2014: important annual requirements for investment advisers

Investment advisers registered with the Securities and Exchange Commission (the “SEC”) have certain annual requirements under the Investment Advisers Act of 1940 (the “Advisers Act”), some of which also either apply to “exempt reporting advisers” (“ERAs”) or warrant consideration as best practices for ERAs. This update reminds investment advisers about certain annual regulatory and compliance obligations, including a number of significant 2014 reporting or filing deadlines.

This update also reminds advisers that are registered as commodity pool operators (“CPOs”) or commodity trading advisors (“CTAs”) with the Commodity Futures Trading Commission (the “CFTC”) and are members of the National Futures Association (“NFA”) of certain CFTC and NFA reporting requirements.

This update does not purport to be a comprehensive summary of all of the compliance obligations to which advisers are subject; please contact your Sidley attorney 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.

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, 2013 fiscal year end must file its annual amendment byMarch 31, 2014. 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 2A is prepared in Adobe Portable Document Format (“PDF”) and filed as an attachment to Part 1A. 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.

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.

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”).¹
• 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).²

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 “exempt reporting advisers” (defined above as “ERAs”) 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, 2013 fiscal year end must file its annual updating amendment by March 31, 2014.

An ERA relying on the private fund adviser exemption must calculate annually the private fund RAUM 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.³ 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 may 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 (the “Compliance Rule”) requires an SEC-registered adviser to 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.⁴ 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:

• 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. 
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.

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.

Other Annual Reminders

Training. 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).

Annual Certification. 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 reread) 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.

Annual Personal Securities Holdings Report. On an annual basis, an adviser must collect from each “access person” an annual personal securities holding report containing certain required information regarding securities holdings and securities accounts.

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.

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 should review at least annually the adequacy of its policies and procedures and make any needed revisions.

An ERA must provide clients and fund investors who are natural persons with a privacy notice on an initial and annual basis.

Recent Regulatory Developments That May Affect An Adviser’s Compliance Program

The following selected regulatory developments may affect the compliance programs of certain advisers. Advisers should review these and other changes in applicable laws, rules or regulations to determine whether compliance policies and procedures need to be added or revised.

Possible Use of General Solicitation. As mandated by the Jumpstart Our Business Startups (“JOBS”) Act, effective September 23, 2013, the SEC amended Rule 506 of Regulation D under the Securities Act of 1933 to eliminate the prohibition against general solicitation and general advertising for the offer and sale of securities conducted under the Rule, subject to certain conditions. Specifically, new Rule 506(c) eliminates the prohibition against unregistered sales of securities made by means of general solicitation, provided that, among other things:

• all purchasers of the securities are “accredited investors”; and
• the issuer takes “reasonable steps to verify” that the purchasers of the securities are accredited investors.

Any adviser intending to take advantage of new Rule 506(c) with respect to any private fund that it advises will need to develop and implement policies and procedures designed to meet those conditions and address various other considerations associated with the use of general solicitation.

Bad Actor Rule. Effective September 23, 2013, the SEC also amended Rule 506 to add new Rule 506(d) (the “Bad Actor Rule”), which prevents private funds and other issuers from relying on the Rule 506 registration exemption if the offering involves certain felons or other “bad actors” who have experienced a “disqualifying event.” The Bad Actor Rule applies to all Rule 506 offerings, not just offerings in which an issuer engages in general solicitation pursuant to new Rule 506(c). With respect to private funds currently being offered that rely on Rule 506, as well as new funds that will seek in the future to rely on Rule 506, an adviser must identify the pertinent covered persons, determine whether any covered persons have disqualifying events and, if so, take pertinent steps so as to not lose eligibility to rely on Rule 506. Advisers to private funds relying on Rule 506 should have in place policies and procedures designed to facilitate compliance with the Bad Actor Rule.

Red Flags Rules. On April 10, 2013, the SEC and the CFTC jointly adopted Regulation S-ID (the “Red Flags Rules”) requiring any SEC- or CFTC-regulated entity that:

• is a “financial institution” or “creditor”; and
• offers or maintains “covered accounts”

to establish a “red flags program” that is designed to detect, prevent and mitigate identity theft.

An SEC-registered adviser must determine (and document) whether it is subject to the Red Flags Rules and periodically review that determination based on any changed circumstances. If an adviser determines that it is required to comply with the Red Flags Rules, it must establish a red flags program. An adviser that believes the Red Flags Rules do not apply to it also may elect to adopt a red flags program as a best practice.

Preparing for the Possibility of an SEC Examination

The books and records of all 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, although the SEC has indicated that it does not expect to examine ERAs on a routine basis. Generally, an adviser being examined 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 conducts 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 before commencing the examination and provide a list of records that the staff intends to review during 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, 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 audit.

SEC Exam Priorities for 2014

On January 9, 2014, the SEC’s National Exam Program (the “NEP”) released its list of examination priorities for 2014 (the “Release”).⁵ 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 areas for improvement.

The Release identified certain examination priorities applicable to investment advisers, including, for example:

• Presence Exam Initiative. The staff will continue the initiative announced in October 2012 to examine a significant percentage of the private fund advisers that registered with the SEC after July 21, 2011. The key focus areas of these examinations are marketing, portfolio management, conflicts of interest, safety of client assets and valuation. The Release also indicated that the staff will continue to prioritize examinations of private fund advisers “where the staff’s analytics indicate higher risks to investors, or where there are indicia of fraud, broker-dealer status concerns, or other serious wrongdoing.” According to the Release, as of September 30, 2013, over 200 presence exams had been completed and the Presence Exam initiative was on mark to meet its goal of examining 25 percent of advisers newly registered under the Dodd-Frank Wall Street Reform and Consumer Protection Act within two years.
• Never-Before Examined Advisers. Under this initiative, the staff will conduct focused, risk-based examinations of advisers that have been registered for more than three years, have never been examined and are not part of the Presence Exam initiative.
• Safety of Assets and Custody. The Release noted that the NEP continues to observe non-compliance with Rule 206(4)-2 under the Advisers Act (the “Custody Rule”). The staff will continue to test compliance with the Custody Rule and confirm the existence of client assets through a risk-based asset verification process. Examiners will pay particular attention to situations in which an adviser fails to realize it has custody and therefore fails to comply with requirements of the Custody Rule.
• Conflicts of Interest. The staff will focus on conflicts of interest inherent in an adviser’s business model, such as undisclosed compensation arrangements, allocation of investment opportunities, side-by-side management of performance-based and asset-based fee accounts, and risk controls and disclosure, particularly for illiquid and leveraged investment products and strategies.
• Marketing/Performance. The staff will review the accuracy and completeness of advisers’ claims about their investment objectives and performance. For example, the staff will review and test hypothetical and back-tested performance, the use and disclosure of composite performance figures, performance recordkeeping and compliance oversight of marketing. The staff also expects to review marketing efforts arising out of newly effective rules adopted under the JOBS Act.
• Quantitative Trading Models. When examining advisers with substantial reliance on quantitative portfolio management and trading strategies, the staff will assess, among other things, whether these firms have adopted and implemented compliance policies and procedures tailored to the performance and maintenance of their proprietary models.

On February 20, 2014, the SEC Office of Compliance Inspections and Examinations provided further information regarding the “Never-Before-Examined Advisers” initiative, including a letter to the senior executive or principal of certain registered advisers.⁶ According to the letter, the initiative includes two distinct exam approaches: risk-assessment and focused reviews. The risk-assessment approach, which is designed to obtain a better understanding of a registrant, may include a high-level review of an adviser’s overall business activities, with a particular focus on the compliance program and other essential documents needed to assess the representations made on disclosure documents. The focused review approach includes conducting comprehensive, risk-based examinations of one or more of the following higher-risk areas of the business and operations of advisers selected for an examination: the adviser’s compliance program, filings and disclosure, marketing materials, portfolio management and safety of client assets.

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 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. The current fee per filing is $150.

Many private fund advisers filed their initial Form PF in 2013. While many large private fund advisers also filed quarterly updates during 2013, many other private fund advisers are preparing their first annual updates for filing by April 30, 2014.

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 web site.⁷

Who Must File

SEC-registered investment advisers that:

• advise one or more private funds; and
• 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 the most recently completed fiscal year

are required to file Form PF.

CFTC-registered CPOs and CTAs dually registered with the SEC are required to file Form PF and submit information with respect to each advised commodity pool that also is 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.⁸

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. Advisers meeting only the minimum $150 million private fund RAUM reporting threshold, as well as large private equity fund advisers, must file Form PF annually within 120 days of their fiscal year end. Large liquidity fund advisers and large hedge fund advisers must file quarterly, within 15 days (for large liquidity fund advisers) and 60 days (for large hedge fund advisers) of their 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. 

Click here to view table.

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 with respect to certain commodity pools that they advise 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”). 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.

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.⁹ 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 CFTC 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.¹⁰ 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. 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.

With respect to 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.¹¹

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.¹²

CFTC Form PQR and NFA Form PQR filing requirements are summarized in the following chart. 

Click here to view table.

Form CTA-PR

Each registered CTA is required to file an annual Form CTA-PR with the CFTC within 45 days of the calendar year end, and each CTA that is an NFA member is required to file a quarterly NFA Form CTA-PR within 45 days of the calendar quarter end.¹³ 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.