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Investment Management Legal and Regulatory Update - January 2012

January 11, 2012

Upcoming Form ADV Filing Deadlines Under Dodd-Frank Act
By March 30, 2012, each SEC-registered investment adviser must file an amendment to its Form ADV to disclose its eligibility to remain registered with the SEC or switch to state registration. An SEC-registered adviser no longer eligible to be registered with the SEC must file a Form ADV-W to withdraw from SEC registration no later than June 28, 2012. In addition, exempt reporting advisers (i.e., certain advisers to venture funds and private funds) must file their initial reports on Form ADV with the SEC no later than March 30, 2012.

Affected Advisers. Previously, investment advisers with assets under management (AUM) of at least $25 million were required to register with the SEC. The Dodd-Frank Act changed that threshold and created a mid-sized adviser category, which requires investment advisers with AUM between $25 million and $100 million to register in the state in which they maintain their principal office and place of business. However, a mid-sized adviser must register with the SEC if the adviser:

  • is not required to be registered as an investment adviser in the state in which it maintains its principal office and place of business;
  • is registered in a state that does not conduct examinations of its investment advisers; or
  • advises a registered investment company or business development company.

Furthermore, a mid-sized adviser that must file in more than 15 states may instead register with the SEC.

The SEC has established a "buffer" on the AUM cutoff for AUM between $90 million and $110 million. Advisers must reach an AUM of $100 million to be eligible to register with the SEC and must register with the SEC if their AUM is more than $110 million. Once they have registered with the SEC, advisers may remain registered with the SEC so long as their AUM remains at or above $90 million. Therefore, advisers currently registered with the SEC may remain registered with the SEC if their AUM remains at $90 million or more.

How to Switch. Mid-sized advisers that currently are registered with the SEC should register with the appropriate state before withdrawing their SEC registration. We recommend that advisers start this process as soon as possible.

In order to register with one or more states, an adviser must prepare a new Form ADV filing through the IARD and pay any applicable fees. The adviser should complete Parts 1A and 1B online, checking all of the states in which it must register. Also, the adviser must file Form ADV Part 2, including the Part 2A firm brochure and Part 2B brochure supplement through the IARD.

An adviser seeking to register in Wisconsin must also submit to the Wisconsin Department of Financial Institutions (WDFI) the additional forms contained in the Wisconsin Investment Adviser Registration Packet, including a completed investment advisory questionnaire, a copy of the adviser's investment advisory contract(s), a designation of supervisor form, a financial certification form and a list of branch offices.

After filing Form ADV and state-required documents, advisers required to register in four to 14 states may sign up for coordinated review on the NASAA website ( Through coordinated review, the states in which the adviser must register discuss the adviser's application and, as a group, strive to come to a consensus on comments to the adviser's application. While NASAA does not charge advisers for this service, it also does not guarantee that the states will reply with uniform comments.

Wisconsin-Specific Requirements. Investment advisers in Wisconsin switching to state registration will be subject to the following requirements under Wisconsin law:

  • WDFI intends to conduct on-site examinations of each switching adviser within 12 months of its registration date, and once every three years thereafter;
  • All advisory contracts must be in writing and the adviser must send a copy of the advisory contract to the client within 20 days of execution;
  • Copies of civil suits and arbitrations involving the adviser must be filed with the WDFI within 20 days of receipt;
  • Advisers that use direct fee deduction must prepare an invoice for the client with details of the fee calculation;
  • Performance-based fees are only permitted with designated institutional investors; and
  • Advisers deemed to have custody must maintain a $35,000 net worth unless they qualify for an exemption.

Sources: Wisconsin Uniform Securities Laws; Wisconsin Department of Financial Institutions Securities Laws; Wisconsin Department of Financial Institutions Investment Adviser Guide; North American Securities Administration Association.

New Reporting Rules for Private Fund Advisers on Form PF
The SEC and the CFTC adopted final rules that require certain private fund advisers to file reports on new Form PF for use by the Financial Stability Oversight Council (FSOC) beginning in 2012 for large advisers and in 2013 for smaller advisers.
Who Must File Form PF. Advisers that (i) are registered with the SEC, (ii) advise one or more private funds and (iii) have at least $150 million in private fund AUM must file Form PF with the SEC. A private fund is defined as any issuer relying on the registration exemptions under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.

Note that the SEC modified the conditions under which an adviser must file Form PF by adding a minimum reporting threshold of $150 million in private fund AUM. Under the proposed rule, all private fund advisers registered with the SEC would have been required to file Form PF.

Investment advisers that are exempt from registration under the Advisers Act, including advisers solely to venture capital funds and advisers solely to private funds that have less than $150 million in regulatory AUM, are not required to file Form PF. However, such exempt reporting advisers are subject to separate information reporting requirements on Form ADV.

Large Private Fund Advisers. Private fund advisers are divided by size into two broad groups - large advisers and smaller advisers. Large private fund advisers are advisers with (i) at least $1.5 billion in hedge fund AUM (large hedge fund advisers), (ii) at least $1 billion in liquidity fund (a private fund that invests in short-term obligations to maintain stability) and registered money market fund AUM (large liquidity fund advisers) or (iii) at least $2 billion in private equity fund AUM (large private equity fund advisers). Smaller advisers are any advisers that do not meet any of the definitions of a large adviser. Large private fund advisers are further subdivided by the type of funds they manage: hedge funds, liquidity funds and private equity funds. The amount of information reported and the frequency of reporting depends on the group to which the adviser belongs.

Aggregation of AUM. To determine whether the adviser meets the $150 million minimum reporting threshold or is a large private fund adviser, the adviser must aggregate (i) the assets of managed accounts that pursue substantially the same investment objective and strategy and invest in substantially the same positions as the private funds (parallel managed accounts) and (ii) the assets of private funds advised by any of the adviser's related persons (other than related persons that are separately operated). An adviser may exclude parallel managed accounts if the value of those accounts is greater than the value of its private funds.

Information to be Disclosed on Form PF. Each adviser required to file Form PF must complete all or part of Section 1, including identifying information about the adviser and its private funds and each private fund's gross and net assets, performance, types of investors, liquidity and borrowing. Advisers to hedge funds must also report information about fund strategy, counterparty credit risk, and the use of trading and clearing mechanisms. A large hedge fund adviser must complete Section 2 of Form PF, including disclosing information regarding exposure by asset class, geographical concentration and portfolio turnover for their hedge funds, as well as various risk information for each hedge fund. A large liquidity fund adviser must complete Section 3, including disclosing information about each fund's assets, portfolio valuation, liquidity of its holdings, risk profile and investor base. Finally, a large private equity fund adviser must disclose in Section 4 of Form PF information for each private equity fund it advises, such as whether a fund controls a portfolio company and details about such investments.

Confidentiality of Information Disclosed on Form PF. Unlike Form ADV, the information disclosed in Form PF generally will 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. Smaller private fund advisers and large private equity fund advisers must complete and file Form PF on an annual basis, within 120 days after the end of each fiscal year. Large hedge fund advisers and large liquidity fund advisers must file Form PF on a quarterly basis, within 60 days and 15 days, respectively, after the end of each fiscal quarter.

Compliance Dates. Most private fund advisers will be required to begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, on or after December 15, 2012.

However, the following advisers must begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, on or after June 15, 2012:

  • Advisers with at least $5 billion in AUM attributable to hedge funds.
  • Liquidity fund advisers with at least $5 billion in combined AUM attributable to liquidity funds and registered money market funds.
  • Advisers with at least $5 billion in AUM attributable to private equity funds.

Sources: SEC and CFTC Joint Final Rules, Release No. IA-3308 (Oct. 31, 2011); SEC Press Release 2011-226, SEC Approves Confidential Private Fund Risk Reporting (Oct. 26, 2011).

SEC Enforcement Update
Investment Adviser Compliance Failures.
On November 28, 2011, the SEC issued enforcement orders against three investment advisers for failing to implement compliance policies and procedures to help prevent securities law violations. Summaries of the three enforcement orders are set forth below.

OMNI Investment Advisors, Inc. and Gary R. Beynon. The SEC's order indicated that OMNI failed to adopt and implement written compliance policies and procedures and to establish, maintain and enforce a code of ethics, despite prior warnings from the SEC. For almost three years, the SEC alleged that OMNI did not maintain a compliance program and that, for two of those three years, OMNI did not have a CCO. When Beynon assumed the role of CCO, he was living in Brazil and failed to perform virtually any compliance responsibilities or supervise OMNI's advisory representatives in Utah. Furthermore, in response to a SEC subpoena, OMNI produced client advisory agreements with Beynon's signature evidencing his supervisory approval, when, in fact, the SEC alleged that Beynon had never read those agreements and had backdated his signature on them. The SEC instituted a bar against Beynon that, among other things, permanently prohibits him from acting in a compliance capacity and supervisory capacity. Beynon also agreed to pay a $50,000 penalty.

Feltl & Company, Inc. The SEC's order indicated that Feltl, a dually-registered broker-dealer and investment adviser, failed to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act, despite prior warnings from the SEC. The firm had an off-the-shelf compliance manual that encompassed both its brokerage and advisory business, with only one chapter devoted to its advisory business. The manual did not address Section 206(3) of the Advisers Act, which prohibits an adviser, acting as principal for its own account, from knowingly selling securities to or purchasing securities from the adviser's clients without disclosing to such clients in writing before the completion of such transactions the
capacity in which the adviser is acting and obtaining the consent of the clients. As a result, the SEC found that the firm engaged in 1,634 principal transactions in a three-year period with its advisory accounts without obtaining consent. In addition, the firm charged undisclosed commissions on transactions in clients' wrap fee accounts. Finally, the SEC's order indicated that the firm was slow to adopt a code of ethics and, following its implementation of a code, it did not require the representatives to submit annual holding reports (although the CCO did review account statements and trade confirmations). In settlement, Feltl agreed to pay a $50,000 fine, to return $142,000 to specific advisory clients and to hire an independent consultant who will review the firm's compliance operations for two years.

Asset Advisors LLC. The SEC order indicated that it had previously warned Asset Advisors about its failure to adopt and implement a compliance program. In response, Asset Advisors adopted written compliance policies and procedures but failed to fully implement a compliance program. Furthermore, Asset Advisors adopted a code of ethics but failed to collect written acknowledgements and personal securities reports. The settlement requires Asset Advisors to pay a $20,000 penalty, to cease operations, to de-register with the SEC and to move advisory accounts to another firm with its clients' consent.

Sources: SEC Press Release 2011-248, SEC Penalizes Investment Advisers for Compliance Failures (Nov. 28, 2011); In the Matter of OMNI Investment Advisors Inc. and Gary R. Beynon, IA Release No. 3323 (Nov. 28, 2011); In the Matter of Feltl & Company, Inc., IA Release No. 3325 (Nov. 28, 2011); In the Matter of Asset Advisors, LLC, IA Release No. 3324 (Nov. 28, 2011).

Improper Fee Arrangements. The SEC found that Morgan Stanley Investment Management Inc. (MSIM), the primary investment adviser to the Malaysia Fund, Inc., represented to investors and the fund's board of directors that the fund's Malaysian-based sub-adviser was providing advice, research and assistance to MSIM for the benefit of the fund. Despite a research and advisory agreement stating that the sub-adviser would provide these services, the SEC found that the sub-adviser did not provide advice, research and assistance. The sub-adviser merely provided two monthly reports based on publicly available information that MSIM did not use in its management of the fund. The SEC found that MSIM willfully violated Section 15(c) of the Investment Company Act by failing to provide the fund's board with information necessary for the board to evaluate the nature, quality and cost of the sub-adviser's services. MSIM agreed to repay the fund $1.8 million for the sub-adviser's fees and pay a $1.5 million penalty. MSIM also agreed to implement policies and procedures specifically governing the Section 15(c) process and its oversight of service providers.

Source: In the Matter of Morgan Stanley Investment Management Inc., IA Release No. 3315 (Nov. 16, 2011).

SEC Pushes Tougher Penalties for Fraud. On November 28, 2011, SEC Chairman Mary Schapiro sent a letter to Congress asking it to pursue legislation that changes the legal formulas used by the SEC to calculate penalties. Her proposals would allow the SEC to triple penalties for certain cases, including repeat offenders, and to calculate penalties based on investor losses. The proposed change would increase penalty caps per violation from $150,000 for individuals and $725,000 for financial firms to $1 million and $10 million, respectively.

Source: SEC Pushes to Toughen Penalties for Offenders, Wall Street Journal (Nov. 30, 2011).

Fund Board Oversight of Risk Management
The Investment Company Institute (ICI) and the Independent Directors Council (IDC) recently published a report titled "Fund Board Oversight of Risk Management" to assist fund directors in understanding and satisfying their fiduciary duties and appropriately overseeing risk. A summary of the key concepts and best practices discussed in the report is set forth below.

Oversight of Risk Management. Investment companies are subject to multiple types of risk, including investment risk and business operational risk. While the securities laws do not impose any specific risk management duties on the board, the board's responsibilities arise from its fiduciary duties of loyalty and care and are part of its overall responsibility to oversee the fund's management. The board's focus should be on the fund's risks, but also includes understanding the adviser's risks that may impact the fund. The board and adviser should discuss how the adviser's own risks mirror, or differ from, the fund's risks, and the board may seek assurances that the fund's risks are being sufficiently considered and monitored by the adviser. A board's role is to provide oversight, not to manage risks. In general, board oversight includes:

  • establishing a common understanding with the adviser as to the sources and levels of risk appropriate for the fund;
  • being aware of the most significant risks to the fund and the steps being taken to manage those risks;
  • understanding the current risk management processes, asking questions and obtaining assurances that the processes are reasonably designed to manage and control the fund's material risks; and
  • encouraging and reinforcing a strong risk-conscious "tone at the top" by the adviser.

Risk Management by Advisers. The adviser must keep the board informed as to fund-related risks. The adviser may provide updates in many forms, such as organizing educational sessions on risk topics, reporting investment changes that increase the fund's risk profile, providing reports on investment risks and on significant business operational risks and escalating material risk-related issues to the board for review.

Communication Between the Board and the Adviser. For both the board and the adviser, open communication is a critical element of risk oversight. Both parties should keep an open dialogue regarding potential risk impact on the shareholders, acceptable levels of risk, current controls and their effectiveness and whether additional measures are required.

Risk Management Themes. The report provides a helpful list of themes that promote risk awareness at an investment company, including:

  • the tone at the top is critical to promoting a risk-conscious culture (i.e., senior management must support a robust risk management program);
  • risk management is a continuing process and not a one-time project;
  • risk management is everyone's responsibility;
  • existing practices should be subject to an independent review to ensure effectiveness; and
  • risk management must be forward-looking and proactive.

Organizational Structures. The specific structure of risk management that an adviser employs will vary among firms based on the adviser's and the fund's size, resources, culture, corporate structure, management structure and management team.

Risk management occurs at three levels: the employee and business unit level; across the enterprise; and senior management and the adviser's board. The employee and business unit level is often in the best position to institute daily controls for risks related to a specific unit's function. Risk management across the enterprise provides an opportunity to evaluate the functionality of the risk oversight done at each business unit level. Furthermore, enterprise oversight may expose risks that are acceptable at the business unit level, but may cause concern at the enterprise level. Senior officers, such as the adviser's CEO and board, monitor the adviser's business risk and investment risk.

Risk Management Tools. Advisers may use various tools to identify, monitor and manage risk, including conducting stress tests and providing assessments based on the results. These risk assessments allow advisers to determine whether the present controls are effective and to potentially identify previously unknown concerns.

Board Practices. There is no uniform approach to board oversight of risk management. Many board committees oversee risk as it relates to that committee's role. For example, an investment committee oversees investment risks and an audit committee oversees accounting and financial reporting risks. The report notes that it is not a common practice for a board to have a committee whose core mandate is risk oversight. Boards may request that the adviser provide regular reports on risk management, explaining the processes and methodologies. Some boards receive investment risk reports quarterly and reports relating to business operational risks less frequently, such as annually. Boards also receive reports indicating the results of an adviser's stress tests or disclosing the fund's significant business risks and current controls over those risks. If significant risks arise, boards may desire to have the adviser prepare a special report with a summary of the risk, the completed action and any proposed remediation. Finally, if the fund has a Chief Risk Officer (CRO), the board may choose to meet with the CRO on a routine, or on an as-needed, basis to discuss general or specific risk questions or concerns.

Source: Investment Company Institute and Independent Directors Council, Fund Board Oversight of Risk Management (Sept. 2011).

SEC Adopts Net Worth Standard for Accredited Investors
The SEC adopted 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 the individual's 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, unless the person incurs that indebtedness within the 60 days prior to purchasing securities in an exempt offering and that indebtedness was not incurred in connection with the person's purchase of a primary residence. Any indebtedness on the primary residence that exceeds its fair market value, however, must be included as a liability in the calculation.

For the convenience of issuers, investors and other market participants, the rules allow for the "grandfathering" of individuals who satisfied the previous accredited investor definition in certain circumstances. The new rules do not apply to purchases of securities made pursuant to a preexisting right to purchase securities if (i) the person held the right on July 20, 2010; (ii) the person qualified as an accredited investor on the basis of net worth at the time the person acquired the right; and (iii) the person held securities of the same issuer, other than the right, on July 20, 2010.

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 must review the threshold requirements to qualify as an accredited investor every four years.

Sources: Net Worth Standard for Accredited Investors, SEC Release No. 33-9287 (Dec. 21, 2011); SEC Press Release No. 2011-274, SEC Adopts Net Worth Standard for Accredited Investors Under Dodd-Frank Act (Dec. 21, 2011).

Proposed FINRA Rule 2210 -- Public Communications
FINRA has proposed changes to NASD Rule 2210, the rule governing broker-dealer communications with the public, including mutual fund advertising and sales literature. The ICI has submitted comment letters on FINRA's proposed rule and subsequent amendments to the proposed rule, requesting changes and criticizing the breadth of the proposed rule. Most recently, in December 2011, FINRA filed Amendment No. 2 to the proposed rule, along with a rebuttal letter responding to industry comments received as of that date. The current proposal consolidates prior NASD rules (Rules 2210 and 2211), NASD Interpretive Materials and NYSE Rules into FINRA Rule 2210.

Communication Categories. NASD Rule 2210 currently divides communications into the following six categories: (i) advertisements, (ii) sales literature, (iii) correspondence, (iv) institutional sales material, (v) independently prepared reprint and (vi) public appearance. The proposed rule covers written communication, including electronic communication, and replaces the current six communication categories with the following three categories: (i) institutional communications, (ii) retail communications and (iii) correspondence.

Institutional communications are written (including electronic) communications distributed or made available only to institutional investors, but do not include a member's internal communications. Under this definition, communications that currently fall under "institutional sales material" would be categorized as institutional communications. Retail communications are written (including electronic) communications distributed or made available to more than 25 retail investors within 30 calendar days. Communications that currently fall under "advertisements" and "sales literature" would be categorized as retail communications. Correspondence is written (including electronic) communication distributed or made available to 25 or fewer retail investors within a 30-day calendar period. While the categories "independently prepared reprint" and "public appearance" would no longer exist, the proposal would retain much of the substance of their exceptions from the filing requirements and limited application of the content standards.

Whereas the prior categories focused on the type of communication, the proposed categories consider the communication's recipient. Any change in the category in which a communication falls will affect that communication's approval, filing and content standards.

Seeking Changes. In its comment letters, the ICI voiced its opposition to the proposed rule, alleging that it creates duplicative costs and unnecessary oversight. For example, the ICI recommended that FINRA exempt the Management Discussion of Fund Performance in shareholder reports from FINRA's filing requirement since shareholder reports are filed with the SEC. The ICI also recommended FINRA exclude templates from filing when the only change is a narrative factual update provided by an entity that is independent of the fund and its affiliates. To date, FINRA has refused to incorporate these recommendations. Consistent with ICI recommendations, FINRA did agree that internal communications that are intended to educate or train registered persons about products and services would be governed by Rule 3010 (Supervision), rather than Rule 2210. Other commentators, such as the Securities Industry and Financial Markets Association, disagreed with FINRA's proposal to reclassify participation in an interactive electronic forum on a social media website as retail communications (rather than public appearances). FINRA defended its reclassification, but added a filing exclusion for retail communications that are posted on online interactive electronic forums. Finally, FINRA has refused to eliminate the requirement that free-writing prospectuses be filed for review, but did propose to eliminate a new member pre-use filing requirement for widely disseminated broker-prepared free-writing prospectuses. The SEC is accepting comments until January 18, 2012.

Sources: Beagan Wilcox Volz, ICI Pushes for More Changes to Communications Rule, Ignites (Dec. 14, 2011); Notice of Filing of Proposed Rule Change to Adopt FINRA Rule 2210, Release No. 34-64984 (July 28, 2011); Notice of Filing of Partial Amendment No. 1 to Proposed Rule Change, Release No. 34-65663 (Nov. 1, 2011); Investment Company Institute, Letter to FINRA re: FINRA Proposal to Adopt NASD Rules Regarding Communications with the Public as FINRA Rules 2210 and 2212 through 2216 (SR-FINRA-2011-035) (Dec. 7, 2011); FINRA Response to Comments re: File No. SR-FINRA-2011-035 -- Rebuttal (Dec. 22, 2011); Notice of Filing of Amendment No. 2 to Proposed Rule Change, Release No. 34-66049 (Dec. 23, 2011).

TBA Contracts Litigation
To-be-announced contracts (TBAs) include bilateral arrangements to buy or sell at a future date "to-be-announced" mortgage-backed securities issued or guaranteed by the Federal National Mortgage Corporation, the Federal Home Loan Mortgage Corporation or the U.S. government (collectively, Agency MBS). TBAs are unique in that the type and number of Agency MBSs delivered on the date of performance indicated in the contract is not specified on the date the parties enter into the contract. Instead, the parties merely agree upon a price and a delivery date. Currently, $302 billion in TBAs are traded daily.

On December 8, 2011, Federal Bankruptcy Court Judge James Peck decided In re Lehman Brothers Inc. In this case, the parties asked Judge Peck to determine whether TBA contract claims qualify as customer claims against Lehman Brothers' estate. Judge Peck explained that, much like securities, TBAs trade in the market; however, buyers do not put up cash or securities against the TBA contract. Furthermore, he stated that TBAs are not classified as futures, investment contracts, warrants or other instruments. Therefore, TBAs are not securities, and the parties never formed a custodial relationship with Lehman Brothers, which is an essential element of customer status under the Securities Investor Protection Act.

Judge Peck's ruling suggests that because TBAs are not customer claims against a bankrupt company, the value of TBAs depends on the counterparty broker-dealer's solvency.

Sources: Stan Wilson, Court Deals Blow to TBA Market, Fund Industry Intelligence (Dec. 16, 2011); In re Lehman Brothers Inc. (Dec. 8, 2011).

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