As we begin the New Year, we thought it would be helpful to remind our clients that manage separate accounts or private funds, whether hedge funds, private equity funds, commingled funds, or commodity pools, of certain obligations that may be applicable to them as "Investment Managers" under various U.S. federal and state laws and regulations.
Compliance with certain of these obligations is required within specific time periods after the end of the calendar year or the Investment Manager’s fiscal year. Other obligations are required on an annual or periodic basis. Certain other obligations may be characterized as a best practice to be undertaken on a periodic basis, as opposed to a strict legal requirement. The beginning of the New Year may be a logical time to review and satisfy many of these obligations.
What follows below is a summary of the primary annual or periodic compliance-related requirements or best practice obligations that may apply to many Investment Managers. This summary is not intended to provide a complete review of an Investment Manager’s obligations relating to compliance with applicable tax, partnership, limited liability, trust, corporate, or securities laws or rules, or non-U.S. or U.S. state law requirements.1
Requirements for all Investment Managers
Determine investment adviser registration status under Investment Advisers Act, as amended by the Dodd-Frank Act.
As a result of the elimination of the "private adviser exemption" from registration under the Investment Advisers Act of 1940, as amended ("Advisers Act"), many Investment Managers are required to be registered with the Securities and Exchange Commission ("SEC"), unless they can rely on one of the narrower exemptions discussed below.
Exempt reporting advisers.
Private fund adviser exemption. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") created an exemption from SEC-registration as an investment adviser for Investment Managers that act as advisers solely to "private funds" (i.e., for purposes of this exemption, funds exempt from registration under Section 3 of the Investment Company Act of 1940, as amended (the "Investment Company Act")) and have assets under management in the United States of less than $150 million.
Venture capital fund adviser. The Dodd-Frank Act created an exemption from SEC registration as an investment adviser for Investment Managers that solely advise "venture capital funds." Generally, a venture capital fund is a private fund that (i) holds no more than 20% of the fund’s capital contributions and uncalled committed capital in assets that are not equity securities of qualifying portfolio companies, (ii) does not borrow or incur leverage in excess of 15% of the funds capital contributions and uncalled committed capital, and any such borrowing is for a non-renewable term of no more than 120 calendar days, (iii) does not offer its investors redemption or liquidation rights except in extraordinary circumstances, (iv) represents to investors that it is pursuing a venture capital strategy, and (v) is not a registered investment company or treated as a business development company.
Advisers relying on the private fund adviser exemption or the venture capital fund adviser exemption generally must file a report as "Exempt Reporting Advisers" ("ERAs") and complete certain items on Part 1 of Form ADV. The deadline for submitting this report is within 60 days of becoming an ERA. Thereafter, ERAs must update their Form ADV on an annual basis.
Foreign private advisers. The Dodd-Frank Act created an exemption from SEC registration as an investment adviser for Investment Managers that qualify as a "foreign private adviser." Generally, to qualify as a foreign private adviser, an Investment Manager must (i) have no place of business in the United States, (ii) have fewer than 15 clients and investors in the United States and aggregate assets under management attributable to such clients and investors of less than $25 million, and (iii) not hold itself out as an investment adviser to the public in the United States or act as investment adviser to a registered investment company.
Family office exclusion. Certain Investment Managers that meet the definition of "family offices" are excluded from the definition of "investment adviser" and are therefore not required to register as investment advisers with the SEC. Family offices that otherwise meet the broad definition of "investment adviser" but fail to meet the SEC’s definition of "family office" are required to register as investment advisers.
A "family office" generally is defined as any entity that provides investment advisory services and meets all of the following criteria: (i) it has no clients other than "family clients," (ii) it is wholly owned by family clients and exclusively controlled (directly or indirectly) by "family members" or "family entities," and (iii) it does not hold itself out to the public as an investment adviser. "Family clients" includes: current and former family members, certain "key employees" of the family office, charitable organizations funded exclusively by family clients, and a variety of other family entities formed for tax and estate planning purposes. "Family members" generally is defined as all lineal descendants of a common ancestor, so long as that common ancestor is not more than 10 generations removed from the youngest generation of family members. This aspect of the rule provides some flexibility in that the common ancestor for purposes of counting the 10 generation limit can be altered in order to capture a new generation as desired.
Requirements for SEC-Registered Investment Advisers
Update and file your Form ADV. Investment Managers that are registered with the SEC as investment advisers under the Advisers Act (such managers, "Registered Managers") must update their Form ADV Part 1 and Part 2 and file Part 1 and Part 2A with the SEC on an annual basis within 90 days of the Registered Manager’s fiscal year end. In addition, a Registered Manager must update its Form ADV promptly at any time certain information becomes inaccurate. Please refer to the General Instructions to Form ADV in order to determine whether the form should be amended promptly. State-registered Investment Managers also may be subject to similar requirements.
Deliver your brochure to clients. Under the Advisers Act, Registered Managers are required to provide new and prospective clients with a narrative brochure (Part 2A of Form ADV) regarding the firm and brochure supplements (Part 2B) regarding certain of the firm’s advisory personnel. Registered Managers must deliver to clients, within 120 days of the end of the Registered Manager’s fiscal year, a free updated brochure that either includes or is accompanied by a summary of material changes, or deliver to each client a summary of material changes that includes an offer to provide a copy of the updated brochure and information on how a client may obtain the brochure. If a Registered Manager’s previous brochure does not contain any materially inaccurate information, such manager is not required to prepare or deliver a summary of material changes to clients. Brochure supplements generally must be updated and delivered to clients when any disciplinary information contained therein has become inaccurate, and Registered Managers should keep their clients apprised of any material information that could affect the advisory relationship.
Prepare and file Form PF. For many Registered Managers, 2013 brings the first required Form PF filing. A Registered Manager that advises "private funds" with more than $150 million in assets under management is required to periodically file Form PF with the SEC. While certain Registered Managers with assets under management in excess of $5 billion were required to submit their Form PFs in August of 2012, the majority of Registered Managers
that advise private funds generally must start filing Form PF either within 60 or 120 days following the end of their first fiscal year ending after December 15, 2012. For Registered Managers that advise hedge funds with over $1.5 billion in gross assets with a fiscal year end of December 31, Form PF will be due on March 1, 2013 and within 60 days after the end of each calendar quarter thereafter. For most other Registered Managers with a fiscal year end of December 31, Form PF will be due on April 30, 2013 and within 120 days after the end of each fiscal year thereafter.
If an adviser is not registered or required to be registered with the SEC because it relies upon any of the available exemptions from registration (e.g., the Private Fund Adviser Exemption, discussed above), the adviser will not need to report on Form PF until it is required to register with the SEC. Private fund advisers that are dually registered with the CFTC will satisfy certain proposed
CFTC reporting obligations by filing private fund information on Form PF. In 2012, the CFTC provided guidance that, due to the overlap in the information required to be reported on Form CPO-PQR and Form PF, CPOs required to complete both Form PF and Form CPO-PQR would have certain reduced reporting requirements with respect to Form CPO-PQR.
Form PF categorizes Investment Managers with certain levels of assets under managements as "Large Private Fund Advisers" and defines certain types of private funds such as "hedge funds," "liquidity funds," and "private equity funds." An investment adviser must look to its regulatory assets under management attributable to private funds (i.e., generally, gross assets) to determine whether it is required to file Form PF and whether it is a Large Private Fund Adviser. Advisers should take note that certain aggregation principles apply when calculating these thresholds and, depending on the type of private funds advised, an adviser will either have to measure its regulatory assets under management attributable to private funds monthly or annually.
All advisers required to file Form PF must complete Section 1 of the form which requests basic information about the adviser and its assets under management and basic fund-level information for each private fund advised. Investment Managers should review the definitions of "hedge fund," "liquidity funds," and "private equity funds" to determine which sections of Form PF the Investment Manager will be required to complete. Investment Managers should note that Form PF includes a broad definition of hedge fund that captures any private fund that (i) charges a performance fee calculated by taking into account unrealized gains, (ii) may borrow in excess of one-half of its net asset value or may have gross notional exposure in excess of twice its net asset value, or (iii) may sell securities or other assets short or enter into similar transactions (other than for the purpose of hedging currency exposure or managing duration). Section 1 requests additional information for any hedge funds advised. Large hedge fund advisers, large liquidity fund advisers, and large private equity fund advisers also must complete Sections 2, 3, or 4 of Form PF, respectively.
As a general matter, the amount of information required to be reported, the frequency with which it is reported, and the initial deadlines for filing Form PF are dependent upon the amount of private fund assets advised and the types of private funds advised. Generally, all advisers to private funds required to report on Form PF, except certain large hedge fund advisers and large liquidity fund advisers, will be required to report on Form PF annually. As described above, certain large hedge fund advisers and large liquidity fund advisers will be required to file Form PF quarterly within 60 days and 15 days, respectively, of the end of each quarter.
Advisers to private funds with a fiscal year end of December 31 should begin the process of completing Form PF now as the information required to be reported may require coordination with an adviser’s back office function and/or service providers.
Review your required compliance procedures and code of ethics. Under Advisers Act rules, Registered Managers must review their compliance policies and procedures no less than annually to assess their effectiveness. Written evidence of these reviews should be retained. In general, the review should encompass the following areas:
General review. According to the SEC, the review should consider any compliance matters that arose during the previous year, any changes in the business activities of the Registered Manager or its affiliates, and any changes in the Advisers Act or its rules that might suggest a need to revise the Registered Manager’s policies and procedures. Although SEC rules require only annual reviews, Registered Managers also should consider the need for interim reviews in response to significant compliance events, changes in business arrangements, and legal or regulatory developments. Registered Managers should pay particular attention to their valuation, confidentiality, and insider trading policies and procedures, which have been areas of recent focus by the SEC. They should also be sure that the policies and procedures have been updated to reflect changes in law and regulation, including the firm’s compliance with any disclosure or reporting requirements that may be required of Registered Managers that manage private funds.
Code of ethics. Registered Managers must review the adequacy of their code of ethics annually and assess the effectiveness of its implementation. In addition, Registered Managers should determine whether they need to provide any ethics-related training of employees, or enhancements to their code in light of current business practices and regulatory developments.
Business continuity/disaster recovery plans. Registered Managers should review and "stress-test" their required business continuity/ disaster recovery plans no less than annually and make any necessary adjustments. Promulgating and reviewing a business continuity/disaster recovery plan also is recommended for all Investment Managers, whether or not registered.
"Pay-to-Play" Practices. Investment Managers that seek to manage assets of state and local governments, including public retirement plans, are generally subject to federal, state, and local laws and regulations that restrict "pay-to-play" practices. Rule 206(4)-5 under the Advisers Act restricts the contribution and solicitation practices of Investment Managers and certain of their related persons. Specifically, Rule 206(4)-5 prohibits an Investment Manager from (i) receiving compensation for providing advisory services to a government entity for two years after the Investment Manager or certain of its executives or employees make a contribution to certain elected officials or candidates, (ii) providing direct or indirect payments to any third party that solicits government entities for advisory business unless this third party is a registered broker-dealer or investment adviser itself subject to "pay-to-play" restrictions, and (iii) soliciting from others, or coordinating, contributions to certain elected officials or candidates or payments to political parties where the Investment Manager is providing or seeking government business. Investment Managers subject to Rule 206(4)-5 also must keep required books and records.
Deliver your fund’s audited financial statements. Under the Advisers Act’s custody rules, Registered Managers that manage private funds and are deemed to have custody of client assets (which generally will be most private fund managers) must provide audited financial statements of their funds, prepared in accordance with U.S. generally accepted accounting principles, to the fund’s investors within 120 days of the fund’s fiscal year-end, or 180 days for a fund-of-funds, to avoid complying with the full requirements of the custody rules. Registered Managers that do not satisfy the audit requirement will need to confirm that they are in compliance with the full requirements of the custody rule, including the annual surprise audit requirement.
Confirm your state notice filings/investment adviser representative renewals. Registered Managers should review their current advisory activities in the various states in which they conduct business and confirm that all applicable state notice filings for the firm are made on IARD. Registered Managers also should confirm whether any of its personnel need to be registered as "investment adviser representatives" in one or more states and, if so, register those persons or renew their registrations with the applicable states, as needed.
Registered Managers should review allegations of sales practice violations made against a registered person in an arbitration or litigation, even in cases where the registered person is not a named party, and amend the registered person’s Form U-4 to disclose such information as necessary. Please be sure to use the most recent version of this form, as it is periodically amended.
Fund your IARD account. Registered Managers should confirm that their IARD electronic accounts are adequately funded so as to cover payment of all applicable registration renewal fees with both the SEC and with any states for the year. Please note that it may take several days for deposited funds to appear in the IARD account.
Requirements for Registered CPOs and CTAs
Review and update your NFA registration. Commodity pool operators ("CPOs") and commodity trading advisors ("CTAs") registered with the Commodity Futures Trading Commission ("CFTC") must update their registration information via the National Futures Association’s ("NFA") electronic online registration system ("ORS"), annual registration questionnaire, and pay their annual NFA membership dues and annual records maintenance fees on or before the anniversary date that the CPO’s or CTA’s registration became effective. The NFA will deem a failure to complete the review of the annual registration questionnaire within 30 days following the date established by NFA as a request for withdrawal from registration.
Complete your NFA self-examination questionnaire. Under NFA rules, registered CPOs/CTAs must complete and sign the NFA’s "self-examination questionnaire" and applicable supplements on an annual basis. The completed questionnaire is not filed with the NFA. Instead, Investment Managers must retain the questionnaire in their files for five years, with the questionnaire being readily accessible during the first two years. Investment Managers that have branch offices should complete a separate questionnaire for each branch office. As part of this review, CPOs/CTAs should review any established compliance policies and procedures and confirm whether amendments to those procedures, or additional procedures, may be warranted in light of the CPO’s/CTA’s current business.
File and distribute your commodity pool certified annual reports. All registered CPOs that manage non-exempt pools and CFTC Rule 4.7-exempt pools must file certified annual reports for their pools with the NFA within 90 days of the pool’s fiscal year-end (including pools that are fund-of-funds). The certified reports must be filed electronically through the NFA’s EasyFile system.
Investment Managers that cannot comply with this deadline must apply to the NFA for additional time to file the certified reports prior to the date on which the certified report was otherwise required to be filed. The Investment Manager also must distribute the certified reports to the pool’s participants within the above 90 day deadline, unless the NFA grants an extension.
Confirm your compliance with NFA quarterly reporting requirements. Registered CPOs are required to file quarterly reports with the NFA regarding their non-exempt pools and Rule 4.7-exempt pools within 45 days after the end of each quarter. Investment Managers that are registered CPOs should confirm they are complying with this requirement on an ongoing basis.
As a reminder, registered CPOs that manage Rule 4.7-exempt pools may be able to avoid the above annual audit and quarterly reporting filing requirements, as well as registration as a CPO altogether, under one of the exemptions available under CFTC Rule 4.13. CPOs may wish to review Rule 4.13 to determine if an exemption is available to them.
Comply with your NFA-required ethics training policy. Under the NFA’s ethics training rules, registered CPO/CTAs should periodically consider whether additional ethics-related training of its registered associated persons ("APs") may be needed, in light of the Investment Manager’s required ethics training policies and procedures.
Review your NFA-required business continuity/disaster recovery plan. Under the NFA’s rules, registered CPOs/CTAs should periodically "stress test" their required business continuity/ disaster recovery plans to assess their effectiveness and make any necessary adjustments. Such plans also should be updated to reflect any material changes to operations.
Confirm your compliance with retail forex rules. Pursuant to CFTC rules, persons who operate pools or exercise discretionary trading authority with respect to "retail forex" transactions must register as commodity pool operators ("Forex CPOs") or commodity trading advisors ("Forex CTAs"), as applicable. Retail forex transactions generally are off-exchange foreign currency transactions with customers who do not qualify as eligible contract participants ("ECPs").2 Forex CPOs and Forex CTAs also are required to file their disclosure documents with the NFA and comply with recordkeeping and reporting requirements. Notwithstanding the foregoing, an Investment Manager engaging in retail forex transactions may be able to rely on exemptions under CFTC Rule 4.13 to avoid registration altogether or CFTC Rule 4.7 to avoid the requirement that it file a disclosure document, provided that the requirements of those exemptions are met.
Investment Managers that engage in retail forex transactions should confirm they are in compliance with the foregoing retail forex rules and other applicable requirements related to retail forex transactions.
Review your swap registration. Amendments to NFA rules that became effective January 1, 2013 require NFA member CPOs and CTAs and their APs that engage in swaps activity subject to CFTC jurisdiction to be approved by NFA as a "swaps firm" or "swaps AP." In order to be approved as a swaps firm and maintain that status, the NFA member must have at least one principal that is registered as an AP and designated as a swaps AP. Obtaining such swaps designations is completed through ORS.
Rescission of 4.14(a)(4) and revision of Rule 4.5. The CFTC rescinded the exemption from CPO registration for certain qualifying pools under CFTC Rule 4.13(a)(4), which was commonly relied upon by the investment managers of privately offered funds, including hedge fund and private equity fund sponsors. Investment Managers that operated a pool formerly exempt under CFTC Rule 4.13(a)(4) must have determined by December 31, 2012, whether such pool qualified for an exemption from registration under 4.13(a) (3) (which provides an exemption from registration for CPOs that operate a pool that does a de minimis amount of commodity interest trading), or whether the Investment Manager was required to register as a CPO. The CFTC also has eliminated the exemption from registration as a CTA pursuant to CFTC Rule 4.14(a)(8)(i) (D) for firms that render commodity trading advice to commodity pools whose CPOs rely on CFTC Rule 4.13(a)(4). Any person that advised a 4.13(a)(4) exempt pool pursuant to an exemption from CTA registration under CFTC Rule 4.14(a)(8)(D) must have determined whether it had to be registered as a CTA by January 1, 2013 in order to continue advising those pools. No-action relief is available for CPOs, CTAs, and the principals and APs thereof who were required to register as a result of the these amendments if, on or before December 31, 2012, they filed a registration application with NFA, including, as appropriate, Forms 7-R and 8-R, as well as any required fingerprint cards for each of its principals and APs. Each CPO, CTA, principal, or AP relying on this no-action relief must also comply with the provisions of the Commodity Exchange Act and the CFTC’s rules that apply to its activities as if it was in fact registered. In addition, the CFTC has revised CFTC Rule 4.5 to limit the use of commodity interests by registered investment companies for non-bona fide hedging purposes to five percent of the liquidation value of the entity’s portfolio, in order for the registered investment company’s manager to claim exclusion from the definition of CPO.
Family Offices. When the CFTC rescinded CFTC Rule 4.13(a)(4), many family offices also lost their basis for claiming an exemption from the requirement to register as a CPO. The CFTC has issued no-action relief giving family offices affirmative relief from the registration requirement so long as they meet the SEC’s definition of a "family office," as discussed above. In order to claim the no-action relief, a family office CPO must file a claim with the CFTC’s Division of Swap Dealer and Intermediary Oversight.
File your annual reaffirmation. CFTC rules have been amended to require persons that claim an exemption under CFTC Rules 4.5, 4.13(a)(1), 4.13(a)(2), 4.13(a)(3), 4.13(a)(5), or 4.14(a) (8) to annually reaffirm their exemptions. Investment Managers claiming one or more of these exemptions will have 60 days after each calendar year-end to reaffirm the notice of exemption through NFA’s Electronic Exemption System. The first notice reaffirming these exemptions is due by March 1, 2013, and annually thereafter. Any person that fails to file a notice reaffirming the exemption will be deemed to have requested a withdrawal of the exemption.
Determine registration status of exempt clients. The NFA’s bylaws prohibit NFA members from carrying an account, accepting an order, or handling a transaction in commodity futures contracts for any non-member of NFA that is required to be registered with the CFTC. In light of the changes to the available exemptions from registration and the new annual reaffirmation requirement discussed above, registered CPOs/CTAs must take reasonable steps to determine the registration and membership status of investors and clients who were previously exempt to avoid violating NFA bylaws. This may involve contacting investors and clients to determine whether they have registered or if they intend to file a notice affirming their exemption, as applicable, and obtaining a written representation to that effect.
Other Requirements or Best Practices for all Investment Managers
Confirm your ongoing new issues compliance. Under Financial Industry Regulatory Authority ("FINRA") Rule 5130 applicable to broker-dealers that are members of FINRA, Investment Managers that purchase "new issues" for a fund or separately managed client account from such FINRA members must obtain written representations every 12 months from the account’s beneficial owners confirming their continued eligibility to participate in new issues. In addition, FINRA Rule 5131 prohibits "spinning," which is the practice of allocating shares in new issues to any account in which certain persons that may influence or direct the provision of investment banking services to the FINRA member, have a beneficial interest. In determining whether an account is subject to the spinning prohibitions, a FINRA member may rely on written representations obtained within the prior 12 months from the account’s beneficial owners. The annual representations under both Rules 5130 and 5131 may be updated annually through "negative consent" letters.
Review your anti-money laundering and OFAC programs. The Financial Crimes Enforcement Network ("FinCEN") has withdrawn its proposed anti-money laundering regulations for unregistered investment companies, certain investment advisers, and CTAs. As a result, most Investment Managers are not required to establish a written anti-money laundering program under the Bank Secrecy Act, as amended by the USA PATRIOT Act ("BSA"). Nonetheless, the SEC has required Registered Managers to have such policies in place under its examination authority. Also, many counterparties, broker-dealers, and clients/investors have required Investment Managers to maintain such policies. Thus, although not a FinCEN requirement, most Investment Managers should maintain anti-money laundering programs. An Investment Manager should review its program, including its anti-money laundering risk assessment, on an annual basis to determine whether the program is reasonably designed to ensure compliance with the BSA given the business, customer base, and geographic footprint of the Investment Manager. In addition, the Investment Manager should review its compliance program to ensure compliance with the economic sanctions programs administered by the Office of Foreign Assets Control ("OFAC"), which are not affected by FinCEN’s decision to withdraw its rules proposal. The foregoing reviews should be independent and conducted by an outside professional, internal audit, or an appropriate officer or employee of the Investment Manager with knowledge of the BSA and the economic sanctions programs administered by OFAC.
Amend your Schedules 13G or 13D. Investment Managers whose client or proprietary accounts, separately or in the aggregate, are beneficial owners of five percent or more of a registered voting equity security, and who have reported these positions on Schedule 13G, must update these filings annually within 45 days of the end of the calendar year, unless there is no change to any of the information reported in the previous filing (except the holder’s percentage ownership due solely to a change in the number of outstanding shares). This is in addition to any amendments that may have been required during the calendar year. Investment Managers reporting on Schedule 13D are required to amend their filings "promptly" upon the occurrence of any "material changes" including (but not limited to) any increase or decrease of one percent or more in their holdings. Investment Managers whose client or proprietary accounts are beneficial owners of ten percent or more of a registered voting equity security also must check to determine whether they are subject to any reporting obligations, or potential "short-swing" profit liability or other restrictions, under Section 16 of the Securities Exchange Act of 1934, as amended ("Exchange Act").
File your Form 13F. All "institutional investment managers," whether or not registered as investment advisers, must file a Form 13F with the SEC if they exercise investment discretion with respect to $100 million or more in securities subject to Section 13(f) of the Exchange Act (generally, U.S. exchange-traded securities, shares of closed-end investment companies, and certain convertible debt securities), disclosing certain information regarding their holdings. The first filing must occur within 45 days after the end of a calendar year during which the Investment Manager reaches the $100 million filing threshold (calculated as of the last trading day of any month in that year), and within 45 days of the end of each calendar quarter thereafter, for so long as the Investment Manager continues to meet the $100 million filing threshold (again, calculated as of the last trading day of any month during the year).
File your Form 13H. Pursuant to Rule 13h-1 under the Exchange Act, Investment Managers that meet the definition of "Large Trader" must register with the SEC using Form 13H. They must also update their Form 13H on an annual basis within 45 days after the calendar year-end and, if any information in Form 13H becomes inaccurate for any reason, file an amended Form 13H by the end of the calendar quarter during which the information becomes inaccurate. "Large Trader" is defined as a person who, directly or indirectly, through the exercise of investment discretion, effects transactions in NMS securities3 (generally, exchange-listed equity securities and standardized options) that exceed, in the aggregate, (i) $20 million fair market value or 2 million shares on any calendar day, or (ii) $200 million fair market value or 20 million shares over the course of any calendar month.
Review your fund offering materials. Except for commodity pool disclosure documents that are filed with the NFA, fund offering materials do not automatically "expire" after a certain time period. However, as a general securities law disclosure matter, and for purposes of federal and state anti-fraud laws, Investment Managers must continually ensure that their fund offering materials are kept up-to-date and contain all material disclosures that may be required in order for the fund investor to be able to make an informed investment decision. Accordingly, now may be an appropriate time for Investment Managers to review their offering materials and confirm whether any updates or amendments are needed. In considering whether changes to offering materials may be needed, Investment Managers should especially take into account the impact, if any, of recent regulatory reforms on their funds. Among other things, Investment Managers should review the fund’s current investment objectives and strategies, valuation practices, redemption policies, risk disclosures (including but not limited to, disclosures regarding market volatility and counterparty risk), their current personnel, service provider and advisor relationships, and any relevant legal or regulatory developments.
Review your compliance procedures. All Investment Managers should, as a best practice, review no less than annually any established policies and procedures, whether or not they are in writing, to confirm their continued efficacy in light of the Investment Manager’s current business practices and market conditions. Investment Managers that do not have written policies and procedures may wish to consider whether it makes sense to establish written procedures in light of the Investment Manager’s current business. Investment Managers should also be sure that their policies and procedures have been updated to reflect changes in law and regulation.
Renew Form D and review your state blue sky filings. Investment Managers to private funds are reminded of the annual mandatory electronic filing for continuous offerings on Form D. Also, many state securities "blue sky" filings expire on a periodic basis and must be renewed. Consequently, now may be an appropriate time for an Investment Manager to review the blue sky filings for its funds and determine whether any updated filings, or additional filings, are necessary.
Review your liability insurance needs. As a general matter, Investment Managers are not required to purchase management liability insurance, such as directors and officers liability coverage, fiduciary liability coverage, or errors and omissions liability coverage. It may be prudent, however, for Investment Managers that do not have such coverage to periodically assess whether management liability insurance makes sense for them in light of their current business and, if so, what type of coverage and in what amounts. Investment Managers that do have coverage should consider reviewing the adequacy of such coverage.
Complying with state and municipal lobbyist regulations. Investment Managers who provide investment advisory services to state or municipal pension or retirement plans ("Government Plans") should consider whether they or their personnel are considered lobbyists in each jurisdiction in which they solicit Government Plans. Traditionally, the regulation of lobbyists at the state- and municipal-levels had largely been limited to those individuals or entities that sought to influence legislative or rulemaking actions. However, many jurisdictions have begun to define lobbying more broadly to include the act of soliciting investment advisory business from Government Plans.
While each state’s lobbying laws are different, those persons or entities that fall within the definition of "lobbyist" are typically required to fulfill some or all of the following requirements: registration with a governmental body and payment of a fee; attending lobbyist education training; and filing periodic reports containing expenditures and other relevant information. Persons who fail to comply with these requirements may be subject to fines, revocation of one’s lobbyist privileges or other sanctions. As a result, Investment Managers who solicit Government Plans should become familiar with the lobbying regulations for each jurisdiction in which they solicit Government Plans.
One obligation that is not directly applicable to Investment Managers, but which may significantly affect them, is the so-called "Volcker Rule" in the Dodd-Frank Act. While the requirement became effective July 21, 2012, the Federal Reserve Board has publicly announced that an entity covered by the Volcker Rule will have until July 21, 2014 to conform its activities to the Volcker Rule if it is working in good faith to comply by that date. Nonetheless, many firms are already taking steps to comply and that is already having a present effect on some Investment Managers.
The statute generally prohibits a bank and its affiliates from engaging in proprietary trading and, more pertinently, from acquiring or retaining any ownership interest in, or sponsoring, a hedge fund or private equity fund. The statute provides for a conformance period for divestitures, once the final regulations go into effect, and that conformance period ranges from two years to ten years depending on the willingness of regulators to grant extensions and the liquidity of a particular fund in which the banking entity had an investment and was contractually committed to invest in as of May 1, 2010. There are also exceptions for banking entity-organized funds only offered to customers of such entities and in which the banking entity only maintains a de minimis investment and also for funds outside the U.S. not offered in the U.S. where the banking entity is a foreign banking firm (not controlled by a U.S. banking firm).
In addition, the statute prohibits any banking entity that serves as an investment manager, investment adviser, or sponsor of a fund, and any of the banking entity’s affiliates, from extending credit to the fund, purchasing assets from the fund, accepting the fund’s shares as collateral for a loan to another person, or issuing a guarantee on behalf of the fund.
"FBAR" filing requirements and Form TD F 90- 22.1.
United States persons with "financial interests" in "financial accounts" in foreign countries must file a Report on Foreign Bank and Financial Accounts ("FBAR") on Form TD F 90-22.1 by June 30 of each year. Investment Managers must evaluate annually whether accounts maintained on behalf of clients, in particular, offshore private funds, trigger FBAR filing obligations. The FinCEN unit at the U.S. Department of the Treasury is considering the filing requirement’s application to individuals with signature authority over, but no financial interest in, certain types of accounts and such individuals need not file an FBAR until June 30, 2014.
Certain entities are required to complete and submit the Department of the Treasury’s Form SLT, which aims to capture information regarding transactions of long-term securities between United States residents and foreign entities. United States entities (including hedge funds, private equity funds, and commingled funds) that (i) issue securities to foreign residents, and/or (ii) hold securities issued by foreign entities are required to file a Form SLT if the amount of such securities exceeds $1 billion (and such securities are not otherwise held by a U.S.-resident third party custodian). For funds that meet these thresholds, the funds’ Investment Managers likely will be the reporting person for purposes of Form SLT. Entities subject to the Form SLT reporting requirement must complete and file a Form SLT on a monthly basis. Additionally, once the $1 billion threshold is met in a month, the reporting entity must provide Form SLTs for the remainder of the calendar year, regardless of whether the $1 billion threshold is met in later months of that calendar year.
New Rules Regarding General Solicitation and Advertising for Sale of Private Securities
Congress has tasked the SEC with devising new rules that will permit general solicitation and advertising in connection with the offer of certain private placements (subject to certain limitations)—notably, however, it remains unclear when and how these new rules will be issued. Section 201(a) of the Jumpstart Our Business Startups Act ("JOBS Act"), signed into law on April 5, 2012, directs the SEC to relax the current rules restricting general solicitation and advertising in connection with the offer of private securities that are exempt from registration under the Securities Act of 1933, as amended, by either (i) Rule 506 of Regulation D, or (ii) Rule 144A, but only so long as each purchaser of securities under Rule 506 is an accredited investor and each purchaser of securities under Rule 144A is a Qualified Institutional Buyer ("QIB") (or a person the seller and anyone acting on behalf of the seller reasonably believes to be a QIB). The new rules will require an issuer of securities under Rule 506 (that elects to use general solicitation and advertising) to take "reasonable steps" to verify that the purchasers are, indeed, accredited investors. Exactly how an issuer will satisfy these "reasonable steps" is one of the central topics of debate with respect to the new rules. Also, note that the content of any general solicitations and advertisements— in connection with sales under either Rule 506 or Rule 144A — will likely remain subject to anti-fraud rules and other laws and regulations. The new rules were originally required to be issued by the SEC by July 4, 2012 but they have been delayed significantly and the SEC has given no definitive guidance regarding when or how they will be ultimately issued. Until they are issued, the current restrictions on general solicitation and advertising remain in place.
Increased "Holders of Record" Threshold Required to Trigger SEC Registration and Reporting; Special Threshold for Banks and Bank Holding Companies
Effective April 5, 2012, Section 501 of the JOBS Act raised the thresholds that require issuers of a certain size (both operating companies and private investment funds) to register with the SEC under the Exchange Act and to file periodic reports. Prior to the JOBS Act amendments, Section 12(g) of the Exchange Act required issuers to register a class of equity securities and become subject to various reporting requirements if, on the last day of the issuer’s fiscal year, such class of securities was "held of record" by 500 or more persons and the issuer had total assets exceeding $10 million. Section 501 of the JOBS Act modified the record holder threshold by splitting it into two thresholds: one applicable to all issuers generally and the other applicable specifically to banks and Bank Holding Companies ("BHCs"). Under the new, generally applicable threshold, an issuer will be required to register and begin reporting if, on the last day of the issuer’s fiscal year, the issuer has total assets exceeding $10 million and a class of equity securities (other than certain exempted securities) held of record by either (i) 2,000 persons, or (ii) 500 persons who are not accredited investors. Under the new threshold specifically applicable to banks and BHCs, an issuer will be required to register and begin reporting if, on the last day of the issuer’s first fiscal year after the effective date of the amended section, the issuer has total assets exceeding $10 billion and a class of equity securities (other than certain exempted securities) held of record by 2,000 or more persons. The JOBS Act also modified the thresholds for deregistration.
ERISA-Related Requirements and Best Practices
There are also changes that have occurred during the past year and others that are still on the horizon under the Employee Retirement Income Security Act of 1974, as amended ("ERISA") and related Department of Labor ("DOL") regulations that are important to Investment Managers that accept clients who are ERISA plans or that manage private funds that are subject to ERISA. These developments and other important ongoing ERISA compliance considerations are summarized below. Please contact us should you have any questions regarding compliance with any of the following requirements or their applicability to your specific situation.
Ongoing Plan- and Participant-Level Disclosures
Disclosures of service provider compensation. Regulations requiring disclosure of compensation and other information by covered service providers ("CSPs") to ERISA-governed retirement plans or ERISA-governed funds became effective July 1, 2012 for both existing and new contracts or arrangements between covered plans and CSPs. These regulations are commonly referred to as the DOL’s "408(b)(2)" or "service provider" regulations.
"CSPs" include those providing fiduciary services directly to a plan or to a plan assets entity (such as a group trust or a fund exceeding the 25% "significant participation" test). The regulations generally require disclosure of all compensation paid to the covered service provider, its affiliates or its sub-contractors. This includes non-monetary compensation, as well as indirect compensation received from parties other than the plan or plan sponsor. In contrast to the Form 5500 Schedule C disclosures (which are briefly summarized below), these disclosures are required only at "point of sale" (and when the disclosed information changes). The 408(b)(2) regulations do not apply to funds that do not exceed the 25% significant participation test. In contrast, the Form 5500 Schedule C reporting requirements (discussed below) apply to plans that do not exceed the 25% significant participation test. Neither the Form 5500 rules nor the 408(b)(2) regulations apply to funds that are not plan assets due to being "operating companies," such as venture capital operating companies or real estate operating companies.
Additional disclosures are required from those CSPs providing fiduciary services to a plan assets entity relating to compensation charged against a plan’s investment in the plan assets entity and the annual operating expenses of the plan assets entity. If a fund that was not previously a plan assets entity becomes one after July 1, 2012, fiduciaries to that fund must make the required disclosures within 30 days from the date on which the fiduciary knows that the fund is a plan assets entity.
The regulations do not require that all mandated disclosures be made in a single document, but the disclosures are required to be in writing. In addition, the DOL strongly encourages CSPs to offer responsible plan fiduciaries a "guide," summary, or similar tool to assist fiduciaries in identifying all of the disclosures required under the final regulations, particularly when service arrangements and related compensation are complex and information is disclosed in multiple documents. The DOL has included a sample guide as an appendix to the final regulations that can be used on a voluntary basis by CSPs. ERISA plan fiduciaries are required to report to the DOL the failure of CSPs to provide disclosure no later than 90 days after the ERISA plan fiduciary requests the disclosure. In addition, if the CSP fails to meet the 90-day deadline, the ERISA plan fiduciary is required to determine whether to terminate or continue the contract or arrangement, and if the failure to disclose relates to future services, the plan fiduciary must terminate the service arrangement as expeditiously as possible. Non-compliant CSPs may be subject to penalties.
Ongoing disclosures to plan participants in ERISA-governed participant-directed plans. The DOL’s final regulations on disclosures required to be provided to plan participants who have a right to direct the investment of the assets of their accounts under 401(k) or other defined contribution plans became effective as of August 30, 2012. These regulations are commonly referred to as the DOL’s "404(a)" regulations. In contrast to disclosures required by the service provider regulations (described above), the plan administrator is required to provide these disclosures to plan participants. Service providers are not directly obligated to make these disclosures (unless they have contractually agreed to do so). Practically speaking, many, if not most, plan administrators look to their service providers for much of the information required to be disclosed. The regulations provide that a plan administrator will not be liable for the completeness and accuracy of information provided by a plan service provider if the plan administrator relies on that information reasonably and in good faith. Now that the regulations are in place, Investment Managers who provide products or services to 401(k) or other participant-directed plans may wish to evaluate the manner in which they have provided this information, particularly in response to any questions raised by plan clients.
The regulations require disclosure of certain information about the plan’s investment options in a comparative chart format so that all investment options under the plan can be compared in an "apples-to-apples" manner. Rules for special disclosures for "target-date funds" have not yet been finalized. Target date funds are investment funds in which the asset allocation generally shifts to become more conservative as retirement approaches. The DOL reopened the comment period for the final regulation for one month last year in order to coordinate with the SEC’s reopened comment period regarding its proposed rules concerning target date funds.
Continue to watch for DOL reproposal of definition of "fiduciary." In October 2010, the DOL issued proposed regulations that would expand the circumstances under which a party who provides investment advice to an ERISA plan or an IRA would be considered a "fiduciary" under ERISA, changing a well-established regulation which has been in place since 1975. The DOL has announced that it will repropose a new definition in the first few months of 2013. The original proposal included broad-based changes that could significantly affect advisory relationships for ERISA plans and IRAs. The proposal generated significant controversy, criticism and concerns about the expansion of the fiduciary definition and its effect on currently permitted services and practices.
The DOL has stated that the reproposal has taken into consideration comments to the original proposal and that the reproposed regulations will be clearer and more reasonably balanced.
Pending the reproposal of the definition, Investment Managers who provide services to ERISA plans, IRAs or private funds subject to ERISA and their affiliates may wish to stay abreast of developments on this regulatory initiative.
Monitor consequences of Dodd-Frank Act for ERISA plans. The Dodd-Frank Act included several provisions that could have significant consequences for ERISA-governed retirement plans.
On April 24, 2012, the CFTC approved final rules including the definition of "major swap participant." Retirement plans are not excluded from the definition. However, as in the proposed regulations, the final regulations exclude swaps "maintained by employee benefit plans for hedging or mitigating risks in the operation of the plan" from certain of the numerical tests proposed to determine "major swap participant" status. This may have the practical effect of excluding many retirement plans.
Under the CFTC’s business conduct rules, plans are categorized as "special entities," with respect to which a swap dealer may have heightened duties. To avoid these duties, a "swap dealer" (other than a swap dealer also acting as an advisor to an ERISA plan counterparty) must have a reasonable basis to believe that the ERISA plan counterparty has a representative that is an ERISA fiduciary. The rules also include a safe harbor that provides that a swap dealer will not be acting as an advisor to an ERISA plan counterparty if the ERISA plan counterparty represents in writing that it has an ERISA fiduciary to evaluate the swap transactions and the ERISA fiduciary represents in writing that it will not rely on the swap dealer’s recommendations, among other representations. The International Swaps and Derivatives Association published a DF Protocol in 2012 that includes representations by special entities designed to assist swap dealers in meeting the safe harbor. Swap dealers will have until May 1, 2013 to comply with the business conduct rules as they relate to special entities.
The Dodd-Frank Act also requires the CFTC and the SEC to study whether stable value "wrap" contracts fall within the definition of "swaps" and, if so, whether stable value contracts should be exempted from the Dodd-Frank Act. The resolution of these issues could significantly affect how plans manage their investments. The CFTC and the SEC issued a set of questions regarding stable value that it invited commenters to address. The comments were due in September 2011; however, the CFTC and the SEC reopened the comment period for the 30-day period beginning on October 2, 2012, and a final report is still pending. Once the report is issued, those Investment Managers with ERISA clients/investors may wish to evaluate the effect of these provisions on its management of ERISA assets.
Monitor developments regarding Puerto Rican plans invested in group trusts. The eligibility of Puerto Rican plans to participate in tax-exempt "group trusts" has been unsettled for some time as the IRS had announced in 2010 that it would issue guidance on this subject. Pending such guidance, Revenue Ruling 2011-1 provided transition relief allowing Puerto Rican plans then participating in group trusts to continue participating until December 31, 2011. As the IRS’s guidance on the group trust eligibility of Puerto Rican plans has not yet been issued, Notice 2012-6 was issued to extend the transition relief provided by Revenue Ruling 2011-1 and allow existing Puerto Rican plan investors in group trust to remain invested in the group trust pending further guidance. Investment Managers of group trusts with Puerto Rican plans should monitor developments in this area carefully.
Review "exclusive benefit" provisions of governmental plans invested in group trusts. Revenue Ruling 2011-1 set forth certain new requirements for group trusts to retain their tax-exempt status. With one exception, group trusts were required to incorporate the new requirements by December 31, 2011. The exception is the requirement set forth in Revenue Ruling 2011-1 that a governmental plan investor in a group trust must have a provision in its governing document that it is impossible for any part of the corpus or income of the governmental plan to be used for, or diverted to, purposes other than for the exclusive benefit of the plan participants and their beneficiaries, a so-called "exclusive benefit" rule. In Notice 2012-6, the IRS extended that deadline for governmental plans for which the authority to amend the plan is held by a legislative body that meets in legislative session. Such a governmental plan will not fail to satisfy the requirements of Revenue Ruling 2011-1 if the plan is modified to satisfy the exclusive benefit rule by the earlier of (i) the close of the first legislative session of the legislative body with authority to amend the plan that begins on or after January 1, 2012, or (ii) January 1, 2015.
Ongoing ERISA Compliance and Monitoring
Review private fund compliance with 25 percent limit. Investment Managers managing private funds that seek to maintain compliance with the 25 percent ("significant participation") exception from ERISA plan assets status should consider periodically reviewing their processes for best practices. For example, Investment Managers of private funds may wish to reconfirm whether their fund-of-funds investors or other fund investors are "benefit plan investors" subject to ERISA or Section 4975 of the Code for purposes of reconfirming their funds’ compliance with the 25 percent "significant participation" exception under ERISA and, if so, the extent to which that investor’s assets are (and will be) plan assets. Only the portion of these investors’ assets that are subject to ERISA need be counted for this purpose. As this percentage can fluctuate over time, we recommend establishing an "upper limit" percentage which the investor will agree not to exceed. However, if your fund is pushing up against the 25 percent limit, you may wish to more closely monitor these limits so as to free up more ERISA capacity. In addition, as noted above, if a fund becomes a plan assets fund after July 1, 2012, the service provider disclosure regulations require disclosure within 30 days of the Investment Manager knowing that a fund is a plan assets fund.
Review private fund compliance with "operating company" exception. Investment managers that have decided to qualify their funds as "venture capital operating companies" or "real estate operating companies" must continue monitoring compliance with the operating company exception on an annual basis, as per the plan assets regulations until the funds are in their distribution periods.
Investment Managers may also wish to consider qualifying their new funds as operating companies—benefits of qualification include an exemption from ERISA’s fiduciary requirements, and as noted above, relief from Schedule C and 408(b)(2) filing requirements. Initial qualification as a venture capital or real estate operating company is relatively easy to attain for funds that take a controlling interest in their portfolio companies or routinely negotiate for some management rights with respect to the portfolio companies; likewise, ongoing compliance should not be burdensome for such funds.
Comply with Form 5500 fee disclosures. Form 5500 is the annual report required to be filed by ERISA plans with the Internal Revenue Service ("IRS") and the DOL. In addition, Form 5500 filings may also be filed on a voluntary/elective basis by collective trusts and other funds, the assets of which are treated as ERISA plan assets.
Schedule C to Form 5500 requires disclosures of fees and other compensation received by service providers (such as Investment Managers) to ERISA plans. Although the Form 5500 filing is generally the responsibility of the ERISA plan investor, plans will look to Investment Managers to provide the information that is needed for the filing. Investment Managers of plan assets funds may elect to file Forms 5500s on behalf of the funds in which case they will need to comply with these additional compensation reporting requirements. Plan investors sometimes request that investment managers make such filings as it relieves the plan investor from some of its more detailed filing requirements.
For example, required reporting includes all money and other things of value (such as gifts, awards, or trips) received by a person directly or indirectly from an ERISA plan in connection with services rendered to the plan. Indirect compensation includes amounts received other than directly from the ERISA plan, such as fees and expense reimbursements from pooled investment vehicles in which a plan invests, float revenue, and soft dollars. Non-monetary compensation includes, for example, gifts, awards, and trips and is reportable on Form 5500 Schedule C subject to certain de minimis exceptions (basically, the non-monetary compensation must be valued at less than $50 and the aggregate of all non-monetary compensation from one source in a calendar year must be valued at less than $100). Please contact us if you have questions about particular types of compensation.
Importantly, these reporting rules apply to direct and indirect compensation in connection with funds that comply with the 25 percent "significant participation" exception from ERISA plan assets status (with the exception of compensation received from operating companies, including "venture capital operating funds" and "real estate operating funds").
Update and confirm your ongoing ERISA-related compliance generally. As a best practice, Investment Managers that manage plan assets should periodically review their existing investment policies and investment guidelines and trading practices and relationships to confirm that they are consistent with current requirements under ERISA. Significant changes in trading practices and investment policies and investment guidelines also should be reviewed for ERISA compliance. ERISA-related policies and procedures also should be reviewed periodically, such as cross-trading policies, proxy voting policies and gift and gratuity policies, to reflect changes in the Investment Manager’s practices or changes in the law.
Consider expanding group trust eligibility based on IRS Revenue Ruling 2011-1. The IRS has expanded the types of investors eligible to participate in a group trust to include custodial accounts under Section 403(b)(7) of the Code, retirement income accounts under Section 403(b)(9) of the Code, and governmental plans that provide retiree welfare benefits. Group trust documents may need to be amended to reflect the expanded eligibility.
File all group trust amendments with the IRS. Investment Managers who sponsor group trusts that have been amended during the current calendar year, including amendments in response to Revenue Ruling 2011-1, discussed above, must timely file all material amendments with the IRS to maintain the group trust’s determination letter.
Review compliance with ERISA’s fidelity bond requirements, if applicable. Investment Managers with ERISA plan clients or those managing plan assets are required by ERISA to maintain a fidelity bond unless the Investment Manager has determined that it is exempt from ERISA’s fidelity bond requirements. Ongoing bonding arrangements should be reviewed on an annual basis to confirm that the Investment Manager is maintaining the bond in the correct amount and with the correct terms to satisfy ERISA’s requirements.
Investment Managers may wish to review whether changes in their ERISA plan clients require changes to bonding arrangements (for example, an ERISA plan that did not previously hold employer securities may have acquired employer securities, necessitating a higher bond amount). Changes to a fund advised by the Investment Manager may also dictate changes to the fidelity bond (for example, if a plan assets fund goes under 25 percent, a fidelity bond may no longer be required and, conversely, when a fund exceeds the 25 percent limit, the fidelity bonding rules would generally be triggered on that date).
Comply with "FBAR" filing requirements. As also described above, United States persons with "financial interests" in "financial accounts" in foreign countries, including employee benefit trusts, must file an FBAR on Form TD F 90-22.1 by June 30 of each year.
Review developments in the law applicable to governmental plan clients. Investment Managers who manage the assets of governmental plans (which are not subject to ERISA) should review developments in the past year in the law applicable to those plans that may affect plan investments. In recent years, a number of states have adopted restrictions on the use of placement agents and giving of political contributions in connection with plan investments, as well as instituted enhanced disclosure requirements for plan service providers. States and municipalities also continue to adopt laws that limit or restrict permissible investments by public pension plans, such as laws that limit investment in certain countries or impose limits on certain categories of investments. In addition, portfolio declines may require rebalancing from alternative or private equity investments to the extent governmental plan-enabling laws limit these types of investments to a specified percentage of the plan’s overall assets. Also, Investment Managers should consider the consequences of a governmental plan’s request to be treated as an ERISA plan in a plan asset vehicle. If an Investment Manager agrees to such a request, the language in the agreement should be carefully tailored so that it is not overbroad and will not trigger unwanted consequences.