A Compilation of Enforcement and Non-Enforcement Actions

23 February 2012 Publication
Authors: Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Enforcement Matters

Former Hedge Fund Manager Faces Prison Time and $8.26 Million Fine for Insider Trading

Joseph Contorinis, a former hedge fund portfolio manager, was sentenced to six years in prison and ordered to pay $8.26 million in disgorgement and fines over his alleged involvement in an insider trading scheme involving the shares of Albertsons Inc. during December 2005 and January 2006.

Mr. Contorinis and six other men were charged by the SEC over their roles in trading on confidential information regarding possible acquisitions of Albertsons Inc. According to the SEC, the scheme resulted in approximately $12 million in illegal profits and avoided losses. Five of the six individuals faced criminal charges.

Mr. Contorinis was sentenced to prison in a separate case, which is currently under appeal. He was ordered by the court to pay a $1 million fine in addition to the $7.26 million in disgorgement. The SEC also requested that the court order treble damages, but that request was denied. The court, in denying the treble damages request, noted that the disgorgement, fine amount, and prison term appeared to be sufficient punishment for Mr. Contorinis.

Non-Enforcement Matters

SEC to Focus Examinations on Firms Who Fail to Set the Appropriate Compliance Tone

Registered investment advisers for which senior management and boards fail to set the “right compliance tone” to support the efforts of the firm’s chief compliance officer (CCO) and enforcement of the firm’s compliance policies and procedures, will be the target of future SEC examinations. This is according to Carlo di Florio, Director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), when he spoke at a recent Compliance Outreach Program.

According to Director Florio, the SEC will especially focus on those firms where it is apparent to the staff that the firm’s CCO lacks the strong support of the firm’s senior management and its board of directors and overall support for enforcing the firm’s compliance policies and procedures. According to Director Florio, the failure by firm management and/or the board will generally result in an ineffective CCO and compliance program. The SEC intends to gauge the amount of compliance support and appropriate tone at the top by engaging with senior management and board members during the examination process.

This direction for the conduct of examinations by the OCIE is in keeping with its new “risk-based” exam process, under which the OCIE targets firms that have the highest potential for significant violations.

In addition, Director Florio announced that the OCIE staff is ready to “field test” its newly developed national examination manual for investment advisers and investment companies. The manual will be made available to the public through the SEC’s Web site, but only after the manual has been thoroughly tested during examinations conducted by the staff. The manual, when it becomes available to the public, should provide registered investment advisers with a better understanding of what to expect during the OCIE’s examination process.

The SEC has attempted to revise its national examination model so that all of its regional offices are instituting the same examination practices and to help coordinate the examinations with other SEC divisions. The “field testing” is expected to be conducted over the next several months with no timetable as to when the manual will be available to the public.

Status of Municipal Advisor Registration Proposals

The Municipal Securities Rulemaking Board (MSRB) proposed rules last year to regulate municipal advisors as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under Dodd-Frank, municipal advisors are required to register with the SEC and the MSRB. The MSRB’s proposed rules are on “hold” until the SEC finalizes its proposed definition of a “municipal advisor.” The initial definition as proposed by the SEC in December 2010, was heavily criticized by several different parties for being, among other things, “overly broad” and would unnecessarily add to the compliance burdens of already heavily regulated entities. The SEC has apparently been preoccupied with more pressing issues since Dodd-Frank was adopted in 2010. Supposedly, the SEC will revisit the municipal advisor definition during the second half of 2012.

Last year, the MSRB proposed rules for municipal advisors that covered such issues as conflicts of interest, pay-to-play, fiduciary duty, and supervisory requirements. Those proposed rules will not be finalized, at least until the SEC arrives at a final definition of municipal advisor.

Until that time, it is recommended that those persons who believe they are or will be conducting activities as a “municipal advisor” as currently defined, should register with the SEC and MSRB as required under Dodd-Frank.

SEC Adjusts Qualified Client Performance Fees Requirement

In a rule adopted by the SEC on February 15, 2012, clients of registered investment advisers who will be charged a performance fee (defined to be “qualified clients”) will have to meet heightened net worth requirements in order to qualify as a qualified client.

Last year, the SEC raised the limits to qualify as a “qualified client” to have at least $1 million of assets under management, or have a net worth of at least $2 million. The final rule adopted this month serves to codify the heightened requirement that went into effect last year and to exclude the value of the client’s primary residence and certain property related debt from the net worth calculation.

The new rule includes a grandfather provision that allows registered investment advisers to continue charging clients a performance fee if they were “qualified clients” before the rule changes. The amendments to SEC Rule 205-3 are effective 90 days after publication in the Federal Register. The Dodd-Frank Act required the SEC to heighten the qualification requirements for a qualified client but it did not require the SEC to also impose the net worth calculation change. The SEC decided to impose the same net worth calculations for qualified clients as required for investors who qualify as “accredited investors” under Regulation D of the Securities Act of 1933.

Dodd-Frank also requires the SEC to make inflation-based adjustments to the requirements for “qualified clients” every five years.

The SEC projects that the exclusion of the value of the client’s principal residence will result in 1.3 million households that will no longer qualify to receive performance fee investment advisory services.

Investment Advisers to Registered Investment Companies and Private Funds May Need to Register as Commodity Pool Operators or Commodity Trading Advisors

The Commodity Futures Trading Commission (CFTC) has amended its rules to narrow the available exemptions from commodity pool operator registration with respect to registered investment companies and private funds.1 The amendments will require the investment advisers of affected registered investment companies and private funds to register as either a Commodity Pool Operator (CPO) or Commodity Trading Advisor (CTA) under the Commodity Exchange Act, and to become members of the National Futures Association. Examination and registration of their associated persons also will be required.

A CPO is a person that is engaged in a business in the nature of a commodity pool and that, in connection with such business, “solicits, accepts or receives from others, funds, securities or property, either directly or through capital contributions, the sale of stock or other forms of securities, or otherwise for the purpose of trading” commodity interests. A CTA is a “person who, for compensation or profit, engages in the business of advising others, either directly or through publications, writings, or electronic media, as to the value of or the advisability of trading in” commodity interests; or who “for compensation or profit, and as part of a regular business, issues or promulgates analyses or reports concerning any of” the foregoing activities.

Those investment advisers that are required to register as CPOs will have to operate under a dual Securities and Exchange Commission (SEC)/CFTC regulatory regime, which may subject such companies to duplicative, inconsistent, or conflicting requirements. In response, the CFTC has proposed new rules to try to harmonize the CFTC’s rules with the SEC’s rules. It is not clear that the proposed rules would actually enable dually registered investment advisers to avoid costly duplicative, inconsistent, or conflicting requirements of the CFTC and SEC.

Requirement to Register as a CPO or CTA. Registered investment companies and private funds that trade in commodity interests, consisting of futures, options on futures, and swaps, including options on commodities, are “commodity pools” under the Commodity Exchange Act and related regulations adopted by the CFTC.2 This status as a “commodity pool” applies regardless of the extent of futures activities engaged in by registered investment companies or private funds, and will apply even if the registered investment company or private fund is not predominantly engaged in trading of commodity interests. Further, absent an exemption, the manager of or adviser to a registered investment company or private fund that is a commodity pool must register as either a CPO or CTA under the Commodity Exchange Act.

Exemption for Registered Investment Companies Narrowed. Prior Rule 4.5 under the Commodity Exchange Act provided a broad exemption for registered investment companies. (With respect to an investment adviser of a registered investment company that is not a CPO, the CFTC takes the position that such investment adviser is typically also not a CPO.) As amended, Rule 4.5 provides that a registered investment company is excluded from the definition of a CPO, but only if the registered investment company annually files a notice of exclusion and is able to make three representations:

  1. The registered investment company must limit its use of commodity interests to bona fide hedging purposes, plus an additional amount such that the aggregate initial margin and premiums required to establish such positions will not exceed five percent of the portfolio, after taking into account unrealized profits and losses. “Bona fide hedging purposes” may not cover all risk management transactions, as it is a narrowly defined standard.
  2. The aggregate net notional value of commodity interests not used solely for bona fide hedging purposes must not exceed 100 percent of the liquidation value of the portfolio of the registered investment company, after taking into account unrealized profits and losses. The preamble to the rule suggests that this is an alternative standard, such that the exemption is available if either the five percent test described in the preceding paragraph or this 100 percent test is met.
  3. The registered investment company must not be marketed to the public as a commodity pool or otherwise as a vehicle for trading in the various markets for commodity interests. The preamble to the rule lists several factors that are indicative of marketing the registered investment company as a vehicle, but says that such factors should be instructive and that no single factor is dispositive. The CFTC will not consider the mere disclosure to investors or potential investors that the registered investment company may engage in derivatives trading incidental to its main investment strategy and the risks associated therewith as being violative of the marketing restriction.

Registration Requirements Related to Controlled Foreign Corporations. Among the non-dispositive factors indicative of marketing is the use of a controlled foreign corporation (CFC) for investing in derivatives. As a result, the third representation discussed above will be particularly problematic for a registered investment company or private fund that uses a controlled foreign corporation for investing in derivatives while meeting tax law requirements.

In addition to being a factor indicative of marketing, CFCs now will themselves be subject to commodity pool status, even when their parent registered investment company or private fund qualifies for an exemption (unless the CFC also qualifies for an exemption, which typically will not be the case). It appears likely, therefore, that any investment adviser to a registered investment company or private fund with a CFC will have to register as a CPO, except in cases where the investment adviser’s responsibilities do not include the CFC.

Proposed Harmonization of CFTC and SEC Rules. Those investment advisers that are required to register as CPOs will have to operate under a dual SEC/CFTC regulatory regime, which may subject such companies to duplicative, inconsistent, or conflicting requirements. In response, the CFTC has proposed new rules to try to harmonize the CFTC’s rules with the SEC’s rules. Specific areas, among others, noted as needing harmonization, and the proposed rules’ fixes, are as follows:

  1. The Commodity Exchange Act requires CPOs a) to deliver disclosure documents setting forth required information to investors and receive from the investors a signed acknowledgement that they have received the disclosure documents (SEC rules do not require an acknowledgement related to delivery of a registered investment company’s disclosure documents); b) to distribute to investors an account statement presented in the form of a Statement of Income (Loss) and a Statement of Changes in Net Asset Value, on a monthly basis (SEC rules require only semi-annual financial reports); and c) to keep their books and records related Commodity Exchange Act compliance at their main business office (SEC rules allow a registered investment company’s administrator and other service providers to maintain books and records on its behalf). The proposed rules would allow registered investment companies to comply with the disclosure document and account statement delivery requirements by making such documents available on their Web sites, and to maintain their records with specified third parties, on the condition that certain information and representations are filed with the CPO’s notice claiming relief.
  2. The Commodity Exchange Act requires certain disclosures that are different from or beyond those required in a registered investment company’s registration statement on Form N-1A or Form N-2 (CFTC rules would suggest much of this disclosure should go in a fund’s summary prospectus, but SEC rules would prohibit the inclusion of such information in the summary prospectus). The proposed rules would allow most of this additional disclosure to be made in the registered investment company’s statutory prospectus (outside of the summary prospectus) or in the registered investment company’s statement of additional information.

Exemption for Private Funds Narrowed. Prior Rule 4.13 of the regulations under the Commodity Exchange Act contained two exemptions from registration as a CPO commonly used by private funds. The first is found in Rule 4.13(a)(3), which provides exemptions with respect to pools operated by the CPO subject to limits on commodity interest trading generally similar to those now applicable to registered investment companies under Rule 4.5 and whose investors meet certain qualification standards. The second was found in Rule 4.13(a)(4), which provided an exemption from CPO status with respect to commodity pools whose participants were all qualified eligible persons (a counterpart to the “qualified purchasers” who can invest in private funds under Section 3(c)(7) of the Investment Company Act of 1940). The new rules eliminate Rule 4.13(a)(4). While Rule 4.13(a)(4) has been eliminated, where the investors are “qualified eligible persons,” a CPO may rely on Rule 4.7 of the regulations under the Commodity Exchange Act to relieve it of the requirement to deliver a disclosure document as well as many of the recordkeeping requirements. (The rule changes also amend Rule 4.13(a)(3) to incorporate references to cleared swaps and other changes to conform to the Dodd-Frank Act amendments.)

The rescission of Rule 4.13(a)(4) may be particularly onerous for foreign CPOs operating a pool with at least one U.S. investor. Such foreign CPOs may be required to register with the CFTC even if foreign regulators also oversee their activities.

Compliance Dates. Here are the applicable compliance dates:

  • For registration purposes only, compliance with Rule 4.5 will be required no later than the later of December 31, 2012, or 60 days after the effective date of a final rulemaking further defining the term “swap,” which the CFTC will publish in the Federal Register at a future date. 
  • For complying with the CFTC’s recordkeeping, reporting, and disclosure requirements, due to the amendments to Rule 4.5, entities that register will be required to comply with these requirements within 60 days following the effectiveness of a final rule implementing the CFTC's proposed harmonization rules. 
  • CPOs claiming exemption under Rule 4.13(a)(4) will be required to comply with its rescission by December 31, 2012; however, compliance will be required for all other CPOs 60 days from publication in the Federal Register.

1 Commodity Pool Operators and Commodity Trading Advisors: Amendments to Compliance Obligations (Final Rules) (Feb. 8, 2012). As of the date of this Legal News publication, the final rules have not been published in the Federal Register.

2 The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Public Law 111-203, 124 Stat. 1376) (Dodd-Frank Act) expanded the products covered by the Commodity Exchange Act definitions of commodity pool, commodity pool operator, and commodity trading advisor to include over-the-counter derivatives, or “swaps,” and also included commodity options within the definition of swap.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

Peter D. Fetzer
Milwaukee, Wisconsin

A. Michael Primo
Boston, Massachusetts