Category Archives: Legal Resources

Expanded Accredited Investor Definition FAQs

Frequently Asked Questions About New Accredited Investor Definition

There has been much discussion about the recent amendments to the “accredited investor” definition adopted on August 26, 2020 (the “Amendments”) by the Securities and Exchange Commission (“SEC”). We have provided a more detailed overview of all the Amendments here, but wanted to address many of the common questions we are receiving from clients specifically regarding the Amendments to the accredited investor definition. Please send us any other questions and we will update the below as they come in…

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Will a person who is a contractor to the management company or fund qualify as an accredited investor now?

The Amendments provide that a “knowledgeable employee” (as defined in Rule 3c-5(a)(4) of the Investment Company Act of 1940) of a 3(c)(1) or 3(c)(7) fund will now be considered an accredited investor. We have been asked by a few clients whether this expanded definition includes contractors. Because the definition of a knowledgeable employee does not include contractors and has not been altered by the Amendments or otherwise, contractors do not currently qualify as accredited investors under this expanded definition.

What about the professional certification designation?

A natural person holding at least one professional certification or designation or credential in good standing from a qualifying educational institution will now be considered an accredited investor.

To determine whether an investor meets this criteria, the SEC will consider: (i) whether the certification, designation or credential results from an examination or series of examinations administered by a self-regulatory organization, other industry body or accredited educational institution; (ii) whether the examination(s) are reliably designed to demonstrate an individual’s comprehension and sophistication in the areas of securities and investing; (iii) whether an investor obtaining such certification, designation or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and (iv) whether it is publicly made available by the self-regulatory organization or other industry body (or is otherwise independently verifiable) that an investor holds the certification, designation or credential.

The professional certifications, designations or credentials currently recognized by the SEC to satisfy this criterion will be posted on the SEC’s website. One important item to note is that an investor does not need to practice in the field(s) related to the certification, designation or credential to meet the good standing requirement, except to the extent that continued affiliation with a firm is required to maintain such certification, designation or credential.

What has prompted this modernization of the accredited investor definition?

Whether an investor meets the definition of an accredited investor has been one of the most important considerations when determining whether an investor is eligible to invest in private capital markets. The primary purpose of this qualification has been to determine whether an investor based solely on an investor’s income or net worth (because they presumably would be able to withstand a loss in the investment). The effects of the limited tests have prevented many investors from partaking in private capital markets, regardless of their actual financial sophistication. Thus, after years of discussions, the SEC has expanded the accredited investor definition to provide new measures of determining financial sophistication that more holistically determine financial sophistication. These Amendments should decrease the economic barrier-to-entry in our private capital markets and result in the participation of newly qualified accredited investors with more diverse backgrounds.

When do the Amendments become effective?

The Amendments will become effective 60 days after publication in the Federal Register. As of the date we are posting this FAQ, the Amendments have not yet been posted to the Federal Register.

What kind of legal documents need to be updated to reflect the Amendments?

The accredited investor definition is used in many different legal documents in many different contexts so the the exact document that will need to be revised or updated will depend on the facts of the situation.

In the private fund context, the Amendments will generally only trigger necessary updates to the private fund subscription documents. While the “old” language is still accurate, it does not encompass all potential accredited investor categories so the language could still be used once the Amendments are effective but will not encompass all categories of potential accredited investor.

Once the Amendments are posted to the Federal Register, we will reach out to our clients to discuss updating their subscription documents.

Do the Amendments change the type of investor a California Exempt Reporting Adviser (“CA ERA”) may charge performance fees from?

No. The private fund adviser exemption in California, which is available only to advisers who provide advice solely to “qualifying private funds”, only permits CA ERAs to charge performance fees to “qualified clients”, as defined in the Investment Advisers Act of 1940. The Amendments do not change this limitation.

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Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact us.

General Data Protection Regulation (GDPR)

Overview of GDPR for US Private Fund Managers

The General Data Protection Regulation (“GDPR”) is a new set of requirements intended to strengthen the protection of citizens’ personal data as well as data movement within the European Union (“EU”).  GDPR was adopted on May 24, 2016 by the European Parliament and the Council of the European Union and went into effect on May 25, 2018.  The regulation replaces Directive 95/46/EC, known as the Data Protection Directive and may apply to certain organizations (including private fund managers) in the US who work with persons in the EU.  This post is designed to give fund managers an overview of the regime and some initial items that should be considered.

What is GDPR?

GDPR sets restrictions on those who process, transfer, or monitor personal data and the procedures by which this is done.  The term “personal data” means any information relating to an identified or identifiable natural person.  The term generally means any information that directly or indirectly can lead to the identification number, location data, online identifier, or similar items related to the identity of a natural person (can include physical, physiological, genetic, mental, economic, cultural, social data, etc).   Organizations that are subject to GDPR but are not compliant can be fined the greater of €20 million or 4% of global annual turnover. GDPR requires that any personal data breach must be reported within 72 hours and justification must be given for any delays.

One of the key aspects of GDPR is that it requires organizations to appoint a Data Protection Officer (DPO) in the following three situations: (1) if the organization is processing public data as a public authority; (2) the organization’s processing operations require regular and systematic monitoring of data subjects on a large scale; and (3) the organization has large scale processing of personal data relating to criminal convictions or special categories that reveal identity of a natural person (including physical, physiological, genetic, etc.).  Although private fund managers may not fall into any of the above categories, it is encouraged under Article 29 Data Protection Working Party (“WP29”) for organizations to appoint a DPO as part of good practice procedures and to demonstrate compliance with GDPR.

Who is regulated?

The requirements of GDPR applies to controllers (the person(s) or entity that determines the purposes and means of processing personal data) or processors (the person(s) or entity that processes personal data on the controller’s behalf) of personal data.  It also applies to the processing activities related to offering goods or services to the data subjects from the EU or monitoring behaviors that take place within the EU.

*** Practically, for private fund managers, GDPR is applicable if you have European investors in a fund or actively solicit or market to European investors.  

What are the initial steps a private fund manager should take?

Depending on the scope of activity, we believe that managers should think about implementing a full GDPR compliance program.  In the meantime, managers subject to the directive should take immediate actions:

  • Send a disclosure statement to EU investors regarding GDPR and the fund’s obligations under GDPR.
  • Attach the disclosure statement regarding GDPR to the fund subscription documents moving forward to ensure that all new investors receive it.
  • Update the fund’s offering documents with a GDPR disclosure.
  • Amend agreements with service providers who processes EU investors’ personal data on the fund’s behalf.
  • Determine whether the fund needs to establish an EU Representative.

How do you create a GDPR compliance program?

Managers with data subject to GDPR will need to take inventory of their data which is covered by the regulation and should create certain procedures and controls with respect to the data.  We believe that initial steps should include the following:

  • Create a list of all types of personal information your fund holds, the source of that information, with whom you share it, what you do with it and how long you will keep it.
  • Create a list of places where your fund keeps personal information and the ways data flows between them.
  • Create a publicly accessible privacy policy, which includes a lawful basis to explain why the fund needs to process personal information, that outlines all processes related to personal data.
  • Appoint a Data Protection Officer (DPO) if necessary.
  • Create awareness among decision makers about GDPR guidelines.
  • Review and/or update the fund’s security technology that is used to process personal data (i.e. firewalls, security verification tools, etc.).
  • Update e-mail security to reduce the risk of phishing and other attacks on protected information.
  • Create a compliance program that includes staff training on data protection items.
  • Create a list of third parties that process personal data for you and update your privacy policy to disclose your use of these third parties.
  • Put a contract in place with any data processors with whom you share data containing explicit instructions for the storage or processing of data by the processor.

Conclusion

Managers should begin this process of exploring the impact of GDPR on their operations immediately if they have not already done so.  Managers should also consult with offshore counsel, compliance consultants, and/or GDPR specialists for guidance on how to best comply with GDPR to meet the fund’s particular needs.  GDPR has radically changed how personal data is processed in the EU and abroad.  The sooner a manager enacts GDPR compliant policies, the sooner the manager can cater to EU citizens and the less likely it will be subject to penalties.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Cole-Frieman & Mallon LLP has is a leader in the hedge fund space and routinely works with managers on legal, regulatory and compliance issues. If there are any questions on this post, please contact Mr. Mallon directly at 415-868-5345.

Initial Coin Offerings (ICOs)

ICO Overview and Securities Law Analysis

After a number of recent, high-profile and wildly successful Initial Coin Offerings or “ICOs”, the blockchain-based asset industry has been abuzz about new ICOs as well as the regulatory issues that surround the space.  This post provides a quick overview of the big securities laws issues surrounding these assets and discusses the regulatory structure currently applicable to the space.

Initial Background

An initial coin offering is the first distribution of a digital currency or digital token, normally offered exclusively through an online offering.  These coins or tokens, like many existing cryptocurrencies such as Bitcoin or Ether, may represent some sort of fractional ownership in something (working similar to a security) or may represent a form of payment (like a currency).  These tokens may be pre-launch (to raise money to develop the use case, similar to crowd-funding) or post-launch (use case already exists).

Are ICOs Securities?

The first and biggest question related to ICOs is whether they are securities offerings (essentially digitized IPOs).  For any inquiry into whether something is a security or not, the starting point is the Howey Test.  Howey is a basic four-part test that is used to determine whether a contract, a transaction, or a series of actions constitutes a security under the Securities Act of 1933. The very broad overview of the Howey prongs are:

  • It is an investment of money
  • There is an expectation of profits from the investment
  • The investment of money is in a common enterprise
  • Any profit comes from the efforts of a promoter or third party

For many ICOs the answers to all of the above are usually “yes”.  We do, however, believe that some ICOs are not securities under the test and, although we start with Howey, that is not where the analysis stops.  As mentioned before in our post dealing with Bitcoin Hedge Funds, we believe that Debevoise’s Securities Law Framework provides a thoughtful approach to think about and analyze this question.  We also believe that the SEC will clarify its position regarding ICOs in the next several months.

Use Case – Blockchain Capital

One of the more interesting ICOs recently has been the ICO for the Blockchain Capital Token (BCAP Token, on TokenHub), which was placed by Argon Group, a blockchain asset investment bank.  Here the value of the BCAP Token is linked to the value of a newly created venture capital fund (which initial assets were received through the BCAP Token ICO process).  The subscription process of the ICO was conducted through a Regulation D 506(a) offering (see Blockchain Capital Token Form D), so there are a number of regulations that the group has already gone through, although none specifically dealing with the ICO itself.  What is particularly amazing is that the offering of $10M was oversubscribed and closed in only 6 hours.  The power of the ICO is apparent – what investment fund manager would not want to raise money in a very quick and efficient manner?

Blockchain Capital paved the way for ICOs linked to private investment funds – we would expect to see tokens linked to hedge funds and private equity funds in the near future.  While the Blockchain Capital offering was limited to accredited investors, the offering still presents questions about regulations, including the potential for fraud.  We liken the ICO process to something akin to the crowdfunding process and believe there are similar risks, in addition to the normal risks associated with the linked asset (in this case, a VC fund).

Future Regulation?

There is no doubt that the regulators will begin to figure out a regulatory regime for ICOs and cryptocurrencies, and this is likely to happen before any sort of Congressional action to change the laws of any of the securities or commodities acts.  The CFTC has already been active in the space (see our previous notes in our Client Update here) and it is very likely that the SEC will be starting the process to issue regulations as well (see here where a group has petitioned the SEC to begin that process).  We believe that during that comment and rulemaking process, the regulators will need to address a number of items, including the process with respect to ICOs.  The SEC needs to move with a deft hand, however, because any onerous regulations will just push business offshore – there are already exchanges who discriminate against potential market participants based on domicile (either with respect to U.S. domicile, or in some cases, New York domicile for fear of issues around the New York BitLicense regulations).

The crowdfunding space became regulated fairly quickly and there are now specific crowdfunding broker-dealers and I believe the same will be the case with the ICO regime.  We believe that any cryptocurrency regulatory regime will include requirements with respect to ICOs and ICO investment banks.

Conclusion

The ICO market is white hot and getting hotter.  It will undoubtedly create both winners and losers (and the winners are likely to be massive winners) and in some cases will usher in new ideas and technologies that will help define the landscape of Web 3.0.  The most important thing for regulators (and lawmakers) is to make sure all investors in these offerings are protected and provided with all necessary information and opportunities as provided through the current securities and commodities laws.  We believe that such regulation will come sooner rather than later.

Related articles:

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

NFA May Impose Capital Requirements, Other Restrictions on CPOs and CTAs

NFA Suggests New Rules, Solicits Comments from CPOs and CTAs

The NFA recently issued a Notice to Members that included a Request for Comments on a proposal to subject CPOs and CTAs to new rules. These rules, which include a minimum capital requirement for CPOs and CTAs, would be intended to protect customer funds and ensure that CPOs and CTAs have sufficient assets to operate as a going concern.

The NFA justified the need for these rules by citing 26 Member Responsibility Actions that were taken over the past 3 years, mostly against CPOs and CTAs for misuse of customer funds and/or misstatements of net asset values and performance information. Comments are due to the NFA by April 15, 2014.

Rules Under Consideration

The NFA did not propose any language for the rules in its Request for Comments, nor did the NFA suggest any details on how the rules might be drafted. Instead, the NFA implied what rules are under consideration by posing questions to CPOs and CTAs on the utility of certain rules, and on what standards should be applied to implement them.

CPOs and CTAs

• Capital Requirements. CPOs and CTAs may be required to maintain a minimum amount of capital, and to file periodic reports with the NFA to demonstrate compliance. However, the NFA’s Request for Comments indicates a degree of flexibility. For example, the NFA asked for members who oppose a capital requirement to suggest alternatives for ensuring that CPOs and CTAs have sufficient funds to operate as a going concern.

• Inactive NFA Members. NFA members that are not actively trading futures or commodity interests may have their NFA membership withdrawn, so that the NFA can stop expending regulatory resources on these firms.

CPOs Only

• Gatekeeper for Pool Disbursements. CPOs may need to retain an independent third party to approve pool disbursements (a “gatekeeper”).

• NAV Valuation and Reporting. An independent third party may be required to prepare or verify a CPO’s pool NAV valuations, and such valuations may need to be submitted periodically to the NFA.

• Performance Results. An independent third party may have to prepare or verify a CPO’s pool performance results.

• Verification of Pool Assets. CPOs and the entities actually holding pool assets may both be required to report pool asset amounts to the NFA, so that the NFA can cross-reference the reports for consistency. This could be similar to rules currently in place for futures commission merchants.

Conclusion

The new rules being considered are in the earliest stages of development, but it is clear that the NFA is concerned about the misuse of customer funds and the risks posed by undercapitalized CPOs and CTAs. Any CPOs or CTAs interested in commenting on the rules under consideration should submit their comments to the NFA via email to [email protected] by April 15, 2014.

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Cole-Frieman & Mallon LLP provides legal advice to the managed futures industry and works with FCMs, IBs, CPOs, and CTAs.  Bart Mallon can be reached directly at 415-868-5345.

SEC Compliance – Custody Issue

Annual Update Guidance on Custody Issue

It is that time of year that registered investment advisers are focusing on the ADV annual updating process.  Occasionally the SEC will provide guidance to managers on common questions applicable to the application or updating process.  Below is a note the SEC sent out to all registered investment advisers regarding the custody issue.  If you have questions on the application of the custody rules to your particular situation, you should discuss with your law firm or compliance consultant.

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To: SEC-Registered Investment Advisers,

This email is a reminder that all SEC-registered advisers that have custody of client assets should answer all questions in Item 9 of Part 1A of Form ADV. Each adviser’s answers will vary depending on facts and circumstances.

For example, advisers that have custody solely because they deduct fees from client accounts would respond “no” in Item 9.A. Additionally, these advisers would likely respond “no” in Items 9.B., and 9.D., and they likely would not need to provide information in Items 9.C. or 9.E. However, in Item 9.F., these advisers likely would need to indicate that there is at least one person acting as qualified custodian for their clients in connection with advisory services they provide to clients.

If you have questions, you may reply to this email.

U.S. Securities and Exchange Commission
Division of Investment Management
100 F Street, N.E.
Washington, DC 20549-8549
Phone | 202.551.6999

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Cole-Frieman & Mallon is a boutique law firm which provides regulatory compliance and consulting services to the investment management industry.  Bart Mallon can be reached directly at 415-868-5345.

Investment Management Law Weekly Overview – Week Ending November 22

Please see below our notes on the past week. If you have questions on any of these items, please feel free to contact us.

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Regulation S-ID Identity Theft Red Flag Rules went into Effect

On Wednesday the new Red Flag rules went into effect for many SEC and CFTC registered managers. In general, certain managers are now required to have identity theft programs in place which will include: staff training for appearance of red flags, procedures for dealing with red flags, certification of procedures from administrators and/or custodians dealing with investor/customer accounts. Managers who have not yet discussed program implementation with their outside counsel or compliance firm should reach out with respect to this issue. For more information, please see our post on Regulation S-ID Identity Theft Rules.

IARD Renewal – Fees Due by December 13, 2013 

SEC and state registered investment advisers will have until December 13th of this year to pay their renewal fees for 2014. To begin, managers will need to retrieve their preliminary statement to find out the amount they owe. Managers will then need to use the IARD’s new E-Bill system (which replaces the old E-Pay system) to pay the total amount due by December 13, 2013, the renewal payment deadline. Firms should submit their electronic renewal payments no later than December 10 in order for payment to post to the renewal accounts by the deadline. For more information, please see the IARD Renewal Checklist.

MF Global Ordered to Fully Reimburse Customers; Subject to $100 Million Fine

It now appears as if all of the futures customers at MF Global will be fully reimbursed. A federal court in New York recently ordered MF Global to pay over $1 billion in restitution to customers. The court also imposed a $100 million civil penalty on the company. For more information, please see the CFTC press release.

Manager Fined $250,000 for Numerous Compliance Violations Including Misstatements in PPM

It is vitally important that fund managers accurately describe their operating procedures in their fund offering documents. This includes such matters as valuation on fund assets. Additionally, managers need to be vigilant in making sure that statements made in the offering documents continue to be accurate. The SEC recently announced the issueance of an order that found, among other items, that the management company failed to adopt and implement written compliance policies and procedures reasonably designed to prevent violations applicable laws and regulations concerning three important areas of private fund management: (i) valuation of fund assets, (ii) the accuracy of disclosures to fund investors about the valuation practice, and (iii) cross trades between clients. In addition to the monetary penalty, the manager was censured and is now required to provide a copy of the SEC order to certain of its clients and investors. The full complaint can be found here.

Enforcement Actions

SEC

• There were a number of enforcement actions at the SEC level for run-of-the-mill financial crimes such as preying on elderly investors and receiving fraudulent kick-backs (note: interestingly, the SEC also charged the firm with aiding and abetting another firm with violation of the SEC’s custody rule).  Additionally, the SEC charged another tipper in the Galleon insider-trading scandal.

CFTC

Forex Pool Fraud – November 19, 2013. Specifically, the Order finds that, from at least June 2010 through April 2013, Prescott fraudulently solicited individuals to invest in Cambridge’s off-exchange forex pool and misappropriated $455,098 of pool participants’ monies, using some of those funds for air travel, hotel accommodations, and gambling. According to the Order, Prescott defrauded pool participants and prospective pool participants by misrepresenting the risks involved in forex trading and executing demand promissory notes in their favor that promised the repayment of the note amount and monthly interest payments, knowing or recklessly disregarding that he could not make those payments by his forex trading. Press release can be found here.

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Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive, and cost-effective legal solutions for financial services matters. Bart Mallon can be reached directly at 415-868-5345.

Third Quarter 2013 Business & Regulatory Update

Below is the third quarter of 2013 update we have sent out to our mailing list.  We will be sending out our end of the year update soon so if you would like to be added to the mailing list, please contact us here.

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Cole-Frieman & Mallon Third Quarter Update

Clients and Friends:

In the third quarter of 2013 we have seen dramatic developments in the world of investment management regulatory compliance. As we move into the fourth quarter, we would like to provide you with a brief overview of some items that we hope will help you stay on top of the business and regulatory landscape in the coming months.

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JOBS Act Update.  Over a year after the Jumpstart Our Business Startups Act (the “JOBS Act”) was signed into law, the Securities and Exchange Commission (“SEC”) issued certain long-awaited  implementing regulations and other proposed rules:

  • General Solicitation Ban Lifted. On July 10, 2013, the SEC adopted New Rule 506(c) under Regulation D, commonly relied upon by private investment funds for selling securities without registration under the Securities Act of 1933 (the “Securities Act”). Effective September 23, 2013, Rule 506(c) permits private funds to engage in general solicitation and advertising to the public, provided that the issuer takes “reasonable steps to verify” that all investors are “accredited investors.” This may be done by (i) reviewing IRS forms that report income, such as Form W-2, Form 1099, Schedule K-1 and Form 1040; (ii) reviewing financial records, such as bank statements, (iii) obtaining written confirmation from a registered broker dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant, or (iv) obtaining a certificate from a current investor who invested prior to September 23, 2013 confirming “accredited investor” status. Reliance on investors’ representations in a questionnaire or subscription agreement is insufficient. It is currently unclear whether private funds utilizing registration exemptions from the Commodity Futures Trading Commission (“CFTC”) may take advantage of the Rule 506(c), as certain such exemptions prohibit general solicitation.
  • Bad Actors Prohibited from Rule 506 Reliance.  As of September 23, 2013, the SEC’s “Bad Actors” prohibition effectively prevents issuers from relying on Rule 506 if the issuer or certain persons affiliated with the issuer (“Covered Persons”) have been subject to certain “Disqualifying Events,” including but not limited to certain criminal convictions, court injunctions, commission disciplinary actions, and suspensions from membership in a self-regulatory organization. Advisers should take immediate steps to obtain representations regarding Disqualifying Events from all Covered Persons, which include holders of at least 20% of an issuer’s outstanding “voting securities.” The SEC has noted that securities conferring on holders the right to elect or remove the directors or General Partner of the issuer, or to approve significant transactions such as acquisitions, dispositions, or financings, are considered voting securities. For offshore funds structured as companies, the adviser should examine whether the share capital structure provides that all shareholders hold voting Common Shares that have the right to remove directors, or that shares are split between voting Management Shares and non-voting Participating Shares. Covered Persons also include third-party marketers, and may include certain other arrangements, such as fee rebates. Issuers whose Covered Persons are subject to Disqualifying Events that occurred after September 23 are prohibited from relying on Rule 506 unless the issuer is able to establish that it did not know and, in the exercise of reasonable care, could not have known that a Disqualifying Event existed. Disqualifying Events that occurred prior to September 23 must be disclosed to offerees in writing a reasonable time prior to sale.
  • Rule 144A Clarification.  The SEC has clarified that there is no ban on general solicitation in offers made pursuant to Rule 144A of the Securities Act. As such, Rule 144A securities may be offered to persons other than “qualified institutional buyers” (“QIBs”), provided that the restricted securities are sold only to persons that the seller reasonably believes are QIBs.
  • Proposed Form D Amendment. The SEC has proposed certain amendments to Form D requirements in response to Rule 506(c). The proposed rules would require issuers relying on Rule 506(c) to make an “Advance Form D” filing at least 15 days before engaging in general solicitation or advertising, and to make certain additional disclosures on Form D, including a description of the type of general solicitation used and the methods used to verify accredited investor status. The SEC also proposed requiring issuers relying on Rule 506 generally to file amendments no later than 15 days after the first sale of securities, and make a closing Form D filing within 30 days after the termination of the offering.
  • Proposed Rule 156 Amendment.  The SEC has proposed an amendment to Rule 156 of the Securities Act to address concerns of potential fraudulent and misleading sales literature arising out of Rule 506(c) reliance. The current version of Rule 156 applies only to registered investment companies, prohibiting the use of any communications, including by writing, radio, or television, to sell or induce the sale of securities if such communication includes information that could be materially misleading. As amended, the new rule would apply to private funds making general solicitations under Rule 506(c). Additionally, the SEC has proposed a requirement that certain legends be included on all written general solicitation materials.
  • Proposed New Rule 510T. The SEC has proposed New Rule 510T of Regulation D to require that an issuer conducting an offering in reliance on Rule 506(c) submit any written general solicitation materials used in connection with the offering to the SEC. If adopted, this would be a temporary rule that would expire two years after its effective date.

Foreign Account Tax Compliance Act (“FATCA”) Deadline Extended. The U.S. Internal Revenue Services (“IRS”) has postponed by six months the effective date for certain requirements under FATCA. Pursuant to IRS Notice 2013-43, foreign financial institutions (“FFIs”) such as offshore funds now have until April 25, 2014 to complete the following steps in order to avoid being subject to a 30% U.S. withholding tax on payments they receive from U.S. sources starting July 1, 2014: (1) register with the IRS through the online web portal found here; (2) enter into an FFI agreement with the IRS via the web portal, or comply with an applicable intergovernmental agreement; and (3) meet the other due diligence, reporting and withholding requirements under FATCA. Offshore fund managers should contact their tax advisers and compliance counsel to prepare for FATCA compliance and, if required, to register with the IRS before April 25, 2014. In addition, fund managers to domestic funds should work with their tax advisers, administrators and legal counsel to properly address the new account onboarding and due diligence procedures required under FATCA, including updating their offering documents and subscription materials.

Futures and Derivatives. Futures and derivatives regulators and self-regulatory organizations have continued to be very active over the last quarter. Important developments include:

  • ISDA 2013 EMIR Protocol and Dodd-Frank Protocol Extension. As of September 15, 2013, all EU-domiciled entities party to over-the-counter derivatives transactions are required to comply with certain portfolio reconciliation, dispute resolution, and disclosure requirements pursuant to the EU’s European Market Infrastructure Regulation legislation (“EMIR”). EMIR compliance also requires the assent and cooperation of each counterparty. As such, the International Swaps and Derivatives Association has provided a standardized protocol (“EMIR Port Rec Protocol“) that can be used by counterparties to amend their agreements.  For U.S. counterparties who have already adhered to the ISDA March 2013 DF Protocol (“DF 2.0,” which contains certain portfolio reconciliation provisions), ISDA published the ISDA DF Protocol Extension on September 10, 2013, the explanatory memorandum for which can be found here, allowing such U.S. counterparties to amend their responses to DF 2.0 as necessary to comply with EMIR rather than simultaneously participating in the EMIR Port Rec Protocol.
  • Upcoming Deadline of New Quarterly Filing Requirement for CTAs. Pursuant to the NFA’s Notice, CTAs are reminded to file Form CTA-PR with the NFA on a quarterly basis via the NFA’s EasyFile system for CTAs within 45 days of the end of each calendar quarter. The first filing will be for the quarter ending September 30, 2013 and will be due on November 14, 2013. If you are a CTA and would like assistance with the filings, please contact us.
  • Changes to CPO and CTA Requirements. The CFTC has recently adopted amended rules affecting CPOs and CTAs. Beginning September 23, 2013, all CPOs and CTAs are permitted to use a Disclosure Document for up to 12, rather than nine months. As of August 22, 2013, CPOs are no longer required to obtain a signed acknowledgment of receipt of disclosure documents from a participant before accepting funds. Additionally, CPOs may, as of September 23, 2013, use third-party service providers to maintain their books and records, provided that certain conditions are met.
  • CFTC Harmonization Rule for CPOs of RICs. The CFTC has changed the requirements for CPOs of Registered Investment Companies (“RICs”) to harmonize its disclosure and compliance requirements with those of the SEC. This “Harmonization Rule” effectively adopts a substituted compliance regime for CPOs of RICs premised upon such entities’ adherence to the compliance obligations under the SEC statutory and regulatory compliance regime. As such, participating CPOs of RICs will now be exempt from certain Commodity Exchange Act (“CEA”) requirements, such as the requirement that CPOs submit their disclosure documents to the NFA prior to distribution. In order to take advantage of this relief, CPOs of RICs must file a notice with the NFA by October 21, 2013 and may do so through the NFA’s Exemption System. The SEC’s staff has issued guidance on the Harmonization Rule, and noted that its recently created Risk and Examinations Office will monitor, among other things, investment companies’ risk management related to commodity interests.
  • New Recordkeeping Requirements for FCMs, IBs, and RFEDs. CFTC Regulation 1.35(a) requires FCMs, IBs, and RFEDs to keep complete, systematic records, including all pertinent data and memoranda, of all transactions relating to their business of dealing in commodity interests and related cash or forward transactions. Starting December 21, 2013, amendments to the rule require FCMs, certain IBs, and RFEDs to tape record all oral communications provided or received concerning quotes, solicitations, bids, offers, instructions, trading and prices that lead to the execution of such transactions. Oral communications include a wide range of media including telephone, voicemail, mobile device, or other digital or electronic media, and must be kept for one year. The CFTC has issued guidance that these groups may reasonably rely on a designated contract market, swap execution facility, or other CFTC registrant to maintain certain records on their behalf.
  • New Rules for Swaps and Clearing Organizations. The CFTC has recently adopted new rules regarding swaps and clearing organizations to implement the Dodd-Frank Act’s new statutory framework. Effective September 23, 2013, cooperatives meeting certain conditions may elect not to submit for clearing certain swaps otherwise required under Section 2(h)(1) of the CEA. The CFTC has also adopted rules, effective October 15, 2013, to implement enhanced risk management standards for systemically important derivatives clearing organizations, including increased financial resources requirements and prohibiting the use of assessments in calculating available default resources. Additionally, the CFTC has issued interpretive guidance regarding the cross-border application of the swaps provisions of the CEA, as added by Dodd-Frank.

Joint Advisory on Business Continuity and Disaster Recovery Planning. The CFTC, SEC, and FINRA have issued a joint advisory regarding firms’ business continuity and disaster recovery planning (“DRP”) in the wake of Hurricane Sandy, which caused widespread damage to Northeastern states and closed U.S. equity and options markets for two days in October 2012. The advisory encourages the implementation of certain best practices to improve responses to, and reduce recovery time after, such devastating large-scale events. Among its recommendations, the advisory suggests that firms contract with multiple telecommunications carriers in the event that one experiences a disruption; implement a communication plan to allow communication and coordination with regulators, emergency officials, and others; and conduct annual or more frequent DRP testing and training, including the incorporation of stress testing.

Sun Capital Implications for Private Funds. The First Circuit Court of Appeals reversed a lower court ruling, holding that a private equity fund qualified as a “trade or business” under the Multiemployer Pension Plan Amendment Act (“MPPAA”) for purposes of determining whether the fund might be liable for pension plan withdrawal liability of one of its portfolio companies. In the ruling, the court considered the following factors: the fund’s ownership of at least 80% of the portfolio company; the fund’s management rights of the portfolio company; and the offset management fee structure, whereby the portfolio company paid a management fee to the fund’s general partner, which in turn offset the amount owed by the fund. Private fund managers should consider these factors when investing in portfolio companies which participate in union-sponsored multiemployer plans or sponsor a defined benefit pension plan.

Amended Financial Responsibility Rules for Broker-Dealers. The SEC has  finalized amendments requiring broker-dealers to comply with new net capital, customer protection, books and records, and notification rules. Prominent changes include new required deductions for the purpose of calculating net capital under Rule 15c3-1 of the Securities Exchange Act of 1934 (“Exchange Act”) and the removal of the limitation on the SEC’s ability to issue an order temporarily restricting a broker-dealer from withdrawing capital or making loans to stockholders, insiders and affiliates. Rule 15c3-3 of the Exchange Act was also amended to require “carrying broker dealers,” defined as broker-dealers that carry accounts that hold proprietary securities and cash of other broker-dealers (“PAB Accounts”), to comply with certain computation, account formation, and segregation rules with respect to those accounts.   Additionally, pursuant to the Dodd-Frank Act, the SEC has adopted certain amendments to reporting and audit rules for broker-dealers.

European Union’s Alternative Investment Fund Managers Directive (“AIFMD”). Managers marketing alternative investment funds in the EU are now subject to the reporting and disclosure obligations under the AIFMD, which went into effect on July 22, 2013. In addition, managers may also need to take steps to ensure compliance with the domestic implementing legislation of the jurisdiction where the investor is located. Certain countries, including the UK, Sweden and Germany (for existing funds as of July 22, 2013), are allowing a one-year transitional period delaying the application of the AIMFD marketing regime for non-EU managers. Some other jurisdictions, such as France, have adopted much more stringent requirements to restrict marketing efforts by non-EU managers. If you are marketing to EU investors, you should carefully review the directive’s provisions as well as applicable national laws to make sure you comply with all requirements.

“Red Flag” Rules for Identity Theft Effective Date Approaching. The joint final regulations (“Regulation S-ID”) released by the SEC and CFTC requiring “financial institutions” and “creditors” regulated by those regulatory agencies to put in place programs to address identity theft risk in any “covered accounts” will go into effect November 20, 2013. The terms “financial institutions” and “creditors” include certain investment advisers, commodity pool operators, commodity trading advisers, broker-dealers and futures commission merchants. The definition of the term “covered accounts” is broad and includes brokerage accounts with a broker-dealer and margin accounts. Most importantly, to comply with the new regulations, a program must be put in place which includes reasonable policies and procedures to do the following: (1) describe relevant “red flag” situations that, if they arise, could indicate a risk of identity theft; (2) detect such red flags as they arise, (3) respond appropriately to red flags, and (4) periodically update the program. All firms should reach out to their compliance consultant or legal counsel as soon as possible to ensure adequate systems are in place to address identity theft risk by the November 20, 2013 deadline.

Compliance Calendar. As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:

September 23, 2013 SEC “Bad Actors” Rule effective
October 21, 2013 Form CPO-PQR and CTA-PR requirements effective for CPOs and CTAs of RICs
October 21, 2013 Deadline for Harmonization Rule NFA notice filing
November 14, 2013 Deadline for Form CTA-PR quarterly filing
November 20, 2013 “Red Flag” Rule compliance deadline
December 13, 2013 IARD Preliminary Renewal Statement Due (submit payment by Dec. 10 in order for payment to post by deadline)
December 21, 2013 New Recordkeeping Requirements for FCMs, IBs, and RFEDs effective
Periodic Filings Form D and Blue Sky filings should be current

Please contact us with any questions or for assistance with any compliance, registration or planning issues on any of the above topics.

Sincerely,

Karl Cole-Frieman & Bart Mallon

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Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for financial services matters.

Second Quarter 2013 Business & Regulatory Update

Below is the second quarter update we have sent out to our mailing list.  If you would like to be added to the mailing list, please contact us here.

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Cole-Frieman & Mallon Second Quarter Update

Clients and Friends:

In the second quarter of 2013 we have seen accelerating activity in the world of investment management regulatory compliance. As we move into the third quarter, we would like to provide you with a brief overview of some items that we hope will help you stay on top of the business and regulatory landscape in the coming months.

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Foreign Account Tax Compliance Act (“FATCA”) Deadline Approaching. Foreign financial institutions (“FFIs”) such as offshore funds may be subject to a 30% U.S. withholding tax on payments they receive from U.S. sources as soon as January 1, 2014 if they fail to complete the following steps before October 25, 2013: (1) register with the IRS through an online web portal which will become available on July 15, 2013; (2) enter into an FFI agreement with the IRS via the web portal, or comply with an applicable intergovernmental agreement; and (3) meet the other due diligence, reporting and withholding requirements under FATCA. Offshore fund managers should contact their tax advisers as soon as possible to prepare for FATCA compliance and, if required, to register with the IRS between July 15 and October 25, 2013. In addition, fund managers to domestic funds should work with their tax advisers, administrators and legal counsel to properly address the new account onboarding and due diligence procedures required under FATCA, including updating their offering documents and subscription materials.

JOBS Act Update. The Jumpstart Our Business Startups Act (the “JOBS Act”) was signed into law over a year ago (April 5, 2012) but the SEC has not yet issued implementing regulations. On Wednesday, May 15 the House of Representatives expressed its frustration with the slowness of this process by passing H.R. 701, a House Resolution requiring the SEC to finalize regulations with respect to “Regulation A+” of the JOBS Act. Regulation A+ refers to the part of the JOBS Act which creates a new category of exempt public securities offerings of up to $50 million raised over a 12-month period. In effect this is an expansion of the current “Regulation A” exemption for offerings of up to $5 million over a 12-month period. For fund managers, it remains to be seen whether Regulation A+ might challenge the predominant practice of relying on the exemption “safe harbor” under Rule 506 of Regulation D of the Securities Act of 1933. For more information, please refer to our blog article on this topic.

New “Red Flag” Rules for Identity Theft. The SEC and CFTC released joint final regulations (“Regulation S-ID”) requiring “financial institutions” and “creditors” regulated by the SEC or the CFTC to put in place programs to address identity theft risk in any “covered accounts.” The terms “financial institutions” and “creditors” cover a wide range of participants in the investment management industry, including certain investment advisers, commodity pool operators, commodity trading advisers, broker-dealers and futures commission merchants (among others). The definition of the term “covered accounts” is broad and includes brokerage accounts with a broker-dealer and margin accounts. Most importantly, to comply with the new regulations, a program must be put in place which includes reasonable policies and procedures to do the following: (1) describe relevant “red flag” situations that, if they arise, could indicate a risk of identity theft; (2) detect such red flags as they arise, (3) respond appropriately to red flags, and (4) periodically update the program. Compliance with the new regulations will become mandatory on November 20, 2013. Persons affected by these “Red Flag” rules should take the next few months to assess their compliance programs to ensure adequate systems are in place to address identity theft risk.

Futures and Derivatives. Futures and derivatives regulators and self-regulatory organizations have continued to be very busy over the last quarter. Important developments include:

  • Filings for Newly-Registered CPOs. All CPOs who became registered on January 1, 2013 or during Q1 2013 were required to make their first Form CPO-PQR filing before May 31, 2013. This requirement applies to CPOs relying on the CFTC Rule 4.7 exemption from certain reporting and disclosure requirements. The next due date for Form CPO-PQR is August 29, 2013. If you are a CPO and have not met your filing requirements or would like assistance with the August filing, please do not hesitate to contact us.

  • Changes to CPO Filings. All CPOs must make quarterly filings through the NFA’s EasyFile system for CPOs, and the due dates of such filings and the information required in them varies depending on the CPO’s aggregate pool assets under management. Prior to the recent rule amendments, CPOs were faced with separate quarterly reporting forms from the NFA and the CFTC, along with different filing deadlines. The distinction between the NFA version and the CFTC version of the form still exists; however, each version has been amended to incorporate certain information required by the other regulator. In addition, the NFA changed certain of its filing deadlines to match CFTC deadlines. The NFA also added a “cover page” to the EasyFile system with questions on the CPO’s aggregate pool assets under management, and based on the CPO’s responses the system automatically determines which version of the Form CPO-PQR needs to be filed. The NFA published a chart and other guidance to assist filers with the changes.
  • Upcoming Changes to CTA Filings. The NFA’s recent Notice states that CTAs will soon be required to file Form CTA-PR with the NFA on a quarterly basis, whereas currently this form is filed annually. However, this rule is not yet in effect. The NFA has stated it will send out an alert well in advance of the effective date. When the new rule goes into effect, CTAs will need to file the Form CTA-PR via the NFA’s EasyFile system for CTAs within 45 days of the end of each calendar quarter.
  • Equity Total Return Swaps and CPO Exemption. As of June 30, 2013 equity total return swaps on foreign securities became designated as “mixed swaps” subject to both SEC and CFTC jurisdiction. As a result, they are no longer exempt from being counted toward the de minimis exemption from CPO registration under CFTC Rule 4.13(a)(3). Fund managers that rely on this exemption from CPO registration and that advise funds trading in equity total return swaps should assess their funds’ exposure to these instruments to determine whether they can continue relying on the de minimis exemption.
  • ISDA March 2013 Dodd-Frank Protocol. The International Swaps and Derivatives Association’s Dodd-Frank Documentation Initiative aims to facilitate compliance with the Dodd-Frank Act. The Documentation Initiative minimizes the need for bilateral negotiation and reduces disruptions to trading by providing a standard set of amendments, referred to as protocols, to update existing swap documentation. The first such protocol was the ISDA August 2012 Dodd-Frank Protocol (the “Protocol 1.0”), which had an effective compliance date of May 1, 2013. The ISDA March 2013 Dodd-Frank Protocol (the “Protocol 2.0”) is now open for adherence, and its compliance date is July 1, 2013. This means that swap dealers will require client adherence to both Protocol 1.0 and Protocol 2.0 as of July 1, 2013. To indicate participation in Protocol 2.0, market participants must respond to the Protocol 2.0 questionnaire, submit an adherence letter and pay an adherence fee of $500.00 through the online ISDA Amend system. Detailed instructions can be found here.

Cash Solicitation Rule in California. There are many potential legal pitfalls involving relationships between investment advisers and third party marketers. One such pitfall involves Rule 206(4)-3 of the Investment Advisers Act of 1940, known as the “cash solicitation rule,” which, among other rules, requires that clients must receive written notice of any referral fees paid to marketers. A recent case from the California Court of Appeals, Lloyd v. Metropolitan West Asset Management, LLC highlights at least two important take-aways with respect to the cash solicitation rule. First, the manager could not prove that the client actually received the required notice, emphasizing the importance of documenting such processes and to contractually sharing the burden of such compliance with marketing firms. Second, the court found that the cash solicitation rule applied despite the fact that the client at issue was a non-U.S. client.

New Front-Running Rule for Broker-Dealers. FINRA issued a new rule on front-running of customer block transactions (“Rule 5270”), which took effect on June 1, 2013. Rule 5270 expands the prohibition on front-running by, among other changes, applying the prohibition to fixed income securities and related instruments. It also lays out three categories of “permitted transactions” in which FINRA member firms may engage: (1) transactions that a firm can demonstrate are unrelated to the customer block order; (2) transactions that are undertaken to fulfill or facilitate the execution of the customer block order; and (3) transactions that are executed, in whole or in part, on a national securities exchange and comply with the marketplace rules of that exchange. More information on Rule 5270, including the full FINRA notice, can be found here.

European Union’s Alternative Investment Fund Managers Directive (“AIFMD”). Starting July 22, 2013, managers marketing alternative investment funds in the EU must comply with reporting and disclosure obligations under the AIFMD. These obligations consist of providing pre-investment and ongoing disclosures to investors, complying with requirements affecting manager remuneration, and preparing annual and regular reports to an EU national regulator.  As a caveat, however, full compliance with the AIFMD may be insufficient for certain managers, because until July 21, 2015, the ability to market to EU investors is still subject to the national law of the jurisdiction where the investor is located. There has been speculation that some countries may move to restrict marketing efforts by US-based managers and/or funds. If you are marketing to EU investors, you should carefully review the directive’s provisions as well as applicable national laws to make sure you comply with all requirements.

Launch of Sansome Strategies LLC.   We are pleased to announce the launch of our affiliated compliance consulting company, Sansome Strategies LLC (“Sansome Strategies”). Sansome Strategies specializes in high-touch, outsourced compliance services for firms in the investment management industry. In addition to working with registered investment advisers and hedge fund managers, Sansome Strategies will also focus on firms operating in the commodities/futures and derivatives spaces.

Further information about Sansome Strategies can be found at: sansomestrategies.com

Please also visit the Sansome Strategies blog: www.compliancefocus.com

Compliance Calendar. As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:

Deadline Filing
July 1, 2013 Dodd-Frank Protocol 2.0 adherence deadline
July 15, 2013 IRS FATCA online registration portal available
August 29, 2013 Form PF (large funds) & Form CPO-PQR due
October 25, 2013 Deadline for registration via IRS FATCA online portal
November 20, 2013 “Red Flag” Rule compliance deadline
Periodic Filings Form D and Blue Sky filings should be current

Please contact us with any questions or for assistance with any compliance, registration or planning issues on any of the above topics.

Sincerely,

Karl Cole-Frieman & Bart Mallon

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Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for financial services matters.

FATCA Hedge Fund Compliance Event

June 19, 2013 – Sponsored by SS&C GlobeOp

We have previously discussed the Foreign Account Tax Compliance Act (“FATCA”) and the legal and compliance implications for hedge fund managers.  As the date draws near for implementation, various service providers to the investment management community will be providing more information to managers on how to prepare.  Below is information on an event happening soon in Chicago.

Please contact us if you would like information on how to register and we hope to see you there.

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Are you ready for FATCA? 

Join us at theWit Chicago for an engaging panel discussion on FATCA compliance requirements, followed by cocktails and networking.

Agenda:

  • 4:30 pm – 5:00 pm Registration 
  • 5:00 pm – 5:50 pm Panel Discussion
  • 6:00 pm – 8:00 pm Cocktail Reception

Moderator:

  • Nate Goodman, Director, Business Development, SS&C GlobeOp

Panelists:

  • Kevin J. K. Glen, Partner, Ernst & Young
  • Patti Griffin, Associate Director, International Tax Services, SS&C GlobeOp
  • Lindsey Simon, Founder, Simon Compliance

Topics will include:

  • Reporting realities
  • How to monitor progress
  • How to leverage technology
  • What resources are needed to gather data and complete the forms
  • What pitfalls you may encounter
  • How to determine if you are ready

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Cole-Frieman & Mallon LLP is a boutique hedge fund law firm.  Bart Mallon can be reached directly at 415-868-5345.

New Jersey Investment Adviser Annual Exam

State Releases Web Version of Annual Written Examination for Registered Investment Advisers

Investment Advisers registered with the State of New Jersey will now be able to complete their Annual Written Examination online. In addition to answering the examination questions, advisers now have the ability to upload related documents online, negating the need to send paper mailings to the state.

A release issued by the New Jersey Bureau of Securities states that “the answers to [the examination] questions are used to determine the need for an on-site or desk examination, as well as to monitor the different approaches used to render the investment advice.”

The examination questions cover topics related to the adviser’s business model, including:

  • Clients and business activities
  • Policies and procedures that the adviser has in place
  • Personnel, associated persons and other business activities
  • Client complaints
  • Advertising and promotional activities
  • Custody and financial condition

Instructions and a link to the examination can be found here.  If you have questions or concerns about the new examination format or the questions contained in the examination, please do not hesitate to contact us.

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Cole-Frieman & Mallon LLP provides legal services for hedge fund managers and other groups within the investment management industry. Bart Mallon can be reached directly at 415-868-5345.