Tag: Dodd-Frank Wall Street Reform and Consumer Protection Act

The SEC Is Making it Harder for Investment Advisers to Earn Performance Fees

The Securities and Exchange Commission is proposing to raise the dollar thresholds for someone to be considered a “qualified client.”

The definition of a qualified client is set out in Rule 205-3. This is an exemption to the Section 205(a)(1) general prohibition on performance fees.  Section 205(e) grants the SEC the power to create an exemption from the limitation “on the basis of such factors as financial sophistication, net worth, knowledge of and experience in financial matters, amount of assets under management, relationship with a registered investment adviser,” and other factors. The SEC created an exemption in Rule 205-3 for “qualified clients.”

Section 418 of the requires the SEC to adjust the standard for a Qualified Client for the effects of inflation within one year and then every five years.

Back in August I predicted the standard would be raised to a minimum investment of $1 million and the minimum net worth would rise to $2 million. I was proven wrong about my prediction of a rise in the accredited investor standard.

The SEC is proposing that the standard increase to a minimum investment of $1 million and the minimum net worth would rise to $2 million. As to net worth, they are excluding the value of a person’s primary residence.

The SEC is using the same primary residence calculation they used in the “new” accredited investor standard. So, if you owe more on your mortgage than the value of your house, then you need to treat the overage as a negative asset. Once again, owning a house can only be a negative for the SEC standards.

While I used the CPI-I standard as the benchmark for inflation, the SEC chose to use the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index”), published by the Department of Commerce

One of the comments the SEC is seeking in the proposed rule is whether the PCE index is the appropriate measure of inflation.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund. Each “equity owner … will be considered a client for purposes of the” limitation.  If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should be “qualified purchasers”  and you won’t need to look much further. If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.

Sources:

Image: http://www.rgbstock.com/image/misbxRm/Money+series+5
licensed for reuse

The Monstrous Size of Dodd-Frank

“What is 20 times taller than the Statue of Liberty, 15 times longer than “Moby Dick” and would take the average reader more than a month to read, even if you hunkered down with it for 40 hours a week?”

If you’ve been Dodd-Frank’ed, you know the answer.

The last round of financial overhaul was the Sarbanes-Oxley Act that came out of the Enron scandal. SOx weighs in at 66 pages. Dodd-Frank eats that for breakfast; It’s in heavyweight class at 849 pages.

That is just the legislation. Dodd-Frank put a big burden on financial regulators to work out the details to implement their vision (as myopic as it may be at times).

“In addition to the 30 rule-making procedures that already have missed the deadline set by Congress, 145 are supposed to be completed by year end…. Officials at the SEC, on the hook for more Dodd-Frank-related regulations than any other U.S. agency, have finished six rules, proposed 28 additional rules, missed deadlines on 11—and still have 50 to go, on which they have yet to issue any proposals.”

So far the regulatory “process has produced more than three million words in the Federal Register—or more than 3,500 11-inch-high pages.” And almost 2/3 of the rules required by Dodd-Frank have not even been proposed.

Congressman Barney Frank thinks missing the deadlines is no a big deal. “There is no penalty for not meeting the deadline,” Mr. Frank said during a webinar sponsored by the National LGBT Bar Association. “There’s no gun at their heads. Nobody gets fired.”

Sources:

Massachusetts Is Looking to Dodd-Frank Investment Advisers and Fund Managers

Just to keep you on your toes if you have less than $150 million under management, states are now filling in the gaps left by Dodd-Frank. If you are under that threshold, you lose the ability to register with SEC and now have to look to at being regulated at the state level.

Massachusetts used to have a very broad exemption if your clients were all “institutional buyers.”

An investing entity whose only investors are accredited investors as defined in Rule 501(a) under the Securities Act of 1933 (17 CFR 230.501(a)) each of whom has invested a minimum of $50,000.

For a private fund manager, this was a great exemption since their investors would need to be accredited investors. As long they kept capital commitments at a minimum of $50, 000 they could usually take advantage of this exemption.

The Massachusetts Secretary of State has proposed removing this exemption as well as cleaning up other aspects of investment adviser/fund manager regulation to get ready for Dodd-Frank.

The proposal would also create new Massachusetts registration exemptions for advisers whose only clients are “venture capital funds” or funds excluded from the definition of “investment company” under Section 3(c)(7) of the Investment Company Act. As you might expect, the term “venture capital fund” would be defined by reference to the SEC’s definition of the term. The SEC has proposed a draft definition of venture capital fund, but not yet finalized it.

What is abundantly clear is that the SEC has run out of time it trying to meet the July 21, 2011 deadline in Dodd-Frank. It’s time to raise the white flag and move the deadline. Since the SEC has not yet finalized the rules, regulated parties would have no time to understand the rules and get changes in place by July 21. Given that thousands of advisers are being kicked out of SC registration and over to state registration, the states do not have the rules in place to deal with the regulatory changes.

Sources:

 

Possible Extension to Registration for Private Fund Managers

Dodd-Frank put enormous pressure on the Securities and Exchange Commission to create dozens of new rules. Tile IV of the law, the Private Fund Investment Advisers Registration Act of 2010, shifts thousands of mid-sized investment advisers from federal to state registration. It also repeals the private adviser exemption, causing most private fund managers to register with the SEC.

Section 419 of Dodd-Frank pegs the transition period at one year. That means there is July 21, 2011 registration deadline. The SEC may be bending on that deadline for the registration of private fund advisers.

In an April 8, 2011 letter to the president of the North American Securities Administrators Association, the SEC indicated it may try to push back that July 21 deadline to the first quarter of 2012.

The letter states that the SEC intends to have the necessary rulemaking done by July 21. Of course, that means the subjects of the rules need to get in line. Since there is only three months until that deadline, the clock is ticking very loudly.

The SEC also needs to get the computer systems in place. Once the rules and forms are finished, they need to update the Investment Adviser Registration Depository System. Back in November, the SEC proposed big changes to the Part 1 of Form ADV to address these new registration and reporting requirements. The final form has not been released. I thought the release may have been because they were re-programming IARD to deal with the new form, allowing them to release the final Form ADV and the registration at the same time. According to this letter, that is not the case. The SEC does not expect IARD to be re-programmed until the end of 2011.

Obviously, this letter merely indicates that at least one person inside the SEC thinks the deadline could be extended. That is a long way from actually extending the deadline. I still have a question about whether the SEC can extend the deadline without some sort of legislative action.

Sources:

The Small Business Capital Access and Job Preservation Act

With the House of Representatives’ change in political control, the Republicans are taking some steps to cut back on Dodd-Frank. Earlier this week the House Committee on Financial Services distributed a press release about five potential bills that would revise the financial service legislation:

  • The Asset-Backed Market Stabilization Act
  • The Small Company Capital Formation Act
  • The Small Business Capital Access and Job Preservation Act
  • The Business Risk Mitigation and Price Stabilization Act
  • The Burdensome Data Collection Relief Act

Besides the sensationalist graphics, the Small Business Capital Access and Job Preservation Act caught my attention because it is targeted at private equity fund managers:

The Financial Services Committee has received testimony regarding the role private equity firms play in preserving existing jobs and creating new ones by providing capital to struggling and growing companies.  The Dodd-Frank Act requires most advisers to private investment funds to register with the SEC, including advisers to private equity funds. The Small Business Capital Access and Job Preservation Act exempts advisers to private equity funds from the registration requirements. The draft legislation will be sponsored by Representative Robert Hurt.

It sounds like a nice bill. But I’m skeptical that it could enacted before the July 21 deadline for private equity fund managers to register under Dodd-Frank (assuming it could pass at all).

The Committee is holding testimony on Wednesday, March 16 at 2 p.m. in room 2128 Rayburn. Scheduled to appear are:

  • Kenneth A. Bertsch, President and CEO, Society of Corporate Secretaries & Governance Professionals
  • Tom Deutsch, Executive Director, American Securitization Forum
  • Pam Hendrickson, Chief Operating Officer, The Riverside Company
  • David Weild, Senior Advisor, Grant Thornton, LLP
  • Luke Zubrod, Director, Chatham Financial

The text of the proposed legislation is just in the form of discussion drafts and I  have not been able to find copies. I’m sure much will hinge on the definition of “private equity fund managers” just as Dodd-Frank created a new category of venture capital fund managers.

Sources:

Incentive Compensation Limitations and Disclosures for Private Fund Managers

At the Wednesday March 2 Open Meeting, the Securities and Exchange Commission voted to approve a new rule that would affect incentive compensation paid to employees of investment advisers and broker-dealers. Commissioners Casey and Paredes voted against proposing the rule as drafted. The other three voted to move the proposed rule into the comment period.

Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires federal regulators to

“prescribe regulations or guidelines to require each covered financial institution to disclose to the appropriate Federal regulator the structures of all incentive-based compensation arrangements offered by such covered financial institutions sufficient to determine whether the compensation structure:

(A) provides an executive officer, employee, director, or principal shareholder of the bank holding company with covered financial institution with excessive compensation, fees, or benefits; or

(B) could lead to material financial loss to the covered financial institution.”

A “covered financial institution” includes investment advisers (as defined under section 202(a)(11) of the Investment Advisers Act), a broker-dealer registered under section 15 of the Securities Exchange Act of 1934, as well as banks, credit unions, FNMA, FHLMC and others designated by regulators, with assets of $1 billion of more.

If you are a private fund manager and have assets of $1 billion or more under management, then this rule would affect you. As drafted the rule applies if you are an investment adviser, regardless of whether you are registered with the SEC as an investment adviser.

Some real estate fund managers are still looking for exemptions for registering with the SEC or registering with the state based on the securities calculation, or by taking the position that they are not a “private fund” under the SEC’s definition. The choice of registration would not affect the applicability of this proposed rule.

This is a joint rulemaking so there needs to be some consistency across financial institutions. A draft of the proposal was published by the FDIC (pdf).

Only incentive-based compensation paid to “covered persons” would be subject to the requirements of this Proposed Rule. A “covered person” would be any executive officer, employee, director, or principal shareholder of a covered financial institution.

The proposed rule defines “incentive-based compensation” to mean any variable compensation that serves as an incentive for performance. It excludes fixed salary.

The first requirement is that a covered financial institution must submit an annual report “disclosing the structure of its incentive-based compensation arrangements that is sufficient to determine whether the incentive-based compensation structure provides covered employees with excessive compensation, fees, or benefits, or could lead to material financial loss to the covered financial institution.” The report must contain:

(1) A clear narrative description of the components of the covered financial institution’s incentive-based compensation arrangements applicable to covered persons and specifying the types of covered persons to which they apply;

(2) A succinct description of the covered financial institution’s policies and procedures governing its incentive-based compensation arrangements;

(3) For larger covered financial institutions, a succinct description of any specific incentive compensation policies and procedures for the institution’s executive officers, and other covered persons who the board or a committee thereof determines individually have the ability to expose the institution to possible losses that are substantial in relation to the institution’s size, capital, or overall risk tolerance;

(4) Any material changes to the covered financial institution’s incentive-based compensation arrangements and policies and procedures made since the covered financial institution’s last report was submitted; and

(5) The specific reasons the covered financial institution believes the structure of its incentive-based compensation plan does not provide covered persons incentives to engage in behavior that is likely to cause the covered financial institution to suffer a material financial loss, and does not provide covered persons with excessive compensation.

Under the SEC proposal, there would be a mandatory deferral of incentive compensation for employees of large financial institutions (over $50 billion). At least 50% of the incentive compensation must be paid over three years. It sounded like this deferral requirement was the point most disliked by the two dissenting commissioners.

This is a fairly ugly rule for private equity funds and real estate funds. Incentive compensation is usually paid upon the realization of the assets.

Under Dodd-Frank, the rule is required to be in place 9 months after enactment. That would mean an April 21, 2011 deadline.

The SEC Wants to Know if You Are Systemically Important

The Securities and Exchange Commission proposed a new rule that would require advisers to private funds to report information for use by the Financial Stability Oversight Council in monitoring risk to the U.S. financial system. Sections 404 and 406 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the SEC to gather this information.

The SEC is proposing a new Rule 204(b)-1 under the Investment Advisers Act that would require SEC-registered investment advisers to report systemic risk information on Form PF if they advise one or more private funds.

Each private fund adviser would report basic information about the operations of its private funds on Form PF once each year. Large Private Fund Advisers would be required to submit this basic information each quarter along with additional systemic risk related information required by Form PF concerning certain of their private funds.

“Large Private Fund Advisers” would be

  • Advisers managing hedge funds that collectively have at least $1 billion in assets as of the close of business on any day during the reporting period for the required report;
  • Advisers managing a liquidity fund and having combined liquidity fund and registered money market fund assets of at least $1 billion as of the close of business on any day during the reporting period for the required report; and
  • Advisers managing private equity funds that collectively have at least $1 billion in assets as of the close of business on the last day of the quarterly reporting period for the required report.

The SEC estimates that approximately 4,450 advisers would be required to file Form PF. Of those, approximately 3,920 would be smaller private fund advisers not meeting the thresholds for reporting as Large Private Fund Advisers.

It looks like the definition of private equity fund for purposes of the Large Private Fund Adviser reporting requirements will exclude real estate funds.

Private equity fund:

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.

Under the proposed rule, real estate private equity funds will be subject to the annual reporting, but not subject to the more detailed quarterly reporting. This is just a proposed rule, so the final requirements and definitions may change in the final rule when it is issued. In the meantime, you can make comments.

Sources:

Proposed “New” Standard for Accredited Investor

If you are involved in the private placement of securities, then you have been waiting to hear how the SEC was going to change the definition of “accredited investor.”

Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the definitions of “accredited investor” to exclude the value of a person’s primary residence for purposes of determining whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of $1 million. Previously, the standards required a minimum net worth of more than $1,000,000, but permitted the primary residence to be included in the calculation.

Other than changing the calculation of net worth change mandated by Dodd-Frank, the SEC has declined to change the definition.

The other test for determining qualification was an individual income in excess of $200,000 in each of the two most recent years (or joint income with a spouse in excess of $300,000). I expected those number to nearly double to keep pace with inflation.

Section 415 of the Dodd-Frank Act requires the Comptroller General of the United States to conduct a “Study and Report on Accredited Investors” examining “the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.” That study is not due for three years. The SEC indicated that they will likely use the results of that study when they once again address the accredited investor standard in 4 years, as allowed under Dodd-Frank.

It seems to me that the SEC found an opportunity to reduce its rulemaking agenda, by not significantly changing a rule. Maybe this is the first sign of the SEC creaking under the weight of the Dodd-Frank mandates.

Sources:

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.

Sources:

Repeal of Dodd-Frank?

Most compliance professionals have trepidation about parts of the Dodd-Frank Wall Street Reform and Consumer Protection Act. I would bet that most of the Representatives and Senators who voted for it (and against it) did not read the whole law and do not understand the changes being made.

But should it be repealed in it’s entirety?

Since the Republicans have taken over the House of Representatives there is growing backlash against the law. Take a look at the new Republican-authored House Committee on Financial Services website. Here are the headline topics:

  • Collateral Damage – the real impact of the Democrat’s bailout bid
  • Financial Regulatory Reform
  • Fannie and Freddie Reform
  • What’s NOT in the Dod-Frank?
  • What’s Really in Dodd-Frank?

Along with the changes to the website comes a H.R. 87: To repeal the Dodd-Frank Wall Street Reform and Consumer Protection Act from Representative Bachman:

“I’m pleased to offer a full repeal of the job-killing Dodd-Frank financial regulatory bill. Dodd-Frank grossly expanded the federal government beyond its jurisdictional boundaries. It gave Washington bureaucrats the power to interpret and enforce the legislation with little oversight.

“Dodd-Frank also failed to address the taxpayer-funded liabilities of Fannie Mae and Freddie Mac. Real financial regulatory reform must deal with these lenders who were a leading cause of our economic recession.”

Speaking personally, I don’t like Dodd-Frank. But repealing it would be worse. I think needs the SEC needs more funding and a longer time frame to promulgate the new regulations. The SEC normal produces just a handful of new rules each year. Dodd-Frank tasks them with dozens that need to be in place in the next few months.

As for Fannie Fae and Freddie Mac being the cause of the crisis, I think Representative Bachman should take the time to read All the Devils Are Here by Bethany McLean and Joe Nocera. (I’m halfway through it.) Fannie and Freddie played a role, but lots of things went wrong to get us into the trouble of 2008.

Putting companies into a limbo of whether they need to change or not is bad. I may not like the law, but uncertainty is worse.

On the other hand, I think the repeal is unlikely. It’s merely a political football to throw around.

Sources: