Hedge and Private Fund Regulation After Dodd-Frank March 11, 2011

Transcription

1 Hedge and Private Fund Regulation After Dodd-Frank March 11, 2011 Kurt Decko Matt Mangan Mark Perlow SF Copyright 2010 by K&L Gates LLP. All rights reserved. Agenda Overview Removal of private adviser exemption Mid-sized private fund adviser exemption State versus federal registration What does it mean to be registered? How do I register? Amendments to Form ADV Part 2 New and old recordkeeping and reporting requirements What is the SEC s examination program? 1 1

2 Dodd-Frank Overview The Dodd-Frank Wall Street Reform and Consumer Protection Act (Act) Signed into law on July 21, 2010 The Act really marks the start of the next stage of the policy-making process It will require 315 rulemakings to implement, plus there are 145 studies required for regulators This process will take years to play out Private adviser provisions are effective July 21, Dodd-Frank Overview (continued) The Act will have a profound effect on the regulatory regime governing investment advisers and private funds Dramatically reshapes the registration, recordkeeping and reporting requirements for advisers Changes the accredited investor and qualified client requirements Limits the ability of banking entities to sponsor or invest in certain private funds through the Volcker Rule Raises the potential for additional regulation of large funds and fund complexes under a new systemic risk regulatory regime Mandates that the Government Accountability Office (GAO) and Securities and Exchange Commission (SEC) conduct a number of studies on issues affecting private funds and their advisers Creates immense uncertainty pending rulemaking and agency guidance 3 2

3 Dodd-Frank Overview (continued) Dodd-Frank rescinds the private adviser exemption effective July 21, 2011 Many advisers to private funds (hedge, PE, RE and VC) currently rely on the private adviser exemption to remain unregistered Section 203(b)(3) of the Advisers Act currently exempts an adviser that during any rolling 12-month period had fewer than 15 clients, does not serve as an adviser to a registered investment company or business development company (BDC) and does not hold itself out to the public as an investment adviser Generally, one fund counts as a single client Most advisers that currently rely on the private adviser exemption will be required to register either with the SEC or state regulator(s) because of the limited scope of the new registration exemptions in the DFA 4 Dodd-Frank Overview (continued) Private Fund Advisers Exemption DFA requires that the SEC provide an exemption for advisers solely to private funds with aggregate AUM in the U.S. of less than $150 million. Under the SEC s proposed rules implementing this exemption: A U.S. fund adviser would have to include all of its funds assets, including the assets of non-u.s. private funds, for purposes of the AUM Limit A non-u.s. fund adviser could have clients that are not funds if they are outside the U.S., and it would only have to count the aggregate assets of its private funds that it manages from a place of business in the U.S. and would be able to exclude the assets of any non-u.s. clients and funds Private fund is defined as one that would be an investment company but for the exclusions in Section 3(c)(1) or 3(c)(7) of the Investment Company Act of

4 Dodd-Frank Overview (continued) DFA raises the minimum AUM for federal registration to $100 million or more Prohibition on federal registration applies to advisers: If required to be registered as an investment adviser in the state in which it has its principal place of business and, if registered, would be subject to examination With AUM between $25 million and $100 million SEC may increase these amounts by rule If not required to be registered in a state, the minimum AUM for federal registration is $25 million Does not apply: To advisers to registered investment companies or BDCs To advisers that would be required to register with 15 or more states and To advisers with their principal office and place of business outside of the United States 6 What Does It Mean to Be Registered? 7 4

5 Compliance for Registered Advisers Regulatory Compliance Program Develop and implement a comprehensive compliance program tailored to adviser s needs Appoint and empower Chief Compliance Officer Develop compliance policies and procedures Develop code of ethics (including regulation and reporting of personal securities holdings and transactions) and insider trading policies Conduct ongoing training and annual compliance review 8 Chief Compliance Officer RIAs are required to appoint a Chief Compliance Officer or CCO. The CCO: may serve other functions within the firm must be given full responsibility and authority to develop and enforce appropriate policies and procedures should have a position of sufficient seniority and authority to force others to follow the firm s compliance policies and procedures 9 5

6 Compliance Manual All RIAs are required to adopt a Compliance Manual. Compliance Manuals typically cover at least the following topics: portfolio management processes, including allocation of investment opportunities trading practices, including brokerage allocation, best execution, soft dollars, trade allocation, principal transactions and cross-trades determining and addressing conflicts of interest custody and safeguarding of client assets preparation, maintenance and delivery of Form ADV advertising and marketing policies valuation of client securities and other holdings recordkeeping policies safeguards for the protection of client information disaster recovery plans 10 Enforcement and Oversight Periodic SEC examinations and strict enforcement Regulation by enforcement actions SEC must apply the Advisers Act and the systemic risk/recordkeeping provisions of Dodd- Frank to hedge fund and other private fund managers, although the SEC has limited resources and doesn t full understand the industry Audits by PCAOB-registered auditors with requirements to report certain deficiencies to the SEC 11 6

7 How Do I Register? 12 SEC Registration Process Registration Process Overview Process will take 3 months, so fund advisers need to start planning now Non-exempt, non-grandfathered fund managers will have to be registered by July 21 Once an adviser has filed with the SEC, the SEC has 45 days either to approve it or take action to deny it Once an adviser s registration becomes effective, it must be in full compliance with the Investment Advisers Act 13 7

8 SEC Registration Process (cont.) Registration Process Documentary Requirements Standard documents Adviser must prepare: Form ADV (SEC filing) Compliance policies and procedures (i.e., manual) Code of ethics Not off the shelf complicated and interdependent documents that must be tailored to manager s operations Compliance manual and code of ethics do not have to be filed with the SEC Other documentation steps Fund documents may need to be reviewed and revised E.g., subscription documents questionnaire must address qualified client status to receive carried interest 14 Timeline for Adviser Registration and Implementation of Compliance Program Present March April 2011 Late May/ Beginning of June 2011 July 21, 2011 Begin preparing Form ADV Parts 1A, 2A and 2B Contemporaneously begin working on Compliance Program & Code of Ethics Begin thinking about other documents that may be affected, such as fund offering documents and IMAs Solicit feedback internally re: draft Form ADV, Compliance Program and Code of Ethics File Form ADV Parts 1A and 2A with SEC via IARD 45-day SEC comment period Registration effective Form ADV Part 2B Brochures completed Compliance Program & Code of Ethics implemented Revisions to IMAs and fund offering documents completed

9 SEC Registration Process (cont.) Form ADV Part 1 SEC s examination blueprint General information about firm, advisory business (employees, clients, compensation, AUM, advisory activities, other business activities), financial industry affiliations, participation or interest in client transactions, custody, control persons and ownership and disciplinary history Part 2 Client brochure Part 2A plain English disclosure about business practices, investment strategies and risks, conflicts of interest and disciplinary information Part 2B supplement focused on advisory personnel 16 SEC Registration Process (cont.) Form ADV Filed and maintained online through the IARD, a national electronic depository Requires setting up an account and getting a number Annual filing and delivery (or offer of delivery) requirements Both parts are filed with the SEC; Part 2 (the brochure ) is to be delivered to investors Must amend if materially inaccurate (and redeliver if change to disciplinary information) 17 9

10 Amendments to Form ADV Part 2 18 Amendments to Form ADV Part 2 Shift from the check-the-box format to a more narrative format Breaks Part 2 into two parts: Part 2A firm brochure that describes the adviser Contains 18 items Filed electronically through IARD and is publicly accessible Part 2B new brochure supplement that describes the investment professionals Contains 6 items Not filed through IARD 19 10

11 New Form Requirements Disclosure required to be succinct and in plain English Provide investors with a description of conflicts of interest that may arise and how the adviser addresses these conflicts Multiple brochures adviser with substantially different services may provide clients with different brochures that relate to such services An adviser need not create a brochure or supplement if it has no clients to whom it must deliver a brochure or supplement Surprising development as the SEC states how valuable the Form ADV is in its inspection and compliance review efforts 20 Plain English and Concise Disclosure Release instructions stress the importance of using plain English, including: Using short sentences Using definite, concrete, everyday words Using active voice Avoiding legal or technical jargon Using examples where possible Putting complex materials into tables or bulleted lists Must be succinct and readable only discuss: Practices the adviser engages in or is reasonably likely to engage in; or Conflicts the adviser has or is reasonably likely to have Inherent tension: Plain English and precision in disclosure, and Goal of keeping disclosure succinct while ensuring it is complete 21 11

12 Part 2A Delivery Initially, brochure must be delivered before or at the time the adviser enters into the advisory contract with the client This change eliminates requirement that if adviser does not deliver 48 hours prior to or upon entering into the contract, the client could terminate the contract within 5 days Annually, within 120 days of the end of its fiscal year, the adviser must deliver either: Updated brochure with summary of material changes, or Summary of material changes with offer to provide a copy of the current brochure Interim delivery must be made if there occurs a new disciplinary event or change of material information in disciplinary event Delivery not required to: Clients that pay less than $500 per year Registered investment companies Business development companies In footnote: client is a private fund, not the investors therein Therefore appears that a private fund adviser does not need to provide Part 2A (and 2B) to investors in a private fund However, providing to private fund investors is common practice 22 Part 2A 18 Items Cover page requirements Item 2 Material Changes Item 3 Table of Contents Item 4 Advisory Business Item 5 Fees and Compensation Item 6 Performance Fees and Side-by-Side Management Item 7 Types of Clients Item 8 Methods of Analysis, Investment Strategies and Risk of Loss Item 9 Disciplinary Information Item 10 Other Financial Industry Activities and Affiliations Item 11 Code of Ethics, Participation in Client Transactions and Personal Trading Item 12 Brokerage Practices Item 13 Review of Accounts Item 14 Client Referrals and Other Compensation Item 15 Custody Item 16 Investment Discretion Item 17 Voting Client Securities Item 18 Financial Information 23 12

13 Part 2A Items Item 2 Material Changes Discuss material changes to the brochure from the last update Item 4 Advisory Business Describe the business Now must disclose if adviser holds itself out as specializing in particular services Item 5 Fees and Compensation Now may omit disclosure of fee schedule and other information in this item if the brochure is only provided to Qualified Purchasers 24 Part 2A Items (continued) Item 6 Performance Fees and Side-by-Side Management Must disclose if adviser charges a performance fee If adviser also manages accounts that do not have a performance fee, adviser must describe conflicts of interest arising from different fee structures and how conflicts are addressed Item 7 Types of Clients Now must describe the types of clients adviser has and the requirements to open or maintain an account, such as minimum account size 25 13

14 Part 2A Items (continued) Item 8 Methods of Analysis, Investment Strategies and Risk of Loss Disclose significant investment strategies (as opposed to primary strategies) Now must disclose how frequent trading strategies may affect investment performance Must disclose the material risks involved for each significant investment strategy used by the adviser Should be more succinct that risk factors in PPM, and will require care to avoid inconsistencies or differences in emphasis 26 Part 2A Items (continued) Item 9 Disciplinary Information Material facts about legal and disciplinary events that would be material to a client's evaluation of the adviser Presumption of materiality if disciplinary events occurred in the past 10 years Disclose events after 10 years if so serious that material to a client s evaluation Fiduciary duty to report all material sanctions 27 14

15 Part 2A Items (continued) Items 10 and 11 Other Financial Industry Activities and Affiliates; Code of Ethics; Participation or Interest in Client Transactions and Personal Trading Now must describe material relationships with related financial industry participants, any material conflicts of interest this creates and how the adviser addresses these conflicts Disclose personal trading by adviser and its personnel important for an adviser that uses affiliated brokers or recommends or invests in affiliated funds An adviser that recommends or selects another adviser for clients must describe: Any compensation or other business arrangements between the advisory firms, and The conflicts created, and how these conflicts are addressed 28 Part 2A Items (continued) Items 10 and 11 (continued) Discuss whether the adviser engages in trades that could result in conflicts of interest with clients, including when and if the adviser or a related person: Buys or sells, for client accounts, securities in which the adviser or a related person has a material financial interest As a principal, buys securities from (or sells securities to) advisory clients [principal trades] Acts as a general partner in a partnership in which the adviser solicits client investments Acts as an adviser to an investment company that the adviser recommends to clients Invests in the same securities (or related securities, e.g., warrants or options) that the adviser or a related person recommends to clients Recommends securities to clients, or buys or sells securities for client accounts, at or about the same time that the adviser or a related person buys or sells the same securities for the adviser s (or the related person s) own account If the adviser engages in one of the foregoing, it must describe its practice, the conflicts that arise and how it deals with those conflicts 29 15

16 Part 2A Items (continued) Item 12 Brokerage Must disclose factors considered in selecting or recommending brokers and determining the reasonableness of the brokers compensation Increased disclosure for soft dollars, including: How conflicts arising from soft dollars are addressed Increased details on products or services that do not qualify for the Section 28(e) safe harbor Now must describe brokerage practices in connection with client referrals Now must describe directed brokerage practices Now must describe trade aggregation policies 30 Part 2A Items (continued) Item 13 Review of Accounts Policies for reviewing accounts must be disclosed, including who is responsible Requirement to disclose these items with greater specificity than in the old ADV may lead to more formalized review processes Item 14 Client Referrals and Other Compensation Describe arrangements for compensation of another party for client referrals, including conflicts and how they are addressed Goes beyond requirements of the Cash Solicitation Rule must disclose non-cash compensation for client referrals No de minimis exception 31 16

17 Part 2A Items (continued) Item 15 Custody Must explain procedure if custodian sends account statements Reflects new custody rule requirements Item 16 Investment Discretion If the adviser has discretionary authority over client accounts, it must disclose arrangements and any limitations Item 17 Proxy Voting Describe proxy voting policies and practices No longer required to describe selection process and payment if adviser uses third party proxy voting service 32 Part 2A Items (continued) Item 18 Financial Information If the adviser requires prepayment of fees six months or more in advance, the adviser must provide clients its audited balance sheet If the adviser has discretionary power or custody of client assets or requires prepayment of fees six months or more in advance, the adviser must disclose any financial condition reasonably likely to impair its ability to meet contractual commitments to clients Must disclose any bankruptcy petitions in the past ten years Appendix 1 Wrap Fee Program Brochure Now requires an adviser to identify any related persons who are portfolio managers in the wrap fee program and describe the associated conflicts 33 17

18 Part 2B One of the more significant new requirements Disclosures must be made about certain key investment professionals of the adviser An adviser must provide disclosure for each portfolio manager who: Formulates investment advice for client assets and has direct client contact; or Makes discretionary investment decisions for client assets, even if no direct client contact If investment advice is provided by a team of more than 5 portfolio managers, the adviser must provide disclosure only for the 5 with the most significant responsibility An adviser need not create a supplement if it has no clients to whom it must deliver a supplement An adviser may create a supplement for each portfolio manager or for a group The supplement requirement creates compliance challenges, as only certain clients will receive certain supplements, depending on which portfolio manager is advising them Advisers will need to track carefully which supplements have been sent to which clients in order to provide them with the appropriate updates 34 Part 2B Delivery and Updating Delivery Initially to each client at or before the time a portfolio manager provides advisory services Interim if there occurs a new disciplinary event or material change to disciplinary information It appears that advisers do not need to provide supplements to investors in a private fund Supplements may be delivered electronically Not required to be filed on IARD Update When changes make it materially inaccurate 35 18

19 Part 2B Items Item 2 Education and Business Experience Item 3 Disciplinary History Item 4 Other Business Activities Item 5 Additional Compensation Item 6 Supervision 36 Part 2B Item Requirements Information about a portfolio manager: Education background and business experience Disciplinary information Other business activities presumption that other activities are less than 10% of business time and income, they are not substantial and must not be disclosed Additional compensation any arrangement under which someone other than a client provides an economic benefit to a portfolio manager for providing advisory services must be disclosed Supervision disclose how the adviser monitors the portfolio manager s advice Creates public accountability for the named supervisors 37 19

20 Recordkeeping and Reporting Requirements Under the Act 38 Advisers Act Recordkeeping Requirements Key advisory records must be kept for a minimum of 5 years, the first 2 in an easily accessible place (6 years if client or fund is plan assets ). Required records include: records related to the adviser s own affairs (LP/LLC agreements, etc.) fund offering and organizational documents all correspondence with clients The recordkeeping rules focus on the content, rather than the form, of the record Any electronic or paper record whose content is covered by the rule must be retained 39 20

21 Systemic Risk Reporting Requirements The Act provides the SEC with authority to require records and reports regarding private funds, including all of the following: AUM and use of leverage, including off-balance sheet leverage Counterparty credit risk exposure Trading and investment positions Valuation policies and practices Types of assets held Side arrangements or side letters Trading practices Such other information as the SEC (in consultation with the Financial Stability Oversight Council (FSOC)) determines is necessary and appropriate in the public interest and for protection of investors or for the assessment of systemic risk The SEC has proposed new Form PF to implement this provision 40 What Is the SEC s Examination Program? Review and Update 41 21

22 Examination Basics What is an SEC examination? Assessment of compliance program Interviews Document review Office of Compliance Inspections and Examinations (OCIE) Risk-based examinations Types of examinations Routine high risk cycle and low risk cycle For Cause driven by a firm-specific issue Sweep driven by an industry issue New: Limited Scope Document Review Possible outcomes of an examination Clean closing letter Deficiency letter Enforcement referral 42 Office of Compliance Inspections and Examinations Its stated mission: Improve industry compliance with the securities laws and industry governance, risk management and compliance practices through exams, industry outreach programs Identify and prevent fraud through risk-targeted exams and coordination with the Division of Enforcement in the identification, investigation and enforcement of fraud actions Monitor new and emerging risks to investor protection and market integrity through joint initiatives with the Division of Risk, Strategy and Financial Innovation, including the development of new risk assessment and surveillance models and risk analytics Inform policy as the eyes and ears of the SEC in the field, through involvement in the rule-making process, with dedicated policy support teams on key regulatory reform rules, studies and initiatives 43 22

23 The National Examination Program OCIE is developing a strong, national examination program to replace the current confederation of regional programs An updated, central National Exam Operations Manual An automated National Exam Workbook to drive consistency, effectiveness, efficiency and accountability in the exam process nation-wide OCIE s first Chief Compliance Officer to enhance and monitor compliance with its own policies and procedures Increased presence of supervisors in the field and involvement senior staff on exams 44 Risk-Focused Examinations OCIE is implementing an enhanced risk-focused exam strategy to better allocate and leverage its limited resources OCIE has a new centralized risk assessment unit that is working closely with the Office of Market Intelligence, the new SEC unit charged with collecting and collating the tips, complaints, and referrals (TCR) that the agency receives each year The data aggregated by the Office of Market Intelligence will be used by OCIE to assess risk at the front end, and will shape the areas and firms that OCIE targets Use of targeted scope correspondence exams to touch a greater percent of the registrant population and to risk-assess registrants with better speed and focus New Specialization Working Groups to identify, understand and proactively examine new and complex industry developments 45 23

24 Risk-Focused Examinations (continued) OCIE is focusing exams on risk management as it relates to corporate governance, enterprise risk management (ERM) and internal controls, especially for larger firms This involves understanding each registrant s business model, products and asset classes, and evaluating the risks and conflicts that are inherent in that business model. It also means seeking an understanding of the risk management governance and compliance control frameworks of the registrant: How do the business units/product teams of a firm ensure they are taking and managing risk effectively? How are key risk management, control and compliance functions structured and resourced? How is senior management ensuring effective oversight of enterprise risk management? 46 Recruiting Specialists, Improving Training OCIE is recruiting industry professionals with specialized expertise to keep up with and understand industry and market practice OCIE is providing examiners more regular and relevant training e.g., more than 300 became certified fraud examiners last year OCIE is consulting its staff to determine areas for risktargeted examination sweeps Both to uncover fraudulent acts or to provide OCIE with insight on best/strong industry compliance practices e.g., OCIE recently conducted a sweep examination of managers of funds of hedge funds, presumably both to learn more about industry due diligence practices and to discover firms that don t make it through these screens 47 24

25 Examinations in Practice Under the new program, when inspecting firms, OCIE staff will focus on five key elements during the initial assessment stage: the independence of legal and compliance departments and officers the adequacy and effectiveness of compliance and risk functions, processes, and controls the level of engagement of senior management in compliance and risk processes, and whether they are setting a solid tone at the top whether the firm is engaged and focused on risk management the adequacy and independence of internal audits OCIE is implementing a due diligence period before entering the registrant s premises, to allow examiners to learn about the firm s business, risks and conflicts of interest SEC examiners will want to engage and interact with the chief executive officer, the board, and top principals of registrants Generally, examinations are longer, more in-depth, with more review of documents to verify compliance and less reliance on interviews 48 Surprise Examinations The SEC intends to conduct surprise examinations of investment advisers based on TCR and information on risk areas referred by other SEC offices The SEC examination staff intends to arrive at these firms unannounced, without giving advisers the opportunity to prepare for the examination, so as to deny advisers time to clean up inappropriate or unlawful conduct These unannounced examinations are intended to supplement, rather than replace, OCIE s usual practice of announcing regular examinations OCIE will continue its focus on verifying advisory client and fund assets with custodians, administrators, auditors and clients OCIE sometimes will do this without first notifying the firm Also checking on consistency in disclosures 49 25

26 What Registration Means for the Private Fund Manager Private fund managers are a priority for the enforcement program New asset management task force Strong interest from criminal prosecutors Their particular focus is insider trading and market manipulation The examination program will likely be focused primarily on private fund managers for a year or two after the legislation is enacted The staff needs to get up to speed on the private fund industry, which it doesn t yet understand The SEC is trying to build up and hire private fund and market expertise, but the agency is under-resourced 50 What Registration Means for the Private Fund Manager (continued) Likely examination priorities include: Insider trading and market manipulation Valuation Conflicts of interest Gates, side letters, side pockets Performance advertising and marketing materials Custody Trading practices Portfolio management and execution of advertised strategies Poor risk disclosure 51 26

27 Questions? 52 27