A Compilation of Enforcement and Non-Enforcement Actions

12 July 2011 Publication
Authors: Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

New Investment Adviser Rules

On June 22, 2011, the SEC adopted certain rules and amendments that implement various federal securities initiatives focusing on investment advisers under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Essentially, the world falls into two broad categories, foreign investment advisers and U.S. investment advisers. Those U.S. investment advisers and foreign investment advisers that do not qualify for the “foreign private adviser” exemption discussed below are further distinguishable by whether they (1) act as investment advisers solely to venture capital funds, (2) act as investment advisers solely to private funds, (3) are family offices providing investment advice solely to family clients, or (4) act as investment advisers to persons in addition to, or other than, venture capital funds, private funds, or family clients.

The new rules do not change the basic analysis for determining whether a person is an investment adviser. Specifically, a person is an investment adviser if that person is engaged, for compensation, in the business of advising others with respect to securities. For example, a person who advises others with respect to assets that are not “securities” under the Investment Advisers Act is not an investment adviser under the old or new rules.

Nor do the new rules change the fact that an investment adviser to a registered investment company must register with the SEC regardless of the size of the registered investment company.

Where the new rules have an impact is in determining whether a person who, for compensation, is engaged in the business of advising others with respect to securities, must register with the SEC as an investment adviser, or is required to register at the state level. This impact is felt most in (1) the elimination of the private investment adviser exemption, which provided that any investment adviser was exempt from registration with the SEC if the investment adviser (a) had fewer than 15 clients in the preceding 12 months, (b) did not hold itself out to the public as an investment adviser, and (c) did not act as an investment adviser to a registered investment company or a business development company, as this change will require some previously exempt investment advisers to register; and (2) the increase in the threshold amount of assets under management needed to be permitted to register with the SEC instead of at the state level, with the amount being increased from $25 million to $100 million under management, as this change will require some SEC registered investment advisers to deregister with the SEC and register at the state level.

Investment advisers who previously relied on the private investment adviser exemption need to determine whether any of the new exemptions apply or whether they need to register with the SEC (or at the state level). The SEC registration deadline for advisers previously relying on the private investment adviser exemption is March 30, 2012, which results in filing the investment adviser registration form, Form ADV, by no later than February 14, 2012.

Foreign Investment Advisers. Although Dodd-Frank eliminated the private investment adviser exemption used frequently by foreign investment advisers, the Act did provide a narrow registration exemption for “foreign private advisers.” A foreign investment adviser that does not qualify as a foreign private adviser is subject to registering as an investment adviser in the United States.

A foreign private adviser is any investment adviser who (1) has no place of business in the United States; (2) has fewer than 15 clients and investors in the United States in private funds advised by the adviser; (3) has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the investment adviser of less than $25 million; and (4) does not hold itself out generally to the U.S. public as an investment adviser, and does not act as an investment adviser to any registered investment company or a business development company.

The new rules clarify the application of this narrow exemption for foreign investment advisers, particularly with respect to how foreign advisers determine whether a client or investor is in the United States and how foreign advisers count clients and investors. In addition, the SEC made it clear that this exemption is not available to an adviser that advises a business development company regardless of the size of such company, and that this exemption is not available to a foreign adviser that holds itself out generally to the public in the United States as an investment adviser.

Venture Capital Fund Exemption. New Section 203(l) of the Investment Advisers Act exempts from SEC registration as an investment adviser those foreign and U.S. advisers who advise solely venture capital funds. If an investment adviser provides investment advice to clients other than venture capital funds, the exemption is not available.

The new exemption’s application is narrowed through the definition of a “venture capital fund.” A venture capital fund is a private fund that (1) holds no more than 20 percent of its aggregate capital commitments (other than short-term holdings) in non-qualifying investments; (2) does not borrow or otherwise incur leverage, other than by engaging in limited short-term borrowings (excluding certain guarantees of qualifying portfolio company obligations by the fund); (3) does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances; (4) represents itself as pursuing a venture capital strategy to its investors and prospective investors; and (5) is not registered as a fund under the Investment Company Act, and has not elected to be treated as a business development company under the Investment Company Act.

The new rule grandfathers certain existing venture capital funds that would not otherwise qualify but (1) have pursued a venture capital investment strategy by representing themselves as being venture capital funds, (2) began raising capital prior to December 31, 2010, and (3) cease raising capital after July 21, 2011.

Investment advisers that qualify for this exemption still have public reporting requirements on Form ADV. See the discussion below under “Exempting Reporting Advisers and Form ADV.”

Private Fund Exemption. New Section 203(m) of the Investment Advisers Act exempts from SEC registration as an investment adviser those U.S. advisers who advise solely “qualifying private funds” (as defined below) as long as the collective private fund assets are less than $150 million. U.S. advisers are required to include worldwide assets under management for purposes of calculating the $150 million threshold. If this threshold is exceeded, or if the investment adviser advises clients other than private funds, then the exemption is not available.

A “qualifying private fund” is a fund that is not registered under the Investment Company Act and is not a business development company under the Investment Company Act. Most often, these will be private funds exempt from registering under Section 3(c)(1) or 3(c)(7) of the Investment Company Act, but would also include a private fund exempt under another section of the Investment Company Act as long as the adviser treats such fund as a private fund under the Investment Advisers Act for all purposes.

The new rule provides that a foreign investment adviser, an adviser with a principal office and place of business outside of the United States, qualifies for the exemption if: (1) the foreign adviser has no client that is a U.S. person, except for one or more private funds and (2) U.S. attributable assets managed by the foreign adviser are less than $150 million. Foreign advisers relying on the new rule will continue to remain subject to the Investment Advisers Act’s antifraud provisions.

Investment advisers that qualify for this exemption still have public reporting requirements on Form ADV. See the discussion below under “Exempting Reporting Advisers and Form ADV.”

Family Office Exemption. New Rule 202(a)(11)(G)-1 exempts a family office from SEC registration as an investment adviser. A family office is any company that has no clients other than “family clients” (as defined below), is wholly-owned and controlled by family members (as defined below), and does not hold itself out to the public as an investment adviser.

The key to this exemption is who qualifies as a family client. A family office may advise the following persons and qualify for the exemption:

  • Family members and former family members. Family members include all lineal descendants (including by adoption, stepchildren, foster children, and, in some cases, by legal guardianship) of a common ancestor (who is no more than 10 generations removed from the youngest generation of family members), and such lineal descendants’ spouses or spousal equivalents.
  • Key employees and, subject to certain conditions, former key employees. Key employees include:
    • Executive officers, directors, trustees, general partners, or persons serving in a similar capacity for the family office or its affiliated family office.
    • Any other employee of the family office or its affiliated family office (other than a clerical or secretarial employee) who, in connection with his or her regular duties, has participated in the investment activities of the family office or affiliated family office, or similar functions or duties for another company, for at least 12 months.
    • Former key employees, provided that upon the end of such individual’s employment, the former key employee may not continue to receive investment advice except with respect to assets advised by the family office prior his or her employment termination, and may not invest additional assets with the family office except with respect to additional assets that the former key employee was contractual obligated to make prior to his or her employment termination that relate to an existing family-office advised investment.
  • Family-related persons. Other family clients generally include:
    • Any non-profit or charitable organization funded exclusively by family clients.
    • Any estate of a family member, former family member, key employee, or, subject to the conditions discussed above, a former key employee.
      Certain family client trusts.
    • Any company wholly owned by and operated for the sole benefit of family clients.

In addition, if a person that is not a family client becomes a client of the family office as a result of the death of a family member or key employee or other involuntary transfer from a family member or key employee, that person is deemed a family client for one year following the completion of the transfer of legal title to the assets resulting from the death or involuntary transfer.

Investment Advisers to Persons Other Than Venture Capital Funds, Private Funds, and Family Clients. Assuming one of the exemptions from SEC registration as an investment adviser is not available, an investment adviser needs to determine whether it is a large adviser (more than $100 million in assets under management), a mid-sized adviser ($25 million to $100 million in assets under management), or small adviser (less than $25 million in assets under management). Large investment advisers must register with the SEC. Mid-sized investment advisers have to register with the state in which they have their principal place of business unless that state does not require advisers to register or that state does not examine advisers registered with the state (currently Minnesota, New York, and Wyoming), in which case the adviser has to register with the SEC. A mid-sized investment adviser that is required to register at the state level may instead opt to register with the SEC if the adviser would be required to register in 15 or more states. Small investment advisers may not register with the SEC, but may need to register in the states where they conduct business.

New Rule 203A5 requires every adviser registered with the SEC as of January 1, 2012, including those with assets under management of more than $100 million, to file an amendment to its Form ADV no later than March 30, 2012 (which would serve as the annual updating amendment for advisers with a December 31 fiscal year end). Those advisers that no longer qualify for registration with the SEC must withdraw their registration by June 28, 2012.

Exempting Reporting Advisers and Form ADV. An investment adviser that is exempt from registering with the SEC because it advises solely venture capital funds or it advises solely private funds with less than $150 million under management (referred to as an “exempt reporting adviser”) is not subject to routine SEC examinations, but must file Form ADV. Specifically, under Rule 204-4, an exempt reporting adviser must file annually Part 1A of Form ADV and update such filing as necessary. All of the reports of these exempt reporting advisers will be publicly accessible on the Investment Adviser Public Disclosure (IAPD) Web site at http://tinyurl.com/3b7dnyn.

While Form ADV is the form used by investment advisers registered with the SEC, an exempt reporting adviser will be held to a different reporting standard than registered advisers. Namely, exempt reporting advisers will only be required to provide certain limited information about the exempt reporting adviser, including the following: basic identifying information; form of organization; exemption on which the adviser relies; information about the adviser’s other business activities; basic information about the private funds it manages (see the discussion below) and financial services industry affiliates; adviser’s control persons; and disciplinary history of the adviser and its employees. Unlike a registered adviser, an exempt reporting adviser will not be required to file Part 2A of Form ADV, or provide more extensive information concerning an adviser’s business, its advisory personnel, and the conflicts of interest that the adviser may face.

The information about the private funds managed by an exempt reporting adviser is limited to the following basic identifying information, which is to be provided on an anonymous, code-based basis: the private fund’s structure (master-feeder, fund of funds, and so forth); the types of the private funds (hedge, private equity, real estate, and so forth); gross assets; minimum investment commitment; certain information concerning the fund’s beneficial owners (i.e., number of investors, approximate percentage of fund owned by the adviser and its affiliates, funds of funds and non-U.S. persons); whether the fund relies on Regulation D in connection with its offering of securities; whether the fund’s financial statements are audited; and information concerning the private funds’ service providers (i.e., its auditors, prime brokers, custodians, administrators, and marketers).

Performance-Based Compensation Rule to Be Revised

The SEC is proposing (see SEC Release No. IA-3198) to issue an order adjusting the dollar amount tests with respect to qualifying as a “qualified client” under Rule 205-3 (Rule) under the Advisers Act.

Under the Advisers Act, an investment adviser is prohibited from entering into, extending, or performing any investment advisory contract that provides for compensation to the adviser based on a share of capital gains on, or capital appreciation of, the funds of a client (Sec. 205(a)(1) of the Advisers Act). These types of fees, also known as performance compensation or performance fees, were prohibited to protect clients from compensation arrangements that might influence advisers to take excessive risks with client funds. In 1985, the SEC adopted the Rule to provide an exemption from the performance compensation prohibition provided the client was a qualified client, having at least $500,000 (later changed in 1998 to $750,000) under management with the adviser or a net worth of more than $1 million (later changed in 1998 to $1.5 million).

Under Dodd-Frank, the SEC is required, prior to July 21, 2011, and every five years thereafter, to adjust for inflation the dollar amount tests included in the Rule.

The SEC is proposing to increase the assets-under-management test to $1 million and the net worth test to $2 million in order to be a qualifying client under the Rule. In addition, for the purposes of the net worth test, the SEC is proposing to exclude from the calculation, the value of the natural person’s primary residence and the debt secured by that property that is no greater than the property’s current market value. This adjustment to the net worth calculation is consistent with the proposal by the SEC to adjust the net worth calculation for determining if a natural person qualifies as an “accredited investor” under Regulation D of the Securities Act of 1933.

The SEC has proposed that for an adviser who was previously exempt from investment adviser registration with the SEC and subsequently is required to register, the prohibition under Sec. 205(a)(1) of the Advisers Act would not apply to contractual arrangements with a client who authorized performance compensation if that arrangement was entered into when the adviser was exempt from registration. For example, if an adviser to a private fund who entered into arrangements with investors of the fund to receive performance compensation when the adviser was exempt from registration, but then subsequently became registered with the SEC, it could continue to collect the performance fee from such investors. However, for any new investors in the private fund after the adviser becomes registered, such investors would have to be qualified clients by meeting the enhanced net worth or assets under-management tests.

The SEC’s proposal is open for comment until July 11, 2011.

Supreme Court Limits 10b-5 Claims

In Janus Capital Group v. First Derivative Traders, No. 09–525 (decided June 13, 2011), a divided U.S. Supreme Court ruled that an investment adviser to a mutual fund cannot be held directly liable under Rule 10b-5 for misstatements in the fund’s prospectus. The decision is welcome news for investment advisers, as the ruling effectively limits private shareholder actions against a fund complex and its subsidiaries in the prospectus disclosure process. However, the case should also serve as a reminder to the boards of directors of investment companies that they are responsible for oversight of disclosure in a fund’s prospectus and should take care to ensure the disclosure is accurate.

The case involved Janus Capital Group, Inc. and its subsidiary, Janus Capital Management LLC ((JCM), collectively, Janus), in its capacity as adviser and administrator to the Janus Investment Fund, and stemmed from a private shareholder action under Rule 10b-5 of the Securities Exchange Act (Exchange Act) related to certain market-timing prospectus disclosure of the Janus Investment Fund. The suit asserted that Janus, due to the inherent control it retained in the prospectus drafting process due to its position as the investment adviser to the Janus Investment Fund, was ultimately liable for allegedly misrepresenting certain disclosure in the Janus Investment Fund’s prospectus.

The Court held that even though Janus may have been “significantly involved in preparing the prospectuses, Janus did not itself ‘make’ the statements at issue,” and could not be held liable for the statements, because the prospectus was subject to the ultimate control of the board of trustees of the Janus Investment Fund. This ruling by the court follows a 2008 Supreme Court decision that sought to curb the implied private right of a shareholder to bring suit against a company’s banks and business partners for providing false information. Referencing this decision, the Court majority stated that the shareholders in the Janus case were seeking to “create the broad liability” that the Court previously “rejected” in 2008, which the majority again rejected in this case.

The decision provides that for “purposes of Rule 10b-5, the maker of a statement is the person or entity with ultimate authority of the statement, including its content and whether and how to communicate it.” In the case of the Janus Investment Fund’s prospectus, the entity with the ultimately authority was the fund’s board of trustees. So, the Court majority’s decision essentially relegates mutual fund prospectus liability to the officers and trustees of the fund, while limiting the liability of other participants in the drafting of the prospectus, such as investment advisers and other service providers.

In addition, the Court majority’s decision is written broadly and will likely act to severely diminish the future merits of similar private lawsuits under Rule 10b-5 regardless of the industry in which they arise.

NASAA Offers Revised Model Rule for Exempt Reporting Advisers

In December 2010, the North American Securities Administrators Association, Inc. (NASAA), which represents the securities administrators of all 50 states, the District of Columbia, the Commonwealth of Puerto Rico, Mexico, and the various provinces of Canada, published for comment a proposed model rule (Model Rule) that would exempt investment advisers to certain types of private funds from state investment adviser registration. In response to public comments from the December proposal, NASAA recently published a revised version of the Model Rule for additional public comment.

An adviser to a private fund or to a venture capital fund who relies on an exemption from SEC registration must also rely on an exemption from the state(s) securities law in which it has a place of business. NASAA proposes that the Model Rule, if and when adopted by NASAA and then the states, will serve as the state investment adviser registration exemption for investment advisers to private funds or venture capital funds as exempt under the Investment Advisers Act of 1940, by way of Section 203(l) and (m).

The Model Rule would be available to advisers to private funds, excluded from the definition of an investment company under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940. However, 3(c)(1) funds would only be included within the Model Rule coverage to the extent that all of the investors in such a fund met the definition of a “qualified client” under SEC Rule 205-3(d)(1). This SEC rule is in the process of being revised (see article herein, Performance-Based Compensation Rule to be Revised) to require a person to have at least $1 million of assets under management with the adviser or a net worth in excess of $2 million not including the value of the individual investor’s personal residence and indebtedness on such residence.

In addition, an adviser to a Section 3(c)(1) fund who would rely on the Model Rule as an exemption from state registration must provide, on an annual basis, audited financial statements to each of the investors along with certain other disclosure information. The Model Rule as currently proposed would also provide a grand fathering provision to cover advisers who manage funds with existing investors who do not qualify as qualified clients.

Further, the exemption would not be available if the adviser or any of its affiliates are subject to a disqualification under Rule 262 of SEC Regulation A. Finally, the adviser would also be required to file a notice and pay a fee with the state securities administrator in order to qualify for the exemption.

NASAA’s revised Model Rule proposal is currently out for comment until July 13, 2011. A copy of the proposal is available on the NASAA Web site at http://www.nasaa.org.

Enforcement Matters

Violation of Regulation M by Investment Adviser to Hedge Fund Results in Sanctions

Brookside Capital, LLC, a registered investment adviser based in Boston (hereinafter, the Adviser), was the subject of a recent administrative order issued by the SEC (SEC IA Release No. 3226, June 28, 2011) in connection with the violation by the Adviser of Rule 105 of Regulation M of the Securities Exchange Act of 1934 and Section 203(e) of the Investment Advisers Act of 1940.

Rule 105 of Regulation M prohibits short selling of equity securities during a restricted period prior (i.e., five business days before the pricing of the offered securities and ending with such pricing) to a public offering and then repurchasing the subject securities in the offering. The Adviser violated Rule 105 in connection with short sales prior to the public offering and then purchased shares in the public offering of Lincoln National Corporation Co. in June 2009. The Adviser, in conducting the transactions in the hedge fund it advises, made profits of more than $1.6 million in such prohibited transactions. The hedge fund primarily invests in equities of public companies. At the time of the investments, the Adviser had no policies, procedures, or controls in place designed to detect or prevent Rule 105 violations.

The sanctions imposed upon the Adviser by the SEC (as agreed to by the Adviser) are as follows: (i) the Adviser is ordered to cease and desist from committing any further violations of Rule 105 of Regulation M; (ii) the Adviser is censured; and (iii) the Adviser is required to pay disgorgement in the amount of its profits (more than $1.6 million), prejudgment interest (approximately $9,000), and a civil penalty of $375,000. According to the SEC release, the SEC took into consideration the Adviser’s remedial acts promptly undertaken by the Adviser and the cooperation afforded the SEC staff.

This enforcement action underscores the need for investment advisers to implement effective written procedures and policies to prevent and detect violations of provisions of the federal securities acts including Rule 105 of Regulation M. Such policies and procedures, if followed, could have prevented the violation and the resulting SEC enforcement.


Legal News is part of our ongoing commitment to providing legal insight to our clients and colleagues. If you have any questions about or would like to discuss these topics further, please contact your Foley attorney or any of the following individuals:

Terry D. Nelson
Madison, Wisconsin
608.258.4215
tnelson@foley.com  

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

Michael A. Primo
Boston, Massachusetts
617.342.4081
mprimo@foley.com