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News February 6 & 13, 2012 Issue

Dodd-Frank Act

Advisers have been experiencing Dodd-Frank Act (DFA) changes on an ongoing basis since the law became effective in the summer of 2010. The dayís third panel tried to make some sense of it all and offer some practical guidance.

Division of Investment Management deputy director Robert Plaze noted that the DFAís change to the federal registration threshold was expected to result in about 3,200 SEC-registered advisers moving to state registration. Every SEC-registered adviser however, must file a new Form ADV by March 30, if only to reaffirm their federally eligible status, he said.

Form PF issues.

Form PF is a very different form from Form ADV, said Plaze. Form PF is designed to support the Financial Stability Oversight Councilís systemic risk mission, not the SECís mission of protecting investors. The data that comes in to the SEC on Form PF will be primarily evaluated by the Office of Financial Research and OCIE.

Who signs the Form PF? The same group that would be qualified as signers on the firmís Form ADV are the qualified signers for Form PF as well, said Plaze.

If a private fund has only one investor, must it file on Form PF?

Whether such a private fund that otherwise meets the filing requirements would be subject to Form PF filing requires an analysis based on the individual facts and circumstances, said Plaze. The issues include whether the fund is relying on Investment Company Act Section 3(c)(1) or Section 3(c)(7) to avoid registration as an investment company, and whether the private fund is considered a pooled investment vehicle. Itís a good law school exam question, he observed, adding that anyone in that situation should consult with their counsel.

A few words on the Volcker Rule.

Plaze noted that the comment period on the proposed rule has been extended to mid-March. Some commenters have observed that if foreign banks are included under the Volcker Rule as proposed, it would extend to all USITS funds (registered funds trading in the European Union) as well. Commenters suggested that the SEC should narrow the ruleís broad language to reach only the offshore hedge funds intended to be targeted by the proposed rule, versus registered funds. The SEC is taking the observation under advisement, said Plaze. It will be an interesting drafting and policy exercise.

The recent American Bar Association no-action letter.

In January the staff of the Division of Investment Management issued a letter to the American Bar Association (ABA) that extended certain relief originally granted to the ABA in 2005 related to an adviserís special purpose vehicles.

What this new letter does, said Plaze, is identify the circumstances when two entities can register jointly on a single Form ADV registration. The letter does not address circumstances where one entity registers and another doesnít.

Plaze noted that technically every individual adviser representative meets the definition of investment adviser in the Advisers Act. Since shortly after the Advisers Act was adopted however, the SEC has interpreted that the Form ADV covers a firm and its adviser representatives. The 2005 letter to the ABA was issued when the Section 203(b)(3) carve out for 14 or fewer clients was in effect. The letter extended the "single enterprise" principle to circumstances where an adviser operating a special purpose vehicle (SPV) could simply provide information about the SPV on the adviserís Form ADV, and would not be required to separately register the SPV.

The recent no-action letter to the ABA confirms that the relief is still valid post-DFA, said Plaze. The letter also provides additional guidance, confirming that more than one SPV may be included on a single Form ADV, the presence of independent directors will not disturb the operation as a single business, and global operations can be permitted provided they operate as a single business.

The letter sets forth the circumstances for that to happen. If you donít meet the terms of the letter, said Plaze, entities must register on separate Form ADVs.

What happens if the principal registering adviser is offshore?

The letter does not address that circumstance and the staff did not offer any guidance or relief on that topic. If that is your circumstance, "you need to come talk to us," said Plaze.

Regulatory AUM and short positions.

The requirements of the amended Form ADV will generate a larger assets under management calculation, thatís why the name has been changed to regulatory assets under management (regulatory AUM), said Plaze. There are different ways to calculate the number, too. Regulatory AUM is not meant to be calculated solely in one way, he said.

Viking Global Investors general counsel Eric Komitee asked about the valuation of short positions in the calculation of regulatory AUM. Viking is a long/short equity fund, he said, and they are having difficulty determining how to accurately reflect short positions in the calculation.

"Follow your accounting practices on your balance sheet," said Plaze. The message is to look at your accounting, your balance sheet, and use that.

The staff anticipates it may issue FAQs on regulatory AUM in response to a number of questions it has received, including this one, he said.

Donít cut and paste risk factors into Form ADV Part 2 from your offering documents.

We have a strong preference that you donít do that, said Plaze. The staff has responded to this in its FAQs on the amendments to Form ADV. The response calls for only the material risks for each strategy, not all possible risks.

Some guidance for family offices.

Family offices are completely outside the Advisers Act, including the anti-fraud provisions, observed Plaze. It is an expression of Congressional intent that any conflicts be settled in family court, and it is not a concern of taxpayer assets to police.

On the topic of maintaining the "separateness" from a registered adviser, do the old no-action letters on separateness apply? Those letters are oldies, but goodies, said Plaze. It is a question of integration. The Section 203(b)(3) exemption has gone away, but the concepts have not gone away.

The key is in the Richard Ellis no-action letter, said Plaze. Those factors were applied in an international context but are also useful here. The factors determining whether a family office may be regarded as having a separate, independent existence from a registered adviser are:

  • Whether the family office is adequately capitalized;
  • Is there a buffer between the registered adviser and the family office Ė something like a board of directors that is independent of the adviser;
  • Separate employees, officers, and directors;
  • Independent provision of advice; and
  • That the family office keeps its advice confidential until communicated to its clients.

Plaze offered another note about family offices Ė spouses are included as family members, but not the spouseís parents. The staff has no plans to change this limitation. The difficulty is that you have to define "family," said Plaze. Weíre all members of the human family, but as a practical matter lines must be drawn on how far you can go.

The DFAís affect on OCIEís operations.

In the wake of the DFA, the estimate of private fund advisers that will be registering ranges from 800 to 2,000. We have hedge fund registrants, which are not new to us, "but clearly this will be a major step up," said OCIE deputy director Norm Champ. OCIE has launched a project around maintaining the confidentiality of information that will be received on Form PF.

Exempt reporting advisers and family offices have been carved out of the registration requirements, and examiners will be respectful of entities that are exempt. However, the staff will want to assure an entityís good faith belief in its exempt status.

The Office of the Whistleblower is up and running.

The SEC is averaging seven whistleblower tips a day collectively from the U.S. and about 24 other countries, said Champ. The tips cover a wide variety of issues, mostly corporate disclosures and financials, market manipulation and offering fraud. The difference in whistleblower tips is that the information coming in through the tips, complaints and referrals (TCRs) system can be more difficult to understand. The whistleblower system is producing a better class of TCRs and a better explanation of whatís going on. The Office of the Whistleblower website posts eligible actions and awards have already been applied for and are in process.

DFA and due diligence.

As a fund-of-funds, we spend a lot of time on operational due diligence and investment due diligence, said Arden Asset Management CCO Thomas Kennedy. The firm meets with several hundred asset managers a year, and compliance meets with a subset of those managers. It is our view that a compliance program is a necessary element of the managerís business whether it is registered or not under the new DFA regime, he said. "Emerging managers" are kind of a new concept for us, where smaller managers are executing specific transactions. How they will handle state regulation is an open question.

Weíre seeing a big gap in timing on readiness for registration, said Kennedy. The big hedge funds saw the writing on the wall and began preparing, other firms procrastinated, hoping it would go away. The biggest challenges tend to be cultural issues, said Kennedy. Traders will have a view that a compliance issue is not their concern, for example. The trader needs to understand that his role, the compliance role, and the legal role must all work together, in sync. Another challenge is in understanding all the disclosures required as a regulated entity.

To navigate these waters, registering advisers should "get the expertise, or hire it," he advised.

Which way to go when producing information to the SEC?

Komitee has been through an SEC examination and as part of that process he inventoried who within his firm maintains what records. That project was enormously valuable, he said. Update the list every six months, and partner with your IT department to track the documents and other information produced, Komitee advised.

He had a computer with access to the data produced to the SEC set up in the room available to examiners. "I like formal production," said Komitee. We have the technology to bates number pages for clarity. Document everything you produce, note where you narrowed responses, what the parameters were, where you made the cut, and also note any OCIE pushback so you can revisit adding to the production, he said.

We see the entire spectrum in the production of information in response to our requests, said Champ, from bates numbered formal productions to an unidentified box of documents. "Iíd say a little more formal is better," he said. For example, identify the materials you produce with a cover letter that says Ďthese documents respond to these questions,í and other similar identification.

When will OCIE release its examination manual?

The examination manual is non-public for now, said Champ. Once the initial version is tested and feedback is incorporated, then "Version 2.0" will be posted. Remember, he said, the exam manual is about "us," not "you." Does it show you how to be a better CCO? Not directly, thatís not the goal of the manual. The manual is aimed at how to be a better examiner. To the extent CCOs can glean information to better their compliance program, that is how it can be valuable to CCOs, he said.