Articles Posted in Private Funds

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Written by Michael Wu and Judy Deng

Earlier this year, the People’s Bank of China (PBoC) issued its Administrative Measures over Pilot Projects on Settlement of Overseas Direct Investments in Renminbi (the “PBoC Measures”).  The PBoC Measures permit the PBoC, under a pilot project, to loan renminbi to Chinese investors to fund outbound acquisitions.  The PBoC Measures are expected to have a positive impact on leveraged buy-out (LBO) firms in China that acquire interests in non-Chinese companies.  Effectively, the PBoC Measures extends the M&A loan capacity of Chinese banks from Chinese domestic M&A transactions to overseas, non-Chinese M&A transactions.  For a more detailed discussion of the PBoC Measures, please click here.

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Written by Michael Wu

California’s Department of Corporations (the “Department”) intends to issue emergency regulations to address the elimination of the “private adviser exemption” under Section 203(b)(3) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”).  Currently, an investment adviser in California may rely on the private adviser exemption by virtue of California Department of Corporations Rule 260.204.9, which specifically refers to the private adviser exemption under Section 203(b)(3) of the Advisers Act.  The Dodd-Frank Wall Street Reform and Consumer Protection Act will eliminate the private adviser exemption under Section 203(b)(3) effective as of July 21, 2011, which in turn would affect a California investment adviser’s ability to rely on Rule 260.204.9.  The Department will issue emergency regulations amending Rule 260.204.9 to preserve the status quo.  Therefore, California investment advisers that currently rely on the exemption from registration for private advisers will be able to continue to rely on that exemption until the Department adopts a final rule regarding private fund advisers.  For more information about this new development please click here.

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Written by Michael Wu

The Securities and Exchange Commission (the “SEC”) recently published a notice of its intent to raise the dollar thresholds that would need to be satisfied in order for an investment adviser to charge its investors a performance fee.  Currently, under Rule 205-3 of the Investment Advisers Act of 1940, as amended, an investment adviser may charge its investors a performance fee if (i) the investor has at least $750,000 under management with the investment adviser, or (ii) the investment adviser reasonably believes that the investor has a net worth of more than $1.5 million.  To comply with the Dodd-Frank Act, the SEC must adjust these dollar amounts for inflation by July 21, 2011 and every five years thereafter.

Thus, the SEC intends to issue an order that would revise the dollar amount tests to $1 million for assets under management and $2 million for net worth.  The SEC is also proposing to amend Rule 205-3 to: (i) provide the method for calculating future inflation adjustments of the dollar amount tests, (ii) exclude the value of a person’s primary residence from the net worth test, and (iii) modify the transition provisions of the rule.  The SEC is seeking public comment on the proposed rule.

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Written by Jay Gould, Ildi Duckor and Michael Wu

On March 18, 2011, the Securities and Exchange Commission released new guidance regarding Form ADV.  The SEC’s Q&As can be found here.  The most significant development pertains to a registered adviser’s obligation to deliver Part 2.  Specifically, Question III.2 reads as follows:

Q: Rule 204-3 requires an adviser to deliver a brochure and one or more brochure supplements to each client or prospective client. Does rule 204-3 require an adviser to a hedge or other private fund to deliver a brochure and supplement(s) to investors in the private fund?

A: Rule 204-3 requires only that brochures be delivered to “clients.” A federal court has stated that a “client” of an investment adviser managing a hedge fund is the hedge fund itself, not an investor in the hedge fund. (Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006)). An adviser could meet its delivery obligation to a hedge fund client by delivering its brochure to a legal representative of the fund, such as the fund’s general partner, manager or person serving in a similar capacity. (Posted March 18, 2011)

Although the SEC’s response focuses on “hedge funds,” because the term “client” is defined the same way for all “private funds,” we can reasonably conclude that advisers to private equity funds and other private funds can satisfy the delivery obligations by delivering the new Part 2 to the general partners of the private equity funds or private funds that they manage – as opposed to the investors in such funds.  This is a significant change because previously most registered advisers provided Part 2 to all of the investors in the funds that they managed.

Please note that registered advisers are still required to file Part 2 of Form ADV with the SEC.

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Written by Jay Gould and Michael Wu

Pillsbury’s Investment Fund and Investment Management group recently submitted a comment letter to the North American Securities Administrator’s Association (the “NASAA”) on behalf of the private investment fund industry.  Specifically, the letter to the NASAA was intended to provide comments regarding the proposed model custody rule of the NASAA that was released on February 17, 2011.

Pillsbury’s letter to the NASAA was written in response to the NASAA’s request for comment regarding its proposed revision to the model rules on NASAA Custody Requirements for Investment Advisers (the “Proposed Rule”).  The letter requested that NASAA reconsider requiring state-registered investment advisers to hedge funds and other private investment funds to provide detailed quarterly statements of all fund trading activity to all investors in their funds.  In Pillsbury’s view, this requirement falls seriously short of both protecting and advancing the interests of investors in such funds.

As written, the Proposed Rule would require state-registered investment advisers to unregistered pooled investment vehicles (i.e., private investment funds) to provide all fund investors with a list of all trading activity by the fund during the previous quarter.  Pillsbury contended that disclosing such information amounts to a requirement that investment advisers disclose their trade secrets.  A fund adviser’s trade secret is how it turns an easily described strategy into competitively differentiated results, and these trade secrets are expressed in the record of an adviser’s actual trade activity and positions over time.  Pillsbury strongly urged the Director to consider revising the Proposed Rule so that it is analogous to the Securities and Exchange Act’s custody rule (i.e., Rule 206(4)-2 of the Advisers Act).

Pillsbury will continue to monitor this and other regulatory developments that affect investment advisers and their investment funds and stands ready to take appropriate action to ensure that the laws and regulations purporting to protect investors are not unduly burdensome for investment advisers and the investment fund industry.

To see a full text of the letter, please continue reading…

 

March 2, 2011
Kenneth L. Hojnacki
Director of Professional Registration & Compliance
Wisconsin DFI Division of Securities
PO Box 1768
Madison, WI 53701-1768
kenneth.hojnacki@dfi.wisconsin.gov

RE:     NASAA Proposed Model Custody Rule –
Comment Letter from Fund Associations

Dear Mr. Hojnacki and other members of the Project Group:

We appreciate the opportunity to comment on the North American Securities Administrator’s Association’s (“NASAA”) proposed revision to its model rules on NASAA Custody Requirements for Investment Advisers, as released for public comment on February 17, 2011 (the “proposed rule”).

This letter is submitted on behalf of the California Hedge Fund Association and the Florida Alternative Investment Association.  I am a member of the Board of Directors of each of these organizations.  Each of these regional industry organizations counts among its membership several hundred advisers to private funds, many of which are, or soon will be, subject to registration as an investment adviser at the state level and which would be affected by the proposed rule.  We have also been in contact with several of the other regional hedge fund industry groups regarding this matter, however, due to the lack of publicity regarding the proposal, the short notice period that NASAA has provided for the proposed rule, and the logistics of circulating this information to these other constituents, it is not possible for us to express the views of the other regional associations.  I suspect that once this proposal becomes more widely understood, those organizations and their members will express views similar to those provided in this letter.  The goal of both the California Hedge Fund Association and the Florida Alternative Investment Association is to ensure that appropriate rules are adopted that serve to both protect and advance investor interests while maintaining the viability of the alternative investment vehicles through which they seek to achieve differentiated returns.

We commend NASAA for its efforts to enhance the investor protections embodied in its proposed rule and to provide greater regulatory uniformity by largely conforming its proposed model custody rule to the SEC’s revised custody rule as adopted on December 30, 2009.

However, we believe that one new requirement of the proposed rule – the requirement to provide detailed quarterly statements of all fund trade activity to all investors in a fund – falls seriously short of both protecting and advancing the interests of investors in pooled funds.

Overview

As proposed, the NASAA proposed model custody rule would require state-registered investment advisers (“advisers”) to unregistered pooled investment vehicles (“funds”) to provide detailed statements of fund trade activity (“custodial statements”) to each limited partner in the fund.  As currently written, unlike the SEC’s revised custody rule and NASAA’s current model custody rule, the proposed rule does not provide an exception to this disclosure requirement for funds for which audited financial statements are distributed annually to its investors (the “exception”).

We believe that this exception is critical to the viability of unregistered pooled vehicles invested in marketable equity securities (“hedge funds”).  The SEC reviewed and amended its custody rule effective December 30, 2009.  In doing so, the Securities and Exchange Commission (the “SEC”) sought to strike the proper balance among competing investor interests, with full consideration of appropriate lessons learned from recent spectacular failings concerning adviser reporting to investors.

The lack of this exception in the proposed rule constitutes a material adverse business risk to state-registered fund advisers, a serious competitive detriment to our investors, and sets an unlevel playing field that threatens to limit the development and availability of private, state-registered fund management in states that adopt this rule.

We believe that it is in recognition of these factors, all of which constitute ultimate detriments to fund investors, that neither the revised SEC custody rule, the previous NASAA model custody rule, nor the individual state rules[i] covering what we believe to be over 95% of assets managed by state-registered fund advisers currently require the delivery of detailed custodial statements to the limited partners of hedge funds subject to an annual financial statement audit.

We therefore respectfully request that, with respect to this exception, NASAA conform its custody rule to that contained in subsection (b)(4) of the SEC’s revised custody rule 206(4)-2, as adopted on December 30, 2009.

In the alternative, we would support a requirement that all investors in pooled funds receive a quarterly statement of aggregate fund activity showing the total amount of any additions or withdrawals from the fund and the total value of the fund at the end of the quarter based on the custodian’s records of activity.  This statement would not have to include individual transactions or portfolio holdings.

You will note that this alternative aggregate capital statement is the same as that proposed by NASAA as an acceptable alternative in its August 5, 2009 comment letter to the SEC on its most recent revision of the SEC custody rule.

We feel that such an aggregate capital statement would strike an appropriate balance between, on the one hand, the value to investors of transparency concerning the amounts and timing of capital flows into and out of, and changes in the size of, funds of which they are members while, on the other hand, still protecting the financial interests of those same investors by keeping proprietary fund trade information from being widely disseminated.

I.             Typical Hedge Fund Investors 

We think it is important to keep in mind that alternative investment vehicles and hedge funds are not intended for typical retail investors.  Fund investors typically include institutional investors (e.g., pensions, endowments, foundations, insurance companies) and other hedge funds (hedge fund of funds), as well as relatively sophisticated high-net-worth individuals.  Indeed, regulatory requirements restrict the availability of these vehicles to institutional and other “qualified purchasers”, “accredited investors”, or those with appropriate financial sophistication and/or financial capacity. [ii]

Such investors want to be free to contract with a fund that provides investment strategies that they view as desirable and in their best interest.  Almost by definition, in order to be successful these funds must make non-obvious investment decisions based on proprietary investment strategies, investment reviews and valuation discrepancies.  The privacy of that information is vital to a fund investor’s interests, not contrary to it, because the fund’s ability to deliver differentiated returns depends on the confidentiality of that information. 

Given the restriction on availability of these funds to only investors with adequate financial sophistication or capacity, and given the other (now enhanced) investor protections included in the proposed rule, such investors should be able to choose for themselves whether or not to invest in vehicles not designed to regularly report underlying trade activity and positions.

We support appropriate investor protections that still allow sophisticated investors to pursue their investment objectives without the imposition of rules that would harm their interests more than help them.

II.          Pooled Investment Vehicles are Different from Separately Managed Accounts

The main difference between pooled investment vehicles and separately managed accounts lies in the fractional ownership structure of pooled investment vehicles.

In a separately managed account, the investor maintains 100% ownership of the portfolio, whereby their interests are 100% aligned with the performance of the portfolio.  However, in pooled investments, investors maintain only fractional shares of ownership.  The investors’ monies are comingled with those of other investors.  As such, potential conflicts of interest may arise if the confidentiality of portfolio positions are not protected.

An investor in a pooled investment vehicle invested in marketable securities could, through the proposed rule’s detailed reporting provision, gain access to proprietary information concerning the investment positions or strategy.  This information could then be used, by the investor or by the investor’s other advisers, for personal benefit to the detriment of other investors in the source vehicle via front-running trades, competing for stock to be borrowed in the case of shorting securities, trading against these positions, et cetera.

An investor in a separately managed account has less incentive to “steal” the manager’s strategies, since the investor realizes all the benefits of those strategies.  In contrast, in a pooled investment vehicle, an investor who uses his knowledge of the fund’s strategies can damage the returns of the other investors in the pooled investment vehicle.

III.       Investor and Industry Risks

Almost all industries have a mechanism for protecting trade secrets and other intellectual property.

Fund advisers turn investment strategies into investment results.  A fund adviser’s trade secret is how it turns an easily described strategy into competitively differentiated results, and these secrets are expressed in the record of an adviser’s actual trade activity and positions over time.

Requiring advisers to report their trades to a diverse group is tantamount to asking them to disclose their trade secrets.  This is one reason why hedge funds, like mutual funds and other pooled vehicles, are specifically designed to keep underlying trades confidential.  Trades and investment positions are kept confidential even from the ultimate beneficiaries, except as reported in the annual financial statements or otherwise required under federal securities laws.

Hedge fund investors are protected by the use of third-party custodians to hold the securities, surprise examinations, the provision of audited financial statements or use of an independent party to approve all withdrawals, among other protections.

Both hedge fund and mutual fund investors intuitively understand the reason for this confidentiality.  Investors in these vehicles freely agree to limits on their access to fund trades in the interest of pursuing differentiated returns.  They understand that the risks associated with disclosing all trades and positions and the fund’s proprietary trading strategies to a diverse population exceeds the benefits to them.

In addition, it would be extremely difficult for a fund adviser to build a sustainable business if required to make such disclosures.  Investors could circumvent the adviser’s fees by investing only the minimum amount necessary to gain access to the fund’s positions or strategy.  Once the strategy or value discrepancies are exposed through transactions, investors could execute the strategy on their own (and to the detriment of those investors in the fund that do not).  The risk of disclosing the fund’s strategy and losing its confidentiality in turn reduces an adviser’s incentive to make private funds available to investors in the first place.

The Dodd-Frank Act defines “proprietary information” for private funds (funds that would be investment companies but for the exemptions in Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940) and their advisers to include:

“sensitive, nonpublic information regarding (i) the investment or trading strategies of the investment adviser; (ii) analytical or research methodologies; (iii) trading data; (iv) computer hardware or software containing intellectual property; and (v) any additional information that the [SEC] determines to be proprietary.” [iii]

This proprietary information is specifically made subject to enhanced confidentiality measures by the Dodd-Frank Act because of its market-competitive nature.

As briefly described above, there are many ways in which disclosure of proprietary information such as detailed fund portfolio trading activity and positions to a diverse group could hinder the fund’s investment performance to the detriment of its investors.

A few additional examples of the risks posed by forced trade and position disclosure are:

Quantitative strategies – algorithmic strategies that typically rely heavily on automated orders to exploit temporal or relational market arbitrage opportunities, often involving sizable orders and thin profit margins.  Disclosure of all trades during the quarter would make it very easy for a competitor to reverse engineer a wide percentage of such strategies and imitate them.  Such small “black box” strategies (that were not solely futures trading) risk being all but completely undermined by total trade disclosure.

Contrarian value strategies – strategies that assert and exploit significant differences between intrinsic value and market price.  These value discrepancies often arise as a result of inattention to a security from market participants, which also typically involves lower (current) trading volumes in that security.  The success of these strategies therefore often depends on a fund manager’s ability to build a substantial position in a security before the market resolves the discrepancy.  It can take time to build such positions under limited volume without alerting the market.  These strategies risk seeing their rare opportunities on such value discrepancies dissipate quickly once exposed to other investors.

Event arbitrage – research that identifies companies that are at risk of, or could benefit from, certain events is very valuable, and insight into the events that a successful fund anticipates based on such research (e.g., acquisitions, regulatory changes, new product opportunities, new market entries, dividend changes, share repurchases, etc.) can be quite valuable.  Disclosure of a fund’s trades in companies could signal to investors and market participants the results of the fund’s proprietary research and assessments.  In addition, since many of these events are market-sensitive (e.g., a buyout acquisition only remains likely if the target’s stock price stays low until announcement), disclosure could lead not just to a reduced position build, but to the evaporation of the entire trade.  It is not uncommon for such anticipatory bidding to affect the very viability of corporate acquisitions.

Option strategies – various option trading strategies (naked short calls, strangles, etc.) are subject to risks similar to that of short positions, but on a magnified basis. Due to the nature of the options markets, certain positions can readily reveal a fund manager’s sentiment on the trading range of an underlying security, including resistance and support levels based on the strike price selections within a portfolio.  The options market is far less liquid than the equities market, allowing a third party to exploit data obtainable on a fund’s positions to force a fund to close existing or open additional positions.

Short positions – given the potential for unlimited losses on short positions, the discovery of short positions in less liquid securities can constitute material market knowledge and may be subject to a manufactured “short squeeze” by other market participants with more resources to the detriment of smaller funds with less resources.  In addition, short positions require an adviser to i) locate and borrow the security and ii) pay to borrow the security before an investor is able to execute a short trade.  The divulgence of the short position may not only prevent the ability to find further borrowed securities given an increased demand, but could also increase the cost of borrow or worse, force the adviser to repurchase the stock at a premium after a squeeze of its short position, all to the detriment of investors.

Strategies involving limited liquidity/supply in general – fund managers typically generate excess returns by exploiting market inefficiencies not yet uncovered by the broader market, of which some of the above are examples.  Discovery of price inefficiencies to exploit is proprietary to the manager.  These inefficiencies are typically fragile, temporary, and disappear when pursued by large or quick capital flows.  Exposure of an adviser’s price inefficiency discoveries to a diverse group of limited partners (including individuals and other funds) substantially increases the risk that these privately-discovered niches will disappear.

IV.        Pooled Investment Vehicles are More Similar to Registered Investment Companies

Individual separate account clients typically have regular access to their own investment activity, while investors in retail open-end mutual funds and closed-end funds do not.  There are important reasons for this.

Pooled investment vehicles invested in marketable securities include hedge funds, mutual funds (registered open-end investment companies), closed-end investment companies and exchange-traded funds, among others.  These funds outline strategies they intend to pursue to achieve returns relative to a particular market segment.  In both cases, investors see themselves as invested in the pool itself and the adviser’s strategy, rather than the individual securities the adviser buys and sells to pursue that strategy.

Investors in pooled funds have no expectation of how long a given underlying security position will benefit them, no control over whether or when a security will be bought or sold, and no authority to obtain their fractional share of it.  Investors in pooled funds recognize that they are delegating those decisions to the fund manager.  Given the degree of this separation between investors and control of a fund’s underlying securities, investors appropriately see themselves as owning an interest in the fund itself as a principal entity, rather than the underlying securities in which the fund invests.[iv]

In fact, ownership in no other investment entity that we know of entitles investors to know transaction-level detail of purchase and sales activities which take place within that vehicle in order to generate profits and/or losses. 

Of course, each of these vehicles provides periodic reporting of fund financial results and investment positions to help investors assess the performance of the fund as a whole. Registered open-end investment companies (mutual funds) and closed-end investment companies marketed to unsophisticated retail investors of unknown suitability are required to report their financial statements to investors annually and most of their investment positions by security type, industry, and country classifications not more than semi-annually.[v]

If that financial reporting strikes the appropriate balance between transparency and trade confidentiality in the interests of investors in registered retail pooled funds, it would seem odd for private pooled funds, whose securities are exempt from registration and which are sold only to sophisticated investors of known suitability, to be required to report vastly more detailed information concerning their similar pooled trade activity.

V.           Significant Competitive Disadvantage to SEC-registered Hedge Fund Advisers

We understand that one goal of the Project Group in drafting the proposed rule was to bring NASAA’s model rule concerning state-registered fund advisers into closer harmony with the rule governing SEC-registered advisers.

However, the proposed rule’s new provision requiring total disclosure of all fund activity and positions to all fund investors introduces discord between the NASAA and SEC rules where none previously existed.

Further, it does so to the competitive advantage of larger firms with more resources at their disposal, at the expense of smaller developing firms with fewer resources available.

As a result, in this respect we believe the proposed rule would have a regressive rather than progressive effect on broadening competition, expanding grass-roots innovation, and on merit-based success.  It would also risk seriously impeding the natural, organic development of smaller fund advisers into larger fund advisers – the more successful a fund is, the more its trades will be raided by others.

This rule risks keeping small funds small and handicapped relative to large funds, and leaves them unconscionably exposed to attack, pre-emption or imitation of their trading and investment strategies.

This element of the proposed rule does not level the competitive playing field for small funds and their investors; rather it unfortunately tilts it in the direction of the large and the powerful.

VI.        Summary

As mentioned at the outset, our goal is to ensure that appropriate rules are adopted that serve to both protect and advance investor interests while maintaining the viability of the alternative investment vehicles through which they seek to achieve differentiated returns.

However, the proposed rule’s provision requiring that hedge funds disclose detailed trade activity to investors is contrary to how private funds are designed to operate, contrary to the best interests of their investors, contrary to how similar pooled investment funds are treated for SEC-registered advisers or in jurisdictions that follow the SEC rather than the NASAA rule, and puts both fund investors and their advisers at a competitive disadvantage in the investment marketplace.

Without a change in this rule, we believe that fund advisers will choose not to launch their funds in states that adopt the NASAA model rule – they may launch them in other states or not at all. This will impede the organic development of the fund management industry in these states, which typically involves transitions from direct financial industry involvement, to state-registered fund advisers, then potentially to SEC-covered advisers. This provision will thus impede the middle growth stage in the development of the broader wealth management industry in states that adopt the model rule in the form proposed.

Since state-registered fund advisers often serve primarily the citizens of their own state, this could leave investors in those states at a competitive disadvantage to the citizens of other states with respect to the availability of private fund management in their state, including hedge funds, venture capital funds and private equity funds.

The effect of this restriction will only be magnified by the transition of fund advisers with $25 – $150 million under management to state regulation in the near future.  These fund advisers will be surprised to discover this onerous requirement in states that adopt the NASAA model rule, and will likely respond unfavorably if it is not changed – to the detriment of both the investing public and the developing wealth management industry in those states.

For these reasons, we strongly encourage NASAA to level the playing field for investors in state-covered pooled investment funds by revising the proposed custody rule to include an exception analogous to that provided in subsection (b)(4) of the SEC’s custody rule 206(4)-2 as revised on December 30, 2009 or, in the alternative, to instead require reporting of the elements of the aggregate capital statement proposed by NASAA as an acceptable alternative on page 3 of its August 5, 2009 comment letter to the SEC on its most recently revised custody rule. 

The goal of enlightened public policy in economic affairs, and good regulation promulgated thereunder, is to keep the goose healthy and its eggs safe for the family, not to endanger the goose.

We believe that the unqualified requirement in NASAA’s proposed model rule to report detailed trade activity to all hedge fund investors threatens both the former and the latter.

Very truly yours,

 

Jay B. Gould, on behalf of:

The California Hedge Fund Association             The Florida Alternative Investment Association                       

cc:        NASAA Investment Adviser Regulatory Policy and Review Project Group

Kelvin M. Blake
Office of the Attorney General
Maryland Division of Securities
kblake@oag.state.md.us

Lindsay DeRosia
Office of Financial & Insurance Services
State of Michigan
derosiaL@michigan.gov

David Finnigan
Office of the Secretary of State
Illinois Securities Department
dfinnigan@ilsos.net

Hugo Mayer
Office of the Securities Commissioner
State of Kansas
hugo.mayer@ksc.ks.gov

Paul Schwartz
Pennsylvania Securities Commission
pschwart@state.pa.us

David Smith
Arkansas Securities Department
david.smith@securities.arkansas.gov

Jackie L. Walter
Department of Banking and Finance
State of Nebraska
jackie.walter@nebraska.gov

Joseph Brady
NASAA Corporate Office
Legal Department
jb@nasaa.org

Sincerely yours,

 

Jay B. Gould
Partner

 

 

 

 

[i]  Including at least NY, CT, IL, CA, TX, FL, AZ, HI, ID, UT, NE, NM, NV & MN.

 

[ii]  Per the U.S. Supreme Court’s decision in SEC v. Ralston Purina, 1953.

 

[iii]  The Dodd-Frank Wall Street Reform and Consumer Protection Act, Title IV “Regulation of Advisers to Hedge Funds and Others”, Section 404 amendment to the Investment Advisers Act of 1940, Section 204, subsection (b) Records and Reports of Private Funds, subsection (10)(B) Proprietary Information.

 

[iv]  This point is more eloquently put by the U.S. Court of Appeals for the D.C. Circuit in its June 23, 2006 judgment in Goldstein v. SEC:

“An investor in a private fund may benefit from the adviser’s advice (or he may suffer from it) but he does not receive the advice directly. He invests a portion of his assets in the fund. The fund manager – the adviser – controls the disposition of the pool of capital in the fund. The adviser does not tell the investor how to spend his money; the investor made that decision when he invested in the fund. Having bought into the fund, the investor fades into the background; his role is completely passive. If the person or entity controlling the fund is not an “investment adviser” to each individual investor, then a fortiori each investor cannot be a “client” of that person or entity.”

[v]  Generally accepted accounting principles applicable to investment partnerships exempt from registration under the Investment Company Act of 1940 require that financial statements for such entities include all information necessary for an investor to adequately evaluate the investment and operating performance and financial position of the entity taken as a whole.  Audited financial statements prepared on this basis are required to include, in addition to the entity’s basic financial statements and related footnote disclosures, a schedule of investment positions similar to that required in the financial statements of registered investment companies which reports each individual security position comprising more than 5% of net assets, as well as position totals by security type, industry, and country classifications.

 

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Written by Ildiko Duckor and Michael Wu

The Commodity Futures Trading Commission (the “CFTC”) recently issued a proposed rule regarding commodity pool operators (“CPOs”) that would rescind the exemptions from CPO registration under CFTC Rules 4.13(a)(3) and 4.13(a)(4).  These exemptions are widely used by hedge fund and other private fund managers advising funds that trade futures and other listed commodity positions, such as commodity options or swaps.  If adopted, managers, sponsors and operators of such funds would need to register as CPOs with the CFTC and become members of the National Futures Association (the “NFA”).  The proposed rule does not have a transition period or any grandfathering provisions.

Full registration as a CPO is a time consuming process and typically takes six to eight weeks.  Unlike hedge fund and other private fund managers currently taking advantage of the exemptions under CFTC Rules 4.13(a)(3) and 4.13(a)(4), registered CPOs are subject to full regulation by the CFTC and NFA.  As a result, registered CPOs must comply with rules that require them to provide disclosure documents to investors (which are subject to review by the NFA) and fulfill recordkeeping and reporting requirements, including the delivery of audited annual financial statements.  Although registered CPOs may continue to rely on CFTC Rule 4.7 for relief from certain disclosure, recordkeeping and reporting requirements, the proposed rule would require CPOs relying on CFTC Rule 4.7 to deliver audited annual financial statements to investors.

The proposed rule would also require hedge fund and other private fund managers that are currently exempt from registration as commodity trading advisors (“CTAs”) because they only advise funds that are exempt under CFTC Rules 4.13(a)(3) and 4.13(a)(4), to register as CTAs with the CFTC and become members of the NFA.  Once registered as a CTA, a hedge fund and other private fund manager would be subject to all of the CFTC and NFA’s requirements applicable to CTAs.

The CFTC has requested comments during the 60-day period beginning on Friday, February 11, 2011.  If the proposed rule is adopted, the CFTC will issue a final rule that will specify when hedge fund and other private fund managers relying on CFTC Rules 4.13(a)(3) and 4.13(a)(4) will need to revise or cease their commodity interest trading or register as CPOs (and, if applicable, CTAs) and become members of the NFA.

The text of the proposed rule can be found here: http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-2437a.pdf

We will update you with more information as it becomes available.

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Written by Michael Wu

On January 26, 2011, the SEC proposed a rule that would require SEC-registered advisers to hedge funds, private equity funds and other private funds to report information to the Financial Stability Oversight Council (“FSOC”) that would enable it to monitor risk to the U.S. financial system.  The information would be reported to the FSOC on Form PF and the information reported on Form PF would be confidential.

The proposed rule would subject large advisers to hedge funds, “liquidity funds” (i.e., unregistered money market funds) and private equity funds to heightened reporting requirements.  Under the proposed rule, a large adviser is an adviser with $1 billion or more in hedge fund, liquidity fund or private equity fund assets under management.  All other advisers would be regarded as smaller advisers.  The SEC anticipates that most advisers will be smaller advisers, but that the large advisers represent a significant portion of private fund assets.

Smaller advisers would be required to file Form PF once a year and would report only basic information about their hedge funds, private equity funds and/or other private funds, such as information regarding leverage, credit providers, investor concentration, fund performance, fund strategy, counterparty credit risk and the use of trading and clearing mechanisms.

Large advisers would be required to file Form PF quarterly and would provide more detailed information than smaller advisers.  The information reported would depend on the type of private fund that the large adviser manages.

  • Large advisers to hedge funds would report, on an aggregated basis, information regarding exposures by asset class, geographical concentration and turnover.  If a hedge fund has a net asset value of at least $500 million, the adviser would report information regarding the fund’s investments, leverage, risk profile and liquidity.
  • Large advisers to liquidity funds would report the types of assets in their liquidity funds, information relevant to the risks of the funds, and the extent to which the liquidity funds comply with Rule 2a-7 of the Investment Company Act of 1940, as amended.
  • Large advisers to private equity funds would respond to questions regarding the extent of leverage incurred by their funds’ portfolio companies, the use of bridge financing and their funds’ investments in financial institutions.

The SEC’s public comment period on the proposed rule will last 60 days.

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Posted by Michael Wu and Judy Deng

On January 11, 2011, the Shanghai Municipal Government released its Implementation Measures on Trial Projects of Foreign-Invested Equity Investment Enterprises in Shanghai (the “Shanghai RMB Fund Regulation”), which will become effective on January 23, 2011. Prior to the release of this regulation, it was widely expected that the Shanghai Municipal Government would launch a Qualified Foreign Limited Partners (“QFLP”) legal regime to help large international institutional investors invest in Shanghai-based private equity funds. Although the Shanghai RMB Fund Regulation was implemented in response to such expectations, we believe it is just the first of many regulations designed to confer national treatment to private equity funds formed by non-Chinese fund managers.  For more information regarding the Shanghai RMB Fund Regulation, please see A Red Envelope From Shanghai?  New RMB Fund Rules Create Opportunities for Non-Chinese Fund Managers.

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Editorial Comment by Jay Gould

A recent action against a hedge fund manager by the Securities and Exchange Commission (the “SEC”) serves as interesting prologue to the state of enforcement against suspected securities frauds once the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) has been fully implemented.  On January 7, 2011, the SEC charged SJK Investment Management LLC, a North Carolina-based hedge fund manager (“SJK”), and CEO Stanley Kowalewski, its owner, with defrauding its hedge fund investors by diverting millions of dollars to themselves through various self-dealing transactions.

Nothing in this case is particularly unique.  Investment advisers who steal from their clients have proven to be a fairly routine occurrence and rarely attract mainstream press coverage unless the theft is on a significant scale.  Briefly, the SEC alleged that Kowalewski diverted investor money from the SJK hedge funds to pay his personal expenses and placed $16.5 million of the hedge funds’ assets into an undisclosed, wholly-controlled, fund that he created, and then misused for, among other things, purchasing a vacation home valued at $3.9 million.  The SEC stated that the agency became suspicious of Kowalewski as a result of an examination.  The examination staff referred the matter over to the Enforcement Division of the Atlanta Regional Office which obtained an order to freeze the assets held by Kowalewski.  Presumably, a receiver will be appointed by the court that will sift through the rubble and one day return whatever is left over to the investors.  In the end, this is just another example of one of approximately 200 Ponzi/investment fraud cases that the SEC has uncovered since the Madoff embarrassment.

What is interesting about this case is that as of July 2011, the SEC will no longer examine the Stanley Kowalewskis of the world.  In most cases, that job will be left to state securities commissions.  As a result of the Dodd-Frank Act, private fund managers with less than $150 million under management and other investment advisers with less than $100 million under management will no longer register with or be routinely examined by the SEC.  The SEC estimates that 4,100 investment advisers that are now registered with it will be forced to de-register and register with their respective state securities regulator.  Although the SEC will retain anti-fraud jurisdiction over these state-registered advisers, the primary regulators will be the often ill-equipped, inexperienced and resource strapped state regulators.  As a result of the budgetary concerns facing most states, it is unlikely that sufficient resources will be directed to enforcing investment frauds perpetrated by small, “under the radar” investment advisers.

And where do the majority of investment frauds occur?  The most recent filing of Kowalewski’s Form ADV indicates that SJK had $71 million under management.  This is not exactly an investment adviser that represents a systemic risk to the stability of the financial world, but this is the type of investment adviser that can cause great pain to every day investors seeking to diversify their assets or plan for their retirement.  In fact, the vast majority of investment fraud schemes that the SEC has uncovered since Madoff have been perpetrated by investment advisers that will not be subject to SEC scrutiny under the new regulatory regime.

The Dodd-Frank Act addressed this concern in part by directing the SEC to conduct a number of studies regarding the regulation of investment advisers.  One such study directs the SEC to make a recommendation as to whether investment advisers should be subject to a self-regulatory organization (“SRO”), much the same way broker-dealers are essentially required to become members of the Financial Industry Regulatory Authority (“FINRA”).  In recent weeks, FINRA has shown great interest in taking on this responsibility, much to the dismay of most independent investment advisers.  This SRO membership requirement would add another layer of expense to, and oversight of, investment advisers.  And some might argue that FINRA, which opposes the idea of creating a uniform fiduciary standard for investment advisers and retail brokers, is exactly the wrong SRO to oversee advisers that have traditionally been subject to a much more rigorous code of conduct.

This shift in regulatory responsibility to the states does not necessarily bode well for small investment advisers and start-up hedge fund managers.  Just as we have seen large investors gravitate toward established investment managers since 2008, the lack of effective regulatory oversight may portend an unwillingness for high net worth and smaller institutions to take a chance on a less well-established investment adviser or fund manager. Such investment advisers or fund managers can expect the lack of SEC oversight to be another hurdle in a very challenging capital raising environment.

But there are steps that state-registered and regulated advisers and fund managers can take to minimize this aspect of the Dodd-Frank Act.  Taking seriously the responsibility for full and current disclosure in fund documents, providing transparency to investors and maintaining sufficient operating systems and infrastructure will help to address the concerns of circumspect investors.  Also, providing clear and current disclosure in the new Form ADV Part 2 that explains the operations and investment approach and adhering to the traditional fiduciary standard that has applied to investment advisers for decades will provide greater comfort to investors.  Finally, choosing the right partners and service providers that can provide the oversight, checks and balances and industry expertise will also be important to investors.

Small investment advisers and fund managers may initially welcome the idea of no longer being subject to direct SEC oversight, but if investment frauds continue at this end of the investment spectrum, that may prove to be a hollow victory.

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By: Michael Wu

As the new year is upon us, we wanted to take a moment to remind you of some of the annual compliance obligations that you may have as an investment adviser that is registered with the Securities and Exchange Commission (the “SEC”) or with a particular state (“Investment Adviser”).  In light of the current regulatory environment, now more than ever, it is critical for you to comply with all of the legal requirements and best practices applicable to Investment Advisers.  The beginning of the year is a good time to review, consider and, if applicable, satisfy these requirements and best practices.

The following is a summary of the primary annual or periodic compliance-related obligations that may apply to Investment Advisers.  The summary is not intended to be a comprehensive review of an Investment Adviser’s tax, partnership, corporate or other requirements, nor an exhaustive list of all of the obligations of an Investment Adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) or applicable state law.  Although many of the obligations set forth below apply only to SEC-registered Investment Advisers, state-registered Investment Advisers may be subject to similar and/or additional obligations depending on the state in which they are registered.  State-registered Investment Advisers should contact us for additional information regarding their specific obligations under state law.

  • Update Form ADV.  An Investment Adviser must file an annual amendment to Form ADV Part 1 and Form ADV Part 2 within 90 days of the end of its fiscal year.  Effective on January 1, 2011, Investment Advisers must file both Part 1 and Part 2A of the Form ADV with the SEC through the electronic IARD system.  Accordingly, if you are SEC-registered adviser whose fiscal year ends on or after December 31, 2010, you must file Part 1A and Part 2A as part of your annual updating amendment by March 31, 2011.  If you are a state-registered adviser whose fiscal year ends on or after December 31, 2010, you must also file Part 1A, Part 1B and Part 2A as part of your annual updating amendment by March 31, 2011.
  • New FINRA Entitlement Program.  FINRA is implementing changes to its Entitlement Program, which provides access to an Investment Adviser’s IARD account.  Every adviser firm (new and existing) is now required to designate an individual as its Super Account Administrator (SAA).  The SAA must be an authorized employee or officer of the adviser firm.
  • Fund IARD Account.  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.  Beginning November 15, 2010, Preliminary Renewal Statements (“PRS”), which list advisers’ renewal fees, are available for printing through the IARD system.  By December 10, 2010, an investment adviser should have submitted to FINRA through the IARD system, its preliminary renewal fee.  Any additional fees that were not included in the PRS will show in the Final Renewal Statements which are available for printing beginning January 3, 2011.  All final renewal fees should be submitted to FINRA through the IARD system by February 3, 2011.
  • State Notice Filings/Investment Adviser Representatives.  An Investment Adviser should review its advisory activities in the various states in which it conducts business and confirm that all applicable notice filings are made on IARD.  In addition, an Investment Adviser should confirm whether any of its personnel need to be registered as “investment adviser representatives” in any state and, if so, register such persons or renew their registrations with the applicable states.
  • Brochure Rule.  On an annual basis, an Investment Adviser must provide its private fund investors and separate account client(s) with a copy of its updated Form ADV Part 2A, or provide a summary of material changes and offer to provide an updated Form ADV Part 2A. The 2011 deadline for providing investors with Form ADV Part 2B depends on whether an Investment Adviser is a new or existing SEC-registered adviser and whether the Investment Adviser is providing it to prospective, new or existing investors.
  • Annual Assessment.  At least annually, an Investment Adviser must review its compliance policies and procedures to assess their effectiveness.  The annual assessment process should be documented and such document(s) should be presented to the Investment Adviser’s chief executive officer or executive committee, as applicable, and maintained in the Investment Adviser’s files.  At a minimum, the annual assessment process should entail a detailed review of:

1)      the compliance issues and any violations of the policies and procedures that arose during the year, changes in the Investment Adviser’s business activities and the effect that changes in applicable law, if any, have had on the Investment Adviser’s policies and procedures;

2)      the Investment Adviser’s code of ethics, including an assessment of the effectiveness of its implementation and determination of whether they should be enhanced in light of the Investment Adviser’s current business practices; and

3)      the business continuity/disaster recovery plan, which should be “stress tested” and adjusted as necessary.

  • Annual/Surprise Audit.  Because Investment Advisers are generally deemed to have custody of client assets, they must provide audited financial statements of their fund(s), prepared in accordance with U.S. generally accepted accounting principles, to the fund(s)’ investors within 120 days of the end of the fund(s)’ fiscal year.  Investment Advisers that do not provide audited financial statements to fund investors should remind their auditors that an annual surprise audit is necessary.
  • Annual Privacy Notice.  Under SEC Regulation S-P, an Investment Adviser must provide its fund investors or client(s) who are natural persons with a copy of the Investment Adviser’s privacy policy on an annual basis, even if there are no changes to the privacy policy.
  • New Issues.  An Investment Adviser that acquires “new issue” IPOs for a fund or separately managed client account must obtain written representations every 12 months from the fund or account’s beneficial owners confirming their continued eligibility to participate in new issues.  This annual representation may be obtained through “negative consent” letters.
  • ERISA.  An Investment Adviser may wish to reconfirm whether its fund(s)’ investors are “benefit plan investors” for purposes of reconfirming its fund(s)’ compliance with the 25% “significant participation” exemption under ERISA.  This is particularly important if a significant amount of a fund’s assets have been withdrawn or redeemed.  The reconfirmation may be obtained through “negative consent” letters.
  • Anti-money Laundering.  Although FinCEN withdrew its proposed anti-money laundering regulations for unregistered investment companies, certain investment advisers and commodity trading advisors, an Investment Adviser is still subject to the economic sanctions programs administered by OFAC and should have an anti-money laundering program in place.  An Investment Adviser should review its anti-money laundering program on an annual basis to determine whether the program is reasonably designed to ensure compliance with applicable law given the business, customer base and geographic footprint of the Investment Adviser.
  • Amend Schedule 13G or 13D.  An Investment Adviser whose client or proprietary accounts, separately or in the aggregate are beneficial owners of 5% or more of a registered voting equity security, and who have reported these positions on Schedule 13G, must update these filings annually within 45 days of the end of the calendar year, unless there is no change to any of the information reported in the previous filing (other than the holder’s percentage ownership due solely to a change in the number of outstanding shares).  An Investment Adviser reporting on Schedule 13D is required to amend its filings “promptly” upon the occurrence of any “material changes.”  In addition, an Investment Adviser whose client or proprietary accounts are beneficial owners of 10% or more of a registered voting equity security must determine whether it is subject to any reporting obligations, or potential “short-swing” profit liability or other restrictions, under Section 16 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
  • Form 13F.  An “institutional investment manager,” whether or not an Investment Adviser, must file a Form 13F with the SEC if it exercises investment discretion with respect to $100 million or more in securities subject to Section 13(f) of the Exchange Act (e.g., exchange-traded securities, shares of closed-end investment companies and certain convertible debt securities), which discloses certain information about such its holdings.  The first filing must occur within 45 days after the end of the calendar year in which the Investment Adviser reaches the $100 million filing threshold and within 45 days of the end of each calendar quarter thereafter, as long as the Investment Adviser meets the $100 million filing threshold.
  • Offering Materials.  As a general securities law disclosure matter, and for purposes of U.S. federal and state anti-fraud laws, including Rule 206(4)-8 of the Advisers Act, an Investment Adviser must continually ensure that each of its fund offering documents is kept up to date, consistent with its other fund offering documents and contains all material disclosures that may be required in order for the fund investor to be able to make an informed investment decision.
    • Full and accurate disclosure is particularly important in light of Sergeants Benevolent Assn. Annuity Fund v. Renck, 2005 NY Slip op. 04460, a recent New York Appellate Court decision, where the court held that officers of an investment adviser could be personally liable for the losses suffered by a fund that they advised if they breached their implied fiduciary duties to the fund.  The fiduciary nature of an investment advisory relationship and the standard for fiduciaries under the Advisers Act includes an affirmative duty of utmost good faith, and full and fair disclosure of all material facts, and an affirmative obligation to use reasonable care to avoid misleading clients.
    • Accordingly, it may be an appropriate time for an Investment Adviser to review its offering materials and confirm whether or not any updates or amendments are necessary.  In particular, an Investment Adviser should take into account the impact of the recent turbulent market conditions on its fund(s) and review its fund(s)’ current investment objectives and strategies, valuation practices, performance statistics, redemption or withdrawal policies and risk factors (including disclosures regarding market volatility and counterparty risk), its current personnel, service providers and any relevant legal or regulatory developments.
  • Blue Sky Filings/Form D.  Many state securities “blue sky” filings expire on a periodic basis and must be renewed.  Accordingly, now may be a good time for an Investment Adviser to review the blue-sky filings for its fund(s) to determine whether any updated filings or additional filings are necessary.  We note that as of 2009, all Form D filings for continuous offerings will need to be amended on an annual basis.
  • Liability Insurance.  Due to an environment of increasing investor lawsuits and regulatory scrutiny of fund managers, an Investment Adviser may want to consider obtaining management liability insurance or review the adequacy of any existing coverage, as applicable.

If you have any questions regarding the summary above, please feel free to contact us.