Filing Deadline for Treasury Department Form SHL Approaches


Every five years, the US Department of the Treasury (“Treasury”) and the Federal Reserve Bank of New York (“FRBNY”) jointly conduct a survey of foreign holdings of US issuers of securities.  Data for the survey is gathered on Form SHL.  US issuers of securities include private funds and their managers.   The filing is due on August 29, 2014.

Filing is required for:

  1. Any firm or fund that has been contacted by Treasury/FRBNY and asked to complete Form SHL; or
  2. Foreign shareholders (or equivalent) holding $100 million or more in reportable US securities.  For US fund managers, this includes:
  • Foreign investors in the manager’s US funds;
  • Offshore feeder funds’ investments into US master funds;
  • The reportable US securities owned by an offshore fund that are not held at a US custodian (e.g., any securities held at a foreign custodian or privately placed US reportable securities that are not required to be held at a custodian pursuant to the SEC’s custody rule);
  • Reportable US securities include:

-Stock, whether common, preferred or restricted;

-US-resident fund shares, whether open-end or closed-end, REITs, money market, index funds and unit investment trusts;

-All other equity interests, including shares or units in unincorporated entities (e.g., limited partnerships);

-Asset-backed securities; and

-Debt securities.

For purposes of determining whether the $100 million threshold has been met, fund managers must include all US-resident parts of their organization, including any US investment funds.  This calculation, as well as all data on Form SHL, must be as of close of business on June 30, 2014.

Form SHL overview:

  1. The Form includes two schedules:
  • Schedule 1 contains basic identifying details about the filer and a summary of the data provided.  A firm that has been contacted by Treasury/FRBNY but does not meet the $100 million threshold need only complete Schedule 1;
  • Schedule 2 requires detailed information for each security being reported, including issuer name, type of instrument, currency denomination and market value.
  1. The form may be submitted electronically or on paper (electronic filing is required for those submitting more than 200 Schedule 2 records); and
  2. All filers, whether on paper or electronic, must obtain a 10 digit Reporter ID by contacting FRBNY by phone at 212-720-6300 or 646-720-6300 or by emailing

Next Steps:

  1. If you have been contacted by the Treasury/FRBNY or think you may meet the threshold, obtain your Reporter ID as soon as possible;
  2. Review your US funds to determine whether any investors are foreign persons, which may involve your fund administrator;
  3. Review holdings information in US securities to determine whether the $100 million threshold has been met (remember to aggregate the holdings of offshore funds with your onshore funds for purposes of calculating the threshold), which may involve gathering needed data from your custodians;
  4. Ask your legal counsel or compliance consulting firm regarding any interpretation issues with respect to Form SHL/its instructions.  The above is an overview only and firms should read the form and instructions in their entirety.

Employee Compliance Training: Basics and Beyond

Depending on the type of registrant, applicable rules may require annual, biannual or other periodic training either for all employees or a subset (e.g., the Associated Persons of CFTC registrant).   New employees must usually also acknowledge receipt and understanding of the firm’s policies and procedures and make other disclosures upon hire.  In this second of two articles on compliance education, we provide tips for both periodic formal training and ongoing outreach to employees.  See our previous article for CCOs to stay informed of regulatory developments and other tools.

  1. Annual or other periodic training can take a few different forms; below are some suggestions:
  • It can be particularly effective to schedule the training during a regular firm meeting, which will ensure that the majority of employees can attend (but be sure to follow up with anyone who was absent);
  • Carefully crafted, a PowerPoint presentation will keep the trainer on track and employees engaged.  Printed, it can double as a useful quick reference to take away (with the caution that it is not a substitute for reading the manual in its entirety);
  • If a PowerPoint is not an option, trainers should prepare an outline for their own use in presenting the information, enabling them to keep their place in the material and manage time.  The outline can also be used when onboarding new employees, providing both a quick reference and helping to keep initial training consistent;
  • Consider asking outside counsel or a compliance consultant to train employees on key issues such as insider trading.  These service providers are often extremely well-versed in the details of notable cases and these examples can help employees understand the nuances.
  1. In addition, CCOs can find ways to reach out to employees throughout the year, including:
  • Having time set aside for compliance matters at regular firm meetings;
  • Distributing email reminders of preapproval requirements and other issues (tip: change these seasonally as relevant issues come up, such as emphasizing prohibitions on/approvals of political contributions at election time, or gift disclosures/approvals around the holidays);
  • Distributing regulatory news of note to employees generally or a relevant subset;
  • Ensuring that they are visible and available within the firm.  For example:

-CCOs may spend some part of their workday sitting at the trading desk, or with other key groups such as client/investor relations or operations.

-Others make a point of circulating around the office and/or;

-Keeping their doors open except when needed for confidentiality reasons and keeping candy or snacks in their office to encourage employees to drop in, whether to ask compliance-related questions or generally catch up.

  1. Recordkeeping

Finally, particularly for formal trainings, CCOs should keep sufficient records to show the content of the training (the PowerPoints and outlines are handy here) and the attendees.  In the latter case, sign-in sheets and/or certificates of attendance will suffice.   If the meeting is being recorded, a roll call would work especially well for small groups (less so for very large groups as it may delay the substantive portion of the meeting).  Calendar entries may be helpful, but are not a complete record as they do not show that a particular person attended.

In terms of ongoing outreach, the email reminders described in Section 2, create documentation of ongoing continuing education for employees.

For initial trainings, CCOs will collect the acknowledgements and disclosures required by the firm’s policies and procedures.  In addition, many keep a spreadsheet or other documentation that an orientation took place (again, the outline, PowerPoint or other reference tool and calendar entries will be helpful here, though not a complete record on their own).

Feel free to share other tips regarding employee training and outreach in the comments!

Online and Continuing Education Resources for CCOs

It can be challenging to stay on top of regulatory developments, not only for compliance staff’s own purposes, but in training employees and maintaining a culture of compliance within a firm.  In this first of two articles we will provide practical tips for CCOs to stay informed; our second article will help them create continuing education opportunities for employees in their firms.

  1. Regulators’ websites are the most obvious source for certain kinds of information:  laws, rules, formal guidance and forms, just to name a few.   However, sometimes it takes some digging to locate the wealth of other, extremely informative tools on these sites.  These include:
  1. Beyond laws and rules, it can be useful to know what other CCOs, legal professionals or other service providers and industry participants have to say about a particular issue.    Opportunities may vary depending on location, but might include:
  • Occasionally conferences in major cities will cover compliance-related topics and a few are dedicated exclusively to compliance matters.   If a live conference is not an option,  webinars on compliance matters (often free) are increasingly available; the Regulatory Compliance Association is one such provider;
  • Local industry groups may have smaller panel events, which even if these are not on a compliance topic, will enable compliance professionals to learn more about issues of note for their colleagues and firms generally;
  • Local or online (searching Groups on LinkedIn is a good place to start tracking some of these down) groups dedicated to compliance and regulatory issues for financial firms;
  • Service providers such as law and accounting/audit firms, especially, produce useful articles and other materials on new regulations that can assist CCOs in drafting and implementing policies in response.   An easy way to access all of these in one place is to follow the firms on social media since they usually share their articles.  Nearly all of them also distribute newsletters, white papers and other updates to subscribers by email (subscribe to their mailing list on their websites).

Feel free to share other continuing education tips and resources in the comments!

Managing Your Search for a Compliance Consultant

Word of mouth is probably among the most preferred ways to hire, whether the hire is an employee or a service provider.  In addition to this useful method, we offer the following tips for hiring a compliance consultant to help ensure the best fit and value:

  1. Scope of Services.  The most important factor in selecting a consultant is determining what your needs are.  If you do not know or are considering more than one scenario, talking to your peers might be helpful to determine how others utilize their consultants.  This is also a good place to start for recommendations.    The scope generally falls into three buckets:  project-based (such as a mock exam), ongoing compliance support, typically for firms with substantial needs, or consulting upon request, typically for firms that handle the majority of compliance work in house.   On the latter two, be sure to check pricing, as these might vary significantly and include/exclude certain services.
  2. Cast a Wide Net.  Once you have determined your needs, begin researching consultants, perhaps starting with firms recommended by your peers or other service providers.   Online searches and industry publications may be other sources.    Particularly if you have a long list, consider how to organize all the detail in a way that allows meaningful comparison; asking prospective consultants to complete the same Request for Information is one way of doing that.  You may also simply collect the information and organize it yourself in a spreadsheet to compare the variables that matter most.
  3. Best of Breed and Expertise.  Consider not only your scope of services (e.g., if you are looking for a mock examination, which consultant seems to be the best at that?) but your type of business, registration status and even strategy or platform to determine if any consultant seems to have expertise in these areas.
  4. Scalability.  Particularly if you are a startup, consider whether or how a consultant can work best with your business as it grows.   This is also a key issue for multi-platform firms, dual-registrants or others with significant complexity to their business.
  5. The Team.  Will your consultant be working closely with other service providers, such as fund administrators, accountants or legal counsel?  If so, ask them for their recommendations.
  6. Fee Structures.    Similar to the first point, this generally falls into three buckets:  flat fee, some form of periodic billing, or hourly.  Project-based engagements are frequently charged as a flat fee, making cost comparison relatively simple among multiple consultants.   However, make sure you understand what is included in the flat fee and when you will be billed, e.g., upon completion, at commencement or some variation of these.

Not all consultants work on an hourly basis; others may do so exclusively.  Be mindful of what your needs are when evaluating hourly arrangements.  Generally, the more robust your needs, the more you should focus on an arrangement that involves periodic billing for a specific suite of services.  Periodic billing arrangements vary significantly in terms of frequency (monthly, quarterly, annually) and levels of services.   If you need to save money, consider the types of compliance-related activities that you can keep in house and choose your consultant and suite of services accordingly (for example, controls, review and testing around trading, fee calculations and other core operations can sometimes be easily incorporated into existing workflows, without the consultant’s day to day involvement).

Regulators expect firms to not only be aware of the applicable requirements and implement them, but to do so in a way that is tailored to their particular business and risks.  When selecting a compliance consultant, be mindful of this expectation and choose the consultant whose experience, knowledge and approach works best for your business.

Primer: Regulation M, Rule 105

Because this is a frequent enforcement area for the SEC, we are providing this primer on how firms can place functioning controls around their trading to prevent violations of Regulation M, Rule 105 (the “Rule”).

  1. The Rule:

The Rule prohibits buying securities in secondary offerings when the buyer has executed short sales in the same security within a “Restricted Period” of time prior to the pricing of an offering.   The Rule covers:

  • Equity securities;
  • Purchased from an underwriter or other distribution participant;
  • That are offered on a firm-commitment basis; and
  • Are a SEC-registered offering for cash or a Regulation A or E offering for cash.

The prohibition is on short sales within the Restricted Period prior to pricing the offering.  The Restricted Period is the shorter of:

  • The five business days prior to pricing; or
  • The time period commencing with the initial filing of the registration statement (registered offerings) or notification (Regulation A or E offerings).

In each case, the Restricted Period ends with the pricing of the offering.

  1. Key Exceptions:

There are three exceptions to the Rule, two of which are covered below (the third is for registered investment companies).

  • Bona Fide Purchase.   A short sale during the Restricted Period will not trigger the prohibition if a subsequent bona fide purchase is made.  Both the short sale and the bona fide purchase must meet the following criteria:

-Purchase(s) must occur after the last Restricted Period short sale and be at least equivalent to the aggregate amount of Restricted Period short sale(s);

-Purchase(s) must be reported transactions effected during regular trading hours and no later than the end of regular trading on the business day prior to the day of pricing;

-Any of the Restricted Period short sales  that were reported transactions must have been effected prior to the last 30 minutes of regular trading on the business day prior to the day of pricing;

-Purchase(s) must be bona fide and not part of a plan or scheme to evade the Rule.  For example, a transaction that does not include the economic elements of risk associated with a purchase is not bona fide.

  • Separate Accounts.  This exception allows a purchase in the secondary offering in one account where a short sale occurred in the Restricted Period in another account for the same person, in limited circumstances.  To meet this exception, the decisions regarding transactions for each account must be made separately and without any coordination of trading or cooperation among or between the accounts.  This is a facts and circumstances test; the SEC identified the following indicators that may assist in this determination, such as:

-The accounts have separate and distinct investment and trading strategies and objectives;

-Those working on the accounts do not coordinate trading between the accounts;

-Any information barriers that exist and the fact that information about positions or investment decisions is not shared;

-The accounts maintain separate statements, including profit and loss;

-There is no allocation of securities between the accounts;

-Managers of multiple accounts (a single entity or affiliated entities) do not: have authority to and do not in fact execute trading in individual securities in the accounts and do not have the authority to and do not in fact pre-approve trading decisions for the accounts.

  1. Compliance Tips:

The first step is to develop clear policies and procedures to prevent violations of the Rule, including:

  • Specific workflow requiring notification to the Chief Compliance Officer or other responsible person prior to purchasing shares in a secondary offering so s/he can review trading activity to determine whether any short sales took place in the Restricted Period;
  • Strict prohibition on participating in the secondary offering if short sales were effected in the Restricted Period, absent full compliance with an exception;
  • Plain English descriptions of the securities covered by the rule, the Restricted Period, relevant exceptions and other key terminology; and
  • Provisions regarding required documentation to establish exceptions.

Once established, the policy should be distributed to all employees, with in-depth training to those involved in portfolio management and trading.   As part of the training, conduct a “dry run” to ensure that the procedures work as intended and that all employees involved in the process understand it.

Documentation will be critical to establish compliance with the Rule.  This includes:

  • The applicable policies and procedures;
  • Evidence that they are being followed, such as logs of subject transactions, any forms completed by traders, e.g., to notify the Chief Compliance Officer, diligence materials regarding any prior short sales, checklists, notes and other real time documentation of compliance with exceptions;
  • Evidence of review and testing.   At minimum, this should be included in a firm’s annual review.  More frequent review and testing may be warranted if this is a high activity area, or for firms that have had prior violations of either the Rule or the procedures required by the policy (even where no violation of the Rule took place).

We have covered the key points of the Rule and its exceptions but we recommend that firms discuss it with their outside counsel and/or compliance consulting firm to answer any questions and ensure that processes are designed appropriately to prevent violations.  The penalties for violations are substantial, regardless of whether there was intent to violate the Rule.   These include not only disgorgement, interest and monetary penalties, but the publicity involved, disclosures required on Form ADV, among others.

While the staff does take into account remedial efforts by a firm, it believes that efforts should have been made to prevent the violations in the first instance.   The SEC’s Risk Alert from September 2013 discusses its examination findings in more detail and is recommended reading.

Startup Spotlight: Recordkeeping Tips

The SEC and states alike require their investment adviser registrants to maintain certain books and records, typically for five years.  We encourage all firms, especially startups, to review the applicable recordkeeping rules to ensure that they understand them and can build appropriate policies and procedures for maintenance.  Though we provide some practical tips below, firms should discuss any questions with their legal counsel and/or compliance consulting firm.

  • Limit compliance files to compliance items.  For example, it might be tempting to include personal trading and HR files in the same employee personnel file, but avoid this.  If a firm is examined, examiners likely will request records of employee trading.   Keeping the two sets of files separate will help firms provide responsive documents efficiently and avoid needlessly expanding the scope of the examination.  Hint:  if examiners do ask for personnel files, it can be a sign that a routine examination is shifting into enforcement territory.
  • Keep it clean.  All files should be well organized and easily accessible or both general business reasons and to make production easier in an exam.  Extraneous notes that are not needed for general business or required recordkeeping should be discarded, as these can be produced accidentally and create confusion in an exam.
  • Don’t get personal.  Make sure that employees keeping any personal items or files at work separate these from their work files, and the firm’s other files.  Similarly, firms may consider permitting employees to access their personal email from their workstations, to avoid having purely personal (and potentially embarrassing) emails archived and come up in document production searches.  Note, however, that a firm’s policies and procedures should prohibit using personal email for firm communications.
  • Archive electronic communications.  These days, the majority of a firm’s business is conducted electronically (including email, instant messages and, increasingly, social media).  Recordkeeping requirements for registrants will likely encompass these sorts of communications.  However, even exempt firms can benefit from archiving their emails, electronic communications, website and social media content.  Archiving makes production much easier in an examination or subpoena response, which the SEC can and does issue to non-registrants if it believes a violation of other securities laws has occurred.  Moreover, people frequently delete emails they subsequently wish they had kept; these can be rescued from the archive.  Finally, general business reasons (e.g., employee and client/investor questions or disputes, human resources issues) may make the cost of archiving worthwhile.

Key issue:  make sure your vendor uses “envelope journaling” to capture emails.  This is a function on Microsoft Exchange that your vendor and internal IT personnel will activate; this process ensures that all emails on the server will be captured automatically.   Archiving that is based on the spam filter or similar may be less expensive, but it is also significantly less reliable.  Spam filters do fail with some frequency, which means that emails cannot be archived while the filter is inoperable.  In these cases, data may or may not be recoverable.  In addition, these methods typically have limited searching, reporting and audit trail functionality.  Firms that use instant messaging and social media for business purposes will have to consider how to separately archive these.

  • Consider available space and filing method.  Determine how much space you have available for compliance files, who needs to access them and what methods are preferred for storing the various records. For example, some CCOs prefer to keep employee attestations, disclosures and similar items in annual binders.  Personal account and trading information can be kept in individual binders for each employee.  Binders also have the advantages of maintaining chronological, alphabetical or other order and ensure that filed items do not get lost.
  • Limit access to sensitive files.  Employees are already unhappy about disclosing sensitive personal information such as securities holdings, trades and political contributions to their employers.  Give them some reassurance by keeping these files in a dedicated area for compliance staff only and under lock and key.
  • Considerations for electronic storage.  Both the SEC and states permit records to be kept and produced in electronic form.  From both a business and regulatory perspective,  firms should ensure that, however records are kept, they are secure.  As more and more firms move toward electronic recordkeeping exclusively, the following should be considered:

-Cloud storage vs. traditional servers  (see our article on cloud storage here);

-The need for compliance-specific platforms (other than email archiving);

-CRMs for managing client and investor data;

-Passwords and security issues.

Cloud-based Document Storage and Sharing: Implications for Investment Advisers

The recordkeeping requirements imposed on investment advisers and other market participants are extensive and the ability to quickly locate particular records is crucial to passing a regulatory exam.  As these firms increasingly turn to more cost-effective and efficient cloud-based storage platforms, advisers should be aware of the SEC’s requirements for electronic storage generally and emerging best practices that are specific to cloud-based document storage and file sharing.

Recordkeeping Rules

In addition to the list of the specific records advisers must retain, the SEC imposes the following requirements for electronic storage:

  • Records must be stored in a way that individual documents can be easily located and retrieved;
  • Advisers should be able to provide the staff with a “legible, true, and complete” copy of any record in the format in which it is stored within 24 hours of a request by the SEC;
  • Similarly, advisers should be able to produce a printed copy of any document within 24 hours;
  • The storage method must be capable of providing the SEC with a means to access, view, and print the records;
  • The adviser must maintain duplicate copies of the records at a separate location; and
  • The adviser must establish procedures to:

-Reasonably safeguard the records from loss, alteration, or destruction;

-Limit access to the records to authorized personnel; and

-Reasonably ensure that records are complete, true, and legible.

Rule 204-2 is technologically neutral, leaving advisers free to adopt any electronic or manual approach (or combination of the two) that meets the rule’s requirements.  Similarly, there is also no formal guidance from the staff on cloud-based storage generally, nor regarding any particular service provider.  However, as more advisers are looking to cloud based solutions, some best practices have emerged.

 Additional Considerations

Best practices have generally centered around conducting diligence on potential service providers and how advisers should factor in their needs, infrastructure and other resources.


We recommend that firms speak with other advisers in their networks about their experience with a particular vendor, including its reliability and responsiveness.  Once a firm has a short list of vendors they are interested in pursuing, it should request additional information and documents from those vendors; examples include:

  • Its privacy policy;
  • Any internal control reports (SAS-70, SSAE-16 or other);
  • Business continuity/disaster recovery plan;
  • Network uptime and support (i.e., whether it is 24x7x365);
  • Ability to change or upgrade storage and services as the adviser’s needs change;
  • Frequency and nature of the vendor’s backup procedures (e.g., current copies only, or historical versions);
  • Any features that exist on the platform to prevent or recover inadvertent loss/deletions;
  • Locations of any mirrored or redundant servers;
  • Whether an adviser’s data has its own servers or if it is on media shared with other customers (and if the latter, what protocols are in place to separate customers’ data);
  • Policies regarding responses to court orders, litigation holds and discovery requests;
  • Any encryption applied to data transmission (such as syncing and downloads) and storage;
  • Whether the vendor is amenable to additional diligence activities such as site visits, meetings with the specific personnel who manage the adviser’s data, discussion and review of physical security controls and the like; and
  • Ability to and any limitations on terminating service and moving documents to a different vendor in the future.

Firms should also consider their particular needs, infrastructure and other resources, such as:

  • Any internal limitations they impose on access to documents and how these can be implemented and maintained on the vendor’s platform;
  • Methods used to sync local documents to the cloud, whether and when a manual sync would be required and the ease of triggering a manual sync;
  • In the event of a delayed or failure to sync, what will/can the firm do to otherwise back up its records;
  • Whether to implement any/additional requirements for complex passwords and the frequency of changing them;
  • To what extent do employees work from home, while traveling, and/or via mobile devices; particularly whether these devices issued by the firm or the firm otherwise has the ability to ensure security of these access points; and
  • To what extent do employees use public networks to access the firm’s cloud.

The last two points in particular raise the subject of encryption and the security of client or investor data on the cloud.  Because privacy laws and compliance manuals typically require specific policies and procedures to protect client/investor data, firms should take care to ensure that their chosen vendor has sufficient methods to encrypt data and protect it from unauthorized access.

Along with social media, cloud-based data storage and sharing is changing how firms of all types do business.  For investment advisers and others with enhanced regulatory obligations, it is important to carefully weigh business needs alongside applicable rules and best practices to ensure that they can take advantage of new technologies and still remain compliant.

Startup Spotlight: Regulatory Fees to Include in the Launch Budget

Launching a new management company and fund can be quite expensive both initially and on an ongoing basis.  Many of the costs are obvious:  law firm professional fees, legal costs such as entity formation, hiring auditors and administrators, leasing office space, stationery and branding, to name just a few.

The costs are less obvious on the regulatory side and it is important to factor in the following to avoid being surprised, especially as the launch date approaches (faster than one might think!):

  • Investment Adviser registration:  ranging from $40 for the smallest of SEC registrants to $500 for some state registrants.  SEC registrants may have to notice file in their home state, or states where they have clients.  State fees vary, ranging from $50 to $500. 
  • Investment Adviser Representative registration:  some SEC and most state registrants will be required to register certain of their employees as Investment Adviser Representatives in one or more states.  Filing fees range from $0 to $285 per representative, depending on the state.  These and the adviser registration fees will be in addition to a law firm or consulting firm’s professional fees to handle the registration. Moreover, representative registration often requires that the registrant pass one or more securities licensing exams, usually the Series 65, which currently costs $135.  Prep courses and materials will be an additional cost. 
  • Disbursement Procedures for state registrants:  Some states, such as California, may require certain of its registered advisers to retain an independent third party that processes and approves deductions of fees and expenses from client accounts.   Depending on the state’s requirements and service provider, there may be a charge per issuance of a letter or other document approving the fee(s) or cost(s).  
  • Auditors.  The SEC and some states require private funds to undergo an annual audit (or surprise exam, though given the choice, most fund managers opt for the audit), so saving money by not hiring an auditor may not be an option.  California’s Exempt Reporting Adviser status also requires an audit for 3(c)(1) funds.
  • Initial and Ongoing Compliance-related costs:  Depending on a manager’s jurisdiction (SEC or a particular state), it may be required to establish a code of ethics, policies and procedures manual, appoint a chief compliance officer, or be subject to other requirements short of a full compliance program.  Even if not required, a manager may establish any or all of these as a matter of best practices.  NB:  most states that register investment advisers have recordkeeping requirements, which are similar to the SEC’s. Costs should be discussed with the applicable service providers and may include: 
  1. Professional fees for drafting documents (code of ethics, policies and procedures, disaster recovery plan and the like);
  2. Archiving for emails and other electronic communications (this should be set up early on to make sure that required books and records are complete);
  3. Any other IT infrastructure to support books and records maintenance (similarly, should be set up early on);
  4. Class action monitoring and processing (most likely post-startup); and
  5. Proxy voting service (most likely post-startup).
  • SEC Form D and State Blue Sky filings:  Private funds typically file Form D with the SEC at launch to claim one or more exemptions from registering its interests as securities under the Federal securities laws.  The SEC filing is free of charge.  However, nearly all of the US states and territories have a corresponding law that permits these “Federal Covered Securities” to be offered in their state as long as a copy of the Form D is transmitted to the state within a certain timeframe.  Most states require a filing fee and some require additional documentation.  These filing fees add up quickly because they are made when the first investor from each state comes into the fund.  Fees range from $0 to $1,500, excluding professional fees (such as law firms and compliance consultants) to prepare them. 

Funds not relying on Regulation D may still be subject to other state laws governing private offerings, some of which require filings (usually with fees, varying significantly within and among the states) and others do not.  Legal counsel can advise on the applicability of these laws; expense-conscious managers may wish to ask about the approximate costs of researching and monitoring compliance with these laws as they are more variable than the Regulation D/Federal Covered Securities system.

Under either Regulation D or other state laws, some states require renewals on an annual or other periodic basis (such as two years in Alaska for Form D or four years in New York for state Form 99), so managers should plan for ongoing fees as well.

Startup Spotlight: Compliance Primer for Investment Advisers

It is a common misconception that compliance is for larger, established SEC-registered investment advisers.  While SEC registrants have more robust compliance obligations than others, including the affirmative requirements to appoint a Chief Compliance Officer and implement a compliance program, many states have “post-effective requirements” for their registrants.  These can include an obligation to conduct business in an ethical manner and maintain certain books and records.  Moreover, the Form ADV itself includes policy-related questions about a firm’s Code of Ethics, proxy voting and brokerage practices, all of which should be considered at or before registration with a particular state.   Finally, various federal securities laws apply to many types of participants in the financial markets, requiring filings or compliance with other general regulations, irrespective of adviser registration.

This article will focus on compliance requirements and best practices for advisers registering in California.  Firms considering registration in other states are welcome to contact us.

  1. Code of Ethics, Proxy Voting, Brokerage and Soft Dollars

ADV Part 2A requires narrative responses describing a firm’s Code of Ethics, proxy voting and brokerage/soft dollar practices, among other things.  The ADV Part 2A (and 2B for state registrants) are filed online and available to the public.  As matters of best practices and client relations, an adviser’s initial state registration process should consider these issues and adoption of relevant policies,[1] each of which are discussed briefly below:

a. Code of Ethics

An adviser’s Code of Ethics (the “Code”) contains policies and procedures designed to prevent insider trading, manage conflicts of interest and avoid other improprieties, or the appearance of these.   Specifically, this includes personal trading by employees, business-related gifts and entertainment, political contributions and lobbying, dealing with regulators, outside business activities, involvement in litigation or other proceedings, use of electronic communication and safeguarding client information.

b.  Proxy Voting

Fund managers will typically vote proxies on behalf of the funds they sponsor.  Traditional advisers (i.e., to individuals and other separate accounts) vary somewhat, either voting or assisting clients in voting, or arranging for custodians to send proxy materials directly to clients, for them to vote (or not) as they wish.  Regardless of the client base or procedures, a firm should maintain a written policy and include corresponding descriptions in its ADV Part 2A.  For advisers that do vote proxies, the policy should detail the guidelines it uses when voting, circumstances in which it abstains from voting, recordkeeping and how clients can obtain disclosure on votes.

c. Brokerage and Soft Dollars

Advisers should have a process in place to select and evaluate the brokers it uses, and be aware of its obligations to achieve best execution of client transactions.  For advisers that use soft dollars, it is especially important to document the benefits they receive, and ensure that they are still fulfilling their client obligations.  The disclosure required in this item is a good outline of how a policy should look and the items to be covered, including: factors used in selecting brokers and determining reasonableness of compensation, soft dollars (associated conflicts of interest, types of services used, whether they are within or outside the Section 28(e) safe harbor, procedures used to allocate business to a broker in return for soft dollar benefits), whether the firm selects brokers based on client referrals, and whether clients can direct brokerage to a particular broker.

  1. Advertising

California-registered advisers are permitted to advertise their services; similar to SEC regulations, advertisements must be true, accurate and not contain any material misstatements.   Advertisement of performance, in particular, requires additional disclosures.  See California Code of Regulations (“CCR”) § 260.235.[2]  Advisers should be aware of these requirements and establish written guidelines that ensure that content in its marketing material meets these requirements.  In addition, an adviser’s internal process should ensure that factual statements are documented, opinions are clearly indicated as such, and that all marketing materials are approved by management (the Chief Compliance Officer if the adviser has one) before they are distributed.

  1. Recordkeeping

California requires its registered advisers to keep certain books and records.  The full list is available at CCR § 260.241.3.  This encompasses primarily financial records (financial statements and underlying worksheets, bank statements, ledgers, records of receipts, disbursements, assets, liabilities, bills and the like), as well as trading records, advisory agreements,  powers of attorney, advertisements, records of personal trading by employees, among other things.  Books and records must be maintained in an easily accessible place for five years (the first two years in the adviser’s office).

In reviewing the list, advisers should consider what other policies and procedures should be implemented to ensure that the appropriate records are kept.  For example, maintaining records of employee personal trading implies a certain degree of infrastructure around gathering duplicate statements and trade confirmations.  As part of this process, state registrants should consider the need for any controls to ensure that personal trading does not conflict with client trading (blackout periods, pre-approvals or others depending on the activity).

Finally, while many of these records would be kept in the normal course (such as the financial records listed above), additional recordkeeping may be prudent for other business reasons.   Archived emails and other electronic communications, for example, are useful sources of data in client or investor disputes, or to locate emails that may have been inadvertently deleted from an employee’s desktop.  Advisers that wish to access employees’ emails for HR, trade secret or other business conduct issues would find such a record invaluable, even beyond duties imposed on them by law, or recommended according to industry best practices.

  1. Fiduciary Duties

Like SEC registrants, California law imposes a fiduciary duty on its registrants, i.e. to act primarily for the benefit of clients, in good faith and exercise the highest standard of care.  Further, state registrants must engage only in activities that promote fair, equitable and ethical principles.    These issues are typically covered in the Code.  For specific examples of activities that are not in keeping with these duties, see CCR § 260.238.

  1. Custody and Financial Requirements

California’s custody rule differs somewhat from the SEC’s.  Under the SEC rule, the ability to deduct fees, by itself, does not create custody.  In California, however, this is considered custody and many advisers will be considered to have custody of their clients’ funds and securities.  Advisers with custody have safekeeping requirements, which may vary depending on the types of clients (private funds, versus separate accounts); in some circumstances, advisers with custody must also maintain a minimum net worth.  The full custody and net worth rules are available at CCR § 260.241.2 and CCR § 260.237.2.  See also our article on additional procedures required for fund managers.

  1. Regulatory Filings/General Securities Laws

Depending on their client base, strategy, business structure or other matters, advisers, regardless of registration status, may be required to file the following:

a. SEC Form D for private funds;

b. State blue sky filings for private funds;

c. Section 16 (Forms 3, 4, 5) for insiders or holders of 10% or more of an issuer’s securities (whether the adviser in the aggregate, or clients they manage);

d. 13G or D for ownership of 5% or more of an issuer’s securities; and

e. 13F for managers with discretionary authority over $100 million or more in issuer’s on the SEC’s 13F List.  Though as a practical matter it is likely that these advisers would be registered with the SEC.

f. 13H for “Large Traders,” whose daily or monthly trading volumes meet certain thresholds.

A firm’s compliance manual typically describes these filings, any applicable thresholds and authorizes the Chief Compliance Officer or other management person to monitor these and make any required filings.

Similarly, following are some general principles and laws that apply to virtually every market participant:

a. Anti-Fraud and Insider Trading

The Securities Exchange Act of 1940 prohibits fraudulent activities of any kind in connection with the offer, purchase, or sale of securities.   This prohibition is broadly construed and forms the basis for a variety of disciplinary and enforcement proceedings.  Insider trading is considered securities fraud and is vigorously prosecuted by the SEC.  All advisers regardless their registration status should implement a Code that is designed to detect, prevent and manage issues relating to securities fraud and insider trading.

b. Trading

Some of the techniques employed by hedge funds, in particular, are heavily regulated, such as short sales. For example,  SEC Rule 105 places significant limits around the timing of short sales in secondary or follow on offerings.  In addition, any adviser that invests in IPOs on behalf of its clients should take extra care to ensure it collects eligibility representations from its clients (or investors in private funds).  New registrants should consult their outside counsel and/or compliance consultant to determine whether any other aspects of their business or strategy create risk areas that should be addressed in their compliance program.

c. Private Offerings

Completely separate from adviser registration, firms that manage private funds must be cognizant of the rules that govern those offerings, including determinations of accredited investor, qualified client and qualified purchaser status, limitations on general solicitation and the number and types of investors permitted in a particular fund.  Many startups take advantage of the exemption from registration found in the Investment Company Act of 1940 Section 3(c)(1), which limits the number of accredited investors to 99.

For startup funds that “soft launch” with a round of friends and family investors that include non-accredited investors, it is important to note that these non-accredited investors should be admitted before the official launch date AND are limited to 35 in number over the life of the fund.  Given these limitations, investor inflows must be carefully monitored to ensure that these are not exceeded, or the fund will lose this exemption.   On a related note, firms taking advantage of California’s Exempt Reporting Adviser regime may not take any non-accredited investors.


For those advisers that eventually transition to SEC registration, having the above policies and procedures in place is a good start toward developing a SEC-level compliance program.  For firms that are completely exempt from registration as an investment adviser, there may still be filings, such as the short form of ADV for Exempt Reporting Advisers and the general filings and requirements discussed in Section 5.    For firms that trade in futures, CFTC registration and NFA membership may be required unless certain quite narrow exemptions are met. This will be discussed more fully in an upcoming article.

This article is a summary of selected laws, regulations and practices that typically apply to fund managers and other investment advisers.  Due to space limitations, we cannot provide an exhaustive discussion of all such issues.  In particular, Section 5 does not cover all laws and regulations that may apply to a particular business, financial services or securities industries generally.  We encourage all startups to discuss their business structure and investment strategies with outside counsel and/or a compliance consulting firm to make sure any specific questions are addressed.


[1] SEC Registrants are required to adopt a Code of Ethics and compliance program, typically including the policies and procedures discussed here.

[2] The online version of the California Code of Regulations does not permit direct linking to specific sections.  The online version is accessible via the Office of Administrative Law’s website:  (click the “online” link at the first bullet point; you will be taken to Westlaw’s home page for the Code, where you click the first link to “Search for a Specific Regulatory Section.”  For all of the CCR references in this article, enter 10 in the “Title” field and copy the code section into the “Section Field” (all of the digits and punctuation after the § symbol).

SEC Case Digest

  1. Investment Management Issues

As the following cases demonstrate, the SEC is actively policing investment managers’ collection of advisory and other fees, advertising and the charging of expenses to funds.

In the Matter of Total Wealth Management, Inc., et al.

In an unusual move, a Chief Compliance Officer was charged, along with the investment advisory firm, its Chief Executive Officer and an investment adviser representative in this case involving undisclosed revenue sharing arrangements.    The defendants recommended the Altus funds, managed by an unrelated firm, to their clients without disclosing that Altus paid them kickbacks for these referrals.  Charges included failure to disclose this arrangement and the resulting conflicts of interest, breach of fiduciary duty, fraud, as well as unrelated violations of the custody rule.

In the Matter of Transamerica Financial Advisors, Inc.

The SEC charged a Florida-based financial services firm with improperly calculating advisory fees and overcharging clients.  Transamerica Financial Advisors offered breakpoint discounts designed to reduce the fees that clients owed to the firm when they increased their assets in certain investment programs.  The firm permitted clients to aggregate the values of related accounts in order to get the discounts.  SEC examinations and a subsequent investigation found that, as a result of failing to process every aggregation request, the firm overcharged certain clients.  Transamerica agreed to settle the SEC’s charges.  The firm reimbursed client accounts (totaling $553,624 including interest) and agreed to pay a $553,624 penalty.

In addition to the reimbursements and sanctions, Transamerica agreed to retain an independent consultant to review its policies and procedures pertaining to its account opening forms, fee schedules, and fee computation methodologies as well as the firm’s account aggregation process for breakpoints.

In the Matter of Clean Energy Capital, LLC et al.

The SEC charged an Arizona-based private equity fund manager and his investment advisory firm for allegedly paying more than $3MM of the firm’s expenses with assets from private equity funds they manage.  When the funds ran out of cash to pay the firm’s expenses, Clean Energy Capital and Brittenham allegedly continued to benefit themselves by loaning money to the funds at unfavorable interest rates and unilaterally changing how they calculated investor returns.  The SEC’s press release emphasized that private equity advisers can only charge expenses to their funds when such charges are clearly described in fund offering documents.

SEC vs. Penn et al.

The SEC alleged that Penn used $9MM of fund assets to pay fees to a company to conduct diligence on potential fund investments.  The company, however, was a front; instead of conducting diligence, it returned the money to entities and accounts controlled by Penn.  The complaint seeks final judgments that would require Penn, his fund, the front company and another accomplice to disgorge ill-gotten gains with interest, pay financial penalties, and be barred from future violations of the antifraud provisions of the securities laws.

In the Matter of Navigator Money Management, Inc.

The SEC charged a New York-based money manager and his firm with making false claims through Twitter, newsletters, and other communications about the success of their investment advice and a mutual fund they manage.  In one instance, it was misleadingly claimed in a newsletter that the firm was “ranked number 1 out of 375 World Allocation funds tracked by Morningstar;” this claim was false on its face because Morningstar ranks funds, not managers.  Moreover, the investigation determined that this broad claim was based on cherry-picked ratings for the fund from October 2010-October 2011 and the it had a poorer relative performance during other time periods.

The money manager agreed to pay a penalty of $100K and he and the firm agreed to be censured and, among other things, retain an independent compliance consultant for a three-year period.

  1. Insider Trading

All of the press surrounding the SAC and related cases (and Galleon before that) might lead observers to believe that only high profile or glamorous people engage in insider trading.  As the following cases illustrate, however, otherwise ordinary people can and will engage in it as well.  Some of these cases are also noteworthy in that they show how the SEC uses trading data and works with agencies, SROs and others to connect the dots in tracking down illegal trades.

SEC vs. Wagner, et al.

The SEC charged two longtime friends with insider trading in connection with a 2012 acquisition of The Shaw Group by Chicago Bridge & Iron Company.  Walter Wagner and Alexander Osborne traded ahead of the public announcement of the acquisition based on information they obtained from John Femenia, who was previously charged in 2012, along with nine others that comprised an insider trading ring that specialized in pending mergers.  Wagner consented to entry of judgment including disgorgement of $528,175, prejudgment interest and an order permanently enjoining him from violations of Section 10(b) of the Exchange Act and Rule 10b-5.   The litigation is continuing against Osborne.

SEC vs. Hawk/SEC vs. Chen

In two unrelated cases the SEC charged two men with trading on material, nonpublic information misappropriated from their wives.  Tyrone Hawk of Los Gatos, CA, allegedly overheard his wife, an employee of Oracle Corp., discussing over the phone the potential acquisition of another company; he then purchased the target company’s stock.  Ching Hwa Chen of San Jose, CA allegedly overheard his wife discussing her employer’s earnings report, then shorted the employer’s stock.  Without admitting or denying the charges, both men agreed to pay fines equal to twice their illegal profits and to settle the cases against them.

SEC vs. Eydelman et al.

The SEC charged a stockbroker and a clerk at a law firm with insider trading that produced illicit profits of $5.6MM over a four-year period.  Steven Metro accessed confidential documents in his law firm’s computer system, then used a middle man to pass the material, nonpublic information to Vladimir Eydelman, a registered representative at Oppenheimer.  Eydelman effected the illegal trades on behalf of a range of individuals, including the middleman.  The middleman then made payment to Metro.  In a parallel action, the U.S. Attorney’s office announced criminal charges against Metro and Eydelman.  The SEC’s press release emphasized the futility of using middlemen, destroying evidence, and forging documents in an attempt to circumvent insider trading laws.

SEC vs. Hixon et al.

In another case involving family members, Frank Hixon Jr. used the brokerage accounts of his father and girlfriend in order to execute trades based on confidential information he obtained on the job, generating illegal insider trading profits of at least $950K.  In addition to an asset freeze, the SEC complaint seeks permanent injunctions, disgorgement of ill-gotten gains with prejudgment interest, and financial penalties.   During the investigation, Mr. Hixon denied knowledge of these accounts, despite the fact that his father is also called Frank Hixon.  Hixon Jr. allegedly conducted the trades in his girlfriend’s account in lieu of the child support payments he was obliged to make for the benefit of their daughter.

Nexen Acquisition

The most recent developments in this major insider trading case involve two Hong Kong-based asset management firms (CITIC Securities International Investment Management (HK) Limited and China Shenghai Investment Management Limited) agreeing to pay nearly $11MM to settle the charges against them.  The case began in 2012 when China-based CNOOC Ltd. announced that it had agreed to acquire Canadian energy company Nexen Inc.  Shortly thereafter the SEC obtained an emergency asset freeze against unknown traders after discovering that traders using brokerage accounts in Hong Kong and Singapore stood to make more than $13MM in potentially illegal profits in connection with the misuse of confidential information.  SEC investigators worked with foreign regulators to identify the illegal trades, setting the stage for a trio of settlements:

SEC vs. Dombrowski et al.

In January of this year, Steven Dombrowski kicked off the trend of embroiling family members in insider trading by using his wife’s account to trade in the stock of his employer despite a company-imposed blackout period.  The SEC is seeking a judgment that permanently enjoins Dombrowski from future violations of various provisions of federal securities laws, orders him to disgorge all of his ill-gotten gains of approximately $286K, plus prejudgment interest, and orders him to pay a civil penalty.  In a parallel action, the U.S. Attorney’s Office announced criminal charges against Dombrowski.

  1. Market Manipulation

These cases illustrate how the SEC continues to work with other market participants and follow the money trail to identify traders whose practices are considered manipulative under the securities laws.

SEC vs. Babikian

The SEC alleged that John Babikian used a pair of penny-stock websites to commit a type of securities fraud commonly known as “scalping.”  The websites sent e-mails to approximately 700K people and recommended the penny stock America West Resources Inc.; meanwhile, Babikian owned and was positioned to sell) 1.4MM shares of America West through a foreign bank.  The emails triggered increases in America West’s share price and Babikian sold shares of America West’s stock for illegal profits of more than $1.9MM.  The court order freezes Babikian’s assets, temporarily restrains him from further similar misconduct, requires an accounting, prohibits document alteration or destruction, and expedites discovery.

In the Matter of Worldwide Capital, Inc. et al.

In the largest-ever monetary sanction for Rule 105 short selling violations, a Long Island-based trading firm and its owner, Jeffrey Lynn, agreed to pay $7.2MM to settle charges.  Lynn allegedly engaged traders to seek soon-to-be-publicly-offered shares, usually at a discount to the market price of the company’s already publicly trading shares.  Lynn and his traders then sold those shares short in advance of the offerings, improperly profiting from the difference between the price paid to acquire the offered shares and the market price on the date of the offering.

To settle the charges, the trading firm and Lynn agreed to jointly pay disgorgement, prejudgment interest, and a penalty, as well as agreeing to cease and desist from violating Rule 105.  Neither the trading firm nor Lynn admitted or denied the findings in the SEC’s order.

In the Matter of Thomas C. Gonnella/In the Matter of Ryan C. King

In separate cases, the SEC charged two traders involved in a fraudulent “parking” scheme.  Gonnella allegedly arranged for King, who worked at a different firm, to purchase several securities with the understanding that Gonnella would repurchase them at a profit for King’s firm.  By “parking” the securities in King’s trading book in order to reset the holding period when he repurchased them, Gonnella was attempting to avoid charges to his trading profits (and ultimately his bonus) for having aged inventory.  King agreed to settle the charges by disgorging his profits and being barred from the securities industry.  Litigation against Gonnella continues.

In the Matter of Gonul Colak and Milen K. Kostov

The SEC charged a pair of college professors in Tallahassee, Fla., with conducting a naked short selling scheme that generated more than $400K in illicit profits.  Colak and Kostov allegedly sold more than $800MM worth of call options in more than 20 companies.  Their trading strategy involved purchasing and writing two pairs of options for the same underlying stock, and targeting options in hard-to-borrow securities in which the price of the put options was higher than the price of the call options.  The two men profited by avoiding the cost of instituting and maintaining the short positions caused by their paired options trading.  Colak and Kostov agreed to settle the SEC’s charges by paying more than $670K.