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.
- 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, 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.
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. 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.
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.
- 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.
- 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.
- 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.
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.
 SEC Registrants are required to adopt a Code of Ethics and compliance program, typically including the policies and procedures discussed here.
 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: http://www.oal.ca.gov/ccr.htm (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).