Asset Management

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.

SEC Finds that Private Equity Fund Adviser Acted as Unregistered Broker

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On June 1, 2016, the Securities and Exchange Commission (“SEC”) announced that a private equity fund advisory firm and its owner agreed to pay more than $3.1 million to settle charges that they engaged in brokerage activity, charged fees without registering as a broker-dealer and committed other securities law violations.

An SEC investigation found that Blackstreet Capital Management, LLC (“Blackstreet”) and its principal performed in-house brokerage services rather than using investment banks or broker-dealers to handle the acquisition and disposition of portfolio companies for a pair of advised private equity funds. Of particular interest is the SEC highlighted that “Blackstreet fully disclosed to its funds and their investors that it would provide brokerage services in exchange for a fee” and that the limited partnership agreements of the advised funds “expressly permitted” the adviser “to charge transaction or brokerage fees.”  However, this did not suffice.

In the press release announcing the Order, Andrew J. Ceresney, Director of the SEC Enforcement Division, emphasized that the rules are clear that “before a firm provides brokerage services and receives compensation in return, it must be properly registered within the regulatory framework that protects investors and informs our markets.”

Of note, the Order did not address whether or not Blackstreet offset transaction fees payable by the advised funds against its management fee. This is significant because in April 2013 the Chief Counsel of the SEC’s Division of Trading and Markets gave a speech in which he stated that “to the extent [a private equity fund] advisory fee is wholly reduced or offset by the amount of [a] transaction fee, one might view the fee as another way to pay the advisory fee, which, in my view, in itself would not appear to raise broker-dealer registration concerns.”  Since the Order does not disclose whether or not there was a fee offset in the case presented, it is unclear whether the current SEC staff holds the view expressed by the Chief Counsel in 2013.

 

Treasury Announces Key Regulations and Legislation to Counter Money Laundering and Corruption, Combat Tax Evasion

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On May 5, 2016, the U.S. Department of the Treasury announced several actions to strengthen financial transparency.  Treasury announced a Customer Due Diligence (CDD) Final Rule, proposed Beneficial Ownership legislation and proposed regulations related to foreign-owned, single-member limited liability companies (LLCs).

CDD Final Rule

The CDD Final Rule adds a new requirement that financial institutions – including banks, brokers or dealers in securities, mutual funds, futures commission merchants, and introducing brokers in commodities – collect and verify the personal information of the beneficial owners who own, control, and profit from companies when those companies open accounts.  The Final Rule also amends existing Bank Secrecy Act (BSA) regulations to clarify and strengthen obligations of these entities.

Specifically, the rule contains three core requirements: (1) identifying and verifying the identity of the beneficial owners of companies opening accounts; (2) understanding the nature and purpose of customer relationships to develop customer risk profiles; and (3) conducting ongoing monitoring to identify and report suspicious transactions and, on a risk basis, to maintain and update customer information.  With respect to the new requirement to obtain beneficial ownership information, financial institutions will have to identify and verify the identity of any individual who owns 25 percent or more of a legal entity, and an individual who controls the legal entity.  The final rule extends the proposed implementation period from one year to two years, expands the list of exemptions and makes use of a standardized beneficial ownership form optional as long as a financial institution collects the required information.

Beneficial Ownership Legislation

Treasury announced it is sending beneficial ownership legislation to Congress.  As part of the legislation, companies formed within the United States would be required to file beneficial ownership information with the Treasury Department, and face penalties for failure to comply.

Foreign-Owned Single-Member LLC Proposed Regulations

Treasury also announced proposed regulations to require foreign-owned “disregarded entities,” including foreign-owned single-member limited liability companies (LLCs), to obtain an employer identification number (EIN) with the IRS.

SEC’s Division of Investment Management Issues Letter Regarding Independent Verification Required by Rule 206(4)-2 Under the Advisers Act

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On April 25, 2016, the Staff of the Division of Investment Management of the Securities and Exchange Commission issued a no-action letter that provides that it would not recommend enforcement action to the Commission under Section 206(4) of, and Rule 206(4)-2 under, the Investment Advisers Act of 1940 if an investment adviser does not obtain a surprise examination by an independent public accountant (as is generally required) where it acts as a sub-adviser in an investment advisory program for which a “related person” “qualified custodian” is the primary adviser (or an affiliate of the primary adviser), and the primary adviser is responsible for complying with Rule 206(4)-2.  A “related person” of another generally is a person who is directly or indirectly controlling or controlled by the other person or under common control with such person.  A “qualified custodian” is a bank, a registered broker-dealer, a registered futures commission merchant and certain foreign financial institutions.”

The Staff’s position was based, in particular, on the following:

  1. the sole basis for the sub-adviser having custody is its affiliation with the qualified custodian and the primary adviser;
  2. the primary adviser will comply with Rule 206(4)-2 (including by having client funds and securities in the investment advisory program verified by a surprise examination conducted by an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”) pursuant to an agreement entered into by the primary adviser);
  3. the sub-adviser does not: (i) hold client funds or securities itself; (ii) have authority to obtain possession of clients’ funds or securities; or (iii) have authority to deduct fees from clients’ accounts; and
  4. the sub-adviser will continue to be required to obtain from the primary adviser or qualified custodian annually a written internal control report prepared by an independent public accountant registered with and subject to regular inspection by the PCAOB as required by Rule 206(4)-2(a)(6).

OCC Releases its Risk Appetite Statement

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On April 12, the Office of the Comptroller of the Currency (“OCC”) released its Risk Appetite Statement, which sets boundaries of acceptable levels of risk in key areas of agency operations.  The OCC stated that:  “By clearly articulating the acceptable level of risks within our operations, agency management and employees have clearer signposts by which to guide their decisions, and external stakeholders can better understand OCC actions in the context of the risks facing the agency.”

These new guidelines were issued as the OCC has signaled a willingness to work with banks as they develop tools for working with financial technology products.  On March 31, the OCC published its perspective on “responsible innovation in the federal banking system” at the same time as it solicited feedback on what more it could do to support innovation.  In publishing its Whitepaper on Supporting Responsible Innovation in the Federal Banking System:  An OCC Perspective, Comptroller of the Currency Thomas J. Curry stated that:  “Innovation holds much promise. . . . Innovation is not free from risk, but when managed appropriately, risk should not impede progress.”

FinCEN Proposes Funding Portals Regulations under Bank Secrecy Act

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On April 4, 2016, the Financial Crimes Enforcement Network, a bureau of the Department of the Treasury (“FinCEN”), proposed amendments to the definitions of ‘‘broker or dealer in securities’’ and ‘‘broker-dealer’’ under the regulations implementing the Bank Secrecy Act (“BSA”). This rulemaking would amend those definitions explicitly to include “funding portals” that are involved in the offering or selling of “crowdfunded securities” pursuant to Section 4(a)(6) of the Securities Act of 1933. The consequence of those amendments would be that funding portals would be required to implement policies and procedures reasonably designed to achieve compliance with the BSA Act requirements currently applicable to brokers or dealers in securities. FinCEN stated that:  “The proposal to specifically require funding portals to comply with the Bank Secrecy Act regulations is intended to help prevent money laundering, terrorist financing, and other financial crimes.”  Written comments of this proposal must be submitted on or before June 3, 2016.

The Jumpstart Our Business Startups Act, enacted into law on April 5, 2012, established the foundation for a regulatory structure for startups and small businesses to raise funds by offering and selling securities through “crowdfunding” without having to register the securities with the Securities and Exchange Commission (“SEC”) or state securities regulators.  In order to take advantage of this exemption for offerings of crowdfunded securities, an issuer must use the services of an intermediary that is either a broker registered with the SEC or a “funding portal” registered with the SEC.

Federal District Court Rules against Designation of MetLife as a “SIFI” under Dodd-Frank Act

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On March 30, the D.C. federal District Court ruled against the designation by the Financial Stability Oversight Counsel (“FSOC”) of MetLife as a “systemically important financial institution” under the Dodd-Frank Act.  The FSOC has designated just four non-banks as SIFIs, but MetLife was the only one to file a lawsuit protesting it.

The overall impact of the ruling remains unclear, however, because it is under based on longstanding concerns about the protection of the firm’s proprietary business information and it widely anticipated that the FSOC will appeal the ruling.

FINRA Reports on Digital Investment Advice

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On March 15, the Financial Industry Regulatory Authority (commonly referred to as “FINRA”) issued a Report that emphasizes that offerings of digital investment advice requires sound governance and supervision, including effective means of overseeing the suitability of recommendations, conflicts of interest, customer risk profiles and portfolio rebalancing.  The Report also outlines lessons for investors and states that training and education are crucial for financial professionals who use digital investment advice tools.  FINRA is the regulatory authority that is responsible, under the supervision of the U.S. Securities and Exchange Commission, for the oversight of broker-dealers.

This Report is the most comprehensive commentary and guidance issued to date by any U.S. regulator regarding digital investment advice.  It merits careful consideration.

Although the rules discussed in the Report apply directly to broker-dealers, rather than investment advisers, the Report addresses the duties applicable to investment management services provided by broker-dealers as well as investment advisers.  Therefore, we expect that the principles and rules set forth in the Report are comparable to those that the SEC will apply to investment advisers that provide digital investment advice.  Report.  Press Release.

Bureau of Consumer Financial Protection Issues Policy on No-Action Letters

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On February 18, the Consumer Financial Protection Bureau issued a new policy statement on No-Action Letters.

Under the Policy, Bureau staff, in its discretion, would issue no-action letters (NALs) to specific applicants in instances involving “innovative financial products or services that promise substantial consumer benefit where there is substantial uncertainty whether or how specific provisions of statutes implemented or regulations issued by the Bureau would be applied.”

A NAL would advise the recipient that, subject to its stated limitations, the staff has no present intention to recommend initiation of an enforcement or supervisory action against the requester with respect to a specified matter. However, NALs would be subject to modification or revocation at any time at the discretion of the staff, and may be conditioned on particular undertakings by the applicant with respect to product or service usage and data-sharing with the Bureau. Also, NALs would be nonbinding on the Bureau, and would not bind courts or other actors who might challenge a NAL recipient’s product or service, such as other regulators or parties in litigation.

SEC Approves Interim Final Rules Implementing Two Provisions of the FAST Act

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On January 13, the Securities and Exchange Commission announced that it approved interim final rules implementing two provisions of the Fixing America’s Surface Transportation (FAST) Act, adopted by Congress in December, that revise financial reporting forms for emerging growth companies and smaller reporting companies.

The Congressionally mandated rules revise Forms S-1 and F-1 to provide that as long as emerging growth companies’ registration statements include all required financial information at the time of the offering, they will be allowed to omit certain historical period financial information prior to the offering.  In addition, the rules revise Form S-1 to allow smaller reporting companies to use incorporation by reference for future filings the companies make under the federal securities laws after the registration statement becomes effective.

The interim final rules also include a request for comment on whether the rules should be expanded to include other registrants or forms.

The rules will become effective when published in the Federal Register and the public comment period will remain open for 30 days following their publication.