There is turmoil in Congress as Republicans take control of the House of Representatives. One of their targets seems to be implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
It’s probably too late to repeal it and too early to start amending it. Too much corporate machinery has been put in place to start changing the statute at this point. It looks like Congress is going to use its control of spending to impede implementation and enforcement.
The SEC has asked for more funding and submitted a budget request of $1.258 billion for fiscal 2011. That was up from the previous year’s $1.118 billion budget. SEC Chairman Mary Schapiro said the agency would need to hire an additional 800 people to meet its expanded duties under Dodd-Frank.
Clearly, SEC will be stretched thin to deal with rule-making, enforcement, and examination if they are starved for budget dollars. More dollars means more staff and more technology to deal with the workload.
For corporate compliance, that means uncertainty about how Dodd-Frank will be implemented. If you are in a venture capital firm, you are wondering if you will have to register with the SEC as an investment adviser. There is proposed rule with the definition. There is a proposed rule with what reporting the venture capital firm will need to make. But you don’t know exactly where the definitions and rules will end up.
If you are a private fund adviser, you know you will need to file a Form ADV. The SEC has proposed a new form. It’s too early to start filling it out, because it may change. They will still need to change the online registration system to address whatever the final form will be.
We are now in 2011. That July 21, 2011 compliance deadline is getting closer and closer, but the SEC is falling further and further behind.
Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act provides an expanded whistleblower program that allows the whistleblower to get part of the money paid to the SEC for the violation. After several years of encouraging the development of internal complaint hotlines and compliance programs, Congress seems to now be encouraging a trip to the Feds before reporting a problem internally. On November 3, 2010, the Securities and Exchange Commission (SEC) published its Proposed Rules for Implementing the Whistleblower Provisions of Section 21F of the Securities and Exchange Act of 1934.
I think the approach is poor and could undermine corporate compliance programs. On the other hand, I think employees are more likely to report the problem internally than externally. Reporting externally is a much bigger step. You don’t know who is getting the report or what they will do with it.
The promise of cash payments is a bit remote. It’s not like the SEC will be cutting a check once you make the call. There will months, if not years, of investigation and litigation before there is any money available. And that is assuming the Feds win. In the meantime, the reporter has jeopardized his or her job and career.
I think the typical person is much more likely to talk to their friendly, internal compliance people before they go racing off to the Feds seeking fame and riches.
Now there is some evidence that I’m correct. The National Whistleblowers Center has released a report on the Impact of Qui Tam Laws on Internal Corporate Compliance. Based on a review of qui tam cases filed between 2007-2010 under the False Claims Act, the overwhelming majority of employees voluntarily utilized internal reporting processes, despite the fact that they were potentially eligible for a large reward under the False Claims Act. 89.7% of employees who would eventually file a qui tam case initially reported their concerns internally, either to supervisors or compliance departments.
Their conclusion:
“The qui tam reward provision of the False Claims Act has existed for more than 20 years and has resulted in numerous large and well-publicized rewards to whistleblowers. However, contrary to the disingenuous assertions by corporate commenters, the existence of this strong and well-known qui tam rewards law has had no effect whatsoever on whether a whistleblower first brings his concerns to a supervisor or internal compliance program. There is no basis to believe that the substantively identical qui tam provisions in the Dodd-Frank law will in any way discourage internal reporting.”
It may not be meaningful for some time. The Securities and Exchange Commission is operating under budget constraints and put the whistleblower office on hold until funding clears up. The new Congress may repeal provisions of Dodd-Frank, but they can limit some of the funding.
Much of the whistleblower program is in SEC Release 34-6323. Comments are open until December 17, 2010. Certainly, the proposed rule could change significantly bases on the comments. There have been lots of comments from the compliance community at the public companies subject to this rule. I would like to see the rule changed as a validation of internal compliance programs.
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.
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 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’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.
Securities Docket produced a webcast “Corporate Compliance after Dodd-Frank: One Voice; How Many Masters?” that focused on the SEC’s proposed new whistleblower rules and their implications for internal controls and compliance programs, investigations, self-reporting incentives and employer/employee relations, including executive compensation and employee reporting responsibilities.
The panelists:
Byron Egan, Partner Jackson Walker L.L.P.
Jeffrey Sone, Partner Jackson Walker L.L.P.
Gary Kleinrichert, Senior Managing Director FTI Consulting
Section 922 of Dodd-Frank provides an expanded whistleblower program that allows the whistleblower to get part of the money paid to the SEC for the violation.
There is a lot of gnashing of teeth among compliance professionals because this provision would encourage an employee to ignore internal complaint processes and head directly to the Feds. Those internal whistleblowing program came out of Sarbanes-Oxley, the legislation enacted as a result of the last financial crisis.
The new program is not applicable to private companies that are not subject to registration under the Securities Act of 1934. Section 922 of Dodd-Frank is an amendment of that law.
Employees with a legal, compliance, audit, supervisory or governance responsibility have limited eligibility for the whistleblower bounty. They are not eligible if the information was communicated to them with the reasonable expectation that they would take steps to respond to the violation. They are then eligible if the company does not disclose the information to the SEC within a reasonable time or proceeds in bad faith.
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In prognosticating the impact, we can look at the False Claims Act which has a similar whistleblower bounty program. Under that legal framework, most people don’t report to the government until they have given their company a chance.
Much of the whistleblower program is in SEC Release 34-6323. Comments are open until December 17, 2010. Certainly, the proposed rule could change significantly bases on the comments.
In addition to laying out the changes to Form ADV, in Release No. IA-3110 the SEC also took a slightly different course on regulating placement agents. Rule 206(4)-5, released in July 2010, required placement agents to either be registered with the SEC as an investment adviser and subject to the limitation on campaign contributions, or register with FINRA. The FINRA registration was subject to enactment of a similar pay-to-play rule by FINRA.
The SEC has abandoned FINRA for the MSRB when it comes to regulating placement agents that interact with government sponsored plans.
The MSRB is undertaking a rule-making to subject municipal advisers to the pay-to-play rules in place for municipal securities dealers under MSRB Rule G-37.
“Municipal advisors” include businesses and individuals that advise municipal entities concerning municipal financial products and municipal securities, as well as businesses and individuals who solicit certain types of business from municipal entities on behalf of unrelated broker-dealers, municipal advisors, or investment advisers.
In comparing the de minimis amounts under Rule 206(4)-5 and MSRB Rule G-37, the MSRB only allows for contributions up to $250 for candidates the person can actually vote for. The SEC rule is $350 for a candidate you can vote for and $150 for a candidate you can’t vote for. Both have a two-year ban for violation of the rules.
Sources:
SEC Release No. IA-3110 – Rules Implementing Amendments to the Investment Advisers Act of 1940
The hard work has begun as federal regulators are trying to implement the provisions of Dodd-Frank. The law pushed lots of the detail out to the agencies so there are lots of unanswered questions.
One of the hot button issues was what to do with financial institutions that were too big to fail. Dodd-Frank came up with the concept of “systemically important.” They created a new entity, the Financial Stability Oversight Council to come up with a definition, figure who should get that designation and design safeguards for those designees.
Private equity lost the battle to get an exemption from registration under the Investment Advisers Act. It may have to fight another battle to avoid the “systemically important” label.
The Independent Community Bankers of America, a major trade group for community banks, said General Electric Co.’s GE Capital and private-equity firms Carlyle Group, KKR & Co.’s Kohlberg Kravis Roberts & Co. and Blackstone Group LP should be tagged as systemically important.
Private equity doesn’t belong in that group, shot back Blackstone spokesman Peter Rose. “We do not trade, we have no leverage at the parent-company level, our investments are clearly disclosed and transparent, our investors are with us for the long term,” he said. “Therefore there is no possibility of a, quote, ‘run on the bank.’ ”
may determine that a U.S. nonbank financial company shall be supervised by the Board of Governors and shall be subject to prudential standards, in accordance with this title, if the Council determines that material financial distress at the U.S. nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States.
The term “U.S. nonbank financial company” means
a company (other than a bank holding company, a Farm Credit System institution chartered and subject to the provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.), or a national securities exchange (or parent thereof), clearing agency (or parent thereof, unless the parent is a bank holding company), security-based swap execution facility, or security-based swap data repository registered with the Commission, or a board of trade designated as a contract market (or parent thereof), or a derivatives clearing organization (or parent thereof, unless the parent is a bank holding company), swap execution facility or a swap data depository registered with the Commodity Futures Trading Commission), that is–
(i) incorporated or organized under the laws of the United States or any State; and
(ii) predominantly engaged in financial activities, as defined in paragraph (6).
[102(a)[4)]
A company is “predominantly engaged in financial activities” if–
(A) the annual gross revenues derived by the company and all of its subsidiaries from activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, from the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated annual gross revenues of the company; or
(B) the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, related to the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated assets of the company.
[102(a)[6)]
Those are some very wide open definitions for who could be considered “systemically important.”
(A) The extent of the leverage of the company;
(B) The extent and nature of the off-balance-sheet exposures of the company;
(C) The extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;
(D) The importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the United States financial system;
(E) The importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;
(F) The extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;
(G) The nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;
(H)The degree to which the company is already regulated by 1 or more primary financial regulatory agencies;
(I) The amount and nature of the financial assets of the company;
(J) The amount and types of the liabilities of the company, including the degree of reliance on short-term funding; and
(K)Any other risk-related factors that the Council deems appropriate.
[113(a)(2)]
Hearing
Then it takes 2/3 of the voting members of the Council, including the Chairperson, to make the designation [113(a)(1)]. Then the financial company designated as systemically important has 30 days to request a hearing and another 30 days to submit material. [113(e)(2)] The Council has 60 days to make a final determination.
Too Big to Fail
This provision of Dodd-Frank is the Anti-AIG and to some extent the Anti-Lehman Brothers portion of the law.It is one of the many ways the law tries to address Too Big to Fail.
Capital has many forms and is made available in many ways. The U.S. government thought AIG was too big to fail because of its size and interconnectedness. They didn’t think Lehman Brothers was too big to fail, but I think they were wrong about that.
Back to the Finger Pointing
Now that the Financial Stability Oversight Council is trying to define Too Big to Fail as systemically important, the finger pointing has begun. Industries and companies are saying “not me” and saying that others should be included.
The problem is that once you are designated “systemically important” it’s not clear what additional burdens will be placed on you and whether there will be any benefit to the designation. It seems the Council has the flexibility to craft different requirements for different companies and different industries.
It may boost your ego to be considered “systemically important” but it will also lead to a regulatory headache. Private investment firms are not exempt from the designation and could be tagged.
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.
With Dodd-Frank‘s elimination of the 15 client exemption, thousands (my guess) of private fund managers will need to register with the Securities and Exchange Commission as investment advisers to their funds. For alternative investment funds, like real estate, you’ll need to look at whether you are giving advice regarding securities.
If you have less than $100 million you will be in the state registration system and may need to have individuals licensed with the state. If you have over $100 million, you be registering with SEC. The deadline is July 21, 2011.
That leaves the question of whether you need a state license for the firm or individuals in the firm, like the Series 65.
One benefit of SEC registration is that the Investment Advisers Act preempts some state licensing for private fund management companies. Section 203(A)(b) prohibits the states from licensing an investment adviser registered with the SEC (or exempt from definition of Section 202(a)(11)).
The exception is that a state may require licensing for an “investment adviser representative” who has a place of business in that state. For a private fund manager, you need to determine if any of the management company employees fit into the definition in Rule 203A-3.
“(a)(1) “Investment adviser representative” of an investment adviser means a supervised person of the investment adviser:
i. Who has more than five clients who are natural persons (other than excepted persons described in paragraph (a)(3)(i) of this section); and
ii. More than ten percent of whose clients are natural persons (other than excepted persons described in paragraph (a)(3)(i) of this section).”
For a private fund manager, the key part of the definition is whether they have any clients who are natural persons. The manager’s funds are the clients and those funds are not natural persons. Employees of the fund manager should fall outside the definition of “investment adviser representative” and therefore not need a license.
The SEC has released the text of its proposed new rules for implementing the whistleblower provisions of Section 21F of the Securities Exchange Act of 1934: Release No. 34-63237.
In fashioning these proposed rules, the Commission has considered and weighed a number of potentially competing interests that are presented in implementing the statute. Among them was the potential for the monetary incentives provided to whistleblowers by Section 21F of the Exchange Act to reduce the effectiveness of a company’s existing compliance, legal, audit and similar internal processes for investigating and responding to potential violations of the federal securities laws. With this possible tension in mind, we have included provisions in the proposed rules intended not to discourage whistleblowers who work for companies that have robust compliance programs to first report the violation to appropriate company personnel, while at the same time preserving the whistleblower’s status as an original source of the information and eligibility for an award. At the same time, the proposed rules would not prohibit a whistleblower in a compliance function from reporting information to the Commission where the company did not provide the information to the Commission within a reasonable time or acted in bad faith.
At this point, it is merely a proposed rule. Comments should be submitted on or before December 17, 2010.
There will be a new Form TCR for submitting a tip, complaint or referral and a new Form WB-DEC, Declaration Concerning Original Information Provided Pursuant to §21F of the Securities Exchange Act of 1934, signed under penalty of perjury, for submission to the SEC to meet the standards of the new regulations.
The Dodd-Frank Wall Street Reform and Consumer Protection Act wiped out the exemption enjoyed by most private funds. I’m still waiting to see how the SEC will define a “venture capital fund manager.” In the meantime, the SEC has published its proposed rule defining a “family office” and its exemption from registration under the Investment Advisers Act.
Historically, family offices have not been required to register with the SEC under the Advisers Act because of the same exemption used by private funds. The Dodd-Frank Act removed that “small adviser” exemption under section 203(b)(3) to enable the SEC to regulate hedge fund and other private fund advisers, but includes a new provision requiring the SEC to define family offices in order to exempt them from regulation under the Advisers Act.
“Family offices” are established by wealthy families to manage their wealth and provide other services to family members. That leaves the fabulously wealthy time to go yachting and leaves others to manage their securities portfolios, plan for taxes, worry about accounting services, and to directing charitable giving. The issue is the the family office management of securities.
In the past, the SEC has issued dozens of exemptive orders for family offices who requested them, removing them from the registration and supervision of the SEC. The proposed rule 202(a)(11)(G)-1 would largely codify the exemptive orders. Most of the conditions of the proposed rule are designed to restrict the structure and operation of a family office relying on the exemption to activities unlikely to involve commercial advisory activities, while still allowing family office activities involving charities, tax planning, and pooled investing.
(b) Family office. A family office is a company (including its directors, partners, trustees, and employees acting within the scope of their position or employment) that:
(1) Has no clients other than family clients; provided that if a person that is not a family client becomes a client of the family office as a result of the death of a family member or key employee or other involuntary transfer from a family member or key employee, that person shall be deemed to be a family client for purposes of this section 275.202(a)(11)(G)-1 for four months following the transfer of assets resulting from the involuntary event;
(2) Is wholly owned and controlled (directly or indirectly) by family members; and
(3) Does not hold itself out to the public as an investment adviser.
The key is how the SEC defines a family member:
(d) (3) Family member means:
(i) the founders, their lineal descendants (including by adoption and stepchildren), and such lineal descendants’ spouses or spousal equivalents;
(ii) the parents of the founders; and
(iii) the siblings of the founders and such siblings’ spouses or spousal equivalents and their lineal descendants (including by adoption and stepchildren) and such lineal descendants’ spouses or spousal equivalents.
I guess that some family offices will be cutting off some distant relations to get under this definition. For “less-beloved” family members, the family office management can use SEC regulation as an excuse to kick them out. Of course, they can still seek and exemptive order from the SEC if they don’t fit under this definition.
The comments should involve a whole new area for the SEC: family law.
As I expected, this exemption is of no value to private funds look for a safe harbor from SEC registration.
