Information on the event is posted below and can be found on the PEI website by clicking here.

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PEI Private Fund Compliance Forum: San Francisco

An enormous collective sigh of relief was felt around the private equity world when the SEC announced that the deadline to register was moved to March 30, 2012. This extension has given private equity firms more time to designate a chief compliance officer, implement a compliance program, and file all necessary forms with the SEC.

The PEI Private Fund Compliance Forum: San Francisco provides private equity and venture capital firms an opportunity to gain a more complete understanding of what newly registered private funds should expect post-registration and how to implement and manage an effective compliance program.

This one and a half day event, divided into panel discussions and in-depth workshop sessions, is tailored to firms that are in the process of registering with the SEC, those firms that are seeking more information about the scope of what is entailed in registration as well as those who are already operating as RIAs that are looking to enhance their compliance functions.

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Panel: Effective and appropriate marketing materials

10:40 – 11:45

• Interpreting rules governing marketing and advertising

• Making sure that presentations are reviewed by compliance

• Making sure your web sites are in compliance

• Guidelines regarding talking to the press

Moderator:

Janis Kerns, Editor, ACA Insight

Panel Members:

Karl A. Cole-Frieman, Partner, Cole-Frieman & Mallon LLP

Jennifer Keese-Powell, Marketing Manager, Hall Capital Partners LLC

Lois Towers, Compliance Officer, Pantheon Ventures (US)

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Cole-Frieman & Mallon LLP provides a variety of services including: hedge fund formation, advisor registration and counterparty documentation, CFTC and NFA matters, seed deals, internal investigations, operational compliance, regulatory risk management, hedge fund due diligence, marketing and investor relations, employment and compensation matters, and routine business matters. For more information please visit us at: http://www.colefrieman.com/.

Marketing, of course, is an issue close to the heart of every hedge fund manager. You spend so much time and effort making your pitchbook and other materials exactly right in terms of strategy, investment process and all the details that help you make the most of your investor meetings. It needs to look great; it needs to tell your story, and as the SEC recently reminded us, it needs to be the truth, the whole truth, and nothing but the truth.

Overview of Case

On October 26, 2011, the SEC filed an action in the US District Court for the District of Massachusetts against Andrey C. Hicks (“Hicks”) and Locust Offshore Management, LLC (“LOM”). Hicks and LOM purported to manage a British Virgin Islands-based investment vehicle named Locust Offshore Fund, Ltd. (the “Fund” and collectively with Hicks and LOM, “Locust”), which employed a strategy based on a quantitative model developed by Hicks. The SEC alleged that the Fund was in fact part of a fraudulent scheme that ultimately funneled incoming subscriptions into Hicks’ personal accounts.

According to the complaint (see SEC v. Hicks & Locust),  the scheme depended on a number of misrepresentations found in LOM’s website, the Fund’s offering memorandum, Hicks’ email correspondence, Hicks’ verbal statements to at least one investor, post-subscription correspondence with investors.

The SEC asserted causes of action under Section 17(a) of the Securities Act (fraudulent interstate transactions), Section 10(b) of the Exchange Act and related rules (prohibiting the use of manipulative and deceptive devices); Section 206(4) of the Advisers Act (prohibiting act, practice or course of business that is fraudulent, deceptive or manipulative), and for equitable relief.

The District Court issued a temporary restraining order and asset freeze against Locust.

Takeaways for Managers

The alleged misrepresentations included the following:

• Statements that the Fund was formed and registered as a professional fund in the British Virgin Islands, when in fact no such entity had existed or been registered there;
• Flowing from the above, any statement identifying Hicks as the portfolio manager, director, or other principal of the Fund or LOM, as well as any statement that LOM was the manager of the Fund;
• Identifying Ernst & Young as the auditor of the Fund, and Credit Suisse as the Fund’s prime broker, when in fact neither company had ever been retained to provide services to the Fund;
• Statements that the 27 year old Hicks held an undergraduate degree and doctorate degree in applied mathematics from Harvard, when in fact he had only attended three semesters as an undergraduate, and was forced to withdraw due to repeated failure to meet academic standards. Hicks received a D minus in the only math course he took;
• Statements that Hicks managed a book of futures, options and foreign exchange investments at Barclays, and grew his book nearly two-fold during his brief tenure, when in fact he had never been employed at Barclays; and
• Assurances to at least one investor that his subscription monies had been received and were “entered into live trading,” and similar statements.

The first investor in the Fund, referred to as Investor A, met Hicks on an airplane and the two fell into conversation. The above statements, found in the offering documents, on the website and in other materials, were reinforced during their conversation. Hicks talked about his education and professional experience, showed Investor A LOM’s website on his Blackberry, and the two parted, exchanging their business cards. The chance meeting and follow-up emails were evidently persuasive; Investor A wired his subscription monies about a month later.

This action highlights several points for managers:

• Do not lie in your marketing materials; in biographies especially, take care to avoid statements that exaggerate education, qualifications, experience and expertise;
• Carefully check all facts, even basic data such as service provider information and fund formation details in all areas where they appear (not merely obvious places like your fund offering documents, but any presentations, pitchbooks, websites or other materials);
• Maintain files of backup materials to document every factual statement made in your offering documents, marketing materials and on your website;
• The anti-fraud provisions of the securities laws have a long reach and managers should be careful about all communications, not just in their marketing materials. Evaluate letterhead, business cards, email signatures and speak with all employees, but especially those involved in marketing, regarding appropriate parameters for meetings (planned or chance) with potential investors.

Conclusion

Although Hicks is an extreme example, all managers should ensure that their funds’ offering documents marketing materials, stationery, written correspondence, and verbal statements are accurate, including with respect to service provider information, fund formation details, and biographies. To the extent that managers provide such information on their websites, all of these details should be confirmed as accurate on the website itself, and in any linked or uploaded materials.

We recommend that your attorney, in-house counsel or compliance consultant review all marketing materials prior to distributing them, and retaining these materials and backup information in your files.

For more information please see the complaint above of the SEC litigation release.

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Cole-Frieman & Mallon is a boutique hedge fund law firm which provides fund formation, business and compliance services to fund managers.  Bart Mallon can be reached directly at 415-868-5345.

SEC has chosen FINRA to accept Form PF filings on its behalf when and if Form PF is adopted.  As background, on January 26, 2011 the SEC issued a proposed Rule 204(b)-1 under the Investment Advisers Act of 1940 which would require SEC registered investment advisers to file a new Form PF with the SEC on either a quarterly or annual basis.  Although the rest of the proposed rule is still under consideration, the SEC has determined that if Form PF is adopted, investment advisers would file Form PF electronically through FINRA.  FINRA currently is the operator of IARD, the system through which investment advisers electronically file their Form ADV and make necessary notice filings to states.  If the rule is passed, FINRA will develop and maintain the filing system for Form PF as well.

The SEC initially anticipated that the proposed rule implementing Form PF would have an initial compliance date of December 15, 2011 – this appears less likely as we get closer to that date and plan to provide updates as appropriate.

Form PF Filing Process and Filing Fees

Because the filing system for Form PF will likely be an extension of the current IARD filing system, we expect the process will be substantially similar to the current process of filing Form ADV.  Investment advisers filing Form PF will likely have to go through the entitlement process and then fund their accounts with the fees necessary to submit the filing through the system.  Managers will have to make quarterly annual filing based on their assets under management. Regardless of assets under management, the filing fees shall be as the same for each filing:

• $150 for each Form PF annual update
• $150 for each Form PF quarterly update

Conclusion

FINRA is the logical choice to accept and manage the filing of Form PF because, as the current operator of the IARD system, they are uniquely situated to develop and deploy the Form PF filing system in a timely manner.  The SEC believes that having FINRA expand its existing platform to accommodate this additional filing would be result in greater efficiency for both the advisers and the SEC.  However, managers should be wary of the continued consolidation of filing platforms as FINRA continues to move towards becoming the SRO for hedge fund managers and other investment advisers.

The text of FINRA’s letter regarding Form PF can be found here: FINRA Form PF Letter

The text of SEC’s notice of intent to have Form PF filed through FINRA can be found here: SEC Form PF Announcement – IA-3297

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Cole-Frieman & Mallon LLP provides comprehensive registration and compliance services to hedge fund managers, including help with filing Form PF.  Bart Mallon can be contacted directly at 415-868-5345.

Expert networks have been a major topic over the last few months and we are seeing the states, in addition to the SEC, focus on this area as a compliance issue for investment advisers.  Massachusetts recently revoked the state investment adviser license of a manager who was using expert networks to gain inside information and then trade on that information.  Massachusetts is now proposing regulations which would require state registered managers to develop certain policies with respect to use of expert networks.

The proposed regulation provides generally that investment advisers may not use expert network services unless the adviser receives a signed certification from the consultant (sourced by the expert network firm) that:

• describes the confidential restrictions the consultant has regarding confidential information and
• the consultant affirmatively states that he will not provide any confidential information to the adviser

In addition to this new compliance requirement, the proposal codifies the general prohibition against trading on inside information.

The full text of the proposed regulation is printed below and can be found here.  The Massachussets Securities Division will hold a public hearing on these and other proposed regulations on June 23 and will accept written comments until June 24.

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Preamble to Proposed Regulation

Investment Advisers Using Matching or Expert Network Services – Dishonest or Unethical Conduct in the Securities Business

The Division proposes to add a new section under 950 CMR 12.205(9)(c)(16) to the existing list of dishonest and unethical practices. The Division believes this addition is necessary to address the rising use of expert network firms by investment advisers to facilitate paid consultations between investment advisers and industry experts.

As alleged in In the Matter of Risk Reward Capital Management Corp., RRC Management LLC, RRC BioFund LP, and James Silverman, Docket No. E-2010-057, some investment advisers have paid expert networks and consultants to access confidential information about publicly traded companies. The rise of expert network firms, and the number of abuses which have been addressed by regulators, make it clear that additional measures are required to ensure that confidential information is not being accessed and traded upon. The Division’s proposed regulations, while not altering investment advisers’ existing duty not to trade on insider information, seek to provide investment advisers with greater clarity as to what is impermissible conduct when paying consultants for information.

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Proposed Regulation

Investment Advisers Using Matching or Expert Network Services – Dishonest or Unethical Conduct in the Securities Business

Add the following new subsection (16) to 950 CMR 12.205(9)(c) (non-exclusive list of practices by an investment adviser which shall be deemed “dishonest or unethical conduct or practices in the securities business”):

16. a. To retain consulting services, for compensation that is provided either directly to the consultant or indirectly through a Matching or Expert Network Service, unless the adviser obtains a written certification, signed by the consultant that:

(i) describes all confidentiality restrictions that the consultant has, or reasonably expects to have, regarding Confidential Information; and
(ii) affirmatively states that the consultant will not provide any Confidential Information to the adviser.

b. Notwithstanding section (a) an investment adviser who comes into possession of material Confidential Information through a consultation is precluded from trading any relevant security until such time as the Confidential Information is made public.

c. Definitions. For purposes of this section:

(i) “Confidential Information” means any non-public information, which one is bound by a confidentiality agreement or fiduciary (or similar) duty not to disclose.
(ii) “Matching or Expert Network Service” means a firm that for compensation matches consultants with investment advisers.

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Cole-Frieman & Mallon LLP is a boutique hedge fund law firm.  In addition to investment adviser registration and compliance, we provide expert network compliance consulting services to SEC and state registered hedge fund managers.  Bart Mallon can be reached directly at 415-868-5345.

• New SEC and CA Hedge Fund Registration Requirements
• Registration Overview & Major Issues
• Compliance Overview
• Discussion of Other Current Regulatory Issues

There were of number of questions asked by the audience regarding many of the new compliance requirements for registered managers.  We have had good experience with the following groups:

• Email and IM Archiving – Smarsh
• Outsourced Compliance/ Outsourced CCO – Gordian Compliance Solutions

If you attended the event and have follow up questions, please feel free to contact us and we will try to get back to you as soon as possible.  The full powerpoint can be downloaded here: CAHF Powerpoint (April 2011) Final

Many thanks to Ron Niemaszyk of Patke & Associates for moderating the event.

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Cole-Frieman & Mallon LLP provides investment adviser registration & compliance services to hedge fund managers.  For more information, please call Bart Mallon at 415-868-5345.

Managers are becoming more aware of the various securities laws and compliance issues involved with the use of expert networks.  While the SEC has recently been active in this area (both in the RR insider trading complaint and the recent expert network action), the states are also becoming more aware of the potential issues involved with expert networks.  Recently the Massachusetts Securities Division instituted an administrative complaint against a Massachusetts state registered fund manager who utilized expert networks to gain inside information.  This post will provide an overview of that compliant.

Overview

James Silverman was registered as an investment adviser representative for a Massachusetts registered IA firm which was managing the RRC Bio Fund, LP (“Fund”).  The IA firm was subject to a routine announced examination by the Massachusetts Securities Division (“Division”).  During that routine examination, the examiners found a number of violations of the various state securities laws including the fact that Silverman was trading on inside information obtained from an expert network firm.

The examiners found that Silverman started using the expert network firm after the Fund suffered a long period of losses.  After utilizing the expert network firm, the Fund posted consecutive years of gains in excess of 50%.  During the course of the relationship with the expert network firm, the Fund paid $80,000 a year to the firm so that Silverman could have access to certain consultants in the biotechnology industry.  Many of these consultants were either insiders or otherwise bound to confidentiality agreements with respect to their activities in the industry.  The expert network firm did not monitor their consultants in any way but, pursuant to the firm’s policies, the consultants’ had a duty to identify and avoid any disclosure that would violate a confidentiality agreement.  The agreement that Silverman signed with the expert network firm provided that Silverman agreed not to elicit or otherwise obtain any “material nonpublic or otherwise confidential information” from the expert consultants.

In addition to the insider trading, Silverman and the IA firm engaged in either blatantly illegal or egregiously sloppy business practices, especially once the examination began.  For example, the complaint states that Silverman did the following:

• deleted notes containing study results prior to producing the notes to the Division in response to its subpoena
• deleted certain documents and correspondence
• failed to maintain required records
• made false filings with the Division
• violated minimum financial requirements
• violated document retention requirements
• improperly assessed performance fees
• left client data vulnerable

The Order

The consequences for breaking the securities laws, whether at the state or federal level, are severe.  The Enforcement Section of the Massachusetts Securities Division sought the following items in its action against Silverman:

• accounting and disgorgement of all ill-gotten gains as a result of insider trading
• disgorgement of direct and indirect remuneration from the insider trading
• revocation of the IA registration for the firm and Silverman
• enjoining Silverman from performing any investment advisory services for compensation on behalf of any person or entity within the Commonwealth of Massachusetts
• imposition of a fine

Protecting Your Firm – Developing Compliance Programs

This case and the earlier SEC actions do not mean that fund managers can no longer use expert network firms.  However, managers need to be careful and the best practice is for managers to develop compliance policies for all interaction with expert network firms.  These policies and procedures need to be tailored to the business practices of each manager and need to be followed consistently.

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Cole-Frieman & Mallon LLP is a boutique hedge fund law firm.  We provide hedge fund compliance and registration services to SEC and state registered hedge fund managers.  Bart Mallon can be reached directly at 415-868-5345.

FINRA recently proposed amendments to Rule 5122 which would increase Broker-Dealer compliance responsibilities with respect to private placements in which the Broker-Dealer “participates.”  FINRA noted that the vast majority of private placements currently remain outside the purview of the rule as it is currently written.  As FINRA’s stated intention is to increase investor protection, the amended rule is designed to combat fraud and abuse, by expanding oversight to all private placements in which a FINRA member participates, subject to certain exemptions.

Current FINRA Rule 5122

In general FINRA Rule 5122 requires a FINRA member firm which acts as the issuer of a private placement to adhere to the following requirements:

• the private placement offering document must include the indended use of offering proceeds, expenses, and the amount of selling compensation to be paid to the broker-dealer and its associated person;
• 85% of the offering proceeds must be used for the business purposes described in the offering documents (i.e. only up to 15% of the proceeds from the offering may be used to pay for offering costs, discounts, commissions or any other cash or non-cash sales incentives); and
• the offering documents must be submitted to FINRA for review at or prior to the time the offering documents are provided to any prospective investor (but the firm does not need to delay the offering until it receives a “no-objections” letter from FINRA).

There are various exemptions available under the rule including if the private placement offering is sold to:

• Institutional accounts
• Qualified purchasers
• Qualified institutional buyers
• Investment Companies
• Banks
• Employees of the issuers

In addition, certain private placements are not subject to the rule.

Major Part of Proposal

In general the major part of the proposed amendment is to apply the requirements of the rule to broker-dealers who “participate” (within the meaning of FINRA Rule 5110(a)(5), see below) in a private placement offering as opposed to only those broker-dealers (and control entities) who act as the issuer in a private placement.  The proposal will significantly expand the scope of the current rule – third-party marketers who enter into selling arrangements with respect to private fund interests will now be subject to greater oversight with respect to these arrangements.

Participation

Rule 5110(a)(5) defines “participation” as the following:

Participation in the preparation of the offering or other documents, participation in the distribution of the offering on an underwritten, non-underwritten, or any other basis, furnishing of customer and/or broker lists for solicitation, or participation in any advisory or consulting capacity to the issuer related to the offering, but not the preparation of an appraisal in a savings and loan conversion or a bank offering or the preparation of a fairness opinion pursuant to SEC Rule 13e-3.

The proposal also would remove the wholesaling exemption (i.e. selling through affiliated broker-dealers) for member firms.

It is not clear now how this would affect the business of third-party marketers and whether this will have a chilling affect on selling agreements.  This proposed amendment also highlights FINRA’s aggressive expansion of regulatory oversight.

If you have specific comments on the proposal, especially with respect to certain elements (investor protection, filing requirements, burdens/efficiencies, 85% of offering proceeds go to the use of proceeds), you should submit comments on the proposal by March 14, 2011

For more information, please see FINRA Regulatory Notice 11-04.

Other good information for broker-dealers FINRA Regulatory Notice 10-22.

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Bart Mallon is an attorney focused on the investment management industry and provides regulatory and compliance services to the broker-dealer community through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.

Below we have provided a list of the major items which registered firms should address with respect to annual compliance.  Many registered CTA and CPO firms have compliance manuals which address (or should address) these items.

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Rule 2-46 Quarterly Report (CPO only)

• Due 2/14/2011
• The following information must be submitted to the NFA:
  • Summary of Itemized Balances
  • Key Relationships
  • NAV
  • Monthly Performance – Rates of Return
  • Schedule of Investments
• More information:
  • We have previously written about the CPO quarterly reporting requirement
  • A guide on how to file is available at the NFA website here.
• Once the report has been filed, complete and keep the Acknowledgment of Quarterly Report Filed (Rule 2-46) form and any related documents with your books and records.

Quarterly Review of Emails

• Registered CPO and CTA firms are responsible for supervising employees and should periodically review employee emails.  It is a good idea to complete a quarterly review of employee emails, document the review and keep the documentation as part of the firm’s books and records.

Yearly Review of Email Procedures

• The firm’s compliance officer should review the effectiveness of the firm’s email review procedures on a yearly basis.  The compliance office should document the review and keep the documentation as part of the firm’s books and records.

Compliance Manual Review

• The compliance officer should review the firm’s compliance manual on an annual basis.  After the compliance manual has been reviewed and updated as necessary, the compliance officer should have each Principal, Associated Person, and Agent certify that he or she has read and understands the compliance manual and has complied with its requirements.

NFA Self-Examination Checklist

• The NFA self-examination needs to be completed on a yearly basis.  The compliance office will need to review the firm’s operations using the NFA’s Self-Examination Checklist (http://www.nfa.futures.org/nfa-compliance/publication-library/self-exam-checklist.HTML), document the self-examination and keep the documentation as part of the firm’s books and records.
• Mallon P.C. has provided an overview of the NFA Self-Examination process.

Privacy Policy

• All firms should provide each fund investor or client with a copy of the firm’s Privacy Policy within 30 days of the close of the fiscal year.  If the firm provides monthly or other periodic statements, the firm might want to include the Privacy Policy with such normal communication.

Ethics Training

• The firm’s compliance officer should review the firm’s ethics training program.  If the program changes, the compliance officer must make sure that all Principals, APs and Agents have completed the appropriate ethics training.  If the policy has not changed, this is a good time to confirm all Principals, APs and Agents have completed all appropriate ethics training.

Annual Report (CPO only)

The report must include:

Bunched Orders Allocation (CTA only)

• CTA firms should periodically review the allocation of bunched orders.  Many firms will have a policy to review these allocations on a quarterly basis.  For more information, please see our post on CTA Bunched Orders.

Other Important Items

• Annual Questionnaire – the annual questionnaire is due within 1 year of the date of registration.  This form is available through the NFA’s ORS (Online Registration System).  For more information see our post on this topic.
• Annual Registration Update – the annual registration update is due within 1 year of the date of registration.  This form is available through the NFA’s ORS (Online Registration System).  In general the NFA will send a letter (and email) and invoice for annual fees and dues.
• Other – some firms have policies regarding their Disaster Recovery Program which may need to be revisited during the annual review process.  Additionally, both CTA and CPO firms should take the opportunity to review their disclosure documents and see if any revisions to those documents should be made.  Other business issues, like bank reconciliations and general bookkeeping matters, should be reviewed in light of the firm’s compliance policies.

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The above list is not indended to be exhaustive and each firm has different compliance requirements depending on unique circumstances.  If your firm would like help with developing a compliance program or if you have questions with respect to these topics, please don’t hesitate to contact us.

Cole-Frieman & Mallon LLP provides comprehensive compliance and regulatory support for CTAs and CPOs.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

While most firms should have by now paid the preliminary statement, each firm can now review their Final Renewal Statement.  The final statement is now available through the IARD system and reflects the firm’s and representatives’ final registration status as of December 31, 2010.  The final statement also reflects any adjustments as a result of registration approvals or terminations since the preliminary statement was issued. Firms and representatives should check their final statement to ensure all renewal fees are paid in full.  If the firm has any amounts due, payment should be made by February 4, 2011.

Below is information on how to access your Final Renewal Statement.

Accessing Your Final Renewal Statement

To check your firm’s Final Renewal Statement, follow these instructions:

1. Log onto IARD here.
2. Enter your firm’s ID and password.
3. Review and accept the terms and conditions.
4. Under the “Accounting” tab at the top of the page, select “Renewal Account.”
5. Under the “Renewal Statement” link in the “Accounting” section, you can retrieve the Final Renewal Statement, which will state “Paid in Full” or “Amount Due.”

If an amount is due, the balance must be received by FINRA and posted to the Renewal Account by February 4, 2011.  Any renewal overpayments should have automatically been transferred to your Daily Account.

Additional information about the Final Renewal Statement can be found here.

If you have any questions regarding your renewal statement or any other investment adviser registration issue, please feel free to contact Mallon P.C. for more information.

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Bart Mallon, Esq. runs the hedge fund law blog and provides hedge fund compliance services to hedge fund managers through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.

On December 28, 2010, the SEC issued a four-month extension for the Part 2B compliance dates.   The new compliance dates for Part 2B are as follows:

• New IAs – All newly registered IAs filing their applications for registration with the SEC from January 1, 2011 through April 30, 2011, have until May 1, 2011 to begin delivering Part 2B to new and prospective clients. These advisers have until July 1, 2011 to deliver Part 2B to existing clients. The compliance dates for delivering Part 2B for newly-registered IAs filing applications for registration after April 30, 2011 remain unchanged.

• Existing registered IAs – All IAs registered with the SEC as of December 31, 2010, and having a fiscal year ending on December 31, 2010 through April 30, 2011, have until July 31, 2011, to begin delivering Part 2B to new and prospective clients. These advisers have until September 30, 2011 to deliver Part 2B to existing clients. The compliance dates for delivering Part 2B for existing registered IAs with fiscal years ending after April 30, 2011 remain unchanged.

The compliance dates for Part 2A remain unchanged.  More information about the compliance dates initially set by the SEC are available here.

For the full SEC release, please see SEC Extends Compliance Deadline for ADV Part 2.

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Other related articles:

• New Form ADV Part 2
• Important Hedge Fund Articles

Bart Mallon Esq. is a hedge fund attorney and provides hedge fund compliance services through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.