Important Annual Requirements; SEC Exam Priorities for 2016; Recent SEC Enforcement Initiatives
Investment advisers registered with the Securities and Exchange Commission (SEC) have certain annual requirements under the Investment Advisers Act of 1940 (Advisers Act), some of which also either apply to exempt reporting advisers (ERAs) or warrant consideration as best practices for ERAs. This Sidley Update serves as a reminder for investment advisers about certain annual regulatory and compliance obligations, including a number of significant 2016 reporting or filing deadlines.
This Sidley Update also reminds advisers that are registered as commodity pool operators (CPOs) or commodity trading advisors (CTAs) with the Commodity Futures Trading Commission (CFTC) and are members of the National Futures Association (NFA) of certain CFTC and NFA reporting requirements.
Select recent regulatory developments and proposals that may affect an adviser’s compliance program are noted, including proposed changes to Form ADV and a new exception to the annual privacy notice requirement. In addition, this Sidley Update provides information regarding certain guidance published in 2015, specifically related to cybersecurity, personal securities transactions reporting and general solicitation, as well as SEC examination priorities for 2016 and recent enforcement proceedings that reflect SEC concerns relevant to advisers.
This Sidley Update does not purport to be a comprehensive summary of all of the compliance obligations to which advisers are subject; please contact your Sidley lawyer to discuss these and other requirements under the Advisers Act, the Commodity Exchange Act and other regulations that may be applicable to investment advisers, CPOs and/or CTAs.1
Amendments to Form ADV; Brochure Delivery to Clients
Annual Updating Amendment
Each registered adviser must file an annual updating amendment to its Form ADV. The annual amendment must be filed within 90 days of the adviser’s fiscal year end; accordingly, an adviser with a December 31, 2015 fiscal year end must file its annual amendment by March 30, 2016.2 Part 1A and Part 2A (the adviser’s brochure) are filed electronically with the SEC via the Investment Adviser Registration Depository (IARD) and are publicly available. Part 2B, the brochure supplement, is not filed with the SEC but must be preserved by the adviser and made available, if requested, to the SEC for examination.
IARD will not accept an annual Form ADV updating amendment without (i) an updated Part 2A
brochure, (ii) a representation by the adviser that the brochure on file does not contain any materially inaccurate information, or (iii) a representation that the adviser is not required to prepare a brochure because it is not required to deliver it to any clients. In addition, the IARD collects annual fees associated with Form ADV filings. An adviser should ensure proper funding is set up electronically prior to filing its annual amendment.
Annual Delivery of Brochure to Clients
Within 120 days of its fiscal year end, a registered adviser must deliver to each client for which delivery is required either:
- its updated Part 2A brochure and a summary of material changes to the brochure, if any; or
- a summary of material changes, if any, accompanied by an offer to provide the updated brochure (which, if requested, must be mailed within seven days or delivered electronically in accordance with SEC guidelines).
The brochure is required to be delivered to "clients," which the SEC staff has acknowledged does not include fund investors; however, many fund advisers voluntarily deliver the brochure to fund investors. Annual delivery of an updated brochure supplement to existing clients is not required; an updated supplement must be delivered only when there is new disclosure of a disciplinary event or a material change to disciplinary information already disclosed. An adviser with a December 31, 2015 fiscal year end must deliver its updated brochure to clients by April 29, 2016.
Key Importance of Accurate and Complete Form ADV Disclosure
Inaccurate, misleading or omitted Form ADV disclosure is a frequently cited deficiency in SEC examinations. Moreover, Form ADV and Form PF are linked electronically, and disclosure in the two forms must be consistent.
Disclosure points of particular importance include, among others:
- An adviser must accurately calculate its regulatory assets under management (RAUM). RAUM must be calculated on a gross basis, without deduction of any outstanding indebtedness or other accrued but unpaid liabilities, according to specific instructions provided in Instruction 5.b. of Form ADV: Instructions for Part 1A (the Part 1A Instructions).3
- An adviser to private funds (i.e., funds that rely on the exclusion from the definition of investment company provided by Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940) must provide specific information regarding those funds on Form ADV. Accurate identification of the fund type(s) advised, according to specific definitions provided in Instruction 6 of the Part 1A Instructions, is of critical importance in determining an adviser’s Form PF filing category (see Form PF Reporting Requirements–Determining an Adviser’s Filing Category below).
- An adviser that has added a new private fund as a client since its last Form ADV annual updating (or other) amendment may need to amend Form ADV to add information regarding the new fund before information regarding the fund can be reported on Form PF. An adviser in this situation may need to file its annual Form ADV amendment early (or file an other-than-annual amendment).4
Annual Form ADV Amendment for Exempt Reporting Advisers
Advisers relying on the "private fund adviser" exemption or the "venture capital fund adviser" exemption from SEC registration are ERAs and are required to file reports on Form ADV Part 1A with the SEC through the IARD. An ERA, like a registered adviser, must amend its Form ADV at least annually, within 90 days of its fiscal year end, and more frequently if required, as specified in General Instruction 4 to Form ADV. Hence, an ERA with a December 31, 2015 fiscal year end must file its annual updating amendment by March 30, 2016.
An ERA relying on the private fund adviser exemption must calculate annually the private fund RAUM that it manages and report the amount in its annual Form ADV amendment. If a U.S.-based ERA reports in its annual amendment that it has $150 million or more of private fund RAUM or has accepted a client that is not a private fund, the adviser is no longer eligible for the private fund adviser exemption.5 A private fund adviser that has complied with all ERA reporting requirements but is no longer eligible for the private fund adviser exemption because its RAUM meets or exceeds $150 million must apply for registration with the SEC up to 90 days after filing the annual amendment and may continue advising private fund clients during this period. An adviser relying on this exemption, however, must be registered with the SEC (or, if pertinent, with one or more states) prior to accepting a non-private fund client. This transition period is not available to an adviser that otherwise would not qualify for the private fund adviser exemption (for example, an adviser that accepts a managed account). The transition period also is not available to advisers relying on the venture capital fund adviser exemption; such advisers must register under the Advisers Act before accepting a client that is not a venture capital fund.
Annual Compliance Program Review
Rule 206(4)-7 under the Advisers Act (Compliance Rule) requires an SEC-registered adviser to designate a Chief Compliance Officer (CCO) and adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder by the adviser and its supervised persons. The Compliance Rule does not enumerate specific elements that must be included in the compliance policies and procedures.6 Rather, the SEC staff has indicated that it expects a registered adviser’s policies and procedures to be based on an assessment of the regulatory and compliance risks present in the adviser’s business that may cause violations of the Advisers Act (a risk assessment) and a determination of controls needed to manage or mitigate these risks.
Periodic and Annual Review
The Compliance Rule also requires a registered adviser to review at least annually the adequacy of its policies and procedures and the effectiveness of their implementation. The required annual review may be conducted in stages throughout the year or all at once, depending on what works best for the adviser; as a matter of "best practices," however, it is recommended that an adviser conduct periodic reviews throughout the year. The SEC staff has stated that an adviser’s compliance program should continue to evolve over time in conjunction with an ongoing risk assessment (and re-evaluation) process.
The annual review should include consideration of any developments during the year that might suggest a need to revise the adviser’s compliance program, including, among other things:
- the results of SEC examinations of the adviser (if any);
- review of material compliance matters that arose;
- changes in the adviser’s business activities or operations (for example, entering into a new line of business); and
- changes to applicable laws, rules or regulations.
The review process should incorporate reasonable "forensic" (i.e., looking at trends over time) and "transactional" (i.e., spot) tests to detect gaps in the compliance program or instances in which the adviser’s policies and procedures may have been circumvented or are not operating effectively. Any issues identified in the testing process should be accompanied by a strategy for remediation and the results of any remediation efforts.
The adviser should document the annual review, as well as steps taken to revise or enhance the compliance program to reflect the results of the review. Upon examination, the SEC will require the adviser to produce documentation evidencing the required annual review. Failure to conduct a timely annual review isan often-cited violation in addition to other charges brought by the SEC’s Division of Enforcement.
Report to Management
As a best practice, an adviser’s senior management, at least annually, should convene a special meeting to review the effectiveness of the adviser’s compliance policies and procedures. A formal written report summarizing the conclusions of senior management should be filed in the adviser’s compliance records, together with a memorandum summarizing the responses, if any, made to perceived deficiencies or inadequacies, as well as evaluating the approach taken to any specific compliance problems that may have occurred during the year. Senior management should be engaged as frequently as necessary during the year to assist in establishing and maintaining a culture of compliance within an adviser’s organization.
Training and Annual Certification
The SEC staff has emphasized the importance of advisers’ educating their supervised persons concerning the general principles, as well as the specific requirements of the adviser’s compliance program. Pertinent training should take place on at least an annual basis and more frequently as convenient or necessary (for example, when a new employee joins the firm or when the testing of policies and procedures demonstrates a lack of understanding of such policies and procedures).
An adviser’s compliance policies and procedures should be documented in a compliance manual that is distributed to all supervised persons. All supervised persons should be required to execute and deliver at least annually a certificate stating that they have read (or have re-read) and understand the provisions in the compliance manual (including any revisions or updates), including the code of ethics and the adviser’s policies and procedures designed to detect and prevent insider trading. Many firms also utilize an annual certification to remind supervised persons of their specific disclosure obligations, such as the obligation to disclose outside business activities, that assist the adviser with complying with its fiduciary duties under the Advisers Act.
Exempt Reporting Advisers
An ERA, as an unregistered adviser, is not required to adopt a comprehensive compliance program pursuant to the Compliance Rule or to comply with certain other rules under the Advisers Act. Unregistered advisers, however, are still subject to the anti-fraud provisions of the Advisers Act. An ERA, therefore, should adopt reasonable compliance policies, procedures and oversight to avoid even the appearance of a violation of the anti-fraud provisions and the ERA’s fiduciary duty to clients. Like a registered adviser, an ERA is subject to the "pay-to-play" rule under the Advisers Act, as well as the Advisers Act requirement that an adviser adopt policies and procedures reasonably designed to prevent insider trading. As a best practice, an ERA should review at least annually the adequacy of its policies and procedures and make any needed revisions. The Director of the SEC’s Office of Compliance Inspections and Examinations (OCIE) recently stated that the SEC staff has already begun performing examinations of ERAs, as further explained below.
Advisers Registered as CPOs and/or CTAs—NFA Self-Examination and Attestation
NFA believes that all NFA members should regularly review the adequacy of their supervisory procedures. To satisfy their continuing supervisory responsibilities, NFA members must review their operations on a yearly basis using NFA’s Self-Examination Questionnaire, which includes a general questionnaire that must be completed by all NFA members and supplemental questionnaires (e.g., CPO and CTA) that must be completed, as applicable.
After reviewing the annual questionnaires, an appropriate supervisory person must sign and date a written attestation stating that he or she has reviewed the NFA member’s operations in light of the matters covered by the questionnaire. A separate attestation must be made for each branch office and, if the branch office reviews its own operations, then the main office must receive a copy of the questionnaire’s signed attestation. (A branch office is an office of the NFA member other than the main office, not a separate entity affiliated with the NFA member.) These attestations should not be forwarded to NFA but should be retained by the member. Signed attestations should be readily available for the most recent two years and retained for the most recent five years.
Other Annual Reminders for Registered Advisers and ERAs
Other annual obligations, as pertinent, include (non-exclusive list):
Review of Disclosure and Offering Documents. An adviser should review all disclosure documents (including fund offering materials) at least annually to ensure that content and disclosure are accurate, up-to-date and consistent across documents (including filings with the SEC and other regulators) and with the firm’s compliance policies and procedures. Advertising materials, pitch books and standard due diligence questionnaire responses should also be reviewed.
Annual Personal Securities Holdings Report. On an annual basis, a registered adviser must collect from each "access person" (by a date specified by the adviser) an annual personal securities holding report containing certain required information regarding securities holdings and securities accounts. The information must be current as of a date no more than 45 days prior to the date the report is submitted.
Annual Delivery of Privacy Notice. An adviser must provide clients and fund investors who are natural persons with a privacy notice disclosing the adviser’s practices for maintaining privacy of non-public personal information, both at or before the establishment of the customer relationship and annually thereafter, except that, as of December 2015, an adviser is not required to make an annual distribution of its privacy notice if the adviser: (i) only provides non-public personal information to unaffiliated third parties for limited, non-marketing-related purposes, and (ii) has not changed its policies and practices from those disclosed in the adviser’s most recent privacy notice provided to clients and fund investors.7
Annual “Bad Actor” Recertification. Private funds and other issuers are not permitted to rely on the exemption from Securities Act of 1933 (Securities Act) registration provided by Rule 506 of Regulation D if the pertinent offering involves certain "bad actors." For continuous or other offerings of long duration, an adviser must update, on a reasonable basis, its factual inquiries (e.g., by email or questionnaire) to determine whether any covered persons have "disqualifying events," which may also require disclosure in Form ADV, and keep records of responses.
Annual Eligibility for "New Issues." An adviser should verify annually the eligibility of clients and fund investors to participate in new issues of publicly offered securities (i.e., initial public offerings or IPOs), to make sure "restricted persons" are properly identified and their participation appropriately restricted.
Form D and "Blue Sky" Filings. Form D filings for private funds with ongoing offerings lasting longer than one year must be amended on EDGAR annually, on or before the first anniversary of the initial Form D filing. On an annual basis, an adviser should also review blue sky filings for each state to ensure any renewal requirements are met.
Annual Affirmation of CFTC Exemptions. Advisers claiming an exemption from registration under CFTC Rules 4.13(a)(1), 4.13(a)(2), 4.13(a)(3) or 4.13(a)(5) or exclusion from the definition of "commodity pool operator" under Regulation 4.5, and CTAs claiming an exemption from CTA registration under Regulation 4.14(a)(8) must affirm the applicable notice of exemption or exclusion within 60 days of each calendar year end—February 29, 2016—or be deemed to have requested a withdrawal of the applicable exemption or exclusion.
Confirming Affirmation of Investors/Clients Claiming Exemptions. In a January 14, 2016 Notice to Members, NFA indicated that registered CPOs and CTAs that take reasonable steps to determine the registration and membership status of investors/clients claiming an exemption or exclusion under CFTC Rules 4.5 or 4.13(a) (or Regulation 4.14(a)(8)) will not be in violation of NFA Bylaw 1101 or Compliance Rule 2-36(d) if, between January 1 and March 31, 2016, they transact customer business with a previously exempt person that fails to become registered and a member of NFA, file a notice affirming its exemption from CPO/CTA registration, or provide a written representation as to why the person is not required to register or file the notice affirming the exemption.8
BEA Reporting Requirements for Cross Border Direct Investments and Transactions in Financial Services. The U.S. Bureau of Economic Analysis (BEA) conducts various surveys of direct investment and transactions in financial services across the U.S. border, one of which, the Form BE-13 Survey of New Foreign Direct Investment in the United States, requires U.S. investment managers and U.S. funds that fall within the scope of the survey to file reports (or claims for exemption) during 2016, whether or not the U.S. investment manager is contacted by the BEA. Form BE-13 is used for reporting each new "direct investment" (ownership of a direct or indirect voting interest of 10 percent or more) by a foreign entity in a newly established, newly acquired, or newly-merged U.S. entity; generally, the deadline for filing Form BE-13 is 45 days after the date that the acquisition is completed or the new legal entity is established. If a U.S. person discovers that it has a reportable transaction after the applicable deadline, it should file the applicable Form BE-13 with the BEA promptly after making the discovery.
The BEA also issues three different benchmark surveys of direct investment or transactions in financial services across the U.S. border, at various five-year intervals, that require U.S. investment managers or U.S. investment funds that fall within the scope of the benchmark survey to report, whether or not the BEA contacts the investment manager.9 However, no such benchmark surveys are due during calendar year 2016. In addition, the BEA may contact U.S. persons to request that they file quarterly or annual surveys of direct investment or transactions in financial services across the U.S. border.
Recent Regulatory Developments, Guidance and Proposals That May Affect An Adviser’s Compliance Program
The following select regulatory developments, guidance and proposals may affect the compliance programs of certain advisers. Advisers should review these and other changes in applicable laws, rules, regulations and/or SEC staff guidance to determine whether compliance policies and procedures need to be added or revised.
In April 2015, the SEC’s Division of Investment Management (IM) provided guidance regarding particular measures advisers could consider when addressing cybersecurity risk, including conducting a periodic assessment of cybersecurity threats to, and vulnerabilities of, the firm’s information systems. IM encouraged advisers to create a strategy to prevent, detect and respond to cybersecurity threats and to implement the strategy through policies, procedures and training. Advisers also were advised to assess whether protective cybersecurity measures are being utilized by their service providers.10
Personal Securities Reporting
Rule 204A-1 under the Advisers Act requires an adviser’s "access persons" to make certain reports regarding their personal securities accounts, holdings and transactions. The rule also provides an exception to these reporting requirements when an access person’s securities are held in accounts over which he or she had "no direct or indirect influence or control." In guidance issued in June 2015, IM stated that the fact that a trustee or a third-party manager has management or discretionary investment authority over an access person’s trust or personal account would not, by itself, enable the access person to rely on the reporting exception. IM also stated, however, that the adviser may be able to implement additional controls to establish a reasonable belief that an access person had no direct or indirect influence or control over the trust or account. Examples of such controls are provided in the guidance and should be considered if an adviser allows any access persons to rely on the reporting exception.11
General Solicitation Guidance
In August 2015, the SEC staff published a series of compliance and disclosure interpretations regarding what constitutes a general solicitation for purposes of Rule 502(c) of Regulation D under the Securities Act.12 Of particular interest, the SEC staff provided guidance to aid advisers and others in distinguishing between what types of internet or other public statements might be deemed publicity for an offering of securities constituting a general solicitation versus statements that are "factual business information." The SEC staff indicated that the distinction depends on the facts and circumstances, but that factual business information typically is limited to information about the issuer, its business, financial condition, products and services or advertisement of such products or services. The SEC staff also stated that factual business information generally does not include projections, forecasts, opinions or information regarding past performance. Advisers should consider the interpretations in connection with a review of their website content, other publicity activities and offering procedures for fund private placements, as applicable.
Proposed Form ADV Amendments.
In May 2015, the SEC proposed amendments to Form ADV that would, among other things, require registered investment advisers to provide more information about separately managed accounts (SMAs) they manage. The proposed SMA-related disclosure would require information about the types of assets held by, and the use of derivatives and leverage in, SMAs. Other proposed Form ADV amendments would require disclosure regarding advisers’ use of social media and information about outsourced CCOs. At the open meeting where the proposed Form ADV amendments were announced, the SEC also announced proposals to require advisers to maintain additonal books and records related to performance calculations and performance-related communications. In addition, the SEC announced proposed changes that would standardize the process of "umbrella" registration of related advisers on one Form ADV.13
Third-Party Exams and Fiduciary Duty. In March 2015 testimony before the House Committee on Financial Services and in other reported statements, SEC Chair Mary Jo White stated that she has directed the SEC staff to prepare recommendations for development of a program of third-party compliance reviews to supplement the OCIE examination program, while acknowledging the numerous challenges to implementing such a program. In the same testimony, White proposed that the SEC implement a uniform fiduciary duty for broker-dealers and investment advisers in an effort to harmonize regulatory treatment and noted that the SEC staff has been providing technical assistance to the U.S. Department of Labor staff in connection with potential changes to the definition of fiduciary under the Employee Retirement Income Security Act (ERISA).14
Anti-Money Laundering Rule for Registered Investment Advisers. In September 2015, the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) published a notice of proposed rulemaking regarding anti-money laundering (AML) requirements for registered investment advisers. The proposal would require each registered investment adviser to establish an AML program and report suspicious activities. The SEC would be granted authority to examine registered investment advisers for compliance with the new requirements. Many registered investment advisers may be required to significantly enhance their compliance programs with respect to monitoring and reporting, training, testing and risk assessment related to AML. Registered investment advisers that have traditionally delegated AML responsibilities to service providers may be required to take a more active role.15
Preparing for an SEC Examination
The books and records of all SEC-registered advisers are subject to compliance examinations by the SEC staff, including the records of any private funds to which the adviser provides investment advice. ERAs also are subject to SEC examination. The SEC historically has not examined ERAs on a routine basis but, reportedly, the SEC’s approach to ERA examination may be changing. Generally, an adviser subject to an examination is required to provide the SEC with access to all books and records related to its advisory business, whether or not they are required to be kept.
The SEC staff generally follows a risk-based exam strategy. The SEC staff has indicated that in most cases, the staff considers the quality of the adviser’s compliance systems and its internal control environment when determining the scope of the examination and the areas to be reviewed. Depending on the nature of the examination, the staff often will contact an adviser in advance and provide a detailed document request list before commencing the examination. Lists will vary depending on the nature and focus of the examination.
Certain proactive steps should be taken to prepare for the contingency of an examination. For example, an adviser should:
- obtain and review sample SEC document request lists to anticipate likely SEC staff requests;
- ensure that its disclosure documents (including filings with the SEC and other regulators), compliance policies and procedures and actual business and compliance practices are all consistent;
- review results from periodic and annual compliance reviews in order to make sure that findings have been addressed;
- review previous SEC examination findings (if any) to make sure that past deficiencies have been remedied; and
- consider conducting a mock examination or gap analysis.
Most advisers that are examined by the SEC staff receive a "deficiency" letter, outlining technical and/or more serious compliance weaknesses or violations. It is critically important that the adviser address all deficiencies, including revisions (as needed) to its compliance program and/or disclosure documents. Even minor deficiencies, if not corrected, may be considered serious by the SEC staff when the next exam occurs, and the staff may take administrative or other enforcement action against such "recidivist" behavior.
SEC Exam Priorities for 2016
It has been reported that, in a November 2015 industry presentation, Igor Rozenblit, co-head of the Private Funds Unit of OCIE, stated that his group is focused on the intersection of conflicts, opacity and complexity while shifting from its recent focus around private equity to a focus on liquid hedge fund strategies. Also, it has been reported that Marc Wyatt, Director of OCIE, said in November 2015 that his team has begun examining ERAs.
In September 2015, OCIE issued a Risk Alert announcing a second Cybersecurity Examination Initiative.16 The initiative is designed to assess the ability of broker-dealers and investment advisers to protect customer and client information and test the implementation of cybersecurity-related controls. Among other points, the Alert made clear that the SEC staff can be expected to ask for documentation of a firm’s cybersecurity program during examination. OCIE indicated it will focus on governance and risk assessment, access rights and controls, data loss prevention, vendor management, training and incident response. With respect to incident response, the Alert notes that examiners may assess whether firms have established policies, assigned roles, assessed system vulnerabilities and developed plans to address possible future events. This includes determining which firm data, assets and services warrant the most protection to help prevent attacks from causing significant harm. The Alert also included a sample request for information and documents that OCIE may review in conducting cybersecurity examinations, which may serve as a useful tool in preparation for examinations.
On January 11, 2016, the SEC’s National Exam Program (NEP) released its list of examination priorities for 2016 (Release).17 The Release highlights areas that the SEC staff perceives to have heightened compliance risk. Compliance officers should take note of these areas of concern and assess these areas for improvement.
OCIE’s current examination priorities, as outlined in the Release, are organized around three themes:
- Retail Investors and Retirement. Protecting retail investors, including those investing for retirement, remains an OCIE priority for 2016. The staff is planning and/or conducting examinations regarding issues such as branch office supervision, exchange-traded funds (ETFs) and suitability related to fee arrangements and the appropriate associated disclosure.
- Market-Wide Risks. The staff will continue to focus on ensuring fair, orderly and efficient markets. In addition to its cybersecurity initiative, OCIE will be looking at fund advisers’ exposure to illiquid
- Data Analytics. The staff will continue to use analytics to identify signals of potential illegal activity and will focus on, among other things, identifying recidivism affecting investment advisers and their employees. Advisers should be reviewing their personnel to ensure that they are exercising appropriate supervision over any employees who have a history of disciplinary issues. OCIE also will be looking at the suitability issues around new, complex and high-risk products and will use analytics to identify inappropriate or excessive trading practices.
In addition to these areas, OCIE will be examining advisers with an eye towards:
- Regulation D Private Placements. The staff will be assessing associated due diligence, disclosure and suitability.
- Never-Before-Examined Firms. OCIE will continue to conduct focused, risk-based examinations of selected registered investment advisers that have not yet been examined.
- Private Fund Advisers. The staff will continue to examine private fund advisers, maintaining a focus on fees and expenses and evaluating the controls and disclosure associated with side-by-side management of vehicles with performance fees and asset-based fee accounts.
Recent Enforcement Proceedings
The SEC announced in October 2015 that it brought a record number of enforcement cases in fiscal year 2015. The SEC’s announcement indicated that the agency brought several "first-of-their-kind" cases and that the agency is leveraging its data analytics to identify enforcement issues.18 OCIE’s recent attention to private equity funds may have generated some of the year’s enforcement activity. Recent enforcement actions and related speeches of relevance to investment advisers included, among others:
- Conflicts of Interest.
- "Conflicts, conflicts everywhere" speech by Julie Riewe. In February 2015, Julie Riewe, co-chief of the Asset Management Unit of the SEC’s Division of Enforcement (AMU),19 stated that AMU was examining conflicts of interest in nearly every ongoing matter to see if advisers are properly discharging their duty to identify conflicts. Riewe stated that after identification, the adviser must either eliminate the conflict, or mitigate the conflict and disclose the conflict to boards, clients and investors. Riewe went on to state that there is no exception to disclosure, no mitigation exception for an adviser that believes it has taken adequate internal steps and no potential conflict exception for an adviser that does not take advantage of a conflict. Advisers should ensure all conflicts that cannot be eliminated are being disclosed and monitored.20
- Accelerated Monitoring Fees. The SEC entered into a settlement after finding that affiliated private equity fund advisers failed to fully inform investors that the advisers had terminated portfolio company monitoring agreements and accelerated the payment of future monitoring fees, using some of the accelerated fees to offset management fees. In addition, the SEC found that the advisers failed to disclose fee arrangements with service providers where the advisers received different terms than the funds they managed.21
- Consulting Fees Paid to Affiliates. A private equity adviser and several of its executives entered into a settlement with the SEC regarding claims that they failed to disclose the use of portfolio company assets to pay for consulting work performed by affiliates of the adviser.22
- Proprietary Products. The SEC entered into a settlement with an investment adviser relating to the failure to disclose certain conflicts of interest, including with regard to a preference for proprietary mutual funds for retail investors in its managed account program. The SEC found that neither SEC registration forms nor marketing materials disclosed the conflicts.23
- Outside Business Activities. The SEC entered into a settlement with an investment adviser, as well as its chief compliance officer at the time of the alleged conduct, charged with breaching its fiduciary duty for failing to disclose a conflict of interest related to the outside business activities of a portfolio manager and related failure to adopt or implement relevant policies and procedures. As part of the settlement, the investment adviser agreed to retain an independent compliance consultant to review its written compliance policies and procedures regarding the outside business activities of employees and any resulting conflicts of interest and to implement the consultant’s recommendations.24
- Expense Allocation.
- The SEC entered into a settlement with an adviser to private equity funds regarding misallocation of "broken deal" or diligence expenses for deals that did not generate investment opportunities for its funds. Notably, this was the first enforcement action regarding such broken deal expenses. The SEC determined that the adviser’s allocation practices were not clearly disclosed, and that the adviser did not implement a policy regarding expense allocation until the end of the period at issue.25
- The SEC also entered into a settlement with a hedge fund advisory firm regarding allocation of fund assets to pay adviser-related operating expenses related to office rent, employee salaries and benefits and similar items without clear authorization under fund operating documents or proper disclosure, including in fund financial statements.26 In an unrelated action, the SEC entered into a settlement with two affiliated private equity advisers for improper allocation of consulting, legal and compliance costs to their funds without proper authorization from the funds’ limited partnership agreements. The SEC specifically found that expenses related to SEC registration, preparing for examinations and responding to an SEC investigation, all with respect to the advisers, were not properly authorized to be charged to the funds.27
- Cybersecurity. The SEC entered into a settlement with an investment adviser that was charged with failure to establish required cybersecurity policies and procedures in advance of a significant breach. Although the SEC noted that there was no evidence that the breach caused financial harm to any clients, the SEC nevertheless sanctioned the adviser, noting the adviser’s failure to conduct periodic risk assessments, make use of firewalls, encrypt data and formulate a strategy for responding to breaches.28 As noted above, OCIE has announced a second round of examinations related to cybersecurity. At a minimum, investment advisers should be identifying risks and developing incident response plans related to cybersecurity issues.
- The SEC entered into a settlement with an investment adviser charged with inflating the value of securities held in its hedge fund portfolios, resulting in higher management and performance fees. The SEC alleged that, although the adviser had disclosed to investors and its administrator and auditor that it was using independent price quotes from broker-dealers, the adviser provided broker-dealer representatives with internally-produced valuations for the broker-dealers to use instead of independently produced price quotes.29
- The SEC entered into a settlement with an alternative fund manager regarding its valuation practices. The SEC found that the manager did not calculate management fees in a manner that was consistent with its disclosed methodologies, nor did the manager adhere to its disclosed valuation practices, with the result that the manager overcharged management fees to the fund.30
- Whistleblowers. The SEC announced significant awards to a former compliance officer and a former investment firm employee who reported misconduct and identified related individuals.31 The SEC also charged an investment adviser for alleged retaliation efforts.32 In addition to considering anti-retaliation policies, advisers should review any confidentiality provisions in employment-related agreements to ensure that the agreements do not prohibit disclosures to the SEC or other government agencies.
- Long/Short Marking. The SEC settled an enforcement action against an investment adviser to hedge funds after the adviser admitted to causing its prime brokers to violate recordkeeping rules relating to long/short marking of its securities. The SEC alleged that over a six-year period, the adviser misidentified trades in data sent to its prime brokers, causing the prime brokers to inaccurately reflect long sales of securities as short sales in their records and in records the prime brokers submitted to regulators. Advisers should ensure that information sent to executing and prime brokers regarding their orders are consistent. In addition, advisers should be ensuring compliance with Regulation SHO and Regulation M with regard to short selling.33
- CCO Liability. In conjunction with settling an enforcement action with an adviser for violations of Section 206(4) of the Advisers Act and Rule 206(4)-2 thereunder (Custody Rule), the SEC settled an enforcement action with the adviser’s former CCO, charged with willfully aiding and abetting, and causing the adviser’s violations. The SEC stated that the adviser repeatedly failed to distribute audited financial statements to fund investors within 120 days of the fiscal year end, despite having been sanctioned in a 2010 SEC enforcement action for similar violations. The SEC further stated that the CCO had failed to comply with the 2010 order, as well as the adviser’s compliance manual, when he failed to implement procedures or safeguards to ensure the adviser’s compliance with the Custody Rule; the CCO’s efforts, consisting only of reminding his colleagues of the deadlines for compliance with the Custody Rule, were insufficient.34
- Compliance Policies. The SEC entered into an enforcement action with a formerly registered investment adviser, claiming that the firm failed both to maintain adequate investment advisory compliance policies and procedures and to ensure proper and timely disclosures about its investment advisory business. Included among the numerous violations cited by the SEC were failure to adopt and implement written policies and procedures by relying on an "off-the-shelf" compliance manual without customizing such manual to fit the circumstances of the firm; failure to implement the procedures the firm did adopt (including failure to conduct adequate "best execution" reviews and reviews of the firm’s marketing materials); and failure to annually review the adequacy of the firm’s compliance policies and procedures. Additionally, the firm conducted inadequate review of access persons’ personal securities trading and failed to amend its Form ADV to correct misstatements therein.35
Form PF Reporting Requirements
Most registered advisers to private funds are required to file Form PF on either a quarterly or annual basis (advisers that are exempt from SEC registration, including ERAs, are not required to file Form PF). The information contained in Form PF is designed, among other things, to assist the Financial Stability Oversight Council (FSOC) in its assessment of systemic risk in the U.S. financial system. Form PF, which is a joint form between the SEC and the CFTC with respect to Sections 1 and 2 of the form, is filed with the SEC via the Private Fund Reporting Depository (PFRD) electronic filing system and is not publicly available.
Given the volume and complexity of the work involved, many private fund advisers face a number of challenges in preparing Form PF, including making decisions regarding (and documenting) assumptions and methodologies, due to the ambiguous or subjective nature of a number of Form PF’s instructions, definitions and questions. The SEC staff has provided assistance with respect to these issues and other Form PF questions, both directly in response to private inquiries and in FAQs posted (and periodically updated) on the SEC’s website.36
Who Must File
An SEC-registered investment adviser is required to file Form PF if it (i) advises one or more private funds, and (ii) collectively, with related persons (other than related persons that are separately operated), had RAUM of $150 million or more attributable to private funds as of the end of its most recently completed fiscal year.
CFTC-registered CPOs and CTAs that are dually registered with the SEC are required to file Form PF and submit information with respect to each advised commodity pool that is also a private fund. Because commodity pools are considered hedge funds for purposes of Form PF, the filing adviser must complete the sections of the form applicable to hedge funds for each commodity pool reported on Form PF. For a dual registrant, filing Form PF can serve to satisfy certain CTFC Form CPO-PQR reporting requirements. Dual registrants also have the option of using Form PF to satisfy certain CFTC reporting requirements with respect to commodity pools that are not private funds in lieu of completing certain sections of Form CPO-PQR.37
To avoid duplicative reporting, Form PF information regarding sub-advised funds should be reported by only one adviser. The adviser that completes information in Form ADV Schedule D Section 7.B.1, with respect to any private fund, is also required to report that fund on Form PF. If, however, the adviser reporting the private fund on Form ADV is not required to file Form PF (e.g., because it is an ERA), then another adviser, if any, to the fund, if required to file Form PF, must report the fund on Form PF.
Determining an Adviser’s Filing Category
The scope of required Form PF disclosure, the frequency of reporting and filing deadlines differ based on the RAUM of the adviser attributable to different types of private funds (in particular, hedge funds, liquidity funds and private equity funds). Accurately determining an adviser’s filing category is a critical first step. Specific definitions of fund types are provided in the Form ADV Part 1A Instructions and the Form PF: Glossary of Terms.
The RAUM thresholds applicable to different categories of Form PF filers are summarized in the chart below. An adviser meeting only the minimum $150 million private fund RAUM reporting threshold, as well as a large private equity fund adviser, must file Form PF annually within 120 days following its fiscal year end. A large liquidity fund adviser or large hedge fund adviser must file quarterly, within 15 days (for large liquidity fund advisers) and 60 days (for large hedge fund advisers) of its fiscal quarter end.
Advisers are required to follow certain aggregation instructions for purposes of determining whether or not they meet the de minimis $150 million private fund asset threshold for reporting on Form PF, as well as the pertinent large private fund adviser thresholds. Aggregation also is required for large hedge fund advisers to determine whether any hedge fund is a "qualifying hedge fund" subject to additional reporting requirements. The aggregation instructions (and, conversely, certain netting instructions for fund of funds advisers and others whose funds invest in other private funds) may raise challenging interpretive issues for many advisers.
Frequency of Reporting and Filing Deadlines
The reporting frequency and upcoming filing deadlines for different categories of Form PF reporting advisers are summarized below. The filing deadlines set forth in the following table are for advisers with a December 31 fiscal year end.
* If the filing due date falls on a holiday, a weekend or a day when the PFRD system is closed, the Form PF filing will be considered timely filed with the SEC if filed no later than the following business day.
How the SEC Staff Uses Form PF Data
While the primary aim of Form PF was to create a source of data for FSOC’s assessment of systemic risk, the SEC also is using the data to support its own regulatory programs, including examinations, investigations and investor protection efforts.38 OCIE staff generally reviews an adviser’s Form PF filing as a part of its pre-exam evaluation and reviews information contained in the filing for inconsistencies with other information obtained during an exam, such as due diligence reports, pitch books, offering documents, operating agreements and books and records. In addition, OCIE staff typically looks for discrepancies between an adviser’s Form PF filing and any publicly available documents related to the adviser, including the adviser’s Form ADV Part 1A and brochure. Enforcement staff also obtains and reviews Form PF filings in connection with ongoing adviser investigations.
Reporting Requirements for Certain Investment Advisers on CFTC and NFA Form CPO-PQR and/or Form CTA-PR
Many advisers to privately offered funds and registered investment companies are required to register as CPOs and/or CTAs with the CFTC and to become members of NFA. CFTC-registered CPOs and CTAs must report certain information on CFTC and NFA Form CPO-PQR (also referred to herein as CFTC Form PQR and NFA Form PQR, as applicable) and Form CTA-PR, respectively. The forms must be filed electronically using NFA’s EasyFile System.
CFTC and NFA Reporting Requirements on Form CPO-PQR
The scope of required disclosure, the frequency of reporting and whether or not a given Form CPO-PQR filing is required by the CFTC and/or NFA is determined generally by the CPO’s aggregated gross pool assets under management (Gross AUM), although NFA requires that registered CPOs complete NFA Form PQR quarterly, even if the CPO is an annual filer for CFTC purposes. As in the case of Form PF, Form CPO-PQR filers are required to follow certain aggregation instructions for purposes of determining the applicable filing category. The CFTC’s Division of Swap Dealer and Intermediary Oversight has posted FAQs regarding Form CPO-PQR, while the NFA has posted FAQs regarding Form PQR.39
Based on the information that the CPO enters on the Cover Page of Form CPO-PQR, all subsequent screens of the Form will be dynamically generated to present only required schedules.40 Because NFA’s previous Form PQR filing has been incorporated into the CFTC’s form, there are not separate filings for the CFTC and NFA. NFA Form PQR now consists of certain questions of CFTC Form PQR Schedule A and step 6 of Schedule B (Schedule of Investments).
As noted above, advisers that are dually registered with the SEC and the CFTC can satisfy certain CFTC Form PQR filing requirements by filing Form PF.41 For example, a large CPO that is a quarterly Form PF filer can file Form PF Sections 1 and/or 2 in lieu of CFTC Form PQR Schedules B and C. Each of these requirements is due within 60 days of quarter end. Similarly, a mid-sized CPO that is an annual Form PF filer can file Form PF Sections 1.b and 1.c in lieu of CFTC Form PQR Schedule B. A dual registrant is required only to submit Schedule A of CFTC Form PQR on an annual basis; however, a dual registrant also will be subject to quarterly NFA reporting requirements pursuant to NFA Form PQR. Note, however, that whereas a mid-sized CPO must meet its CFTC Form PQR reporting obligation within 90 days of calendar year end, the filing deadline for an annual Form PF filer is 120 days from fiscal year end. Hence, a mid-sized CPO that wishes to meet a portion of its CFTC reporting requirements through Form PF may need to file its Form PF within 90 days (rather than 120 days) of its year end (assuming a calendar year fiscal year).
With respect to pools with co-CPOs, the CPO with the greater Gross AUM is required to report for the pool. If a pool is operated by co-CPOs and one of the CPOs is also a dual registrant that files Form PF Sections 1 and/or 2 (and thus is only required to file CFTC Form PQR Schedule A), the non-investment adviser CPO must nevertheless file the applicable sections of CFTC Form PQR.
Each CPO that is an NFA member must file NFA Form PQR on a quarterly basis within 60 days of the quarters ending in March, June and September and a year-end report within 60 or 90 days (depending on the size of the CPO) of the calendar year end. Large CPOs that file the required CFTC Form PQR schedules on a quarterly basis satisfy their NFA Form PQR filing requirements through filing CFTC Form PQR.42
CPOs that file Form PF with the SEC, in lieu of certain portions of CFTC Form PQR, are required to file NFA Form PQR with the NFA on a quarterly basis within 60 days of the quarter end, except for the December 31 quarter, when the filing will be due within 90 days.43
CFTC Form PQR and NFA Form PQR filing requirements are summarized in the following chart.
Each registered CTA is required to file an annual Form CTA-PR with the CFTC within 45 days of the calendar year end and a quarterly NFA Form CTA-PR within 45 days of the calendar quarter end.44 The same form is used for both the CFTC and the NFA filings. All Form CTA-PR filings are made through NFA’s EasyFile System. The CFTC and the NFA have posted FAQs regarding Form CTA-PR.45