Articles Tagged with Investment Advisers

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Written by: Jay B. Gould

On September 23, 2013, the JOBS Act rules that roll back the 80 year old ban on the use of general advertising and public solicitation by issuers of unregistered securities will be a reality. At least it will be a reality for fund managers that do not rely on an exemption from the Commodity Futures Trading Commission. Private funds managers will decide over time whether they would like to avail themselves of the new rules, which will allow them to post performance numbers on their websites, talk openly about their funds on CNBC and Bloomberg, sponsor NASCAR events, and just generally be more open and transparent about their businesses. The responsibilities associated with these new rights are the requirements that the fund manager verify the accredited status of each investor, refrain from committing financial fraud, and file a revised Form D to indicate that the fund is following the new rules. Whether to use these new rules will be a tough call for many fund managers as they consider whether greater transparency provides a benefit for their specific business model. Hedge funds have often avoided the glare of public scrutiny, but the trade-off of building a more recognizable brand and more easily reaching potential investors could provide motivation for some fund managers to give these new rules a try.

But what happens if a fund manager is initially enamored of the new rules and decides to advertise generally, but later changes his mind? Can a fund manager go back to the old “pre-existing, substantial relationship” days, and how do you do that once the fund has been “generally offered” to the public? This could happen for any number of reasons. Perhaps the most prevalent would be that the manager reaches capacity in the fund in either assets, such as a quant fund, or investor slots, which would more likely be the case for a fund that relies on Section 3(c)(1) for its exemption from investment company registration. A fund manager in one of these situations may have originally liked the idea of generally advertising, but subsequently finds public solicitation of limited utility and not worth the potential added scrutiny from regulators and market participants.

If a fund commences an offering pursuant to Rule 506(c) using general solicitation, and later wants to go back and use the old rules, (i.e., rule 506(b)), the issue is one of integration. Rule 506(b) prohibits general solicitation; accordingly, the only way to stop using the public offering rules once a fund manager has done so, would be to wait a period of time so the rule 506(c) offering is not integrated with the rule 506(b) offering. Rule 502(a) of Regulation D provides for a safe harbor from integration so long as the selling effort of the earlier offering ceases for six months, and the fund does not commence a subsequent offering for 6 months after completion of the earlier offering. Therefore, a fund manager would need to cease the offering, file the Form D to indicate that the offering is over, and wait six months before commencing the “private” offering. A new Form D would need to be filed for the private offering under Rule 506(b) once that offering commences.

There is another way whereby fund managers could go straight from the public offering to the private offering without the six month cooling off period. It is possible that a fund manager could use the five factor test safe harbor of Rule 502(a) to avoid integration and commence a new private offering immediately. For most hedge fund managers, this would be fairly tough test to meet. The five factors that a fund would need to consider are as follows:

(a) Whether the sales are part of a single plan of financing;
(b) Whether the sales involve issuance of the same class of securities;
(c) Whether the sales have been made at or about the same time;
(d) Whether the same type of consideration is being received; and
(e) Whether the sales are made for the same general purpose.

In order to meet the requirements of the five factor test, the fund seeking to avoid integration would need to offer a different class of shares/interests, for a different investment purposes, with different terms and conditions. For many hedge fund managers, this will be a difficult standard to meet. So the bottom line here appears to be that you can put Humpty Dumpty back together again, he will just need six months in intensive care.

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Written by:  Jessica Brown

On July 25, 2013, the Securities and Exchange Commission’s (“SEC”) Division of Investment Management released its first annual report to Congress, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), regarding how it used private fund data collected from investment advisers on Form PF. Dodd-Frank gave the SEC authority to require registered investment advisers to file reports and maintain records regarding the funds they advise. The SEC adopted Form PF in 2011 as the mechanism through which registered advisers must provide this information to the SEC.

Although it acknowledges that the intent of the Dodd-Frank provision was to provide data for the Financial Stability Oversight Council (“FSOC”) to assess systemic risk, the SEC is using the data to support its own regulatory programs as well.  

In this first report to Congress, the SEC indicated that is has been focused on the Form PF electronic filing system, resolving technical issues with security and data collection, guiding Form PF filers through the new form and system, establishing protocols for internal access and protection of data, and providing the FSOC with access to the data. Various divisions of the SEC have begun to use the Form PF data to assist with monitoring, identifying and examining investment advisers and private funds. The SEC also plans to provide non-proprietary Form PF data about large hedge funds to the International Organization of Securities Commission for its report on the global hedge fund market.

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Written by:  Kimberly Mann

Private investment fund structures frequently include one or more vehicles that are organized under the laws of the Cayman Islands. The Cayman Islands is a preferred jurisdiction because there is no tax on income, profits or capital gains, nor is there withholding tax. In addition, at the time of its formation, an entity may purchase a tax exemption certificate which will preserve its tax-free status for several years. Formation in the Cayman Islands is relatively efficient and inexpensive and a number of different types of business organizational structures that offer limited liability for investors may be used. Advisors to Cayman funds also may avoid licensing requirements if they fall within an available exemption.

Cayman entities likely will become even more attractive to fund managers, sponsors and investors as a result of recent changes to Cayman law pertaining to fiduciary duties, third party beneficiaries of indemnification provisions, the manner in which fund documents may be executed, the use of foreign partnerships as general partners of Cayman limited partnerships and the adoption of a limited liability company statute, all of which help to bring Cayman law in line with Delaware law. However, fund managers are advised to remember important anti-money laundering obligations that apply to investment funds under Cayman law.

Anti-money Laundering Requirements

Notwithstanding the recent liberalization of certain laws and the absence of registration or licensing requirements in many cases, managers of Cayman vehicles are subject to strict anti-money laundering compliance requirements under the Proceeds of Crime Law (“PCL”) and the Money Laundering Regulations promulgated under the PCL. In addition, the Cayman Islands Monetary Authority Guidance Notes on Prevention and Detection of Money Laundering and Terrorist Financing in the Cayman Islands (“Guidance Notes”) provide important guidelines for anti-money laundering compliance. Under the Cayman anti-money laundering regime, fund managers must
(i) establish client identification procedures, (ii) implement suspicious transaction reporting procedures, (iii) maintain know-your-client information and suspicious transaction records, (iv) develop internal controls, policies and procedures that are appropriate to prevent money laundering, (v) implement an anti-money laundering training program for staff members and (vi) designate a compliance officer at the management level with the requisite skills and experience to manage the compliance program and report to the board of directors or its equivalent.

The purpose of the Guidance Notes is to assist funds and other financial services providers to comply with applicable Cayman Islands Money Laundering Regulations. The Guidance Notes describe the types of documentation that should be used as evidence of the identity of investors and their beneficial owners and signatories. The type of documentation required depends, in large measure, upon the nature of the investor or beneficial owner. For example, identification documents for natural persons would include a current valid passport, a recent utility bill and a reference letter from a lawyer, accountant or other respected professional. Appropriate documentation for a corporate investor would include a certificate of incorporation, a copy of recent financial statements of the company, identification evidence of each of the principal beneficial owners holding a 10% or greater interest in the company or otherwise exercising control over the company and copies of the resolutions of the board of directors authorizing the investment in the fund. If copies of identifying documents are submitted, they should be certified by a lawyer, accountant, notary public, member of the judiciary or other suitable certifier. The Guidance Notes are not required to be followed slavishly; rather, the Cayman Islands Monetary Authority expects financial services providers to exercise prudent judgment and take the Guidance Notes into account when devising their anti-money laundering policies and procedures.

A Pragmatic Approach – Using an Intermediary

Under the Money Laundering Regulations, evidence of identity is satisfactory if it is reasonably capable of establishing that the investor is who it claims to be. There are circumstances under which it may be duplicative, onerous or unhelpful for a fund manager to obtain and verify identification evidence about a prospective investor. In those cases, it may be appropriate to rely on the due diligence of a third party intermediary that will serve as an “eligible introducer.” An eligible introducer is, among other things, (i) a lawyer or certified or chartered accountant or firm of lawyers or certified or chartered accountants, conducting business in a country with legislation equivalent to the Money Laundering Regulations, (ii) a member of a professional body in a country listed in Schedule 3 of the Money Laundering Regulations that is subject to disciplinary action for failure to comply with guidelines similar to the Guidance Notes or (iii) a financial institution in a country listed in Schedule 3 of the Money Laundering Regulations that has regulations equivalent to the Money Laundering Regulations, if the financial institution is subject to the jurisdiction of a regulatory authority outside the Cayman Islands that is the functional equivalent of the Cayman Islands Monetary Authority. Use of an eligible introducer may be pragmatic in order to create efficiencies in cases where the introducer would have already conducted procedures to verify the identity of the prospective investor. An eligible introducer must ensure that its documentation is accurate and up-to-date. The nature of the relationship between the introducer and the fund manager and between the introducer and the prospective investor, as well as the bona fides of the introducer, will determine whether it is appropriate to use the introducer as an intermediary for anti-money laundering purposes.

Required Due Diligence on the Intermediary

It is important for a fund manager to keep in mind that it is responsible for ensuring that the procedures utilized by the introducer are substantially in accordance with the Guidance Notes and that documentary evidence of the introducer upon which the manager will rely is satisfactory. Evidence is satisfactory if it complies with the requirements of the anti-money laundering regime of the country from which the introduction is made. Fund managers or administrators typically require an eligible introducer to provide a comfort letter or eligible introducer form providing assurances that (i) the intermediary qualifies as an eligible introducer, (ii) the introducer’s due diligence procedures are satisfactory, (iii) the introducer has information that clearly establishes the identity of the investor or the investor’s beneficial owner, (iv) the introducer will make available upon request copies of documentation that it has obtained regarding the identity of the prospective investor or the prospective investor’s beneficial owner and (v) due diligence and other identification documentation will be retained by the introducer for the time period required by the regulations to which the introducer is subject. In addition to the comfort letter or eligible introducer form, the fund manager should obtain independent evidence of the eligibility of the introducer, such as confirmation that the introducer is a regulated entity or a member in good standing of a professional body. It is also advisable to test, from time to time, the introducer’s ability to furnish requested identifying documentation promptly. If it turns out that reliance should not have been placed on an introducer, the fund manager must carry out its own due diligence procedures on the prospective investor or beneficial owner.

Exemptions for Certain Types of Investors

Documentary evidence of identity is not required under all circumstances. For example, evidence of identity is not typically required where the investor is a governmental entity, agency of government or a statutory body. In addition, financial institutions in countries listed in Schedule 3 of the Money Laundering Regulations, companies with securities that are listed on exchanges or other markets approved by the Cayman Islands Monetary Authority and pension funds are examples of entities for which exemptions exist.  For pension funds, evidence that the investor is a pension fund may consist of a copy of a certificate of registration or an order, approval or regulation of a governmental, regulatory or fiscal authority in the jurisdiction in which the pension fund was established. In the absence of any such evidence, the fund manager should obtain the names and addresses of the trustees or other persons authorized to make investment decisions on behalf of the pension fund.

Summary

The failure to take the Guidance Notes into account could result in sanctions under Cayman law. The Guidance Notes make clear that fund managers should consider money laundering and terrorist financing prevention as part of their risk management strategies and not as a stand-alone requirement. Policies should be tailored to the nature and scope of the fund’s business. Prior to accepting subscribers, a fund manager or its administrator should ensure that documentary evidence of the identity of each prospective investor has been provided and reviewed. Where there are questions, or if insufficient information has been provided by a prospective investor, the manager or administrator should follow up until the prospective investor and its beneficial owners have been adequately identified and determined to be suitable from an anti-money laundering perspective. Subscription materials should be reviewed and modified, if necessary, to include anti-money laundering attestations and documentary requests. Fund managers that are U.S. persons also should check the names of prospective investors and their beneficial owners to determine whether they are on the list of specially designated nationals published by the Office of Foreign Assets Control.  Managers that are registered with the U.S. Securities and Exchange Commission as investment advisors likely have an anti-money laundering system in place that meets the requirements of the Guidance Notes. Managers that are not registered investment advisors may not have such policies and procedures in place and may benefit from assistance from counsel or a consultant in establishing and maintaining a satisfactory system.

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Written by:  Jay B. Gould and Jessica Brown

On July 10, 2013, the Securities and Exchange Commission (“SEC”) voted to lift the ban on general solicitation and advertising by private funds (and other private company issuers) as mandated by Congress in the Jumpstart Our Business Startups Act (“JOBS Act”). In addition to lifting the ban on general solicitation, the SEC approved a disqualification rule that will prospectively prohibit any felon or “bad actor” from relying on Rule 506 exemptions. Finally, the SEC voted to propose amendments to the current private offering rules.

I.          New Rule 506(c) 

Summary

Rule 506(c), as adopted by the SEC, permits private issuers to use general solicitation and general advertising when making a securities offering, provided the issuer only sells to accredited investors.[1] Issuers must take affirmative and reasonable steps to verify that each investor is accredited under the Rule 501 definition, and cannot simply rely upon a representation from the investor.

Verification Rule

The burden now shifts to private fund managers to determine “reasonableness” when making a determination of an investor’s accredited status. In response to comments it received, the SEC has provided some ideas an issuer can consider when determining its verification procedures. The non-exclusive, non-required verification methods published by the SEC include: (i) review federal tax forms, (ii) confirm net worth through documentation, or (iii) obtain written confirmation from a registered broker-dealer, registered investment adviser, licensed attorney in good standing, or registered CPA.  Accordingly, private fund managers will be able to rely upon certain third parties to make a determination of accreditation.

Current Rule 506 Exemptions

Rule 506(c) does not modify or repeal any of the current Rule 506 exemptions and issuers may still rely on those exemptions as written.   Therefore, private fund managers that do not see the value in advertising or soliciting to the public, or find the conditions of the new rules too onerous, may continue under the current private offering regime and will remain subject to all of the same restrictions on communications with the public to which they are currently subject. 

Form D

The current Form D filing document will be amended to include a “check-the-box” option to designate if the issuer is relying on the new Rule 506(c) in its present offering.  For those private funds and other issuers that do intend to generally advertise, the SEC has proposed that a Form D would need to be filed with the SEC 15 days in advance of the offering and again within 30 days after the offering closes.  It is proposed that an issuer that fails to make these filings would be prohibited from using the public advertising rules in the future.

II.        Rule 144A

Similar to the changes to Rule 506, under the new rules, securities sold pursuant to Rule 144A may be “offered” to investors other than qualified institutional buyers, because information about such offerings would be made public by way of general advertising, but the securities may only be sold to investors the seller reasonably believes to be qualified institutional buyers.[2]

III.       Felons and “Bad Actors” Disqualification

The SEC unanimously adopted a rule that disqualifies certain felons and “bad actors” from relying on any Rule 506 exemption.[3] This disqualification will be effective sixty days after the publication of the final rules in the Federal Register. 

The SEC identified a number of events that would disqualify an issuer from relying on Rule 506, such as securities-related criminal convictions, court injunctions and restraining orders, final orders from regulators and agencies, certain SEC disciplinary orders, anti-fraud or registration-related cease-and-desist orders from the SEC, SEC stop orders, suspension or expulsion from membership or association with a self-regulated organization, or recent U.S. Postal Service false representation orders. 

However, much to the consternation of the lone dissenting Commissioner Luis Aguilar, this provision will not bar persons who have committed financial and other crimes in the past.  It will only bar such bad actors on a going forward basis. Presumably, the fact that a principal of an issuer is a convicted felon would be a material fact that would be required to appear in the offering materials of the issuer, and for private funds, this information would, in most cases, get picked up in the Form ADV of the fund manager.

IV.       What Happens Next

Timing

The effective date of Rule 506(c) and the disqualification rule is 60 days following the date the rule is published in the Federal Register. For an ongoing offering under Rule 506 that began before the effective date of Rule 506(c), the issuer may elect to continue the offering after the effective date in accordance with the requirements of either the current Regulation D rule or new Rule 506(c), which permits general solicitation and advertising.  Accordingly, if an issuer chooses to continue its offering under Rule 506(c), any general solicitations that take place after the effective date, will not impact the exempt status of offers and sales that took place prior to the effective date in reliance on Rule 506(b).

What Funds Can Do Now

After the effective date of Rule 506(c), private funds that are not otherwise disqualified from using the Rule 506 exemptions may begin advertising and soliciting generally. An issuer that chooses to advertise or solicit generally must put policies and procedures in place to ensure that reasonable steps are taken to verify that each purchaser is accredited and that no sales are made to non-accredited investors.

Limitations, CFTC Considerations and Fund Advertising

Since February 2012, when the Commodity Futures Trading Commission (“CFTC”) rescinded Rule 4.13(a)(4), most private funds have relied upon the de minimus exemption of Rule 4.13(a)(3) in order to be exempt from CFTC registration. Other funds that trade futures or other instruments that are subject to CFTC oversight above the de minimus threshold, avail themselves of the “registration lite” exemption in Rule 4.7, pursuant to which all fund investors must be “qualified eligible persons.”  However, both of these exemptions require that the fund securities must be offered and sold without any marketing to the public in the United States.  Therefore, until the CFTC acts to amend these exemptive rules on which many private fund managers rely, none of these private funds will be able to use the general solicitation provisions of new Rule 506(c).  The Managed Funds Association submitted an outline of proposed rule amendments to the CFTC that would harmonize the CFTC rules with the SEC’s JOBS Act rules, but it is uncertain when the CFTC will act on this matter.

For a discussion of these provisions, see this discussion on Bloomberg. 

Proposed Amendments to Regulation D, Form D and Rule 156

In connection with the approval of Rule 506(c), the SEC proposed amendments to Regulation D, Form D and Rule 156 under the Securities Act. These proposed “investor protection” amendments are intended to enhance the SEC’s ability to evaluate market changes, the nature of advertising used by issuers, the steps taken by the issuer to verify that all investors were accredited and the intended use of the proceeds of the sale. It is likely that these provisions will soon become part of the new Form D and be applicable to private fund managers that advertise or solicit to the public. 

Finally, fund managers and their compliance officers should familiarize themselves with the requirements of Rule 156, as it appears likely that this anti-fraud rule will soon apply to the sales literature and advertising produced by hedge fund and private equity funds.

Questions regarding new Rule 506(c), the CFTC rules, Rule 156 and other implications regarding this recent SEC action should be directed to your Pillsbury attorney contact.

 

[1] Rule 501 of Regulation D defines an individual as an “accredited investor” if they have individual net worth, or joint net worth with the person’s spouse, in excess of $1 million at the time of the purchase, excluding the value of the primary residence of such person, or with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.

[2] Rule 144A defines “qualified institutional buyers” as certain institutions that own and invest at least $100 million in securities of issuers that are unaffiliated with the institutions, banks and financial institutions must also have a net worth in excess of $25 million. A registered broker-dealer qualifies if it owns and invests on a discretionary basis over $10 million in securities of issuers that are unaffiliated with the broker-dealer. 

[3] An issuer will be disqualified from relying on Rule 506 exemptions if any “covered person” has had a “disqualifying event.” The rule defines “covered persons” as: (i) the issuer, (ii) the issuer’s predecessors and affiliated issuers, (iii) directors and certain officers, general partners and managing members of the issuer, (iv) 20 percent beneficial owners of the issuer, (v) promoters, (vi) investment managers and principals of pooled investment funds, and (vii) persons compensated for soliciting investors as well as the general partners, directors, officers, and managing members of any compensated solicitor.

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Written by:  Jay B. Gould

On June 21, 2013, the Securities and Exchange Commission (“SEC”) entered a cease and desist order (technically called an “Order Instituting Administrative and Cease-and-Desist Proceeding”) against the former President of Stanford Capital Management, Jason A. D’Amato.  You may read the full SEC Order here.  Because this case is part of the broader case of former knight turned Ponzi purveyor, Allen Stanford, it would be easy to dismiss this order as an outlier and not readily applicable to other investment advisers and fund managers.  That would be a mistake.  The D’Amato Order provides useful insight into the SEC’s concerns with the use and misuse of hypothetical and back tested performance information as well as certain compliance failings that all fund manager should understand and appreciate.

To briefly summarize the facts, in 2000, Stanford began offering a mutual fund allocation program to its advisory clients.  D’Amato was hired in 2003 as an assistant analyst to track performance and create personalized pitchbooks for use by Stanford financial advisers in one-on-one presentations with prospective clients.  D’Amato calculated the performance returns for each strategy by back testing then existing allocations in each strategy against historical market data for the previous five years (i.e., if a client held a particular allocation of mutual funds from 2000 through September 2004, the pitchbook showed how it would have performed).  The pitch materials all contained charts showing the performance of each strategy dating back to 2000 with charts variously labeled “Hypothetical Performance,” “Hypothetical Historical Performance,” or “Model Performance.”  Amazingly enough, the back tested performance outperformed the index as well as actual performance in every strategy and, in some cases, by substantial margins.  In fact, the numbers were so skewed that the financial advisers who had to use these materials in front of prospective clients began complaining to Stanford management because none of their clients had ever achieved the returns disclosed on the performance charts.  So, Stanford hired an outside consultant to come in and verify the numbers, or not. 

For at least 2005 and 2006, the consultant concluded that: (i) actual returns earned by Stanford clients were, in most cases, hundreds of basis points lower than the returns published in the pitchbooks; and (ii) D’Amato and his team of analysts did not keep sufficient records to show contemporaneous changes in each of the Stanford strategies prior to 2005, so the consultant could not verify the advertised performance numbers before 2005.  But no problem, even though performance data for 2000 through 2004 could not be verified, Stanford management chose to continue using those figures in the pitchbooks using terms like “historical performance” to describe numbers for which no backup existed.  Additionally, the unaudited and unverified “data” was blended with other audited and composite data from different time periods and then published alongside actual performance.  You might think that crafting appropriate disclosures or disclaimers that would make this potpourri of numbers understandable to clients would be difficult or even impossible.  Apparently, so did Stanford because they decided not to include any.    

During this time, D’Amato began holding himself out to coworkers, clients, prospective clients, financial advisers, and others as a Chartered Financial Analyst (“CFA”).  Sadly, D’Amato was not, and had never been, a CFA and, in fact, he had failed the CFA Level I exam the first and only time that he took it.  Not to be deterred by minor details, D’Amato used the CFA designation in his e-mail signature block on thousands of e-mails and on his business cards.  He also fabricated an e-mail that he purportedly received from the CFA Institute that congratulated him on passing the Level III CFA exam and on achieving charterholder status.  D’Amato then passed that e-mail to Stanford’s human resources department, which in turn passed it along to Stanford’s compliance department which in turn threw him a party, or at least did not verify the authenticity of the “CFA” e-mail.  And what does this behavior get you in the near term?  Sir Allen Stanford was so impressed by how carefully D’Amato polished up the handle, that he was promoted to President of the Stanford investment adviser.  Simply by using totally bogus performance numbers and misrepresenting his qualifications and background, D’Amato increased assets under management from less that $10 million in 2004 to over $1.2 billion by the end of 2008, generating $25 million in management fees in 2007 and 2008.  And then Sir Allen’s Ponzi scheme came crashing down, taking D’Amato in its wake.

For fund managers and investment advisers, there are a number of takeaways from the D’Amato case.  First, when back tested or hypothetical “performance” is used in marketing materials, full and accurate disclosure must be made to investors and potential investors.  The methodology used must be sound and records must be kept.  Similarly, with respect to actual performance, calculations must be accurate and verifiable and must be presented in a context that does not make otherwise accurate information misleading in any material way.  Fund managers, in particular, should not dismiss the D’Amato case because it occurred in the context of mutual funds and more “retail” type investors.  The SEC and state regulators are willing to go back and look at past marketing presentations for inflated or inaccurate claims, all of which are required to kept as part of an adviser’s books and records.

For compliance personnel, remember, you have personal liability under Rule 206(4)-7 under the Investment Advisers Act of 1940 for the proper administration of the firm’s compliance policies and procedures.  Verifying past educational accomplishments, and confirming duties, titles, and responsibilities at former employers of advisory personnel is a basic function of the compliance role.  Even if the employee is the president of the organization, and especially if this particular executive officer ordered or condoned the use of misleading marketing materials after other employees complained about them.

The consequences to D’Amato for his role in this scheme is also worth noting.  D’Amato was fined $50,000, but more importantly, he was barred from the industry for five years and must apply to the SEC for the ability to associate with an investment adviser, broker dealer or any other regulated entity at the conclusion of that bar, should he believe that he has a future in the securities business. 

 

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On April 8, 2013, we reviewed a recent speech by David Blass, the Chief Counsel of the Division of Trading and Markets of the Securities and Exchange Commission (the “SEC”), in which Mr. Blass provided his views on whether certain investment fund managers might be operating in a way that would require registration as a broker dealer.  For hedge fund managers, the problem typically arises in the context of paying internal sales people based on the amount of capital raised.  As we noted, the widespread misreading or abuse of Rule 3a4-1, the issuer’s exemption safe harbor on which so many hedge fund managers rely, is now clearly on the SEC’s radar.

But there are other ways to become entangled in broker dealer registration requirements that many private equity funds (and some hedge funds) will also need to consider.  The SEC staff is aware that advisers to some private funds, such as managers of private equity funds executing a leverage buyout strategy, may collect fees other than advisory fees, some of which look suspiciously like brokerage commissions.  It is not uncommon for a fund manager to direct the payment of fees by a portfolio company of the fund to one of its affiliates in connection with the acquisition, disposition (including an initial public offering), or recapitalization of the portfolio company.  These fees are often described as compensating the fund manager or its affiliated company, or personnel for “investment banking activity,” including negotiating transactions, identifying and soliciting purchasers or sellers of the securities of the company, or structuring transactions.  These are typical investment banking activities for which registration as a broker dealer is required.

Perhaps through its presence exams, the SEC staff recognizes that the practice of charging these transaction fees is fairly common among certain private equity fund managers.  Blass suggested that if the payment of these investment banking type fees were used to offset the management fee, then a valid argument could be made that no separate brokerage compensation was generated.  However, the industry argument that the receipt of such fees by the general partner of the fund should be viewed as the same person as the fund, so there are no transactions for the account of others was not an argument that the SEC staff appeared ready to endorse.  As long as the fee is paid to someone other than the fund for the types of activities described above, then the general partner or its affiliate would need to go through the analysis as to why broker dealer registration is not required.  The private equity fund bar has also advanced the policy argument that requiring private equity fund managers to register as broker dealers serves no useful purpose.  This policy argument that advocates the position that the SEC should exempt certain firms and not others for the same conduct, as attractive as it might be for managers of private equity funds, is a total non-starter from the regulator’s perspective.  The SEC staff will remain fixated on the type of activity and the fees generated from that activity when attempting to determine whether registration is required.

Particularly among private equity fund managers, many of which have not had a history of being a regulated entity, this violation of the broker dealer registration requirement is not viewed as a serious matter because “everyone else is doing it.”  But the SEC is putting private equity on notice that this is an area that the staff will focus on in examinations and will eventually bring enforcement action.  In addition to being subject to sanctions by the SEC, another possible consequence of acting as an unregistered broker-dealer is the potential right to rescission by investors.  A transaction that is intermediated by an inappropriately unregistered broker-dealer could potentially be rendered void.  A purchaser of securities would typically seek to void a transaction if the price had moved against him, leaving the fund manager scrambling to make up the difference between the sales price and the value at rescission.   Private equity fund managers and those hedge fund managers that conduct similar activities should give greater attention to this issue for which the SEC staff has provided fair warning.

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In a speech before the American Bar Association’s Trading and Markets Subcommittee on April 5, 2013, David Blass, the Chief Counsel of the Division of Markets and Trading, put hedge fund managers and private equity fund managers on notice that they may be engaged in unregistered (and therefore, unlawful) broker dealer activities as a result of the manner by which hedge fund managers compensate their personnel and, in the case of private equity fund managers, the receipt of investment banking fees with respect to their portfolio companies.  The good news is that Mr. Blass indicated that the Staff of the Securities and Exchange Commission (the “SEC”) is willing to work with the industry to come up with an exemption from broker dealer registration for private fund managers that would allow some relief from the prohibitions against certain sales activities and compensation arrangements regarding the sales of private fund securities.  This post will address only the sales compensation activities of hedge funds with an explanation of the private equity investment banking fee discussion to follow.

Mr. Blass indicated that he believed that private fund advisers may not be fully aware of all of the activities that could be viewed as soliciting securities transactions, or the implications of compensation methods that are transaction-based that would give rise to the requirement to register as a broker dealer.

Mr. Blass provided several examples that fund managers should consider to help determine whether a person is acting as a broker-dealer:

How does the adviser solicit and retain investors?  Thought should be given regarding the duties and responsibilities of personnel performing such solicitation or marketing efforts. This is an important consideration because a dedicated sales force of internal employees working in a “marketing” department may strongly indicate that they are in the business of effecting transactions in the private fund, regardless of how the personnel are compensated.

Do employees who solicit investors have other responsibilities?  The implication of this point is that if an employee’s primary responsibility is to solicit investors, the employee may be engaged in a broker dealer activity irrespective of whether other duties are also performed.

How are personnel who solicit investors for a private fund compensated?  Do those individuals receive bonuses or other types of compensation that is linked to successful investments?  A critical element to determining whether one is required to register as a broker-dealer is the existence of transaction-based compensation. This implies that bonuses tied to capital raising success would likely give rise to a requirement for such individuals to register as broker dealers.

Does the fund manager charge a transaction fee in connection with a securities transaction?  In addition to considering compensation of employees, advisers also need to consider the fees they charge and in what way, if any, they are linked to a security transaction.  This point is aimed more at the investment banking type fees that a private equity fund might generate, but it would also be relevant in the context of direct lending funds or other types of funds that generate income outside of the increase or decrease of securities’ prices.

Mr. Blass also addressed the use or misuse of Rule 3a4-1, the so-called “issuer exemption.”  That exemption provides a nonexclusive safe harbor under which associated persons of certain issuers can participate in the sale of an issuer’s securities in certain limited circumstances without being considered a broker.  Mr. Blass stated his mistaken belief that most private fund managers do not rely on Rule 3a4-1, which, in fact, they do.  Blass suggests that private fund managers do not rely on this rule because in order to do so, a person must satisfy one of three conditions to be exempt from broker-dealer registration:

  • the person limits the offering and selling of the issuer’s securities only to broker-dealers and other specified types of financial institutions;
  • the person performs substantial duties for the issuer other than in connection with transactions in securities, was not a broker-dealer or an associated person of a broker-dealer within the preceding 12 months, and does not participate in selling an offering of securities for any issuer more than once every 12 months; or
  • the person limits activities to delivering written communication by means that do not involve oral solicitation by the associated person of a potential purchaser.

Mr. Blass rightly points out that it would be difficult for private fund advisers to fall within these conditions.  That, however, has not stopped most private fund managers from relying on some interpretation of the “issuer’s exemption” no matter how attenuated the adherence to the conditions might be.

Although Mr. Blass indicated a willingness to work with the industry to fashion an exemption from broker dealer registration that is specifically tailored to private fund sales, he also reminded the audience that the SEC is quite willing to take enforcement action against private funds that employ unregistered brokers.  Last month, the SEC settled charges in connection with alleged unregistered brokerage activities against Ranieri Partners, a former senior executive of Ranieri Partners, and an independent consultant hired by Ranieri Partners.  The SEC’s order stated (whether or not supported by the facts) that Ranieri Partners paid transaction-based fees to the consultant, who was not registered as a broker, for the purpose of actively soliciting investors for private fund investments. This case demonstrates that there are serious consequences for acting as an unregistered broker, even where there are no allegations of fraud.  The SEC believes that a fund manager’s willingness to ignore the rules or interpret the rules to accommodate their activities can be a strong indicator of other potential misconduct, especially where the unregistered broker-dealer comes into possession of funds and securities.

Private fund managers are encouraged to consider this statement and review their sales and compensation arrangements accordingly.

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REGISTER NOW!

Pillsbury and the California Hedge Fund Association invite you to join us on Thursday, April 25, 2013 for an educational program featuring Ms. Jan Lynn Owen, the Commissioner of the California Department of Corporations (DOC) and Person to be Announced from the U.S. Securities and Exchange Commission.

The Commissioner and her staff will discuss the new investment adviser registration rules that were recently adopted by the DOC, including the “exempt reporting adviser” provisions, the interplay between the DOC rules and those of the post-Dodd-Frank rules of the Securities and Exchange Commission.

This program will provide startup hedge fund managers and new investment advisers with the information they need to navigate the registration process, regulatory requirements, and examination focus of the DOC and the SEC, including:

  • Eligibility for reliance on the “exempt reporting adviser” provisions and what that means in the registration process
  • What the DOC and SEC expect to see in hedge fund manager and investment adviser compliance programs
  • Examination and enforcement by the DOC and the SEC and coordination efforts between the two agencies
  • Tax planning and compliance for fund managers at the state, local and federal levels
  • New DOC and SEC rules in the concept or proposal stage aimed at investment advisers

Date & Time
4/25/2013

3:30 pm – 4:00 pm PT
Registration

4:00 pm – 4:30 pm PT
Keynote: Jan Lynn Owen

4:30 pm – 5:45 pm PT
Panel Discussion

5:45 pm – 7:30 pm PT
Reception

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

Event Contact
Juliana Curmi 

Featured Speaker
Jan Lynn Owen, Commissioner, California Department of Corporations

Host and Moderator
Jay B. Gould, Partner, Pillsbury

Additional Speakers
Jerry Twomey, Deputy Commissioner, Division of Securities Regulation, California Department of Corporations

Doug Bramhall, Tax Managing Director, KPMG

Kristin A. Snyder, Associate Regional Director–Examinations, Securities and Exchange Commission, San Francisco Regional Office 

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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.