Asset Management LLC has been repeatedly late in providing investors with audited financial statements of its private funds, and the firm’s co-founders along with its chief compliance officer and chief operating officer were responsible for the firm’s failures to comply with the custody rule.  As investment adviser registrants are painfully aware, chief compliance officers have personal liability for compliance failures under Advisers Act rule 206(4)-7.  This particular enforcement action was brought pursuant to section 203(f) of and rule 206(4)-2 under the Advisers Act.  It remains to be seen whether the SEC will bring a separate action against the Sands Brothers’ chief compliance officer under rule 206(4)-7.

Also nervously awaiting any further action by the SEC would be the accountants and lawyers that advised the Sands Brothers and their hedge funds with respect to the custody matter.  The accounting firm or firms that conducted the audit of the Sands Brothers hedge funds likely knew that the funds did not meet the requirements of the custody rule.  It is less certain whether the external lawyers knew or should have known about these violations.  However, if either the accountants or lawyers knew of these violations and advised that they were only technical in nature and immaterial or  unimportant, the SEC could take separate administrative action pursuant to SEC rule 102(e) to bar any such party from practicing before the SEC.  We previously wrote about the more aggressive posture that the SEC signaled with respect to service providers, specifically lawyers that assist or “aid and abet” violations of the securities laws.  The SEC has a fairly high standard to meet when bringing these types of cases, but that has not deterred the regulator from aggressively pursuing more accountants and lawyers in recent months.

According to the SEC’s order instituting the administrative proceeding, Sands Brothers was at least 40 days late in distributing audited financial statements to investors in 10 private funds for fiscal year 2010.  The next year, audited financial statements for those same funds were delivered anywhere from six months to eight months late.  The same materials for fiscal year 2012 were distributed to investors approximately three months late.  According to the SEC’s order, Sands Brothers and the two co-founders were previously sanctioned by the SEC in 2010 for custody rule violations.

If you have been late on the delivery of your audited financial statements and have not availed yourself of the “surprise audit” provision of the custody rule, or if you manage “side car” funds that have never been audited, you should immediately get in touch with your Pillsbury attorney contact.

 

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Replacing Circular 75, Circular 37 simplifies the SAFE registration process for Chinese residents seeking offshore investments and financings, and it liberalizes cross-border capital outflow by Chinese residents. In addition, Circular 37 also permits registration of equity incentive plans of non-listed Special Purpose Vehicles.

In July 2014, the State Administration of Foreign Exchange (SAFE) of the People’s Republic of China released the Notice of the State Administration of Foreign Exchange on Administration of Foreign Exchange Involved in Offshore Investment, Financing and Round-Trip Investment Conducted by Domestic Residents Through Special Purpose Vehicles (SPVs) (Circular Hui Fa [2014] No. 37) (Circular 37). Circular 37 superseded Circular 75 (Circular Hui Fa [2005] No. 75), which regulated the same subject matter and was issued by SAFE almost ten years ago.

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Read this article and additional publications at pillsburylaw.com/publications-and-presentations.

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In a press release yesterday, the CFTC issued an exemptive letter, CFTC Letter No. 14-116, providing relief from certain provisions of CFTC Regulations 4.7(b) and 4.13(a)(3) that restrict marketing to the public.  The exemptive relief was issued to make CFTC Regulations 4.7(b) and 4.13(a)(3) consistent with SEC Rule 506(c) of Reg. D and Rule 144A, which were amended by the Jumpstart Our Business Startups Act (JOBS Act), to permit general solicitation or advertising subject to certain limitations.

Generally, the JOBS Act adopted SEC Rule 506(c) to permit an issuer, subject to the conditions of the rule, to engage in general solicitation or general advertising when offering and selling securities, and amended SEC Rule 144A to permit the use of general solicitation, subject to the limitations of the rule, when securities are sold to qualified institutional buyers (“QIBs”) or to purchasers that the seller reasonably believes are QIBs.  Prior to the CFTC’s exemptive relief, commodity pool operators (“CPOs”) relying on CFTC Regulations 4.7(b) and 4.13(a)(3) were not able to use general solicitation under Rule 506(c) or Rule 144A, as the CFTC exemptions prohibited general solicitation.

The new relief from provisions in CFTC Regulations 4.7(b) and 4.13(a)(3) is subject to the following conditions:

  1. The exemptive relief is strictly limited to CPOs who are 506(c) Issuers or CPOs using 144A Resellers.
  2. CPOs claiming the exemptive relief must file a notice with the Division.  The notice of claim of exemptive relief must:
  • State the name, business address, and main business telephone number of the CPO claiming the relief;
  • State the name of the pool(s) for which the claim is being filed;
  • State whether the CPO claiming relief is a 506(c) Issuer or is using one or more 144A Resellers;
  • Specify whether the CPO intends to rely on the exemptive relief pursuant to Regulation 4.7(b) or 4.13(a)(3), with respect to the listed pool(s);

 i.      If relying on Regulation 4.7(b), represent that the CPO meets the conditions
of the exemption, other than that provision’s requirements that the offering be
exempt pursuant to section 4(a)(2) of the 33 Act and be offered solely to QEPs,
such that the CPO meets the remaining conditions and is still required to sell
the participations of its pool(s) to QEPs;
ii.       If relying on Regulation 4.13(a)(3), represent that the CPO meets the
conditions of the exemption, other than that provision’s prohibition against
marketing to the public;

  • Be signed by the CPO; and
  • Be filed with the Division via email using the email address dsionoaction@cftc.gov and stating “JOBS Act Marketing Relief” in the subject line of such email.
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China imposes controls on the inflow and outflow of foreign exchange. Given the involvement of State Administration of Foreign Exchange and various other governmental agencies in the process, repatriating funds from China can be a trap for the unwary. Foreign investors should familiarize themselves with the approval requirements and procedures.

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The U.S. House of Representatives took a major positive step towards increasing the nation’s cyber security posture today when, on a voice vote, it passed H.R. 3696, the “National Cybersecurity and Critical Infrastructure Protection Act.”

The NCCIP bill, co-sponsored by House Homeland Security Chairman Mike McCaul, Ranking Member Bennie G. Thompson, Subcommittee Chair Patrick Meehan, and Subcommittee Ranking Member Yvette Clarke, clarifies a number of roles and responsibilities of the Department of Homeland Security (DHS), and it also strengthens key public/private partnerships.

One of the most interesting and potentially helpful elements of the NCCIP bill is in Title II, Section 202. There, the House approved additional language to be inserted into the Support Anti-Terrorism by Fostering Technologies Act of 2002 (the SAFETY Act). The language would add the term “qualifying cyber incident” to the SAFETY Act, thereby making it perfectly clear that cyber attacks unconnected to “acts of terrorism” may trigger – at the discretion of the Secretary of Homeland Security – the liability protections offered by the SAFETY Act.

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Read this article and additional publications at pillsburylaw.com/publications-and-presentations.

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The Securities and Exchange Commission (SEC) yesterday adopted a series of amendments to the rules that govern money market funds.  The most controversial of these amendments will require institutional prime and tax-exempt money market funds to maintain a floating net asset value (NAV) and will allow the boards of institutional and retail prime and tax-exempt money market funds to impose liquidity fees and to suspend redemptions temporarily if the funds’ weekly liquid assets fall below a certain threshold.  Funds will have two years to comply with these amendments.

Retail and government funds will be not subject to the floating NAV requirement.  A retail fund is defined as a fund that has policies and procedures reasonably designed to limit all beneficial owners to natural persons.  A government fund is defined as a fund that invests 99.5% of its assets in cash and government securities.  Floating NAVs will be rounded to the fourth decimal place.  In conjunction with the SEC amendments, the Treasury Department and the Internal Revenue Service proposed rules providing a simplified tax accounting method to track gains and losses on floating NAV money market funds and providing relief from the wash sale rules.

If a money market fund’s weekly liquid assets fall below 30% of its total assets, a fund board would be permitted to impose a liquidity fee of up to 2% on redemptions and to suspend redemptions (impose a “gate”) for up to 10 business days.  If the liquid assets fall below 10%, the fund would be required to impose a liquidity fee of 1%, unless the fund board determines that a lower or higher fee (ranging from no fee to a 2% fee) would be in the best interest of the fund.  Government funds would not be subject to these requirements, but could voluntarily opt into them if previously disclosed to investors.

Concern has been expressed that the floating NAV requirement will impose new costs on money market funds, prompt institutional investors to shift cash to government funds, bank deposits and unregulated funds, and impair the short-term funding of businesses and governments.  Concern has also been expressed that the liquidity fee and gate requirements will trigger runs.

The SEC at the same time adopted less controversial amendments to the diversification, disclosure and stress testing requirements for money market funds, as well as to the reporting requirements for money market funds and for private funds that operate like money market funds.  In addition, it reproposed amendments to remove references to credit ratings in the rules and forms relating to money market funds.

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In a move that should place securities lawyers and their clients on notice, Commissioner Kara Stein of the Securities and Exchange Commission (“SEC”) recently indicated that lawyers may become targets of SEC enforcement actions when a registrant has been poorly advised by its attorney and the result of that advice ends up harming investors or violating regulatory standards.  The SEC has the ability to sanction, fine and bar attorneys and accountants from practicing before the SEC pursuant to SEC Rules of Practice 102(e).  As a practical matter, a bar pursuant to Rule102(e) precludes an attorney or an accountant from representing a regulated entity, such as an investment adviser or broker dealer, in any further dealings with the SEC or otherwise.

Several years ago, before he retired, I asked Gene Gohlke, then the acting head of the SEC’s Office of Compliance, Inspections and Examinations, why it was that the SEC brought Rule 102(e) proceedings against accountants, but rarely against attorneys.  “Lawyers are different,” was the answer I received.  And that has been the approach  of the SEC for quite some time, only bringing proceedings to bar attorneys in the most obvious and egregious cases.  My question to Mr. Gohlke was prompted by what I saw as questionable legal advice from certain “boutique” law firms that were providing not just aggressive advice, but simply incorrect advice.  You may recall that before the relatively recent Mayer Brown no-action letter, hedge fund managers were being advised that they could hire third party marketers that were not registered as broker dealers through “solicitation agreements” pursuant to Rule 206(4)-3 under the Investment Advisers Act of 1940.  This position, which was advocated by every former real estate or anti-trust  lawyer turned hedge fund lawyer, was flatly wrong, but generally embraced by fund managers.  When the SEC finally caught on that some fund managers were hiring unregistered broker dealers, Bob Plaze, then associate director of the Division of Investment Management of the SEC, somewhat famously quipped that if fund managers had been interpreting the Dana letter to allow such activity, they had been interpreting it wrong.

Additionally, in his recent speech, David Blass put fund managers on notice that they have been misinterpreting the scope of the “issuer’s exemption,” Rule 3a4-1 under the Securities Exchange Act of 1934.  Fund managers are now on notice that they need to either hire third party brokers, or pay their internal employees based on something other than the amount of capital raised on behalf of the fund.  This also grew out of a misunderstanding of that rule by the aggressive and misinformed section of the securities bar.  There are many other examples, such as relying on the “issuer’s exemption” when the fund is organized as a unit trust, rather than a partnership or exempted company (don’t do it), misinterpretation of what constitutes permissible use of soft dollars within the safe harbor Section 28(e), operation of the custody rule, execution of short sales, and many more.  When the SEC finds deficiencies in a fund management organization, it is typically the fund manager that suffers the consequences, not the attorney that advised the fund management company.

But with the SEC now identifying attorneys as key “gatekeepers,” all of that could change.  Commissioner Stein is “troubled greatly” by enforcement cases where the lawyers that gave advice on the transaction and prepared and reviewed disclosures that were relied upon by investors are not held accountable.  The Commissioner identified that when lawyers do provide bad advice, or effectively serve to assist fraud, their involvement is used as a shield against liability, both for themselves and for others.  The problem has been surfaced by the SEC, now we will see how and against whom enforcement action is taken in order to make an example for the industry.

What does this mean for fund managers?  First, fund managers need to recognize that “forum shopping” is dangerous.  You can always find a lawyer somewhere that is complacent, desperate, or unethical enough to tell the fund manager whatever they want to hear.  This is a short term folly and can only lead to a bad result in the longer term.  Second, the market has changed substantially since the heady days of 2002-2007.  It is no longer just the overworked and understaffed regulators with which fund managers need to concern themselves.  Investor sophistication in the due diligence area has increased substantially and now endowments, family offices and ultra-high net worth investors want to understand that the fund manager has made good decisions with respect to their service providers and has not opted for a low-end option that the fund manager can dominate and control.  Particularly for start-up fund managers that have essentially one shot at executing on a successful offering, the choice of an administrator that has no FATCA solution, or a lawyer that is unknown or not respected, can kill the offering before it ever gets started.  As attorneys, we recognize that competition in the asset management business is fierce and raising assets has rarely been more difficult; however, this is a business that is built on trust and confidence.  Fund managers need to demonstrate with every decision they make; they are motivated by the best interests of their investing clients.

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The Commodity Futures Trading Commission (“CFTC”) staff recently issued guidance to registered CPOs regarding the delegation of commodity pool operator (“CPO”) functions from persons that might otherwise be subject to CPO registration.  For non-natural persons delegating CPO functions to a registered CPO, the relief from registration is conditioned on the CPO that is delegating its authority (the “Delegating CPO”) controlling, being controlled by, or being under common control with, the registered CPO (the “Designated CPO”).  The new staff letter removed the previous requirement that “unaffiliated directors” of the commodity pool that would be considered CPOs agree to be jointly and severally liable with the registered CPO for violations of the Commodity Exchange Act or the CFTC‘s regulations by the registered CPO.  This new no-action relief is not self-executing.  Each Delegating CPO must apply to the CFTC in order to take advantage of this new CFTC staff position.

In order to coordinate filing obligations for the CFTC and the Securities and Exchange Commission (SEC), many CPOs, which may also be registered investment advisers, seek to delegate their obligations to affiliated commodity trading advisors or registered CPOs.  Information provided in Form PF may be used to fulfill portions of the filing requirements for Form CPO-PQR under CFTC regulations, if the same entity is filing both reports.  However, previous CFTC guidance on this point was ambiguous at best. The new staff letter is meant to provide clear and consistent guidance for when CPO delegation will be permitted, but will not adversely affect no-action relief that was previously granted under the former CFTC position.

The new staff letter sets forth specific criteria for the approval of CPO delegations. The criteria in the new CFTC letter for obtaining CFTC delegation approval are as follows:

  • The Delegating CPO must have delegated to the Designated CPO all of its investment management authority with respect to the commodity pool pursuant to a legally binding document.
  • The Delegating CPO must not participate in the solicitation of participants for the commodity pool or manage any property of the commodity pool.
  • The Designated CPO must be registered as a CPO with the CFTC.
  • The Delegating CPO must not be subject to a statutory disqualification.
  • There must be a business purpose for the Designated CPO being a separate entity from the Delegating CPO other than solely to avoid the Delegating CPO registering with the CFTC.
  • The books and records of the Delegating CPO with respect to the commodity pool must be maintained by the Designated CPO in accordance with CFTC Regulation 1.31.
  • If the Delegating CPO and the Designated CPO are each a non-natural person, then one must control, be controlled by, or be under common control with the other.
  • Delegating CPOs that are (i) non-natural persons or (ii) board members other than “unaffiliated board members” must execute a legally binding document with the Designated CPO in which each party undertakes to be jointly and severally liable for any violation of the Commodity Exchange Act or the CFTC’s regulations by the other party in connection with the operation of the commodity pool.
  • “Unaffiliated board members” that are Delegating CPOs must be subject to liability as a Board member in accordance with the laws under which the commodity pool is established.

The new staff letter itself includes a form of no-action request that a Delegating CPO would file with the CFTC, including identifying information about the Delegating CPO and the Designated CPO, and certifications by the Designated CPO and Delegating CPO regarding satisfaction of the criteria set forth in the new staff letter. Unfortunately, the no-action letter request must be submitted pursuant to the process set forth in CFTC Regulation 140.99 in paper form instead of by e-mail.