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Chair Mary Jo White’s remarks on August 5, 2015 highlighted the SEC’s continuing implementation of the Dodd-Frank Act. Title VII of the Dodd-Frank Act requires the SEC and CFTC to establish a regulatory framework for the over-the-counter swap market. The SEC is specifically tasked with regulating security-based swap (“SBS”) dealers and major participants.

The Dodd-Frank Act added Section 15F to the Exchange Act requiring the SEC to adopt rules to provide for the registration of SBS dealers and major participants. Once registered, SBS dealers and major participants will be required to update information about their business activities, structure, and background in addition to information about affiliates. Moreover, SBS dealers and major participants will be immediately subject to SEC examination and inspection authority upon registration.

Additionally, SBS dealers and major participants are required to perform documented due diligence to ensure there is a framework to enable compliance with federal securities laws. The due diligence will serve as the basis for the senior officer of the SBS dealer or major participant to certify that written policies and procedures reasonably designed to prevent violations of federal securities laws have been implemented at the time of registration.

Under Section 15F(b)(6) it is unlawful, unless otherwise provided by rule, regulation, or order of the SEC, for SBS dealers or major participants to permit a statutorily disqualified associated person to effect or be involved in effecting SBS transactions on their behalf. However, to facilitate the registration process of entities currently engaged in SBS business the SEC provides a limited exception from the statutorily disqualified associated person bar if (1) the associated persons are not natural persons and (2) the statutory disqualifications occurred prior to the compliance date of the final rule once it is published in the Federal Register.

In light of the statutory disqualifications that will apply to dealers and major participants; the SEC has proposed Rule of Practice 194 which provides a process to determine whether it is in the public interest to permit a statutorily disqualified associated person to continue to engage in SBS transactions on behalf of a SBS entity. Comments on proposed Rule of Practice 194 will be due 60 days after it is published in the Federal Register.

Read the SEC release on SBS registration rules HERE.

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In the Federal Register for July 23, 2015, the Treasury Department published proposed regulations regarding the circumstances under which partnership allocations and distributions will be treated as disguised payments for services. These proposed regulations are aimed at attempts by investment fund managers to convert ordinary, management fee income into tax-favored long-term capital gains through the use of management fee waivers.

The proposed regulations draw heavily on the legislative history to Internal Revenue Code section 707(a)(2)(A), enacted as part of the Deficit Reduction Act of 1984 (P.L. 98-369), which provides that allocations and distributions to a partner by a partnership will be disregarded and instead treated as disguised payments for services if the performance of such services and the related direct or indirect allocation and distribution, taken together, are properly characterized as a transaction between the partnership and a partner acting other than in his capacity as a member of the partnership.

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Read this article and additional publications at pillsburylaw.com/publications-and-presentations.  You can also download a copy of the Client Alert.

Related post: Proposed Treasury Regulations May End Private…

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Pillsbury hosted a panel event for 100 Women in Hedge Funds on July 28 discussing conflicts of interests hedge fund managers face in managing multiple account types, such as funds, institutional separate accounts and sub-advised mutual funds.  Kristin Snyder, Associate Regional Director for Examinations, San Francisco Regional Office of the Securities and Exchange Commission, emphasized that while the SEC does not expect advisers to have conflict-free business models, clear disclosure and effective mitigation of material conflicts are essential fiduciary duties of an adviser.  Other panelists and representatives of hedge fund managers (Frank Martin, President, Standard Pacific Capital, LLC) and institutional investors (Michelle Young, Managing Director, Ohana Advisors), provided insights into identifying, assessing, mitigating, and managing those conflicts. Ildiko Duckor, Partner and co-head of Pillsbury’s Investment Funds and Investment Management group, moderated the panel and offered tips and comments on practical solutions to account conflicts.

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On July 15, 2015, the Wage and Hour Division of the U.S. Department of Labor (DOL) issued Administrator’s Interpretation No. 2015-1, adopting a very expansive interpretation of the definition of employees under the Fair Labor Standards Act (FLSA) under which many workers currently treated as independent contractors will need to be reclassified as employees. The Administrator’s Interpretation identifies the issue of a worker’s economic dependence as the most important factor in distinguishing between independent contractors and employees. The Administrator’s Interpretation puts employers on notice that “the FLSA covers workers of an employer even if the employer does not exercise the requisite control over the workers, assuming the workers are economically dependent on the employer.”

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

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In a letter to SEC Chair Mary Jo White, the Treasurers and Comptrollers of 13 states have urged the SEC to crack down on private equity funds and require better disclosure of expenses to limited partners.

Fees and expenses in the private equity space have in general been a recent focus of the SEC.  In a high-profile case this spring, Kohlberg Kravis Roberts & Co. (KKR) was fined nearly $30 million for misallocating so-called “broken deal” expenses to its flagship private equity funds and none to co-investors.   KKR, however, failed to adopt policies and procedures governing broken deal expense allocations during the period in question, which contributed to a finding of breach of fiduciary duty.  KKR also did not expressly disclose in its funds’ limited partnership agreements and related offering materials that it did not allocate any of the broken deal expenses to co-investors.

The issue that the state Treasurers brought up in their letter to the SEC may be differently motivated. The main complaints of the letter, inadequate expense reporting and opaque calculations of management fee offsets, surfaced shortly after some large state pension funds came under fire for failing to track and providing incorrect reporting of the amount of fees and carried interest paid to the private equity managers they invested with over the course of many years. One of the Treasurers noted that the letter was independently generated following discussions of transparency issues among the Treasurers for more than a year, and not as a result of those criticisms.

The full Treasurers and Comptrollers’ letter to the SEC is available HERE.

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It has been a common practice of private equity firms to convert their right to receive management fees from the funds they manage into the right to receive profits and distributions from the funds through management fee waiver arrangements.  As a result of these arrangements, the firms achieve a lower tax rate because the profits and distributions they receive in place of the fees usually receive capital gains treatment while the fees would otherwise have generated ordinary income, subject to higher tax rates.  In the proposed regulations, the IRS suggests that these arrangements may be disguised payments for services and result in ordinary income anyways.

While the proposed regulations would be effective when final regulations are published, the IRS has indicated that it believes the principles reflected in the proposed regulations generally reflect Congressional intent—signaling that it may apply these principles to existing arrangements even prior to the adoption of final regulations.

Read the proposed rule in the Federal Register HERE.

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Chair Mary Jo White’s opening remarks on July 15 kicking off the annual broker-dealer compliance outreach program drew a parallel between the goals and work of the SEC and those of compliance professionals. Ms. White acknowledged the challenges and hardship that compliance professionals face, the critical importance of their role to investors and the integrity of the markets. Her acknowledgment comes after the upset that compliance professionals experienced when BlackRock’s CCO was found personally liable and slapped with a civil penalty. (See our previous post regarding BlackRock’s censure and its compliance officer’s personal liability.) Ms. White’s assurance that “it is not our intention to use our enforcement program to target compliance professionals” was hedged by her statement that “we must, of course, take enforcement action against compliance professionals if we see significant misconduct or failures by them.”

Ms. White named the following examination priorities: fee structures; suitability; order routing conflicts; recidivist representatives; microcap activity; excessive trading; transfer agent activity; and issues of importance to retail investors and investors saving for retirement.

Read more of Chair Mary Jo White’s opening remarks at the Compliance Outreach Program for Broker-Dealers HERE.

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Pillsbury partner Ildiko Duckor will participate in the 100 Women in Hedge Funds sponsored event titled “HOT topics in Compliance: Conflicts of Interests in Account Management and more” on July 28, 2015.

In quest for assets and investors, hedge fund managers continue to diversify their client base. When they are successful, they may end up with a broad spectrum of accounts: managed accounts, 40 Act registered funds and proprietary accounts in addition to hedge funds. With variety comes complication – from a compliance perspective.

Are your side-by-side account management procedures up to par?

Join us in a panel discussion with experts from the SEC, Legal/Compliance, and Managers/Investors highlighting just what you need to know about the following compliance hot button topics:

  • Conflicts of interests in the center of the SEC’s focus – arising from trade allocations, expense allocations, related party transactions, side letters and proprietary account biases
  • Best practices you should have in place now
  • Investors’ main concerns during negotiations with the managers and what you need to know about their due diligence expectations

For more information, visit 100 Women in Hedge Funds.

Date & Time
7/28/2015
6:00 pm PT

Location
Pillsbury’s San Francisco office
Four Embarcadero Center
22nd Floor
San Francisco, CA 94111

Event Contact
Jessica Slater

Speakers

Ildiko Duckor
Kristin Synder, Securities and Exchange Commission
Frank Martin, Standard Pacific Capital, LLC
Michelle Young, Ohana Advisors

Sponsors
Pillsbury
100 Women in Hedge Funds

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Threats go way beyond simple theft of client information — Can you fend off a big heist?

Recently, the government identified hedge funds as a “weak link in the U.S. financial system’s defense against hackers and terrorists.” The messenger was no less than John Carlin, head of the Justice Department’s National Security Division, speaking at this year’s annual SALT hedge fund conference in Las Vegas. Since then, there have been reports that some of the biggest names in asset management and banking were affected by cyber-attacks. It is, in fact, a Who’s Who of asset managers, banks, and brokers.

This February, the SEC’s summary of its cybersecurity sweep has revealed that over three-quarters of the 100 brokers and advisers examined were subject to cyber-attacks, directly or through third-party service providers, even though upward of 80% of broker and adviser firms have implemented cybersecurity policies. The SEC followed up with guidance in April, making it clear that it intends to conduct more exams of advisers. These exams will be “more substantial,” with longer onsite visits and sit-down meetings with senior management.

Yet for all the heartburn caused by these SEC examinations, they seem to be only scratching the surface when it comes to the types of cyber-threats confronting hedge funds.

The SEC notes that it is focusing on protecting “client assets” by reviewing security measures such as password storage and the vetting of third parties. Those kinds of questions and exam goals indicate that the SEC is mostly interested in protecting against the theft of client data and information. But those are by no means the only potentially damaging threats faced by investment advisers nor are they the only ones that can impact investor assets.

As Carlin pointed out in his comments, hedge funds are a particularly desirable target for criminal cartels, foreign governments, and militaries around the world, basically anyone seeking profit, disruption in financial systems, or both. Hedge funds have valuable and vast assets, including their trading strategies and trades, as well as algorithms, in addition to those the SEC is worried about. Hedge funds are also easier to hack than banks, which have recently reinforced their cybersecurity defenses and, unlike most hedge funds, have teams available to handle the threats.

All hedge fund managers and investment advisers should therefore question how effective their cybersecurity controls are in light of the following real threats posed by cyber-criminals:

  • Hacking and stealing your strategy and algorithms. They will use your own and your employees’ handheld and portable devices, social media posts, and blogs, for phishing and otherwise hacking your internal systems. They will use high-frequency trading algorithms to steal your proprietary trade information in order to front-run you or otherwise engage in manipulative trading. They will steal and use your algorithms to replicate your strategy.
  • Blackmailing and extortion. They will hack and encrypt your data, and blackmail you for payment in return for your data. The Department of Justice is reportedly working with several hedge funds on just such cyber-extortion cases, as Carlin remarked.
  • Corrupting your data and crippling your trading process: They will use a form of malware that will intentionally distort or change data, making information unreliable at best or useless at worst. Perhaps even worse, the corruption of proprietary algorithms used to make investment decisions could go unnoticed for some time. In that event, advisers and their clients face losses, regulatory action, and reputational damage following the disclosure – likely mandatory — of such an incident.
  • Wiping your data: Perhaps the most dreaded of all attacks: hackers have repeatedly demonstrated their ability to literally wipe servers clean of data. Victims are left scrambling to reconstruct files either from scattered data backups or even paper records. This process is extremely laborious and time- consuming, and is not guaranteed in any way to completely restore records. In fact, this type of event is virtually guaranteed to put a broker/dealer or investment adviser out of business, as the reputational damage alone will likely be catastrophic.
  • Disrupting your operations: Too many companies take for granted the availability of their information technology systems. And, when those systems fail, managers tend to assume a technical fault that can be resolved quickly. As the cyber-attack on Sony Pictures proved, however, any company can be paralyzed by the deliberate introduction of malware, which also happened in 2013 to a large hedge fund. A well-crafted attack can render a company unable to do business for months at a time. Unfortunately, the tools and skills needed to conduct such an attack against you are readily available across the globe.

The key takeaway is this: just focusing on making sure hackers don’t break into accounts to steal investor information is not enough. There are many other ways hackers can wreak havoc, and the financial industry has to be prepared to respond to that wide variety of scenarios.

Stay tuned for our article on tips to prevent, detect and respond to cyber-attacks.

Ildiko Duckor is a partner and co-head of Pillsbury Winthrop Shaw Pittman LLP’s Investment Funds and Investment Management Practice. She specializes in hedge funds. She can be reached at ildiko.duckor@pillsburylaw.com or 415-983-1035.

Brian Finch (@BrianEFinch) is a partner in Pillsbury Winthrop Shaw Pittman LLP’s Government Law & Strategies Practice. He specializes in cybersecurity. He can be reached at brian.finch@pillsburylaw.com or 202-663-8062.

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A U.S. person with a financial interest in or signature authority over a foreign bank, securities (including brokerage account, margin account, mutual fund, trust) or other financial account in another country that has an aggregate value exceeding $10,000 at any time during the 2014 calendar year must file FinCEN Report 114 by June 30, 2015. FinCEN Report 114 supersedes Form TD F 90-22.1. Individuals filing the report must file electronically through the BSA E-Filing System.

For additional information on filing FBAR, see the Treasury Department’s FBAR E-Filing FAQs and the BSA E-Filing System FAQs.

If you need assistance, please call an attorney in our Investment Funds and Investment Management group.