California Proposes Significant Rule Changes for Registered Investment Advisers

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1 Alert California Proposes Significant Rule Changes for Registered Investment Advisers The California Department of Corporations, the regulatory body for the investment advisory community in California, has released a sweeping series of proposed rule changes. This is not your ordinary rulemaking effort - it is an overhaul of the regulatory framework that governs California registered advisers. There are, however, some welcome changes that will benefit hedge fund managers and while there are a host of new rules which advisers will be forced to comply with, they are familiar. As discussed below, nearly every proposed change reflects a current S.E.C. rule or interpretation. Accordingly, counsel and compliance consultants will not have to recreate the wheel. The following are just a few of the proposed changes: Significant revisions to the custody rule allowing fund managers to choose between the "audit approach" or "gatekeeper approach";1 Requirements which will mandate that advisers adopt a written "Code of Ethics", including policies and restrictions on personal trading, written business continuity plans and insider trading policies; The imposition of the S.E.C.'s rules and interpretations on advertising; and The adoption of a policy on "soft dollars". The revisions to the custody rule are a welcome change as firms have struggled for years with some of the nuances of the so-called PIMS or Bennett "custody letter" arrangements. The proposed changes will allow fund managers to elect to follow the audit approach first established by the S.E.C. four years ago and forego the need to have yet another service provider. But with the good, comes the bad. The revised custody rule, if adopted, will result in all fund managers having custody of client assets thereby raising their net worth requirements to $35,000. Further, many of the proposed rule changes will require California registered advisers to adopt compliance programs similar to those of their well-funded peers who have registered with the S.E.C. It is anticipated that the proposed rules will pass without significant objection. For those interested in submitting comment letters, the deadline for such submissions is October 30 th, The DOC hopes to have an implementation date of January 1 st, 2008 but that appears overly optimistic.

2 Following is a summary of the more significant proposed changes. Due to the breadth of the changes, we can only provide brief summaries of the proposed changes and suggest that registered advisers contact the Firm with more specific questions. Finally, the following summaries are provided with the hedge fund manager in mind and attempt to answer the questions that will most likely be asked by this audience. Summary of the Proposed Changes I. Advertising and Marketing Rules The primary proposed change to the marketing and advertising rules is to effectively adopt the restrictions on performance advertising found in the S.E.C.'s Clover Capital no-action letter. The proposed rules would require all performance advertising to be net of all fees and expenses charged and to be accompanied by certain disclosures where relevant. There are additional disclosures required where the performance results are model results and not based on actual trading. II. Brochure Rule The proposed rule changes include a version of the S.E.C.'s Brochure Rule. The Brochure Rule requires that advisers provide a disclosure document (a.k.a. their brochure) to all advisory clients and prospective advisory clients at least 48 hours in advance of entering into an advisory contract. Further, advisers must make an offer to provide their current brochure to all advisory clients at least annually. An adviser's brochure may be its Form ADV, Part II or a separate document that contains at least the information required to be found in its Form ADV, Part II. Not surprisingly, most advisers use their Part II as their brochure. Unfortunately, the Department of Corporations did not take this opportunity to answer a question that has been confounding fund managers for years - does the brochure rule apply to investors in their funds or only to those who are about to enter into an advisory contract with the adviser? Most advisers take the safe approach and provide their Part II along with their PPM and/or subscription documents. III. Custody Rule and Minimum Financial Requirement Rules a. Custody Rule The proposed changes to the custody rule may be the silver lining to what appears to be a storm cloud. The proposed custody rule offers hedge fund managers greater flexibility and allows them to choose between the audit approach followed by the S.E.C. or to continue using the gatekeeper (a.k.a. an independent representative) procedures outlined in the Bennett and PIMS no-action letters, albeit with slight modifications. Under the proposed rule, hedge fund managers will be deemed to have custody of client assets by virtue of their access to the fund's assets. There are then several requirements imposed on advisers who are deemed to have custody of client assets which are designed to protect those clients and their assets. These requirements, however, are easily satisfied and it is fair to say that most hedge fund managers are already in full compliance with the proposed custody rule. In summary, those managers with custody will be required to use a "qualified custodian" to house those assets.2 All broker-dealers are qualified custodians provided that

3 they are not under common control (e.g., share common ownership) with the adviser. Advisers with custody must also then ensure that the qualified custodian provides each client and each investor in a fund with account statements showing all transactions in the account. An adviser to a fund may, however, avoid the account statement requirement if the fund has its financial statements audited annually and such audited financial statements are provided to investors within 120 days of the fund's fiscal year end.3 For those advisers who have followed the requirements in the Bennett and PIMS noaction letters in order to avoid being deemed to have custody of client assets, the proposed rule change will simplify the administration of their funds and reduce costs. The downside of the proposed changes is that there appears to be no flexibility in the timing of a fund's audit (e.g., stub-year audits), as well as the higher ($35,000) net worth requirements discussed below. b. Minimum Financial Requirements The proposed regulations add a few new wrinkles to the long-standing net worth requirements for California advisers. The most significant proposal would require advisers to prepare, on a monthly basis, net worth calculations to ensure that they are satisfying their net worth requirements. As touched upon above, all fund managers will be required to maintain a net worth of $35,000 and the proposed rules will require managers to check and confirm this every month. There is no filing requirement but the calculations will be part of an adviser's "books and records" obligations. Thus, be prepared to show an examiner that you have been complying and performing these calculations monthly. If an adviser's net worth falls below its required minimum, the adviser must notify the Department of Corporations the following business day and must also notify its clients that it has fallen below its minimum financial requirements. IV. Policies and Procedures Possibly the biggest change proposed by the regulations is in the area of policies and procedures. Advisers will be required to adopt written policies and procedures in three key areas: a Code of Ethics, Business Continuity Plans and Insider Trading. Again, the regulations on these topics essentially mimic the requirements imposed on S.E.C.-registered advisers. a. Code of Ethics Each adviser will be required to adopt a written Code of Ethics containing policies and procedures on a specified list of topics. The majority of this list is inconsequential and will have little impact on advisers. The areas that will require the most attention are personal trading and gifts and entertainment. Advisers will be required to adopt policies on personal securities trading, monitor these policies, and then maintain documents reflecting the personal trading of the adviser's personnel subject to the rules ("access persons"). The rules, like those of the S.E.C., provide the adviser great flexibility in determining its personal trading policies but do impose a minimum as far as record-keeping is required. All access persons will be required to provide a "holdings report" at the commencement of their employment and at least annually thereafter. The holdings report must contain a list of all "reportable securities" held, directly or beneficially, by the access person. Each access person is also required to provide transaction reports, no less than quarterly, showing all securities transactions in any account held or controlled by the access person. Finally, pre-approval of transactions in IPO's and private placements is required for all access persons.

4 b. Business Continuity Plans Advisers will also be required to adopt and implement a written business continuity plan. The plan must describe the actual procedures that the adviser will follow in the event of a disaster. The regulations propose a variety of "minimum requirements" of a continuity plan including the designation of an alternate office, a description of the system used to back-up and store data and electronic files, and even a succession plan in the event of a death of an advisory representative. While not specifically identified, the minimum requirements certainly appear to include a requirement that all s be retained and stored. Further, disclosure of an adviser's continuity plan must be made at the time a client's account is opened and offered annually thereafter. c. Insider Trading Policies The proposed regulations will also impose a requirement on advisers to adopt and implement policies and procedures designed to prevent the misuse of material, non-public information. V. Soft Dollar Arrangements The Department of Corporations has even stepped into an arena typically left to federal regulators - the use of soft dollars. The proposed regulations are, again, nothing more than a formal adoption of S.E.C. policies. Accordingly, an adviser will not be deemed to have breached its fiduciary obligations to clients if it pays more than the lowest available commission rate in exchange for the adviser receiving additional brokerage and research services. The proposed regulations, however, seem to take a step backwards in that they reintroduce the somewhat dated requirement that the research be "provided by" the broker. Current S.E.C. interpretations, coupled with numerous no-action letters, allow advisers to use soft dollars to pay for third-party research. VI. Solicitor's Rule Again, the proposed regulations dip into the S.E.C.'s bag of tricks for rulemaking. The key component of the Solicitor's Rule is the requirement that the solicitor and the adviser have a contractual relationship and that the solicitor provide a disclosure statement, to be acknowledged by the client, disclosing the nature of the relationship and the fees to be paid to the solicitor for the referral. The proposed regulations do not provide any indication as to whether the Department of Corporations will deem an investor in a fund to be a "client" for purposes of this rule. The S.E.C.'s current view, following the D.C. Circuit Court of Appeals' decision in Goldstein v. S.E.C., no longer requires the use of disclosure statements for investors in hedge or private equity funds. The Anticipated Impact on California Registered Investment Advisers Registered advisers will undoubtedly be forced to incur additional costs in the adoption and establishment of some of the required policies and procedures, most notably with the adoption of business continuity plans. There will, however, be cost-savings with the adoption of the new custody rules in that most advisers will be able to forego the use of gatekeepers and their inherent costs. The proposed rules are, as stated throughout this memo, essentially the adoption of S.E.C. rules and policies. Counsel familiar with S.E.C. rules and regulations will be able to quickly adapt policies and procedures once the proposed rules become effective. In summary,

5 California advisers will benefit by virtue of the fact that the rules are not exactly "new", just new to them. This memorandum is only an introduction to the changes proposed by the Department of Corporations and does not provide specific guidance on complying with the rules should they be adopted. We urge affected advisers to contact our compliance and regulatory attorneys for detailed guidance, including the adoption and implementation of appropriate policies and procedures. Also, Sadis and Goldberg LLP will be hosting an event entitled "Planning for Your Year- End Compliance Obligations" on December 6 th, The agenda for the event is flexible and if there is enough interest we would be glad to offer a break-out session on these proposed rule changes. Please feel free to Dennis R. Hirsch with questions, or to be added to the mailing list for our events and newsletters, at drhirsch@sglawyers.com. [1]1 There appears to be two significant errors in the revised custody rule. We have been told by the Department of Corporations that it is their intention to adopt the model custody rule issued by NASAA. If so, then the current text of the proposed rule has significant cross-reference errors. This memorandum provides commentary and a description of NASAA's model custody rule on the assumption that the errors will be corrected before adoption. Our firm has been working with the Department of Corporations in an attempt to clarify its intentions and, hopefully, correct these errors. [2]2 Similar to the S.E.C.'s custody rule, there is an exception to the qualified custodian requirement for certain privately placed securities. [3]3 This time frame is extended to 180 days for funds of hedge funds. The information contained herein was prepared by Sadis and Goldberg LLP for general informational purposes and does not constitute legal advice. This information is presented without any representation or warranty as to its accuracy, completeness or timeliness. Transmission or receipt of this information does not create an attorney-client relationship with Sadis and Goldberg LLP. Electronic mail or other communications with Sadis and Goldberg LLP