SEC Speaks Out About Using the Word "May" in Disclosures

The SEC has once again brought action against a firm for failure to properly disclose existing conflicts of interest. According to the SEC’s Order, the firm entered into an ‘undisclosed’ arrangement with an unaffiliated broker-dealer to provide trade execution for the adviser’s clients at a commission rate of $0.01 per share. However, under their existing arrangement, the broker-dealer charged the adviser’s clients between $0.04 and $0.06 per share, and then paid the amount exceeding $0.01 per share commission to the adviser’s affiliated broker-dealer as a “referral fee.” In that way, the affiliated broker-dealer and the adviser were actually paid between $0.03 and $0.05 per share on the adviser’s client.

The adviser’s ADV Part 2A disclosed that its affiliated broker-dealer “may” receive referral fees when obviously it was receiving them. All advisers should review their disclosures on at least an annual basis to make sure they accurately reflect what is occurring as opposed to what might occur in the future.

Please click here to read the full Order.

SEC Administrative Hearings Gain More Bite

Traditionally, the Securities and Exchange Commission (“SEC”) has only been able to impose penalties on regulated entities and individuals through the administrative process. Since passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC is now able to apply civil penalties against any person or company. This change has created some increased efficiencies as well as potential problems.

Prior to Section 929P of Dodd-Frank, the best alternative to an administrative hearing for non-regulated entities was for the SEC to file a lawsuit in Federal Court. Defendants often consider the administrative option to be quicker and less costly. But the advantages of the administrative option for the SEC appear to be even greater and include: limited discovery, no right to a jury trial, and inherently biased administrative law judge, and a biased appeal to the SEC Commissioners. This last point brings up an obvious ethical problem.

The administrative judges are appointed by the SEC and any appeal of the judges’ decision is appealed to the SEC Commissioners. Since it takes a vote of the SEC Commissioners to proceed with an enforcement action, those Commissioners are hearing the appeal of the case they authorized to proceed in the first place. The judges are not held to any code of conduct or code of ethics.

Since the passage of Dodd-Frank, the SEC has not lost a single administrative process case. They have a 100% success rate. However, their record was only about 60% successful when they filed lawsuits in Federal Court.

The SEC has been open with its intention to try more cases in its administrative process and defendants who had hoped to fight the SEC’s allegation in Federal Court may find that they are instead sent to an administrative process without many of the tools they had hoped to use such as the right to a jury, expansive discovery, dispositive motions, evidentiary challenges, or even time to prepare for trial.

One good option to help prevent an administrative process is to better understand your business and how to avoid actions that can introduce you to the process. A solid Compliance program that helps define your potential risks and implements processes to mitigate your risk exposure is essential. Please click here to read the complete story.

If you would prefer to focus your attention on your clients and the day-to-day operation of your firm, Red Oak Compliance Solutions is here to help with any or all of your compliance requirements.

The SEC Filed a Record Number of Enforcement Cases in 2014

The SEC just issued a press release announcing that they filed a record number of enforcement cases in the 2014 fiscal year that ended September 30. The SEC reported that it filed 755 enforcement actions during this time frame as compared to 686 and 734 in the prior two years. The SEC obtained orders totaling $4.16 Billion in disgorgement and penalties as compared to $3.4 Billion and $3.1 Billion for 2013 and 2012. The SEC highlighted cases against investment advisers and investment companies including cases against a private equity firm for misallocation of expenses. Andrew J. Ceresney, Director of the SEC's Division of Enforcement stated, "I am proud of our excellent record of success and look forward to another year filled with high-impact enforcement actions." Please click here to read the full story.

If you have any questions or concerns regarding your compliance program, Red Oak Compliance Solutions is here to help you enhance your compliance program and help keep you away from any questionable activity.

Culture of Compliance

As my Compliance career has progressed, I’ve noticed a few recurring themes like, we sure could use more Analysts and there must be better a better way. While that may be the same sentiment in other industries; a recent survey by Cipperman Compliance Services (“CCS”) indicates that my assumptions were correct. They found that the compliance function in the surveyed firms tended to be underfunded and understaffed. Their survey included asset managers, broker-dealers, alternatives managers and wealth managers.

A number of findings, while no surprise at all, were a little troubling including, 74% of respondents (responsible for compliance duties) believed that their firms should commit more resources to the compliance function and 83% of broker-dealers and 58% of asset managers said they needed to focus more resources on compliance.

Compliance is your level of protection for your Clients, the Advisors and for the firm itself. According to the old adage, “the best defense is a good offense” and I tend to agree. When compliance is understaffed and/or underfunded, the process becomes reactionary or defensive, with only the resources to respond to issues as they arise rather than taking the offensive and trying to uncover weaknesses in the system before there are problems.

So what kind of commitment to compliance would be adequate? Todd Cipperman the Chief Executive Officer of CCS says, “Firms should spend a minimum of 5% of revenues or 2 bps of assets under management on the compliance function. Investing in compliance protects the franchise and preserves assets under management. We view compliance as the firm’s defense. And defense wins championships.” I couldn’t agree more.

Please click here to read the full story.

Trust - How would you handle a net capital issue?

Trust, an essential element in the relationship between financial Representatives , the public and the regulators is delicate and must be nurtured over time . . . and it can be lost in an instant.

That’s what Charles “Chuck” Moore and Crucible Capital Group learned on August 8, 2014 when the SEC announced charges against the New York brokerage firm and its founder for allegedly violating the net capital requirements and subsequently falsifying books and records to conceal the deficiencies. The uniform net capital rule was created by the U.S. Securities and Exchange Commission ("SEC") in 1975 to regulate directly the ability of broker-dealers to meet their financial obligations to customers and other creditors.

The rule requires those firms to value their securities at market prices and to apply to those values a haircut (i.e., a discount) based on each security's risk characteristics. The haircut values of securities are used to compute the liquidation value of a broker-dealer's assets to determine whether the broker-dealer holds enough liquid assets to pay all its non-subordinated liabilities and to still retain a "cushion" of required liquid assets (i.e., the "net capital" requirement) to ensure payment of all obligations owed to customers if there is a delay in liquidating the assets.

“The net capital rule is a principal tool by which the SEC monitors the financial health of brokerage firms,” said Amelia A. Cottrell, an associate director in the SEC’s New York Regional Office. “It is therefore crucial that SEC examiners have prompt access to accurate and complete information about a firm’s financial condition.” It would be fair to say that most companies face financial challenges at some point. How firms deal with these challenges can either build or destroy trust. The charges allege that Charles “Chuck” Moore and Crucible Capital Group attempted to disguise the firm’s extensive and repeated net capital insufficiencies by improperly off-loading its liabilities onto the books of an affiliated firm and improperly treating non-marketable stock as an allowable asset.

Apparently Crucible entered into an expense-sharing agreement with another firm owned by Moore called Angelic Holdings. Angelic contracted to pay Crucible’s expenses. The vendors of Crucible were to bill Angelic for services they performed for Crucible. Moore provided SEC examiners with copies of invoices that had been doctored to eliminate significant past due amounts. The SEC examiners and investigators noted the falsifications. They also found that Angelic did not have the resources to pay the debts of vendors making the expense sharing agreement illegitimate. The case has been referred to criminal authorities for prosecution. Click here to read the SEC Press Release.

If you would prefer to focus your attention on your clients and the day-to-day operation of your firm, Red Oak Compliance Solutions is here to help with any or all of your compliance requirements.

FINRA Fines Heating Up

Summer temperatures in Texas are heating up almost as fast as the Financial Industry Regulatory Authority’s (FINRA’s) monthly “Disciplinary and Other FINRA Actions” publication. Reported recently by ThinkAdvisor.com citing an analysis by the law firm Sutherland Asbill & Brennan (Sutherland), FINRA is on track to assessing 49% more in fines this year than last year’s $57 million.

The first half of 2014 has already seen fines totaling $42.4 million compared with $23 million during the first half of 2013. At the current rate, fines in 2014 will total approximately $85 million which is still lower than the $111 million reported by FINRA in 2006. The Sutherland study also noted that FINRA “appears to be repositioning itself as its actions shift from cases relating to the financial crisis to more technical issues,” such as books and records and trade reporting violations.

Issues drawing the most heat so far this year are:

• Books and Records: $13.7 million in fines, 61 cases
• Anti-Money Laundering: $11.3 million in fines, 17 cases
• Net Capital: $9.7 million in fines, 18 cases
• Unregistered Securities: $9.2 million in fines, 11 cases
• Trade Reporting: $6.7 million in fines, 92 cases

One reason noted by Sutherland for the higher total is that fines themselves have been higher in 2014 than 2013. During the first half of 2013 there were only two fines of $1 million or more totaling $2.3 million. So far this year there have been five fines totaling $20.4 million. One anti-money laundering compliance failure case involving penny stock transactions resulted in an $8 million fine.

The study by Sutherland also found that as fines are heating up, disciplinary actions are cooling off . . . slightly. Fines are up 49% so far this year and disciplinary actions are down about 7% with 558 actions during the first half of this year (597 during first half of 2013). Please click here to ready the full article.

While there is not much we can do about the temperature, Red Oak stands ready to help you and your firm keep your cool year round.

State Securities Regulators Survey Investment Advisors on Cybersecurity

Several states have now joined the SEC and FINRA’s initiative to assess cybersecurity preparedness and have sent out questionnaires or will be shortly.

These questionnaires contain questions ranging from the very specific to the very broad. Some questions include:

• Does your firm utilize laptop or tablet computers, or other portable electronic devices?
• Is the encryption software installed on all laptop or tablet computers, or other portable electronic devices?
• Identify the encryption software vendor: __________________
• Does your firm utilize antivirus software?
• Identify the antivirus software vendor: ___________________
• Is the antivirus software installed on all fixed workstations and portable electronic devices?
• How often are updates downloaded to the antivirus software?
• Has your firm created and implemented a written information security program?

We believe the states will institute regulations regarding cybersecurity by early next year after assessing the responses to their questionnaires. Click here for a copy of the questionnaire for Massachusetts.

Updated SEC Guidance on Testimonial Rule and Social Media

The Security and Exchange Commission (SEC) recently issued an update regarding “Guidance on the Testimonial Rule and Social Media”. This Guidance discusses how financial advisers may use testimonials on social media sites without violating the Investment Advisers Act of 1940 (“Act”). The Act prohibits testimonials, since by their very nature they emphasize the comments that are favorable to the investment adviser and ignore those which are unfavorable (Rule 206(4)-1).

In today’s electronic world, people expect to be able to read reviews before they buy a product or use a service. But there are no reviews for financial advisers. This Guidance may help clients to find objective information regarding financial advisers.

The SEC Guidance attempts to address some of the questions that firms and advisers have been asking. It states that under certain circumstances, financial advisers may now accept “testimonials” on social media sites, however the testimonials must be completely independent and have no “material connection” to the financial advisers or investment advisory representatives (IARs).

The guidance includes:

• No explicit client experiences on financial advisers’ personal social media sites
• No posts from other social media sites unless the public has equal access to all the commentary available and the commentary is from an independent source
• No adviser or firm authored or edited testimonials
• No compensation for testimonials
• No highlighting favorable or removing unfavorable testimonials

If firms do decide to allow Recommendations, they will need to update their existing social media polices with enough detail so that financial advisers understand that they must remain independent of the creation and editing of testimonials. Editing recommendations or making suggestions of content is prohibited. Firms will also need to put plans in place for how to handle the negative commentary that is bound to come.

Please click here to read the full guidance.

Private Equity Funds Examinations: Heighted Scrutiny and Common Deficiencies

In May 2014 the SEC Deputy Director announced the SEC’s Presence Exam Initiative is nearly complete. The Presence Exam Initiative is being implemented in order to strengthen transparent regulation of the private equity industry and to finely tune questioning and testing during examinations, including during examinations of newly registered private fund registrants. The SEC is dedicating additional resources toward these private fund regulatory endeavors because the biggest private equity investors are not high net worth individuals but rather are U.S. workers through their pension funds, endowments, and foundations that invest in private equity funds. Private equity industry’s assets under management have increased yearly and are the highest ever, measured last year at 3.5 trillion dollars. Historically, the most frequent deficiencies have been due to inadequate policies and procedures or inadequate disclosures. However the Deputy Director noted that when the SEC examined how fees and expenses are handled by advisers to private equity funds, the SEC identified what was believed to be violations of law or material weaknesses in controls over 50% of the time.

COMMON PRIVATE EQUITY FUND DEFICIENCIES: The SEC deputy director identified various common compliance deficiencies. Private equity advisers are faced with many conflicts including the ability to control a non-publicly traded company and the relative lack of disclosure requirements for non-publicly traded companies, whereas the private equity adviser can then be tempted to instruct a portfolio company it controls to hire the adviser or affiliate to provide certain services and to set the terms of the engagement or instruct the company to add to its payroll adviser employees who manage the investment. Another issue consists of limited partnership agreements that are broad in characterization of the types of fees and expenses that can be charged to portfolio companies as opposed to being born by the advisers; which then allows advisers to charge fees and pass along expenses that are not reasonably contemplated by investors and are not properly disclosed. Properly defined valuation policies and procedures, investment strategies, and mitigation for conflicts of interest are needed. Limited partnership agreements also need to use precise language in order to provide limited partners with sufficient information rights, so that the limited partners can adequately monitor their investments as well as the operations of their manager.

Other deficiencies identified include “Zombie” advisers that are unable to raise additional funds, and have been found managing legacy funds long past their expected life, which may not be in the best interest of investors. Separate accounts and side-by-side co-investments invested alongside the main co-mingled vehicle many times do not properly allocate broken deal expenses or other costs associated with generating deal flow. Operating partners are expensed to the fund or to the portfolio companies they advise without sufficient disclosure to investors, and are then deceivingly presented as full members of the adviser’s team.

Some advisers have been found shifting expenses from themselves to their clients during the middle of a fund’s life without disclosure to limited partners to create hidden fees; by firing adviser employees and hiring them back as “consultants”, billing their funds separately for back-office functions traditionally included in the management fee, or automating the investor reporting function with a software package and then unfairly billing the client for the efficiency gain. Other advisers have been found causing their portfolio companies to extend five year monitoring agreements to ten years or to self-renew annually without adequate disclosure, whereas the agreement is later triggered by a merger or IPO and the adviser collects a fee to terminate the monitoring agreement, and the termination usually takes the form of the acceleration of all the monitoring fees due for the duration of the contract, discounted at the risk-free rate.

A common valuation issue the SEC has seen is advisers using a valuation methodology that is different from the one that has been disclosed to investors which enhances the fund’s rate of return. The SEC had found advisers that cherry-pick comparables or add back inappropriate items to EBITDA such as costs recurring after a strategic sale without rational reasons and/or disclosures, or changing from using trailing comparables to using forward comparables. Changing the valuation methodology must be consist with the valuation policy unless there is logical purpose, and requires additional disclosure(s).

The SEC Deputy Director strongly encourages a strong culture of compliance reinforced through an independent, empowered and fully supported compliance department. Click here to read the full text.

CYBER-SECURITY—RED HERRING OR RED ALERT?

With all the high profile data breaches lately (Target, Chase, Michael’s Stores, American Express etc.), it was inevitable that FINRA and the SEC, along with the State regulators, would not only talk about cyber-security and issue notices and rules regarding it, but would also make it a priority. They now have and you better be ready.

On April 15, the SEC Office of Compliance Inspections and Examinations (OCIE) published a risk alert on cyber-security. The tone of the alert is ominous to say the least:

“OCIE’s cyber-security initiative is designed to assess cyber-security preparedness in the securities industry and to obtain information about the industry’s recent experiences with certain types of cyber threats. As part of this initiative, OCIE will conduct examinations of more than 50 registered broker-dealers and registered investment advisers focused on the following: the entity’s cyber-security governance, identification and assessment of cyber-security risks, protection of networks and information, risks associated with remote customer access and funds transfer requests, risks associated with vendors and other third parties, detection of unauthorized activity, and experiences with certain cyber-security threats.”

There is no doubt that cyber-security is lacking in the financial services industry and that clients’ data may certainly be at risk. However, an initiative like this spells trouble, in the form of extra work and costs, for the industry as a whole. For evidence of that, simply review the appendix to the alert that provides a sample document/examination request that will be used by the SEC. As you read through the items, try and figure out how your firm would answer if asked. Please don’t assume this will be limited to the selected 50 broker/dealers and investment advisers because it won’t be. FINRA already included cyber-security in its 2014 exam priorities and issued a Targeted Exam Letter in January of this year. State regulators never like to be late on an issue so expect inquiries from them either directly or during upcoming exams.

With so much regulatory focus on this issue, what should small and medium investment advisers and broker/dealers? If you’ve ruled out opening a restaurant in the Bahamas, we recommend the following steps:

1. Do a risk assessment of your current cyber-security. Meet with the principals of your firm and review the appendix as a group answering as many questions as possible. If you have IT department or consultant, they should participate. If you have an outside compliance consultant, they should be there as well;
2. Produce an action plan related to how you will bridge the gaps you have identified. If your IT and/or compliance consultant hasn’t been involved yet, get them involved during this step. You will need to rank the risks by severity and also do a cost analysis for each as these solutions can sometimes be quite expensive;
3. Implement your plan. Documentation of the solutions you identify and implement is critical if you are called to defend your measures prior to full implementation. This is a developing area that is being emphasized but the regulators, believe it or not, will often take into account risk identification and solution design and not just demand total compliance day one. Waiting for them to come in and tell you what to do is not the best option;
4. Update your Compliance Manual and/or Written Supervisory Procedures. These updates will certainly not be as detailed as your IT plan but should reflect the systems and solutions you have implemented. At a minimum, annual updates are required.

Cyber-security is and should be serious business. Red Oak Compliance Solutions stands ready to assist you in your efforts to evaluate your risks and implement solutions. Please call us at 888.302.4594 or email us at info@redoakcompliance.com to discuss these important issues.

Firm to Pay $3.75 Million Fine for Failing to Store Emails in Proper Format

Barclays Capital Inc. self-reported to FINRA that it failed to preserve electronic business-related records in non-rewritable, non-erasable format (also referred to as “Write-Once, Read-Many” or “WORM” format). Specifically, Barclays reported that it failed to retain countless attachments to emails sent through Bloomberg L.P., and failed to retain approximately 3.3 million instant messages (“IMs”) communicated through Bloomberg.

Although Barclays performed conformance testing and validation in connection with its records management program, the testing did not focus on the format in which the records were being stored or software malfunction. The firm relied on a software program to save the electronic messages for retrieval, but there was a configuration error with the program that was not detected for three years which failed to associate attachments with subsequently processed emails that included the same attachment, and rather saved the attachments as parsed text, which was not WORM compliant. Barclays estimated it generated 500,000 emails on a daily basis. Since the software program was functioning according to its default settings (which were improperly configured), no alerts were generated indicating that the program had malfunctioned. IMs were not saved into their database due to a similar software program malfunction.

As related to these issues, Barclays failed to establish and maintain an adequate Written Supervisory Procedures compliance document along with an adequate system to avoid such failures. Further, the firm did not have an individual or group at the Firm that was responsible for preparing Written Supervisory Procedures aimed at WORM compliance, and did not have auditing specifically designed to verify WORM compliance. Written Supervisory Procedures must be reasonably designed to achieve compliance with applicable securities laws and regulations.

Due to these failures and violations stated above of Exchange Act Rule 17a-4, NASD Rules 3110 and 2110 and FINRA Rules 4511 and 2010, in December 2013 Barclays agreed to pay the $3.75 million dollar fine, and Censure.

Further information on this settlement of the alleged rule violations is accessible by clicking here.

Necessary Preparation for NFA Exams

Without proper preparation and an adequate compliance program, the National Futures Association (NFA) Exam can be burdensome and lead to NFA disciplinary action. Beginning in 2013, many investment advisers to registered funds and controlled foreign corporations (CFCs) are now required to register as commodity pool operators (CPOs) and become members of the NFA. The NFA will examine a newly registered CPO within the first year and other CPOs every three to five years; though CPOs may be examined more frequently as deemed necessary based on NFA review of assets under management, financial statements, advertising materials, and customer complaints.

The NFA sometimes makes a surprise on-site visit, but usually the NFA contacts the CPO by phone two weeks prior to the on-site examination of the CPO and then sends an initial document request list. This list usually requests the CPO’s (1) CFTC compliance policies and procedures, financial records, organizational documents, investor records, performance advertising (2) lists of: principals and associated persons, sub-advisers and other fund service providers, futures commission merchants, swap dealers, and (3) trade blotter, a list of securities held by each fund, and a description of brokerage arrangements.

The NFA staff will then take a week or so to conduct an on-site review of the CPO’s business and investment activities, and will focus on the review of: (1) the CPO’s compliance policies and procedures; and the resulting CPO’s compliance with rules and procedures including NFA rules, CFTC’s Harmonization Rules, recordkeeping, reporting, etc., (2) the CPO’s annual self-examination process (3) CPO advertising materials, and (4) proper registration of CPO employees. If the NFA determines the CPO is potentially violating NFA rules, a written report will be issued and ultimately an enforcement action by complaint may be issued to the CFO.

CPOs should be prepared for a possible NFA examination at any time, by maintaining updated compliance documents, conducting the annual self-examination, and conducting a mock NFA examination. Once the CPO becomes aware of a pending NFA examination, the CPO should contact a consultant with expertise about the NFA’s examination process and have the consultant review information and documents before submittal to the NFA. The consultant should review e-mails and other communications. Whether or not to divulge information that may be protected by attorney-client privilege should be determined on a case-by-case basis. A log of documents provided to NFA staff should be maintained. The CPO should contact its external auditor, as accounting issues may arise during examination. The CPO should advise employees about the NFA staff’s visit, and designate a senior officer to serve as an “exam liaison” with the NFA staff and advise the other employees the “exam liaison” will provide all the information to NFA staff and should be present during any discussions and interviews with NFA staff. All questions and document requests/submittals should be directed through the “exam liaison”. NFA staff should be provided with workspace and a pleasant work environment, as well as prompt responses to assure integrity and competence of the CPO.

FINRA Exam Priorities for 2014

If you are interested in seeing what the SEC’s Exam Priorities are for 2014, please click here to download their letter.

Red Oak can help you prepare and respond to SEC exams or questions. Contact us to find out more.

Common State Exam Deficiencies

We believe many states are finding deficiencies similar to what the Texas State Securities Board’s (“TSSB”) has published in their newsletter, “Texas Regulatory Review”. The TSSB's recent publication offers insights into the common exam deficiencies they found for the first half of 2013.

It also offers clarification on TSSB’s view of what is and is not advertising and the books and records requirements. Finally they discuss the new 2011 rule that requires Advisers to obtain certain client profile information and update it every 3 years. Please click here to read the complete newsletter.

If you have any questions, please feel free to call us.

New SEC Exam Initiative

Time to get ready for a new era of examination for those Investment Advisers that have been deemed lower risk. Today the Securities and Exchange Commission announced that it is launching an initiative directed at investment advisers that have never been examined before, focusing on those that have been registered with the SEC for three or more years. Please click here to read the complete press release.

FINRA Proposes CARDS Data Repository

FINRA is currently accepting comments on a purposed rule to add a CARDS data reporting system requirement for all broker dealers so that FINRA can have access to more client information for auditing purposes.

Once CARDS is implemented, clearing firms (on behalf of introducing firms) and self-clearing firms would submit in an automated, standardized format specific information relating to their customers’ accounts and the customer accounts of each firm for which they clear. Such information would include, at a minimum:

• Account Information: This information identifies account types associated with account activity, firms and their branches and associated persons responsible for supervision and sales
• Account types and categories (e.g., retirement, brokerage, cash, margin, options, discretionary, day trading)
• Customer investment profile information (e.g., investment objective, date of birth)
• An identifier for beneficial owners or control persons
• Servicing registered persons and locations (e.g., registered person CRD number and branch CRD number)
• Account Activity Information: In conjunction with account information, account activity information serves as the primary basis for risk identification related to suitability reviews, fraud detection, anti-money laundering and other sales practice related reviews.
• Details of account activity (e.g., purchases and sales transactions, event dates)
• Additions/withdrawals, securities and account transfers
• Margin and balances
• Security Identification Information: Security identification information is required for FINRA to determine the characteristics of securities.
• Description of securities (e.g., CUSIP, symbol, description, name, ISIN, SEDOL)

This is a lot of information and may prove to be difficult to provide. Everyone should review the notice and send a letter to FINRA with either support or reasons for changing this. The comment period has been extended to March 21, 2014. Please click here to read the full Notice.

General Advertising of Private Investment Funds

An 80-year ban on general advertising and solicitation of private investment funds is coming to an end. The revised SEC rules apply to hedge funds, private equity groups, venture capital firms and other private funds. Previous to the change, firms could only solicit to “accredited investors” after they’ve been properly verified as accredited. The revised rules will allow advertising by methods previously prohibited such as television ads, brochures, full-page print advertisements, and content rich websites with information about the fund’s philosophy, process, risk controls, investment team, etc.

Purchasers of private funds must still be considered “accredited investors” with assets of at least $1,000,000 (excluding primary residence) or annual income of at least $200,000 in each of the two most recent years with a reasonable expectation of similar earnings in the current year. Since general advertising increases the possibility of risk of sales to unqualified buyers, the SEC has actually tightened the verification procedures of accredited status by firms using general advertising. No longer will investors be able to simply check a box stating that they qualify as an accredited investor. Firms utilizing general advertising will need to document, a) income with 1040’s or W-2’s, and b) net worth requirements with bank and brokerage statements or written confirmation from third parties like broker-dealers, registered investment advisers, attorneys or CPA’s.

The revised general advertising rules may open the door to fresh sources of capital by reaching smaller accredited investors that do not have assets of at least $5,000,000. The SEC estimated that at least 8.7 million households qualified as accredited investors in 2010 but only 234,000 participated in Rule 506 offerings . This new source of capital may be especially important to start-up funds who may be willing to accept a $250,000 or $500,000 investment which is well below the $1,000,000+ minimums that many larger more established firms have established.

This broader access to smaller accredited investors poses other potential problems, including:

• Larger number of smaller investors with less experience will require more cost and attention, necessitating increased operations and staffing.
• More advertising will bring increased SEC attention
• Designing, executing and evaluating the performance of advertising is expensive and generally beyond the scope of a small fund.

While the revised rules on general advertising may open the door to more investors and capital, spurring growth in new offerings, the larger well-established funds with access to institutional money may be less responsive to the increased ability to advertise. Having 5 investors with $500,000,000 each is much less work than 5000 investors with $500,000 each.

SEC Guidance to Fund Advisers Serving “at cost” or for no Compensation

The U.S. Securities and Exchange Commission’s Division of Investment Management has recently offered guidance with regards to Fund Advisers serving “at cost” or for no compensation (No. 2013-09 Oct 2013). At the heart of the guidance are a couple of Sections of the Investment Company Act of 1940 (Company Act) that appear to question whether a person or company that temporarily serves a fund “at cost” or for no compensation is an investment adviser under the Company Act. Section 2(a)(20) of the Company Act defines an investment adviser of an investment company to include, any person “who pursuant to contract with such company regularly furnishes advice to such company with respect to the desirability of investing in, purchasing or selling securities or other property, or is empowered to determine what securities or other property shall be purchased or sold by such company.” Section 2(a)(20)(iii) on the other hand excludes from this definition “a company furnishing such services at cost to one or more investment companies, insurance companies, or other financial institutions.”

A common example of an investment adviser offering temporary advisory services to a fund at cost or for no compensation involves an “assignment” of an investment advisory contract. Section 15(a)(4) of the Company Act says it is unlawful for a person to act as investment adviser for a fund except pursuant to a written contract which must be approved by the vote of a majority of the fund’s outstanding voting securities and must provide for the contract’s automatic termination in the event of its assignment. Since assignment can include any direct or indirect transfer or hypothecation of a contract by the assignor or of a controlling block of the assignor’s outstanding voting securities, it can be difficult for a fund to get timely shareholder approval of a new advisory contract.

However, Rule 15(a)(4) also provides a temporary 150-day period during which a person may act as an investment adviser for a fund under an interim contract without shareholder approval, subject to specified conditions. Under Rule 15(a)(4), in the event of a failure to obtain shareholder approval as provided for in the rule, the investment adviser may be paid its costs incurred in performing the interim contract. Although rule 15(a)(4) provides relief for substantially all circumstances in which a fund might need additional time to obtain shareholder approval of an advisory contract in the case of an assignment, division staff occasionally have also provided similar relief in no-action letters for particular circumstances.

And while the Commission has granted certain temporary exemptions from the provisions of Section 15(a)(4) conditioned on such person’s serving during the interim period on an “at cost” basis or for no compensation, it did not interpret such persons to not be investment advisers as defined in Section 2(a)(20) which would be inconsistent with the investor protections mandated by the Company Act.

Sample SEC Exam Request Letter - Dec 2013

If you are interested in seeing what a recent SEC Exam Request Letter is asking, you can click here to download a Dec 2013 version.

Red Oak can help you prepare and respond to SEC and state exams. Contact us to find out more.