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.

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.

 

With New SEC Unit and Data Mining, Advisers Face Closer Scrutiny in 2012

With a renewed focus on analytics and more readily available data, expect the SEC’s scrutiny of investment advisers, including advisers to mutual funds, hedge funds, and private equity funds, to get  tougher.

In December, in a speech before the Consumer Federation of America’s Financial Services Conference, the SEC’s Director of Enforcement, Robert Khuzami, once again emphasized many of the organizational and structural changes that have already occurred and that will continue to impact the way investment advisers and mutual funds will be watched and regulated going forward.  Moreover, advisers may begin to feel the heat from these changes in a deeper, and for their investment adviser reps, and more personal way.  With changes to its organizational structure, the SEC created the Asset Management Specialized Unit to evaluate data and risk-based analytics.  One of the investigative practices the unit is implementing involves adopting a kind of early-warning framework to detect what Khuzami says is the kind of “retail fraud” that may foreshadow more serious problems within assets management and mutual funds.    

Utilizing a retail approach, what might the SEC’s enforcement division be looking at for potential signs of fraud?  Khuzami gives a few examples.  One involves the SEC scouring an adviser’s Form ADV to determine if they’ve lied about their educational achievements, their business affiliations, and their assets under management.  “For us, it’s advisers who lie about graduating Phi Beta Kappa, conceal their association in a past failed business venture, or inflate their assets under management who might well be the same persons who outright steal your money when the markets turn against them,” says Khuzami.

A second approach, for mutual funds, might involve the SEC reviewing databases in an effort to identify poor performance, when at the same time, the fund has relatively high fee arrangements, for them and their sub-advisers.  This, Khuzami says, may suggest excessive fee arrangements that can eat away at the mutual fund investment returns.  See More……

 

Effective July 21, 2011, Advisers to Hedge Funds and Private Equity Funds Face Registration

Under Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act, effective July 21, 2011, changes to the registration and reporting and recordkeeping requirements of the Investment Advisers Act of 1940 require advisers to private funds (hedge funds and private equity funds) to register with the SEC. In the past, many of these advisers relied on the so-called “private adviser” exemption to avoid registration. Under Section 403 of the Dodd-Frank Act, now some of these same advisers that exclusively advise venture capital funds and private fund advisers with less than $150 million in assets under management in the United States, face narrower exemptions for adviser registration. However, foreign private advisers and advisers to licensed small business investment companies are exempted.

Under the Dodd-Frank Act, the SEC will also have the authority to collect data from investment advisers about their private funds for the purposes of the assessment of systemic risk by the Financial Stability Oversight Council. Finally, the Dodd-Frank Act modifies the allocation of regulatory responsibility for mid-sized advisers between state regulators and the SEC. View More…