As reported by Core Compliance and Legal Services, Inc.,  on December 21, 2011, the DOC released its initial notice of proposed rulemaking concerning private fund adviser exemption. The overhaul of federal financial services and securities laws resulting from Dodd-Frank included the elimination of the “private adviser” exemption set forth in Section 203(b)(3) of the Investment Adviser Act of 1940 and the creation of a new regulatory regime for advisers to private funds.

The new provisions adopted by the SEC under Dodd-Frank exempt advisers to private funds from registration if they (1) exclusively advise venture capital funds and (2) manage less than $150 million of assets. The proposed California rule would likewise exempt advisers from state registration if they advise only “qualifying private funds” (defined by SEC Rule 203(m)-1). The California rule also includes several investor protection safeguards, including requiring that the exempt adviser not be subject to statutory disqualifications (also known as “bad boy” provisions) and requiring the adviser to file periodic reports on Form ADV containing the information required by exempt reporting advisers under SEC Rule 204-4.

If the proposal is adopted, California firms that solely manage qualifying funds (and meet the additional requirements) with under $150M in AUM may not be required to register with any regulatory agency. For additional information on the proposed regulation, please contact Sarah Weber at (619) 298-2880 or sarah.weber@jackolg.com.

The Notice provides helpful guidance for determining whether products require heightened supervision, as well as specific supervisory and compliance procedures firms should have in place.

Characteristics of Complex Products

FINRA notes that “any product with multiple features that affect its investment returns differently under various scenarios is potentially complex” and provides a non-exclusive list of characteristics to consider, including:

• Asset-backed securities secured by a pool of collateral (i.e. mortgages or consumer credit card payments) whose risks are not readily apparent;
• Any product with an embedded derivate component that is difficult to understand (i.e. structured notes with an embedded derivative); and
• Investments tied to the performance of markets not readily understood (i.e. an exchange traded product with exposure to futures on the CBOE Volatility Index).

If there is any question firms are cautioned to “err on side of applying their procedures for enhanced oversight to the product.”

Best Practices for Heightened Supervision

Broker-dealers and their registered representatives (RRs) must perform a reasonable basis suitability determination before recommending complex securities, which provides “an understanding of the potential risks and rewards associated with the recommended security or strategy.” Further, firms should have formal written procedures to ensure that reps do not recommend a complex product before it has been thoroughly vetted.

Broker-dealers also should ensure that their RRs are adequately knowledgeable about the complex products they offer. Ideally the RR “should be competent to develop a payoff diagram of a structured product to facilitate his or her analysis of its embedded features and recognize that such a product typically can be decomposed into bond and derivative parts.” The RR must also be fully knowledgeable on the risks associated with each part of the complex product. Importantly, “[r]egistered representatives should consider whether less complex or costly products could achieve the same objectives for their customers” as the contemplated complex product.

For additional information on FINRA Regulatory Notice 12-03, please contact sarah.weber@jackolg.com or by phone at (619)298-2880.

The MFA asserts that technological changes, and Rule 502(c)’s innate vagueness, make compliance with the prohibition both unnecessarily risky for private funds and extremely costly to funds and the economy as a whole. Fund managers “expend considerable time and resources when making any sort of communications or participating in industry events, and often…refrain from such activity” entirely to avoid the risk of losing the protection of Reg D. This over-cautious stance results in a “lack of publically available, verified information about hedge funds,” which in turn has created the perception that “the industry [is] secretive,” likely “discourage[ing] institutional investors from allocating capital to private funds.”  The MFA argues that lifting the prohibition will lead to a change in this misperception about the industry and allow potential investors to “gather information about private funds at relatively low costs and lead to the more efficient allocation of capital.” MFA – and other supporters of this reform – assert that increased investment in such funds will fuel the economy since many hedge funds are exposed to risks that traditional retail investors commonly avoid.

The MFA’s petition is not the first call for the rollback of the advertising and solicitation ban for private funds. The Senate and the House both introduced legislation that would mandate similar changes to Reg D. Indeed, as noted in the MFA’s petition, the SEC itself has questioned the necessity of the ban with respect to the exemption under Section 3(c)(7) of the Investment Company Act , which only allows sales to “qualified purchasers” – defined as individuals with at least $5 million in investments and institutions with at least $25 million in investments . Only time will tell whether the SEC or Congress will implement reform, but the voices in favor of a change seem to be getting louder.

If you have any question about compliance with Reg D, or any other compliance concern, please post your comments here or contact the author at sarah.weber@jackolg.com.

In order to facilitate this change and allow those registrants who will no longer be required to register with the commission to transition to state oversight, all SEC registered investment advisers (regardless of their fiscal year-end) must file an amendment to Form ADV Part 1 between January 1, 2012 and March 30, 2012.

In addition to completing the newly required additional information in this form, the AUM information in Form ADV Part 1, Item 5, must be updated to December 31, 2011 for this filing. For advisers that have a fiscal year-end of December 31, the form should be filed as their “annual amendment.” For those advisers with a different fiscal year-end date, the form should be filed as an “other than annual amendment.”

After this filing is completed, any SEC registered investment adviser with AUM less than $100 million must file with one or more state authorities, and then withdraw registration from the SEC by June 28, 2012. Advisers with their principal place of business in Wyoming or New York will remain registered with the SEC because these jurisdictions do not subject investment advisers to examination.

For additional information about Form ADV or transitioning from SEC to state registration, please contact us at info@jackolg.com or by phone at (619) 298-2880.

The same day, highlighting the agency’s focus on enforcement in the ever-evolving world of social media, the SEC issued guidance on an RIA’s use of social media in a new National Examination Risk Alert, Investment Adviser Use of Social Media (the “Alert”), highlighting three areas of concern:

• The need for Compliance policies and procedures concerning social media;
• Third-party content on an RIA’s social media site (and  whether “liking” is a prohibited testimonial); and
• Recordkeeping responsibilities with respect to social media.

Social Media Compliance Regulatory Concerns

The Alert gives a list of factors for RIAs to consider in developing an effective compliance oversight program with respect to the use of social media. This includes using sampling or search methodologies to monitor content and communications by employees. Other recommendations include:

• Implementation of “usage guidelines” that lay out appropriate and inappropriate uses of social media, as well as articulation of clear guidelines with respect to acceptable content;
• Establishing appropriate monitoring of social media site posts, including periodic or real-time monitoring; and
• The assessment of information security risks that may be posed by social media sites, particularly protecting sensitive customer and firm proprietary information.

Third-Party Content (Dislike Your Likes)

Third-party postings on an RIA’s social media site, including merely clicking “like,” may be interpreted as an improper testimonial.  As described by the Alert, “If, for example, the public is invited to ‘like’ an IAR’s biography posted on a social media site, that post could be viewed as a type of testimonial prohibited by Rule 206(4)-1(a)(1).”  Consequently, a conservative approach may be to limit third-party postings and establish notifications to monitor posts real-time.

Recordingkeeping Responsibilities for Social Media

The recordkeeping obligations under the Advisers Act do not distinguish between different types of media. The Alert provides new guidance on factors for RIAs to consider as they adopt recordkeeping policies and procedures for social media, including: determining whether each communication is a required record; establishing employee training programs to educate advisory personnel on do’s and don’ts; and testing to ascertain compliance with social media policies.

RIAs and their employees should take this new and extremely useful guidance to heart as they navigate the world of social media. For additional information, please contact the author at sarah.weber@jackolg.com.

The enforcement action filed against ThinkStrategy Capital Management LLC is particularly instructive.  In this action, the SEC charged the New York-based firm and its managing director with fraud in connection with two hedge funds they managed. At its peak, ThinkStrategy reportedly managed approximately $520 million in assets.  However, the SEC’s complaint filed on Nov. 9, 2011 alleges that ThinkStrategy engaged in a pattern of deceptive conduct designed to bolster the funds’ track record, size, and credentials.  Specifically, the SEC alleges that ThinkStrategy materially overstated the funds’ performance and gave investors the false impression that their returns were consistently positive and minimally volatile.  ThinkStrategy also allegedly inflated the funds’ assets, exaggerated the firm’s longevity and performance history, and misrepresented the size and credentials of firm’s management team.

Given the new information the SEC will acquire through Form PF, we can expect to see increased regulatory scrutiny against private fund managers rooted in suspiciously inflated performance returns.

For additional information please contact us at info@jackolg.com or at (619) 298-2880.

• Tailor the focus of branch exams to the business conducted in that branch and assess the risks specific to that business;
• Schedule the frequency and intensity of exams based on underlying risk (rather than on an arbitrary cycle) and examine branch offices at least annually;
• Engage in a significant percentage of unannounced exams, selected through a combination of risk based analysis and random selection;
• Deploy sufficiently senior branch office examiners who understand the business and have the gravitas to challenge assumptions; and
• Design procedures to avoid conflicts of interest by examiners that may serve to undermine complete and effective inspections.

To provide further guidance, the Risk Alert also identified certain shortcomings in firms’ branch office examination processes.  The following were noted as significant deficiencies which impact the integrity of the overall branch inspection process.  In these instances, firms:

• Utilized generic examination procedures for all branch offices, regardless of business mix and underlying risk;
• Attempted to leverage novice or unseasoned branch office examiners who do not have significant depth of experience or understanding of the business to challenge assumptions;
• Performed the inspection in a “check the box” fashion without questioning critically the integrity of underlying control environments and their effect on risk exposure;
• Devoted minimal time to each exam and little, if any, resources to reviewing the effectiveness of the branch office exam program;
• Failed to follow the broker-dealer’s own policies and procedures by not inspecting branch offices as required, announcing exams that were supposed to be unannounced, or failing to generate a written inspection report that included the testing and verification of the firm’s policies and procedures, including supervisory policies and procedures;
• Failed to have adequate written supervisory procedures, particularly in firms that used an independent contractor model and allowed registered personnel to conduct business away from the firm; and
• Lacked heightened supervision for individuals with disciplinary histories (both past and present).

While the Risk Alert pertains to broker-dealer branch office inspections, many of its tips and suggestions are equally applicable to the risk assessments and tests that should be conducted by investment advisers and private fund advisers.

For additional information on broker-dealer branch inspections, please contact Brent Cunningham, Associate Attorney by email at brent.cunningham@jackolg.comor by phone at (619) 298-2880.

Upon receipt of Form 13H, the SEC will assign to each large trader an identification number that will uniquely identify the trader, which the large trader must then provide to its broker-dealers. After an initial filing, a large trader must file Form 13H as follows:

• Within 45 days after the end of each full calendar year; and
• Promptly after the end of any calendar quarter during  which time any of the information contained in the previously filed Form 13H becomes inaccurate for any reason.

Investment advisers and broker-dealers with discretionary authority over client assets may want to consider performing a review of trading activity over the last 12 to 24 months to determine whether they may fall under the definition of large trader, thus being required to make Form 13H filings. Should such firms determine that filings maybe necessary, the following additional steps should be considered:

• Implementing controls to capture aggregated transaction information going forward; and
• Establishing policies and procedures covering requirements and compliance with Rule 13h-1.

For additional information on or assistance with Form 13H, please contact Brent Cunningham, Associate Attorney by email at brent.cunningham@jackolg.comor by phone at (619) 298-2880.

Proposed FINRA Rule 5123 would require broker-dealers and their representatives to provide a PPM or term sheet to each investor prior to the sale of a private placement. Such disclosure would be required to describe the anticipated use of the offering’s proceeds, the amount and type of the offering’s expenses, and the amount and type of compensation to be provided to sponsors, finders and consultants in connection with the private placement.  Proposed Rule 5123 would also require “notice” filings of broker-dealers’ private placement activities. Specifically, the proposed Rule would require broker-dealers to file with FINRA the PPM, term sheet or other disclosure document (including exhibits) with FINRA no later than 15 calendar days after the date of first sale, and to timely file any material amendments to such document.

Notably, proposed Rule 5123 would exempt several types of private placements from the requirements noted above. Some of the Rule’s exemptions include private placements sold only to one or more of the following purchasers:

• Institutional accounts;
• Qualified purchasers;
• Qualified institutional buyers; and
• Investment companies.

As offerings sold exclusively to qualified purchasers are exempt, so-called 3(c)(7) funds would not have to comply with proposed Rule’s requirements.

For additional information proposed FINRA Rule 5123, please contact Brent M. Cunningham, Associate Attorney by email at brent.cunningham@jackolg.com or by phone at (619) 298-2880.

The following are two important exclusions from the definitions of “Placement Agent” under AB 1743:

• One-Third Rule – personnel of external managers who spend one-third or more of his or her time managing securities; and
• Competitive Bidding Process Rule – personnel of an external manager whereby the external manager is: (1) registered as an investment adviser or broker dealer with the SEC; (2) has been elected through a competitive bidding process; and (3) whose contract specifies the manager’s fiduciary standard of care.

It is important to specify that AB 1743 only applies to lobbying state retirement funds, such as the California State Teachers’ Retirement System (CalSTRS) and the California Public Employees’ Retirement System (CalPERS).  However, local lobbying ordinances may still govern the solicitation of local pension funds. Accordingly, if you are marketing your services to local retirement funds you should be mindful of any applicable registration, reporting or other requirements.

For additional information placement agents and lobbyist registration, please contact Brent Cunningham, Associate Attorney by email at brent.cunningham@jackolg.com or by phone at (619) 298-2880.