Timing.  Managers with existing “covered plan” clients or fund investors must provide the required disclosure by July 1.  After July 1, managers must provide the relevant disclosure to new ERISA clients/investors before entering into contracts with such persons.

Ramifications of Non-Compliance.  As of July 1, 2012, an adviser not in compliance with these disclosure obligations will be subject to the prohibited transaction rules; a plan fiduciary may need to terminate an existing contract with the adviser or withdraw from the adviser’s fund and may be precluded from entering into a new contract or making a new investment with the adviser.  A non-compliant adviser would also be subject to Internal Revenue Code section 4975 excise taxes and penalties.

Background.  ERISA Section 408(b)(2) is a statutory exemption from ERISA’s section 406 prohibited transactions provisions, the provisions that would otherwise prevent the service provider from contracting to provide services to the plan.  Generally, ERISA plan fiduciaries are required to select and monitor service providers and plan investments with prudence and solely in the interest of the plan participants and beneficiaries. ERISA Section 408(b)(2) mandates that the plan fiduciaries only enter into service provider arrangements that are “reasonable”  with “reasonable” compensation paid for services that are necessary for the plan. The new provisions in Rule 408b-2 require covered service providers to provide fiduciaries with specific information the fiduciaries will need in order to meet their obligations under Section 408(b)(2) to determine the reasonableness of the total compensation (direct and indirect) paid to a plan service provider, its affiliates and/or subcontractors, identify potential conflicts of interest that may affect the service provider’s performance, and have the information to satisfy the fiduciaries’ own reporting and disclosure requirements under ERISA.

Information Required in Disclosure. Rule 408b-2 describes the information that should be included in the adviser’s disclosure.  EBSA has provided a sample summary chart which sets out the required categories and indicates where the fiduciary could find the information (i.e., in which document, section, page).   EBSA encourages advisers to use this sample guide as a template to cover the following categories of information:

• Description of the services that the adviser will provide the plan;
• Statement concerning which services the adviser will provide in the capacity of an ERISA fiduciary and which as a registered investment adviser;
• Direct compensation that the adviser will receive from the plan;
• Indirect compensation that the adviser will receive from parties unrelated to the adviser (sources, services, arrangements);
• Compensation that will be paid among the adviser and related parties;
• Compensation the adviser will receive if the plan terminates the agreement;
• Cost to the plan of the adviser’s recordkeeping services;
• Fees and expenses (i.e., transactional fees and total annual operating expenses) related to each of the plan’s investment options, e.g., each fund in which the plan is invested.

A Fact Sheet provided by the Department of Labor’s Employee Benefits Security Administration (“EBSA”)  provides examples of the type of information to be considered in providing the above disclosure.

Method of Disclosure.  The disclosures must be in writing, but can be made via electronic media if the disclosure is readily accessible to the plan fiduciary and there is clear notice to the fiduciary on how to access the information. In the future, advisers may want to consider including the disclosure in their Forms ADV. The rule does not require a service provider to set out the disclosure obligations in a written contract.

Ongoing Disclosure Obligations; Correction of Errors.  Generally, changes to initial information should be provided as soon as practicable, and no later than 60 days from when the adviser is informed of the change. Disclosure of changes to investment-related information must be made at least annually.  Upon a plan fiduciary or administrator’s request, an adviser must disclose relevant information reasonably in advance of the date such person says it must comply with ERISA’s requirements.  Generally, if an adviser learns of an error or omission in the disclosure it has provided, it should make corrections within 30 days.

Covered Plans.  As noted above, the rule applies to ERISA-covered defined benefit and defined contribution pension plans.  Simplified Employee Pension plans, SIMPLE retirement accounts, IRAs and certain annuity contracts and custodial accounts are not subject to the rule.  There will be separate disclosure requirements for welfare benefit plans.

Covered Service Providers (“CSPs”).  The rule applies to the following covered service providers who expect at least $1,000 in compensation to be received for services to a covered plan:

• ERISA fiduciary service providers to a covered plan or to a “plan asset” vehicle in which such plan invests;
• Investment advisers registered under Federal or State law;
• Record-keepers or brokers who make designated investment alternatives available to the covered plan (e.g., a “platform provider”);
• Providers of one or more of the following services to the covered plan who also receive “indirect compensation” in connection with such services: accounting, auditing, actuarial, banking, consulting, custodial, insurance, investment advisory, legal, recordkeeping, securities brokerage, third party administration or valuation services.

Resources. The Final Rule Release, Fact Sheet and EBSA’s Sample Guide should be consulted for further information. The Department of Labor is expected to issue FAQs to clarify questions related to this new rule.

Rule 13h-1; Form 13H.  Rule 13h-1, adopted on July 27, 2011, applies to “large traders” and registered broker-dealers and is designed to help the SEC identify and obtain trading information on “large traders.”  Generally, “large traders” are traders of U.S. listed equities trading 2 million shares or $20 million on any day or 20 million shares or $200 million in any month,  and will be the persons with investment discretion (e.g., the investment advisers or commodity pool operators) over these accounts.  Large traders may be U.S. or foreign, regulated or unregulated, and include individuals, companies, general partnerships and limited partnerships. Large traders are required to file a Form 13H and are assigned “LTIDs,” large trader identification numbers that they are required to provide to registered broker-dealers with which they have accounts in which they may trade NMS Securities, e.g., exchange-listed equity securities and standardized options.

New Large Trader FAQs. The SEC has posted Large Trader FAQs with additional guidance for large traders on determining if they meet the filing thresholds, completing Form 13H, filing/amendment dates and  LTID numbers and for broker-dealers regarding broker/dealer recordkeeping and reporting. Among the issues clarified are the following:

• NMS Security.  NMS Securities include exchange-listed equity securities and standardized options, but do not include exchange-listed debt securities, securities futures, or open-end mutual funds, which are not currently reported pursuant to an effective transaction reporting plan.  The FAQs provide links to the effective transaction reporting plans and the effective national market system plan for the reporting of transactions in listed options that are relevant for purposes of Rule 13h-1, current as of March 2012.
• Identifying Activity Levels.  The FAQs make it clear that when calculating the threshold trading levels, that the level applies to all of a person’s trading in NMS Securities and that transactions should not be netted within or among accounts, provide examples about how to calculate options in determining whether or not a threshold is met
• Item 6: Identification of Registered Broker-Dealers. Item 6 requires the filer to identify all registered broker-dealers at which the large trader or its Securities Affiliates have an account for the trading of NMS Securities, whether or not any NMS securities transactions were effected during the reporting period. At the filer’s option, it may list non-registered broker-dealers (e.g., non-U.S.), and broker-dealers that handle accounts involving  non-NMS Securities.
• First Annual Filing; Annual Filings following Amendment Filings. For large traders who registered by the December 1, 2011 compliance date, the first annual filing will be required for the period ending December 31, 2012. For large traders who register starting in 2012, an annual filing is required at the end of each calendar year. At this time, a large trader that has filed an amended Form 13H to reflect changes made during the fourth calendar quarter is still required to file the annual update to Form 13H, within 45 days after the calendar year-end.

 Exemptions of Certain Transactions from Calculation of Thresholds.  In its Order, the SEC has exempted the following transactions involving securities offerings from the Rule 13h-1 definition of the term “transaction” for the sole purpose of determining whether a person meets the identifying activity thresholds for being a large trader:

•  any transaction that is part of an offering of securities by or on behalf of an issuer, or by an underwriter on behalf of an issuer, or an agent for an issuer, whether or not such offering is subject to registration under the Securities Act of 1933, regardless of whether such transaction is effected through the facilities of a national securities exchange; and

• sales of securities by a selling shareholder in connection with an initial public offering or in a registered secondary offering if such selling shareholder is a current or former employee of the issuer and the securities being sold were acquired as part of the person’s compensation as an employee of the issuer. Rule 13h-1 as adopted included exemptoins for certain transactions that are not effected with an intent that is normally associated with secondary-market trading activity.

Extension of Compliance Date for Most Broker-Dealers. The Rule 13h-1 Adopting Release set  a December 1, 2011 compliance date for large traders to identify to the SEC on Form 13H, and a later compliance date of April 30, 2012 for registered broker-dealers to maintain records, report, and monitor large trader activity.  In response to input from industry groups, the Financial Information Forum (“FIF”) and the Securities Industry and Financial Markets Association (“SIFMA”), the SEC’s Order extends the broker-dealer compliance date to May 1, 2013 for most registered broker-dealers.

The SEC has ordered a shorter compliance date extension, to November 30, 2012, for recordkeeping and reporting (but not monitoring) requirements for certain broker-dealers that it considers will have an easier time complying with those requirements.  The November 30, 2012 compliance date will apply  to clearing broker-dealers that (1) are themselves large traders, or (2) have large trader customers that are either broker-dealers or that trade through a “sponsored access” arrangement. A “sponsored access” arrangement is one in which the large trader is allowed by the broker-dealer to enter orders directly to a trading center where the orders (i) are not processed through the broker-dealer’s own trading system (other than certain risk management controls); and  (ii) are routed directly to a trading center (which may be supported by a service bureau or other third party technology provider).

The SEC indicates in the Order that it is extending the compliance date to allow broker-dealers additional time to develop, test, and implement enhancements to their recordkeeping and reporting systems as required under Rule 13h-1, and, for those broker-dealer requirements for which the compliance date has been extended to May 1, 2013, for the SEC to consider requests for relief from certain provisions of the Rule.

Additional Resources. The Final Rule release may be found here and a copy of Form 13H may be found here.

All private fund managers required to report on Form PF generally will be required to fill out a separate Section 1b for each private fund advised.  Item B. Question 16 asks the manager to “specify the approximate percentage of the reporting fund’s equity that is beneficially owned” by each listed category of investors (detailed below), with the total adding up to approximately 100%.

The instructions for Question 16 note that a manager may respond using “good faith estimates based on data currently available” to the manager with respect to interests purchased prior to March 31, 2012  that have not been transferred on or after that date.  March 31, 2012 was the effective date of Form PF and the related rules under the Commodity Exchange Act and Investment Advisers Act of 1940.  In the Form PF Adopting Release, the SEC explained that they were permitting this flexibility because they realized that “advisers managing funds with securities outstanding prior to the adoption of Form PF would have to take additional steps in order to obtain this information because the investor diligence process will already have been completed.”  The SEC expects that managers will have had the time to take those additional steps to acquire data with respect to the beneficial ownership of interests purchased (or transferred) on or after March 31, 2012.

In order to accurately answer Question 16, a private fund manager will need to know which of the following groups each of its private fund investors (or transferees, if applicable) falls into:

(a) Individuals that are United States persons (including their trusts);

(b) Individuals that are not United States persons (including their trusts);

(c) Broker-dealers;

(d) Insurance companies;

(e) Investment companies registered with the SEC;

(f) Private funds;

(g) Non-profits;

(h) Pension plans (excluding governmental pension plans);

(i) Banking or thrift institutions (proprietary);

(j) State or municipal government entities (excluding governmental pension plans);

(k) State or municipal government pension plans;

(l) Sovereign wealth funds and foreign official institutions; or

(m) Investors that are not United States persons and about which the foregoing beneficial ownership information is not known and cannot reasonably be obtained because the beneficial interest is held through a chain involving one or more third-party intermediaries.

Form PF includes a catch-all category “Other” for any investors not fitting into any of the above categories.

Form PF Filers; Further Information: An investment adviser meeting all of the following criteria will be required to file Form PF:  (i) the adviser is an SEC-registered investment adviser or an SEC-registered investment adviser that is also registered with the Commodity Futures Trading Commission as a commodity pool operator or commodity trading adviser; (ii) the adviser manages one or more private funds; and (iii) the adviser and its related persons (as defined in Form ADV), collectively, had at least $150 million in private fund assets under management as of the last day of its most recently completed fiscal year.  Initial filing dates, frequency and timing of filings and which sections of Form PF are required will depend on factors including the type of private fund adviser (i.e., hedge fund, liquidity fund or private equity fund), regulatory assets under management attributable to such funds and the adviser’s fiscal year end. Liquidity fund advisers with over $5 billion in liquidity fund assets under management (and a December 31 fiscal year end) will be the first Form PF filers, with a July 15, 2012 filing deadline.  Hedge fund advisers with over $5 billion in hedge fund assets under management will have an August 29, 2012 deadline.  Initial filing dates for all other private fund advisers with December 31 fiscal year ends will not be until 2013. For further information, see the SEC’s Small Entity Compliance Guide about Form PF. The SEC Division of Investment Management is expected to issue an FAQ on Form PF, including clarifications on how to calculate assets in the fund of funds context.

Private Funds Reporting Depository (PFRD).  Form PF information will be submitted and viewed via a new system called the Private Fund Reporting Depository (PFRD). The PFRD system is scheduled to be effective June 4, 2012; user testing of PFRD is already possible. SEC-registered advisers are expected to receive entitlement to PFRD on June 1, 2012.

HedgeOp encourages each of our private fund manager clients to contact counsel regarding updates to subscription agreements to reflect the information requested on Form PF.

The Final Rules generally will be effective 60 days after the date of publication in the Federal Register, but their practical effect is tied to registration of these entities, which is not yet required. The CFTC has published a Final Rule governing the registration process for swap dealers and major swap participants and has said that swap dealer and major swap participant registration will begin 60 days after publication of the final CFTC definition of “swap.” The SEC has not yet finalized dealer and major participant registration rules; security-based swap dealers and major security-based swap participants will not have to register with the SEC until the dates that will be provided in such final registration rules.

This post is an overview of the definitions of  “swap dealer” and “security-based swap dealer.” The definitions of “major swap participant” and “eligible contract participant” and the CFTC’s Final Rule and Interim Final Rule on Commodity Options, adopted at the same meeting, will be discussed in future posts. This post is based on the meetings at which the Final Rules were approved, the SEC’s Fact Sheet and the CFTC’s Fact Sheets and Q&As, which should be consulted for further guidance. This post does not reflect an analysis of the 644-page Final Rules release, which the CFTC and SEC have only recently posted.

Regulatory Background: Title VII of Dodd-Frank.  Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) established a regulatory framework for the over-the-counter swaps markets, requiring dealers and major participants to register and subjecting them to certain requirements, including regulations governing capital, margin, position limits, conflicts of interest, business conduct, reporting, recordkeeping, and disclosure. Among other mandates, Title VII required the CFTC and SEC to act jointly to define the terms adopted in the Final Rules, and to define terms such as swap, security-based swap, and security-based swap agreement. Under Dodd-Frank, the SEC has the authority to regulate security-based swaps (e.g., those based on a single security, a loan, a narrow-based group or index of securities or events relating to a single issuer or issuers in a narrowly-based security index), while the CFTC will regulate all other swaps, including interest and commodity-linked swaps (such as energy and agricultural swaps), which, as noted previously, constitute the vast majority of the swaps market. The CFTC and SEC share authority over mixed swaps, which are security-based swaps that also have a commodity component.

De Minimis Thresholds for Swap and Security-Based Swap Dealers.  Most significantly, the Final Rules raise de minimis thresholds for registration as a swap dealer or a security-based swap dealer manifold from the $100 million notional threshold in the Proposed Rule. For most asset classes, the de minimis threshold for an initial  phase-in period (further discussed below) will be $8 billion in  gross notional activity measured over the preceding twelve months; following the phase-in period, the general threshold will drop to $3 billion, subject to adjustment by each Commission based on data collected during the phase-in period. The phase-in of $8 billion represents $32 million notional per trading day, while the $3 billion threshold represents $12 million notional per trading day. These increased de minimis thresholds, discussed below in greater detail, reduce the number of companies that will be required to register and be subject to regulatory oversight, while still capturing the majority of swap dealer activity. Notably, swaps not connected to “dealing” activity, e.g., swaps that are used for certain hedging purposes, will not count toward the thresholds. The Final Rules do not place limits on the number of swaps that a person can enter or on the number of a person’s swap counterparties in a dealing capacity.

Swaps/Security-Based Swaps with “Special Entities.”  The Final Rules set a de minimis threshold of $25 million in notional amount over the prior 12 months for swaps and security-based swaps with special entities (which generally includes certain governmental enitities, municipalities, employee benefit plans and certain other entities). This threshold is not expected to change following the phase-in period. 

Phase-In Periods.  The phase-in periods will differ for the CFTC and SEC de minimis thresholds. The termination dates are not yet set and generally are tied to the dates each Commission completes its study of the swap markets.  Absent Commission action, the phase-in periods will terminate automatically five years after data starts to be reported to swap data repositories.

Swap Dealer/Security-Based Swap Dealer.  The first question to be addressed is whether the person is actually engaging in “swap dealing” activity.   Dodd-Frank sets out four activities that will determine the answer to this question, considering whether the person is:

• holding itself out as a dealer in swaps;
• making a market in swaps;
• regularly entering into swaps with counterparties as an ordinary course of business for its own account; or
• engaging in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.

The CFTC and SEC final definitions track these four activities with respect to swaps and security-based swaps, respectively. The Final Rules provide interpretive guidance on the following aspects of applying the definitions:

• market participants may consider SEC precedents to distinguish between dealing and trading;
• focus on entities that routinely seek to profit by accommodating other market participants’ demand for swaps to clarify what Dodd-Frank meant by “makes a market in swaps”;
• focus on the activities that are usual and normal in the person’s course of business and whether a person has an identifiable swap dealing business to clarify the term “regular business”; and
• direction on the distinction between hedging and dealing.

The Final Rules exclude from the definition of swap dealer/security-based swap dealer persons that enter such swaps for their own accounts, whether individually or as fiduciaries, but not as a part of a regular business.

De Minimis Thresholds. If it is determined that the person engages in swap dealing activity, the next question is whether or not the person’s swap dealing activity exceeds the de minimis thresholds.

CFTC’s De Minimis Thresholds. The de minimis thresholds for the initial phase-in period are as set out above. Following the phase-in period, the $8 billion gross notional de minimis threshold will drop to $3 billion, subject to adjustment by the CFTC based on the data collected during that time.  The $25 million gross notional threshold will not change following the phase-in period. According to the CFTC’s statements in the Final Rules Release, persons who could avail themselves of the higher initial phase-in period de minimis threshold will not be required to do so; a person that is engaged in dealing activity involving swaps in excess of the $3 billion threshold may choose to start the process of registering as a swap dealer during the phase-in period.

The CFTC’s Q&A specifies that the following swaps are excluded by the Final Rule: swaps entered into by an insured depository institution in connection with originating a loan, swaps between majority-owned affiliates, agricultural swaps between an agricultural cooperative or cooperative financial institution and its members, and swaps entered into to hedge physical positions. An interim final rule defines “hedging,” drawing on the CFTC’s interpretation of “bona fide hedging”, so that swap activity for the purpose of portfolio hedging and anticipatory hedging would not be considered “hedging.” The CFTC’s Fact Sheet provides further detail on the criteria to be considered in excluding certain hedging swaps.  The CFTC welcomes comment on whether these swaps are appropriately excluded.

The CFTC estimates that 125 entities will be covered as swap dealers or major swap participants under the Final Rule, and that only six will be major swap participants.

SEC’s De Minimis Thresholds.  For the initial phase-in period, companies conducting more than (i) $8 billion of  aggregate gross notional activity in credit default swaps, (ii) $400 million in such activity in other security-based swaps, or (iii) $25 million in such activity in swaps with a “special entity,” in each case measured over the preceding twelve months, will be considered swap dealers that will be required to register with, and be regulated by, the SEC. Following the phase-in period, the de minimis thresholds will drop to $3 billion and $150 million, for credit default swaps and other security-based swaps, respectively, subject to adjustment by the SEC based on the data collected during that time.  The $25 million threshold will not change. According to the Final Rules Release, any person that chooses to register with the SEC as a security-based swap dealer will be deemed  a security-based swap dealer subject to all applicable regulatory requirements, regardless of whether the person engages in security-based swap dealing activity in an amount that is below the applicable de minimis threshold or phase-in level.

The SEC estimates that the $3 billion de minimis threshold would capture  up to 99.9% of dealing activity, that single-name credit default swaps will constitute 95% of the security-based swaps market, and that up to 50 firms may register as security-based swap dealers.

Registration; Limited Designation.  If the person engages in swap dealing activity that exceeds the de minimis thresholds, the person is a swap dealer and will be required to register. When it does register, it may apply to limit its designation as a swap dealer to a particular type, class or category of swap or security-based-swap or to specified activities of the person in connection with swaps. The application to limit designation may be made with the registration application or at a later time.

Additional Information. The Final Rules Release may be found here.  For the CFTC Fact Sheet and Q&A on the Final Rulemaking with Further Definitions, see here and here.  The SEC’s Press Release and Fact Sheet may be found here.

In addition to finalizing proposed rules, both the CFTC and the SEC are working on an approach to the cross-border application of Title VII, to establish  international standards for products and entities in this area.

HedgeOp is carefully following the regulatory process and will keep you informed of further developments in SEC and CFTC rules governing the swaps market.

The “Investment Adviser Oversight Act of 2012”  would give the Securities and Exchange Commission (“SEC”) authority to approve the registration of, and to oversee, National Investment Adviser Associations (NIAAs). SEC-registered investment advisers and investment advisers that are regulated or required to be regulated as investment advisers in the states in which they maintain their principal offices and places of business generally would be required to become members of a registered NIAA.

Exempt Investment Advisers.  Under the proposal, the following investment advisers would be exempt from the NIAA membership requirement:

(1)     any investment adviser with at least one client that is a registered investment company;

(2)     any investment adviser with 90% or more of its total assets under management attributable, individually or in the aggregate, to one or more of the following persons pursuant to a written investment advisory agreement:

o    a client that is not ‘in the United States’ (as defined in Advisers Act section 202);

o    a qualified purchaser under the Investment Company Act of 1940 (the “Company Act”);

o    an issuer that would be an investment company, but for section 3(c)(5)(C), 3(c)(10) or 3(c)(11) of the Company Act or Rule 3a-7 issued under the Company Act’

o    a private fund;

o    a company that has elected to be a business development company pursuant to section 54 of the Company Act and has not withdrawn its election;

o    an SEC-registered investment adviser or an investment adviser that is regulated or required to be regulated as an investment adviser in a State in which it maintains its principal office and place of business;

o    an SEC-registered broker or dealer; and

o    an employees’ securities company that has been granted an exemption under section 6(b) of the Company Act (and any such company that has filed an application for such an exemption and that is exempt pending final determination of such application);

(3)     any investment adviser that is controlling, controlled by, or under common control with one or more investment advisers described in (1) or (2) (‘affiliated investment advisers’), if the affiliated investment advisers and all such investment advisers described in such paragraph, have combined assets under management 90 percent or more of which are attributable to one or more of the types of clients described in paragraph (1) or (2), unless the SEC, by order, determines that such affiliated investment adviser is an independent affiliate;

(4)     any investment adviser that is a member of any other national investment adviser association registered with the Commission; and

(5)     any other investment adviser or class of investment advisers that the SEC may exempt by rule or regulation.

NIAAs.  The legislation would require the SEC to determine whether an NIAA has the capacity to carry out the purposes of the Advisers Act and to enforce compliance by its members and their employees with the Advisers Act, the SEC’s rules, and the NIAA’s rules before the association can register as an NIAA.

Specifically, the proposed legislation would require the SEC to determine that the NIAA’s rules:

• are designed to prevent fraud and protect investors;
• are consistent with the Advisers Act and fiduciary duties under the Act and state law;
• do not impose any burden on advisers that is not in the public interest or for investor protection;
• provide for periodic examinations of members and their related persons, and for coordination of those examinations with the SEC and state securities authorities;
• assure a fair representation of the public interest and the investment adviser industry in its selection of directors and administration of its affairs, and provide that a majority of its directors do not come from the securities industry; and
• provide for equitable allocation of dues and fees and establish appropriate disciplinary procedures for members and their associated persons that violate the Advisers Act, SEC rules or NIAA rules.

State Authority.  The proposal gives the states authority over investment advisers with under $100 million in assets under management, provided that the state conducts periodic on-site examinations.  This approach is consistent with Dodd-Frank’s having given the states authority over small investment advisers.  The proposal specifically states that the legislation does not preempt state authority to “adopt rules, investigate possible violations of State law, initiate enforcement proceedings, or otherwise regulate any investment adviser that is subject to State authority under section 203A(a).”  In addition, under the proposal, the NIAA would not conduct periodic examinations of any investment adviser in a state in which the investment adviser is regulated or required to be regulated and maintains its principal office and place of business; and that has adopted a plan to conduct an on-site examination of all such investment advisers on average at least once every four years.

As indicated in the Instructions to the Form 13H, an Amended Filing must be filed “promptly following the end of the calendar quarter in which any of the information contained in a Form 13H filing becomes inaccurate for any reason.”  In the context of initial filings and reactivating filings, the SEC suggests that “under normal circumstances,”  “promptly” means within ten days.

Per the Instructions, a large trader must file an Amended Filing when, for example, it changes its name, business address, organization type (e.g., the large trader partnership reincorporates as a limited liability company), or regulatory status (e.g., a hedge fund registers under the Investment Company Act), or when its organizational chart changes in a manner relevant under Item 4(a) (e.g., it adds or removes a Securities Affiliate).”  The Final Rule Release gives a few other examples of information that may have changed: contact information, trading strategy, list of broker-dealers at which the large trader has an account, or description of affiliates.

The JOBS Act combines six smaller bills that will alter SEC rules to increase capital formation, help start-ups grow, allow more small businesses to go public and create more jobs. The Senate voted 73 to 26 to approve the JOBS Act earlier this week, and sent  the bill back to the House for approval of certain amendments made by the Senate to add investor protections.  The House overwhelmingly approved the bill as amended in a 380-41 vote.  All “No” votes in the Senate had been by Democrats.  SEC Chairman Mary Schapiro and numerous consumer and investor groups had expressed concerns that the JOBS Act is excessive deregulation, weakening protections put in place after Enron and the dot-com era, and promoting “boiler room” operations.

General Solicitation and General Advertising.  With the new amendments, private funds will be able to market their offerings more easily and to wider audiences; currently, private funds are limited to marketing to persons with whom they have pre-existing, “substantive” relationships.  The SEC’s amendments may provide further guidance on the types of marketing activities that would be permitted.  In any case, although general solicitation and general advertising will be permitted, there will still be a restriction on  who may purchase the private securities. Only accredited investors, generally, individuals with at least $1 million in net worth, not including the value of a primary residence, or entities with at least $5 million, will be permitted to buy the securities.

The “Access to Capital for Job Creators Act,” Title II of the JOBS Act, requires the Securities and Exchange Commission (the “SEC”)  to revise Rule 506 so that the Rule 502(c) prohibition against general solicitation and general advertising does not apply to offers and sales of securities made in a Rule 506 offering where all purchasers are accredited investors.  The SEC is mandated to require the issuer to take “reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined” by the SEC.  Rule 506 will remain a safe harbor under Section 4(2) of the Securities Act of 1933, the general exemption from registration for transactions by an issuer “not involving any public offering.”  The SEC will be required to revise its rules within 90 days of enactment of the JOBS Act.

Private funds making offerings in the United States generally rely on Rule 506 to exempt them from the requirement to register their securities and on either Section 3(c)(1) or Section 3(c)(7) under the Investment Company Act of 1940 to exempt them from the requirement to register as investment companies.  As discussed, Rule 506 currently includes a prohibition on general solicitation; Section 3(c)(1) and Section 3(c)(7) each require the issuer not to make a public offering, which has been interpreted as prohibiting general solicitation. As mentioned above, to avoid a general solicitation, an issuer (or its agent) generally has been required to have a pre-existing relationship with a potential investor, and a basis to believe that the investor meets sophisticated or accredited investor criteria, before the issuer (or its agent) is permitted to notify the potential investor that unregistered securities are available for sale.

Interplay with Other Regulations. In determining what changes may be made in their marketing activities, private funds may need to consider other regulations by which they may be governed that require the delivery of certain disclosure documents or that may require them not to make public offerings, e.g., if a fund is a “commodity pool” with disclosure document requirements or a commodity pool operator is exempt from registration under a provision of  Commodity Exchange Act 4.13 that may require that there be no advertising of the pool or that it may not be marketed to the public. These issues will require further analysis.

Exchange Act Registration Threshold.  Another provision of interest will raise the investor threshold for registration under the Exchange Act from 500 “holders of record” to 2,000. Private funds relying on the Section 3(c)(7) exemption from registration under the Investment Company Act of 1940 are currently subject to the 499 holders cap pursuant to the Exchange Act and would now be permitted to have up to 1,999 holders of record before being subject to Exchange Act registration.

Rule 144A.  The Act requires the SEC to revise Securities Act of 1933 Rule 144A(d)(1) within 90 days of enactment to provide that securities sold under the revised exemption may be offered to persons other than qualified institutional buyers, including by means of general solicitation or general advertising, provided that securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe is a qualified institutional buyer.

HedgeOp will closely monitor the SEC site and provide further updates on any developments.

Under the Proposed Rules, which include guidelines and examples of red flags, both Commissions would require written policies and procedures for identifying red flags, detecting  their occurrence, responding to red flags and identity theft and periodically updating the Program.  The Proposed Rules and guidelines are risk-based and the regulated entity would consider financial, operational, compliance, reputation, or litigation risks in determining whether there is a “reasonably foreseeable risk” of identity theft that would call for the entity to put a Program into place.  As more fully explained below, it is expected that most registered investment advisers, commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs”) would not be required to put Programs in place under the Proposed Rules.

Entities Covered by the Proposed Rules.  Per the SEC’s “scope” provision, broker-dealers, registered investment companies and registered investment advisers that are “financial institutions” or “creditors” under the FCRA (see definitions below) would come under the SEC’s proposed Regulation S-ID.  Exempt reporting advisers (and other entities not registered with the SEC) would not be subject to the SEC’s rule as proposed.  The CFTC would add Subpart C—Identity Theft Red Flags to CFTC Regulations Part 16, “Protection of Consumer Information under the Fair Credit Reporting Act”. Subpart C would govern specific “financial institutions” and “creditors”, including CPOs, CTAs and major swap participants, entities that the CFTC considers will be more likely to open or maintain covered accounts, or pose a reasonably foreseeable risk to customers or to the safety and soundness of the financial institution or creditor from identity theft.

Most RIAs, CPOs and CTAs Unlikely to be Required to Put Programs in Place. The SEC estimates that, by nature of their operations, only 10% of registered investment advisers would qualify as financial institutions or creditors carrying covered accounts, the categories that would require them to put Programs in place.  The CFTC similarly estimates that only 10% of CTAs and CPOs are likely to  qualify for purposes of the CFTC’s proposed rule. Most registered investment advisers are unlikely to hold transaction accounts and so would not qualify as “financial institutions” covered by the SEC’s proposed rule. Nevertheless, the SEC has not excluded them from the definition of “financial institution” and requests comments on whether investment advisers or any other SEC-registered entity should be omitted from the list of entities covered by the proposed rule. The Commissions state that the proposed definition of “creditor” would not include investment advisers, CPOs or CTAs, because they generally bill in arrears, i.e., on a deferred basis, are not considered to be “advancing funds” to investors and clients under the proposed definition.

“Financial Institution”.  The Commissions are proposing to define “financial institution” as having the same meaning as in the FCRA. “Financial institution” is defined to include certain banks and credit unions, as well as “any other person that, directly or indirectly, holds a transaction account belonging to a consumer.”  A “transaction account” is defined as “a deposit or account on which the depositor or account holder is permitted to make withdrawals by negotiable or transferable instrument, payment orders of withdrawal, telephone transfers, or other similar items for the purpose of making payments or transfers to third parties or others.”

The SEC does not detail any particular entities to be included as “financial institutions” under the proposed rule.  The CFTC’s proposed rule, however, does specify that “financial institution” includes “any futures commission merchant, retail foreign exchange dealer, commodity trading advisor, commodity pool operator, introducing broker, swap dealer, or major swap participant that directly or indirectly holds a transaction account belonging to a customer.”

“Creditor”.  The Commissions propose to define “creditor” by reference to its definition in the FCRA, as amended by the Red Flag Program Clarification Act of 2010 to clarify that businesses that may “advance funds … or that may bill in arrears for services provided, should not be considered creditors.” The SEC does not add any entities to the definition, but the CFTC’s proposed definition of “creditor” would include “any futures commission merchant, retail foreign exchange dealer, commodity trading advisor, commodity pool operator, introducing broker, swap dealer, or major swap participant that regularly extends, renews, or continues credit; regularly arranges for the extension, renewal, or continuation of credit; or in acting as an assignee of an original creditor, participates in the decision to extend, renew, or continue credit.”

Small Impact Foreseen.  In part due to accepted best practices, the Commissions believe that financial institutions and creditors subject to their authority are probably generally in compliance with the 2007 Rules of the FTC or the other agencies. Because the rules and guidelines proposed are substantially similar to the 2007 Rules, even if an entity is subject to the Proposed Rules, the Commissions expect that it would not be required to make significant changes to its policies or operations.  The Commissions   also anticipate that a financial institution or creditor that is required to adopt a Program would be able to integrate the new policies and procedures with policies and procedures it has already adopted pursuant to other legal requirements, such as Investment Company Act of 1940′s compliance rule 38a-1, Investment Advisers Act of 1940′s compliance rule 206(4)-7, and Regulation S-P’s safeguards rules covering broker-dealers, investment companies and investment advisers. Because the Commissions estimate that putting Programs in place will not be time-consuming, the Proposed Rules suggest that the Final Rules would go into effect thirty (30) days after publication in the Federal Register.

Other Helpful Resources.  In addition to the guidelines and examples of red flags provided in the Proposed Rules, businesses may find helpful resources at the FTC’s Identity Theft site. States generally have their own identity theft laws as well.

The amendments:

• codify revisions to Rule 205-3 dollar thresholds that the SEC issued by Order on July 12, 2011 (effective September 19, 2011), pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”);
• exclude the value of a natural person’s primary residence and certain associated debt from the net worth test for a natural person to be considered a qualified client;
• add certain transition provisions to the rule, allowing for the continuation of some arrangements; and
• require the SEC to issue an order every five years adjusting the thresholds for inflation.

Background.  Under Advisers Act Section 205(a)(1), an investment adviser is not permitted to enter into an agreement under which the adviser is compensated based on a share of the client’s capital gains as a disincentive for the adviser to take undue risk with client’s funds in order to increase its advisory fees.  However, Rule 205-3 permits investment advisers to charge performance-based compensation to certain investors that are “qualified clients” based on their net worth or assets; the SEC has determined that qualified clients do not need the protection of Section 205(a)(1), as they generally are financially experienced and able to bear the risks of the arrangements.  A person may be a “qualified client” if it is a qualified purchaser (as defined in the Investment Company Act of 1940), or meets an “assets under management test” or a “net worth test”.

Adjustment of Dollar Amount Thresholds.  The SEC has raised the dollar amount thresholds for Rule 205-3’s “assets under management test” and “net worth test”, as follows:

(i)  “assets under management test” – the minimum a client must have under management with the investment adviser immediately after entering the advisory contract is $1.0 million (up from $750,000); and

(ii) “net worth test” – the adviser must have a reasonable belief that the client’s net worth (together with assets owned jointly by a natural person client’s spouse) is more than $2.0 million (up from $1.5 million).  Net worth is to be calculated only at the time the advisory contract is entered into.

Assets under Management Test.  An investment adviser can include the assets that a client is contractually obligated to invest in private funds managed by the adviser in its determination of the amount of a client’s assets under the adviser’s management. Only bona fide contractual commitments may be included, i.e., those that the adviser has a reasonable belief that the investor will be able to meet.

Net Worth Determination:  Exclusion of the Value of Primary Residence and Certain Secured Debt.  The SEC amended the net worth test in the definition of “qualified client” to exclude:

(i)     the fair market value of a natural person’s primary residence; and

(ii)    certain debt secured by that property, such as a mortgage or home equity line of credit (up to the fair market value of the residence).

• Fair market value.  The fair market value of the primary residence is determined as of the time the advisory contract is entered into, even if the investor changed his or her primary residence during the 60-day period.  No third party valuation is required.

• Secured debt greater than residence value.  If the secured debt is greater than the residence value, the excess is considered a liability in the net worth calculation, even if the borrower is not personally liable for the excess amount by contract or operation of law.

• 60-Day Lookback for Increase in Secured Debt:  Any increase in the amount of debt secured by the residence in the 60 days before the advisory contract is entered into (other than in connection with the acquisition of the residence) must be included as a liability, even if the estimated value of the residence exceeds the aggregate amount of secured debt.  This restriction is to prevent investors from incurring debt for the purpose of inflating their net worth to qualify for the “qualified client” threshold.

Similar “Accredited Investor” Net Worth Calculation: This amendment is similar to a change in the Securities Act of 1933 Regulation D definition of “accredited investor” that was required by Dodd-Frank and the parallel exclusion from “investments” for purposes of determining if an investor is a “qualified purchaser” under the Investment Company Act of 1940.  The SEC has posted a helpful guide to the new “accredited investor” net worth standard, with sample calculations here.

Transition Provisions.  The Rule includes transition provisions intended to permit an adviser to maintain existing performance fee arrangements for (i) a registered investment adviser’s existing clients, (ii) clients of registered investment advisers that were previously exempt, and (iii) transfers by gift or bequest or in a separation or divorce.  In each case below, the transition provisions apply as well to additional investments made by these clients and additional investments made by private fund investors in private funds in which they were already invested.

• Registered Investment Adviser’s Existing Clients.  A registered investment adviser may continue to charge performance fees under an advisory contract to clients who entered into the contracts with the registered investment adviser before May 22, 2012 and were “qualified clients” at the time, even if they would not be “qualified clients” under the amended rule.

• Previously Exempt Investment Advisers.  If a registered investment adviser had been exempt from registration under Advisers Act Section 203, the adviser may continue to charge performance fees to clients under advisory contracts entered into when the adviser was exempt.

• Transfers.  A person who becomes an owner of an interest by gift or bequest or in a separation or divorce does not have to be a qualified client at the time of transfer, and is governed by the advisory agreement in place before the transfer.

Inflation Adjustment of Dollar Amount Thresholds.   The SEC’s next adjustments for inflation will be issued by order on or about May 1, 2016 and every five years after that date. These adjusted amounts will apply to contractual relationships entered into on or after the effective date of these orders, and will not apply retroactively to contractual relationships previously in existence.

The Risk Alert is addressed to both broker-dealers and investment advisers. Carlo di Florio, Director of OCIE, suggested that firms consider the observations in the Risk Alert  “as they review their compliance and supervisory controls to detect and deter unauthorized trading” and other unauthorized activities.  As the SEC has repeatedly stated, a firm must set the tone from the top and create a culture of compliance. OCIE recommends involving management and non-management personnel in the efforts.

The following are highlights of the 7-page Risk Alert, which may be found here:

Unauthorized trading/activities.  Unauthorized trading and activities may include:

• rogue trades in customer, client, or proprietary accounts
• personal trading activities of associated persons or other employees
• trades that exceed firm limits on position exposures, risk tolerances, and losses
• intentional mismarking of positions
• creating and/or maintaining records of nonexistent (or sham) transactions
• creating and/or maintaining inaccurate or altered records

Personnel who may be involved. OCIE urges firms to examine their operations to try to identify circumstances that might allow an individual (or group) to enter into or conceal unauthorized transactions. OCIE points out that unauthorized activities could be perpetrated by a variety of persons associated with a firm:

• traders or assistants on trading desks
• portfolio managers
• brokers
• investment advisers
• order placement personnel
• risk managers
• other personnel, including those in administrative positions in a firm’s mid- or back-office

Controls.  The OCIE provides a number of examples of controls that might be appropriate for a firm to put in place, emphasizing that controls must be tailored to a firm’s business and operations. These might include:

• a collaborative effort – consider involving the firm’s “operational risk, audit, legal and compliance to work closely with management in performing an independent identification of risks and practices that could permit unauthorized trading”
• consider a review of reports of past unauthorized trading incidents suffered by the industry to glean ideas
• front office – have a management “open-door” policy, set up independent and clear reporting lines, encourage discussions with direct and indirect reports, educate  regarding complex securities/trading strategies
• mandatory vacations without remote access to trading accounts
• review of personal and family investments and trading accounts, to the extent that the firm has access to this information
• review of email, phone logs and other communications such as text messages or social networking activities, to the extent available
• independent trading reviews
• review and/or test internal controls on a regular basis, considering the policies in light of internal business changes and current market conditions

Situations that May Raise Concerns. OCIE suggests scrutinizing the following, where appropriate:

• changes in trading patterns
• a high volume of trade cancellations or corrections
• manual trade adjustments
• unexplained profits for a particular trader or client
• transfer of personnel into trading positions
• extended settlements/”rolling” of positions
• silo systems, where transaction information may exist in multiple systems

Other Resources.  The Risk Alert refers registered investment advisers to “Compliance Programs of Investment Companies and Investment Advisers”, Advisers Act Release No. 2204 available at http://www.sec.gov/rules/final/ia-2204.htm, for a prior discussion of risks and suggested practices to prevent or mitigate problems. OCIE has made various resources available at http://www.sec.gov/about/offices/ocie.shtml.

HedgeOp notes that this is the fourth Risk Alert issued by OCIE in the past six months. Previous Alerts addressed Master/Subaccounts, Broker-Dealer Branch Inspections (issued jointly with FINRA) and Investment Advisers’ Use of Social Media. The Risk Alerts generally highlight issues OCIE has been focusing on in examinations and make suggestions regarding mitigating risk and compliance practices.

HedgeOp encourages advisors to keep the issues raised in this Risk Alert in mind when conducting periodic or annual risk assessments and reviews of compliance policies and procedures.