Posts by: Editorial Board

California Enacts Legislation Requiring Public Investment Funds to Make Disclosures Concerning Fees and Expenses Paid to Private Fund Managers

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On September 14, 2016, Governor Jerry Brown approved an amendment to the California Government Code, effective January 1, 2017, that requires a “public investment fund,” defined to mean “any fund of any public pension or retirement system, including that of the University of California,” to make certain disclosures at least annually concerning investments in each “alternative investment” vehicle in which it invests.  An “alternative investment vehicle” is defined to mean “the limited partnership, limited liability company, or similar legal structure through which a public investment fund invests in an alternative investment.”  An “alternative investment,” in turn, means an investment in a private equity fund, venture fund, hedge fund, or absolute return fund.”

Such disclosures include: (i) the fees and expenses that the public investment fund pays directly to the alternative investment vehicle, the fund manager or related parties; (ii) the public investment fund’s pro rata share of fees and expenses not included in (i) that are paid by the alternative investment vehicle; (iii) the public investment fund’s pro rata share of carried interest distributed to the fund manager or related parties; and (iv) the public investment fund’s pro rata share of aggregate fees and expenses paid by all of the portfolio companies held within the alternative investment vehicle to the fund manager or related parties.

These disclosure requirements are in alignment with: (i) enforcement actions brought by the Securities and Exchange Commission over the past several years against private fund managers for failure to adequately disclose conflicts of interest and the fees and expenses borne by investors in their funds; (ii) similar legislative initiatives in other states; and (iii) the publication by the Institutional Limited Partners Association of a proposed reporting template that captures greater detail on fees, expenses and carried interest paid to private fund managers and their affiliates.

SEC Adopts Amendments to Form ADV

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On August 25,  2016, the Securities and Exchange Commission (SEC) adopted amendments to Form ADV that are designed to provide additional information regarding advisers, including information about their separately managed account business, incorporate a method for private fund adviser entities operating a single advisory business to register using a single Form ADV, and make clarifying, technical and other amendments to certain Form ADV items and instructions. The SEC also adopted amendments to the Investment Advisers Act of 1940 books and records rule.

In particular, the amendments to Part 1A of Form ADV are intended to provide a more efficient method for the registration on one Form ADV of multiple private fund adviser entities operating a single advisory business (“umbrella registration”). Although under existing staff guidance a large number of advisers have already been making umbrella registration filings, the method outlined in the staff guidance for filing an umbrella registration was limited by the fact that the form was designed for a single legal entity. These amendments are intended to eliminate confusion for filers and the public. Press release.

New Jersey Appellate Court Clarifies Definition of Compensation under Advisers Act

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On August 12, 2016, the United States Court of Appeals for the Third Circuit affirmed the decision of the District Court of New Jersey and held in United States v. Everett C. Miller that the defendant was an “investment adviser” within the meaning of the Investment Advisers Act of 1940 (the “Advisers Act”), notwithstanding defendant’s arguments that he did receive “compensation” and was not engaged “in the business” of acting as an investment adviser.

The Advisers Act does not explicitly define “compensation” or what constitutes being engaged “in the business.”  Consequently, the Court of Appeals based its decision on a 1987 Release issued by the Staff of the Securities and Exchange Commission (Investment Advisers Release No. 1092) which states, in part: “The Staff considers a person to be ‘in the business’ of providing advice if the person . . . holds himself out as an investment adviser or as one who provides investment advice.” In reaching its decision that the defendant provided advice for “compensation,” the Court recognized that the Advisers Act also does not define “compensation.”  The Court again cited the SEC Release which defines compensation as “any economic benefit, whether in the form of an advisory fee or some other fee relating to the total services, rendered, commissions, or some combination of the foregoing . . .” and concluded that: “It is not necessary that an investor pay a discrete fee specifically earmarked as payment for investment advice.”  Opinion.

FinCEN Issues Customer Due Diligence Rule (CDD) FAQs

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On July 19, 2016, the Financial Crimes Enforcement Network (“FinCEN”) issued FAQs regarding the customer due diligence requirements (“CDD”) that it published on May 11, 2016, for certain financial institutions, including brokers, dealers, future commission merchants and introducing brokers in commodities.  The FAQs provide interpretive guidance with respect to these requirements, including, in particular, the new regulatory requirement to identify and verify the identity of the “beneficial owners” of virtually all legal entity customers, other than a sole proprietorship and an unincorporated association.  The CDD defines “beneficial owner” as:

  • “each individual, if any, who, directly or indirectly, owns 25% or more of the equity interests of a legal entity customer; and
  • a single individual with significant responsibility to control, manage, or direct a legal entity customer, including an executive officer or senior manager. . .
  • or any other individual who regularly performs similar functions.”

The FAQs states:  “In short, covered financial institutions are now required to obtain, verify, and record the identities of the beneficial owners of legal entity customers.”

NY DFS Adopts Final Anti-Terrorism and Anti-Money Laundering Regulation

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On June 30, 2016, the New York Department of Financial Services (“NY DFS”) adopted a final anti-terrorism and anti-money laundering regulation (the “Final Regulation”) that requires institutions subject to regulation by the NY DFS to maintain programs to monitor and filter transactions for potential Bank Secrecy Act (“BSA”) and anti-money laundering (“AML”) violations and prevent transactions with sanctioned entities.

Of particular significance is that under the Final Regulation, which will be effective January 1, 2017, relevant regulated NY DFS institutions are required to review their transaction-monitoring and filtering programs and ensure that they are reasonably designed to comply with risk-based safeguards. These institutions also must adopt (at the institution’s option) an annual board resolution or senior officer compliance finding to certify compliance with the Final Regulation beginning April 15, 2018. The resolution or finding must state that documents, reports, certifications and opinions of officers and other relevant parties have been reviewed by the board of directors or senior official to certify compliance with the Final Regulation.

The proposed version of the Final Regulation, which was issued on December 1, 2015, included a much more draconian requirement that a senior financial executive annually deliver an unqualified certificate to the NY DFS that his or her institution “has sufficient systems in place to detect, weed out, and prevent illicit transactions” and that he or she has reviewed the compliance programs of the regulated Institution, or caused them to be reviewed, and that such programs comply with all of the requirements of the proposed regulation. The provisions of the proposed regulation are discussed in the December 22, 2015 Orrick Alert.

The NY DFS noted in its announcement of the Final Regulation that: “The risk-based rule adopted by DFS today takes into consideration comments that were submitted by the financial services industry and others during the extended comment period for the previously-proposed regulation, which ended March 31, 2016.”

Institutions must maintain supporting data for the certification, for review by NY DFS, for five years.

The key requirements of the Final Regulation include the following:

Annual Board Resolution or Senior Officer Compliance Finding

To ensure compliance with the requirements, each regulated institution shall adopt and submit to the Superintendent a board resolution or senior officer compliance finding by April 15 of each year. Each regulated institution shall maintain for examination by DFS all records, schedules and data supporting adoption of the board resolution or senior officer compliance finding for a period of five years.

Maintain a Transaction Monitoring Program

Each relevant regulated institution shall maintain a reasonably designed program for the purpose of monitoring transactions after their execution for potential BSA/AML violations and Suspicious Activity Reporting. The system, which may be manual or automated.

Maintain a Watch List Filtering Program

Each relevant regulated institution shall maintain a reasonably designed filtering program for the purpose of interdicting transactions that are prohibited by federal economic and trade sanctions.

Federal Reserve Announces Extension of Conformance Period under Section 13 of the Bank Holding Company Act

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On July 7, 2016, the Federal Reserve announced that it will extend until July 21, 2017 the conformance period for banking entities to divest ownership in certain legacy investment funds and terminate relationships with funds that are prohibited under Section 619 of the Dodd-Frank Act, commonly known as the Volcker Rule. The Board had announced in December 2014 that it would make this extension to provide for orderly divestitures and to prevent market disruptions. This is the final of the three one-year extensions that the Board is authorized to grant.

In making this announcement, the Federal Reserve emphasized that: “This extension would permit banking entities additional time to divest or conform only ‘legacy covered fund’ investments, such as prohibited investments in hedge funds and private equity funds that were made prior to December 31, 2013. This extension does not apply to investments in and relationships with a covered fund made after December 31, 2013 or to proprietary trading activities; banking entities were required to conform those activities to the final rule by July 21, 2015.”

The Federal Reserve also noted that the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, and the Commodity Futures Trading Commission: “plan to administer their oversight of banking entities under their respective jurisdictions in accordance with the Board’s conformance rule and this extension of the conformance period.”

Finally, the Board noted that: “upon the application of a banking entity, the Board is permitted under section 619 to provide up to an additional five years to conform investments in certain illiquid funds, where the banking entity had a contractual commitment to invest in the fund as of May 1, 2010.” Release.

SEC Proposes Rule Requiring Investment Advisers to Adopt Business Continuity and Transition Plans

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On June 28, 2016, the Securities and Exchange Commission proposed a new rule that would require registered investment advisers to adopt and implement written business continuity and transition plans.  In announcing the proposed rule the SEC stated that:  “The proposed rule is designed to ensure that investment advisers have plans in place to address operational and other risks related to a significant disruption in the adviser’s operations in order to minimize client and investor harm.”

The risks identified by the SEC include: business disruptions – whether temporary or permanent – such as a natural disaster, cyber-attack, technology failures, and the departure of key personnel.

The proposed rule also would require an adviser’s plan to include policies and procedures addressing the following specified components: maintenance of systems and protection of data; pre-arranged alternative physical locations; communication plans; review of third-party service providers; and plan of transition in the event the adviser is winding down or is unable to continue providing advisory services.

The proposed rule and rule amendments also would require advisers to review the adequacy and effectiveness of their plans at least annually and to retain certain related records.

In addition to the proposed rule, SEC staff issued related guidance addressing business continuity planning for registered investment companies, including the oversight of the operational capabilities of key fund service providers.

The proposed rule can be found by clicking here. Comments are due on or before September 6, 2016.

Financial Stability Board Issues Asset Management-Related Policy Recommendations

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On June 22, 2016, the Financial Stability Board (FSB) published for public consultation Proposed Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities. The document sets out 14 proposed policy recommendations to address the following structural vulnerabilities from asset management activities that could potentially present financial stability risks:

  1. Liquidity mismatch between fund investments and redemption terms and conditions for fund units;
  2. Leverage within investment funds;
  3. Operational risk and challenges in transferring investment mandates in stressed conditions; and
  4. Securities lending activities of asset managers and funds.

The key recommendations for liquidity mismatch and leverage focus on both public and private funds.

The FSB reported that it “intends to finali[z]e the policy recommendations by the end of 2016, some of which will be operationalized by the International Organization of Securities Commissions (IOSCO).”

SEC Issues Order Increasing the Net Worth Test Under Rule 205-3 Under the Investment Advisers Act of 1940 to $2.1 Million

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Section 205(a)(1) of the Investment Advisers Act of 1940 (the “Advisers Act”) generally prohibits an investment adviser from entering into, extending, renewing, or performing any investment advisory contract that provides for compensation to the adviser based on a share of capital gains on, or capital appreciation of, the funds of the client. Rule 205-3 under the Advisers Ac exempts an investment adviser from this prohibition in certain circumstances when the client is a “qualified client.”  The definition of “qualified client” includes an assets under management standard set as $1,00,000 and a net worth test that set at (in the case of a natural person, with assets held jointly with a spouse), more than $2,000,000.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) amended Section 205(e) of the Advisers Act to provide that, by July 21, 2011 and every five years thereafter, the SEC shall adjust for inflation the dollar amount thresholds included in rules issued under Section 205(e), rounded to the nearest $100,000.  Rule 205-3 now states that the SEC will issue an order on or about May 1, 2016, and approximately every five years thereafter, adjusting for inflation the dollar amount thresholds of the rule’s assets-under-management and net worth tests based on the Personal Consumption Expenditures Chain-Type Price Index (published by the United States Department of Commerce).  Based upon this requirement, no change in the assets under management test is required, but the dollar amount of the net worth test would increase to $2,100,000.

Accordingly, on June 14, the SEC issued an Order, effective as of August 15, 2016, that:

  1. for purposes of Rule 205-3(d)(1)(i) under the Advisers Act, a “qualified client” means a natural person who, or a company that, immediately after entering the contract has at least $1,000,000 under the management of the investment adviser; and
  2. for purposes of Rule 205-3(d)(1)(ii)(A) under the Advisers Act, a “qualified client” means a natural person who, or a company that, the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,100,000.

Banking Agencies Permit “Reduced Content” Living Wills for Smaller FBOs

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On June 10, 2016, the Federal Reserve Board and Federal Deposit Insurance Corporation announced they are permitting 84 foreign banking organizations (not identified) with limited U.S. operations to file “reduced content” resolution plans for their next three resolution plans.  As reported, the decision is intended “to increase clarity and reduce burden by creating more certainty around future filing requirements.”  All of the 84 firms have less than $50 billion in total U.S. assets.  The agencies said “the reduced content plans should focus on changes the firms have made to their prior resolution plans, actions taken to improve the effectiveness of, or that may alter, those plans, and, where applicable, actions to ensure any subsidiary insured depository institution is adequately protected from the risks arising from the activities of nonbank subsidiaries of the firm.  The first of these reduced content plans must be submitted to the agencies by December 31, 2016. To file reduced content plans for the next three years, the firms must maintain less than $50 billion in U.S. assets and not experience any material events.