Private Fund Advisers and State Registration

As a result of the shifting boundaries between state and federal regulation of investment advisers, NASAA created a model rule for Registration Exemption for Investment Advisers to Private Funds. The rule tracks the general parameters of the new federal rules for investment adviser registration for private fund advisers.

Massachusetts became the latest state to adopt its own regulations with such an exemption. A new private fund adviser exemption was adopted by the Massachusetts Securities Division, along with amendments to the “qualified institutional buyer” definition and IA custody requirements.

While the amendments took effect February 3, 2012, they will be not be enforced until August 3, 2012. You’ve got six months to get in compliance. The rules apply to adviser firms doing business in the Commonwealth, which generally means having a place of business in Massachusetts.

The new Massachusetts exemption is available to advisers to private funds that take money only from “qualified clients.” That definition carries over from Rule 205-3. Under that updated SEC rule,  “qualified clients” must have at least $1 million of assets under management with the adviser, up from $750,000, or a net worth of at least $2 million, up from $1 million.

Private funds using the Section 3(c)(7) exemption under the Investment Company should already meet this standards. Managers to section 3(c)1 funds will need to increase their threshold for investors from accredited investors to qualified clients.

The Massachusetts regulation tries to complement the SEC changes affecting private fund advisers under Dodd-Frank. So private fund advisers with between $25M-$150M in AUM, would have to file the exempt-reporting adviser sections of Form ADV. Those with more than $150M in AUM would have to notice file in the state as well as register with the SEC. Those private fund advisers with under $25M in AUM would also complete the exempt reporting sections of the form for Massachusetts.

States are still trying to catch up to the Dodd-Frank requirements:

They are well behind, leaving some uncertainty for managers of smaller private funds about their registration requirements.

Sources:

Are You a CPO?

The first question is what is a CPO and why should I care? The Commodities and Futures Trading Commission decided to tighten the exemptions from registration potentially pulling some hedge funds and private equity funds that previously ignored the CFTC. Davis Polk held a webinar on this topic. Some private fund managers may get the CPO label and have to deal with the CFTC regulatory regime.

CPO is the CFTC acronym for “Commodity Pool Operator”, which refers to any person engaged in the business of soliciting investors for an investment trust operated for the purpose of trading in commodity interests.

  • Commodity interests include futures (including agricultural, metal and financial futures), commodity options and, upon the issuance of final rules under Dodd-Frank, swaps.
  • Swaps include a wide variety of transactions, including interest rate swaps, many types of currency swaps, energy and metal swaps, agricultural swaps, commodity swaps, swaps on broad-based indices, and swaps on government securities.

The CFTC has long expressed the view that transacting in any amount of futures contracts (either directly or indirectly) would cause a fund sponsor to be deemed a commodity pool operator. There is no de minimis exception in the definition. So the CFTC position results in the conclusion that fund sponsors who have interest rate swaps or foreign exchange swaps will likely be deemed to be commodity pool operators and will need to evaluate whether an exemption is available. Even a funds of funds may also be deemed to be commodity pools depending on the investment activities of underlying funds.

There used to be a broad exemption. CFTC Rule 4.13(a)(4) provides a blanket exemption from CPO registration for sophisticated investor funds (i.e., those offered to Qualified Purchasers). The CFTC has decided to rescind this exemption.

A private fund sponsor will be required to register unless each of its funds satisfies the de minimis trading limitations under the terms of Rule 4.13(a)(3). Under these requirements, either:

  • Initial margin and premiums for commodity interest transactions must be less than 5% of the liquidation value of the fund; or
  • Aggregate net notional value of commodity interest transactions must be less than 100% of the liquidation value of the fund.

In addition to those de minimis trading requirement, Rule 4.13(a)(3) is available so long as:

  • the fund is offered privately to certain types of investors; and
  • the fund is not marketed as a vehicle for trading in the commodity futures or commodity options markets.

Investors in a Rule 4.13(a)(3) vehicle may include, among others:

  • any accredited investors under Reg D; and
  • knowledgeable employees as defined under Rule 3c-5 under the 1940 Act and certain other employees.

Most private equity and real estate private equity fund should be able to meet these hurdles and can focus on the 5% margin test and the 100% net notional exposure test.

5% margin test: The aggregate initial margin and premiums for commodity interest transactions (and minimum security deposits for retail forex transactions) must be less than 5% of liquidation value of the fund (including unrealized profits and losses to date).

100% net notional exposure test: The aggregate net notional value of commodity interest positions must not exceed 100% of the liquidation value of the fund.

  • Notional value is defined by asset class.
  • Futures contracts are valued by multiplying the number of contracts by the size of the contract.
  • Futures options are based on the strike price per unit and adjusted by the option’s delta.
  • Futures contracts with the same underlying commodity may be netted across markets.
  • Notional value of swaps cleared by the same DCO may be netted, “where appropriate”.

The 5% margin test or 100% net notional exposure tests are required to be met at each time that a commodity position is established.

The CFTC has requested comments during the 60-day period beginning on Friday, February 11, 2011.  If the proposed rule is adopted, the CFTC will issue a final rule that will specify when hedge fund and other private fund managers relying on CFTC Rules 4.13(a)(3) and 4.13(a)(4) will need to revise or cease their commodity interest trading or register as CPOs (and, if applicable, CTAs) and become members of the NFA.

The text of the proposed rule can be found here: http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-2437a.pdf

Compliance Bits and Pieces for March 2

These are some stories that recently caught my attention:

Behind the Crackdown on Insider Trading by Peter J. Henning in the NYtimes.com’s DealBook

One reason prosecutors have pursued it is the explosive growth of hedge funds and investment advisory firms, which trade billions of dollars worth of securities and have a voracious appetite for information about companies. The investment horizon for some firms can measured in hours or days, not years, and rapid-fire trading of large volumes of securities has become more of the norm as they try to squeeze out the last little bit of profit. Any informational advantage can mean enormous gains, and the pressure to perform is relentless, so trading on inside information is a short step for some.

Blackstone dominates 2011 PERE Awards

The flurry of investment and fundraising activity by The Blackstone Group last year has convinced the private equity real estate industry to vote the New York-based private equity and real estate titan to eight wins in the 2011 Global PERE Awards. Other winners include CBRE, Fortress and APG.

This 8-Word Social Media Policy Could Save Your Job by David Coursey in Forbes.com

Don’t lie, don’t cheat, don’t steal, don’t reveal.

Legislative Package Combines Financial Services Committee Bills into JOBS Act

The JOBS Act is designed to help startups and entrepreneurs get off the ground, access investors and create jobs. These initiatives are supported by bipartisan members on both sides of the Capitol, as well as the President’s Jobs Council and the business community.

  • H.R. 3606: Reopening American Capital Markets to Emerging Growth Companies Act
  • H.R. 2940, the Access To Capital For Job Creators Act
  • H.R. 1070, the Small Company Capital Formation Act
  • H.R. 2167, the Private Company Flexibility and Growth Act
  • H.R. 4088, the Capital Expansion Act
  • H.R. 2930, the Entrepreneur Access To Capital Act

[March 1 Was] the Deadline for MA Data Privacy Law  by John H. Lacey in Massachusetts Data Privacy law Blog

On March 1, 2010, two years ago, the regulations associated with the Massachusetts Data Privacy Law went into effect. The regulations, found at 201 CMR 17, require business who possess “Personal Information” (PI) of Massachusetts’ residents to protect that data in fairly specific ways. Arguably, the most important aspect of the regulations was the requirement that all businesses have a “Written Information Security Program” or WISP. …

March 1, 2012 is the deadline for those businesses who possess “PI” to address any third-party contracts where the third-party possesses or otherwise maintains PI on behalf of the business.

SEC Releases Risk Alert on Unauthorized Trading

The Risk Alert issued by the agency’s Office of Compliance Inspections and Examinations (OCIE) notes that although broker-dealers and investment advisers are subject to different regulatory requirements, both face similar risks of financial and reputational losses arising from unauthorized trading.

Valuations, Private Equity, and the SEC

The SEC has been poking around valuations for a while. First it was from the chaos of the 2008 financial crisis. The sudden illiquidity and drop in prices left many scratching their heads about the proper valuations for their assets.

That was the main charge against the Bear Stearns hedge fund managers. The Justice Department and the SEC brought parallel criminal and civil charges against former Bear Stearns executives Ralph Cioffi and Matthew Tannin in 2008. They were accused of lying to investors about the health of their hedge funds. The problem was that they were holding mostly complex securities backed by subprime mortgages that were hard to value.

Valuations are always difficult with private equity funds because by definition most of the assets are private securities, with little or no market to determine price. The difficulty is offset by the result of the valuation. That is, there is very little. It’s rare that a private equity fund limited partner/investor can redeem its interest. Private equity limited partners commit their capital long term to the fund since the fund makes long term investments that take many years to realize.

A private equity fund investor can be happy that the fund is performing well or be disappointed that the the fund is under-performing based on valuations. Either way, they are largely stuck as investor. But that’s okay because the investors true returns come when the investment is realized, not when there is a valuation.

There is some opportunity for malfeasance. Marketing would be the weak spot. A private equity fund manager might be inclined to overstate valuations on unrealized investments to make their track record look better when raising money for a new fund.

Federal regulators and the Massachusetts attorney general are investigating whether a private equity fund that was part of Oppenheimer Holdings Inc. overstated the value of one of its holdings. The result would be to make it look like the fund was performing better than it actually was.

According to the Wall Street Journal, the fund manager place a value of $9.3 million on an investment. Some other trading on that investment indicated a value of only $2 million, and an intermediary placed the value at $6 million. According to the Boston Globe, the result was to set the interim performance of the fund at 38 percent instead of a loss of 6.3 percent. I assume that the investigators are claiming that the fund manager used those inflated valuations to lure investors.

Valuations have clearly been a target for securities regulators for several years. The SEC sweep letter sent to several private equity firms was just a continuation of this investigative objective.

Part of the business model of private equity is that they are able to better value companies and re-structure them for success. That means that valuations of their underlying assets are going to vary from those of other firms and appraisers.

The key is documenting your approach and then documenting that you followed that approach.

Sources:

Image is Measuring by Jonathan Khoo

Proposed Identity Theft Red Flags Rules

Identity theft is a serious problem. Title X of the Dodd-Frank Wall Street Reform and Consumer Protection Act increased the scope of firms that would be subject to federal regulatory requirements on identity theft rules. The Securities Exchange Commission and the Commodities Futures Trading Commission just published a proposed rule addressing that new scope.

Section 10889(a)(8), (10) of Dodd-Frank amended the Fair Credit Reporting Act by adding the CFTC and SEC to the list of federal agencies required to create and enforce identity red flag theft rules. The new rule proposal would require SEC-regulated entities to adopt a written identity theft program that would include reasonable policies and procedures to:

  • Identify relevant red flags.
  • Detect the occurrence of red flags.
  • Respond appropriately to the detected red flags.
  • Periodically update the program.

The proposed rule would include guidelines and examples of red flags to help firms administer their programs.

As newly registered investment adviser, this looked like a daunting prospect. The rule does list specific entities in its definition of “financial institution.” That means investment advisers and private fund managers are not excluded.

However, the requirements are further limited to a “transaction account: a deposit or account on which the depositor or account holder is permitted to make withdrawals by negotiable or transferable instrument, payment orders of withdrawal, telephone transfers, or other similar items for the purpose of making payments or transfers to third parties or others.” 12 U.S.C. 461(b)(1)(C).

Smartly, the SEC recognizes that most registered investment advisers (and private fund managers) are unlikely to hold transaction accounts and would not qualify as a “financial institution”. One of the questions soliciting comments in the proposed rule is whether the rule should “omit investment advisers or any other SEC-registered entity from the list of entities covered by the proposed rule?”

I think it makes sense to look at the account itself and not just the institution. Particularly in the case of private fund managers, there is usual limited windows when cash can come out of the accounts and be returned to investors.

Even if the limited partner interests are not a transaction account. It may make sense to look at the final rule as a model for some internal policies and procedures.

Sources:

Technical Problems

Sometimes things just go wrong. No matter how hard you try (or don’t) you need to expect the unexpected. Software and systems inevitable break and go down. And when a system goes down, it will inevitably go down at the least convenient time.

The key is testing, redundancy, and back-up. You can’t prepare for all of the potential problems. But you can prepare for some.

My latest technical problem happened right here. Something went wrong with the code that runs this website. Technical support offered some mumbo jumbo on what I could do. I only know just enough html and css to get myself in trouble. I tried a few things, but they each failed to work. I was in way over my head.

I could have spent hours and hours poring through the error logs and files. Or I could have hired someone who knew what they were doing to help out. I don’t have the time or money to do that.

That left me with one choice. Nuke it and start over. Fortunately, I have a system that runs regular back ups. And it worked.

The website’s design is still a mess. The problem appears to have resided somewhere in the old design. That can be fixed eventually. The key is that the data is still intact.

Lesson Learned. Prepare, back-up, and test. I think there is even an SEC rule on the topic.

I end with a recent cartoon from Saturday Morning Breakfast Cereal on the stock market, blame, and reward.

Compliance Bits and Pieces for February 24

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

The SEC’s Whistleblower’s Office did not email you

It’s spam, linked to a virus. [Insert joke here…]

Are Auditors Reporting Fraud And Illegal Acts? The SEC Knows But Isn’t Telling by Francine McKenna in re: The Auditors

Section 10A of the Securities and Exchange Act of 1934 requires reporting by auditors to the Securities and Exchange Commission (SEC) when, during the course of a financial audit, an auditor detects likely illegal acts that have a material impact on the financial statements and appropriate remedial action is not being taken by management or the board of directors…..

So I prepared a Freedom of Information Act (FOIA) request in June and then again in October for the same information Congress and the GAO had previously requested from the SEC. The first request I made covered the entire period since the last report to Congress, 2003, until the present. It also referred to a tracking system that the 2003 report said would be implemented to help track these submissions by auditors and the SEC’s actions on them.

AML Moneyball by C.M. Matthews in WSJ.com’s Corruption Currents

As the field of anti-money laundering software vendors gets more and more crowded, it’s not always easy to spot a stud from a dud.

In 2012, financial institutions will spend an estimated $504 million on AML software products. When a bank relies on software to filter AML watch lists or monitor suspicious transactions, there’s a lot of pressure to get it right.

Celent’s survey of AML compliance vendors is a good place to turn to for the confused financial institution (or AML vendors who want to keep up with their competitors). It reads like Moneyball for AML compliance professionals (though it’s doubtful the report has enough crossover appeal for a Hollywood movie).

Conflicts of Interest in Joint Ventures – the Rights of “Consenting Adults” in the Conflict of Interest Blog

The governance and operation of JVs can certainly raise conflict of interest concerns. For an employee of a JV’s co-owner who is either on the JV’s board or is seconded to the JV whose interests to be treated paramount? Given the inherent tension in situations of this sort, those involved have good reason to clearly articulate applicable duties and expectations.

SEC Sweep Letter for Private Equity Funds

The San Francisco Office of the SEC has an informal inquiry into the valuations of private equity funds. IA Watch has received a copy of the sweep letter from the Division of Enforcement directed to a private equity fund manager.

Some highlights in the request:

  • All formation and offering documents for the fund, including private placement memoranda, limited partnership agreements, and operating agreements
  • List of investors and capital commitments
  • List of all investments, realized amount, and gross IRR
  • All communications with investors regarding fund performance
  • Support for valuations of the fund assets for the most recent fiscal year

It seems to be a fairly short list for an SEC document request. But any SEC document request is intimidating.

The request shouldn’t be construed as indication that there has been a violation of the federal securities law. It’s indication that the SEC is continuing to look for funds and managers that manipulated valuations.

Sources:

Middle Names and Form ADV

When filling out Form ADV, Schedule A and Schedule B require you to disclose control persons, owners, and significant indirect owners of the investment adviser. The instructions call for the full legal name: Last name, first name, and middle name.

And the SEC means it. They require full legal names (last, first, and middle name). If there is no middle name or only a middle initial, the information provided next to the name should reflect as such; (NMN) or (MI ONLY).

Unfortunately, FINRA’s system does not place one of those red stars next to the middle name field indicating that it’s a required field. Similarly, the online IARD filing system’s completeness check does not pick up a missing entry for a middle name.

Dodd-Frankenstein

You would expect that a publication with a libertarian tilt like The Economist would not look favorably at the Dodd-Frank Wall Street Reform and Consumer Protection Act. They call it Too big not to fail. Being The Economist, the article argues with the facts on its side.

  • Dodd-Frank: 848 pages
  • Federal Reserve Act of 1913: 32 pages
  • Glass-Steagall act: 37 pages
  • Sarbanes Oxley: 66 pages

“The scope and structure of Dodd-Frank are fundamentally different to those of its precursor laws, notes Jonathan Macey of Yale Law School: “Laws classically provide people with rules. Dodd-Frank is not directed at people. It is an outline directed at bureaucrats and it instructs them to make still more regulations and to create more bureaucracies.”

It’s not a matter of more regulation. The focus should be on better regulation. Much of Dodd-Frank is just tacked on because it had the momentum to become law. I’m pretty sure extractive minerals had nothing to do with the financial crisis. But Section 1502 of Dodd-Frank requires public companies to make extensive disclosures on the use of conflict minerals in their supply chain.

There are some good things. An unregulated derivatives market was a bad thing. Although, I’m not sure they are getting the regulations right in the new regulated derivatives market.

The test will be the next financial crisis. I assume one will come. Inevitably there will be an oversupply of capital in some area of investment and investors will run in to trouble. Companies will be in trouble, consumer will be in trouble, and investors will be in trouble. Will Dodd-Frank succeed in reducing that likelihood and reducing the impact? Only time will tell.