An Outline of The SEC’s 2014 Examination Priorities

Last week I wrote about FINRA’s 2014 exam priorities. This week, the SEC announced its 2014 examination priorities covering a number of topics important to investment advisers, investment companies, broker-dealers, clearing agencies, exchanges and other self-regulatory organizations, hedge funds, private equity funds, and transfer agents.

While the SEC makes clear the list is not exhaustive, areas that firms will see heightened scrutiny include fraud detection and prevention, corporate governance and enterprise risk management, technology controls. Included also are issues concerning the growing relationship between broker-dealers and investment advisers, new rules and regulations, and retirement investments and rollovers. Continue reading “An Outline of The SEC’s 2014 Examination Priorities”

More SEC Guidance To Avoid Blowing The Venture Fund Adviser Registration Exemption

The SEC has just published additional guidance for those venture capital funds advisers relying on an exemption to not  register as investment advisers under the Investment Advisers Act of 1940, and who may worry that the way they  structured a fund (or whether certain actions discussed below) might jeopardize the ability to rely on the exemption. In response to such inquiries, the SEC’s Division of Investment Management has provided additional guidance in the form of five examples or “scenarios” for advisers relying on the “venture capital fund” exemption or “VC Exemption” where they advise one or more venture capital funds. First, some background:

Continue reading “More SEC Guidance To Avoid Blowing The Venture Fund Adviser Registration Exemption”

PRIVATE FUND OFFERINGS: With General Solicitation Relaxation Comes New Scrutiny

 

SearchingWhile under the JOBS Act the capital formation process in private offerings may have gotten easier, the regulatory scrutiny may have gotten harder.

In a speech before the PLI Hedge Fund Management Conference in New York, Norm Champ, the SEC’s Director of the Division of Investment Management, addressed the increased oversight advisers to hedge funds relying on private offering exemptions can expect.  Of concern is  the adopted amendments to rules under the Securities Act of 1933 permitting general solicitation and general advertising in private securities offerings relying on Rule 144A or Rule 506 under the Securities Act and the rule’s  disqualifying of so-called “bad actors” who rely on its safe harbor.

In short, as to advertising, Rule 506 eliminates the prohibition on general solicitation and general advertising for some private fund offerings, with exceptions noted in the rule.  Generally, to find potential accredited investors, once the removal of the ban goes effective in the next few weeks, hedge fund will be able to use certain other methods of  solicitating and advertising.  With this comes the requirement that issuers take reasonable steps, defined by an objective assessment standard, to verify “accredited investor” status, to ensure that all purchasers of the securities are accredited investors.  Champ also stressed the importance of  advisers maintaining, reviewing and updating their policies and procedures to ensure, among other things, they are reasonably designed to prevent the use of fraudulent or misleading advertisements.

Other issues hedge funds will need to concern themselves with, related to  general solicitation, and  included in SEC proposals and related request for industry comment, include the following:

  • requiring issuers to file the Form D before a general solicitation begins and when an offering is completed to evaluate how general solicitation impacts investors in the private placement market, and expanding the information that issuers must include on Form D.
  • requiring private fund issuers  to include a legend in any written general solicitation materials disclosing that the securities being offered are not subject to the protections of the Investment Company Act of 1940.
  • requiring general solicitation materials containing performance data, to have additional disclosure explaining the context and limitations on the usefulness of such data.
  • extending to private funds Rule 156 of the Securities Act of 1933 guidance on when information in sales literature could be fraudulent or misleading under federal securities laws currently applicable to registerd funds.
  •  manner and content restrictions on private fund solicitation materials that include performance advertising specific to certain types of performance advertising, such as model or hypothetical performance.
  • using  an inter-Divisional group within the SEC to assess practices and developments in the Rule 506(c) market place, by looking at accredited investor verification practices used by issuers and other participants in these offerings, and studying risk characteristics that might identify potentially fraudulent behavior.
  • reviewing the definition of accredited investor as it relates to natural persons.

The “Bad Actor” Disqualification

As for the “bad actor” rule, the second amendment to Rule 506 implementing
Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Champ warned of  serious regulatory consequences should the SEC make a  bad actor finding.  To avoid the finding, hedge  fund advisers should conduct appropriate due diligence when they hire employees, third-party solicitors, and when they screen investors.  Champ also reminded hedge funds that while disqualification applies only for triggering events that occur after the effective date of the rule, matters that existed before the effective date of the rule that would otherwise be disqualifying must be disclosed to investors.

Generally, an issuer cannot rely on the Rule 506 exemption from registration if the issuer or any other person covered by the rule is disqualified by a “triggering event,” including certain criminal convictions, certain SEC cease-and-desist orders and court injunctions and restraining orders.  Hedge funds are not the only potential “bad actors. ”  Others, Champ reminded, could  include  “the hedge fund’s general partner or managing member, its investment adviser and principals, significant shareholders holding voting interests, affiliated issuers and any placement agent or other compensated solicitor.”

Finally, from a risk perspective, how will the SEC determine which hedge funds engaged in general solicitation to examine and/or investigate?

One way, he notes, is that registration and reporting reforms related to Dodd-Frank, over the past few years, including, the adoption of amendments to Form ADV and the creation of Form PF allows the SEC to cull more  information about individual hedge fund’s practices.  Another way, is the  Division of Investment Management establishment of a Risk and Examinations Office (“REO”) staffed with analysts with strong quantitative backgrounds, along with examiners, lawyers and accountants who will  conduct quantitative and qualitative financial analysis of the investment management industry, including private funds, advisers, types of funds, strategies and make up of a fund.

SEC Risk Alert: Business Continuity and Disaster Recovery Planning

The SEC has issued a new Risk Alert stemming from its observations of  the  business continuity and disaster recovery planning practices of  a number of  investment advisers.  The alert follows an National Examination Program (“NEP”) review of the plans of approximately 40 investment advisers following  Hurricane Sandy.  The SEC says the goal is to encourage investment advisers to review their business continuity and disaster recorvery plans (“BCPs”) to improve responses and recovery times for threats that might disrupt market operations.

Certain weakenesses observed, and that advisers would do well to heed,  include the following areas:

  • Preparation for widespread disruption. Some advisers whose BCPs did not adequately address and anticipate widespread events experienced more interruptions in their key business operations and inconsistent communications with clients and employees.
  • Planning for alternative locations.  Some advisers who switched to back-up sites or systems reported that the buildings where they usually conduct their business were closed for days.  At least, one adviser reported its building was closed for several weeks.  Other problems included extended outages of power, phone systems, and internet service and lack of geographically diverse office operations.
  • Preparedness of key vendors.  Some advisers failed to even evaluate the BCPs of their service providers or keep a list of vendor’s contact information.  Some advisers did not acquire or critically review service providers’ Statement on Standards for Attestation Engagements No. 16 reports. 
  • Telecommunications services and technology.  Some advisers failed to hire service providers to make sure back-up servers functioned properly, relying solely on self-maintenance, which led to more interruptions in their operations.
  • Communication plans.  Poor planning, inconsistencies and weak deployment in how to contact employees during a crisis.  Some plans did not identify which employees would execute and implement  various parts of the BCP.
  • Reviewing and testing.  Inadequate testing of operations and systems relative to size and nature of  advisory businesses.  Some problems here were based on adviser failures to conduct certain critical tests based on costs and other disincentives.  

The risk alert also encourages advisers to consider those best practices and lessons learned that were described in the Joint Review of Business Continuity and Disaster Recovery of Firms by the Commission’s National Examination Program, the Commodity Futures Trading Commission’s Division of Swap Dealers and Intermediary Oversight and the Financial Industry Regulatory Authority on August 16, 2013.  They are  available at http://www.sec.gov/about/offices/ocie/jointobservations-bcps08072013.pdf

While the alert serves as a friendly reminder, to avoid a potential enforcement action, the advice covered should be reviewed, and where appropriate, implemented.  The days of  preparing a boilerplate disaster recovery handbook to be left to collect dust on an adviser’s bookshelf have long passed.

FORM 13F: FILINGS DUE AUGUST 15

 

The August 15 deadline for investment advisers to make Form 13F filings to report equity security securities holdings of their managed accounts is approaching.  Form 13F must be filed within 45 days of the end of a calendar quarter.

As required by Section 13(f) of the Securities Exchange Act of 1934, and rule 13f-1, Institutional investment managers ( which includes investment advisers)  must file Form 13F with the SEC if they exercise investment discretion for accounts holding Section 13(f) securities.  Section 13(f) securities are defined in the rules as securities having an aggregate fair market vaule of at least $100 million on the last trading day of any month of any calendar year. 

What types of securities are Section 13F securities? The SEC has said that “[s]ection 13(f) securities generally include equity securities that trade on an exchange (including the Nasdaq National Market System), certain equity options and warrants, shares of closed-end investment companies, and certain convertible debt securities.  The shares of open-end investment companies (i.e., mutual funds) are not Section 13(f) securities.”  Advisers can find Section 13(f) securities on the Official List of Section 13(f) Securities.  An updated list of 13(f) securities is published on a quarterly basis.

Advisers can also find valuable information about the filing’s requirements in the Frequently Asked Questions About Form 13F.   

Deadline: Financial Statement Distribution for Funds of Hedge Funds

Calendar on desk - June 30thAdvisers to funds of funds who maintain custody of clients funds as defined in Investment Advisers Act Rule 206(4)-2, and whose fiscal year ends December 31,  have a deadline looming.   The deadline is June 30 (180 days of the end of their fiscal year) for distributing to fund investors audited financial statement prepared in accordance with GAAP to fund investors  is approaching.

Normally, for advisers to other pooled investment vehicles, including  limited partnerships and limited liability companies, the deadline for distributing annual audited financial statements  is within 120 days of the end of their fiscal year.  The SEC extended the deadline from 120 days to 180 days for funds of  hedge funds because the earlier deadline made it hard for some fund of hedge funds to timely complete their fund audits prior to audits being completed for the underlying funds in which they invested.

 

Regulation S-ID: New Rules For Identity Theft

From Section 1088 of the Dodd-Frank Act comes final rules and guidelines from the SEC that would require entities covered by the rules to establish programs aimed at detecting, preventing, and mitigating identity theft.  Previously, Dodd-Frank required the SEC and the U.S. Commodity Futures Trading Commission (“CFTC”) to adopt joint rules requiring entities that are subject to these agencies’ respective enforcement authorities to address identity theft.

Regulation S-ID  is an expansion of  the initial requirements of  amendments in 2003 to the Fair Credit Reporting Act.  Those amendments  required federal agencies deemed “financial institutions,”  or “creditors” to issue joint rules and regulations regarding identity theft.  The rules were enacted in 2007.  At the time, neither the SEC nor the CFTC adopted the identity theft rules because the laws did not authorize either agency to do so.  Instead, entities that the SEC and CFTC regulate such as broker-dealers and futures commission merchants were covered by the rules of other agencies.  Even though the SEC was not one of the included agencies, many of its regulated entities were likely to have already been subject to similar rules enacted earlier by those other agencies, as a result of activities that cause these entities to qualify as “financial institutions” or “creditors.”

The SEC  rules are similar to those that other agencies adopted in 2007.  The SEC and CFTC rules include guidance to help firms determine how to comply with the new rules.  The SEC’s identity theft rules would apply to broker-dealers, investment companies, and investment advisers.  The CFTC’s rules would apply to entities such as futures commodity merchants, commodity trading advisors, and commodity pool operators.

The final rules note that Rule S-ID will become effective 30 days after its publication in the Federal Register.  The compliance date for the final rules will be six months after their effective date.

 

The SEC’s “Presence Exams” letter to Private Fund Advisers

As part of its National Exam Program, the SEC’s Office of Compliance and Examinations (“OCIE”) has just mailed a letter to senior executives and Chief Compliance Officers of newly-registered investment advisers apprising them of what practices they can expect to be examined.  

While the letter primarily concerns risk-based exams of advisers to private funds that registered with the SEC after July 21, 2011, the significance the OCIE examination staff is attaching to certain adviser practices in these so-called “Presence Exams” should be weighed by all advisers regardless  – whether they’re new or a private fund.  As we have discussed these and other areas of exam focus in previous posts, OCIE’s hot areas referenced, and set for review, include:

  1. Marketing materials;
  2. Portfolio management;
  3. Conflicts of interest;
  4. Safety of Client Assets; and
  5. Valuation of Client holdings and assessment of fees based on valuations.

Through the SEC’s lens, each of these topics is being viewed in three phases: engagement; examination; and reporting.  

 

Hedge Funds Should Heed SEC’s Latest Investor Bulletin

Add a few recent SEC actions against hedge funds that include a hedge fund manager running a $37 million Ponzi scheme; a former director in a compensation scheme that netted hundreds of thousands of dollars in undisclosed income; co-founders of a Chicago-area investment firm misleading investors and supervisory failures resulting in penalties of more than $1 million; a private fund manager and his investment advisory firm taking more than $17 million in losses in a Ponzi-like scheme.

And now add to that two even more recent cases: a hedge fund manager over the course of several years invest the majority of a fund’s assets in a private business owned by the manager’s affiliated company; and a manager who used his hedge fund as a ruse to misappropriate over $550,000 from a retired schoolteacher, and you get the math of why SEC hedge fund oversight will continue to intensify.  Given many of the enforcement actions in the past two years are the result of  fairly egregous conduct, the SEC Office of Investor Education and Advocacy’s most recent  Investor Bulletin is still  instructive, not simply for investors, but also, for the hedge funds who serve them.

The bulletin warns investors about continued hedge fund-related misconduct in the markets while mentioning these cases as examples of why investors need to take precaution before making hedge fund investments.  While there’s nothing surprising about precautions and recommendations that include

  •  a need for investors to understand a hedge fund’s investment strategy and its use of leverage and speculative techniques before making the investment;
  • a need for investors to evaluate a hedge fund manager’s potential conflicts of interest and take other steps to research those managing the fund;

the bulletin highlights the need for registered advisers to hedge funds to pay particular attention to conflicts of interest when making investment decisions, particularly when determining how investment opportunities are allocated.  Advisers also have to be wary about engaging in principal transactions when managing hedge funds — for example, engaging in rebalancing or other types of cross trades.  Among others, they should concern themselves with the valuations assigned to particular securities, and calculations of  all fees and other income sources. 

For hedge fund advisers, these bulletins, whose primary aim is educating the investing public, are another way to take a deeper look for potential conflicts that may lead to violations and to understand the emphasis SEC examiners and regulators will place on such conflicts.

A Resolution for Advisers and CCOs: The (New Year’s) Annual Review

It’s a New Year!  And for advisers it’s again time for a new year’s resolution, only this kind of resolution is not voluntary.  Like holidays, it comes once a year, and while the responsibility for it falls on the adviser, the obligation to “administer” (or the commitment to follow our new year’s theme) falls on the Chief Compliance Officer – it’s called the Annual Compliance Review.  Further, consider it the type of resolution made mandatory by Rule 206-4(7) of the Investment Advisers Act of 1940 known as the “Compliance Rule.”

This new year’s “resolution” requires advisers and their CCOs not simply to resolve that they will do better with compliance than last year, but requires them actually to adopt and implement written policies and procedures reasonably designed to prevent a violation of the federal securities laws, and to evaluate their adequacy and effectiveness.

With this in mind, as CCO what have you resolved to do this year?  As the SEC’s Final Rule  clearly mandated, will your annual review of 2011, at a minimum,  address the adequacy of your policies and procedures in the following areas:

  • Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with clients’ investment objectives, disclosures by the adviser, and applicable regulatory restrictions;
  • Trading practices, including procedures by which the adviser satisfies its best execution obligation, uses client brokerage to obtain research and other services (“soft dollar arrangements”), and allocates aggregated trades among clients;
  • Proprietary trading of the adviser and personal trading activities of supervised persons;
  • The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements;
  • Safeguarding of client assets from conversion or inappropriate use by advisory personnel;
  • The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
  • Marketing advisory services, including the use of solicitors;
  • Processes to value client holdings and assess fees based on those valuations;
  • Safeguards for the privacy protection of client records and information; and
  • Business continuity plans.

After considering those questions, among others, will advisers resolve in the new year to test 2011 to determine whether they have (i) met regulatory deadlines? (ii) conducted a risk assessment to determine any unique compliance risk exposure to its business?(iii) determined whether compliance procedures needed to be changed to better reflect the adviser’s business practices? (Obsolete procedures or programs that the firm cannot follow should be repealed) (iv) conducted adequate transactional, forensic or periodic tests of its procedures and programs in the areas mentioned in the Final Rule? (In both speeches and its own seminars, the SEC has made clear the importance of proper testing); and (v) adequately documented the annual review?  The SEC examination staff will ask advisers for documentation of their annual compliance review.  Further, Investment Advisers Act Rule 204-2(17)(ii) and Investment Company Act Rule 38a-1(d)(3) to preserve records documenting the annual review.

When looking back on your annual compliance review for 2011, what resolutions/changes or enhancements will you be making?