Year: 2010

Regulation of Private Fund Advisers at the State Level

The Dodd-Frank Wall Street Reform and Consumer Protection Act raised the level for registration with the SEC and removed the commonly used exemption from registration used by private fund advisers. That means smaller traditional investment advisers will be kicked out of the SEC registration and into the state registration systems. That also means that advisers to funds with less than $150 million are potentially subject to state-level registration and regulation.

In general, advisers to private funds with less than $150 million in assets under management will be exempt from SEC registration but still must submit reports to the SEC and maintain certain books and records. This, along with venture capital fund advisers are the new “exempt reporting advisers” category. They are not excluded from the definition of “investment adviser” under the Investment Advisers Act and are not required to register under the Investment Advisers Act.

That means states are not preempted by Section 203A of the Investment Advisers Act from requiring “exempt reporting advisers” to register.

Advisers to private funds with more than $150 million under management are federal covered advisers and merely have to notice file in the states in which they maintain a place of business. (Investment adviser representatives for private fund advisers are required to register with the states if they meet the definition of investment adviser representative under SEC Rule 203A-3.)

The North American Securities Administrators Association has begun looking at the issue of how states with regulate private fund advisers under the $150 million level. They have issued their Proposed NASAA Model Rule on Private Fund Adviser Registration and Exemption.

The model rule would provide the basis for an exemption from state registration only for advisers only to 3(c)(7) funds, including venture capital funds formed under 3(c)(7). Presumably funds falling under the 3(c)(1) exemption would be subject to state registration.

Under the proposed model rule, an investment adviser solely to one or more private funds will be exempt from state registration requirements if the adviser satisfies certain specified conditions:

  • The adviser cannot be subject to a disqualification under 230.262 of title 17, Code of Federal Regulations.
  • The adviser’s clients must be limited to private funds that that qualify for the exclusion from the definition of “investment company” under Section 3(c)(7) of the Investment Company Act of 1940.
  • The adviser must file with the state the report required by the SEC for exempt reporting advisers.
  • The adviser must pay the fees specified by the state.

The proposed rule could change depending on how the SEC changes its proposals for implementing the new registration and reporting requirements in Release No. IA-3110 and Release No. IA-3111. Once the NASAA finalizes the proposed rule, it would be up to the states to adopt the rule. They may not adopt it all or may change it significantly.

NASAA is seeking comments on their proposed rule. Comments should be submitted electronically to [email protected], but written comments may be mailed to NASAA, Attn. Joseph Brady, 750 First Street, NE, Suite 1140, Washington, DC, 20002. The deadline for submission of comments is January 24, 2011.

Sources:

Corporate Compliance after Dodd-Frank: Dealing with Whistleblower Bounties

Securities Docket produced a webcast “Corporate Compliance after Dodd-Frank: One Voice; How Many Masters?” that focused on the SEC’s proposed new whistleblower rules and their implications for internal controls and compliance programs, investigations, self-reporting incentives and employer/employee relations, including executive compensation and employee reporting responsibilities.

The panelists:

  • Byron Egan, Partner Jackson Walker L.L.P.
  • Jeffrey Sone, Partner Jackson Walker L.L.P.
  • Gary Kleinrichert, Senior Managing Director FTI Consulting

Section 922 of Dodd-Frank provides an expanded whistleblower program that allows the whistleblower to get part of the money paid to the SEC for the violation.

There is a lot of gnashing of teeth among compliance professionals because this provision would encourage an employee to ignore internal complaint processes and head directly to the Feds. Those internal whistleblowing program came out of Sarbanes-Oxley, the legislation enacted as a result of the last financial crisis.

The new program is not applicable to private companies that are not subject to registration under the Securities Act of 1934. Section 922 of Dodd-Frank is an amendment of that law.

Employees with a legal, compliance, audit, supervisory or governance responsibility have limited eligibility for the whistleblower bounty. They are not eligible if the information was communicated to them with the reasonable expectation that they would take steps to respond to the violation. They are then eligible if the company does not disclose the information to the SEC within a reasonable time or proceeds in bad faith.

———

In prognosticating the impact, we can look at the False Claims Act which has a similar whistleblower bounty program. Under that legal framework, most people don’t report to the government until they have given their company a chance.

Much of the whistleblower program is in SEC Release 34-6323. Comments are open until December 17, 2010. Certainly, the proposed rule could change significantly bases on the comments.

Sources:

CFIUS Annual Report on National Security Transactions

The Committee on Foreign Investment in the United States is a multi-agency regulatory body empowered to review transactions involving a foreign person and a U.S. business that may affect national security. On November 14, 2008, the Department of the Treasury issued its final rule to implement the Foreign Investment and National Security Act of 2007, which provided guidelines for the Committee on Foreign Investment in the United States when reviewing investments by foreign persons in U.S. businesses for national security issues.

If your transaction has implications for national security and your investment vehicle has significant foreign ownership of the party or the other side has significant foreign ownership, they you need to pay attention to CFIUS. There has been little guidance on what level of control and what would be a threat to national security.

Recently, CFIUS delivered its unclassified Annual Report to Congress for the calendar year 2009 and it offers some insight into the breadth and power of this little known agency.

In 2009, 65 CFIUS notices were filed and determined to describe “covered transactions” within their regulatory review.

Of the 65 notices filed, 7 were voluntarily withdrawn from CFIUS consideration the initial review and investigation phases. New notices were filed in 3 transactions and 3 transactions were abandoned. The seventh withdrew the transaction with the declared intent of re-filing a CFIUS notice.

Twenty-five of the covered transactions were subject to investigation, extending the period of delay for the transaction.

In 2009, CFIUS agencies negotiated, and parties adopted, mitigation measures for five different covered transactions. These measures involved acquisitions of U.S. companies in the computer software, telecommunications, and energy sectors. No transaction was blocked.

In a key finding, the CFIUS judged that judge that foreign governments are “extremely likely” to continue to use a range of collection methods to obtain critical U.S. technologies. Sources:

Placement Agents and the MSRB

In addition to laying out the changes to Form ADV, in Release No. IA-3110 the SEC also took a slightly different course on regulating placement agents. Rule 206(4)-5, released in July 2010, required placement agents to either be registered with the SEC as an investment adviser and subject to the limitation on campaign contributions, or register with FINRA. The FINRA registration was subject to enactment of a similar pay-to-play rule by FINRA.

The SEC has abandoned FINRA for the MSRB when it comes to regulating placement agents that interact with government sponsored plans.

Section 975 of Dodd-Frank Wall Street Reform and Consumer Protection Act created a new category of regulated persons called a “municipal adviser.” This new category will regulated by the Municipal Securities Rulemaking Board.

The MSRB is undertaking a rule-making to subject municipal advisers to the pay-to-play rules in place for municipal securities dealers under MSRB Rule G-37.

“Municipal advisors” include businesses and individuals that advise municipal entities concerning municipal financial products and municipal securities, as well as businesses and individuals who solicit certain types of business from municipal entities on behalf of unrelated broker-dealers, municipal advisors, or investment advisers.

In comparing the de minimis amounts under Rule 206(4)-5 and MSRB Rule G-37, the MSRB only allows for contributions up to $250 for candidates the person can actually vote for. The SEC rule is $350 for a candidate you can vote for and $150 for a candidate you can’t vote for. Both have a two-year ban for violation of the rules.

Sources:

Compliance Bits and Pieces for December 10

These are some compliance-related stories that recently caught my eye:

Business Ethics and the “New York Times” Rule by Chris MacDonald in The Business Ethics Blog

The first thing to say about the Newspaper Test is that it probably is a useful heuristic. Asking the question it poses at very least serves as an opportunity to pause and ask yourself whether the action you’re about to take is one that could withstand publicity and scrutiny. But there are two clear problems with the Newspaper Test….

Top Five Reasons to Have a Compliance Committee by Meghan Daniels in SAI’s Viewpoint

Many companies integrate a compliance committee into their compliance and ethics programs. Compliance committees usually comprise a cross-section of representatives across the business, who share a unique perspective or interest related to the compliance and ethics program. Compliance committees often meet on a regular schedule and participate in a wide range of discussions and activities, from official responsibilities such as preliminary policy approvals to less formal activities such as discussions about trends or communication strategies.

How does the AIFM Directive Impact Fund Raising in the EU by Non-EU Managers? by Michael Wu in Pillsbury’s Investment Fund Law Blog

Although the majority of the Directive’s rules are likely to become effective by January 2013, some of the rules affecting non-EU funds and non-EU fund managers will be deferred until 2015 or later. Thus, non-EU managers may still actively raise funds in the EU, but will have to comply with a number of additional regulatory requirements beginning in January 2013.

A Brief Rumination On Metaphysics, Trusts and Accredited Investors by Keith Paul Bishop in California Corporate & Securities Law blog

This is what I understand the Staff to be saying. When (i) the grantors of a trust are accredited under Rule 501(a)(5); and (ii) the trust may be amended or revoked at any time by the grantors, then a trust is deemed NOT TO EXIST. Then, they seem to be saying that this non-existent trust is deemed accredited. So there you have it, a non-existent trust may be deemed to be an accredited investor.

Three Great (and Free) Webcasts Next Week

The Fabulous Fab Rule

Don’t write emails so provocative that they wind up reproduced on the front page of the Wall Street Journal.

With many fund managers having to register under the Investment Advisers Act, they will now be subject to more extensive record-keeping requirements. That means more emails will be saved for a longer period of time.

Those questionable emails will preserved for litigants and federal regulators to see, long after you hit the delete button in Outlook.

E-mails from Goldman Sachs Group Inc. director Fabrice Tourre are the center of the case saying Goldman misled investors. In one he wrote, “The whole building is about to collapse anytime now,” according to the complaint. “Only potential survivor, the fabulous Fab.”

(I need to give credit to Kevin LaCroix of The D&O Diary for the new name for this rule: The Essential Lessons of the “Faithless Servant”.)

Here is another great email quote from the Fabulous Fab:

“When I think that I had some input into the creation of this product (which by the way is a product ofpure intellectual masturbation, the type of thing which you invent telling yourself: “Well, what if we created a “thing”, which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price ?”) it sickens the heart to see it shot down in mid-flight. .. It’s a little like Frankenstein turning against his own inventor;)”

The other detrius that ended up in front of the Senate Subcommittee on Investigations were the email love letters from Fab to his girlfriend. Another reminder to keep personal email off the company’s network and company time.

Sources:

Who Can Define Values?

A cynical look from Dilbert at corporate culture creation:

Dilbert.com

Some of the comments to the comic reinforce this cynical view of corporate values (and ethics):

kmulchandani:

Just Brilliant! i had a boss who always preached in a code of ethics and values, but when it came to him he was always excused. Quoting him it was – “for the greater good” or “my experience tells me that in this case it can be ignored”. “Values” are a subjective term, flowing down a corporate hierarchy, with the ones on top enforcing them onto their “minions”.

It’s not about stating what values and ethics should be. It’s what values and ethics are evidenced by the actions of your company’s employees at all levels in the organization.

Holiday Compliance – Don’t Impale Rudolph

It’s the holiday season. Like the Macy’s Thanksgiving Day parade, your community may run a similar parade.

They need to pay attention to compliance issues.

Particularly, they need to compare the height of the parade’s balloons to overhead power lines and traffic signals. For your entertainment, a parade that failed.

Do You Want to be Systemically Important?

RMS Titanic

The hard work has begun as federal regulators are trying to implement the provisions of Dodd-Frank. The law pushed lots of the detail out to the agencies so there are lots of unanswered questions.

One of the hot button issues was what to do with financial institutions that were too big to fail.  Dodd-Frank came up with the concept of “systemically important.” They created a new entity, the Financial Stability Oversight Council to come up with a definition, figure who should get that designation and design safeguards for those designees.

Private equity lost the battle to get an exemption from registration under the Investment Advisers Act. It may have to fight another battle to avoid the “systemically important” label.

The Independent Community Bankers of America, a major trade group for community banks, said General Electric Co.’s GE Capital and private-equity firms Carlyle Group, KKR & Co.’s Kohlberg Kravis Roberts & Co. and Blackstone Group LP should be tagged as systemically important.

Private equity doesn’t belong in that group, shot back Blackstone spokesman Peter Rose. “We do not trade, we have no leverage at the parent-company level, our investments are clearly disclosed and transparent, our investors are with us for the long term,” he said. “Therefore there is no possibility of a, quote, ‘run on the bank.’ ”

What does this all mean?

According to section 113 of Dodd-Frank Wall Street Reform and Consumer Protection Act, the Financial Stability Oversight Council

may determine that a U.S. nonbank financial company shall be supervised by the Board of Governors and shall be subject to prudential standards, in accordance with this title, if the Council determines that material financial distress at the U.S. nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States.

The term “U.S. nonbank financial company” means

a company (other than a bank holding company, a Farm Credit System institution chartered and subject to the provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.), or a national securities exchange (or parent thereof), clearing agency (or parent thereof, unless the parent is a bank holding company), security-based swap execution facility, or security-based swap data repository registered with the Commission, or a board of trade designated as a contract market (or parent thereof), or a derivatives clearing organization (or parent thereof, unless the parent is a bank holding company), swap execution facility or a swap data depository registered with the Commodity Futures Trading Commission), that is–
(i) incorporated or organized under the laws of the United States or any State; and
(ii) predominantly engaged in financial activities, as defined in paragraph (6).
[102(a)[4)]

A company is “predominantly engaged in financial activities” if–

(A) the annual gross revenues derived by the company and all of its subsidiaries from activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, from the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated annual gross revenues of the company; or
(B) the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, related to the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated assets of the company.
[102(a)[6)]

Those are some very wide open definitions for who could be considered “systemically important.”

Then the Financial Stability Oversight Council has to make a determination using these considerations:

(A) The extent of the leverage of the company;
(B) The extent and nature of the off-balance-sheet exposures of the company;
(C) The extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;
(D) The importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the United States financial system;
(E) The importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;
(F) The extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;
(G) The nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;
(H)The degree to which the company is already regulated by 1 or more primary financial regulatory agencies;
(I) The amount and nature of the financial assets of the company;
(J) The amount and types of the liabilities of the company, including the degree of reliance on short-term funding; and
(K)Any other risk-related factors that the Council deems appropriate.
[113(a)(2)]

Hearing

Then it takes 2/3 of the voting members of the Council, including the Chairperson, to make the designation [113(a)(1)]. Then the financial company designated as systemically important has 30 days to request a hearing and another 30 days to submit material. [113(e)(2)] The Council has 60 days to make a final determination.

Too Big to Fail

This provision of Dodd-Frank is the Anti-AIG and to some extent the Anti-Lehman Brothers portion of the law.It is one of the many ways the law tries to address Too Big to Fail.

Capital has many forms and is made available in many ways. The U.S. government thought AIG was too big to fail because of its size and interconnectedness. They didn’t think Lehman Brothers was too big to fail, but I think they were wrong about that.

Back to the Finger Pointing

Now that the Financial Stability Oversight Council is trying to define Too Big to Fail as systemically important, the finger pointing has begun. Industries and companies are saying “not me” and saying that others should be included.

The problem is that once you are designated “systemically important” it’s not clear what additional burdens will be placed on you and whether there will be any benefit to the designation. It seems the Council has the flexibility to craft different requirements for different companies and different industries.

It may boost your ego to be considered “systemically important” but it will also lead to a regulatory headache. Private investment firms are not exempt from the designation and could be tagged.

Sources:

Image of the RMS Titanic is from Wikimedia.

It Has a Name: Operation Broken Trust

Apparently, many of the recent financial fraud actions in the news have been part of a nationwide operation organized by the Financial Fraud Enforcement Task Force to target investment fraud: Operation Broken Trust.

“To date, the operation has involved enforcement actions against 343 criminal defendants and 189 civil defendants for fraud schemes that harmed more than 120,000 victims throughout the country. The operation’s criminal cases involved more than $8.3 billion in estimated losses and the civil cases involved estimated losses of more than $2.1 billion. … Starting on Aug. 16, 2010, within a three-and-a-half month period, Operation Broken Trust involved 231 criminal cases and 60 civil enforcement actions. Eighty-seven defendants have been sentenced to prison, including several sentences of more than 20 years in prison.”