ADV Annual Updating Amendments

ADV Annual Updating Amendments are due for most registered investment advisers and exempt reporting advisers within 90 days of the fiscal year end. That sets the filing date for 2016 firmly on March 30th.

In updating the Form ADV, firms should be particularly mindful of changes in these key areas:

  • Identifying information, including contact persons;
  • Information about the advisory business, including:
    • Employee counts;
    • Client counts; and
    • Regulatory Assets Under Management.
  • Private fund reporting;
  • Offering memoranda and subscription documents;
  • Firm strategies, policies and procedures;
  • Conflicts of interest;
  • Custody changes; and
  • Use of consultants for compliance and cybersecurity.

Firms should especially lean on their brokers, custodians, administrators, legal counsel and compliance consulting firm to accurately and correctly complete the Form ADV Annual Updating Amendment process.

2015 SEC Enforcement Round Up

Fees and Expenses

SEC Charges Santa Barbara-Based Hedge Fund Firm, Executives and Auditor for Improper Expense Allocations

Alpha Titans LLC, a Santa Barbara, CA based hedge fund misallocated assets from two affiliated private funds to pay for firm expenses. The SEC investigation found that the firm’s principal, Timothy McCormack, and general counsel, Kelly Kaeser, used private fund assets to pay more than $450,000 in office rent, salaries and benefits, and other expenses without authorization or appropriate disclosure to investors. The firm’s auditor, Simon Lesser, falsely approved of audit reports that the funds’ financial statements were accurately presented. These statements failed to include almost $3 million in expenses to outside entities controlled by McCormack.

McCormack and Kaeser are banned from the securities industry for a year; Kaeser also received a one-year suspension from practicing as an attorney on behalf of any SEC entity. Lesser is barred from practicing as an accountant on behalf of any SEC entity for three years.

SEC Charges KKR With Misallocating Broken Deal Expenses

Private equity firm Kohlberg Kravis Roberts & Co. misallocated over $17 million in “broken deal” expenses to its funds. These expenses, often associated with broken deals, diligence or unsuccessful buyouts, must be allocated equally among all participating funds and co-investors. The SEC marked this lack of disclosure and misallocation as a failure to adopt appropriate policies and procedures for broken deal expense allocation and a breach of fiduciary duty.

KKR is ordered to pay approximately $30 million to settle the charges, including a $10 million penalty.

SEC Charges Seattle-Area Hedge Fund Adviser With Taking Unearned Management Fees

Washington based Summit Asset Strategies Investment Management and its CEO, Chris Yoo, falsely inflated fund asset values in order to generate fees. Yoo incorrectly valued bank assets at approximately $2 million when the actual value was less than $200,000. Additionally, he failed to disclose a conflict of interest with his other firm, Summit Asset Strategies Wealth Management, where he received fees when referring clients to invest in the fund.

Yoo and his firms have been ordered to pay combined disgorgement and fines in excess of $1.3 million. Individually, Yoo is banned from the securities industry.

Conflict of Interest

SEC Charges BlackRock Advisors With Failing to Disclose Conflict of Interest to Clients and Fund Boards

The SEC charged BlackRock Advisors LLC with breaching its fiduciary duty by not disclosing a conflict of interest between Daniel Rice III, a portfolio manager, and his outside business, Rice Energy. Rice was the general partner of Rice Energy, having invested nearly $50 million in the company. Rice Energy, following a joint venture with a publicly-traded coal company, eventually became the biggest holding in BlackRock’s $1.7 billion Energy & Resources Portfolio, managed by Rice. Rice Energy accounted for almost 10% of the fund’s holdings.

BlackRock has paid a $12 million penalty to settle the charges and must engage an independent compliance consultant to conduct an internal review.

SEC Charges Private Equity Firm and Four Executives With Failing to Disclose Conflicts of Interest

New York private equity firm Fenway Partners LLC and its principals Peter Lamm, William Smart, Timothy Mayhew Jr., and CFO Walter Wiacek are charged with failing to disclose conflicts of interest to investors. Through the fund or portfolio companies the individuals caused over $20 million in consulting fees to be paid to an affiliated entity, Fenway Consulting Partners LLC, and other firm employees all while working primarily at Fenway Partners. These fees were never offset against management fees regularly charged to the fund by Fenway Partners, effectively double billing the fund.

Together the parties have agreed to pay over $10 million into a fund for harmed investors.

Compliance Violations

SEC Charges Issuer for Failing to Make Public Filings

The SEC charged W2007 Grace Acquisition I Inc. with failing to make required public filings. In 2007, the firm suspended reporting obligations for its class B and class C preferred shares as the shares had less than 300 holders of record. In 2014, the firm incorrectly counted its holders of record and therefore neglected to report, missing 8 required public filings.

W2007 Grace Acquisition I Inc. agreed to pay $640,000 to settle all charges.

SEC Charges Citigroup Global Markets for Compliance and Surveillance Failures

Citigroup Global Markets was charged with failing to enforce policies and procedures to prevent and detect the misuse of material nonpublic information. It was also charged with failing to prevent and detect principal transactions by an affiliate. The SEC found that Citigroup failed to review thousands of trades by several trading desks over a 10-year period. The firm also routed nearly 500,000 trades to an affiliated market maker who then executed the purchases from its own account.

Citigroup was fined $15 million and ordered to retain a consultant to improve its surveillance and trade order process.

Wolverine Affiliates Charged With Failing to Maintain Policies to Prevent Misuse of Material Nonpublic Information

Wolverine Trading LLC and Wolverine Asset Management LLC were charged by the SEC with failing to maintain and enforce policies and procedures to prevent the misuse of material nonpublic information. Employees at Wolverine Trading repeatedly shared information regarding trading positions, specifically TVIX, an exchange-traded note, with others at Wolverine Asset Management. Wolverine Asset Management unfairly profited from market opportunities it should not have had to the tune of over $350,000.

The firms together have been fined approximately $1.15 million to settle the charges.

SEC Charges Investment Adviser With Failing to Adopt Proper Cybersecurity Policies and Procedures Prior To Breach

R.T. Jones Capital Equities Management, a St. Louis-based investment adviser, was charged with failing to adopt written cybersecurity policies and procedures. For nearly 4 years, the firm stored all sensitive personally identifiable information of its clients on a third-party web server. The firm neglected to take steps to protect client information and was hacked in 2013, giving the intruder access to all data stored on the server.

The firm has been charged with violating Rule 30(a) of Regulation S-P, the “safeguards rule”, and fined $75,000.

Insider Trading

SEC Charges Four in California Insider Trading Ring

John Gray, an analyst at Barclays Capital, along with his friends Christian Keller and Kyle Martin, traded on insider information in advance of several corporate news announcements. They attempted to conceal their actions by trading in another person’s name, using prepaid disposable phones and making structured cash withdrawals. Additionally, Gray shared information with a fourth participant, Aaron Shepard. In total, profits from trading on the nonpublic information amounted to nearly $750,000.

Gray has been barred from the securities industry. Keller has been barred from serving as an officer or director of a public company for 10 years. Martin and Shepard, due to significant cooperation during the SEC’s investigation, were not assessed additional penalties.

SEC Announces Charges Against Atlanta Man Accused of Insider Trading in Advance of Tender Offer

The SEC charged Charles L. Hill for trading in advance of a tender offer by NCR Corporation to purchase Radiant Systems. Hill was aware that his friend, from whom he received the information, was close friends with a Radiant Systems executive. Trading on the nonpublic information, Hill purchased 100,000 shares of Radiant Systems worth nearly $2.2 million and realized a profit of approximately $740,000.

SEC Charges Friends With Insider Trading on Acquisition of Cooper Tire

Amit Kanodia and Iftikar Ahmed, two longtime friends, were charged with trading in advance of an acquisition of Cooper Tire by Apollo Tyres Ltd. Kanodia’s wife was the general counsel at Apollo and heavily involved in the deal. She shared this information with her husband, Amit, who then passed the information to his friend Ahmed and another party. Ahmed purchased significant shares in Cooper Tire and sold them immediately following the announcement for a gain of over $1.1 million. As a kickback, Ahmed transferred $220,000 to a charity controlled by Kanodia.

SEC Charges Father and Son in $1.1 Million Insider Trading Scheme

The SEC charged Sean Stewart, a managing director at an investment bank, with providing insider information about future mergers and acquisitions to his father, Robert Stewart. Robert placed trades ahead of more than half a dozen merger and acquisition announcements. Over four years, proceeds from these trades exceeded $1.1 million. Although the duo tried to use in-person meetings and coded e-mails to discuss trades, the SEC claims new technology helps identify relationships among traders and even suspicious trading across multiple securities.


SEC Announces Fraud Charges Against Purported Hedge Fund Manager

Moazzam Malik, a purported New York hedge fund manager, solicited investors in order to fund his extravagant lifestyle. By promising investors high returns, he raised over $800,000 although his fund never held more than $90,000. Malik attempted to continue recruiting new investors amidst redemption requests by changing the name of his firm several times and even going so far as to create a fictitious employee to represent to one investor that Malik had died.

SEC Halts Ponzi-Like Scheme by Purported Capital Fund Manager in Buffalo

Gregory Gray Jr. and his firms Archipel Capital LLC and BIM Management LP are charged with operating a Ponzi-like scheme in New York. Gray and his firms solicited money for pre-IPO shares in high-profile companies including Twitter and Uber at a low price, raising almost $5.3 million. When Gray was unable to purchase these shares, he falsified stock purchase agreements and paid investors with the stolen funds.

SEC Announces Fraud Charges Against Investment Adviser Accused of Concealing Poor Performance of Fund Assets From Investors

Lynn Tilton and her firm, Patriarch Partners, are charged with defrauding investors and collecting fees stemming from false valuations. The New York based firm failed to value assets in the manner described in the funds’ offering documents. Tilton’s practices hid the declining value of the assets from investors and caused nearly $200 million in unearned fees to be generated for the firm.

SEC Charges Hedge Fund Advisory Firm With Conducting Fraudulent Fund Valuation Scheme

The SEC charged the Connecticut-based firm AlphaBridge Capital Management with fraudulently inflating the prices of securities in its hedge fund portfolios. The firm provided internal valuations to broker-dealers to pass of as their own. These valuations were then provided to investors leading them to believe they were receiving these securities at a discount.

AlphaBridge and its owners have paid a combined $5 million to settle the charges.

SEC Charges New Jersey Fund Manager With Securities Fraud

William Wells, through his firm Promitor Capital Management, solicited investors by falsely holding himself out as an investment adviser to invest in certain stocks. Wells raised in excess of $1.1 million for his highly speculative options trading that resulted in a total loss of funds. In order to raise additional funds to pay back redemption requests, Wells falsified account statements showing positive returns and provided them to new investors.

Wells is the subject of an ongoing SEC investigation and faces criminal charges in New York.

SEC Investigations Target Private Equity Fees and Disclosures

The Securities and Exchange Commission (“SEC”) has prioritized investigating private equity firms this year, particularly, their fee structures. This increase in enforcement highlights the SEC’s concern for transparency in fee disclosures (see our previous article on private equity fees) made to investors; a concern that was articulated by Andrew Bowden in his “Spreading Sunshine in Private Equity” speech. Specifically, Mr. Bowden stated that the SEC’s recent examinations of private equity firms indicated that 50% of the examined firms had material weaknesses in their disclosures. Recent enforcement areas include:

  • Accelerated monitoring fees. As a part of a private equity firm’s investment, portfolio companies may enter into agreements that include monitoring fees for, on average, 10 years. These fees provide the portfolio companies with valuable advisory services on matters such as restructuring, IPOs and mergers or buyouts. A term associated with these types of fees is that if a company is sold or taken public, these monitoring fees are accelerated into a lump sum. That lump sum payment can reduce the value of the portfolio company before sale, negatively impacting the earnings of the funds and, ultimately, the investors’ returns. While monitoring fees were discussed in the offering documents, the SEC found that the acceleration clause was often not disclosed until later when it was triggered by the sale of a portfolio company. Going forward, firms should ensure their offering documents clearly describe these fees and all of their material terms.
  • Broken deal expenses. Firms incur costs for deals that do not close, such as unsuccessful buyouts. These expenses, including diligence of the deal and related costs, are then allocated to the fund. This can become an issue for fund complexes that include a primary fund comprised of the majority of the outside investors, along with parallel vehicles for investors with specific needs, and employee co-investment and others. The SEC found that some managers allocated broken deal expenses to the primary fund and not the parallel vehicles. In particular, not allocating these expenses to the employee co-invest raised concerns for the SEC. Firms should establish a uniform process for distributing fees among all vehicles in a fund complex and disclosing this process to investors. (See our article on private equity co-investment)
  • Conflicts of interest. Occasionally firms use the same service provider for firm business as they do for their funds. It is also fairly common in private equity, venture and real estate investing to retain the same specialty service providers for multiple funds, deals or projects. In one case, the SEC found that retaining a law firm that provided discounts to the firm in exchange for the fund’s business created a potential conflict of interest. Specifically, the SEC believed that this benefitted the firm at the cost of investors (even though there may well be an argument for overall cost savings and efficiencies for the firm and funds alike). In order to avoid SEC scrutiny, firms should evaluate all service providers to funds, portfolio companies, deals and projects, paying particular attention to those in common with the firm. Even when these arrangements ultimately benefit funds and their investors, the SEC may find the potential for conflicts of interest.

The SEC does not expect firms to carry all the expenses of their funds’ investment activities. However, firms should act on the SEC’s concerns about fees, expenses and other potential conflicts of interest. Key initiatives may include reviewing and revising their fee disclosures for transparency, establishing policies and procedures for selecting and monitoring service providers, allocating fees and expenses among various funds and reviewing potential conflicts of interest.

SEC Provides Clarity on Venture Capital Exemption

Recently, the Securities and Exchange Commission (“SEC”) issued a no-action letter in response to a request for clarification of the Venture Capital Exemption (“Exemption”) to Section 203 of the Investment Advisers Act of 1940. Section 203 specifically addresses the registration of investment advisers and any applicable exemptions firms may rely on.

Under the Exemption, any firm that acts as an investment adviser solely to one or more venture capital funds is not required to register with the SEC. This is subject to the requirement that the investments must be made in qualifying portfolio companies (“Qualifying Companies“). Qualifying Companies must not be any of the following:

  • A publicly-traded company, U.S. or foreign;
  • Have a control relationship with a publicly-traded company;
  • Incur leverage in connection with the investment by the private fund and distribute such borrowing to the private fund in exchange for investment; or
  • A fund.

The examples below address two issues these restrictions place on venture capital firms, significantly because they must be met on the date of the initial investment. A fund or manager may invest in a Qualifying Company that later becomes publicly-traded without hindering the fund or manager’s reliance on the Exemption. If this occurs, however, the fund or manager would be said to have a control relationship with a publicly-traded company. As a result of this control relationship, the fund or manager would not be able to invest in further Qualifying Companies while continuing to rely on the Exemption, as seen in Example 1.


The second example below highlights the same restriction, under slightly different circumstances. A fund or manager (“Unaffiliated Manager”), not relying on the Exemption, has a controlling interest in a Qualifying Company and a publicly-traded company. Additional funds or managers, relying on the Exemption, would then be prohibited from investing in that particular Qualifying Company because of Unaffiliated Manager’s control relationship with a publicly-traded company.


Per the above examples, the restriction disallowing Qualifying Companies from being under common control with a publicly-traded company creates issues for venture capital firms. Specifically, the issues are:

  • When a fund or manager invests in a Qualifying Company that later becomes publicly-traded, it is deemed to have a control relationship with that company and prohibited from investing in further Qualifying Companies;
  • Any fund or manager (not relying on the Exemption) that is invested in a Qualifying Company and a publicly-traded company has a control relationship with both companies. As a result of this relationship, additional funds or managers relying on the Exemption may not invest in that Qualifying Company.

This not only poses problems for initial investments in Qualifying Companies, but also for follow-on investments. These follow-on investments are often critical for companies receiving funding from firms relying on the Exemption. The SEC agreed that under these circumstances, the literal wording of the rule appears to have unintended consequences of preventing investments in Qualifying Companies. Accordingly, the SEC confirmed that it would not recommend enforcement action given similar circumstances. Firms that intend to rely on the Exemption should read the no-action letter in its entirety and consider documenting all supporting information so it is available in an examination. Any concerns about the applicability of the no-action relief should be addressed to outside counsel and/or a firm’s compliance consultant.

Cybersecurity Policies: What Are Regulators Looking For From Your Firm?

With increasing regulatory pressure to implement comprehensive cybersecurity policies, now is a good time to make sure your firm is prepared. The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (“OCIE”), the National Futures Association (“NFA”) and the Commodity Futures Trading Commission are all releasing proposed rules, guidance and/or examination priorities focused on cybersecurity safeguards. Most recently, the SEC issued a Risk Alert announcing a second round of cybersecurity exams. The first round of exams surveyed and identified the cybersecurity risks and preparedness of the securities industry. This second round will assess certain aspects of cybersecurity policies to determine firms’ progress toward full implementation. The NFA and OCIE guidance is largely overlapping but equally useful for implementing effective cybersecurity policies; these are the key areas every firm should be prepared to address:

  1. Implementation of a Formal Cybersecurity Program. A firm’s cybersecurity team should include a firm’s internal IT department or outside IT provider, the CCO, legal counsel and/ or compliance consulting firm. At minimum, a firm’s cybersecurity policy should cover the following:
    1. Identifying sensitive information and any vulnerabilities that would allow such information to be misappropriated or accessed by unauthorized persons;
    2. Steps to protect sensitive information, systems and devices. This should include password policies, hardware and software security (i.e., anti-virus and intrusion detection software) and data security, among others;
    3. Procedures for monitoring and detecting cyberattacks on firm systems;
    4. Steps to take once a breach has been detected;
    5. Plan for recovery and restoration of information, systems and services;
    6. Employee training on protecting firm systems and information;
    7. Provide for periodic policy testing and updates.
  2. Governance and Risk Assessment. Senior management should be involved to make decisions and set the “tone at the top.” Involving management early on will help foster a culture of compliance and awareness, ultimately making implementation smoother. Examiners will evaluate how frequently policies are updated, whether the risk assessment process is comprehensive and whether policies are robust enough to sufficiently protect the firm. Management buy-in is essential to ensure that the CCO and IT staff have sufficient support to meet examiners’ expectations.
  3. Access Rights and Controls. Examiners will look for appropriate controls to prevent unauthorized access to systems or information. This is a key part of any cybersecurity policy and should include, at a minimum:
    1. Tiered access. User access should be restricted to the systems and data they require to carry out their duties.
    2. Password control. Users should be prompted to use complex passwords and update them at regular intervals (e.g., every 90 days).
    3. Remote access controls. This can include protocols such as locking the account after several failed login attempts, requiring secure connections and/or closing inactive connections.
    4. User account control. Policies for maintaining user accounts are crucial to minimizing the risk of unauthorized access. Expired accounts, such as those of former employees, are especially easy targets for hackers as they are seldom monitored. This policy should cover the appropriate time period for removing accounts, such as upon termination, and who is responsible for doing so.
  4. Data Loss Prevention. Firms should establish procedures for monitoring and updating their systems on a regular basis. Most commonly, firms can use software that monitors the amount of data being downloaded or uploaded to the system in order to detect anomalies. This may also include firm policies for verifying customer fund transfer requests. Where applicable, it is important to ensure firm policies for preventing identity theft interact appropriately with cybersecurity policies.
  5. Vendor Management. Firms should carefully evaluate potential vendors for appropriate policies and safeguards, especially if they have access to the firm’s network. Some vendors that may have access include IT consultants, cloud-based document storage companies, brokers and third-party fund administrators. Hackers frequently do not infiltrate a target firm’s systems directly, but instead will attempt to breach the security of a vendor to gain back door access. Similarly, vendor diligence should cover any situation in which it will keep the firm’s data on its own systems.
  6. Incident Response and Recovery. A firm’s cybersecurity policy should describe relevant breach scenarios, safeguards in place for protecting effected data and establish a process for restoring services and any lost or compromised data. Firms should be backing up their systems regularly (the interval will depend on the firm), either on its own servers or through a third-party IT firm. Backup sites and servers should be tested regularly for reliability. Firms using a cloud-based platform for data storage and recovery should thoroughly diligence these services. Public services usually do not provide sufficient security for purposes of regulators’ recordkeeping and disaster recovery rules. Firms looking to use a cloud-based solution should consider the increasing number of services specifically designed for regulated entities.
  7. Employee Training. The best policies, systems and software will fail if an employee, mistakenly or maliciously, allows his or her access to be used in misappropriating sensitive data. Essential topics to cover are:
    1. Remote access policies and procedures;
    2. Use of company or personal mobile devices;
    3. Use of unsecure remote internet connections;
    4. Opening messages or attachments from unknown sources;
    5. Procedures for handling unauthorized access, viruses, or any other cybersecurity threat.

Although these are the primary focus areas for the OCIE and NFA, firms should consider any other issues or risks that are relevant to their business. Neglecting to implement an appropriate policy can lead to SEC enforcement action, including fines. The most effective cybersecurity plan will leverage the expertise of a firm’s legal counsel, IT staff and compliance team or outside compliance consulting firm.

The New AML Rules: Implications for Private Fund Managers

On August 25, 2015, the Financial Crimes Enforcement Network (“FinCEN”), a bureau of the U.S. Treasury Department, issued aproposed rule requiring all financial institutions, including registered investment advisers, to implement and monitor anti-money laundering (“AML”) programs. Other types of financial institutions, such as banks and broker-dealers, have long been required to meet AML requirements. This program will close what FinCEN calls a “big hole” in the regulatory structure that would allow clients to move or deposit dirty money without attracting much attention. Examination and enforcement authority for the rule will be delegated to the Securities and Exchange Commission (“SEC”).

The proposed rule has 3 components:

  • Include investment advisers within the general definition of “financial institution” in the regulations implementing the Bank Secrecy Act (“BSA”) and adding a definition of investment adviser;
  • Requiring investment advisers to establish AML programs; and
  • Requiring investment advisers to report suspicious activity.

Compliance with the proposed rule is required for any firm registered or required to register with the SEC under Section 203 of the Investment Advisers Act of 1940. This includes all advisers and subadvisers. Currently, firms that are exempt from SEC registration will also be exempt from this rule. Firms required to comply must establish an internal AML program; an effective program will include, at minimum:

  • Development of internal policies, procedures and controls;
  • Designation of a compliance officer;
  • Implementation of an ongoing employee training program; and
  • Independent audit function to test the effectiveness of these programs.

Previously, financial institutions with AML requirements were obligated to file FinCEN Form 8300. This form required financial institutions to report on the receipt of over $10,000 in cash or negotiable instruments. Under the proposed rule, this form would be replaced with a Currency Transaction Report (“CTR”). A CTR is required for transfers of more than $10,000 by, through or to a financial institution. Firms would also be required to create and retain records for extensions of credit and cross-border transfers of currency, monetary instruments, checks and investment securities over $10,000. Furthermore, any questionable transaction above the Suspicious Activity Report (“SAR”) threshold that involves, in the aggregate, at least $5,000 in funds or other assets would require advisers to file an SAR. Suspicious activities are transactions that an adviser knows or believes to:

  • Involve funds from illegal activity or is intended to disguise funds or assets derived from illegal activity;
  • Is designed to evade the requirements of the BSA;
  • Has no business or apparent lawful purpose, and the investment adviser knows of no reasonable explanation for the transaction;
  • Involves the use of the investment adviser to facilitate criminal activity; or
  • A client who, among others:
    • Exhibits unusual concern regarding the adviser’s compliance with government reporting requirements or is reluctant to provide information on its business activities;
    • Appears to be acting as an agent for another entity and is reluctant to provide responses to questions about that entity;
    • Shows a pattern of unusual withdrawals inconsistent with investment objectives; or
    • Exhibits a total lack of concern for returns or risk.

Although it remains to be seen which parts of the proposed rule will make it into the final rule, there are a few things to note:

  • Advisers that are required to comply will be burdened with additional compliance policies and programs, client background checking and recordkeeping and SEC/FinCEN reporting;
  • Although advisers could argue that financial institutions subject to AML requirements carry and conduct all financial transactions for them, FinCEN counters that those financial institutions lack appropriate access to detailed client information required for a thorough check; and
  • While the proposed rule may only apply to advisers required to register with the SEC currently, the amendment to include exempt and state registered advisers is believed to follow.

Compliance FAQ: Investment Adviser Registration

Q: What kinds of adviser registration are there?

A: Most states and the U.S. Securities Exchange Commission(“SEC”) register investment advisers.   For the SEC, registrants must select a basis for registration on Form ADV. If it does not meet any of those criteria, then it will normally register with a state. Though not technically a registration, the SEC and many states have an Exempt Reporting Adviser (“ERA”) regime, which requires a filing on a shorter form of the ADV.  It is only available to firms that exclusively manage private funds and there are usually other requirements. We recommend discussing all of your options with legal counsel or a compliance consultant.

Q: You mentioned private funds.  What is that?

A: The Investment Company Act of 1940 (“Company Act”) requires registration of pooled investment funds, with some exceptions. Mutual funds are usually registered under the Company Act and are also known as registered investment companies, RICs, registered funds, or sometimes just registered products. Funds that meet the criteria for one of the exemptions (usually the ones at Section 3(c)(1) or 3(c)(7) of the Company Act) are, by definition “private funds.” In addition to the Company Act exemptions, private funds will also normally rely on exemptions from registration under the Securities Act of 1933 (“Securities Act”), either Section 4(2) of the Securities Act itself, or, more commonly, the safe harbors found in Regulation D, specifically Rule 506. Regulation D offerings require a filing with the SEC on Form D and most states will also require submitting a copy of Form D along with a filing fee to their securities regulator(these are known as “blue sky” filings).

Q: Do individual employees have to register?

A: It depends on whether the firm is registered with the SEC or a state and the kinds of clients you have.  Registered individuals are referred to as Investment Adviser Representatives or IARs. SEC registrants whose direct clients include individual natural persons may need to register their client representatives in the states where they have more than a de minimis number of clients.  For state-registered firms, you will nearly always have one or more persons registered as IARs.  Who has to register may vary by state. Note that “client” means a direct client of a firm, not an investor in a fund. In the latter case, the fund is the firm’s client and because it is an entity, not a person, it would not require IAR registration (this is the case for SEC registrants; state registrants should confer with their legal counsel and/or compliance consultant on any variances).

Q: Are there examination requirements for IARs?

A: Yes and no. IARs of SEC registrants are not required to pass an exam. IARs of state registrants must have passed the Series 65 within a certain period of time before registering. There are alternative and waiver requirements, which can vary but typically include individuals who already have the 7 and 66 or who have professional charters such as the CFA.

Q: How do I register my firm as an investment adviser?

A: Both full registrants and ERAs submit their initial and amended filings on the Investment Adviser Registration Depository (“IARD”). Brand new firms must open an account on IARD before preparing their initial filing on Form ADV. The process is completely electronic, include the Part 1A and 1B, which are online, fill-in-the-blank forms, and the narrative Part 2A, which is converted to a PDF and uploaded to your filings. State registrants must also file Part 2B, which contains biographical, disciplinary and other information about the individuals at the firm who perform investment advisory functions. SEC registrants complete Part 2B as well, but they do not file it on IARD.

Q: Are there filing fees?

A: Yes. Initial and annual amendment filings have a fee, as do IAR registrations (initial and annual).  These vary depending on the jurisdiction(s) you are filing in. Fee information is available here. So-called “other than annual” amendments do not have filing fees.

Q: Do I need a law firm or compliance consultant to help me with registration?

A: Not necessarily. Regulators believe the forms can be completed by someone at the registering firm.  However, we recommend that brand new firms work with legal counsel or a compliance consulting firm in some capacity to complete their initial registrations. There are a number of ways to work with a service provider on registration, including having them review forms completed by the firm, or to handle the entire process from beginning to end.  We have worked with clients who complete the fill-in-the-blank Part 1 on their own (with a few questions to us), and tasked us with drafting Part 2 for them. Depending on your budget, familiarity with the registration forms and process and amount of time you can allocate, you will likely find one option that suits you best.

Having an experienced service provider manage the entire process has a number of efficiencies, particularly for state registrants. State regulators tend to ask a lot of questions and request additional documents and information before they will approve new registrations. You may wish to have legal counsel or a consultant assist with these requests. Keep in mind that state registration includes IARs and exam requirements, which add a lot of time and effort to the process.

Q: Should I also use legal counsel or a consultant for amendments?

A: Oftentimes, routine amendments are easily handled directly by the firm. See our article on commonly amended ADV items. Significant or complex amendments, particularly for the Part 2A should probably go through your legal counsel or compliance consultant.

Q: I have a choice of either fully registering in my home state or being an ERA. What should I think about?

A: If you plan on managing only private funds for the foreseeable future and there is no investor demand for state registration, you may prefer to file as an ERA. This saves a lot of time in terms of your initial and amended filings as well as professional fees in preparing them (filing fees are usually about the same as for full registration). The compliance obligations are also less onerous and more flexible than for full registration, though we do still recommend some core policies and procedures. Sansome’s typical compliance manual for an ERA is simple enough to manage in-house at minimal cost and time spent. In sum, ERA status can save a lot of time and money that can be allocated to starting and growing your business.

If there is some likelihood of having clients in separately managed accounts (“SMA”), you may wish to proactively register in your state, rather than scramble to get it done before you sign your first SMA.  Keep in mind that some state registration processes are lengthy and/or complicated. Full state registrants are subject to “post-effective requirements” that include rules around advertising, recordkeeping, custodial arrangements and other areas. State registrants are also subject to periodic examination by their regulator. Though the rules are not as extensive as for SEC registrants, firms should be prepared to establish a compliance program and manage it either in-house or with the assistance of a compliance consulting firm.

ERA status will usually require having the funds audited and a clean regulatory record (including principals of the firm). Depending on your state’s custody requirements, full registrants may not have an alternative to having their funds audited in any case. It is worth remembering that many investors and other service providers expect an annual audit. Firms wishing to avoid audit requirements or whose predecessor firms or principals have a disciplinary history should consult their legal counsel before reaching a decision on this issue.

Is the SEC’s 180 Day Examination and Enforcement Limit More Guideline than Rule?

The Securities and Exchange Commission’s (“SEC”) compliance examination and enforcement investigation can be an excruciating experience for firms. Prior to the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), examination and enforcement investigations could often go on for over a year. SEC enforcement investigations are private and often have two steps: a) an informal investigation, otherwise known as a nonpublic informal Matter Under Inquiry (or “MUI”), that can be launched by any SEC staff attorney by simply filing a one-page SEC form, b) a formal investigation, usually following the MUI, that requires the SEC staff attorney request a Formal Order of Investigation, based on believed facts of securities violations, be issued by a Commissioner. A Formal Order of Investigation gives the SEC examiner more authority to compel the production of books, records, documents and testimony via subpoenas. If the examiner finds there are securities violations, an administrative, civil or criminal action may be brought against the firm and any wrongdoers. In light of the burden examination and enforcement investigations place on firms, Section 4E of the Dodd-Frank Act places a deadline on the SEC for completing these investigations.

The Dodd-Frank Act specifies that SEC staff has 180 days to complete any compliance investigation or examination, sometimes known as a routine examination. After the 180 days have passed, the SEC shall provide the firm with a written statement that the investigation or examination has concluded, or request the firm undertake corrective action. In certain complex cases, the deadline may be extended for one additional 180-day period after providing notice to the Chairman of the Commission (“Chair”).

Enforcement investigations are also limited to 180 days, upon which the SEC staff must either provide a written Wells notification and file an action or provide the Director of the Division of Enforcement (“Director of Enforcement”) notice of its intent not to file. This process also has an exception for certain complex actions. The Director of Enforcement may provide notice to the Chair and extend the investigation period for one additional 180-day period. If the investigation is not completed after that first extension, the Director of Enforcement may, upon approval of the SEC, extend the investigation for one or more additional successive 180-day periods.

For most firms, this statute reads like a light at the end of the investigative or examination tunnel, at least so it would seem. The SEC often interprets rules to bend them in its favor. However, Montford & Co. (“Montford”), an investment advisory firm, challenged a SEC action claiming that the investigators had exceeded the 180-day limit. Under Section 4E of the Dodd-Frank Act, Montford should have been notified of an extension of the investigation, the SEC’s intention to file an action, or the completion of the investigation with no findings. The appellate court in Washington, D.C. hearing the case decided against Montford. The court found that because Section 4E “failed to specify consequences to the SEC for exceeding the 180-day period, the time limit was no limit at all.”

Uncertain timeframes for concluding investigations or examinations is problematic. Among other things, the disruption to a firm’s business, issues relating to client or investor diligence and disclosures, insurance coverage and legal expenses will only add to the pressure of being investigated. The Dodd-Frank Act seemed to provide a fair compromise, providing both a reasonable window of time to complete an investigation and options to extend the time in appropriate cases.   It is unfortunate that the Montford court made the logical leap that no consequences for the SEC means no time limit.

Priority Topics for Annual Employee Training

Complexities in regulation and firm policies and procedures, including the constantly changing nature of each, are just some of the reasons periodic employee training is beneficial to any firm. See our tips for conducting employee training. Firms should consider, among other things, the following key topics for their next employee training:

  1. Personal Trading. Educating employees about the firm’s policies and procedures on personal trading is a proactive way to prevent problems that could result in deficiencies during a Securities and Exchange Commission (“SEC”) exam. In 2014, the SEC charged 34 companies and individuals with violating firm policies relating to personal account trading. Training should cover the firm’s pre-approval requirements, if any, annual disclosures of holdings and quarterly transaction reporting. Maintaining an up-to-date restricted list and circulating it to employees will help prevent prohibited trades.
  2. Insider Trading. In 2014, the SEC brought at least 30 new insider trading cases. Given the prominence of insider trading in the SEC’s enforcement program, firms should have robust policies and procedures that address its particular risks. The training should anticipate employee questions and concerns such as:
  • What constitutes insider trading (elements and examples of the classical vs. misappropriation theories);
  • Risk areas such as deals or other direct contact with insiders of public companies, use of expert networks or other research providers;
  • How the SEC investigates possible insider trading; and
  • Possible repercussions (including discipline by the firm, SEC penalties and criminal liability).

In addition to regular annual training, firms with a higher risk of receiving material non-public information should consider enhanced training, whether more frequently or additional sessions for traders, portfolio managers and/or analysts.

  1. Advertising and Marketing Activities. SEC exams always focus on advertising and marketing activities. It is essential for employees to understand that any materials distributed to more than one person are subject to the SEC’s advertising rules. These include, among others: requirements for balanced content, opinions are clearly indicated, no client or investor testimonials and certain parameters for presenting performance data. All employees should be aware of the firm’s advertising and marketing policies. Targeted training to those in marketing and investor relations should emphasize retention of all research, documentation of factual statements and the basis for any performance calculations (which the SEC will continue to review in exams).
  2. Cybersecurity. Employees are often the first line of defense, and ironically, the biggest threat to a firm’s cybersecurity. Proper policies and training, such as regularly changing passwords, password complexity, a “clean desk” policy, and prudent use of portable electronics can help the firm avoid cyber-attacks. The training should address the need to keep the firm’s proprietary information secure to prevent misappropriation. Finally, employees should be trained to recognize emails that appear to be from a known source, such as a client or investor, but are actually fraudulent attempts to gain information or commit a financial crime (aka “phishing”). In particular, any requests for withdrawals from client or investor accounts should be evaluated for authenticity and potential issues escalated per the firm’s identity theft policies and procedures.
  3. Suitability. Private client and retail advisers should make suitability a priority topic. This is especially true for firms investing retirement assets into complex or structured products and higher yield securities. In addition to establishing appropriate policies and procedures, firms should educate employees on key issues such as:
    • Collecting information about clients’ investment objectives, sophistication and risk profiles;
    • Conducting due diligence on recommended investments;
    • Disclosing investment information to clients;
    • How the firm determines and monitors suitability for its clients; and
    • The firm’s requirements for documenting and reviewing suitability determinations.
  4. Foreign Corrupt Practices Act (“FCPA”). Firms with international operations should conduct FCPA training to reinforce firm policies. There are a number of pitfalls to complying with the FCPA because the law itself is nuanced and the SEC and Department of Justice interpret it quite broadly. Accordingly all employees doing business abroad should be trained on the specific aspects of firm policies that impact their job and to immediately escalate questions or concerns to the Chief Compliance Officer. Compliance should regularly review any payments, gifts of value, or favors that could be construed as a potential bribe to obtain or keep business.
  5. Rule 105, Regulation M. Broadly speaking, the rule prohibits short selling of securities in advance of an anticipated secondary offering. This has been a major enforcement area in recent years. Employees involved in portfolio management and trading should be trained on the rule and its very narrow exceptions to avoid violations, however unintentional. Firms that are active in this area should train all employees annually and revisit periodically, especially as secondary offerings occur.


Standards for Insider Trading Liability Remain Unclear

The Federal courts are grappling with the impact of the Second Circuit’s Newman decision (see our analysis). The Newman decision, though complex in reasoning, boils down to a simple fact: the tippee (Newman) was so far removed from the tipper of the inside information that it was difficult, and the government failed, to prove that Newman knew of any benefit to the tipper. U.S. v. Salman, just decided in the Ninth Circuit Court of Appeals, has an entirely different set of circumstances. Perhaps more importantly, the two courts applied different standards for what constitutes a benefit to the tipper.

The Second Circuit stated that a personal relationship alone was not enough to prove benefit, specifically that the benefit must “represent at least a potential gain of a pecuniary or similarly valuable nature.” However, in Salman, the Ninth Circuit held that the “gift of confidential information to a trading relative or friend” of itself constitutes a benefit. Unlike Newman, it is worth noting that the facts of Salman are all but a slam dunk for the prosecution. Among other things:

  • The tippees in this case are Bessam Yacoub Salman (“Salman”) and Mounir (“Michael”) Kara;
  • The tipper was Maher Kara (“Maher”), an employee with Citigroup’s healthcare investment banking group;
  • Salman and Michael were Maher’s family members;
  • Maher came to Michael for help in understanding chemistry concepts related to his work at Citigroup;
  • Maher provided Michael with inside information that he knew would be traded on;
  • Michael shared this information with Salman, disclosing to him that it was insider information received from Maher;
  • Salman covered his tracks by setting up an account in the name of his sister and husband and destroyed all evidence to “protect” Maher. He then mirrored the trading in Michael’s account;
  • Salman and Michael knew they were trading on insider information;
  • Maher testified he gave Michael the insider information to “benefit him.”

Unlike the Newman decision, where the ultimate tippee was removed from the original tipper by multiple unknown sources, the Salman reasoning is significantly more obvious due to the relationship among the participants, evidence of consciousness of guilt and their admission of key facts. However, the bottom line for firms whose place of business is within the Ninth Circuit’s jurisdiction (including, among others: Alaska, Arizona, California, Nevada, Oregon and Washington) will be subject to a broader standard than that applied in Newman.