Articles Posted in Private Funds

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Private equity firms were put on notice last year that they may be subject to registration as broker dealers when David Blass, head of the Division of Markets and Trading at the Securities and Exchange Commission (“SEC”), provided his insights at an industry conference.  Since that time, the SEC has published their examination priorities list, which included the presence exams of new registrants, a portion of which would review that status of private equity fund managers under the broker dealer rules.  Following up on this warning to the industry, the SEC has also targeted unregistered brokers for enforcement action.

Recently, at a speech in front of another industry group, Mr. Blass provided further guidance on how a private equity firm might structure its compensation arrangements in order to avoid the need to register as a broker dealer.  Consistent with the advice that Pillsbury has been providing private fund clients for many years, Mr. Blass warned against paying “transaction based” compensation and further suggested that if a private fund employee has “an overall mix of functions,” and sales is one aspect of those duties, it is less likely that the SEC staff would view such an arrangement as one that would require broker dealer registration.  An employee of a private fund manager would not be prohibited from being compensated on the overall success of the firm, and certainly sales of fund securities contribute to that overall success.  But tying compensation to assets raised looks like the traditional broker dealer compensation and should be avoided.

Mr. Blass indicated that the SEC is close to finalizing guidance on issues connected to private fund manager employee compensation.  However, the SEC staff has further to go before providing guidelines to the industry on the broker dealer registration issues posed by deal fees that private equity firms sometimes collect on transactions.  It is unlikely that Mr. Blass will see his initiatives through to completion, as he will soon be joining the staff of the Investment Company Institute where he will one day lobby against his former positions.

If you would like additional background on how the private fund managers came to find themselves in the gray zone of broker dealer registration as a result of paying their employees for performance, you may want to re-visit this article.

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Written by: Ildiko Duckor

The California Commissioner of Business Oversight (“Commissioner”) recently amended California’s custody rule 10 C.C.R. Section 260.237 (the “New Custody Rule”).  The New Custody Rule will be effective on April 1, 2014.

All investment advisers licensed or required to be licensed in California must comply with the New Custody Rule.  California Exempt Reporting Advisers are not affected.

What is “having custody?”

Holding or having authority to obtain possession of client funds or securities, for example:

  • Possession of client funds or securities unless received inadvertently and returned to the sender promptly.
  • Any arrangement (such as a general power of attorney) that authorizes you to withdraw client funds or securities maintained with a custodian by instructing the custodian.
  • Any capacity with authority to access to client funds or securities (such as general partner of a limited partnership, managing member of a limited liability company or trustee of a trust).

If you “have custody” of assets.

  • Qualified Custodian.  You must maintain those assets with a “qualified custodian” such as a bank, trustee, or prime broker.
  • Notice on ADV.  You must notify the Commissioner on your ADV that you have or may have custody.
  • Notice to Clients*. You must notify your client in writing of the custodian’s name and address, and the manner in which the assets are maintained, and any changes to this information.
  • Quarterly Custodian’s Account Statement*.  You must reasonably ascertain that the custodian sends quarterly account statements with specific information to each client (for example, by being cc-d on electronic statements the custodian sends).
  • Surprise Exam*.  You must retain a CPA (by written agreement) to have an annual “surprise exam” of client assets, and report the examination and any resignation of the CPA on your ADV.
  • Internal Control Report.  If you or your affiliate serves as the qualified custodian:
    • The CPA firm conducting the surprise exam must be registered with and subject to examination by the PCAOB.
    • You must obtain an annual internal control report with specified content.
  • Exceptions.  There are certain exceptions from some of the New Custody Rule’s requirements for mutual fund shares, certain private securities, and for advisers that “have custody” only because they deduct fees (if certain conditions are also satisfied).

Fund Managers’ Obligations.

If you are a general partner of an investment limited partnership or a managing member of a limited liability company (or are in a similar position with respect to a pooled fund vehicle):

  • Quarterly Investor Account Statement.  You must send to all fund investors quarterly account statements showing:
    • the total amount of all additions to and withdrawals from the fund,
    • a listing of all additions to and withdrawals from the fund by an investor,
    • the opening and closing value of the fund at the end of the quarter,
    • the total value of an investor’s interest in the fund at the end of the quarter, and
    • a listing of securities positions on the closing date of the statement pursuant to FASB Accounting Standards Codification 946-210-50-4 through 6.
  • Independent Expense Verification*.  You must retain (by written agreement) an independent accountant or attorney obligated to act in your investors’ best interests and send him/her all invoices or receipts with details regarding calculations, so the independent person can:
    • review all fees, expenses and withdrawals from the fund,
    • determine that payments conform to the fund agreement, and
    • forward to the custodian approval for payments of the invoices.
  • Audited Fund Exceptions*.  You need not comply with the following requirements:  Notice to Clients, Quarterly Custodian’s Account Statement, Surprise Exam and Independent Expense Verification; if:
    • Your fund is audited annually, in accordance with GAAP, by an independent CPA registered with and subject to examination by the PCAOB.
    • The audited financials are distributed to all investors and the Commissioner within 120 days of the end of the fund’s fiscal year.
    • A final liquidation audit is performed, in accordance with GAAP, upon the fund’s liquidation, and the audited financials are distributed to investors and the Commissioner promptly upon completion of the audit.
    • The independent CPA is required by agreement to notify the Commissioner on Form ADV if it resigns or is terminated.
    • You notify the Commissioner that you intend to use the audit exception route.

For further details and interpretation of the intricacies of the New Custody Rule as they apply to you, please contact your Pillsbury Investment Funds and Investment Management team member.

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Written by:  Jessica M. Brown and Michael G. Wu

On March 10, 2014, the U.S. Commodity Futures Trading Commission and the Financial Services Agency of Japan signed a Memorandum of Cooperation which expresses the agencies’ intent to work together to supervise and oversee regulated entities that operate on a cross-border basis in Japan and the United States.  The agencies intend to cooperate in the interest of their respective derivative market regulations. The full text of the Memorandum can be found here.

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Written by:  Jay B. Gould and Jessica M. Brown

The Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations released a “Risk Alert” on January 28, 2014, which focuses on the due diligence investment advisers perform in alternative investments[1] and managers for their clients. After observing an increasing trend in advisers recommending alternative investments to their clients, the SEC examined a group of SEC-registered investment advisers, who collectively manage more than $2 trillion. The purpose of the examination and the Risk Alert is to review how the advisers perform due diligence, utilize investment teams to review fund structures and complex investment strategies, and identify, control and disclose conflicts of interest.

While the Risk Alert focuses on the narrow market segment of advisers who recommend to their clients discretionary investments in alternative investments managed by outside advisers/managers, the recommendations and due diligence practices can serve as practical guidance for all investment advisers and fund managers.

Observations

The SEC notes four primary trends in the due diligence that advisers perform on alternative investments and their managers:

  1. Position-level transparency and client risk mitigation
  2. Use of third parties to supplement and validate information provided by managers
  3. Quantitative analyses and risk measures on the investment and managers
  4. Enhancing and expanding due diligence teams and policies

Warning Indicators

The SEC notes a number of red flags that advisers find with respect to managers that warrant additional due diligence. These warning signs include:

  • managers who refuse transparency requests;
  • performance returns that conflict with factors known to be associated with the manager’s strategy;
  • unclear investment and research process;
  • lack of a sufficient control environment and separation of duties between the business and investment units;
  • portfolio holdings that conflict with a purported strategy;
  • insufficiently knowledgeable personnel to carry out the strategy intended to be implemented;
  • changes in manager investment style;
  • investments that are overly complex or opaque;
  • lack of third-party administrator;
  • inexperienced auditor;
  • repeated changes in service providers;
  • unfavorable background check results;
  • discovery of undisclosed conflicts of interest;
  • insufficient compliance or operational programs; and
  • lack of sufficient fair valuation process.

Advisers should review whether their due diligence process identifies these warning indicators and whether there are additional warning indicators they should consider to meet their fiduciary obligations. 

Adviser Compliance Practices

The SEC identifies the areas in which they found material deficiencies or control weaknesses with the investment advisers. Based on the deficiencies the SEC identifies, advisers who recommend alternative investments should ensure:

  • the due diligence policies and procedures for alternative investments/managers are reviewed annually;
  • disclosures made to clients do not deviate from actual practices, are consistent with fiduciary principles and describe any notable exceptions to the adviser’s typical due diligence process;
  • marketing materials are not misleading or unsubstantiated regarding the scope and depth of the due diligence process;
  • due diligence processes are written policies that contain sufficient detail and require adequate documentation; and
  • if responsibilities are delegated to third-party service providers, periodic reviews of those service providers’ adherence to their agreements.

Conclusion

The SEC reminds advisers that they are fiduciaries and must act in the best interest of their clients. In order to meet their fiduciary obligations when selecting alternative investments for clients, an adviser must evaluate whether such investment meets the client’s investment objectives and is consistent with the strategies and principles of investment presented to the adviser by the manager.

While the Risk Alert focuses on a narrow market segment of advisers, the recommendations and due diligence practices have a broader application. Any SEC-registered adviser, exempt reporting adviser or state-registered adviser can review their own operational due diligence policies and procedures to see if they can be bolstered by incorporating any of the recommendations contained in the Risk Alert. Further, managers of alternative investments should consider whether any of their practices or policies are included in the list of warning indicators and make the changes necessary to smoothly pass an adviser’s due diligence process.

[1] Included in the SEC’s definition of “alternative investments” are hedge funds, private equity funds, venture capital funds, real estate funds, funds of private funds, and other private funds.

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The annual affirmation process started on December 3, 2013. Advisers who relied on an exemption or exclusion from CPO registration under CFTC Regulation 4.5, 4.13(a)(1), 4.13(a)(2), 4.13(a)(3), 4.13(a)(5) or an exemption from CTA registration under 4.14(a)(8) and filed a notice with the NFA must affirm the exemption or exclusion annually within 60 days after the end of the calendar year. Failure to affirm the exemption or exclusion will result in the exemption or exclusion being withdrawn at the end of the affirmation period. Accordingly, those who filed a notice of exemption or exclusion in 2013 have until March 3, 2014 to affirm the exemption or exclusion or face losing their exemption or exclusion. Those who filed a notice of exemption or exclusion during the affirmation period of December 3, 2013 to March 3, 2014 will not need to affirm until the 2014 calendar year end. To obtain information about the annual affirmation process and filing, please visit the NFA website.

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If your management company or fund was formed as a California limited liability company, you need to review your Operating Agreement to determine whether amendments need to be made.

On January 1, 2014, California’s Beverly-Killea Limited Liability Company Act (Old Act) was superseded by the California Revised Uniform Limited Liability Company Act (New Act). The New Act includes a number of substantive changes that may adversely affect existing California limited liability companies unless they amend their operating agreements.

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

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Written by:  Joseph T. Lynyak, III and Anthony H. Schouten

More than three years following the passage of the Dodd-Frank Act, and intense inter-agency negotiations, the federal financial regulatory agencies collectively adopted the final version of the “Volcker Rule,” or “Rule”—which imposes new and potentially severe limitations on domestic and foreign banking entities’ activities in regard to proprietary trading and investments in “covered funds.”  The 72-page final Rule is accompanied by over 800 pages of interpretative guidance, to address more than 1,200 questions that the federal agencies asked commenters to address.

This Alert provides an overview of the principal elements of the Rule and identifies several significant concerns that have already been raised by industry participants. Importantly, we provide our thoughts regarding the process by which banking entities might analyze their current business models and transactional structures, with the goal of avoiding an interruption in deal flow and/or business models by identifying possible coverage by the Rule, as well as adopting modifications to comply with the Rule and prevent or minimize adverse business consequences.

Additional client communications will explore in detail categories of activities and transactions impacted by the Rule, as well as interpretative guidance issued by the federal banking agencies.

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

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Written by: Jessica M. Brown

As a result of recent amendments made by the U.S. Department of Treasury to the Treasury International Capital Form B (“Form B”), private funds and investment advisers may be required to file Form B.  Form B requires a fund manager or investment adviser to report certain information concerning “claims” and “liabilities” of the reporting institution to or from foreign residents.

Filing obligations may arise for private funds that provide credit to foreign entities, invest directly in foreign debt instruments, directly hold foreign short-term securities, or have a foreign credit facility.  Claims or liabilities that are serviced by a U.S. entity or held by a U.S. custodian or subcustodian, do not need to be reported.  Claims or liabilities with a foreign subsidiary or affiliate of a U.S. entity (such as a swap counterpart) are reportable on Form B.  Investment advisers are required to report on behalf of the funds they manage and U.S. funds are not required to report on their own behalf.

There are a number of different Form B reports and generally advisers or managers with total claims or liabilities under $50 million in all geographical regions, or $25 million in an individual country, are exempt from filing.  Detailed filing requirements and descriptions of each Form B can be found here.

The Federal Reserve Bank of New York (the “NY Fed”) requires investment advisers who have reportable claims or liabilities to report this information on certain monthly and quarterly reports. Reportable claims and liabilities as of December 31, 2013, must be reported by January 15, 2014 on the first monthly report, by January 20, 2014 for the first quarterly report. 

The NY Fed will grant extensions and determine appropriate filing deadlines on an individual basis and encourages new filers to contact them.

Please contact us immediately if you have any questions.

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Today, the Securities and Exchange Commission published its 2014 priorities for its National Examination Program (“NEP”).  These priorities cover a wide range of issues at financial institutions, including investment advisers and investment companies, broker-dealers, clearing agencies, exchanges and other self-regulatory organizations, hedge funds, private equity funds, and transfer agents.  Similar to the 2013 priorities, the 2014 priorities were published to focus on areas that are perceived by the SEC staff to have heightened risk.

The examination priorities address market-wide issues and those specific to each of the NEP’s four program areas — (i) investment advisers and investment companies(“IA-IC”), (ii) broker-dealers (“B-D”), (iii) exchanges and self-regulatory organizations (“SROs”, and collectively, “market oversight”), and (iv) clearing and transfer agents (“CA” and “TA”).  For investment advisers and investment companies, the SEC has specifically outlined its priorities as follows: 

  • Core Risks
    • Safety of Assets and Custody
    • Conflicts of Interest Inherent in Certain Investment Adviser Business Models
    • Marketing Performance 
  • New and Emerging Issues and Initiatives
    • Never-Before Examined Advisers
    • Wrap Fee Programs
    • Quantitative Trading Models
    • Presence Exams
    • Payments for Distribution in Guise
    • Fixed Income Investment Companies 
  • Policy Topics
    • Money Market Funds
    • “Alternative” Investment Companies
    • Securities Lending Arrangements

The market-wide priorities include fraud detection and prevention, corporate governance and enterprise risk management, technology controls, issues posed by the convergence of broker-dealer and investment adviser businesses and by new rules and regulations, and retirement investments and rollovers. 

The full SEC press release can be found HERE and a full text of the 2014 Examination Priorities can be found HERE. 

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As the new year is upon us, there are some important annual compliance obligations Investment Advisers either registered with the Securities and Exchange Commission (the “SEC”) or with a particular state (“Investment Adviser”) and Commodity Pool Operators (“CPOs”) or Commodity Trading Advisors (“CTAs”) registered with the Commodity Futures Trading Commission (the “CFTC”) should be aware of.

See upcoming deadlines below and in red throughout this document.

The following is a summary of the primary annual or periodic compliance-related obligations that may apply to Investment Advisers, CPOs and CTAs.  The summary is not intended to be a comprehensive review of an Investment Adviser’s securities, tax, partnership, corporate or other annual 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.

List of annual compliance deadlines in chronological order:

 

State registered advisers pay IARD fee November-December (of 2013)
Form 13F (for 12/31/13 quarter-end) February 14, 2014
Form 13H annual filing February 14, 2014
Schedule 13G annual amendment February 14, 2014
Registered CTA Form PR (for December 31, 2012 year-end) February 14, 2014
TIC Form SLT Every 23rdcalendar day of the month following the report as-of date
TIC Form SHCA March 3, 2014
Affirm CPO exemption March 3, 2014
Registered Large CPO Form CPO-PQR December 31 quarter-end report March 3, 2014
Registered CPOs filing Form PF in lieu of Form CPO-PQR December 31 quarter-end report March 31, 2014
Registered Mid-Size and Small CPO Form CPO-PQR year-end report March 31, 2014
SEC registered advisers and ERAs pay IARD fee Before submission of Form ADV annual amendment by March 31, 2014
Annual ADV update March 31, 2014
Delivery of Brochure April 30, 2014
Form PF filers pay IARD fee Before submission of Form PF
Form PF (for advisers required to file within 120 days after December 31, 2013 fiscal year-end) April 30, 2014
FBAR Form TD F 90-22.1 (for persons meeting the filing threshold in 2013) June 30, 2014
FATCA registration Must be completed by April 25, 2014
Form D annual amendment One year anniversary from last amendment filingIf the fund will be using 506(c) to generally solicit, the Form D must be amended to check the box that indicates the offering will be made under 506(c) 

 

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