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

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

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

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

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

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As we have previously reported, the Securities and Exchange Commission (“SEC”) has taken a significantly heightened interest in whether people who engage in certain promotional activities on behalf of issuers of securities should be subject to regulation as a broker dealer.  The David Blass speech of April 5, 2013 put hedge fund general partners on notice that certain sales practices undertaken by hedge fund personnel may require registration as a broker dealer.  The SEC has recently followed up this guidance with enforcement action.

On May 15, 2014, the SEC  charged a Tiburon, California based securities salesman for selling millions of dollars in oil-and-gas investments without being registered with the SEC as a broker-dealer or associated with a registered broker-dealer.  The defendant, Behrooz Sarafraz, agreed to settle the SEC charges by paying disgorgement of his commissions, prejudgment interest, and a penalty for a total of more than $22 million.

According to the SEC’s complaint filed in federal court in San Francisco, Sarafraz acted as the primary salesman on behalf of TVC Opus I Drilling Program LP and Tri-Valley Corporation, which were based in Bakersfield, California.   From February 2002 to April 2010, these companies raised more than $140 million for their oil-and-gas drilling venture.  While Sarafraz was raising money for these entities, he was not associated with any broker-dealer registered with the SEC.  The SEC also alleged that Sarafraz worked full-time locating investors for the Opus and Tri-Valley oil-and-gas ventures.  He described the investment program to investors and recommended they purchase Opus partnership interests or securities of Tri-Valley and its affiliated entities.  In return, Sarafraz received commissions that ranged from seven to 17 percent of the sales proceeds that he and members of a sales network generated.  The SEC alleges that Opus and Tri-Valley paid Sarafraz approximately $18.3 million in sales commissions.  He paid approximately $1.9 million to others as referral fees and kept the remaining $16.4 million for himself.

For the two companies for which Sarafraz raised money, this could be just the beginning of the process.  If investors have lost money or would otherwise seek to unwind these transactions, it is possible that the investors could sue the companies and Sarafrax for rescission.  Typically, in a rescission recovery case, the plaintiffs who purchased through the unregistered broker can receive the higher of the current market price of the price that they originally paid for the securities.  Hedge funds and other private companies that use solicitors should take note.

The SEC also charged New York-based Rafferty Capital Markets with illegally facilitating trades for another firm that was not registered as a broker-dealer as required under the federal securities laws.  According to the SEC’s order instituting settled administrative proceedings, Rafferty agreed to serve as the broker-dealer of record in name only for approximately 100 trades in asset-backed securities that were actually introduced by the unregistered firm.  While Rafferty held the necessary licenses and processed the trades, it was the unregistered firm that managed the business.  Five of the firm’s employees became registered representatives with Rafferty but they performed their work in the offices of the unregistered firm, which retained sole authority over their trading decisions and determined their compensation.  Rafferty had no involvement in the trading or compensation decisions while the registered representatives executed the trades through Rafferty’s systems on behalf of the unregistered firm.  Based on the agreement, Rafferty kept 15 percent of the compensation generated by these trades and sent the remaining balance to the unregistered firm.

The SEC’s order found that Rafferty willfully violated Federal securities laws and also willfully aided and abetted and caused the unregistered broker-dealer’s violation of the registration provisions of the Securities Exchange Act.  Rafferty consented to a cease-and-desist order that censures the firm and requires the disgorgement of $637,615 as well as payment of $82,011 in prejudgment interest and a $130,000 penalty.  This case should serve as a cautionary tale for hedge fund and other private fund managers that seek to hire sales people who construct sham arrangements with a broker dealer in order to appear to be in compliance with the broker dealer registration provisions.  Expect more of these types of action from the SEC in the near future.

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The Securities and Exchange Commission (“SEC”), on March 31, 2014, announced insider trading charges against two men who allegedly traded on information they overheard from their respective wives.  On April 3, 2014, the SEC announced charges against two friends who traded tips related to an impending acquisition deal.  The spouse cases and friend cases differ with respect to the culpability of the tipper.  In the friend cases, the tipper and the tippees were all aware that they were breaching their duties to maintain the information and not trade on it.  In the spouse cases, the wives were unaware of their husbands’ intentions and actions and had previously informed their husbands of the prohibition on trading on any information gleaned from them.

Friends

The SEC has charged three friends who worked together to trade on nonpublic information related to the acquisition of The Shaw Group by Chicago Bridge & Iron Company.  John W. Femenia was employed by a major investment bank from which he obtained the information about the impending acquisition.  Femenia told his friend Walter D. Wagner the nonpublic information and Wagner passed that information along to Alexander J. Osborn.  Osborn and Wagner proceeded to invest substantially all of their liquid assets based on the information from Femenia.  When the public announcement was made, Wagner and Osborn profited approximately $1 million collectively.

Femenia was charged in December 2012 for knowingly being the source of nonpublic information to a whole insider trading ring.

Wagner settled with the SEC by disgorging all illicit profits and a parallel criminal action against him was announced on April 3rd. The SEC case against Osborn is ongoing.

Family

The SEC charged two men with insider trading, in unrelated cases, for illegally trading on information they obtained from their wives. In each case, the husband overheard his wife on a business call in which market moving information was discussed. The SEC found that both men were aware of the prohibition on trading on the information obtained from their spouses and knowingly violated the duty and profited from the information.

Both men have settled their cases with the SEC and each has agreed to pay more than double the profits realized.

The lessons from these cases apply to any person who may obtain material nonpublic information about public entities that they have a duty to protect. Investment advisers and broker-dealers should be sure their insider trading training and policies address the friends and family issue directly. Employers should remind their employees to be cognizant of who can overhear their phone conversations or potentially see their written communication with clients or co-workers and take as many precautions as practicable to prevent the insider information from being used illegally.

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The U.S. Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) previously announced that its 2014 Examination Priorities included a focus on technology, including cybersecurity preparedness.  In connection with that statement of examination priority, OCIE recently issued a Risk Alert to provide additional information concerning its initiative to assess cybersecurity preparedness in the securities industry.

As part of this initiative, OCIE will conduct examinations of more than 50 registered broker-dealers and registered investment advisers focused on the following:

  • the entity’s cybersecurity governance,
  • identification and assessment of cybersecurity risks,
  • protection of networks and information,
  • risks associated with remote customer access and funds transfer requests,
  • risks associated with vendors and other third parties,
  • detection of unauthorized activity, and
  • experiences with certain cybersecurity threats.

OCIE has provided a sample form of request for information and documents that investment advisers and broker dealers can expect to receive prior to this type of examination.

Although the SEC has stated that they believe the sample document request (see Appendix) should help to empower compliance professionals with questions and tools they can use to assess their firms’ level of preparedness, registrants should also expect the SEC to use the sample document as a basis for finding deficiencies, to the extent the guidance is not followed.

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The Financial Markets Association is hosting its annual Securities Compliance Seminar in Nashville, TN on April 23-25,2014.  This seminar is intensive training for intermediate as well as seasoned compliance specialists, internal auditors, attorneys, and regulators that focuses on current compliance topics, new rules or interpretations and regulatory developments, including a Dodd-Frank regulatory update.  The seminar gives attendees the opportunity to sharpen their skills through general and breakout sessions.  Satisfy CLE/CPE requirements.

Click HERE to view the complete program.

The brochure is also available on FMA’s website, www.fmaweb.org. 

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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 Jay B. Gould

On March 10, 2014, Financial Industry Regulatory Authority, Inc. (“FINRA”) submitted a proposed rule to the Securities and Exchange Commission (“SEC”) that would require disclosure to certain clients and FINRA regarding the details of a broker-dealer representative’s financial recruiting incentives (the “Proposed Rule”). The Proposed Rule is intended to ensure that the former clients of a representative who has changed firms are aware of: (i) the recruitment compensation that induced the representative to change firms, and (ii) all of the costs and potential risks associated with transferring their assets to the new firm (the “Recruiting Firm”). In addition to disclosures to clients, the Proposed Rule would require the Recruiting Firm to report to FINRA at the beginning of a representative’s employment, any significant total compensation increases the representative will receive in the first year, compared to the representative’s compensation the prior year.

Under the Proposed Rule, if a Recruiting Firm directly or through the representative, tries to induce the representative’s clients from a prior firm to transfer assets to the Recruiting Firm, the Recruiting Firm would be required to disclose to the potential client if the representative has received, or will receive, $100,000 or more in either (i) aggregate “upfront payments” or (ii) aggregate “potential future payments.” Upfront payments include compensation received upon commencement of association or specified amounts guaranteed to be paid at a future date (e.g. cash, deferred cash bonus, transition assistance, forgivable loans, equity awards, loan-bonus arrangements, or ownership interests. Potential future payments include those offered as a financial incentive contingent upon the representative meeting performance-based goals, allowance for additional travel or expense reimbursement in excess to what is typical for similarly situated representatives, or a commission schedule for a representative who is paid on a commission basis in excess of what is typically provided to similarly situated representatives.  Where the Recruiting Firm partnered with another entity, such as an investment adviser or insurance company, to recruit a representative, the disclosed upfront payments and potential future payments would include any payments from those third parties connected to the recruitment.

The amount of recruitment compensation received would be disclosed separately for aggregate upfront payments and aggregate potential future payments using ranges for each: $100,000 to $500,000; $500,001 to $1,000,000; $1,000,001 to $2,000,000; $2,000,001 to $5,000,000; and above $5,000,000. In addition to the amounts that must be disclosed, the Recruiting Firm would be required to disclose the basis for determining the upfront and potential future payments. Pursuant to the Proposed Rule, disclosure would not be required to be disclosed to clients that meet the definition of an “institutional account” under FINRA Rule 4512(c), however accounts held by natural persons would not qualify for the institutional account exception under the Proposed Rule.

Client disclosures, pursuant to the Proposed Rule, would also be required to include whether transferring assets from the representative’s prior firm to the Recruiting Firm would cause the client to incur any costs the Recruiting Firm would not reimburse. Further, if the assets are not transferrable, the Recruiting Firm would be required to disclose the costs the client may incur, including taxes.

The Proposed Rule would require the disclosures be made to the client at the time of first individualized contact by the representative or Recruiting Firm that attempts to convince the client to transfer assets. Written disclosures would be required if the contact is in writing. If the contact is oral, the disclosures would be made orally with written disclosures to follow. The disclosure requirement would be mandated for the representative’s first year with the Recruiting Firm.

The second component of the Proposed Rule would require the Recruiting Firm to report to FINRA if it reasonably expects the total compensation paid to the representative, in his/her first year, to increase the representative’s prior year’s compensation by the greater of 25% or $100,000. The compensation information reported to FINRA would not be available to the public under the Proposed Rule.

The SEC will review the Proposed Rule and is expected to seek public comment. The Proposed Rule has not yet been published on the SEC’s website as of the date of this posting.

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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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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.