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Rule 206(4)-2 –Custody of Funds or Securities of Clients by Investment Advisers

a. Safekeeping required. If you are an investment adviser registered or required to be registered under section 203 of the Act, it is a fraudulent, deceptive, or manipulative act, practice or course of business within the meaning of section 206(4) of the Act for you to have custody of client funds or securities unless:

1. Qualified custodian. A qualified custodian maintains those funds and securities:

i. In a separate account for each client under that client’s name; or

ii. In accounts that contain only your clients’ funds and securities, under your name as agent or trustee for the clients.

2. Notice to clients. If you open an account with a qualified custodian on your client’s behalf, either under the client’s name or under your name as agent, you notify the client in writing of the qualified custodian’s name, address, and the manner in which the funds or securities are maintained, promptly when the account is opened and following any changes to this information. If you send account statements to a client to which you are required to provide this notice, include in the notification provided to that client and in any subsequent account statement you send that client a statement urging the client to compare the account statements from the custodian with those from the adviser.

3. Account statements to clients. You have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each of your clients for which it maintains funds or securities, identifying the amount of funds and of each security in the account at the end of the period and setting forth all transactions in the account during that period.

4. Independent verification. The client funds and securities of which you have custody are verified by actual examination at least once during each calendar year, except as provided below, by an independent public accountant, pursuant to a written agreement between you and the accountant, at a time that is chosen by the accountant without prior notice or announcement to you and that is irregular from year to year. The written agreement must provide for the first examination to occur within six months of becoming subject to this paragraph, except that, if you maintain client funds or securities pursuant to this section as a qualified custodian, the agreement must provide for the first examination to occur no later than six months after obtaining the internal control report. The written agreement must require the accountant to:

i. File a certificate on Form ADV-E (17 CFR 279.8) with the Commission within 120 days of the time chosen by the accountant in paragraph (a)(4) of this section, stating that it has examined the funds and securities and describing the nature and extent of the examination;

ii. Upon finding any material discrepancies during the course of the examination, notify the Commission within one business day of the finding, by means of a facsimile transmission or electronic mail, followed by first class mail, directed to the attention of the Director of the Office of Compliance Inspections and Examinations; and

iii. Upon resignation or dismissal from, or other termination of, the engagement, or upon removing itself or being removed from consideration for being reappointed, file within four business days Form ADV-E accompanied by a statement that includes:

A. The date of such resignation, dismissal, removal, or other termination, and the name, address, and contact information of the accountant; and

B. An explanation of any problems relating to examination scope or procedure that contributed to such resignation, dismissal, removal, or other termination.

5. Special rule for limited partnerships and limited liability companies. If you or a related person is a general partner of a limited partnership (or managing member of a limited liability company, or hold a comparable position for another type of pooled investment vehicle), the account statements required under paragraph (a)(3) of this section must be sent to each limited partner (or member or other beneficial owner).

6. Investment advisers acting as qualified custodians. If you maintain, or if you have custody because a related person maintains, client funds or securities pursuant to this section as a qualified custodian in connection with advisory services you provide to clients:

i. The independent public accountant you retain to perform the independent verification required by paragraph (a)(4) of this section must be registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules; and

ii. You must obtain, or receive from your related person, within six months of becoming subject to this paragraph and thereafter no less frequently than once each calendar year a written internal control report prepared by an independent public accountant:

A. The internal control report must include an opinion of an independent public accountant as to whether controls have been placed in operation as of a specific date, and are suitably designed and are operating effectively to meet control objectives relating to custodial services, including the safeguarding of funds and securities held by either you or a related person on behalf of your advisory clients, during the year;

B. The independent public accountant must verify that the funds and securities are reconciled to a custodian other than you or your related person; and

C. The independent public accountant must be registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules.

7. Independent representatives. A client may designate an independent representative to receive, on his behalf, notices and account statements as required under paragraphs (a)(2) and (a)(3) of this section.

b. Exceptions.

1. Shares of mutual funds. With respect to shares of an open-end company as defined in section 5(a)(1) of the Investment Company Act of 1940 (“mutual fund”), you may use the mutual fund’s transfer agent in lieu of a qualified custodian for purposes of complying with paragraph (a) of this section;

2. Certain privately offered securities.

i. You are not required to comply with paragraph (a)(1) of this section with respect to securities that are:

A. Acquired from the issuer in a transaction or chain of transactions not involving any public offering;

B. Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and

C. Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

ii. Notwithstanding paragraph (b)(2)(i) of this section, the provisions of this paragraph (b)(2) are available with respect to securities held for the account of a limited partnership (or a limited liability company, or other type of pooled investment vehicle) only if the limited partnership is audited, and the audited financial statements are distributed, as described in paragraph (b)(4) of this section.

3. Fee deduction. Notwithstanding paragraph (a)(4) of this section, you are not required to obtain an independent verification of client funds and securities maintained by a qualified custodian if:

i. you have custody of the funds and securities solely as a consequence of your authority to make withdrawals from client accounts to pay your advisory fee; and

ii. if the qualified custodian is a related person, you can rely on paragraph (b)(6) of this section.

4. Limited partnerships subject to annual audit. You are not required to comply with paragraphs (a)(2) and (a)(3) of this section and you shall be deemed to have complied with paragraph (a)(4) of this section with respect to the account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) that is subject to audit (as defined in rule 1-02(d) of Regulation S-X (17 CFR 210.1-02(d))):

i. At least annually and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year;

ii. By an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules; and

iii. Upon liquidation and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) promptly after the completion of such audit.

5. Registered investment companies. You are not required to comply with this section with respect to the account of an investment company registered under the Investment Company Act of 1940.

6. Certain Related Persons. Notwithstanding paragraph (a)(4) of this section, you are not required to obtain an independent verification of client funds and securities if:

i. you have custody under this rule solely because a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services you provide to clients; and

ii. your related person is operationally independent of you.

c. Delivery to Related Person. Sending an account statement under paragraph (a)(5) of this section or distributing audited financial statements under paragraph (b)(4) of this section shall not satisfy the requirements of this section if such account statements or financial statements are sent solely to limited partners (or members or other beneficial owners) that themselves are limited partnerships (or limited liability companies, or another type of pooled investment vehicle) and are your related persons.

d. Definitions. For the purposes of this section:

1. Control means the power, directly or indirectly, to direct the management or policies of a person, whether through ownership of securities, by contract, or otherwise. Control includes:

i. Each of your firm’s officers, partners, or directors exercising executive responsibility (or persons having similar status or functions) is presumed to control your firm;

ii. A person is presumed to control a corporation if the person:

A. Directly or indirectly has the right to vote 25 percent or more of a class of the corporation’s voting securities; or

B. Has the power to sell or direct the sale of 25 percent or more of a class of the corporation’s voting securities;

iii. A person is presumed to control a partnership if the person has the right to receive upon dissolution, or has contributed, 25 percent or more of the capital of the partnership;

iv. A person is presumed to control a limited liability company if the person:

A. Directly or indirectly has the right to vote 25 percent or more of a class of the interests of the limited liability company;

B. Has the right to receive upon dissolution, or has contributed, 25 percent or more of the capital of the limited liability company; or

C. Is an elected manager of the limited liability company; or

v. A person is presumed to control a trust if the person is a trustee or managing agent of the trust.

2. “Custody”means holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. You have custody if a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services you provide to clients. Custody includes:

i. Possession of client funds or securities (but not of checks drawn by clients and made payable to third parties) unless you receive them inadvertently and you return them to the sender promptly but in any case within three business days of receiving them;

ii. Any arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and

iii. Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities.

3. Independent public accountant means a public accountant that meets the standards of independence described in rule 2-01(b) and (c) of Regulation S-X (17 CFR 210.2-01(b) and (c)).

4. Independent representative means a person that:

i. Acts as agent for an advisory client, including in the case of a pooled investment vehicle, for limited partners of a limited partnership (or members of a limited liability company, or other beneficial owners of another type of pooled investment vehicle) and by law or contract is obliged to act in the best interest of the advisory client or the limited partners (or members, or other beneficial owners);

ii. Does not control, is not controlled by, and is not under common control with you; and,

iii. Does not have, and has not had within the past two years, a material business relationship with you.

5. Operationally independent: for purposes of paragraph (b)(6) of this section, a related person is presumed not to be operationally independent unless each of the following conditions is met and no other circumstances can reasonably be expected to compromise the operational independence of the related person:

i. Client assets in the custody of the related person are not subject to claims of the adviser’s creditors;

ii. advisory personnel do not have custody or possession of, or direct or indirect access to client assets of which the related person has custody, or the power to control the disposition of such client assets to third parties for the benefit of the adviser or its related persons, or otherwise have the opportunity to misappropriate such client assets;

iii. advisory personnel and personnel of the related person who have access to advisory client assets are not under common supervision; and

iv. advisory personnel do not hold any position with the related person or share premises with the related person.

6. Qualified custodian means:

i. A bank as defined in section 202(a)(2) of the Advisers Act or a savings association as defined in section 3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act (12 U.S.C. 1811);

ii. A broker-dealer registered under section 15(b)(1) of the Securities Exchange Act of 1934, holding the client assets in customer accounts;

iii. A futures commission merchant registered under section 4f(a) of the Commodity Exchange Act (7 U.S.C. 6f(a)), holding the client assets in customer accounts, but only with respect to clients’ funds and security futures, or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon; and

iv. A foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients’ assets in customer accounts segregated from its proprietary assets.

7. Related person means any person, directly or indirectly, controlling or controlled by you, and any person that is under common control with you.

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Cole-Frieman & Mallon LLP provides comprehensive legal support to hedge fund managers.  Bart Mallon can be reached directly at 415-868-5345.

The Dodd-Frank Act required the SEC to revise upward the dollar thresholds for a person to be deemed a “qualified client” pursuant to Rule 205-3. The qualified client definition is important because SEC registered investment advisers (including hedge fund managers) cannot charge performance fees to those investors who are not qualified clients. Previously an individual needed to have a net worth of $1.5 million or have $750,000 of AUM with the investment adviser. The new thresholds are $2 million and $1 million respectively.

It does not appear that there are any grandfathering provisions that will be applicable and it is currently unclear whether managers will need to seek confirmation from current investors/clients as to whether such investors meet the new qualified client definition. If managers are required to seek additional confirmation from current investors, this will obviously create additional legal and administrative expenses for managers. Regardless, for any future investors/clients, SEC registered investment advisers (and those groups that will be registering within the next 9 months) should make sure that the new qualified client definition is included in all subscription documents and other investment advisory contracts.

Another important issue is how this change will affect state registered investment advisers. Many state laws and regulations either mirror the federal laws and regulations or make specific reference to Rule 205-3. It is likely that many states will be coming out with guidance on this issue either through notifications or orders, or through legislative changes. Nonetheless, most state registered investment advisers should begin making plans to adapt to the changes at the federal level.

As more information from the states become available, we will be providing updates on this blog.

The notice of the SEC order is reprinted below and can be found here.

The actual SEC Order can be found here: SEC Order – Qualified Client Definition

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SEC Issues Order Raising Performance Fee Rule Dollar Limit to Adjust for Inflation

FOR IMMEDIATE RELEASE

2011-145

Washington, D.C., July 12, 2011 – The Securities and Exchange Commission today issued an order that raises, to adjust for inflation, two of the thresholds that determine whether an investment adviser can charge its clients performance fees. The order carries out a requirement of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

SEC’s Order

Rule 205-3 under the Investment Advisers Act allows an investment adviser to charge a client performance fees if the client meets certain criteria, including two tests that have dollar amount thresholds. Under today’s order, an investment adviser will be able to charge performance fees if the client has at least $1 million under the management of the adviser, or if the client has a net worth of more than $2 million. Either of these tests must be met at the time of entering into the advisory contract. The previous thresholds were $750,000 and $1.5 million respectively, and were last revised in 1998.

The Dodd-Frank Act requires that the Commission issue an order to adjust for inflation these dollar amount thresholds by July 21, 2011 and every five years thereafter. The Commission published a notice of its intent to issue the order on May 10, 2011. The Commission also proposed amendments to rule 205-3, which are currently under consideration.

The order will be effective on September 19, 2011, which will be approximately 60 days after its publication in the Federal Register.

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Bart Mallon is an attorney with a practice focused on hedge funds and investment adviser registration. He can be reached directly at 415-868-5345.

Overview of Major Items on ADV to Update

When a firm completes an annual update to Form ADV, the firm should go through each question and make sure disclosures are accurate and up to date.  In general the firm’s chief compliance officer will complete the update or work with an outside investment adviser compliance firm or law firm to complete the update.

Some of the key items of Form ADV which need to be updated include:

• Employees (Items 5.A. and 5.B.)
• Number of clients (Items 5.C. and 5.H.)
• Number of accounts (Item 5.F.)
• Assets under management (Item 5.G.)
• Other material changes can also be disclosed on the Annual Updating Amendment, such as changes to reportable disciplinary and financial disclosures, contact information, custody, and ownership.   [Note: these items need to be updated on Form ADV within 30 days of when they take place.]

While Part 1 of Form ADV can be completed using the online form on the IARD system, the new ADV Part 2 must be filed electronically as a text-searchable PDF.  You will not be able to submit a PDF file of a scanned copy Part 2 on the IARD system.

New Regulations Regarding ADV Part 2

IA firms applying for SEC registration as of January 1, 2011 and existing firms filing Annual Updating Amendments are now required to use the new Part 2A, the “firm brochure.”  In addition, the SEC has established the following compliance dates regarding Part 2B, the “brochure supplement:”

SEC Compliance Dates for Delivery of Brochure Supplements to Clients

*On December 28, 2010, the SEC extended the compliance dates by four months to provide certain IAs more time to deliver the brochure supplement.

Incorporating the New ADV Part 2 for State Registrations

Because not all states have adopted the new ADV Part 2, state-registered IAs should check their state rules to confirm whether they need to use the new form or if they can continue to use the old form.  In many states, the next amendment to Form ADV must include the new ADV Part 2, even if it is not the Annual Updating Amendment.  For example, as of January 1, 2011, states including Alaska, California, Connecticut, Indiana, Maine, Maryland, Massachusetts, Ohio, Oregon, and Tennessee are requiring that registered IAs use the new ADV Part 2 as part of any amendment, as well as the required Annual Updating Amendment.

For more information on ADV Part 2, especially with respect to state adoptions, please see our update on new ADV Part 2.

For information on expected costs to prepare the new Form ADV 2, please see this post.

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Bart Mallon provides investment adviser registration and compliance services through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.

*note: if a fund manager also has separately managed accounts, the manager will need to be SEC registered unless the manager has less than $100 million in AUM.

Of course it will be up to the states to decide whether or not to adopt the proposed rule, but if the proposal is adopted by any state, it would mean that many more managers would need to register at the state level if such managers were not registered with the SEC (in many, but perhaps not all cases).  I have written a number of times that most state securities divisions do not have the resources to handle an increase in IA registrations so I believe it unlikely that states securities divisions will lobby the legislatures for an increase in registrations under the NASAA proposal (for many states).  This proposal is essentially the first step toward states discussing the larger issue of how the securities laws will change in response to the changes from Dodd-Frank – we are likely to hear more about this story in the coming months as the SEC and states begin to more fully understand how legislative changes will affect their normal operating routines with respect to investment advisers.

Below we have provided some background on the proposed rule and the text of the proposed rule.

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Background & NASAA’s Proposed Model Rule

Prior to Dodd-Frank, the “private adviser exemption” from SEC registration applied to any investment advisor who during the course of the preceding 12 months had fewer than 15 clients (a fund is counted as one client) and who did not generally hold itself out to the public as an investment advisor.   Most hedge fund managers generally would utilize this exemption from IA registration with the SEC.  Title IV of the Dodd-Frank Act eliminated this exemption and in its place, created new registration and reporting rules for private fund advisers.

As we noted above, certain managers (including managers to venture capital funds and private equity funds) with less than $150 million in AUM will be exempt from SEC registration.  These managers exempt from SEC registration are called “exempt reporting advisers” (ERAs) and, although exempt from “registration” with the SEC, must still submit reports to the SEC (see Exempt Reporting Adviser Requirements).  In addition, these managers may still be required to register at the state level.

NASAA is proposing that managers of Section 3(c)(7) funds be exempt from state registration and that all other fund managers be subject to registration with the state securities division.  The stated rationale for this proposal is that investors in Section 3(c)(7) funds must be qualified purchasers and therefore do not need managers to be registered with the state securities commission.  To qualify for the NASAA exemption at the state level, the adviser must:

1. not be subject to a disqualification (which includes various criminal, civil, and regulatory disciplinary events),
2. solely advise 3(c)(7) fund(s),
3. file with the state the report that is required by the SEC (the condensed Form ADV, discussed in the Exempt Reporting Advisers article), and
4. pay applicable fees.

IA representatives associated with the ERA firm would also be exempt from state registration and licensing requirements.

NASAA’s proposed model rule would not apply to advisers of private funds with $150 million or more in AUM which are required to register with the SEC and satisfy any state notice filing requirements.

Request for Comments

NASAA is seeking comments on this proposed model rule.  Comments should be submitted electronically to advcomments@nasaa.org or by mail to NASAA, Attn: Joseph Brady, 750 First Street, NE, Suite 1140, Washington, DC, 20002 by January 24, 2011.

NASAA’a proposed model rules are reprinted below and can be found here.

Our Thoughts

We have not heard states discussing the NASAA proposal.  We also do not think that anything will be happening with this model rule immediately as states will be focusing on trying to figure out how to deal with the expected increase in state applications because of Dodd-Frank.

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Proposed NASAA Model Rule on Private Fund Adviser Registration and Exemption Rule XXX. Registration exemption for exempt reporting advisers

a. Subject to the provisions of paragraph (b) herein, an investment adviser solely to one or more private funds, shall be exempt from the registration requirements of Section XXX [identify authority] and shall be considered an exempt reporting adviser in this state if the adviser satisfies the following conditions:

(1) neither the adviser nor any of its advisory affiliates are subject to a disqualification as described in Section 230.262 of title 17, Code of Federal Regulations, or any successor thereto;

(2) the adviser acts as an adviser solely to private funds that qualify for the exclusion from the definition of “investment company” under Section 3(c)(7) of the Investment Company Act of 1940;

(3) the adviser files with the state a copy of each report and amendment thereto that an exempt reporting adviser under the Investment Advisers Act of 1940 would be required to file with the Securities and Exchange Commission pursuant to SEC Rule 275.204-4, along with a consent to service of process complying with Section XXX [identify authority]; and

(4) the adviser pays the fees specified in Section XXX [identify authority].

b. A federal covered investment adviser shall not be eligible for this exemption and shall comply with the state notice filing requirements applicable to such advisers.

c. An investment adviser representative is exempt from the registration requirements of Section XXX [identify authority] if he or she is employed by or associated with an adviser that is exempt from registration in this state pursuant to paragraph (a.) above.

d. As used in this rule a private fund means an issuer that would be an investment company as defined in section 3 of the Investment Company Act of 1940 but for sections 3(c)(1) or 3(c)(7) of the Act.

e. The report filings described in paragraph (a.)(3) above shall be made electronically through the IARD. A report shall be deemed filed when the report and the fee required by Section XXX [identify authority] are filed and accepted by the IARD on the state’s behalf.

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Bart Mallon is an attorney who works with both state and SEC registered fund managers.  His firm, Cole-Frieman & Mallon LLP, routinely provides regulatory and compliance services to registered investment advisers.  He can be reached directly at 415-868-5345.

• Background on the new Part 2
• The structure and disclosure items of the Firm Brochure (Part 2A)
• The structure and disclosure items of the Brochure Supplement (Part 2B)
• Overview of states which have adopted new Part 2

Background

On July 21, 2010, the Securities and Exchange Commission (“SEC”) adopted a new Part 2 that became effective October 12, 2010.  The old Part II (and Schedule F which qualifies much of the information on the old Part II) contained a series of check-the-box options and also provided much of the same information which is also provided on Form ADV.  The new Part 2 will no longer be in the check-the-box format.  Instead, it will take the form of a narrative brochure written in plain English–the purpose of which is to provide clients with a more clear disclosure of the adviser’s business practices, conflicts of interest, and background.

The new Part 2 consists of three parts:

1. The “Firm Brochure” (Part 2A)
   • SEC-registered firms and firms registered in states that have adopted the new Part 2 must complete.
   • Filed electronically on the IARD system.
   • Publicly available.
2. A Wrap Fee Program Brochure (Part 2A, Appendix 1)
3. The “Brochure Supplement” (Part 2B)
   • SEC-registered firms and firms registered in states that have adopted the new Part 2 must complete.
   • Not filed electronically.
   • Not publicly available.

The SEC has not provided a specific form that IAs must use when preparing the new Part 2.  The following provides general guidelines on how to structure the Firm Brochure and Brochure Supplement, as well as what content to include.  A full version of the new Part 2 instructions is available here.  Firms applying for SEC registration for the first time after January 1, 2011 are required to use the new Part 2.  Existing SEC-registered firms may use either the old Part II or the new Part 2 between October 12, 2010 and December 31, 2010.  However, beginning January 1, 2011, firms will have to use the new Part 2 for their 2011 annual updating amendment.

More information about the filing and delivery deadlines for the new Part 2A and 2B are available here.

Firm Brochure (Part 2A)

The Firm Brochure requires an adviser to provide information about the firm’s business practices and conflicts of interest. Many of the disclosure items are similar to those required in the old Part II, such as a discussion of the advisory business and the types of clients.  However, new disclosure items include a discussion of material changes since the last annual amendment as well as a discussion of potential conflicts of interest and how the firm will address such conflicts.

The Brochure consists of 18 separate disclosure items for SEC-registrations and additional items specifically for state-registrations.  Each item must be addressed, even if it is not applicable to the adviser.  The adviser may simply state it is not applicable.  The following is a summary of the disclosure items in the Firm Brochure:

• Item 1 – Cover Page
  • Firm name, business address, contact information, website (if any) and the date of the Brochure.
  • Specific disclaimer stating the Brochure was not approved by the SEC or any state authority.
  • If the firm refers to itself as a “registered investment adviser,” a specific disclaimer that registration does not imply a certain level of skill or training.

• Item 2 – Material Changes
  • If the firm is making an annual update, the Brochure must discuss material changes in the Brochure since the last annual update in a summary.  The summary can also be a separate document attached to the Brochure.

• Item 3 – Table of Contents
  • Must be detailed enough so that clients can locate topics easily.
  • Must list items in the same order as they are listed in the Brochure, and contain the same headings.

• Item 4 – Advisory Business
  • Describe the firm, how long it’s been in business, and identify the principals.
  • Describe the types of advisory services offered.
    • If the firm specializes in a particular type of services, e.g. financial planning, quantitative analysis, etc. provide greater detail.
    • If the firm provides investment advice only with respect to limited types of investments, explain and disclose that advice is limited in such way.
  • Explain whether the firm tailors advisory services and whether clients can impose restrictions on investments.
  • If the firm participates in wrap fee programs, describe the differences in how such accounts are managed versus other accounts and disclose that the firm receives a wrap fee.
  • If the firm manages client assets, disclose the amount managed on a discretionary basis and the amount managed on a non-discretionary basis.

• Item 5 – Fees and Compensation
  • Describe how the firm is compensated and provide a fee schedule.  Note: This requirement is not required for Brochures delivered solely to qualified purchasers.
  • Provide other compensation-related disclosures: whether fees are deducted from client assets or whether clients will be billed for fees; any other types of fees (custodian fees, mutual fund expenses, brokerage/transaction costs); payment of fees in advance or arrears; and asset-based sales charges or service fees.

• Item 6 – Performance-Based Fees and Side-By-Side Management
  • Discuss whether the firm charges performance-based fees or supervised persons manage accounts that pay such fees; and discuss how the fees are charged.
  • In addition, if the firm or supervised persons also manage accounts that do not charge such fees, discuss the potential conflicts of interest and how the firm will address such conflicts.

• Item 7 – Types of Clients
  • Describe the firm’s clients.
  • Describe any requirements for opening/maintaining an account.

• Item 8 – Methods of Analysis, Investment Strategies and Risk of Loss
  • Describe the methods of analysis and investment strategies used to formulate investment advice.  Disclose that investing in securities involves risk of loss.
  • For significant investment strategies or methods of analysis, discuss material risks involved with such strategies and methods.  If there are significant or unusual risks, discuss in detail.  If strategies involve frequent trading, discuss how frequent trading affects performance.
  • If the firm recommends primarily a particular type of securities, explain the material risks.  If there are significant or unusual risks, discuss in detail.

• Item 9 – Disciplinary Information
  • Disclose material facts about legal or disciplinary events about the firm or a management person.  This item lists events that are presumed to be material if they occurred in the prior 10 years, unless (1) the event was resolved in the firm’s or the management person’s favor, or was reversed, suspended or vacated, or (2) the firm rebutted the presumption of materiality to determine that the event is not material.
  • In the interest of full and fair disclosure of material facts, disclose events not on the list, events not presumed material, and/or events that are more than 10 years old.
  • The Firm can rebut events that are presumed material.

• Item 10 – Other Financial Industry Activities and Affiliations
  • Discuss whether the firm or management persons are registered or have pending applications to register as broker-dealers, broker-dealer reps, FCMs, CPOs, CTAs, or associate persons.
  • Describe material relationships with related financial industry participants (e.g. broker-dealers, registered reps of broker-dealers, investment companies or other pooled investment vehicles, FCMs, CPOs, CTAs, accounting firms, law firms, real estate brokers, etc.).
  • Describe material conflicts of interest that arise from such relationships and how those conflicts are addressed.
  • If the firm selects or recommends other investment advisers for clients, the firm must disclose compensation arrangements (if any) with those advisers and any other business relationships with such advisers, as well as any material conflicts of interest and how the firm address them.

• Item 11 – Code of Ethics, Participation or Interest in Client Transactions and Personal Trading
  • Include a summary of the code of ethics and state a copy is available upon request.
  • If the firm or a related person:
    • (i) recommends to clients, or buys or sells for client accounts, securities in which the firm or a related person has a material financial interest;
    • (ii) invests in the same securities (or related securities, e.g., warrants, options or futures) that the firm or a related person recommends to clients; or
    • (iii) recommends securities to clients, or buys or sells securities for client accounts, at or about the same time that the firm or a related person buys or sells the same securities for the firm’s own (or the related person’s own) account, then the firm must describe the practice and discuss conflicts of interest (including how such conflicts are addressed).

• Item 12 – Brokerage Practices
  • Describe how the firm selects brokers and determines the reasonableness of brokers’ compensation
  • If the firm receives research or other products or services other than execution from a broker-dealer or a third party in connection with client securities transactions (“soft dollar benefits”), disclose the firm’s practices and discuss the conflicts of interest they create.  Provide more detail for products/services that do not qualify under the Section 28(e) safe harbor.
  • If the firm considers, in selecting or recommending broker-dealers, whether the firm or a related person receives client referrals from a broker-dealer or third party, disclose this practice and discuss the conflicts of interest it creates.
  • If the firm routinely recommends, requests or requires that a client direct the firm to execute transactions through a specified broker-dealer, describe the firm’s practice or policy.
  • If the firm permits a client to direct brokerage, describe the practice.
  • Describe whether and under what conditions the firm aggregates the purchase or sale of securities for various accounts.

• Item 13 – Review of Accounts
  • If the firm periodically reviews client accounts, describe the frequency and nature of review, as well as the titles of the persons who conduct the review.
  • If accounts are reviewed on other than a period basis, describe what triggers review.
  • Describe the content and indicate the frequency of regular reports.

• Item 14 – Client Referrals and Other Compensation
  • If a non-client provides economic benefit to the firm for providing investment advice or services to clients, describe the arrangement, potential conflicts of interest and how such conflicts are addressed.
  • If the firm or related persons compensate any non-supervised persons for referrals, describe the arrangement and compensation.

• Item 15 – Custody
  • If the firm has custody of client assets and a qualified custodian sends quarterly, or more frequent, account statements directly to your clients, explain that clients will receive account statements from the broker-dealer, bank or other qualified custodian and that clients should carefully review those statements.
  • If the firm also provides statements, urge clients to compare such statements with those provided by the qualified custodian.

• Item 16 – Investment Discretion
  • If the firm has discretionary authority over accounts, disclose this, along with any limitations clients may place on that authority.
  • Discuss procedures before discretionary authority is assumed.

• Item 17 – Voting Client Securities
  • Describe voting policies for client securities, if any.  Discuss any conflicts of interest and how such conflicts are addressed.  Explain that a copy of the policies are available upon request.
  • If the firm does not vote client securities, disclose that fact.

• Item 18 – Financial Information
  • If the firm requires or solicits prepayment of more than $1,200 in fees per client, 6 months or more in advance, include a balance sheet for the most recent fiscal year.
  • If the firm has discretionary authority over client assets, custody of client funds or securities, or require prepayment discussed above, discuss any financial conditions that are reasonably likely to impair the ability to meet contractual commitments with clients.
  • Discuss any bankruptcy petitions during the past 10 years.

• Item 19 – Requirements for State-Registered Advisers
  • Identify and describe the formal education and business background of principal executive officers and management persons.
  • Describe any business in which the firm is actively engaged (other than the provision of investment advice) and amount of time spent.
  • In addition to the fees discussed in Item 5, if the firm or a supervised person is compensated for advisory services with a performance-based fee, explain how the fees are calculated and discuss the conflict of interest.
  • Disclose material facts about certain disciplinary items and other financial industry relationships or arrangements.

Brochure Supplement (Part 2B)

The Brochure Supplement requires an adviser to provide information about the certain advisory personnel.  The following is a summary of the disclosure items in the Brochure Supplement.

The Firm must prepare a Brochure Supplement for (i) any supervised person who formulates investment advice for the client and has direct client contact and (ii) any supervised person who has discretionary authority over the client’s assets.  A Supplement is not required if the supervised person has no direct client contact and has discretionary authority over client assets only as part of a team. Note: If investment advice is provided by a team of more than five supervised persons, Brochure Supplements only need to be prepared for the five supervised persons with the most significant responsibility for the day-to-day advice.

• Item 1 – Cover Page
  • Identify the advisory firm and the supervised persons covered in the Supplement (include name, business address, and phone number).
  • Standard disclaimer similar to the one in the Firm Brochure.

• Item 2 – Educational Background and Business Experience
  • Describe the supervised person’s formal education and business background for the past 5 years.
  • Include professional designations, if any.

• Item 3 – Disciplinary Information
  • Discuss the material facts related to any legal or disciplinary events that are material to a (prospective) client’s evaluation of supervised persons. This item lists events that are presumed to be material if they occurred in the prior 10 years, unless (1) the event was resolved in the supervised person’s favor, or was reversed, suspended or vacated, or (2) the firm rebutted the presumption of materiality to determine that the event is not material.
  • In the interest of full and fair disclosure of material facts, disclose events not on the list, events not presumed material, and/or events that are more than 10 years old.
  • The Firm can rebut events that are presumed material.
  • Disclose any event for which the supervised person has ever resigned or otherwise relinquished a professional attainment, designation or license in anticipation of it being suspended or revoked (other than for suspensions or revocations for failure to pay membership dues), if the firm knows or should have known that the supervised person relinquished his or her designation or license.
  • Note: If a Brochure Supplement is delivered electronically, the firm may disclose that a supervised person has a disciplinary event and provide a ink to BrokerCheck or IAPD (along with an explanation of how the client can access the disciplinary history).

• Item 4 – Other Business Activities
  • If the supervised person is actively engaged in any investment-related business, including registration (or pending registrations) as a broker-dealer, registered representative of a broker-dealer, futures commission merchant (“FCM”), commodity pool operator (“CPO”), commodity trading advisor (“CTA”), or an associated person of an FCM, CPO, or CTA, disclose this fact and describe the business relationship.

• Item 5 – Additional Compensation
  • If a non-client provides an economic benefit to the supervised person, describe the arrangement (not including regular salary).

• Item 6 – Supervision
  • Discuss how supervised persons are supervised, including how the firm monitors advice provided to clients.
  • Provide the name, title, and phone number of the person responsible for supervising the supervised persons.

• Item 7 – Requirements for State-Registered Advisers
  • Disclose material facts about certain disciplinary items.
  • Discuss any bankruptcy petitions.

[Note: the SEC recently extended the date for compliance with Part 2B.]

States That Have Adopted the New Part 2

The following states have followed suit and adopted the new Part 2 or informally indicated an intent to do so.

• Alaska – adopted the new Part 2 (more information available here)
  • October 12, 2010 – December 31, 2010: IA applicants and currently registered IAs may use either the old Part II or new Part 2.
  • As of January 1, 2011: IA applicants are required to use the new Part 2 and registered IAs must file the new Part 2 by no later than the registrant’s next amendment filing or its annual updating amendment filing, whichever comes first.

• Arizona – adopted the new Part 2 (more information available here)
  • October 12, 2010 – January 1, 2011: currently registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update
  • As of January 1, 2011: IA applicants must use the new Part 2.

• California – adopted the new Part 2 (more information available here)
  • October 12, 2010 – January 1, 2011: IA applicants and currently registered IAs may use either the old Part II or the new Part 2.
  • As of January 1, 2011: IA applicants will have to file the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.

• Colorado – will require but not sure starting when

• Connecticut – adopted the new Part 2 (more information available here)
  • October 12, 2011 – December 31, 2010: IA applicants and currently registered IAs may use either the old Part II or the new Part 2.
  • As of January 1, 2011: IA applicants will have to use the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.
  • As of January 1, 2011: IAs registered on or before December 31, 2010 should file the new Part 2, no later than June 1, 2011.

• Illinois – will require but not sure starting when

• Indiana – adopted the new Part 2 (timelines may have been updated) (more information available here)
  • October 12, 2010 – January 1, 2011: IA applicants and currently registered IAs may use either the old Part II or new Part 2.
  • As of January 1, 2011: IA applicants are required to use the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.

• Maine – adopted the new Part 2 (more information available here)
  • October 12, 2010 – January 1, 2011: IA applicants and currently registered IAs may use either the old Part II or new Part 2.
  • As of January 1, 2010: IA applicants must use the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.

• Maryland – adopted the new Part 2 (more information available here)
  • As of October 12, 2010: IA applicants must use the new Part 2 as part of its initial application and any amendment.
  • October 12, 2010 – December 31, 2010: currently registered IAs and those pending registration as of October 12, 2010 may use either the old Part II or the new Part 2 for any amendments
  • As of January 1, 2011: registered IAs must file the new Part 2 by no later than the registrant’s next amendment filing or its annual updating amendment filing, whichever comes first.

• Massachusetts – adopted the new Part 2 (more information available here)
  • October 12, 2010 – December 31, 2010: currently registered IAs are required to file the registrant’s next annual updating amendment using the new Part 2; until such time, the registrant may use the old Part II for regular amendment filings.

• Ohio – adopted the new Part 2 (more information available here)
  • October 12, 2010 – December 31, 2010: IA applicants and currently registered IAs filing amendment may use either the old Part II or the new Part 2.
  • As of January 1, 2011: currently registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.  IA applicants are required to use the new Part 2.
  • As of April 30, 2011: registered IAs must have converted to the new Part 2.

• Oregon – adopted the new Part 2 (more information available here).
  • October 12, 2010 – January 1, 2011: IA applicants and currently registered IAs filing amendment may use either the old Part II or the new Part 2.
  • As of January 1, 2011: IA applicants must use the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.

• Tennessee – adopted the new Part 2 (more information available here).
  • October 12, 2010 – December 31, 2010: IA applicants and currently registered IAs filing amendment may use either the old Part II or the new Part 2.
  • As of January 1, 2011: applicants must use the new Part 2 and registered IAs must file the new Part 2 by no later than the registrant’s next amendment filing or its annual updating amendment filing, whichever comes first.

• Texas – currently in comment period, final approval expected in mid-2011, encouraging use of the new Part 2 (more information available here).

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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.

1. Section 203(l) (see Rule 203(l)-1) generally exempts investment advisers who only advise one or more “venture capital funds” and
2. Section 203(m) (See Rule 203(m)-1) generally exempts investment advisers who only advise private funds and have AUM in the U.S. of less than $150MM.

To implement these new exemptions and to assist the SEC with identifying such advisers, their owners, their business models, and any potential risks to investors, proposed Rule 204-4 would require these “exempt reporting advisers” (“ERAs”) to submit, and to periodically update, reports to the SEC by completing specific items on Form ADV.

This article provides an overview of what information ERAs would have to report.

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ERA Reporting Items

Proposed Rule 204-4 requires exempt reporting advisers to provide the SEC with the following items on Form ADV:

• Item 1 – Identifying Information
  • A new question would require ERAs (and registered advisers) to indicate whether the adviser had $1 billion or more in AUM to assist the SEC in identifying excessive incentive-based compensation arrangements.
  • ERAs (and registered advisers) would be required to provide contact information for the adviser’s chief compliance officer, indicate whether any control person is a public reporting company, and add “limited partnership” as a cohise advisers can select to indicate how their organization is formed.

• Item 2C – SEC Reporting by Exempt Reporting Advisers

• Item 3 – Form of Organization

• Item 6 – Other Business Activities:  this item would require the ERAs to indicate the advisers other business activities.  The list of activities would be expanded to include trust companies, registered municipal advisors, registered security-based swap dealers, majority security-based swap participants, and accountant firms.

• Item 7 – Financial Industry Affiliations from Private Fund Reporting: this item would be expanded as Item 6 will be expanded.

• Item 10 – Control Persons

• Item 11 – Disclosure Information
  • ERAs (and registered advisers) would have to indicate whether the disclosure (i.e. criminal, regulatory) pertains to the adviser or any of its supervised persons

• Schedule A – Direct Owners

• Schedule B – Indirect Owners

• Schedule C - Amendments to Schedule A and B

• Schedule D
  • Items 6 and 7.A. would require additional information corresponding with the answers provided in Items 6 and 7 in the main part of Form ADV.
  • Item 7.B. would require ERAs (and registered advisers) to provide more information about the private funds they (and not their related persons) advise, which generally includes all pooled investment vehicles, regardless of whether they are organized as limited partnerships.
  • Item 7.B.1. would require ERAs (and registered advisers) to provide more information about the basic organizational, operation, and investment characteristics of the fund, amount of assets, nature of the investors, and service providers.
  • Part A of Item 7.B.1. would also require additional information including:
    • the name of the fund (including an option to preserve the anonymity of the private fund client);
    • the state or country where the fund is organized;
    • the name of the general partner, directors, trustees or other persons with similar positions;
    • the organization of the fund (e.g. master-feeder);
    • regulatory status of the fund; and
    • other questions about the fund’s investment activities (e.g. size of the fund, gross/net assets, minimum investment amounts, conflicts of interest, etc.)
  • Part B of Item 7.B.1. would require ERAs (and registered advisers) to provide information about the 5 types of service providers that generally perform the “gatekeeper” role for a fund–auditors, prime brokers, custodians, administrators and marketers.

The ERA would not be required to prepare a client brochure (Form ADV Part 2).

Updates to Form ADV

In addition to filing an initial Form ADV, ERAs would also be required to file updating amendments (pursuant to the new amendment to Rule 204-1).  Rule 204-1 would require ERAs, like registered advisers, to amend Form ADV:

• at least annually, within 90 days of the fiscal year end;

• more frequently, as required by Form ADV.  The new General Instruction 4 of Form ADV would require ERAs to update Items 1, 3, and 11 if they become inaccurate in any way.  They would be required to update Item 10 if it becomes materially inaccurate; and

• pursuant to Rule 204-4, the ERA would have to amend Form ADV when it ceases to be an ERA (indicate it is filing a final report pursuant to Rule 204-4).  Note: many times, the adviser would be simultaneously applying for registration.

Filing Deadlines

ERAs would be required to file their initial report on Form ADV by August 20, 2011.

Filing Fee

The ERAs would have to pay a filing fee charged by FINRA.   Currently, the SEC anticipates that the fees would be the same as those for registered IAs and range from $40 to $200, based on AUM.

Other Items

Why Form ADV?

The SEC has proposed for ERAs to use Form ADV to meet their reporting requirement because the Form ADV and IARD system are already established and doing so avoids additional delay and expense related to creating a new form.  In addition, many ERAs will already have to use Form ADV for their state registrations – using Form ADV allows such advisers to satisfy the state requirement and Rule 204-4 in a single filing.  The ERA reports filed via Form ADV will be publicly available on the SEC’s website.

Other Changes to Form ADV

Form ADV would be re-titled to reflect its dual purpose–as the “Uniform Application for IA Registration” and “Report by Exempt Reporting Advisers.”  The ERA would indicate that it was reporting to the SEC, rather than registering with the SEC.

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Other related hedge fund articles:

• SEC Extends Compliance Date for Form ADV Part 2b
• 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.

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.

In summary, the new rules:

• clarify eligibility for SEC registration for hedge fund and other asset managers
• establish reporting requirements for certain “exempt reporting advisers”
• require greater disclosure by registered IAs and each managed private fund in Form ADV
• clarify the scope of new exemptions from SEC registration
• propose amendments to the “pay to play” rules of the Act

This post will provide an overview of these proposals in greater depth.  Please feel free to comment below or contact us with your thoughts on the new rules as we are currently in the process of drafting a comment letter to the SEC about the proposed rules.

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Rule 203A-1 Switching to or from SEC Registration

The new Rule 203A-1 provides state and SEC registered IAs with information on the time requirements for switching registration status.

State-registered switching to SEC-registered: After filing an annual amendment indicating eligibility for SEC registration (and not relying on an exemption from registration under sections 203(l) or 203(m) of the Act discussed below), apply for registration with the SEC within 90 days.

SEC-registered switching to State-registered: After filing an annual amendment indicating you are no longer eligible for SEC registration (and not relying on an exemption from registration under sections 203(l) or 203(m) of the Act discussed below), you must file Form ADV-W to withdraw SEC registration within 180 days of your fiscal year end (unless you are then eligible for SEC registration).  Note: during dual registration, the Act and applicable state laws apply.

For full text and overview please see our post on Rule 203A-1.

Rule 203A-5 IA Registration Transition Rules

IAs registered with the SEC on July 21, 2011 must report their AUM (via amendment to Form ADV) to the SEC by August 20, 2011, or 30 days after the effective date of the amendments, and to report the market value of its AUM determined within 30 days of the filing.  If such IAs are at that time below the threshold for SEC registration, the IA must withdraw from SEC registration by October 19, 2011 (and generally be registered with the state in which the adviser’s maintains its principle office and place of business).

In addition, the SEC is also proposing amendments to Form ADV which will require registered IAs to provide additional information regarding: (i) the private funds they advise, including AUM, the nature of the investors in the fund and the fund’s service providers; (ii) their advisory business, including information about the types of clients they have and potentially significant conflicts of interest; and (iii) additional information about non-advisory activities and financial industry affiliations.

For full text and overview please see our post on Rule 203A-5.

Rule 204-4 Reporting by Exempt Reporting Advisers:

Certain “exempt reporting advisers” exempt from SEC registration pursuant to Sections 203(l) and 203(m) of the Act (discussed below) must file Form ADV (but not Form ADV Part 2) with the SEC, following instructions specifically pertaining to such advisers.  Such advisers must file their initial Form ADV no later than August 20, 2011.

For full text and overview please see our post on Rule 204-4.

Rule 202(a)(30)-1 Foreign Private Adviser Exemption

This new exemption from SEC registration applies to “foreign private advisers.”

A “foreign private adviser” is an investment adviser that:

• has no place of business in the U.S;
• has less than $25 million in aggregate assets under management from U.S. clients and private fund investors;
• has fewer than 15 U.S. clients and private fund investors; and
• neither holds itself out to U.S. investors as an investment adviser nor acts as an investment adviser to any investment company registered under the Investment Company Act or any company that has elected to be a business development company.

“Foreign private advisers” do not need to comply with the reporting requirements under the new Section 204-4.

For full text and overview please see our post on Rule 202(a)(30)-1.

Rule 203(l)-1 Venture Capital Fund Exemption

This new exemption from SEC registration applies to advisers that solely advise “venture capital funds.”

A “venture capital fund” is a private fund that:

• represents it is a venture capital fund;
• invests in only equity securities of a portfolio company and 80% of such securities must have been acquired directly from the portfolio company;
• has a management company which provides guidance to the portfolio company regarding management and operations of the portfolio company or the fund must control the portfolio company;
• uses less than 15% leverage which may only be short term; and
• provides fund investors with no withdrawal rights except in extraordinary circumstances.

The proposed rule also provides a grandfathering provision for certain presently existing venture capital funds.

For full text and overview please see our post on Rule 203(l)-1.

Rule 203(m)-1 Private Fund Adviser Exemption

This new exemption from SEC registration applies to advisers that solely advise private funds and have AUM in the U.S. of less than $150MM.  [HFLB note: the adviser may still be required to register pursuant to state law.]  The adviser must aggregate the value of all assets of the private funds it manages to determine whether it falls below the $150MM threshold.  AUM must be determined quarterly, with valuation based on the fair value of assets at the end of the quarter.  If an adviser’s AUM exceeds $150MM in private fund assets, the adviser must register as an investment adviser with the SEC within one calendar quarter.

For full text and overview please see our post on Rule 203(m)-1.

Rule 206(4)-5 Pay to Play Rules

Under the proposed amendment, an adviser would be permitted to pay a registered municipal advisor, instead of a “regulated person,” to solicit government entities on its behalf if the municipal advisor is subject to the Municipal Securities Rulemaking Board’s (the “MSRB”) pay-to-play rules.

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As with any proposed rulemaking process, there are a number of ambiguities with respect to the proposals and a number of questions regarding the application of certain rules to the certain situations.  These issues are expected to be identified during the comment process and hopefully the SEC will be able to modify the proposed rules as appropriate when the final rules are promulgated.  One central open issue is the change from SEC to state registration for managers with less than $100MM AUM – it seems pretty clear that most states will not be able to handle an increase in the amount of managers that will be subject to state regulation.

As discussed in the proposals, public comments are due on January 24, 2011.

A full copy of the proposed rules are available here.

Comments received by the SEC on the proposed rules are available for review here.

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Other related hedge fund articles:

• Hedge Fund Registration
• New ADV Part 2
• Important Hedge Fund Articles

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

This past week the Congressional Budge Office (“CBO”) released a cost estimate of H.R. 3818, the Private Fund Investment Advisers Registration Act of 2009.  In a number of private conversations I have had about hedge fund registration over the last 9-12 months one of the issues that was continually raised was appropriate funding for the SEC.  As we have seen recently (most notably from the Inspector General’s Madoff report), the SEC’s budget is not large enough to adequately fulfill their investor protection mandate.  Adding hedge fund registration would obviously further burden the cash-strapped agency (for more see Schumer Proposal to Double SEC Budget).  According to the CBO, and based on the SEC’s estimates that it will need to add 150 employees, the estimated outlays over four years will be equal to $140 million.

However, taxpayers should understand that this assumes that registration will only be required for those managers with at least $150 million in assets under management.   At the $150 million AUM level, the CBO expects that 1,300 hedge fund managers would be required to register.  The current draft of the Senate hedge fund registration bill calls for managers with $100 million in AUM to register – lowering the AUM exemption threshold will increase the amount of managers required to register.  Additionally, there are outstanding political issues.  First, it is unclear whether the final bill will require private equity fund managers and venture capital fund managers to register – we do not necessarily understand the arguably arbitrary carve-out for these industries.  Second, it is clear that a majority of the state securities commissions are unable and unwilling to be responsible for overseeing managers with up to $100 million in assets.  Hedge fund managers who would subject to state oversight would rightly want to be subject to SEC oversight (which does not say much for many state securities commissions).  These issues will continue to be addressed during the political sausage-making process.

Of additional interest – the CBO estimates that hedge fund registration is likely to cost around $30,000 per each SEC registrant which is welcome news to investment adviser compliance consultants and hedge fund lawyers!

For full report, please see full CBO Hedge Fund Cost Estimate.

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Other related hedge fund law articles include:

• RIA Compliance Overview
• SEC Emphasizes IA Compliance for Hedge Funds
• How to register as an Investment Advisor
• Important Information for Registered Investment Advisors

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog and provides hedge fund manager registration service through Cole-Frieman & Mallon LLP He can be reached directly at 415-868-5345.

For a greater background discussion on the legal precedents which helped shaped the state of law today, please see Insider Trading—A U.S. Perspective, a speech by staff of the SEC.

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Insider Trading

“Insider trading” is a term that most investors have heard and usually associate with illegal conduct. But the term actually includes both legal and illegal conduct. The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC. For more information about this type of insider trading and the reports insiders must file, please read “Forms 3, 4, 5″ in our Fast Answers databank.

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information.

Examples of insider trading cases that have been brought by the SEC are cases against:

• Corporate officers, directors, and employees who traded the corporation’s securities after learning of significant, confidential corporate developments;
• Friends, business associates, family members, and other “tippees” of such officers, directors, and employees, who traded the securities after receiving such information;
• Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded;
• Government employees who learned of such information because of their employment by the government; and
• Other persons who misappropriated, and took advantage of, confidential information from their employers.

Because insider trading undermines investor confidence in the fairness and integrity of the securities markets, the SEC has treated the detection and prosecution of insider trading violations as one of its enforcement priorities.

The SEC adopted new Rules 10b5-1 and 10b5-2 to resolve two insider trading issues where the courts have disagreed. Rule 10b5-1 provides that a person trades on the basis of material nonpublic information if a trader is “aware” of the material nonpublic information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-existing plan, contract, or instruction that was made in good faith.

Rule 10b5-2 clarifies how the misappropriation theory applies to certain non-business relationships. This rule provides that a person receiving confidential information under circumstances specified in the rule would owe a duty of trust or confidence and thus could be liable under the misappropriation theory.

For more information about insider trading, please read Insider Trading—A U.S. Perspective, a speech by staff of the SEC.

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Other related hedge fund law articles include:

• Hedge Funds and Insider Trading
• Hedge Fund Best Practices
• Overview of Securities Exchange Act of 1934
• RIA Compliance Information
• Hedge Funds and Insider Trading: PIPEs

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog and the Series 79 exam website.  He can be reached directly at 415-868-5345.