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Investment Management Legal and Regulatory Update - April 2011

April 18, 2011

12b-1 Reform Deferred Again

An SEC spokesperson has indicated that the SEC will likely not take up the issue of Rule 12b-1 fee reform until the second half of 2011 and potentially 2012. Although the SEC has not issued official guidance on timing, this estimate was quoted in several news reports. The SEC has indicated that significant funding increases will be necessary to execute mandates under the Dodd-Frank Act, however, the recently-approved 2011 budget provides only a modest increase, which could result in the SEC triaging resources and postponing action on certain issues, including Rule 12b-1 fees.

Source: Joe Morris, 12b-1 Reform Dead Till Second Half, Ignites (Apr. 8, 2011).

SEC Publishes FAQs About Form ADV Part 2 and the Pay To Play Rule

The SEC's Division of Investment Management recently issued staff responses to questions about Part 2 of Form ADV and Rule 206(4)-5 under the Advisers Act (the "pay to play rule"). The responses to FAQs for Part 2 of Form ADV address topics including compliance dates and preparation, filing and delivery of brochures. The pay to play responses cover topics including compliance dates and interpretations of key definitions in the rule, such as the definition of a covered associate, which was flagged by the ICI as a term requiring additional clarification. The FAQs are available at the following links:

SEC Staff Responses to Questions About Part 2 of Form ADV (updated as of Mar. 18, 2011), available at:

SEC Staff Responses to Questions About the Pay to Play Rule (updated as of Mar. 22, 2011), available at:

SEC Expects to Extend Private Fund Adviser Registration Deadline

The SEC expects to extend the registration deadline for investment advisers to private funds until the first quarter of 2012. SEC staff have indicated that the SEC will finalize rules relating to the exemptions from private fund adviser registration (e.g., family office advisers, venture capital advisers and foreign advisers) by July 21, 2011, which was the original deadline for registration and the effective date for the private fund adviser amendments set by the Dodd-Frank Act.

Sources: SEC Staff Correspondence to the North American Securities Administrators Association, Inc. (Apr. 8, 2011); Godfrey & Kahn Investment Management Legal and Regulatory Update (Jan. 2011).

New Reporting Rules Proposed for Private Fund Advisers on Form PF

The SEC and CFTC jointly proposed rules requiring certain private fund advisers to periodically report systemic risk information to the SEC on new Form PF for use by the Financial Stability Oversight Council (FSOC) established by the Dodd-Frank Act.

Who Must File Form PF. Private fund advisers, defined as SEC-registered investment advisers who advise one or more private funds, as well as commodity pool operators (CPOs) and commodity trading advisors (CTAs) who are also registered as investment advisers with the SEC and advise a private fund, would be required to file Form PF with the SEC. A private fund is proposed to be defined as any issuer relying on the exemptions under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act.

An investment adviser that is exempt from registration under the Advisers Act, including advisers solely to venture capital funds and advisers to private funds that have less than $150 million in assets under management (AUM), would not be required to file Form PF. However, such exempt reporting advisers would be subject to separate information reporting requirements on Form ADV.

Information to be Disclosed on Form PF. The proposed rules include definitions that categorize certain private funds as either hedge funds, liquidity funds (i.e., private "money market" funds) or private equity funds, and the type of information required varies by the type and size of the funds.

Smaller private fund advisers would report only basic information regarding the private funds they advise. This would include information regarding leverage, credit providers, investor concentration and fund performance. Smaller advisers managing hedge funds would also report information about fund strategy, counterparty credit risk and use of trading and clearing mechanisms.

Large Private Fund Advisers. Private fund advisers of hedge funds, liquidity funds or private equity funds that hold at least $1 billion in AUM (defined as large private fund advisers) are required to provide more information on Form PF regarding those funds than smaller private fund advisers. The focus of the reporting would depend on the type of private fund that the adviser manages. The requested additional disclosure could potentially be onerous. For example, large private fund advisers to hedge funds would be required to disclose the market value of assets invested (on a short and long basis) in different types of securities and commodities and information regarding portfolio liquidity, while large private fund advisers to private equity funds would be required to disclose the weighted average debt to equity ratio of controlled portfolio companies and the range of the debt to equity ratio among the portfolio companies.

To determine if the $1 billion AUM threshold for any of the fund types has been met for purposes of the adviser's Form PF, the proposed rules would require the private fund adviser to aggregate (1) the assets of the private fund or funds of that type (and, in the case of liquidity funds, the assets of any registered money market funds managed), (2) the assets of managed accounts advised by the firm that pursue substantially the same investment objective and strategy and invest in substantially the same positions as the private funds and (3) the assets of that type of private fund advised by any of the adviser's related persons.

Confidentiality of Information Disclosed on Form PF. Proposed Form PF is designed to collect non-public information to assist the FSOC in monitoring and assessing systemic risk. Unlike Form ADV, the information disclosed on Form PF will generally remain confidential. However, the SEC will make Form PF information available to the FSOC, subject to the confidentiality provisions of the Dodd-Frank Act, and the SEC may use Form PF information in enforcement actions.

Frequency of Reporting. The proposed rules would require that private fund advisers complete Form PF on an annual basis, with annual updates due no later than the deadline for the private fund adviser to file its annual updating amendment to Form ADV. Large private fund advisers would be required to file Form PF quarterly, within 15 days of the end of each calendar quarter.

The proposed rules are expected to have a compliance date of December 15, 2011. Accordingly, private fund advisers would be required to make initial annual filings 90 days after the end of their first fiscal year occurring on or after December 15, 2011 (e.g., a small private fund adviser with a December 31 fiscal year end would file its first Form PF by March 31, 2012). Large private fund advisers would need to make their initial quarterly Form PF filing by January 15, 2012.

Sources: SEC and CFTC Joint Proposed Rules, Release No. IA-3145 (Jan. 26, 2011); SEC Press Release No. 2011-23, SEC Proposes Private Fund Systemic Risk Reporting Rule (Jan. 25, 2011).

Comment Period Ended: April 12, 2011

Proposed Amendments to Exemptions Under Commodity Exchange Act May Affect Mutual Funds

The CFTC has proposed amendments to the rules regarding CPOs and CTAs. The proposed amendments to Rule 4.5 would reinstate, with respect to registered investment companies, pre-2003 provisions that limited the level of speculative futures trading and prohibited funds from marketing themselves as futures trading vehicles. Practitioners and the mutual fund industry generally have expressed concern that the proposed changes to Rule 4.5 would essentially cause mutual funds with exposure to commodities to have to comply with the CFTC's regulatory regime and disclosure requirements, which may be different from and inconsistent with SEC requirements.

The changes under the proposed amendments also include the following:

  • rescinding the exemptions from CPO registration provided by CFTC Rules 4.13(a)(3) and (4), which are relied on by many private fund sponsors;
  • requiring annual reports for Rule 4.7 funds to be audited;
  • requiring annual confirmation of notices of claims of exemption; and
  • requiring a new risk disclosure statement regarding swap transactions.

Proposed Amendments to Rule 4.5 Exclusion. Many registered investment companies currently rely on the Rule 4.5 exclusion from CPO registration, which now only requires a one-time filing with the CFTC and notice in a fund's SAI. Under the proposed rules, substantive restrictions would be reimposed, such that the investment company's use of commodity futures and options will be limited to (1) bona fide hedging transactions and (2) speculative futures positions held only by a qualifying entity, provided that the futures margin and option premiums for such speculative positions will not exceed 5% of the liquidation value of the fund's portfolio. The language that the speculative futures positions may be held only by a qualifying entity would appear to permit only the entity that files for exemptive relief to rely on the exemption and not, for example, a separate special purpose entity created to hold positions for tax purposes, unless such entity independently satisfies Rule 4.5's requirements.

In addition, a fund intending to rely on the Rule 4.5 exclusion must not market itself to the public as a commodity pool or as a vehicle for trading in (or otherwise seeking investment exposure to) the commodity futures or commodity option markets.

Rescission of CPO Registration Exemptions. The CFTC proposed to repeal Rules 4.13(a)(3) and (4), which provide an exemption from CPO registration for operators of commodity pools that have de minimis futures activity, and for operators of commodity pools that restrict participation to certain sophisticated investors, so long as certain conditions are satisfied. Because many sponsors of private funds rely on one of the Rule 4.13(a) exemptions, unless other exemptions are available, such sponsors may be required to register with the CFTC as CPOs.

Annual Filings for Claims of Exemptions. Under the CFTC's proposed amendments, all persons claiming exclusionary or exemptive relief from CPO registration (including under Rules 4.5 and 4.13) would be required to file a notice on an annual basis.

Sources: CFTC Fact Sheet and Q&A - Proposed Rules on Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors; and Amendments to Compliance Obligations of Commodity Pool Operators and Commodity Trading Advisors (Jan. 26, 2011); 76 Fed. Reg. 7976 (Feb. 11, 2011); Peter Ortiz, Industry Reacts to Proposal to Toughen Commodities Regs, Ignites (Feb. 1, 2011).

Comment Period Ended: April 12, 2011

SEC Proposes Net Worth Standard for Accredited Investors

The SEC proposed amendments to the net worth standard for accredited investors in various federal securities rules, including Regulation D, as set forth in the Dodd-Frank Act. The Dodd-Frank Act requires SEC rules to exclude the value of an individual's primary residence in calculating whether an individual (either alone or together with his or her spouse) has a net worth that exceeds $1 million when determining accredited investor status.

The amendments clarify that "net worth" means the excess of total assets at fair market value over total liabilities. This net worth calculation must exclude the value of the person's primary residence. The related amount of indebtedness (e.g., mortgage) on the person's primary residence up to its fair market value need not be included as a liability in the "net worth" calculation; however, any indebtedness on the primary residence in excess of its fair market value must be included as a liability in the calculation.

The new net worth standard will remain in effect until July 21, 2014. The SEC may revise other aspects of the accredited investor definition in future rulemaking. Beginning in 2014, the SEC will be required to review the threshold requirements to qualify as an accredited investor every four years.

Sources: SEC Rel. No. 33-9177 (Jan. 25, 2011); SEC Press Release No. 2011-24, SEC Proposes Net Worth Standard for Accredited Investors Under Dodd-Frank Act (Jan. 25, 2011).

Comment Period Ended: March 11, 2011

SEC Issues Study Regarding Enhancing Investment Adviser Examinations

The SEC's Division of Investment Management released a study required by the Dodd-Frank Act that reviews and analyzes the need for enhanced examination and enforcement resources for investment advisers. The study findings include the following:

  • the number and frequency of examinations has declined over the past six years due to combined effects of fewer SEC examiners and growth in the number of SEC registered advisers and assets managed by such advisers; and
  • although the number of advisers registered with the SEC is expected to decrease near term due to the higher threshold of the Dodd-Frank Act, over the longer term, the number of SEC registered advisers is expected to increase.

The study proposes several alternatives to address the expected strain on SEC resources and to augment the SEC's efforts to oversee advisers. The staff recommendations include charging advisers "user" fees to cover examination costs, authorizing a new investment adviser SRO to assist with examinations and authorizing FINRA to conduct examinations for investments advisers it already oversees.

Sources: Study on Enhancing Investment Adviser Examinations by the Staff of the Division of Investment Management of the SEC (Jan. 2011); Godfrey & Kahn Investment Management Legal and Regulatory Update (Jan. 2011).

SEC Proposes Rules Regarding References to Credit Ratings for Investment Companies

The SEC proposed rules to remove references to credit ratings issued by nationally recognized statistical ratings organizations (NRSROs) in Rules 2a-7 and 5b-3 under the Investment Company Act and Forms N-1A, N-2, N-3 and N-MFP under the Investment Company Act and the Securities Act. The Dodd-Frank Act directed the SEC to review its regulations for references to NRSRO credit ratings in situations that required the use of an assessment of the creditworthiness of a security or money market instrument, and replace those credit-rating references with other standards of creditworthiness that the SEC determined to be appropriate. "The focus of these efforts is to eliminate over-reliance on credit ratings by both regulators and investors, and to encourage an independent assessment of creditworthiness," said SEC Chairman Mary L. Schapiro.

Based on its review, the SEC proposed to remove the references to credit ratings in Rule 2a-7 governing money market funds and Rule 5b-3 relating to securities collateralizing repurchase agreements and replace them with alternative standards of creditworthiness. The proposed changes to Rule 2a-7 are addressed in further detail below.

Proposed Changes for Money Market Funds. The proposed removal of references to credit ratings by NRSROs in Rule 2a-7 would affect five elements of the rule, including:

  • whether a security is an eligible security; and
  • whether a security is a first tier security.

The current objective standard provided by credit ratings in the definitions of eligible security and first tier security would be replaced by a subjective determination. Under the proposed amendment to Rule 2a-7, a money market fund's board of directors (or the fund's adviser as its delegate) would be required to:

  • first, assess the credit quality of the security and determine that it presents minimal credit risks and therefore is an eligible security; and
  • second, determine whether the portfolio security is a first tier or second tier security.

A security would be first tier only if the board or the adviser determines that the security's issuer has the highest capacity to meet its short term financial obligations. A security would be second tier if the board or the adviser determines that the security presents minimal credit risks, even if it is not a first tier security. Similar to the current rule, under amended Rule 2a-7 a money market fund would be required to invest at least 97% of its assets in first tier securities.

Amended Rule 2a-7 would also require that if the money market fund's board becomes aware of any credible information about a portfolio security or an issuer of a portfolio security that suggests that the security is no longer a first tier or second tier security, the board will have to reassess promptly whether the portfolio security continues to present minimal credit risks. This change would remove the current objective standard under Rule 2a-7 that requires reassessment of a security that has been downgraded by an NRSRO. The board would be required to exercise reasonable diligence to stay up-to-date on new information about portfolio securities. This level of diligence has likely already been exercised by advisers under the current Rule 2a-7 requirement that portfolio investments be limited to securities that the board determines present minimal credit risk.

Sources: SEC Proposed Rule, Release No. 33-9193 (Mar. 3, 2011); SEC Press Release No. 2011-59, SEC Proposes Rule Amendments to Remove Credit Rating References in Investment Company Rules and Forms (Mar. 3, 2011).

Comments Due: April 25, 2011

SEC Proposes Rules on Registration of Security-Based Swap Execution Facilities

The SEC has proposed Regulation SB SEF, which sets forth rules to govern the creation, registration and operation of security-based swap execution facilities (SB SEFs) under the Dodd-Frank Act.

The Dodd-Frank Act established a framework for regulating the over-the-counter swaps markets and divided regulatory authority between the SEC and the CFTC. The SEC was authorized under the Dodd-Frank Act to regulate security-based swaps, which are derivative contracts broadly defined as swaps based on (1) a single security, (2) a loan, (3) a narrow-based group or index of securities or (4) events related to a single issuer or issuers of securities in a narrow-based security index, and include credit default swaps. The Dodd-Frank Act defined an SB SEF as a trading system or platform in which multiple participants have the ability to execute or trade security-based swaps by accepting bids and offers made by multiple participants in the facility or system.

Proposed Regulation SB SEF would:

  • interpret the definition of a SB SEF as set forth in the Dodd-Frank Act;
  • set out the registration requirements for SB SEFs;
  • implement the 14 core principles for SB SEFs outlined in the Dodd-Frank Act, including monitoring of trade processing, timely publication of trading information and the avoidance of conflict of interests; and
  • establish the process for SB SEFs to file rule changes and establish new products with the SEC.

Sources: SEC Proposed Rule, Release No. 34-63825 (Feb. 2, 2011); SEC Press Release No. 2011-35, SEC Proposes Rules for Security-Based Swap Execution Facilities (Feb. 2, 2011).

Comment Period Ended: April 4, 2011

MSRB Proposes Rules Regarding Municipal Advisor Fiduciary Duty, Guidance Regarding Fair Dealing Obligations and Municipal Advisor Gifts and Gratuities

The MSRB proposed Rule G-36 to implement the federal fiduciary duty standard applicable to municipal advisors under the Dodd-Frank Act. The MSRB also proposed guidance to municipal advisors on their fair dealing obligations under existing Rule G-17. In addition, the MSRB proposed an amendment to extend the limitations of Rule G-20 (gifts and gratuities) to municipal advisors.

Fiduciary Duty. Proposed Rule G-36 would require municipal advisors to act in accordance with their fiduciary duties to municipal entities, which include a duty of loyalty and a duty of care. Municipal advisors must act in good faith and in the best interests of a municipal entity, to provide written disclosure of possible conflicts of interests and to receive written consent to any such conflicts. In addition, the MSRB would require municipal advisors to provide their services in a competent manner, to consider alternative financing options and to conduct a reasonable inquiry into a municipal entity's financial circumstances before providing advisory services.

Fair Dealing. The MSRB proposed guidance to municipal advisors regarding their fair dealing obligations under Rule G-17. The fair dealing obligations would apply when municipal advisors providing advice to obligated persons (defined as any person, including an issuer of municipal securities, who is either generally or through an enterprise, fund, or account, committed by contract or other arrangement to support the payment of all or part of the obligations on the municipal securities to be sold in an offering of municipal securities) or solicit business from municipal entities. Although the Dodd-Frank Act does not impose a fiduciary duty on municipal advisors in their solicitation of municipal entities on behalf of third parties, the guidance indicates that such activities are covered by Rule G-17's fair dealing provisions.

Gifts and Gratuities. Municipal advisors would become subject to existing restrictions on personal gifts or gratuities. Amended Rule G-20 would prohibit municipal advisors from giving, directly or indirectly, any thing or service of value over $100 to a person other than an employee or partner of the municipal advisor, if such payments or services are in relation to the municipal advisor's municipal advisory activities. Occasional gifts of meals or tickets to certain events hosted by the municipal advisor and attendance at legitimate business functions sponsored by the municipal advisor would be permitted.

Sources: MSRB Notices 2011-14 and 2011-13 (Feb. 14, 2011); MSRB Press Release, MSRB Requests Comment on Draft Municipal Advisor Fiduciary Duty Rule and Fair Dealing Obligations (Feb. 14, 2011); MSRB Notice 2011-16 (Feb. 22, 2011); MSRB Press Release, MSRB Requests Comment on Municipal Advisor Gifts and Gratuities Rule (Feb. 22, 2011).

Comment Period Ended:
Fiduciary Duty and Fair Dealing Proposals:
April 11, 2011
Gifts and Gratuities Rule: April 5, 2011

SEC Settles Enforcement Action with Adviser on IPO Allocations

On February 7, 2011, the SEC settled an enforcement action against Alpine Woods Capital Investors and its CEO for violations involving IPO allocations and deficiencies related to the investment adviser's compliance program.

The SEC's action against Alpine related to a period when Alpine disproportionately allocated IPOs to its two smallest, most recently-opened funds (the Funds), compared to its other larger, existing funds. The SEC found that Alpine did not adequately follow its own compliance policies and procedures in connection with IPO allocations.

IPO trading materially contributed to the positive performance of the Funds. Although mutual funds are required to discuss the factors that materially affect fund performance in their annual shareholder reports, Alpine presented the returns of the Funds in their reports without disclosing the impact of the IPO trading. The Funds' disclosure documents also failed to disclose the IPO trading and did not discuss the risks associated with short-term IPO trading, including the risks that the returns might not be sustained because of a lack of available IPOs and that the impact of short-term IPO trading on the Funds' performance could lessen if the Funds experienced significant growth in AUM.

The settlement order emphasized that the failures in allocation procedures and disclosure were the result of an underfunded compliance program. Despite the firm's growth in AUM, the SEC found that Alpine and its CEO did not increase the compliance resources and staff necessary to support its policies and procedures (and did not respond to requests from the CCO for additional resources in a timely manner). In addition, similar to other small investment advisers, Alpine's CCO filled three full time executive roles (CCO, CFO and chief administrative officer) and had little staff support.

Investment advisers may consider revisiting their IPO allocation policies and procedures as well as overall compliance resources in light of the size and complexity of the firm's business.

Sources: Beagan Wilcox Volz, Firm Catches SEC Heat for IPO Allocation to Funds, Ignites (Feb. 9, 2011); Securities Act Release No. 9182, Order In the Matter of Alpine Woods Capital Investors, LLC and Samuel A. Lieber (Feb. 7, 2011).


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