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Contributed by: The Family Office Association

The Family Office Association is pleased to contribute its latest Q&A “white paper” regarding family enterprise governance to the Investment Funds Law Blog.  The Q&A has contributions from James Grubman, Ph.D. and Dennis Jaffe, Ph.D., two of the world’s leaders on the topic of family enterprise governance.  Among other things, the Q&A discusses implementing mechanisms for inclusive decision-making, formulating a family governance plan, including non-blood line family members into the governance process and incorporating a family council.  Read more from the Family Office Association Q&A white paper.

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Last month, the Securities and Exchange Commission (the “SEC”), published its examination priorities for 2013.  As we suggested in our Blog posting at that time, the SEC is fixated on examining and bringing enforcement against its newest class of investment adviser – managers of private equity funds.  Fast forward four weeks, and we should not be surprised to see that the SEC is doing what they said they would do.  Today, the SEC charged two investment advisers at Oppenheimer & Co. with misleading investors about the valuation policies and performance of a private equity fund of funds they manage.

The SEC investigation alleged that Oppenheimer Asset Management and Oppenheimer Alternative Investment Management disseminated misleading quarterly reports and marketing materials, which stated that the Oppenheimer Global Resource Private Equity Fund I L.P.’s holdings of other private equity funds were valued “based on the underlying managers’ estimated values.”  The SEC, however, claimed that the portfolio manager of the Oppenheimer fund actually valued the Oppenheimer fund’s largest investment at a significant markup to the underlying fund manager’s estimated value, a change that made the performance of the Oppenheimer fund appear significantly better as measured by its internal rate of return.  As part of the Order entered by the SEC, and without admitting or denying the regulator’s allegations, Oppenheimer agreed to pay more than $2.8 million to settle the SEC’s charges and an additional $132,421 to the Massachusetts Attorney General’s office.

In its press release, the SEC reiterated its focus on the valuation process, the use of valuations to calculate fees and communicating such valuations to investors and to potential investors for purposes of raising capital.  The SEC’s order also claimed that Oppenheimer Asset Management’s written policies and procedures were not reasonably designed to ensure that valuations provided to prospective and existing investors were presented in a manner consistent with written representations to investors and prospective investors. This claim gave rise to an alleged violation of Rule 206(4)-8 (among other rules and statutes) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), the rule that the SEC passed after the Goldstein case permitted many funds to de-register as investment advisers from the SEC.

This case illustrates the new regulatory landscape for private equity fund managers.  Many private equity fund managers have not dedicated the time and resources to bringing their organizations in line with the fiduciary driven rules under the Advisers Act.  Many of these managers have not implemented the compliance policies and procedures required by the Advisers Act, nor have their Chief Compliance Officers been empowered to enforce such compliance policies and procedures when adopted.  Much of this oversight goes to the fact that many private equity fund managers do not have a history of being a regulated entity nor have they actively sought out regulatory counsel in their typical business dealings.  Private equity fund managers generally use outside counsel to advise them on their transactional or “deal” work and they often do not receive the advice that a regulated firm needs in order to meet its regulatory obligations.  Oppenheimer serves notice that failing to meet these regulatory obligations can have dire consequences.

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Last week the SEC issued a Risk Alert and an Investor Bulletin on the Custody Rule after its National Examination Program (“NEP”) observed significant deficiencies in recent examinations involving custody and safety of client assets by registered investment advisers.  The stated purpose of the Risk Alert was to assist advisers with complying with the custody rule.  The Investor Bulletin was issued to explain the purpose and limitations of the custody rule to investors.  We encourage advisers and investors to review the Risk Alert and the Investor Bulletin, and remind advisers, particularly advisers to private equity funds,  fund of funds and funds that invest in illiquid assets that they may only self custody securities if they satisfy the requirements for “privately offered securities” (i.e., securities are (i) not acquired in any transaction involving a public offering, (ii) uncertificated, (iii) transferable only with the prior consent of the issuer and (iv) are held by a fund that is audited). Many advisers may not be in compliance with the custody rule because they self custody assets that do not satisfy the definition of privately offered securities.  Please feel free to contact us for more information on the Risk Alert, Investor Bulletin or the custody rule.

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Written by Bruce A. Ericson

The U.S. Supreme Court’s recent decision in Gabelli v. Securities Exchange Commission (Feb. 27, 2013) rejects an attempt by the Securities and Exchange Commission to extend a statute of limitations by invoking a “discovery rule.” The SEC had proposed that, in an action by the SEC to impose a civil penalty for securities fraud, the time to bring an action should not begin running until the fraud was discovered, or reasonably could be discovered by the SEC. The Supreme Court rejected the SEC’s view.

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This article has been posted to the Pillsbury website.  To view additional publications, please visit https://www.pillsburylaw.com/publications.

 

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Written by:  Jessica R. Bogo

A Financial Industry Regulatory Authority (“FINRA”) hearing panel held that FINRA’s own rules prohibiting judicial class action waivers in broker-dealer customer arbitration agreements are preempted by the Federal Arbitration Act and unenforceable. Once this decision becomes final, it will likely change the landscape of broker-dealer arbitrations. Many other broker-dealers will adopt a judicial class action waiver in their customer arbitration agreements and end decades of securities class action lawsuits, which generally provide little benefit to class members.

In a thoughtful 48-page decision, a FINRA hearing panel on Thursday, February 21, 2013 followed the U.S. Supreme Court’s holding in AT&T Mobility LLC v. Concepcion, 131 S.Ct. 1740 (2011) (“Concepcion”) and held that FINRA Rules prohibiting broker-dealers from adopting judicial class-action waivers in customer arbitration agreements are unenforceable and preempted by the Federal Arbitration Act (“FAA”). For more background on Concepcion and recent California litigation post-Concepcion, please see our prior client alerts including, “Recent Maverick Ruling in CA Appellate Court Finds Concepcion Does Not Overrule Gentry.”

The decision arises from a Complaint filed on February 1, 2012 by FINRA’s Department of Enforcement against Charles Schwab & Co., Inc. (“Schwab”). In September 2011, Schwab added a provision to its pre- dispute arbitration agreements requiring customers to “waive any right to bring a class action, or any type of representative action” against Schwab or any related third party “in court.” The Complaint alleged that the waiver violated FINRA’s Rules prohibiting self-regulatory organizations (“SROs”) from adopting pre-dispute arbitration agreements that prohibited customers from filing judicial class actions.

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Written by:  G. Derek Andreson, James L. Kelly, Christopher M. Zochowski, and Ryan R. Sparacino

This article was also published in Law360.

Until a few years ago, private equity firms enjoyed relative insulation from regulatory scrutiny of overseas acquisitions and the operations of multi-national portfolio companies. No longer is that the case. Spurred by the unfounded belief that PE firms are not invested in compliance or the conduct of their portfolio companies, the DOJ and SEC are now training their attention on how PE firms exert oversight and control over their portfolios, with a particular emphasis on FCPA issues. PE firms should prepare for this new scrutiny by taking proactive measures to demonstrate both their awareness and their commitment to earning profits on a level playing field. Most importantly, PE firms must recognize that these efforts are not about appeasing regulators, but go directly to maximizing return on investment. 

It’s About Deal Risk, Not Legal Risk 

A private equity firm’s foreign investments carry unique risks in the anti-corruption world: the firm may have exposure to substantial fines, penalties and reputational harm through the conduct of a portfolio company, even though the firm maintains only partial control.

This risk arises not only in the context of acquisitions, but also in strategic combinations such as joint ventures. And under successor liability principles, the conduct at issue may have occurred years before the firm considered taking a stake in the company or venture.

These risks permeate the deal cycle, including the exit phase. A sophisticated buyer in today’s market will take a hard look at a target’s anti-corruption compliance. If the compliance program falls short of industry standards, that fact may persuade the buyer to look for other opportunities, or it may convey additional leverage in negotiations.

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On February 21, 2013, the Staff of the Securities and Exchange Commission (the “Staff” and the “SEC,” respectively) published its 2013 priorities for the National Examination Program (“NEP”) in order to provide registrants with the opportunity to bring their organizations into compliance with the areas that are perceived by the Staff to have heightened risk.  The NEP examines all regulated entities, such as investment advisers and investment companies, broker dealers, transfer agents and self-regulatory organizations, and exchanges.  This article will focus only on the NEP priorities pertaining to the investment advisers and investment companies program (“IA-ICs”)

As a general matter, the Staff is concerned with fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest, and the use and implications of technology.  The 2013 NEP priorities, viewed in tandem with the “Presence Exam” initiative that was announced by the SEC in October 2012, makes it abundantly clear that the Staff will focus on the approximately 2000 investment advisers that are newly registered as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”).

The Staff intends to focus its attention on the areas set forth below.   

New and Emerging Issues.

The Staff believes that new and emerging risks related to IA-ICs include the following:

  • New Registrants.  The vast majority of the approximately 2,000 new investment adviser registrants are advisers to hedge funds or private equity funds that have never been registered, regulated, or examined by the SEC.  The Presence Exam initiative, which is a coordinated national examination initiative, is designed to establish a meaningful “presence” with these newly registered advisers.  The Presence Exam initiative is expected to operate for approximately two years and consists of four phases: (i) engagement with the new registrants; (ii) examination of a substantial percentage of the new registrants; (iii) analysis of the examination findings; and (iv) preparation of a report to the industry on the findings.  The Presence Exam initiative will not preclude the SEC from bringing enforcement actions against newly registered advisers.  The Staff will give a higher priority to private fund advisers that it believes present a greater risk to investors relative to the rest of the registrant population or where there are indicia of fraud or other serious wrongdoing.  We expect to see the SEC bring enforcement actions against private equity and hedge fund managers for issues related to valuations, calculation of performance-related compensation and communications to investors that describe valuations and performance-related compensation.
  • Dually Registered IA/BD.  Due to the continued convergence in the investment adviser and broker-dealer industry, the Staff will continue to expand coordinated and joint examinations with the broker dealer examination program of dually registered firms and distinct broker-dealer and investment advisory businesses that share common financial professionals.  It is not uncommon for a financial professional to conduct a brokerage business through a registered broker-dealer that the financial professional does not own or control and to conduct investment advisory business through a registered investment adviser that the financial professional owns and controls, but that is not overseen by the broker-dealer.  This business model presents many potential conflicts of interest.  Among other things, the Staff will review how financial professionals and firms satisfy their suitability obligations when determining whether to recommend brokerage or advisory accounts, the financial incentives for making such recommendations, and whether all conflicts of interest are fully and accurately disclosed.
  • “Alternative” Investment Companies.    The NEP will also focus on the growing use of alternative and hedge fund investment strategies in registered open-end funds, exchange-traded funds (“ETFs”), and variable annuity structures.  The Staff intends to assess whether: (i) leverage, liquidity and valuation policies and practices comply with regulations; (ii) boards, compliance personnel, and back-offices are staffed, funded, and empowered to handle the new strategies; and (iii) the funds are being marketed to investors in compliance with regulations.
  • Payments for Distribution In Disguise.    The Staff will also examine the wide variety of payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards’ oversight of the same.  With respect to private funds, the Staff will examine payments to finders or other unregistered intermediaries that may be conducting a broker dealer business without being registered as such.  Payments made pursuant to the Cash Solicitation Rule will also be a focus of private fund payment arrangements.

Ongoing Risks.

The Staff anticipates that the ongoing risks selected as focus areas for IA-ICs in 2013 will include:

  • Safety of Assets.  The Staff has indicated that recent examinations of investment advisers have found a high frequency of issues regarding the custody and safety of client assets under the Investment Advisers Act of 1940 (“Advisers Act”) Rule 206(4)-2 (the “Custody Rule”).   The staff will focus on issues such as whether advisers are: (i) appropriately recognizing situations in which they have custody as defined in the Custody Rule; (ii) complying with the Custody Rule’s “surprise exam” requirement; (iii) satisfying the Custody Rule’s “qualified custodian” provision; and (iv) following the terms of the exception to the independent verification requirements for pooled investment vehicles.  Many private equity funds and fund of funds have been slow to adopt policies and procedures that comply with the Custody Rule.
  • Conflicts of Interest Related to Compensation Arrangements.  The Staff expects to review financial and other records to identify undisclosed compensation arrangements and the conflicts of interest that they present.  These activities may include undisclosed fee or solicitation arrangements, referral arrangements (particularly to affiliated entities), and receipt of payment for services allegedly provided to third parties. For example, some advisers that place client assets with particular funds or fund platforms are, in return, paid “client servicing fees” by such funds and fund platforms. Such arrangements present a material conflict of interest that must be fully and clearly disclosed to clients.  These types of compensation arrangements are commonplace among private equity fund advisers, many of which have just recently registered.  In fact, many private equity funds have compensation arrangements that the Staff believes requires broker dealer registration.  We believe that the Staff will make this point quite clearly by bringing enforcement actions against certain private equity fund general partners for engaging in unregistered broker dealer activity.  Enforcement actions are viewed as an effective way to get the message across to an industry that has long ignored this particular issue.
  • Marketing/Performance.  Marketing and performance advertising is viewed by the Staff as an inherently high-risk area, particularly among private funds that are not necessarily subject to an industry standard for the calculation of investment returns.  Aberrational performance of certain registrants and funds can be an indicator of fraudulent or weak valuation procedures or practices.  The Staff will also focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the assumptions or methodology utilized, and related disclosures and compliance with record keeping requirements.   The Staff is starting to think about how the anticipated changes in advertising practices related to the JOBS Act will affect their reviews regarding registrants’ use of general solicitations to promote private funds.  Whether private funds will be permitted to advertise performance under the JOBS Act rules remains to be seen.  Certainly, there have been loud and influential voices that advocated for the position that the SEC should continue to study performance advertising by private funds before allowing it in the adoption of the highly anticipated rules.
  • Conflicts of Interest Related to Allocation of Investment Opportunities.  Advisers managing accounts that do not pay performance fees (e.g., most mutual funds), side-by-side with accounts that pay performance-based fees (e.g., most hedge funds) face potential conflicts of interest.  The Staff will attempt to verify that the registrant has controls in place to monitor the side-by-side management of its performance-based fee accounts and non-performance-based fee accounts with similar investment objectives, especially if the same portfolio manager is responsible for making investment decisions for both kinds of client accounts or funds.  For certain types of strategies, such as credit strategies, where one fund may be permitted to invest in all securities in the capital structure, whereas other funds may be limited in what they can purchase by credit quality or otherwise, these potential conflicts of interest are particularly acute.  Fund managers must have policies in place that account for these potential conflicts, manage the conflicts and document the investment resolution.
  • Fund Governance.  The Staff will continue to focus on the “tone at the top” when assessing compliance programs.  The Staff will seek to confirm that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses or viability.  Chief Compliance Officers will want to make sure that those items that are required to be undertaken in the compliance manual actually occur as stated and scheduled.

Policy Topics.

The staff anticipates that the policy topics for IA-ICs will include:

  • Money Market Funds.  The SEC continues to delude itself regarding the regulation of money market funds.  This once sleepy and relatively benign product is now the pillar of the commercial paper market and functions like and deserves the regulation of a banking product.  But the SEC, and the mutual fund trade organization, are loathe to cede authority to banking regulators for this “dollar per share”  product.  Accordingly, the SEC will continue to try to find ways for thinly capitalized advisers to offer and manage  money market funds by requiring money market funds to periodically stress test their ability to maintain a stable share price based on hypothetical events, such as changes in short-term interest rates, increased redemptions, downgrades and defaults, and changes in spreads from selected benchmarks (i.e., basically, all of the market events that have proven fatal to money market funds in the past and which will be so again as long as these funds remain fundamentally flawed).
  • Compliance with Exemptive Orders.  The staff will focus on compliance with previously granted exemptive orders, such as those related to registered closed-end funds and managed distribution plans, employee securities companies, ETFs and the use of custom baskets, and those granted to fund advisers and their affiliates permitting them to engage in co-investment opportunities with the funds.  Exemptive orders are typically granted pursuant to a number of well-developed conditions with which the registrant promises to adhere.  The market timing and late trading scandals of 2003 illustrated that once a registrant has obtained an exemptive order, it may or may not abide by all of the conditions of that order.
  • Compliance with the Pay to Play Rule.  To prevent advisers from obtaining business from government entities in return for political “contributions” (i.e., engaging in pay to play practices), the SEC recently adopted and subsequently amended, a pay to play rule. The Staff will review for compliance in this area, as well as assess the practical application of the rule.  Advisers should be aware that most states have their own pay to play rules and many of them have penalties that are far more onerous than the SEC’s rule.

We will continue to monitor this and other new developments and provide our clients with up to date analysis of the rules and regulations that may affect their businesses.

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Pillsbury partner Jay Gould talks about Challenges and Opportunities for Starting a Hedge Fund in 2013, a program co-sponsored by the law firm, and why he thinks 2013 will indeed be a good year for hedge fund managers. Learn more: https://www.pillsburylaw.com/investment-funds-and-investment-management

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Written by: Louis A. Bevilacqua

On January 10, 2013 the Financial Industry Regulatory Authority (“FINRA”) issued a voluntary Interim Form for funding portals (the “Interim Form”). The Interim Form is designed for prospective crowdfunding portals under the Jumpstart our Business Startups Act (the “JOBS Act”), which was enacted on April 5, 2012. Title III of the JOBS Act, which relates to crowdfunding, requires the Securities and Exchange Commission (the “SEC”) and FINRA to promulgate rules before crowdfunding portals can commence operations. The Interim Form permits companies that intend to become funding portals under Title III of the JOBS Act to voluntarily submit to FINRA information regarding their business. FINRA expects that the information received will help it develop rules specific to crowdfunding portals.

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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”) 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.  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.

u  List of annual compliance deadlines in chronological order:

State registered advisers pay IARD fee November-December (of 2012)
Form 13F (for 12/31/12 quarter-end) February 14, 2013
Form 13H annual filing February 14, 2013
Schedule 13G annual amendment February 14, 2013
Registered CTA Form PR (for December 31, 2012 year-end) February 14, 2013
TIC Form SLT Every 23rd calendar day of the month following the report as-of date
TIC Form SHCA March 1, 2013
Affirm CPO exemption March 1, 2013
Registered Large CPO Form CPO-PQR December 31 quarter-end report March 1, 2013
Registered Small CPO Form CPO-PQR year-end report March 31, 2013
Registered Mid-size CPO Form CPO-PQR year-end report March 31, 2013
Registered CPOs filing Form PF in lieu of Form CPO-PQR December 31 quarter-end report March 31, 2013
SEC registered advisers and ERAs pay IARD fee Before submission of Form ADV annual amendment by March 31, 2013
Annual ADV update March 31, 2013
Delivery of Brochure April 30, 2013
Form PF Filers pay IARD fee Before submission of Form PF
Form PF (for advisers required to file within 120 days after December 31, 2012 fiscal year-end) April 30, 2013
FBAR Form TD F 90-22.1 (for persons meeting the filing threshold in 2012) June 30, 2013
Form D annual amendment One year anniversary from last amendment filing

 

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