Job Description For CCOs of Advisers to Private Investment Funds

help wanted join the insanity now

Back in 2005, Associate Director Office of Compliance Inspection and Examinations of the SEC, Gene Gohlke gave a speech addressing hedge funds who would soon have to register under the doomed hedge fund rule. He focused on what the funds needed in a Chief Compliance Officer.

Rule 206(4)-7 requires a registered investment adviser to designate an individual responsible for administering the policies and procedures required to avoid violation of the Investment Adviser Act and its rules. That’s all the rule requires of a CCO.

The release adopting the Rule 206(4)-7 provides some more background on the requirement:

An adviser’s chief compliance officer should be competent and knowledgeable regarding the Advisers Act and should be empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the firm. Thus, the compliance officer should have a position of sufficient seniority and authority within the organization to compel others to adhere to the compliance policies and procedures. [C.1.]

The release also makes it clear that the adviser does not have to hire an additional person to take on the rule.

Knowledgeable

A CCO must have a good understanding of the requirements imposed by the Advisers Act, the related rules, and other aspects of the regulatory regime for advisers. A CCO should also remain current regarding changes to the regulatory requirements as the SEC changes and adds to them.

Competent

Gohlke lays out the need to have familiarity with the steps needed to create a compliance program:

  • Risk identification and assessment.  Know how to identify conflicts and other compliance factors creating risk exposure for the firm and its clients in light of the firm’s particular operations.
  • Creating policies and procedures. Address the risks identified. The policies and procedures should address all conflicts of interest and other risks the firm is exposed to and not a set of risks that advisers in general may have.
  • Implementation. Recognizing the principles of good management and controls.

Position in Organizational Structure

The compliance officer should have a position of sufficient seniority and authority within the organization to be able to compel others to adhere to the firm’s compliance policies and procedures. CCOs should be a member of the senior management of a firm.

The 24 Functions

Gohlke lays out a list of 24 functions that CCOs of advisers should perform or consider performing. (He admits that this ia an ambitious list and that they are above and beyond what is required by Rule 206(4)-7.)

  1. Advises senior management on the fundamental importance of establishing and maintaining an effective culture of compliance within the firm.
  2. Confers with and advises other senior management of the firm on significant compliance matters and issues.
  3. Is not only available but is sought out on a “consulting” basis regarding compliance matters and issues by business people throughout the firm. Should become known as the “go to person” on compliance matters.
  4. Becomes involved in analyzing and resolving significant compliance issues that arise.
  5. Ensures that the steps in the firm’s compliance process – risk identification, establishing policies and procedures and implementing those policies and procedures – are appropriate and are undertaken timely by staff of the firm to whom those functions have been assigned.
  6. Becomes personally involved in various steps of the process such as serving on risk or policies and procedures committees when necessary and appropriate.
  7. Ensures that compliance policies and procedures are comprehensive, robust, current and reflect the firm’s business processes and conflicts of interest.
  8. Ensures that appropriate principles of management and control are observed in the implementation of policies and procedures. These principles include separation of functions, clear assignment of responsibilities, measuring results against standards and reporting outcomes.
  9. Ensures that all persons within the firm with compliance responsibilities are competently and fully performing those functions.
  10. Ensures that quality control (transactional) testing is conducted as appropriate to detect deviations of actual transactions from policies or standards and that results of such tests are included on exception and other management reports and are promptly addressed, escalated when necessary, and resolved by responsible business people.
  11. Ensures there is timely and appropriate review of material and repetitive compliance issues as indicators of possible gaps and weaknesses in policies and procedures or risk identification processes and facilitates the use of such information in keeping the firm’s compliance program evergreen.
  12. Undertakes periodic analyses and evaluation of compliance issues found in the regular course together with the results of appropriate forensic testing conducted by compliance staff as a means for obtaining additional or corroborating evidence regarding both the effective functions of the firm’s compliance program and the possible existence of disguised or undetected compliance issues.
  13. Ensures that compliance programs of service providers used by the adviser are effective so that the services provided by these firms are consistent with the adviser’s fiduciary obligations to its clients.
  14. Establishes a compliance calendar that identifies all important dates by which regulatory, client reporting, tax and compliance matters must be completed to ensure that these important deadlines are not missed.
  15. Promotes a process for regularly mapping a firm’s compliance policies and procedures and conflicts of interest to disclosures made to clients so that disclosures are current, complete and informative.
  16. Manages the adviser’s compliance department or unit in ways that encourages proactive work, a practice of professional skepticism and “thinking outside the box” by compliance staff.
  17. Manages the adviser’s code of ethics which is a responsibility given to CCOs of advisers by rule 204A-1 under the Advisers Act.
  18. Undertakes or supervises others in performing the required annual review of an adviser’s compliance program. Every adviser is required to conduct at least an annual review of its compliance program. The review should consider any compliance matters that arose during the previous year, any changes in the business activities of the adviser or its affiliates, and any changes in the Advisers Act or applicable regulations that might suggest a need to revise the policies or procedures. Although the rule requires only annual reviews, advisers should consider the need for interim reviews in response to significant compliance events, changes in business arrangements, and regulatory developments.
  19. Reports results of the annual review to senior management and ensures that recommendations for improvements that flow from the review are implemented as appropriate.
  20. Is a strong and persistent advocate for allocating an appropriate amount of a firm’s resources to the development and maintenance of an effective compliance program and compliance staff.
  21. Recognizes need to remain current on regulatory and compliance issues and participates in continuing education programs.
  22. Ensures that staff of the firm is appropriately trained in compliance-related matters.
  23. Is the adviser’s liaison and point of contact with SEC examination staff, both during exams and as part of the SEC’s CCOutreach program.
  24. Is active in industry efforts to develop and implement good compliance practices for advisers to private investment funds.

That’s  a big list of things to take on.

Although the SEC does not require a separate individual to take on the role of CCO, I occasionally hear some skepticism when a person assumes this role as an additional part of their job. The question the SEC asks is “what responsibilities did you relinquish in order to have time to take on the CCO role?”

Sources:

Help Wanted image is by Andi Szilagyi

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.

Sources:

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.

Sources:

Image of the Empire State Building is by Christian Mehlführer

The Newspaper Rule and a Massachusetts Politician

One of the classic statements in a compliance program is “don’t do something if you would be embarrassed to see a story about it on the front page of the newspaper.” Just because something is legal, it does not mean it’s ethical or a good thing to do.

A recent example popped up in Massachusetts politics involving Middlesex County Sheriff James V. DiPaola. (I just voted for him in November.) He was planning to retire, even though he had just been re-elected. Retire, but continue working as the Sheriff.

It turns out there is an exception in the Massachusetts Pension Law that allows retirees to run for paid elective office without losing their pensions.

DiPaola was a Malden police officer for 18 years before being elected a state representative in 1992. He then became Middlesex sheriff in a 1996 and was re-elected three times (including 2010). If he had kept working his pension would have remained mostly flat, since he has enough years of service to receive the maximum benefit allowed.

It turns out, if he retired before the election and didn’t collect his salary for the rest of 2010, he could collect his pension and receive his salary as Sheriff. A legal, but ethically troubling position.

Instead, he did the right thing.

“I’d always be remembered for this, for double-dipping, that that would be my legacy,’’ … crediting a Globe reporter’s question for his spark of conscience. “From a financial perspective it was great. It was legal. But I tossed and turned all night. I did put myself first this time, and I don’t want it to end that way.’’

In part his decision was forced by reporter from the Boston Globe. Sean Murphy had confronted DiPaola. With the real threat of having his action end up on the front page of the newspaper, DiPaola changed his mind.

Unfortunately, the revelation ended tragically when DiPaola died from apparent suicide this past weekend.

Sources:

Happy Thanksgiving

That means an extra long weekend for me.

Down the road at Plimouth Plantation they hold onto the belief that the first Thanksgiving in the United States happened in 1621 at their location:

The history of Thanksgiving goes much further back than Plymouth and 1621. In fact, people across the world from every culture have been celebrating and giving thanks for thousands of years. In this country, long before English colonists arrived, Native People celebrated many different days of thanksgiving. “Strawberry Thanksgiving” and “Green Corn Thanksgiving” are just two of kinds of celebrations for the Wampanoag and other Native People.

In 1621, the English colonists at Plymouth (some people call them “Pilgrims” today) had a three-day feast to celebrate their first harvest. More than 90 native Wampanoag People joined the 50 English colonists in the festivities. Historians don­t know for sure why the Wampanoag joined the gathering or what activities went on for those three days. Form the one short paragraph that was written about the celebration at the time, we know that they ate, drank, and played games. Back in England, English people celebrated the harvest by feasting and playing games in much the same way.

The English did not call the 1621 event a “thanksgiving.” A day of “thanksgiving” was very different for the colonists. It was a day of prayer to thank God when something really good happened. The English actually had their first thanksgiving in the summer of 1623. On this day they gave thanks for the rain that ended a long drought.

Enjoy the long weekend, if you can.

The First Thanksgiving by Jean Leon Gerome Ferris

The US Private Equity Fund Compliance Guide

One of the struggles with implementing a compliance program for a private equity fund is that the Investment Advisers Act is targeted at retail operations dealing with relatively liquid investments. Neither fits well with the private equity model of institutional investors and large, illiquid transactions. Most of the guidance and discussion about how to implement a compliance program focuses on the retail side. Given the changes coming from Dodd-Frank, most private fund managers will need to register with the SEC as investment advisers.

Private equity firms are going to need some good guides to help them out. PEI Media just published The US Private Equity Fund Compliance Guide. It is a useful resource to private equity firms putting together a compliance program.

Since it was just put together this year, the guide includes most of the new laws and regulations coming out of Dodd-Frank as they relate to private equity fund compliance. Of course, given the huge slate of rule-making in the pipeline, the guide will start getting out-of-date. You need to start sometime and the regulatory framework will continue to evolve.

Charles Lerner of Fiduciary Compliance Associates took the helm as editor of the guide and farmed out the individual chapters to a talented group of contributors. Most chapters do a great job of trying to translate the regulatory regime of the Investment Advisers Act to the realities of a private equity fund manager. A few chapters come up short. They merely tack on a paragraph at the end of the chapter pointing out that much of the preceding is irrelevant for most private equity firms or fail to provide a meaningful discussion for private equity.

Some chapters do a great job of addressing the problems that are more closely associated with private equity. The “Side Letters” chapter does a great job putting those agreement in the context of potential conflicts and the requirements of the Investment Advisers Act. I would give the same praise to the “Identifying Potential Conflicts of Interest” chapter.

Overall, I found the guide to be a great resource in helping me to craft my compliance program. My copy is already getting filled with notes and annotations. The downside it that it’s expensive: $795.

You can take a look at the table of contents for the guide and see how it fits into what you are doing and whether it would be worth the price.

The SEC Defines Venture Capital

The SEC is moving much faster in releasing proposed rules after the SEC Open Meetings. After Friday morning’s open meeting discussing the exemption from registration for venture capital funds, the SEC has released the full text of the proposed rule merely several hours later.

I have been waiting to see how broad this exemption will be. I’m still holding on to the slim chance that I could squeeze into the exemption. Given that the SEC is still looking for some broad reporting and subjecting venture capital firms to examination, I’m not sure the exemption will offer much benefit.

Here is the SEC’s proposed definition of a venture capital fund for purposes of the exemption:

A venture capital fund is any private fund that:

(1) Represents to investors and potential investors that it is a venture capital fund;

(2) Owns solely:

(i) Equity securities issued by one or more qualifying portfolio companies, and at least 80 percent of the equity securities of each qualifying portfolio company owned by the fund was acquired directly from the qualifying portfolio company; and

(ii) Cash and cash equivalents, as defined in § 270.2a51-1(b)(7)(i), and U.S. Treasuries with a remaining maturity of 60 days or less;

(3) With respect to each qualifying portfolio company, either directly or indirectly through each investment adviser not registered under the Act in reliance on section 203(l) thereof:

(i) Has an arrangement whereby the fund or the investment adviser offers to provide, and if accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of the qualifying portfolio company; or

(ii) Controls the qualifying portfolio company;

(4) Does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the private fund’s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days;

(5) Only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw, redeem or require the repurchase of such securities but may entitle holders to receive distributions made to all holders pro rata; and

(6) Is not registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), and has not elected to be treated as a business development company pursuant to section 54 of that Act (15 U.S.C. 80a-53).

SEC Release IA-3111 Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers

Proposed Changes to Form ADV

The SEC has released its proposed changes to Form ADV to better deal with private fund registration and the exempt, but reporting required of venture capital funds: Release No. IA-3110

The Securities and Exchange Commission is proposing new rules and rule amendments under the Investment Advisers Act of 1940 to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules and rule amendments are designed to give effect to provisions of Title IV of the Dodd-Frank Act that, among other things, increase the statutory threshold for registration by investment advisers with the Commission, require advisers to hedge funds and other private funds to register with the Commission, and require reporting by certain investment advisers that are exempt from registration. In addition, we are proposing rule amendments, including amendments to the Commission’s pay to play rule, that address a number of other changes to the Advisers Act made by the Dodd-Frank Act.

Can I Be a Venture Capital Fund Manager?

That was one of the topics for the Securities and Exchange Commission Open Meeting on November 19.

In Shapiro’s opening remarks, it was clear that the SEC wants all private funds to register. Even thought venture capital funds are exempt from registration, they will need to supply information to the SEC.

The key in defining “venture capital” will be the lack of leverage in the funds and the non-public status of their investments.

They will not have to disclose the full panoply of information that is required by Part 2 of Form ADV. So they will not have to disclose compensation and conflict information.

The SEC has only been able to examine 10% of registered investment advisers each year.

They made it clear that private fund advisers will not be excluded from the “systemically important” label under Dodd-Frank. Big advisers will need to keep an eye on this rulemaking, scheduled to be released in January.

Then on to the specifics.

There are proposed changes to Form ADV to reflect the new thresholds for registration and some other changes. private funds will need to disclose key gatekeepers such as auditors and third-party marketers.

They will also include information for the venture capital funds that have to report, but not register. These exempt-reporting advisers will still be using Form-ADV. They will need to disclose information about ownership, fund structures, and disciplinary activity.

As for venture capital funds, it seemed clear that they struggled trying to come up with a definition of a “venture capital fund.” The definition in the proposed rule will include these limitations:

  • must get 80% of the shares directly from the company
  • investments must be in a private company
  • provide significant management assistance to the company
  • only borrow a portion of their fund’s capital
  • limited redemption rights to limited partners
  • self-label as a venture capital fund

They will allow a grandfathering for venture capital funds, giving them some time to restructure to fall under the definition. That should be a relief for fund wondering how they can meet the July 21, 2011 deadline and not take a hit on their illiquid investments.

Commissioner Casey did not like the approach of the rule on venture capital funds and Form ADV. She noted that the statute is ambiguous on the reporting requirements and thinks the rule is putting too much of a burden on venture capital funds.

(I missed Commissioner Walter’s remarks.)

Commissioner Aguilar focused on the valuation and leverage discussions for funds. He seemed to really be interested in having such a big database of information about private fund advisers.

Commissioner Paredes focused on the insertion of the venture capital exemption outside of the Section 203 exemptions.  To him that means they are subject to much more oversight and subject to examination. He is concerned about the distraction of the fund mangers from growing small companies. He seemed skeptical that the regulatory oversight will help investors. He was concerned about the requirement of “providing managerial assistance” and how that may affect a VC investor that does not get a board seat. He realizes that the SEC is stuck with the statutory framework enacted by Congress. (I guess that’s the problem with getting an exemption tacked on to the bill instead of a thoughtful reworking of the regulatory framework.)

As usual with the SEC, the actual text of the rules was not released as part of the meeting and we will have to wait to see the details. Of course, these are just proposed rules so there will be an opportunity to comment and the SEC may make some changes to the rules based on the comments.

Compliance Bits and Pieces for November 19

Here are some recent compliance related stories I found interesting.

SEC Charges Two Longtime Madoff Employees with Fraud

The Securities and Exchange Commission today charged a pair of longtime employees at Bernard L. Madoff Investment Securities LLC (BMIS) with playing key roles in the Madoff Ponzi scheme. One employee produced phony account statements for investors and feathered her own accounts for personal gain, while the other conspired to cash out Madoff’s friends and family as the fraud collapsed in addition to creating phony account statements and tracking the Ponzi scheme bank account.

SEC Charges Steven Rattner in Pay-to-Play Scheme Involving New York State Pension Fund

The SEC alleges that Rattner secured investments for Quadrangle from the New York State Common Retirement Fund after he arranged for a firm affiliate to distribute the DVD of a low-budget film produced by the Retirement Fund’s chief investment officer and his brothers. Rattner then caused Quadrangle to retain Henry Morris – the top political advisor and chief fundraiser for former New York State Comptroller Alan Hevesi – as a “placement agent” and pay him more than $1 million in sham fees even though Rattner was already dealing directly with then-New York State Deputy Comptroller David Loglisci and did not need an introduction to the Retirement Fund.

To Crack Down on Insider Trading, UK to Require Recording Calls in the WSJ.com’s Law Blog

On Thursday, the U.K.’s Financial Services Authority said that starting in November next year, firms will have to record the cell phone conversations of some employees as part of its push to detect insider dealings.

Webinar Replay: The New Pay-to-Play Rules from Compliance Avenue

Earlier this year, the SEC adopted anti-fraud rule 206(4)-5 (the “Pay to Play Rule”) which serves to limit political contributions and “pay to play” activities. Prior to the effective date of this rule, all investment advisers should ensure that they build out comprehensive political contribution reporting and pre-clearance policies.

Mortgage Lending Practice after the Dodd-Frank Act by Bradley K. Sabel in the Harvard Law School Forum on Corporate Governance and Financial Regulation

On July 21, 2010, the President signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), enacting numerous provisions intended to reform the mortgage lending industry with an eye towards consumer protection. Many of these provisions are contained within Title XIV of the Dodd-Frank Act, the Mortgage Reform and Anti-Predatory Lending Act (the “Mortgage Act” or the “Act”)

Implications of Dodd-Frank for UK and EU fund managers and advisers

Many UK and EU investment managers and advisers (including those in the private equity, hedge
fund and real estate sectors) may be required to register with the US Securities and Exchange Commission (the “SEC”) with effect from 21 July 2011, even if they are already authorised by the UK Financial Services Authority or another EU regulator. Firms that register must comply with a number of US federal legal and regulatory requirements, many of which overlap with UK FSA rules. Some firms exempt from registration will still need to comply with certain record-keeping and reporting requirements. Whilst many of the detailed provisions of implementing legislation are yet to be finalised by the SEC, and there is considerable uncertainty about the scope of certain exemptions, firms should begin to consider the impact of the changes and plan for compliance.
2011.