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News May 7, 2012 Issue

Compliance Hot Topics For CCOs

Just when you thought you could take a breather (and you probably should, if only briefly), hereís a heads up on all things compliance that if youíre not already working on, should be on your radar.

At the ACA Compliance Group/ACA Insight Spring Compliance Conference, a panel of experts responded to the question Ė What is most important to CCOs in this regulatory environment?

Form ADV issues.

You just filed Form ADV and figure that item can go to the bottom of the pile, right? Donít move it there so fast, said ACA Compliance Group partner Gary Watkins. There are a few housekeeping items you should attend to first.

Deliver your firm brochure electronically.

If youíre not already doing this, you should be transitioning to it, said Watkins. Also remember those notice filings to your relevant states. If your firm has a place of business in a state, or more than five clients in a state, you should be notice filing there.

Form PF issues.

"I think this is the most complicated and challenging form of all time," said Watkins. The information required is overwhelming, and the first filing deadline (for liquidity funds) is in July.

Filers need to focus on responding to Form PF and getting it right. Any time the SEC adopts a new rule, it is likely that theyíre going to bring an enforcement action that makes an example of someone whoís not complying with the rule, said Watkins. You donít want your firm to end up in the cross hairs.

This is a 42-page form, with eleven pages of instructions and ten pages of definitions, said Lowenstein Sandler partner David Goret. "In my view it may become a more useful tool to you as CCOs than it will be for the SEC," he said.

One SEC advantage Ė it will allow them to be better informed when they come in to examine you. In some respects that is better, in some respects it may be worse.

How to count assets under management for Form PF purposes.

Just what is considered a Section 3(c)(1) or Section 3(c)(7) fund? Are co-investment vehicles included? How about family entity limited partnerships?

On Form PF, all are included, said Watkins. This is important because Form PF asset thresholds are met on an aggregate basis.

It is important to get clarity and advice on just what entities must be included, said Goret. If you mess up, it will make the SEC suspicious that other errors are out there and they will be more inclined to dig, he said.

Another important issue in responding to Form PF is the separate and distinct definitions that can rope an adviser into the filing requirement, said Watkins. For example, under the definitions, if you have the ability to short, youíre a hedge fund. To qualify as a private equity fund, the fund cannot engage in shorting and the fund must overtly disclose that it does not short.

This is important because hedge fund and private equity fund filing requirements are dramatically different under Form PF. The obligations flow from the determination of whether a fund is a hedge fund or a private equity fund.

The difference can be the difference between 50 man hours or 500 man hours to complete Form PF, said Watkins.

Private funds of funds must also file on Form PF, but need only complete the first section of the form.

The initial filing deadlines vary based on the size and type of private fund being reported. After the initial filings however, hedge funds with assets of more than $1.5 billion and liquidity funds with assets of more than $1 billion must file Form PF on a quarterly basis. All other filers must report annually.

Form PF is divided into four parts, each targeting the collection of information specific to different types of private funds, said Goret. All filers complete parts 1A and 1B. Hedge funds Ė and remember thereís a specific definition of "hedge fund" for Form PF filing purposes Ė complete part 1C and the "long, drawn out" questions in part 2. Liquidity fund managers complete part 3, and private equity fund managers complete part 4.

Goret has gone over the form many times. "I think there is a method to the madness. I think ultimately, itís going to make everybody smarter," he said.

It is critically important that compliance staff identify where this information resides within the firm and how to systematically capture it for reporting on a quarterly basis, said Goret.

The SECís Division of Investment Management now has a private funds branch, said Watkins. He anticipates that the group will post Form PF FAQs down the road, and that the group will be a resource for private fund advisers.

How confidential is Form PF information?

Form PF is submitted confidentially through a separate filing system, the Private Fund Registration Depository (PFRD), that is parallel to the current IARD filing system, both of which are operated by FINRA, said Watkins. The filings are not subject to Freedom of Information Act requests, and generally, no one will see the information but the SEC and possibly other regulators.

Advisers can "anonymize" their funds by giving them a number or other code identifier, but the identification must be used consistently by the adviser in its own day to day tracking methodologies and records.

At the end of the day, the goal is to assess systemic risk, not to examine individual funds, said Goret. Code identification should be sufficient.

Prudential Investment Management CCO James Hartmann agreed in principle, but as the veteran of eight SEC examinations at various firms he was more skeptical. "Weíll see if the identifiers hold up as the SEC starts doing exams," he said.

ERISA disclosures.

The Section 408(b)(2) disclosures are due July 1. "If it is applicable to you, youíve got some homework to do," said Watkins. Your compensation will be deemed unreasonable unless you make the appropriate disclosures. Private fund managers do not have to worry about this unless more than 25 percent of the fundís assets are ERISA assets. Watkins noted that the Department of Labor has a sample model disclosure form for guidance.

Pay to play rules.

Pay to play is a huge issue in an election year, said Goret. Firms active in this area should have strong policies and procedures. We recommend you make this part of your new hire process, said Goret. It is important to get a certification from the new hire, and to do a background check. Drill down not just at the federal election level, but also the state and local levels as well.

SEC Examinations.

There are no more routine examinations, said Watkins. He estimates that about half are risk selected, and half result from a tip, complaint, or referral. The SEC has made an effort to bring more expertise on board. Last year, the staff had six senior specialized examiners. Now more hiring has occurred and continues. For example, the Atlanta regional office has a current job posting for a specialized examiner.

Yes, the specialized units are the "swat teams" on the staff for various focus areas, said Hartmann. He also cautioned that advisers should keep an eye on the UKís Financial Services Authority (FSA). Theyíve recently brought a number of high profile cases on market conduct, tippees, and tippers. The FSA is bringing more criminal actions as well. The agency is following SEC practices and getting more aggressive. It is a very recent trend that began late last year and early this year, and worth noting, he said.

Now you will see senior people in examinations, said Watkins. The staff will say they are there for training and observation, but registrants should be very careful if senior staff joins an exam team.

In general, the SEC is really monitoring examiners now to ensure they close out examinations. The Dodd-Frank Act imposed a 180-day limit, and they are under pressure to get the exams done.

Donít expect two weeks notice of an examination, either, said Goret. Put together a team at your firm to respond if an examination comes your way.

It is important to have an exit interview, said Hartmann. The SEC may have bad or wrong facts or misunderstand something theyíve seen. You may disagree on the conclusions the staff might draw, but at least be sure they have a correct understanding and that the facts are right. Once something is put in a deficiency letter, you can respond, but the impression is out there. "Itís hanging over the firm like a Sword of Damocles," said Hartmann. If youíre not careful, it can cost the firm clients. He hears people say ĎI never want a deficiency letter.í "Well, youíre going to get one. It isnít their job not to find things," he said.

The top ten deficiencies found in SEC exams.

According to SEC staff who spoke at an ACA compliance roundtable in February 2011, the number one deficiency is meeting the terms of the compliance program rule itself. Here are the top trouble spots identified by the staff:

10. Trade allocations;

9. Pricing and valuation;

8. Brokerage execution;

7. Portfolio management;

6. Information processing;

5. Safety of client assets;

4. Personal trading;

3. Performance advertising;

2. Information disclosure and reporting;

1. Compliance program rule.

Current SEC Focus areas include:

  • Insider Trading
  • Valuation
  • Hedge fund side pockets
  • Performance advertising and marketing
  • Private fund expenses and fees
  • Custody
  • Compliance program
  • Trading
  • Conflicts of Interest
  • Marketing and sales of complex derivatives products.

What is the SEC looking for?

  • Accurate risk assessment, of both the firmís business risks and compliance risks;
  • Policies and procedures that appropriately address the firmís business and risks;
  • Regular training;
  • Testing;
  • Full, fair, and accurate disclosures; and
  • Documentation Ė of the business, of forensic testing, to evidence controls, of the annual review.

Final advice:

Your policies and procedures must be tailored to your firmís business, but donít make them too narrow or specific, said Watkins. More general and broad policies and procedures address a wider variety of situations that can come up. Policies that are too narrow will open your program up to additional scrutiny, he said.