Category: Investment Advisers Act

Risk Disclosures and Form ADV Part 2 for Fund Managers

If you’re a fund manager getting ready to register because you’ve been Dodd-Frank’ed, then you are likely in the middle of drafting Part 2 of Form ADV, the brochure. One item that caused my to pause was the risk factor requirements in Item 8.

8.B:  For each significant investment strategy or method of analysis you use, explain the material risks involved. If the method of analysis or strategy involves significant or unusual risks, discuss these risks in detail. If your primary strategy involves frequent trading of securities, explain how frequent trading can affect investment performance, particularly through increased brokerage and other transaction costs and taxes.

Fund sponsors spend a great deal of time, money, and energy drafting risk factors for their fund’s private placement offering memorandum.

Do you need to duplicate those risk factors in response to 8B or can you ignore them?

The SEC staff answered that question about Part 2 of Form ADV.

Question II. 4

Q: Item 8.B of Part 2A requires an adviser to explain the material risks for each significant investment strategy or method of analysis the adviser uses. Does Item 8.B require an adviser that uses pooled investment vehicles as a significant investment strategy or method of analysis to duplicate the risk disclosures contained in a prospectus or other offering document for the pooled investment vehicle?

A: An adviser may satisfy the requirement of Item 8.B by providing a brief explanation of the material risks for each strategy and referring clients to the prospectus, offering memoranda, or other documents that a client participating in the pool will or has received that set out a more detailed discussion of risks. (Posted March 18, 2011)

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The SEC’s Asset Management Unit

Yesterday, Bruce Carton of Securities Docket hosted a webinar: The SEC’s Asset Management Unit and Strategies for Avoiding Trouble in 2011 and Beyond. He managed to get Bruce Karpati, the co-head of the SEC’s Asset Management unit, to participate. Also joining the presentation were John Reed Stark, Managing Director of Stroz Friedberg and former Chief, SEC Office of Internet Enforcement; and Bradley J. Bondi, a litigation partner at Cadwalader, Wickersham & Taft LLP and former counsel to SEC Commissioners Troy Paredes and Paul Atkins for enforcement matters.

The SEC’s Asset Management Unit focuses on investment advisers and investment companies. If you run a private fund, this unit is keeping an eye on you.

You can see replay of the presentation yourself, but here are the things that caught my attention:

Private fund registration under Dodd-Frank is very important to his unit. They work closely with OCIE. They are looking forward to the new data that will come from fund registration and Form PF.

They are especially concerned about the level of transparency, even for private funds, and the information given even to institutional investors.

Weak and fraudulent valuation processes are high on his list of concerns. In particular, he is concerned about private funds with an incentive to overvalue assets. He mentioned the Palisades funds use of side pockets that lead to an enforcement action. He also mentioned the

Another highlight was “investment drift.” Make sure that your investment activity is not wandering from the areas that you told your investors you were going.

Of course, insider trading and expert networks are taking up a fair amount of his unit’s time and energy.

He raised the “suspicious performance investigation” where the SEC is looking at funds that have consistently outperformed market. The leading example is the Madoff scandal. Madoff’s outlying performance should have been a red flag for investors. The SEC wants to spot these kind of problems.

He is looking at adviser background misrepresentation. It sounds like they are ready to bring fraud charges for misstating educational background and experience.

Stark praised the unit. As a lawyer who would be on the opposite side of the table he would prefer someone with specialized knowledge of the investment management industry than a generalist enforcement lawyer.

Stark focused on the In the Matter of AXA Rosenberg Group LLC, et al.(Feb.2011) involving a flaw in the computer model for a quantitative fund. The model’s algorithm had a flaw that resulted in under-performance. This is tough one for compliance because the compliance geeks are rarely in the room with the math geeks.

Bondi laid out a series of compliance policies and issues that new investment adviser registrants should be concerned about.  He spent a great deal of time focusing on privacy and security breaches. (Maybe too much for the focus of this presentation.)

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participants in April 5 Webcast, Karpati, Stark and Bondi

SEC Answers Questions About the Pay to Play Rule

The staff of the Division of Investment Management at the Securities and Exchange Commission has prepared responses to some questions about Rule 206(4)-5 under the Investment Advisers Act of 1940.

Here are a few that caught my eye:

Question II.6. Covered Associates’ Family Members.

Q: Are contributions by an advisory employee’s family members covered under the rule?

A: Generally not. However, rule 206(4)-5 and section 208(d) of the Advisers Act prohibit doing anything indirectly which would be prohibited if done directly (see rule 206(4)-5(d)).

Question II.7. Independent Contractors.

Q: If certain personnel of an investment adviser are considered “independent contractors,” rather than “employees,” for state law or tax law purposes, will they still be regarded as covered associates if they solicit or supervise those who solicit government entities on behalf of the adviser?

A: The term “employee” is not defined in the Advisers Act. The staff interprets the term “employee” to include “independent contractors” acting on behalf of an investment adviser (see Interpretive Release No. IA-1000, at II.C.3).

Question III.1. Foreign Governments.

Q: Does the definition of government entity include foreign governments?

A: No.

You can’t run political contributions through your spouse to avoid this rule and you can’t hire someone as an independent contractor to try and circumvent the rule. You can contribute to the political campaigns of foreign officials, but that raises issues elsewhere.

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Are you an Investment Adviser?

There has been a lot of focus on the effect of Dodd-Frank on private fund managers. Many had relied on the small adviser exception from registration. If you had fewer than 15 clients (funds) you were exempt from regulation. With the loss of that exclusion, the industry has been looking to other ways to fall outside the requirements of registration.

One may be to take another look at the definition of investment adviser and see if it really applies to what your fund does.

Section 202(a)(11) of the Advisers Act defines an “investment adviser” as

“any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”

Let’s break it down into its three components:

  1. for compensation
  2. engaged in the business
  3. provide advice about securities

A person or firm must satisfy all three elements and not fall into one of the half dozen statutory exclusions to be regulated under the Advisers Act.

For fund managers, the “compensation” is easily satisfied. A fund manager is giving advice to its funds. Presumably, they are not doing it for free.

The term “securities” is very broadly defined in Section 202(a)(18) of the Investment Advisers Act.

Whether a person providing financially related services is an “investment adviser” is a facts and circumstances test. In  Release IA-1092 (.pdf) the SEC took a look at whether financial planners are investment advisers and provided some ways to look at whether you are in “engaged in the business” of “providing advice about securities.”

Here are some activities that the SEC believes falls into the category:

  • Giving advice about securities, even if it does not relate to specific securities
  • advise concerning the relative advantages and disadvantages of investing in securities in general as compared to other investments
  • in the course of developing a financial plan for a client, advises the client as to the desirability of investing in, purchasing or selling securities
  • a person who advises employee benefit plans on funding plan benefits by investing in, purchase, or selling securities, as opposed to, or in addition to, insurance products, real estate not involving securities, or other funding media
  • providing advice as to the selection or retention of an investment manager (under certain circumstances)

“Engaging in the business” of providing investment advice is a little trickier. Giving advice need not be the principal business activity. “The Giving of advice need only be done on such a basis that it constitutes a business activity occurring with some regularity. The frequency of the activity is a factor, but it is not determinative.”

It comes down to how often a fund manager gives advice to the fund about securities as part of the fund’s operations and investment process.

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Image is Have a Heart. by A. Golden / CC BY-NC-ND 2.0

More Information on Part 2 of Form ADV

In October 2010, the Securities and Exchange Commission created a new Part 2 for Form ADV. Instead of filling in blanks, investment advisers need to create a brochure for delivery to clients and prospective clients. For fund managers getting ready to register, that means writing a brochure, not just filling in boxes.

One question for fund managers is “who do you have to give the brochure to?” The SEC answered that question and many others about Part 2 of Form ADV.

Question III. 2

Q: Rule 204-3 requires an adviser to deliver a brochure and one or more brochure supplements to each client or prospective client. Does rule 204-3 require an adviser to a hedge or other private fund to deliver a brochure and supplement(s) to investors in the private fund?

A: Rule 204-3 requires only that brochures be delivered to “clients.” A federal court has stated that a “client” of an investment adviser managing a hedge fund is the hedge fund itself, not an investor in the hedge fund. (Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006)). An adviser could meet its delivery obligation to a hedge fund client by delivering its brochure to a legal representative of the fund, such as the fund’s general partner, manager or person serving in a similar capacity. (Posted March 18, 2011)

Question III. 3

Q: Must an adviser to a hedge fund or other private fund file as part of its Form ADV the brochure it is required to deliver to the hedge fund or other private fund?

A: Yes.

That answers the legal questions. You don’t have to deliver it to investors, but you do need to file it with the SEC.  From a practical perspective, potential investors in the fund often ask for a copy of the Form ADV as part of their due diligence. So you end up giving it to many of your investors and not just the fund.

The other missing piece for fund managers is the new Part 1 of Form ADV. The SEC proposed some significant changes and has not yet released the final form. The SEC is cutting this one close. Early June is the hard deadline for filing. Before that the SEC will need to get the IARD system updated with the new fields. Perhaps they are updating IARD now so it will be ready when the final rule comes out? I doubt it.

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Custody and Private Funds

Last year, the Securities and Exchange Commission put a new rule in place restricting an investment adviser’s ability to have custody of its clients’ assets. Given that many private fund managers are going to have to register as investment advisers they need to figure out how to comply with this rule.

The rule is the anti-Madoff rule. The SEC wants client assets separate from the manager’s control and for the manager to safeguards in place to prevent a manager from sending out false statements to investors. This includes having a third party custodian and having the custodian send statements directly to investors and subjecting the accounts to a surprise inspection by an auditor.

Safekeeping required

Rule 206(4)-2(a) If you are an investment adviser registered or required to be registered under section 203 of the Act, it is a fraudulent, deceptive, or manipulative act, practice or course of business within the meaning of section 206(4) of the Act for you to have custody of client funds or securities unless:

(1) A qualified custodian maintains those funds and securities:

(i) In a separate account for each client under that client’s name; or

(ii) In accounts that contain only your clients’ funds and securities, under your name as agent or trustee for the clients.

If your fund has securities, then you need a “qualified custodian” holding those securities. There is an exception for “privately offered securities” that will make life much easier for private equity funds and real estate funds.

Use of a Qualified Custodian

So who can you use as a “qualified custodian“?

(d)(6) Qualified custodian means:

(i) A bank as defined in section 202(a)(2) of the Advisers Act or a savings association as defined in section 3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act (12 U.S.C. 1811);

(ii) A broker-dealer registered under section 15(b)(1) of the Securities Exchange Act of 1934, holding the client assets in customer accounts;

(iii) A futures commission merchant registered under section 4f(a) of the Commodity Exchange Act (7 U.S.C. 6f(a)), holding the client assets in customer accounts, but only with respect to clients’ funds and security futures, or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon; and

(iv) A foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients’ assets in customer accounts segregated from its proprietary assets.

Surprise audits and custodian statements

In addition to the requirement in (a)(1) that a qualified custodian hold the securities, there are addition requirements in (a)(2), (a)(3) and (a)(4) that you notify the client about the custodian, require separate statements be sent to the client and that the account be subject to surprise audits.

When investment funds are the clients these requirements make less sense, so (a)(5) requires funds to send the account statements to their limited partners.

There is an exception for pooled investment vehicles:

(b)(4) Limited Partnerships subject to annual audit. You are not required to comply with paragraphs (a)(2) and (a)(3) of this section and you shall be deemed to have complied with paragraph (a)(4) of this section with respect to the account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) that is subject to audit (as defined in rule 1-02(d) of Regulation S-X (17 CFR 210.1-02(d))):

(i) At least annually and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year;

(ii) By an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules; and

(iii) Upon liquidation and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) promptly after the completion of such audit.

If your auditor is not subject to inspection by PCAOB, you would have to switch auditing firms for your private fund to use this exception. You need to make sure your auditing firm has the horsepower to get the audited down in time for you to get financial statements out in within 120 days of fiscal year end.

Certain privately offered securities

There is a exception for having to deliver “privately offered securities” to the qualified custodian. Certain privately offered securities are:

(A) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;

(B) Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and

(C) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

Notes and Interests in Subsidiaries and Portfolio Companies

For real estate private equity, the problem will be notes. They may be considered securities. Notes won’t meet the definition of uncertificated and they are most likely transferable.

For entities and portfolio companies, the key will be to make sure the subsidiaries under the funds are not certificated and there is requirement for consent in order to transfer. I think fund managers are going to have to back and inventory their subsidiary entity documents.

Of course you may be able to make an argument that the interest in the subsidiary is not a security. If it’s wholly-owned you can make a strong argument that the ownership is not a security since you are not relying solely on the efforts of others. But if the subsidiary is corporation you may be stuck treating it as a security. It’s generally hard to argue that shares in a corporation are not a security.

In the SEC Q&A about the custody rule:

Question II.3

Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

A: No. Rule 206(4)-2 applies only to clients’ funds and securities.

So you don’t need to deliver all of the fund assets to the custodian. Just those that are securities and cash. Presumably, fund managers are already keeping their funds’ cash in a bank account and not in a mattress. They just need to make sure that the cash accounts are in the fund names.

At first, I thought the limited partnership exception would allow private fund managers to completely avoid the burden of this rule. That was too broad. Now I think fund managers are stuck with hiring a qualified custodian if they register with the SEC. I would guess there will lots of private fund managers looking for custodians before they register.

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SEC Study on Enhancing Investment Adviser Examinations

Now that most private funds managers are required to register with SEC as investment advisers, the SEC is considering abandoning them to regulation by FINRA.

The SEC released the much anticipated report, a 40-page “ Study on Enhancing Investment Adviser Examinations” mandated by Section 914 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The report is more a plea for resources than an abandonment. The report makes a simple statement: ” the Commission will likely not have sufficient capacity in the near or long term to conduct effective examinations of registered investment advisers with adequate frequency. The report points out that the frequency of examination is a function of the number of registered investment advisers (and their complexity) and the amount of SEC’s OCIE staff dedicated to examination. While the number of advisers and their complexity have increased, the staff of OCIE has decreased. The complexity will only increase as thousands of private fund managers come under the registered investment adviser umbrella.

The SEC staff recommended three options for Congress to consider:

  1. Self-Funding Authorize the SEC to impose user fees on registered investment advisers.
  2. Self Regulatory Organization Authorize one or more SROs, under SEC oversight, to examine all registered investment advisers.
  3. Limited SRO Authorize FINRA to examine all of its members that are also registered as investment advisers for compliance with the Advisers Act.

I read the report as a plea for more resources to oversee investment advisers.

Dodd-Frank is clearly pulling private fund managers into the domain of the Investment Advisers Act. That will require extra resources. On the other hand, they are kicking advisers with less than $100 million in assets out for SEC oversight and over to state registration and oversight. It’s unclear if that trade will result in more, less or about the same number of advisers under SEC oversight. The SEC has stated that about 3,500 advisers will go over to the states. They can only guess how many fund managers will become new registrants. (My guess is that the SEC will have a net loss.)

The report is interesting but holds not legal influence. All of the recommendations require Congressional action. My perception of Congress is that little will be done that helps Dodd-Frank during the next two years.  I doubt they will give up the appropriations as a control method over the SEC.

In addition to the official report, Commissioner Elisse Walter issued a separate dissenting opinion expressing her disappointment with the SEC’s final report and reiterating her stance in favor of an SRO, citing funding as an issue that is too great to overcome both in the short and long terms.

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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.

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Calculating Regulatory Assets Under Management for Private Funds

For private fund managers, one troubling aspect of Form ADV had been the calculation of  “assets under management” in item 5.F. If securities are less than 50% of the portfolio then the portfolio would not be a securities account.

Except for real estate debt funds, most real estate funds would end up with $0. (I’m not sure whether that would mean you do not have to register since you are then not giving advice for a securities portfolio or whether that would push you into state registration.)

As a private equity fund or real estate fund purchased assets and sold assets, the manager could be ping-ponged in and out of SEC registration.

In the Proposed Changes to Form ADV published on November 19, the SEC has  proposed revisions to Form ADV that better addresses the reality pf private funds.

In the proposed changes, the SEC has come up with a new method for calculating values that makes much more sense for private funds.

5(b)(4). Determine your regulatory assets under management based on the current market value of the assets as determined within 90 days prior to the date of filing this Form ADV. Determine market value using the same method you used to report account values to clients or to calculate fees for investment advisory services.

In the case of a private fund, determine the current market value (or fair value) of the private fund’s assets and the contractual amount of any uncalled commitment pursuant to which a person is obligated to acquire an interest in, or make a capital contribution to, the private fund.

In the release, the SEC states the an adviser should include “in its regulatory assets under management the value of any private fund over which it exercises continuous and regular supervisory or management services, regardless of the nature of the assets held by the fund.”

This calculation makes it very clear that private fund managers with even a small amount of securities in their funds are going to be forced to register with either the SEC or their state regulators as an investment adviser.

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Yes, the SEC Wants Real Estate Fund Managers to Register

Earlier I had pointed out how a real estate fund manager could be considered an investment adviser and have to register with the SEC under the Investment Advisers Act.

In the Proposed Changes to Form ADV published on November 19, the SEC has made it clear that real estate funds are part of the mix.  They have proposed  revisions to Form ADV that better deal with more private funds being covered by the Investment Advisers Act.

In the proposed new Schedule D to Form ADV, the SEC requires you to designate the type of fund.  If you are still wondering if a real estate fund might need to register, look through the list of fund types:

Question 10: Type of Private Fund: For purposes of this question the following definitions apply:

“Hedge fund” means any private fund that:

a. Has a performance fee or allocation calculated by taking into account unrealized gains;
b. May borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net asset value (including any committed capital); or
c. May sell securities or other assets short.

A commodity pool is categorized as a hedge fund solely for purposes of this question. For purposes of this definition, do not net long and short positions. Include any borrowings or notional exposure of another person that are guaranteed by the private fund or that the private fund may otherwise be obligated to satisfy.

“Liquidity fund” means any private fund that seeks to generate income by investing in a portfolio of short term obligations in order to maintain a stable net asset value per unit or minimize principal volatility for investors.

“Private equity fund” means any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund, or venture capital fund and does not provide investors with redemption rights in the ordinary course.

“Real estate fund” means any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course and that invests primarily in real estate and real estate related assets.

“Securitized asset fund” means any private fund that is not a hedge fund and that issues asset backed securities and whose investors are primarily debt-holders.

“Venture capital fund” means any private fund meeting the definition of venture capital fund in rule 203(l)-1 under the Advisers Act.

“Other private fund” means any private fund that is not a hedge fund, liquidity fund, private equity fund, real estate fund, securitized asset fund, or venture capital fund.

“Real estate fund” made the list. I take that as a clear sign that the SEC wants real estate fund managers to register under the Investment Advisers Act.

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Image of the Empire State Building is by Christian Mehlführer