A Compilation of Enforcement and Non-Enforcement Actions

29 April 2011 Publication
Authors: Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

Update on Dodd-Frank Investment Adviser Registration Requirements

Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which became law on July 21, 2010, repealed effective July 21, 2011, the private advisor exemption from registration as an investment adviser under the Investment Advisers Act of 1940 (Advisers Act). As the result, many advisers of hedge funds, private equity funds, and other private investment vehicles will be required to register as investment advisers under the Advisers Act unless they qualify for one of two new registration exemptions. The private adviser exemption was available to an adviser if the adviser, during the preceding 12 months, had fewer than 15 clients (each fund being one client) and did not hold itself out to the public as an investment adviser. In addition, Dodd-Frank prohibits an adviser from registering with the SEC under the Advisers Act if it (a) has assets under management of less than $100 million, and (b) is required to register in the state in which it maintains its principal office and place of business and, if registered, would be subject to examination by such state. Dodd-Frank also imposes new disclosure and recordkeeping requirements on many investment advisers who will qualify for a registration exemption under the Advisers Act.

The two new registration exemptions are for (i) advisers whose only clients are funds excluded from the definition of an investment company by way of Section 3(c)(1) (i.e., a private fund with not more than 100 equity owners) or 3(c)(7) (i.e., a private fund where all of the equity owners are “qualified purchasers”) and has less than $150 million of assets under management, and (ii) advisers whose only clients are venture capital funds as defined by rule by the SEC. Advisers who rely on one of these exemptions will be subject to certain reporting and recordkeeping requirements to be determined by rule by the SEC.

The SEC recently announced that the required rules to implement the requirements for so-called mid-sized investment advisers (i.e., SEC-registered investment advisers with assets under management between $25 million and $100 million) to withdraw from SEC registration and register with their home states and for requiring advisers to hedge and private equity funds with more than $150 million of assets under management to register with the SEC, will be ready by July 21, 2011. However, the SEC has extended the date from July 21, 2011 until March 30, 2012 for advisers to come into compliance with these new requirements imposed under Dodd-Frank.

This extension for advisers to come into compliance with the new requirements imposed by Dodd-Frank will provide the industry with the necessary time to review the SEC’s finalized rules implementing the changes and make the required filings, as appropriate.

SEC Urges Registered Investment Advisers to Disclose Compliance Issues

A popular theme of SEC officials is to urge registrants to self-report their compliance problems to the SEC, and to do so as soon as they occur. Recently, Norm Champ, the SEC’s Deputy Director of its Office of Compliance Inspections and Examinations (OCIE), told an audience of registrants that “in general, things go better when people disclose. . . and tell the SEC about a problem.” Some registrants remain skeptical of the value of self-reporting problems to the SEC. Some believe that the benefits are not always evident to a registrant after self-reporting to the SEC.

According to Mr. Champ, in explaining OCIE’s current examination program of registered investment advisers, the SEC wants to ensure that examinations are focused on the riskiest behaviors and that a lot of the pre-examination preparation will be focused on narrowing the items to review onsite so that the examination can be more effective, for both OCIE staff and the registrant. In addition, OCIE’s examiners are more likely than before to deal directly with a much higher level of individual within the registered firm. Due to the fact that there are currently fewer than 1,000 examiners to examine more than 11,000 investment advisers, thousands of broker-dealers, and other registrants, OCIE must conduct more focused and efficient examinations.

Mr. Champ urged registrants to disclose problems to the examiners up front instead of seeking to hide such issues. If the examiners sense that a problem has been covered up, it is likely that the examiners will spend additional time during the examination to root out the problem and closely scrutinize the firm’s efforts to resolve the problem. According to Mr. Champ, disclosing the issue up front should help eliminate the additional amount of time spent on-site by OCIE staff.

Advisers Are Reminded to Conduct an Annual Compliance Review

Rule 206(4)-7 under the Advisers Act requires a registered investment adviser to: (i) adopt and implement written policies and procedures reasonably designed to prevent a violation of the Advisers Act and regulations thereunder and all federal securities laws, and (ii) to review, at least annually, its policies and procedures to consider any compliance issues that occurred over the year, any changes in the business activities of the adviser, and any changes in the Advisers Act that might require additions or revisions to the adviser’s policies and procedures.

The SEC has suggested that the adviser’s policies and procedures address, at a minimum, the following:

  1. Trading practices, including the parameters for selection of broker-dealers
  2. Portfolio management processes
  3. Proprietary and personal trading of the firm and its supervised persons
  4. Maintenance of required records
  5. Marketing of advisory services
  6. Use of solicitors
  7. Valuation of client holdings and appropriateness of management fees
  8. Custody of clients assets
  9. Form ADV disclosure, with an emphasis on a description of the firm’s conflicts of interest

The SEC recommends that compliance audits be conducted at least annually, but more often if situations dictate that a compliance audit be conducted. For example, a compliance audit may be triggered if there have been material changes in the adviser’s business, management, or personnel or if litigation or client complaints have occurred that indicate a need for changes in the firm’s policies and procedures.

The adviser needs to keep a record of its compliance audits, including the actions taken to address issues uncovered during the audit. The revisions to the adviser’s compliance manual need to be distributed to all supervised persons and each supervised person should be required to indicate in writing, at least on an annual basis, their review and understanding of the revised policies and procedures.

Recent SEC Developments

The following is a brief summary highlighting certain SEC developments relating to investment advisers and investment companies.

On March 30, 2011, the SEC proposed rules that would require U.S. stock exchanges to adopt new corporate governance requirements for compensation committees of listed issuers of equity securities. The NYSE and NASDAQ currently exempt closed-end and open-end management investment companies registered under the Investment Company Act of 1940 from their compensation committee requirements. The proposed rules also would require new disclosures in annual proxy statements regarding advice obtained by compensation committees from compensation consultants, which would apply to all public companies, not just listed companies.

Significantly, proposed new Rule 10C-1 under the Securities Exchange Act of 1934 would require stock exchanges to establish specific independence requirements for members of compensation committees and to consider relevant factors in adopting those requirements. The SEC notes in the proposing release that there are strong arguments that have been advanced against barring from compensation committees directors associated with significant shareholders, such as a venture capital fund, even if the shareholder is an “affiliate” of the issuer.

On March 18, 2011, the staff of the SEC’s Division of Investment Management published “Staff Responses to Questions about Part 2 of Form ADV” (Q&A), available online at http://tinyurl.com/3c9pcxd. The Q&A addressed several topics of interest, including the following:

  • The staff clarified that a currently registered adviser that is transitioning to the new brochure format may choose not to identify and discuss material changes from its previous brochure in Item 2 of Part 2A
  • An adviser has some flexibility with the format of its responses in the new brochure, as its does not need to include headings of the sub-parts to each item or to follow the order of the sub-parts within each item
  • An adviser that uses multiple significant investment strategies must describe in the new brochure the material risks for each significant investment strategy
  • An adviser that uses pooled investment vehicles as a significant investment strategy may shorten its disclosure in the new brochure by providing only a brief explanation of the material risks of the pooled investment vehicles, while referring clients to the prospectus or offering memoranda that a client has received for a more detailed discussion of the risks of the relevant pooled investment vehicles
  • An adviser to a hedge fund or private equity fund may satisfy its obligation to deliver the new brochure by delivering such brochure to a legal representative of the hedge fund or private equity fund

On March 2, 2011, the SEC proposed rules related to incentive-based compensation practices at covered financial institutions with assets of no less than $1 billion, which would include an investment adviser (whether or not the investment adviser is registered with the SEC). The proposed rules have four main components: (1) a prohibition against incentive-based compensation arrangements that encourage executive officers, employees, directors, or principal shareholders of an investment adviser to expose the adviser to inappropriate risk by providing such persons with excessive compensation; (2) a prohibition against establishing or maintaining any incentive-based compensation arrangements for executive officers, employees, directors, or principal shareholders of an investment adviser that encourage inappropriate risks by the adviser that could lead to material financial loss; (3) the requirement that the investment adviser adopt policies and procedures appropriate to its size, complexity, and use of incentive-based compensation to help ensure compliance with the requirements of the new rules, including the above-reference prohibitions; and (4) the requirement that the investment adviser annually report certain information to the SEC concerning its incentive-based compensation arrangements for officers, employees, directors, or principal shareholders.

Enforcement Matters

Hedge Fund Managers Admit to Fraud in Court and Settle With SEC

Two Florida hedge fund managers admitted in federal court that they intentionally misled investors in hedge funds they managed regarding investments made through Thomas J. Petters, who has been convicted of running a Ponzi scheme (USA v. Vannes et al., Case No. 0:11-CR-00141 U.S. Dist. Ct. Minn.). Mr. Petters was convicted of fraud in 2009 and was sentenced in 2010 to serve 50 years in prison.

The managers, Bruce Prevost and David Harrold, pled guilty to four counts of securities fraud. The managers operated four Florida hedge funds and lied to investors to encourage them to invest in Mr. Petters’ company. Mr. Petters sold notes to hedge funds purportedly to purchase electronics and consumer products through his company. His company would then in turn, sell the electronics and other products to big box stores. But Mr. Petters was conducting a Ponzi scheme and nothing was ever bought or sold.

The hedge fund run by Mr. Prevost and Mr. Harrold received their payments from Mr. Petters’ company and not from any goods sold, as investors were told. In total, Mr. Prevost and Mr. Harrold received more than $58 million in management fees from their hedge funds. The investments covered more than six years and totaled approximately $1 billion. In February 2008, the two fund managers facing the likelihood that Mr. Petters’ company was going to default on the notes investors purchased, decided to trade more than $1 billion worth of notes in order to further mislead investors by creating the appearance that Mr. Petters’ company could repay the notes held by the hedge funds. Even during this time, the hedge fund managers continued to sell interests in their hedge funds to new investors, raising more than $75 million in new investments. These sales continued although Mr. Prevost and Mr. Harrold knew that there was little or no chance that Mr. Petters’ company would be able to pay back the principal or interest on the notes purchased by the hedge funds.

Both Mr. Prevost and Mr. Harrold face a maximum prison sentence of 20 years. Mr. Prevost and Mr. Harrold consented to a permanent injunction barring them from future violations, to the payment of a civil fine in an amount to be determined, and to turn over all of their ill-gotten gains.


Legal News is part of our ongoing commitment to providing up-to-the minute information about pressing concerns or industry issues affecting our clients and colleagues.

If you have any questions about this Legal News or would like to discuss the topic further, please contact your Foley attorney or the following individual:

Terry D. Nelson
Madison, Wisconsin
618.258.4215
tnelson@foley.com

Peter D. Fetzer
Milwaukee, Wisconsin
414.297.5596
pfetzer@foley.com

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