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At the end of this month, the annual updating amendments for investment advisers’ Form ADV will be due. The following are some of the 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.

This summary consists of the following segments: (i) List of Annual Compliance Deadlines; (ii) 2016 Enforcement Priorities In The Alternative Space; (iii) New Developments; and (iv) Continuing Compliance Areas.

See the deadlines below and in red

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In commemorating the 75th anniversary of the Investment Company Act and Investment Advisers Act, David Grim discussed his views about the past, present and future of the investment management industry.  He selected four topics which in his opinion best illustrate the adaptability which the authors gave the 1940 laws governing the asset management industry.

Those topics are: (1) the role of exchange-traded funds (ETFs), (2) the role of private fund advisers, (3) the role of disclosure and reporting in our regulatory framework, and (4) the role of the board in fund oversight.

He called disclosure one of the critical pieces of the 40 Acts, and noted that the amount of information available to investors about funds and advisers through publicly available forms, prospectuses and offering documents has increased exponentially since 1940.  Specifically regarding private funds, he noted that the vast number of newly registered advisers after the passage of Dodd-Frank have resulted in a new era of transparency that has been beneficial to both investors and private fund advisers, in addition to the SEC.  The public availability of aggregated information has shed light on persistent questions and some misconceptions about the private fund industry. Investors have also benefitted by being able to make more informed choices when investing.

The full remarks are available here.

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(This article was published in the first February 2016 issue of “The Review of Securities and Commodities Regulation” and is reprinted here with permission.)

The last half of 2015 has been characterized by a lot of debate and press attention on the role of the Chief Compliance Officer (“CCO”) at investment advisers. It has attracted attention within the highest levels at the SEC as reflected in a series of public statements and speeches, including the public disagreement of two Commissioners on whether or not there is a new trend targeting CCOs. While this debate has been unusual, it has led to a healthy and productive discussion about the CCO’s role. Below, we will discuss in turn: (a) recent statements over the past six months by SEC leaders about CCOs and whether or not there is a new trend targeting them, (b) what qualities are essential to an effective CCO and whether or not the job should be outsourced, and (c) how an effective compliance leader can prevent and detect any problems and be truly effective in preparing the firm for SEC examinations.

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On January 11, the Office of Compliance Inspections and Examinations (OCIE) of the SEC announced its 2016 Examination Priorities (“Priorities”). To promote compliance, prevent fraud and identify market risk, OCIE examines investment advisers, investment companies, broker-dealers, municipal advisors, transfer agents, clearing agencies, and other regulated entities. In 2016, OCIE will continue to rely on the SEC’s sophisticated data analytics tools to identify potential illegal activity.

This year, private fund advisers should pay attention to the following OCIE Priorities:

  • Side-by-side management of performance-based and asset-based fee accounts: controls and disclosure related to fees and expenses
  • Cybersecurity: testing and assessments of firms’ implementation of procedures and controls
  • High frequency trading: excessive or inappropriate trading
  • Liquidity controls: potentially illiquid fixed income securities – focus on controls over market risk management, valuation, liquidity management, trading activities
  • Marketing / Advertisements: new, complex, and high risk products, including potential breaches of fiduciary obligations
  • Compliance controls: focus on repeat offenders and those with disciplined employees

Highlights for other market participants:

  • Never-Before-Examined Investment Advisers and Investment Companies: focused, risk-based examinations will continue

  • Broker-Dealers

    :

    • Marketing / Advertisements: new, complex, and high risk products and related sales practices, including potential suitability issues
    • Fee selection / Reverse Churning: multiple fee arrangements – recommendations of account types, including suitability, fees charged, services provided, and disclosures
    • Market Manipulation: pump and dump; OTC quotes; excessive trading
    • Cybersecurity: testing and assessments of firms’ implementation of procedures and controls
    • Anti-Money Laundering: missed SARs filings; adequacy of independent testing; terrorist financing risks
    • Registered representatives in branch offices – focus on inappropriate trading
    • Retirement Accounts: suitability, conflicts of interest, supervision and compliance controls, and marketing and disclosure practices
  • Public Pension Advisers: pay to play, gifts and entertainment
  • Mutual Funds and ETFs: liquidity controls – potentially illiquid fixed income securities
  • Immigrant Investor Program: Regulation D and other private placement compliance

For additional details, visit the SEC’s Examination Priorities for 2016. Please call an Investment Funds and Investment Management Attorney to discuss your firm’s risk areas.

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On November 3, 2015, an Illinois federal jury convicted Michael Coscia, a high-frequency commodities trader, of six counts of commodities fraud and six counts of spoofing—entering a buy or sell order with the intent to cancel before the order’s execution.1 Coscia’s conviction was the first under the criminal anti-spoofing provisions added to the Commodity Exchange Act (CEA) by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. In the press release touting its victory, the prosecution announced: “The jury’s verdict exemplifies the reason we created the Securities and Commodities Fraud Section in Chicago, which will continue to criminally prosecute these types of violations.” High-frequency traders should take note that the conviction on all six counts of spoofing charged in Coscia’s case may embolden prosecutors across the nation to pursue other spoofing cases with vigor. Given the real possibility of a felony indictment and conviction for spoofing—the latter of which exposes a defendant to imprisonment for up to ten years and significant monetary fines—high-frequency traders should carefully evaluate their strategies and conduct.2

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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.

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On November 18, 2015, the staff from the U.S. Commodity Futures Trading Commission’s (“CFTC”) Division of Swap Dealer and Intermediary Oversight issued a swap dealer de minimis exception preliminary report (“Preliminary Report”).

The Preliminary Report was issued pursuant to the SEC and CFTC joint regulation defining the term “swap dealer” and providing for a de minimis exception to the swap dealer definition. Under the regulation, a person shall not be deemed to be a swap dealer unless its swap dealing activity exceeds an aggregate gross notional amount threshold of $3 billion (measured over the prior 12-month period), subject to a phase-in period during which the gross notional amount threshold is set at $8 billion. Under the terms of the regulation, the phase-in period will terminate on December 31, 2017, and the de minimis threshold will fall to $3 billion, unless the CFTC sets a different termination date for the phase-in period or modifies the de minimis exception.

The Preliminary Report discusses:

  • Relevant statutory and regulatory provisions defining the term “swap dealer” and implementing the de minimis exception.
  • Data considered in preparing the Preliminary Report.
  • Policies underlying swap dealer registration and regulation and the de minimis exception that form the basis for evaluating the swap market data.
  • Data in light of alternative approaches to a de minimis exception.

Comments on the Preliminary Report must be submitted on or before January 19, 2016 and may be submitted electronically via the CFTC’s Comment Online Process. The staff will complete and publish for public comment a final report after considering the comments it receives on the Preliminary Report.

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Congress has replaced the TEFRA partnership audit rules with a new regime that redistributes the burdens of the audit process between partnerships and partners on the one hand and the IRS on the other, and also eliminates many rights that individual partners might previously have had in the audit process.  Even more troubling, these new rules create the possibility that absent careful attention and planning, the economic burden of partnership tax adjustments will be both increased and redistributed among the partners, both past and present, in a manner that does not reflect their economic agreement.  While the changes aren’t effective for quite some time (returns for taxable years beginning after December 31, 2017) and while there are likely to be further changes before the rules become effective, these new rules alter the landscape so drastically that partnerships and their partners will need to determine how to address them long before they become effective.

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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.

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On December 1, 2015, the Securities and Exchange Commission (SEC) charged GAW Miners, LLC (“GAW Miners”), ZenMiner, LLC (“ZenMiner”) and Homero Joshua Garza (“Garza”) the managing member of both GAW Miners and ZenMiner (together the, “Defendants”) with fraud under (i) Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and (ii) Section 17(a) of the Securities Act of 1933 (“Securities Act”). The Defendants were also charged with engaging in the offer and sale of unregistered securities under Sections 5(a) and 5(c) of the Securities Act for selling $20 million worth of shares in their virtual currency digital mining contract called a “Hashlet”.

The charges stem from the Defendants’ operation as a virtual currency “miner” which uses computing power to be the first to solve complex algorithms. The first virtual currency miner to solve a complex algorithm that confirms a transaction is rewarded with newly-issued bitcoins by the bitcoin protocol.

While virtual currency mining is not illegal, the SEC found:

  • Hashlets were touted as always profitable and never obsolete and had more than 10,000 investor purchases.
  • The Hashlet contract purportedly entitled the investor to control a share of computing power that GAW Miners claimed to own and operate while Hashlets were depicted in marketing materials as a physical product or piece of mining hardware.
  • GAW Miners directed little or no computing power toward any mining activity and misled investors to believe they would share in returns.
  • Garza and his companies owed investors a daily return that was larger than the actual return they were making on their limited mining operations because they sold far more computing power than they owned.
  • Investors were paid back gradually over time with “returns” out of funds collected from other investors.

The Press release is available HERE.

A full copy of the SEC order is available HERE.

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The Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) released a “Risk Alert” on November 9, 2015, the purpose of which is to raise awareness of compliance issues observed in connection with the examination of registered investment advisers and investment companies that outsource their Chief Compliance Officers (“CCO”) to unaffiliated third parties.

We encourage our registered investment adviser clients, including hedge fund and private equity managers, that have outsourced their firm’s CCO function to compliance service providers or other third parties to carefully review the following SEC risk alert summary and review their outsourcing arrangement in view of the SEC’s observations.

Outsourced CCO Initiative

The OCIE staff (the “staff”) conducted 20 examinations as part of an Outsourced CCO Initiative to evaluate the effectiveness of compliance programs and outsourced CCOs by considering a number of factors such as:

  • Whether the CCOs appropriately identified, mitigated, and managed compliance risk;
  • Whether the compliance program was designed to reasonably prevent, detect and remedy violations of federal securities laws;
  • Whether there was open communication between those with compliance responsibilities and service providers;
  • Whether the CCOs have authority to influence compliance policies and procedures of the registrants and had sufficient resources to carry out their responsibilities; and
  • Whether compliance was an important part of the registrants’ culture.

Observations of successfully outsourced CCOs

The staff observed compliance strength in outsourced CCOs with the following characteristics:

  • Regular and often in-person communication between the CCOs and registrants;
  • Strong relationships between the CCOs and registrants;
  • Registrants’ support of the CCOs;
  • CCOs having independent access to documents and information; and
  • CCOs having knowledge of the registrants’ business and regulatory requirements.

Observations of unsuccessfully outsourced CCOs

The staff observed compliance weakness in outsourced CCOs with the following characteristics:

  • CCOs providing compliance manuals based on templates not tailored to the registrants’ businesses and containing inappropriate policies and procedures;
  • CCOs visiting registrants’ offices infrequently, conducting limited annual reviews of documents or insufficient evaluation and assessment of training pertaining to compliance matters;
  • CCOs not performing critical control testing procedures and lacking documentation to evidence testing of control procedures;
  • Critical areas of the registrants’ operations were not identified by CCOs resulting in certain compliance policies and procedures not being adopted, including those necessary to address conflicts of interest;
  • CCOs using generic checklists to gather pertinent information regarding the registrants;
  • Registrants providing incorrect or inconsistent information to the CCOs about firm business practices;
  • Lack of follow-up by CCOs with registrants to resolve discrepancies; and
  • CCOs having limited authority within the registrants’ organizations to improve adherence to compliance policies and procedures and implement necessary changes in disclosure practices, such as fees, expenses and other areas of client interest.

Conclusion

The staff reminds registrants that CCOs, whether direct employees, contractors or consultants, must have sufficient knowledge and authority to fulfill their role. In addition, each registrant is responsible for the adoption and implementation of its compliance program and accountable for any deficiencies.

Finally, the staff emphasizes that all registrants, and especially those that use outsourced CCOs, may find the issues identified in the Risk Alert useful to evaluate whether (i) their business and compliance risks have been appropriately identified (ii) policies and procedures are tailored to the specific risks their businesses encounter and (iii) their respective CCOs have the necessary power to effectively perform their responsibilities. Registrants and their funds are advised to review their business practices regularly to determine whether the practices are consistent with compliance obligations under Rule 206(4)-7 under the Investment Advisers Act of 1940 and Rule 38a-1 under the Investment Company Act of 1940.

Please contact the Investment Funds and Investment Management Group if you would like to discuss the SEC alert or need help reviewing your outsourcing arrangement.

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Yesterday, Pillsbury hosted the first in a series of risk management and regulatory compliance round tables for fintech companies. The meetings will explore technology-related risk and compliance issues in the financial services space, such as in mobile banking, online brokerage, automated (“robo”) investment advisers, P2P lending, to name a few. Pillsbury partnered with  the Professional Risk Managers’ International Association (a non-profit professional association), Oyster Consulting (a firm providing comprehensive consulting and compliance services for financial firms) and La Meer Inc. (a risk management solutions company).