This newsletter discusses recent key guidance releases, regulatory changes, noteworthy news and certain upcoming compliance deadlines. You are welcome to contact us to discuss any of the topics and deadlines.

RECENT GUIDANCE AND UPDATES

Jay Clayton Appointed Chairman of the SEC; Increased Examinations of Investment Advisers

Are You Prepared for an Exam?

ILPA Publishes Guidance on Subscription Lines of Credit

SEC Cyber Security Ransomware Alert

SEC Private Funds Statistics

REGULATIONS WITH RAMIFICATIONS

FINRA Letter Suggests Family Offices may be Investment Advisers

Revised Fiduciary Rule is Implemented by Dept. of Labor

SEC Amendments to Form ADV regarding Wyoming

Colorado Adopts Private Fund Exemption and Other Amendments to Investment Adviser Rules

Cayman Islands Introduces Limited Liability Partnership Vehicle

ENFORCEMENT MATTERS

Supreme Court Limits SEC Ability to Seek Disgorgement

Supreme Court Will Review Scope of Dodd-Frank Whistleblower Protections for Internal Reports

$2.5 Million SEC Whistleblower Award Goes to Government Employee

SELECTED Q3 2017 COMPLIANCE CALENDAR

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Jay Clayton Appointed Chairman of the SEC; Increased Examinations of Investment Advisers

Mr. Clayton was confirmed by the Senate on May 2, 2017 and sworn in as Chairman of the SEC on May 4, 2017. Prior to the SEC, Chairman Clayton was a partner at Sullivan & Cromwell LLP.

In a speech given by Chairman Clayton on June 27, he noted that the SEC is expected to increase its examinations of investment advisers by 20%, as well as continue its focus on investment advisers’ cybersecurity policies and shortcomings. Since his confirmation, we have noticed an uptick in private fund adviser examinations, in particular private fund advisers the SEC has not yet examined. If the SEC contacts you regarding an examination, we encourage you to contact us for assistance in responding to and cooperating with the SEC during the examination.

Are You Prepared for an Exam?

In light of the recent surge of private fund adviser examinations by the SEC, we have summarized eight steps a private fund adviser is advised to take before the SEC knocks on the door.

  1. Ensure all required records are organized and complete. Typically the first step of an SEC exam, after the introductory telephone call or meeting, is the SEC’s submission of a written request for documents and information about the firm. The SEC may make only a few requests to more than one hundred requests. It is not unusual for the firm’s response to these requests to be due in one or two weeks, and often little or no regard is given to holidays. This can be an incredibly short amount of time to identify, collect, prepare, and deliver the applicable documents to the SEC. The more organized and complete a firm’s records are, the more quickly and confidently the firm will be able to respond to the SEC’s documentation and information requests.
  2. Prepare and routinely update a summary of the firm’s business. As mentioned above, the SEC often commences an exam by calling the firm to notify the firm that it will be examined. While often nothing of substance is covered on this call, it can be helpful to be prepared to provide the SEC with basic background information about the firm, including its organizational structure, business purpose and basic operations. Additionally, the SEC will oftentimes begin the on-site portion of its exam with a meeting between the exam staff and the firm’s CCO and/or others in upper-management. At this meeting, firms often opt to make a short presentation (some using PowerPoint) to the SEC examiners about the firm and answer questions about the firm’s business. Due to the often short time frame between the initial phone call and on-site examination meeting, as well as the amount of time and work it takes to respond to the SEC’s requests for documents and information, it can be very helpful to be prepared in advance to provide the SEC with this important background information.
  3. Clearly establish each employee’s role during an exam. As a continuation of the general theme that “time is of the essence” during an SEC exam, the more organized and prepared a firm is in advance of an exam, the more effectively the firm is likely to be able to manage it. By identifying in advance who will be the face of the firm to the SEC, who will work with outside counsel, if engaged, in responding to the SEC’s requests, and who will manage the oftentimes sizeable task of collecting documents and preparing responses, a firm will be better equipped to efficiently cooperate with and respond to the SEC.

    It may be best to identify the person to fill each role by title/position, rather than by name, to manage the effect of employee turnover on this aspect of the firm’s exam preparation. Also, in many instances, the same person (typically the CCO) will perform some or all of the three jobs. The CCO is uniquely positioned to liaise with the SEC due to his/her understanding of the firm’s compliance obligations and the firm’s operations.
  4. Regularly and honestly assess the firm’s compliance program.   An internal audit or mock exam can be helpful way to assess the health of the firm’s compliance program. Additionally, the firm should regularly review and update its policies and procedures and ensure that its compliance program has sufficient resources (e.g., staff, technology, budget) to be effective. Firms are also encouraged to implement technology appropriate for its size and complexity to aid with compliance operations, as well as to give its CCO the authority and power to effectively implement and enforce the firm’s compliance program.
  5. Stay abreast of the SEC’s hot topics and areas of focus for their exams. Annually, the SEC publishes its exam priorities, which summarizes the areas of compliance on which it is primarily focused during its exams that year. Recently, cyber-security, custody, wrap free programs, electronic investment advice, Exchange-Traded Funds, multi-branch advisers, senior and retirement investors, public pension advisers, and private fund advisers have been hot topics. It will be important for the firm to know where it stands on the on exam priority issues in particular as the firm likely will be asked to produce records and information related to one or more of them. If there are any particular risks to the firm related to one of these areas of interest, a firm should be prepared to demonstrate how it mitigates or manages those risks and to produce the firm’s written policies or procedures related to those issues.

    The SEC’s 2017 exam priorities can be found here.
  6. Proactively identify anomalies in books and records. The SEC may use advanced data analytic programs to review a firm’s data, including its trading records. If a firm’s books and records or trading data contain anomalies or other significant discrepancies prior norms, the firm should be prepared to explain the cause.
  7. Train the firm’s employees how to comport themselves during on-site visits. Early in the exam process, the SEC will typically set a date on which it will arrive at the firm’s office and begin the on-site portion of its exam. Employees should be trained to not discuss business where the SEC’s exam staff may overhear it, including exercising caution in what is discussed in elevators, shouted down the hall, or otherwise said in the earshot of others. The firm’s employees should also be instructed to act professionally and courteously toward the SEC staff.
  8. Establish and maintain a tone from the top that compliance is important. The SEC has repeatedly stated that a firm’s upper-management should emphasize the firm’s compliance obligations in its business practices and to its employees. A senior officer’s involvement with a compliance related committee, as well as the company’s provision of adequate resources to its compliance department (e.g., staff, technology, budget), are strong indicators of a sound tone at the top. The SEC will notice upper-management’s apathy towards compliance during an exam. 

ILPA Publishes Guidance on Subscription Lines of Credit

The use of subscription lines to cover capital calls has evolved from short term bridge facilities (generally terms up to 90 days) into longer-term facilities for cash management and completing transactions thus allowing fund managers to spread out capital calls from fund investors. This expanded use of subscription lines, however, raises issues on the alignment of limited partner and general partner economic interests. The Institutional Limited Partners Association recently published new guidance on private funds’ use of subscription lines. Primary concerns include the effect such credit lines have on IRR calculations, credit line expenses, and the lender’s control rights under credit agreements. Additional information about this guidance can be found here.

SEC Cyber Security Ransomware Alert

In May, the SEC published a Risk Alert detailing a widespread ransomware attack known as WannaCry, WCry, or Wanna Decryptor. Hackers gained access to enterprise servers through the Microsoft Remote Desktop Protocol, phishing e-mails, or by exploiting a critical Windows Server Message Block version-1 vulnerability. The SEC recommended taking two steps in order to protect against WannaCry ransomware:

  1. Review the alert published by the United States Department of Homeland Security’s Computer Emergency Readiness Team.
  2. Evaluate and ensure that all applicable Microsoft Patches for Windows operating systems are correctly and promptly installed.

As noted in the SEC’s Observations from Cybersecurity Examinations, published on August 7, 2017, the SEC has observed shortcomings in advisory firms’ preparedness for cyber-attacks, including failing to adhere to a firm’s written cybersecurity policies, using outdated operating systems that were no longer supported by security patches, and failing to tailor a firm’s cybersecurity policies to its own business practices. We encourage all investment advisers to review the Observations from Cybersecurity Examinations, as it provides helpful guidance on this important issue. Similarly, the Financial Industry Regulatory Authority has created a list of cyber security resources and best practices that can be found here.

SEC Private Funds Statistics

In April, the SEC released its Private Fund Statistics for the third calendar quarter of 2016. The report, based on information reported in Form PF filings, provides a summary of industry trends and statistics of private funds. The data shows a steady rise in the number of funds from 2014 through 2016, as well as a rise in the aggregate private fund gross asset value and net asset value.

FINRA Letter Suggests Family Offices may be Investment Advisers

In May, the Financial Industry Regulatory Authority (“FINRA”) issued an interpretive letter regarding the meaning of the term “investment adviser” as used in Rule 5131. Rule 5131 prohibits underwriters from selling new issues to accounts in which officers or directors of certain public and non-public companies hold an interest. The letter suggested that family offices may be considered investment advisers under 5131(b)’s limited exception, which could facilitate a family office’s participation in new issues. The full FINRA letter can be found here.

Revised Fiduciary Rule is Implemented by Dept. of Labor

In a surprise to many in the industry, the Department of Labor elected to implement the proposed revisions to the “Fiduciary Rule” that we previously discussed in our most recent newsletter. The revised Fiduciary Rule, which became effective on June 9, expands the scope of who is considered a fiduciary under the Employee Retirement Income Security Act of 1972. Under the new rule, the act of marketing an investment fund or an adviser’s services to a potential retirement plan client, including a client investing through an IRA, could result in the investment adviser being deemed a fiduciary to the client and impose a higher “best interest” standard of care on investment advisers. Under the best interest standard, an investment adviser would not, for example, be able to charge a fee to the client in return for the advisory services that it provides to the client. There are limited exceptions to the new rule, but, taken as a whole, it significantly restricts the ability of investment advisers to market their investment funds and services to retirement plan clients. If you would like to market you investment fund or advisory services to retirement plan clients, including clients who would invest through their personal IRA, please contact us for additional information about how to do so while complying with the new Fiduciary Rule.

SEC Amendments to Form ADV regarding Wyoming

In May, the SEC published technical amendments to Form ADV under the Investment Advisers Act of 1940 (“Advisers Act”) in order to reflect a new Wyoming state law regulating investment advisers. Wyoming previously did not require registration of investment advisers, which resulted in Wyoming-based investment advisers with less than $100 million in assets under management being required to register as a mid-sized adviser with the SEC. The new Wyoming statute requires state-level registration of such mid-sized advisers, and the SEC has revised the Form ADV to accommodate this statute. The amendments became effective July 1, 2017. A link to the amendments can be found here.

Advisor Action Item – If registering on or after July 1, 2017, an investment advisers with principal office and place of business in Wyoming may not register with the SEC unless it has greater than $100 million in assets under management, advises a registered investment management company, or is eligible to rely on one of the exemptions from the prohibition on registration in Rule 203A-2 of the Advisers Act.

Colorado Adopts Private Fund Exemption and Other Amendments to Investment Adviser Rules

Colorado is catching up with many other states that have adopted state-level investment adviser registration exemptions for certain private fund advisers. Under new rules Colorado’s Division of Securities adopted on May 19, 2017, Colorado-based investment advisers who advise certain private investment funds and are not eligible to register as investment advisers with the SEC can be exempt from registering as investment advisers in Colorado. The new exemption became effective on July 15, 2017.

The new rules exempt Colorado-based private fund advisers from registering as investment advisers with the State of Colorado if:

  1. The adviser solely advises “qualifying private funds” (i.e., a private fund exempt from registration under Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (the “Investment Company Act”));
  2. The adviser and its advisory affiliates have not been subject to a “bad actor” disqualifying event under Rule 506(d) of Regulation D; and
  3. If any of the adviser’s qualifying private funds are exempt from registration as an investment company under Section 3(c)(1) of the Investment Company Act (a “3(c)(1) Fund”) of, then:
  • all investors in the investment adviser’s 3(c)(1) Funds must be “qualified clients”;
  • the investment adviser must make certain written disclosures to each investor at the time of such investor’s investment in the 3(c)(1) Fund; and,
  • the investment adviser must deliver annual audited financials to the 3(c)(1) Fund’s investors. 

Additional information on the new exemption can be found here.

In addition to the private fund exemption, the Colorado Division of Securities also adopted other amendments to its rules and regulations applicable to Colorado-registered investment advisers. Two notable amendments are a net worth requirement and cybersecurity policy requirement. Colorado-registered investment advisers are now required to have a net worth of at least $10,000 if they have discretionary authority over client funds and at least $35,000 if they have custody of client funds. Failure to maintain the requisite net worth must be self-reported to the Colorado Division of Securities. Colorado-registered investment advisers must also now establish and maintain written procedures designed to ensure cybersecurity of its clients’ assets and information. The policy should address, among other items, the adviser’s use of electronic communications, the adviser’s policies with respect to and training of its employees with regard to cybersecurity, and the adviser’s authentication practices. Colorado-registered investment advisers now must also include cybersecurity as part of its risk assessment procedures. 

Cayman Islands Introduces Limited Liability Partnership Vehicle

In June, the Cayman Islands introduced legislation that allows for registration of limited liability partnerships (“LLP”). The enactment date has not yet been released but it is anticipated that applications for registration will begin to be accepted in late 2017.

Supreme Court Limits SEC Ability to Seek Disgorgement

The Supreme Court held that a five year statute of limitations applies to actions by the Securities and Exchange Commission for disgorgement. The decision imposes a significant new limit on the SEC’s ability to seek recoupment of defendants’ profits in enforcement actions. The decision brings an end to a regulatory regime in which the SEC has applied separate time limits to its claims to monetary recovery depending on the theory of recovery, with SEC actions for “civil penalties” subject to the five-year statute of limitations of 28 U.S.C. § 2462, but its actions for “disgorgement” of profits not subject to any time limit.

Additional information on the case and ruling can be found here.

Supreme Court Will Review Scope of Dodd-Frank Whistleblower Protections for Internal Reports

On the last day of its session, the Supreme Court announced it will consider whether the Dodd-Frank whistleblower protections extend to corporate insiders who blow the whistle on their employers by reporting the alleged misconduct internally only rather than to the Securities and Exchange Commission. The Court will hear the appeal of Digital Realty Trust Inc. arising from an opinion of the 9th Circuit that held that the whistleblower protections of Dodd-Frank applied when the company allegedly fired its former executive for reporting alleged misconduct of his supervisor internally, but not to the SEC. 

Additional Information on the case can be found here.

$2.5 Million SEC Whistleblower Award Goes to Government Employee

On July 25, 2017, the SEC announced another whistleblower award – this one for almost $2.5 million. What sets this award apart from earlier awards is its recipient – “an employee of a domestic government agency.” This award shows that it is not only a company’s employees who may take internal issues to the SEC. Instead, outside contractors and even government employees may go to the SEC. This award suggests that the SEC will continue to publicize large monetary awards to encourage whistleblowers to provide evidence of larger-scale issues.

Additional information on the whistleblower award and order can be found here.

SELECTED Q3 2017 COMPLIANCE CALENDAR

The following compliance calendar includes selected upcoming deadlines for SEC-registered investment advisers and is not indented to be complete. State-registered investment advisers may be subject to additional or different deadlines. Please contact us to discuss which deadlines are applicable to you.

DEADLINE

FILING

August 14, 2017

Form 13F quarterly filing is due for applicable investment advisers.

August 29, 2017

Quarterly Form PF filing is due for all “large hedge fund advisers”.

August 29, 2017

Quarterly Form CPO-PQR is due for commodity pool operators.

September 30, 2017

Quarterly Form 13H is due in Q3 2017 for “large traders” with a Form 13H filing obligation and who have changes to any information reported.

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