Financial Industry Developments€¦ · Data destruction policy (Regulation S-P; Massachusetts;...
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Transcript of Financial Industry Developments€¦ · Data destruction policy (Regulation S-P; Massachusetts;...
Financial Industry Developments
Nicholas S. Hodge, Partner K&L GatesSean P. Mahoney, Partner, K&L GatesPaul J. Marnoto, Partner, K&L Gates
OCIE Cybersecurity Risk Alert
Background April 15, 2014 -- SEC OCIE published a
National Exam Program Risk Alert setting forth OCIE expectations for RIAs and BDs with respect to cybersecurity 50 RIA’s and BD’s examined Alert includes a sample document request Request can be viewed (in part) as an indication of
what OCIE was expecting to see
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Bases for Cybersecurity Exams Rule 15c3-5 (Exchange Act) requires broker-dealers with market access to
maintain policies and procedures to protect “information and information systems from unauthorized access, use, disclosure, disruption, modification, perusal, inspection, recording or destruction” Seems to be viewed as imposing a general
requirement to address cybersecurity 5
Bases for Cybersecurity Exams Rule 206(4)-7 (Advisers Act); Rule 38a-1
(’40 Act) Require compliance policies and procedures SEC noted in preamble to Rule 38a-1 that
business continuity obligations fall under advisers’ fiduciary duties
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Specific Documents Requested Written information security policy
(Regulation S-P, Regulation S-ID) Documentation of responsibilities of
employees and managers for cybersecurity Written guidance and periodic training for
employees and vendors
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Specific Documents Requested Data destruction policy (Regulation S-P;
Massachusetts; FACT Act) Records management program is essential
for cybersecurity and for a number of other reasons
Written cybersecurity incident response policy (i.e., “playbook”)
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Specific Documents Requested Written policy and training addressing
removable and mobile media Vendor management information security questionnaires cybersecurity contractual requirements
Written incident alert thresholds
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Other Requests or Expectations Written inventories and assessments Identification of standards (such as NIST)
used by firm Expectation that firm has process to keep up
with emerging best practices (e.g., FS-ISAC) Protection against DDoS attacks Cybersecurity insurance
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Results of OCIE Reviews Ed Schmidt, Senior Technology Officer for
OCIE, commented on the results of cybersecurity examinations at a September 11-12 conference
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Concerns of Firms Examined Network Breach Employee misconduct Social engineering Mobile device security Malware Vendor management Compromise of computers or clouds
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Attacks Experienced 87% of firms experienced attacks 20% of firms experienced attacks directly
and through vendors
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What Firms Are Doing Participating in industry information
sharing groups (e.g., FS-ISAC) Using various security frameworks COBIT (Control Objectives for Information and
Related Technology) Information Security Forum SANS Institute
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Private Equity Developments
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Private Equity Developments
SEC Presence Exams – Notes from the Frontline
Impact of SEC’s “Broken Windows” Enforcement Approach
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Presence Exams
Introduce National Exam Program and OCIE to new registrants Promote compliance with the Investment
Advisers Act and focus on certain areas of particular importance Report observations from exams
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Three Primary Objectives:
Presence Exams
Marketing Portfolio Management Conflicts of Interest Safety of client assets Valuations
Five Areas of Particular Focus
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Presence Exams
Transaction-based compensation Failure to comply with the Custody Rule Misallocation of expenses among clients Portfolio company fees E-mails part of books and records Transactions pre-dating registration “Misleading” use of brand name Untimely submission of personal securities holdings reports
Observations from the Front Lines
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“Broken Windows” Strategy
“Broken Windows”
Based on the premise that no securities law violation is too small to prosecute and that minor enforcement actions lead to greater overall compliance.
SEC’s “tough cop” Approach
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“Broken Windows”
Lack of clear guidance as to the applicability of certain rules (e.g., transaction-based compensation)
Enforcement actions brought for even minor violations Risk of reputational harm due to SEC’s recent practice of
publicizing even minor enforcement actions
When combined with focused Presence Exams, leading the private funds industry to be more conservative.
Creating Culture of Fear?
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“Broken Windows”
Greater transparency of portfolio company fees More disclosure of fees that are not subject to
management fee offsets (e.g., compensation of operating partners and other consultants)
Managers foregoing certain fees to avoid engaging in potential broker activities.
Effect of Strategy on Industry
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Private Placement Developments
The Committee noted that accredited investor status is intended to define a class of investors who are able to fend for themselves and therefore do not need the protections that the Securities Act of 1933 was intended to provide. The Committee expressed the view that the “current definition is, at best, a highly imperfect proxy for financial sophistication and access to information.”
SEC Investment Advisory Committee Recommendations of October 9, 2014 Regarding Accredited Investor Definition
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Rather than focusing on increasing the financial thresholds in Rule 501, the Committee has urged the SEC to consider alternative approaches, such as: Basing the definition on ownership of financial
assets or liquid assets. Enabling individuals to qualify as accredited
investors based on their financial sophistication, as evidenced by the attainment of professional credentials such as the series 7 securities license or the Chartered Financial Analyst designation.
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Committee recommendations to the SEC
Enabling individuals to qualify as accredited investors based on investment experience.
Limiting private offerings to a percentage of assets or income.
Facilitating third-party verification of accredited status.
It is not clear at this time whether the SEC will propose rules to implement any of these recommendations.
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Adopted by the SEC on July 10, 2013. Limits availability of the Regulation D Rule 506 safe harbors
to offerings not involving a Covered Person that is subject to an enumerated Disqualifying Event (a “Bad Actor”).
Issuers must conduct an inquiry exercising “reasonable care” to determine whether a Bad Actor is involved in the offering.
Effective for all Rule 506 offerings occurring after September 23, 2013.
Disclosure to investors prior to subscription required for any disqualifying event occurring prior to September 23, 2013 involving a Covered Person.
Update on Rule 506(d) of Regulation D (the Bad Actors Provision)
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“Disqualifying Events” include (among other things): Felony or misdemeanor convictions relating to
securities or false SEC filings; SEC disciplinary orders; and Being subject to an order, judgment, decree,
suspension, expulsion, or bar of any court or state securities commission that restrains a Covered Person from participating in securities and other finance-related activities.
Rule 506(d) - Disqualifying Events
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“Covered Persons” include: The issuer, any predecessor of the issuer, or any affiliated issuer; Any director, executive officer, or other officer of the issuer
participating in the offering; A general partner or managing member of the issuer; Beneficial owners of 20 percent or more of the issuer’s
outstanding voting equity securities (calculated on the basis of voting power);
Any promoter connected with the issuer in any capacity at the time of sale; and
Any person that has been paid or will be paid for solicitation of purchasers in connection with the offering and any director, officer, general partner, or managing member of any such solicitor.
Rule 506(d) - Covered Persons
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SEC guidance requires that the issuer look through the investor to determine beneficial ownership of securities.
Look through considerations include: Voting Power - includes the power to vote, or direct
the voting of, the investor’s interests in the issuer (e.g., a voting agreement). Investment Power - includes the power to dispose
of, or to direct the disposition of, the investor’s interests in the issuer (e.g., discretionary investment management relationships).
Rule 506(d) - 20% Beneficial Owners
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Issuers cannot assume that a 20% beneficial owner does not exist because no single investor holds 20% or more of the issuer’s outstanding voting securities. Issuers should require each investor to disclose
the existence of voting and investment power relationships.
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Requires that the issuer make a factual inquiry into whether any Covered Person is subject to a Disqualifying Event on an ongoing basis.
SEC guidance indicates that a combination of the following would satisfy the reasonable care standard: Representations regarding Bad Actor status; Contractual covenants to update Bad Actor
representations; and Periodic renewal of Bad Actor representations and
covenants through negative response letters.
Rule 506(d) - Reasonable Care
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Absent cooperation from Covered Persons, responsibility falls upon the issuer to verify Bad Actor status. Research vendors offer background check tools,
but, absent guidance from the SEC, it is uncertain whether these tools would satisfy the reasonable care standard.
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Identify all Covered Persons and those likely to become Covered Persons.
Integrate Bad Actor representations into placement agreements and reserve right to terminate the agreement and payment of fees if the placement agent and/or sub-agent becomes subject to a Disqualifying Event. Obtain Bad Actor representations from the fund’s,
adviser’s, managing member’s, etc. officers, executive officers and directors.
Rule 506(d) - Best Practices
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Integrate Bad Actor representations into subscription materials and obtain Bad Actor representations from existing shareholders.
If any existing investor refuses to provide beneficial ownership and/or Bad Actor representations, consider engaging counsel to evaluate Rule 506(d) implications.
Obtain annual renewal of Bad Actor representations by negative consent.
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Funds are wary of the 20% beneficial owner test. Cayman funds that delegate voting rights to STAR
Trusts are typically exempt because shareholders do not own “voting securities.” Some domestic funds have adopted provisions in
their organizational documents that prevent investors from acquiring 20% of the fund’s voting securities by shifting a portion of their investment into a class with no voting rights.
Act quickly upon notice that a Bad Actor is involved in an offering.
Rule 506(d) – Practical Guidance
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SEC and State Regulator Orders and Settlements Funds and investment advisers continue to
struggle with the 506(d) implications of regulatory orders and settlements. In light of the look through guidance, all orders and
settlements where an issuer, its investment adviser or its GP or any of their affiliates is a party requires a 506(d) analysis. If the settlement or order would result in
disqualification, request waiver from the SEC or state regulator as part of the negotiations.
Rule 506(d) – Practical Guidance
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Recertification The SEC indicated periodic re-certification of
506(d) representations is necessary, but has not provided guidance on the frequency. Many industry participants view annual affirmation by negative consent to be sufficient.
Rule 506(d) – Outstanding Interpretive Issues
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Ongoing Disciplinary Obligations The SEC considers a Disqualifying Event that
limits the activities of an entity to terminate when the obligation terminates or the required action is accomplished. Ongoing obligations (e.g., requiring a compliance specialist to review procedures periodically) may result in indefinite reporting under 506(e) or indefinite disqualification, if not waived.
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Money Market Fund Rule Revisions
Clair E. Pagnano, Partner, K&L Gates LLPGeorge P. Attisano, Counsel, K&L Gates LLP
MONEY MARKET FUND RULE CHANGES On July 23, 2014, the SEC adopted revisions to Rule 2a-
7 under the Investment Company Act of 1940, and related rules and forms
All money funds, except retail and government funds, must adopt a floating NAV structure
Money funds will be permitted to impose liquidity fees and redemption gates during times of market stress In certain cases, liquidity fee will be mandatory Government funds are exempt, but may voluntarily impose fees
and gates New disclosure requirements Revised diversification and stress-testing requirements
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FLOATING NAV Money funds must adopt a floating NAV structure unless they
are retail or government funds. Floating NAV funds must: Use market valuations (instead of amortized cost) to determine NAV Calculate NAV to the 4th decimal place, i.e., $1.0000 (or equivalent
for other stable value funds) Retail and government funds may continue to:
Use amortized cost to value all holdings Calculate a stable $1 NAV (or equivalent)
NOTE: all funds, including floating NAV money funds, may use amortized cost to value securities with remaining maturities of 60 days or less
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FLOATING NAV Retail funds can be sold only to natural persons
SEC expects funds to rely primarily on Social Security numbers Can establish procedures to determine that beneficial owners
investing through omnibus and tax-advantaged accounts are natural persons
Government funds must invest at least 99.5% of total assets in cash, government securities, and/or repurchase agreements that are collateralized solely by government securities or cash
Tax rules proposed to simplify accounting and exempt floating NAV funds from wash sale rules
Compliance date for floating NAV: October 14, 2016
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FEES & GATES: LIQUIDITY FEES
If weekly liquid assets fall below 30%, a money fund may impose a liquidity fee of up to 2% if the board (and a majority of independent directors) determines this to be in the best interests of the fund
If weekly liquid assets fall below 10%, the fund will have to impose a 1% liquidity fee on all redemptions However, the board (and a majority of independent directors)
may determine that the fee is not in the best interests of the fund, or that a lower or higher fee (up to 2%) is in the fund’s best interests
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FEES AND GATES: LIQUIDITY FEES
Board considerations: Changes in spreads for portfolio securities (based
on actual sales; dealer quotes; pricing vendor, mark-to-model, or matrix pricing; or otherwise) The maturities of the fund’s portfolio securities Actual or expected changes in the fund’s liquidity
profile in response to redemptions
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FEES AND GATES: LIQUIDITY FEES
Board considerations, continued: The capability of the fund and its intermediaries to
rapidly impose a liquidity fee differing from a previous or default fee
For a floating NAV fund, the extent to which the fund’s NAV reflect liquidity costs
The fund’s past experience, if any, with imposing liquidity fees
Compliance date for liquidity fees: October 14, 2016
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FEES AND GATES: REDEMPTION GATES If weekly liquid assets fall below 30%, a money
fund may suspend redemptions for up to 10 business days, with the approval of the board (and a majority of independent directors) Gate may be imposed for fewer than 10 days or lifted
before the 10th day Fund may not be gated more than 10 business days
in any 90-day period Compliance date for redemption gates: October
14, 2016
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DISCLOSURE: NEW FORM N-CR
Triggered by: Imposition or removal of fees or gates Financial support from sponsor Security defaults For retail and government funds, a decline in NAV
below $0.9975 Must be filed within one business day of
triggering event
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DISCLOSURE: NEW FORM N-CR Financial support by the sponsor includes: Capital contribution Purchase of a security in reliance on Rule 17a-9 Purchase of any defaulted or devalued security at par Letter of credit or indemnity Capital support agreements (whether or not the fund
ultimately receives) Performance guarantee Other similar action reasonably intended to increase
or stabilize the value or liquidity of the fund’s portfolio
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DISCLOSURE: NEW FORM N-CR
Financial support does not include: Routine fee waiver or expense reimbursement Routine inter-fund lending Routine inter-fund fund share purchases Other actions that the board considers not intended to
increase or stabilize the fund’s value or liquidity Compliance date for new Form N-CR: July 14,
2015
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DISCLOSURE: PROSPECTUS New standard prominent risk disclosure: Floating NAV or no guarantee that stable $1.00 will be
preserved Possibility of fees and/or gates (unless government
fund does not opt in) No guarantee of sponsor support (unless provided)
Floating NAV funds: disclose tax and operational issues
Fees and gates: discuss circumstances in which fees and gates may be imposed
Compliance date for prospectus disclosure: October 14, 2016
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DISCLOSURE: SAI
Disclose occasions during past 10 years when: Weekly liquid assets fell below 10% or 30% and the
imposition of any fees or gates (but not for instances before April 14, 2016)
Fund sponsor provided financial support Compliance date for SAI disclosure: April 14,
2016
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DISCLOSURE: WEBSITE Daily updated posting of:
Levels of daily and weekly liquid assets Net shareholder inflows and outflows Market-based NAVs Sponsor support Any imposition of fees and gates
Maintain information for 6 months Compliance date for website disclosure related to
Form N-CR: July 14, 2015 Compliance date for website disclosure not related
to Form N-CR: April 16, 2016
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DISCLOSURE: FORM N-MFP Information will become publicly available
immediately upon filing (instead of current 60-day delay)
New information required: NAV (and shadow price), daily and weekly liquid assets, and
shareholder flows on a weekly basis within the monthly filing NAV (and shadow price) to the fourth decimal place (or
equivalent for other stable value funds) Include exempt government and retail funds as a category option
Compliance date for amended Form N-MFP: April 14, 2016
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STRESS TESTING
Rule 2a-7 stress testing provisions revised to require funds to test the ability to maintain weekly liquid assets of at least 10% and minimize principal volatility under certain specified scenarios
New rules increase board reporting requirements
Compliance date for stress testing: April 14, 2016
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DIVERSIFICATION Amendments to Rule 2a-7 diversification provisions:
Affiliate Aggregation — Certain entities that are affiliated with each other must be treated as single issuers for the 5% issuer diversification test
Removal of 25% Basket — Money funds, other than tax-exempt funds, will have to meet the 10% diversification limit for guarantors and demand feature providers. For tax-exempt funds, the limit will be 15%
Asset-Backed Securities — Sponsors of asset-backed securities must be treated as guarantors subject to the 10% diversification limit, unless the board (or its delegate) determines that the fund is not relying on the sponsor to determine quality or liquidity
Compliance date for diversification amendments: April 14, 2016
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NEXT STEPS
Retail or Institutional? Assess to what extent existing shareholder base is retail or
institutional Determine whether to reorganize existing retail and institutional
share classes into separate funds or create new funds Review charter documents to assess if shareholder approval is
needed for various actions Consider establishing government funds, or amending
investment policies of existing funds to qualify as government funds
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NEXT STEPS Revise Rule 2a-7 procedures to reflect floating NAV (if applicable),
fees and gates, new disclosure requirements, new stress testing requirements, and new diversification standards
Revise prospectus and SAI, Form N-MFP, and website disclosures For floating NAV funds, update systems to enable routine
transactions at floating NAV For retail funds, develop procedures to ensure that funds are sold
only to natural persons Develop procedures for filing Form N-CR on occurrence of triggering
event
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INTERPRETIVE ISSUES
Retail funds Beneficial ownership: are “direct or indirect pecuniary
interest” and “sole or shared voting or investment power” alternative tests?
Can a managed account invest in retail funds? Does a forfeiture feature in a defined contribution plan
disqualify the plan from investing in a retail fund? Is an estate of a natural person a natural person?
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INTERPRETIVE ISSUES
Retail funds, continued Can a retail fund permit a non-natural person (such
as a sponsor) to own shares of the fund to facilitate operations (e.g., for seed money, merger or liquidation costs)?
In a master-feeder structure, if all the feeders qualify as retail funds, does the master also qualify?
Can a retail fund invest in another retail fund without being considered a non-natural person shareholder of the acquired fund?
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INTERPRETIVE ISSUES
Retail funds, continued Outside the reorganization context, can a retail fund
involuntarily redeem non-eligible investors without giving 60 days’ notice?
Can insurance company separate accounts qualify as intermediaries or omnibus account holders?
Fees/Gates May an intermediary net purchases and redemptions
for purposes of applying a liquidity fee?
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INTERPRETIVE ISSUES
Government funds May qualification be tested only upon each acquisition
of securities? Performance record If an existing fund with retail and institutional share
classes reorganizes into separate retail and floating NAV funds, may both funds continue to show performance of original fund?
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Broker-Dealer Regulatory UpdateMichael S. Caccese, Partner, K&L GatesKenneth G. Juster, Partner, K&L Gates
AGENDA
High Frequency Trading Crowd Funding / Online Platforms Marketing and Placement Agents Broker-Dealer “Status” Issues for Private
Funds
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High Frequency Trading
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WHAT IS HIGH FREQUENCY TRADING?
Use of low-latency tools, such as co-located servers, and direct data feeds from exchanges
Aggressive short-term trading using computer algorithms Typically used by proprietary trading firms and hedge
funds, though tools are also used by brokers to execute customer trades
Difference of opinion: Michael Lewis (“Flash Boys”) claims HFT disadvantages retail
investors Some industry commentators claim HFT adds liquidity to the
markets and lowers cost of execution
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HFT: REGULATORY LANDSCAPE
SEC Chairwoman Mary Jo White is focused on equity market structure issues and HFT Developing an anti-disruptive trading rule to address
the use of aggressive, destabilizing trading strategies in vulnerable market conditions
Two proposed registration rules: Clarify status of unregistered active proprietary traders as
“dealers” under the Exchange Act Eliminate exception from FINRA membership requirements
for dealers that trade in off-exchange venues
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REGULATION SCI
Regulation Systems Compliance and Integrity (“SCI”) Adopted November 19, 2014 Designed to strengthen infrastructure of US securities
markets Requires SROs, clearing agencies, ATSs, plan
processors and exempt clearing agencies to establish policies and procedures to ensure systems have adequate capacity, integrity, resiliency, availability and security
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RECENT HFT ENFORCEMENT ACTION
In re Athena Capital Research, LLC (Oct. 16, 2014) First HFT manipulation case HFT firm used algorithmic trading and rapid fire orders to “mark
the close” Large purchases or sales in last two seconds before 4:00 close
to drive closing prices higher or lower Manipulative trading in violation of Section 10(b) of the
Exchange Act and Rule 10b-5 Cease and desist, censure, and $1 million fine
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Crowdfunding
CROWDFUNDING – JOBS ACT Crowdfunding generally refers to the use of the Internet and social media to
raise capital, normally from a large number of people and in relatively small amounts from each
JOBS Act – Crowdfunding is subject to SEC rulemaking SEC proposed Regulation Crowdfunding for comment in October 2013 As proposed, not available to private fund issuers
True “crowdfunding,” as contemplated by the JOBS Act is currently notpermitted until the SEC acts on regulations that were proposed last year
Because of a number of restrictions/conditions (including information requirements, maximum fundraising amounts, and various mandatory reports) that are either required by the JOBS Act or anticipated in SEC regulations, it is unclear whether true “crowdfunding” will, in fact, prove to be a popular way to raise assets
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CROWDFUNDING LOOK-ALIKES New and creative structures for capital formation emerge
and are tested against the realities of the market
Many structures that are called “crowdfunding,” are different than the crowdfunding contemplated by the JOBS Act Rule 506(c) fundraising Community/Donation-Based Support
Ex. Kickstarter and Indiegogo
Human/Income-Contingent Capital Venture Fund Model Peer-to-Peer Lending
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Rule 506(c) “Crowdfunding,” as the term is colloquially used, more typically refers not to
JOBS Act “Crowdfunding,” but rather to Rule 506(c) private placements or, even more broadly, to any online investment platform
Rule 506(c) allows for the public solicitation of investors to raise an unlimited amount of capital so long as all of the investors are accredited. There are few of the (anticipated) complexities associated with true Crowdfunding and most of the advantages
Many of the existing online securities crowdfunding sources (e.g., EquityNet, CircleUp) are broker-dealers offering securities through a Crowdfunding look-alike website that offers a capital formation tool based on Rule 506(c), but are not “Crowdfunding” as contemplated by the JOBS Act
From a securities law standpoint, many so-called “crowdfunding” sites are merely a modern wrapper around an otherwise traditional Rule 506(b) offering
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ONLINE PLATFORMS – LENDING Though sometimes labeled “crowdfunding,” these sites (including popular
peer-to-peer lending sites such as Lending Club and Prosper) are not true Crowdfunding sites
With variations, these sites offer investors an opportunity to choose among loan proposals from individuals and commercial entities
With some platforms, investors select the loans, or fractions thereof, in which they want to invest
With other platforms, a sponsor selects the actual loans
Investors are typically issued a payment dependent note
Some platforms aggregate loans via an SPV structure such that an investor actually receives an SPV interest
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ONLINE PLATFORMS – REAL ESTATE Typically, these sites offer an opportunity to invest, on a debt
or equity basis, in a real estate project with a third-party developer In some cases, platforms have tried to acquire property directly, and hire
a developer afterward, but this approach can be very expensive, is far more complicated to implement, and shifts enormous risks to the platform sponsor
Real estate platforms typically follow either a debt or equity model In the equity model, the sponsor creates an SPV to invest in a project
(or, more typically, an SPV related to the project) In a debt model, similar to lending platforms, the sponsor issues a class
of its (or an affiliate’s) debt or preferred stock securities to investors, and uses the proceeds to invest directly in the project (or project SPV)
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ONLINE PLATFORMS – VENTURE CAPITAL Based on no-action letters issued to AngelList and
FundingClub in March 2013. Platforms offer accredited investors investments in private
funds, each of which invests in a single private company (or other asset(s))
Investment adviser (or exempt reporting advisor) affiliated with the platform provides investment advice and administrative services to the investment vehicle
Transaction-based compensation not permitted, but investment adviser can receive incentive compensation (i.e., carried interest in private funds) without broker registration
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ONLINE PLATFORMS – REGULATORY ISSUES Online platforms often create complicated U.S. federal and state securities
law issues, primarily around whether the sponsor of the site is acting as an investment adviser and/or broker-dealer This analysis will typically turn on whether the platform is offering or selling
securities, the nature of the sponsor’s services, and the manner of compensation With many business models, a site sponsor will be deemed to be an investment
adviser and/or a broker-dealer Another common issue is whether the SPV or (with sponsors that issue debt) the
sponsor itself is an investment company
Apart from the SEC, online platforms may invest in asset classes that are themselves highly regulated: Lending platforms are subject to a variety of state and local lending laws Real estate platforms are subject to state and local real estate licensing and similar
laws
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Marketing and Placement Agents
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MARKETING AND PLACEMENT AGENTS
David Blass, formerly Chief Counsel, SEC Division of Trading and Markets (April 5, 2013) Raising awareness of broker-dealer status issues in the private
fund industry Two primary issues:
Dedicated sales force may require broker-dealer registration Transaction-based compensation arrangements may trigger broker-
dealer registration requirements Use of issuer’s exemption for private fund sales
Failure to ensure fund marketers are appropriately registered can create liability for sponsor/advisor Ranieri Partners case – “aiding and abetting” liability
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THE “ISSUER EXEMPTION” – RULE 3A4-1 Creates a safe harbor from federal broker-dealer registration
requirements. The safe harbor is available only to “associated persons” of an
issuer (as defined by Rule 3a4-1) who participate in the issuer’s sale of its securities who can not: Be “statutorily disqualified” (e.g., barred, suspended from membership,
participation, or association with a member of any SRO, including FINRA) during the time of participating in the sale;
Receive transaction-based compensation for his or her participation in the sale of the issuer’s securities; and
Be an “associated person” of a broker-dealer Employees of adviser to a mutual fund are included in Rule 3a4-1
definition of “associated person of an issuer” BUT, 1940 Act restrictions generally prevent use of safe harbor for
distribution of mutual funds
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ISSUER’S EXEMPTION
If a fund’s associated persons meet all three factors, they must then comply with one of the following three alternatives: Limit solicitation to sophisticated purchasers such as various
financial institutions and intermediaries or limit sales to securities exempt section 3(a)(7), 3(a)(9) or 3(a)(10) of the Securities Act of 1933
Ensure that the employee who engages in sales activity performs “substantial” duties other than selling securities (“substantial” is measured in terms of work time and volume of work performed in activities unrelated to selling interests in the fund)
Limit sales to purely passive activities such as written solicitation
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ISSUER’S EXEMPTION
David Blass: “As you all know, Rule 3a4-1 generally is not used by private fund advisers.”
The safe harbor would generally not be available to full-time, internal marketing employees, including those associated with funds in continuous distribution.
The difficulty of remaining within the safe harbor limits its usefulness and can create uncertainty.
Open dialogue with industry on where the “broker-dealer” line should be drawn, but momentum has slowed after Blass’ departure from the SEC (June 2014)
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SELLING FUNDS THROUGH DUAL EMPLOYEES
Wearing “broker hat” vs. “adviser hat” No bright line test General guidelines:
Broker: Marketing securities, participating in execution of trades, receipt of
transaction-based compensation Adviser
Marketing strategies, providing investment advice, receipt of asset-based compensation, no reference to broker-dealer or naming of particular securities in marketing materials
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DUAL EMPLOYEE COMPLIANCE ISSUES
Outside business activity notifications Dual employment agreement Disclose correct firm on
Letterhead/business cards General marketing materials Presentations, pitch books, sales literature, etc.
All securities activities through BD – no selling away Compliance and supervision by both entities
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IMPACTS OF MARKETING THROUGH BROKER-DEALER FINRA advertising rules apply Potential filing requirement (retail materials) No model, hypothetical, backtested performance Limitations on related performance (3(c)(7) only) Materials subject to FINRA inspection Content standards of Rule 2210
No superlatives, may not predict or project performance “Fair and balanced” standard
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Broker-Dealer “Status” Issues
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BROKER-DEALER STATUS ISSUES
SEC remains focused on broker-dealer status issues in the private fund industry
Following Dodd-Frank, numerous private fund advisers became RIAs
As they are now being examined by the SEC, they are being questioned about their business practices
Routine exam questions regarding fee structures
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BROKER DEALER STATUS ISSUES
Focus is on various fees received by fund sponsors or their affiliates: Compensation of sales people linked to successful investments Acquisition or disposition fees “Investment banking” fees “Transaction structuring” fees “Success” fees
Some of these fees may raise “broker” registration obligations
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RECENT SEC RELIEF
M&A Brokers No-Action Letter (Feb. 4, 2014) Provides an exemption from “broker” registration for an M&A
broker, if certain conditions are met: No ability to bind parties to a transaction No provision of financing for a transaction No custody, control, possession or handling of funds/securities No public offering, restricted securities, no shell companies Consent required if representing both sides of transaction May not form a group of buyers Buyer will “control” and “actively operate” the target company No passive buyers Not barred or suspended from associating with a broker-dealer
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M&A BROKERS LETTER
Two key indicia that buyer is not passive: “Control”
Power, directly or indirectly, to direct the management or policies of a company
Control will be presumed to exist if, upon completion of the transaction, the buyer or group of buyers has 25% or more ownership
“Actively Operate” May be demonstrated by the power to elect executive officers and approve
the annual budget or by service as an executive or other executive manager, among other things.
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Questions?
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European Issues
C. Todd Gibson, Partner, K&L Gates
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UCITS & AIFMD UCITS
UCITS V Ireland Consultation on Effectiveness of Fund Management
Companies ESMA Guidelines on ETFs and other UCITS Issues Money Market Fund Reform Update
AIFMD Summary and Scope Impact on US Managers Key Implementation Issues and Questions
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UCITS
8/28/2014 - Directive published in the EU Official Journal 9/17/2014 – Directive came into force 3/18/2016 – Deadline for transposition by
Member States into national law
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UCITS V - Timeline
UCITS
Remuneration AIFMD-like rules that apply to senior management, risk takers
and control functions Will remuneration rules to extend to a delegate investment
manager? Proportionality applies ESMA to issue additional details in Level 2 guidelines regarding
applicability to staff
UCITS V
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UCITS
Remuneration (continued) Variable Remuneration - Shares
50% paid in UCITS shares (or certain other), with vesting periods Does not apply if management of UCITS is less than 50% of the
total assets managed by the management company Variable Remuneration – Bonuses
40% deferral over minimum of 3 years (or recommended holding period of UCITS concerned)
Deferral higher where variable compensation is a large component of total compensation
UCITS V
100
UCITS
Remuneration (continued) Disclosure of remuneration policy Annual report information regarding amounts
paid, split into fixed and variable components
UCITS V
101
UCITS
Depositary Functions Single depositary Increased liability
Liable for any assets held “in custody” Verification of ownership/recordkeeping Overarching duty of care for losses suffered by UCITS resulting from
depositary’s negligence or intentional failure to properly fulfill its obligations
UCITS V
102
UCITS
Depositary Functions New rules relating to delegation to sub-custodians –
depositary cannot discharge or transfer liability onto sub-custodian with respect to the UCITS
Limited exceptions relating to delegations in emerging markets, subject to conditions
UCITS V
103
UCITS
Irish consultation on the effectiveness of management company supervision of delegates (CP86) – comments due 12/12 Covers variety of topics Delegate supervision Board composition/managerial functions
Consultation on Effectiveness
104
UCITS
Delegate Supervision Draft version of “good practices” for directors Streamlining of managerial functions
Combining financial-related, new “distribution” function Modifications to Irish residency requirement for directors
2 directors in Ireland at least 110 days per year Can substitute for one of these directors a person (i) who can engage with
the Central Bank within 24 hours, (ii) “unconnected” to the depositary or a service provider, and (iii) is “competent” in one of the managerial functions
Consultation on Effectiveness
105
UCITS
Board composition rationale Document as part of authorization process
how board composition as a whole enables it to fulfill its responsibilities Role of lawyers on Irish fund boards
Consultation on Effectiveness
106
UCITS
Issued 2013 and currently effective, with subsequent updates, ESMA issued guidance and related Q&A’s on various issues impacting ETFs and UCITS funds
ETFs & Financial Indices Guidance regarding names and disclosures applicable to UCITS
ETFs Guidance regarding use of a financial index and composition of
the index Commodity indices cannot relate to single commodity (including
sub-categories, such as crude oil, gasoline, heating oil)
ESMA Guidance – ETFs and UCITS Issues
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UCITS
Collateral Management for OTC and EPM techniques (including repurchase agreements) Guidance regarding liquidity, issuer credit quality, valuation, etc. Collateral diversification
“..sufficiently diversified in terms of country, markets, and issuers.” Issuer diversification – collateral basket has a maximum exposure to a given
issuer of 20% of the fund’s net asset value (multiple collateral pools are aggregated)
Per ESMA Q&A (Question 6(g)): For government bonds, applies to issuer, and not issue
ESMA Guidance – ETFs and UCITS Issues
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UCITS
Currently Two “Tracks” European Council (Italian Presidency)
Debating numerous options (redemption fees, gates, prohibition of sponsor support, capital requirements)
European Parliament Reviewing proposals from ECON committee Modifies the European Commission text (no VNAV or capital buffer),
carve-outs for retail and government funds
Debate continues with final proposals not expected until late 2015
Money Market Fund Reform Update
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AIFMD
What is the Alternative Investment Fund Managers Directive?
What is an Alternative Investment Fund (AIF)? Broadly defined, but exempts UCITS, securitization special purpose
entities; “family office” vehicles; joint ventures; funds restricted to only having one investor (excluding master funds with one feeder); separately managed accounts (no “pooled return”)
Includes US investment companies, Cayman hedge funds, etc.
Summary & Scope
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AIFMD
Applies to (but different treatment): EU-established manager of AIF (registered office in a
Member State) Non-EU AIFMs actively marketing (directly or
indirectly) AIF into the EU Does not apply, in most jurisdictions, to a “reverse
solicitation” (investment made at the sole initiation of the investor
Summary & Scope
111
AIFMD
Who is the “investor”? Nominee accounts, discretionary SMAs,
investors that are funds, etc.
Summary & Scope
112
AIFMD
How are US managers impacted? Cross-border marketing of AIFs to EU
investors Private offerings of US RICs Delegation (e.g., sub-advisory) relationships
Impact on US Managers
113
AIFMD
Cross-border marketing permitted: Manager complies with Art. 22 (Annual Report), Art. 23
(Disclosure to Investors) and Art. 24 (Reporting to Regulator) Comply with local national private placement regime (NPPR) in
EU Member State where fund marketed Any local application procedure has been followed in each EU
Member State where fund is to be marketed
Impact on US Managers
114
AIFMD
Delegation Arrangements/Multiple Advisers Who is the AIFM?
Only one per fund Can be internal or external Excludes firms providing advice only Must engage in either portfolio management or risk management or both;
can delegate subject to limits Responsible to fund and investors for portfolio management and risk
management (and cannot delegate such responsibility) AIFM must have the expertise and resources to review delegate “on an
ongoing basis”
Impact on US Managers
115
AIFMD
Delegation Arrangements (continued) AIFMD Remuneration Rules Similar to UCITS V Rules Although AIFMD may not apply to a US delegate,
expectation that they will extend to delegate to some extent via “appropriate contractual arrangements”
Impact on US Managers
116
AIFMD
Identify what currently unknown information is critical to your organization’s business plan – e.g., which EU Member States might you want to market into, and therefore, which local versions of the AIFMD are most mission critical for you: take steps to monitor how the AIFMD is being implemented in the relevant jurisdictions
Heighten awareness of AIFMD internally If an AIF is proposed to be actively marketed into the EU:
Perform a gap analysis in respect of the AIF’s annual report and offering materials for additional disclosures required for EU marketing; and
Review EU regulator disclosure form and registration process; assess information required and additional processes (e.g., AIFMD version of a US Form PF)
Determine any restrictions or prohibitions on sales to EU investors and communicate to distribution partners
Final Thoughts
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Registered Fund Board of Directors and Fund Governance IssuesMark P. Goshko, Partner, K&L Gates LLPClair E. Pagnano, Partner, K&L Gates LLP
OVERVIEW Organization of the SEC SEC Examinations Section 12(b) and Rule 12b-1 SEC Enforcement Update on Section 36(b) Litigation Money Market Fund Reform and Rule 2a-7 SEC Rulemakings
3
ORGANIZATION OF THE SEC SEC consists of 5 divisions and 23 offices, with approximately 4,100
total employees Division of Investment Management
Employs approximately 200 staff Regulates the asset management industry, including investment companies
and registered investment advisers Division of Enforcement
Nearly 1,300 employees For the 12-month period ended 9/30/14, brought 755 enforcement actions
and obtained sanctions totaling $4.16 billion Office of Compliance Inspections and Examinations (OCIE)
Comprised of approximately 450 examiners, accountants and lawyers Administers the National Exam Program that oversees investment
companies and investment advisers
Requested budget for 2015 is $1.7 billion (2014 - $1.46 billion; 2013 - $1.27 billion)
4
SWEEP EXAMS BY THE SEC
Fixed-income funds Sweep is in response to expected volatility in the bond market
due to potentially rising interest rates SEC is also focused on disclosure about the impact from rising
interest rates and board oversight of bond funds Sweep is expected to cover 25 to 30 firms
Focus of the sweep exam Policies and procedures related to liquidity risks and illiquid
assets Results of stress tests of portfolio liquidity Board oversight of liquidity management
5
SWEEP EXAMS BY THE SEC
Liquid alternative funds Focused on those funds with non-traditional asset classes and/or
non-traditional strategies Risks posed by valuation, liquidity, leverage and disclosure SEC expects to examine 15 to 20 complexes
Focus of the sweep exam Use of derivatives (portfolio holdings and trade blotters) Risk management regarding alternative funds and holdings Pre-trade/post-trade compliance results Liquidity (assessment of fund’s liquidity; stress testing) Valuation
6
SWEEP EXAMS BY THE SEC
Cybersecurity OCIE is conducting exams of 50 broker-dealers and investment
advisers to assess their cybersecurity preparedness Focus on the following areas:
Cybersecurity governance Identification and assessment of cybersecurity 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 Prior experiences with certain cybersecurity threats
7
SWEEP EXAMS BY THE SEC “Distribution in guise”
Begun in 2013, sweep focused on mutual fund distribution fees SEC staff recently indicated that it completed the sweep Several related enforcement actions are expected (“guidance through enforcement” like
Morgan Keegan for valuation)
SEC assessed the payment amounts, services provided and the “interaction of the service agreements”
Focus of the sweep exam Underlying notion that payments ostensibly for sub-transfer agency,
recordkeeping or other services were effectively for distribution SEC looked for link between payments and distribution not previously
disclosed and potential Rule 12b-1 violations Who is getting paid? For what? Particular focus on direct or indirect connections to a preferred fund
arrangement, marketing, promotion or access to investors
8
1940 ACT RESTRICTIONS ON FUND PAYMENTS FOR DISTRIBUTION
Section 12(b) of the 1940 Act Prohibits a mutual fund from acting as
distributor of its own shares Rule 12(b)-1 under the 1940 Act Mutual fund will not be deemed a distributor if it
makes payments for distribution in accordance with the rule Paid pursuant to a written plan adopted in accordance
with the rule Annual, in-person board approval
9
1940 ACT RESTRICTIONS ON FUND PAYMENTS FOR DISTRIBUTION
Adviser payments for distribution and Rule 12b-1 Fund is not permitted to indirectly act as distributor
Violation of Section 12(b) and Rule 12b-1(a)(2) Adviser is not prohibited from paying for distribution (sound business
practice) and may pay for distribution using revenue from advisory fee Creates a potential inference that the mutual fund is making an indirect
use of fund assets to pay for distribution Advisory fee payments as “distribution in guise”
Board has responsibility during 15(c) process to assess reasonableness of advisory fee and contract in light of Gartenberg factors Advisers generally do not discuss their revenue sharing and distribution
arrangements during the 15(c) process Adviser’s position is that any revenue sharing and distribution payments are
separate and distinct from the advisory fee
10
1940 ACT RESTRICTIONS ON FUND PAYMENTS FOR DISTRIBUTION
SEC guidance on “indirect use of fund assets”1
An adviser is permitted to use its legitimate resources to pay for distribution
SEC in “distribution in guise” sweep raised issues similar to those outlined in its 1998 “Fund Supermarkets” Letter2
There should not be allowances in an advisory fee for distribution payments Federated fees for shareholder services and recordkeeping are charged
separately from 12b-1 fees and are not paid pursuant to 12b-1 plans
If the fee/advisory contract does not result in a breach of fiduciary duty under Section 36(b) of the 1940 Act, adviser may use revenue from the advisory fee to pay for distribution (even if such amounts exceed profits on the contract)3
1 Bearing of Distribution Expenses by Mutual Funds, Investment Company Act Release 11414 (Oct. 28, 1980)2 Investment Company Institute, Letter from Douglas Scheit (pub. avail. Oct. 30, 1998)3 Payment of Asset-Based Sales Loads by Registered Open-End Management Investment Companies, Investment Company Act Release No. 16431, at note 125 (Jun. 13, 1988)
11
TRENDS IN SEC ENFORCEMENT
Market structure and exchanges Gatekeepers: attorneys, accountants and
compliance professionals and their roles in the securities industry
Insider trading and material non-public information Fair Valuation
12
RECENT ENFORCEMENT ACTIONS Insider Trading and Material Non-Public Information (MNPI)
SEC v. Rengan Rajaratnam Manager actively tried to cultivate new insider sources for Galleon Managment and
played key role in what the SEC has dubbed “the most expansive insider trading scheme ever perpetrated”
Defendant is brother of primary defendant in the headliner Galleon insider trading case Manager was fined more than $840,000 and agreed to a 5-year industry ban
SEC v. Lawson, Lawson & Cerullo Software company founders, relying on MNPI regarding the company’s prospective
merger, sold company shares in advance of share price decrease Sanctions totaled nearly $5.8 million in disgorgement and matching penalties
SEC v. CITIC Securities & China Shenghai Investment Management Accounts managed by the two firms were frozen by the SEC as a result of suspicious
activity preceding a 50% spike in shares of Nexen, Inc. Enforcement action capped a series of related SEC proceedings recouping nearly $30
million in gains made due to insider trading
13
RECENT ENFORCEMENT ACTIONS Fair Valuation
In late 2012, the SEC began proceedings against former Morgan Keegan directors of Morgan Keegan’s registered funds Board oversight of valuation procedures Delegation of valuation responsibilities Valuation methodologies Insufficient valuation materials for Board review
Morgan Keegan directors ultimately reached settlement with the SEC
Industry responses to Morgan Keegan No formal SEC guidance Third-party assessment of fund valuation policies and procedures Back-testing Increased Board review of valuation issues
14
RECENT ENFORCEMENT ACTIONS Money market fund manager charged with fraud and Rule 2a-7 violations
Advisory firm and portfolio manager misled fund’s board and failed to comply with Rule 2a-7’s risk-limiting provisions
The manager misled the board about the credit risk posed by securities in the portfolio, the fund’s exposure to Eurozone credit crisis of 2011 and the fund’s diversification
Enforcement action resulted when fund’s performance and gross yield were identified as “consistently different” from the rest of the market
Adviser sanctioned for improper cross trading SEC alleged that the firm improperly allocated the savings resulting from these
affiliated transactions and denied certain clients approximately $6.2 million in savings
In its order, the SEC noted that cross trading can pose substantial risks due to the adviser’s inherent conflict of interest in obtaining best execution for both the buying and the selling client
15
UPDATE ON SECTION 36(B) LITIGATION Two approaches by plaintiffs bringing Section 36(b)
excessive fee cases Portion of fee retained by advisers hiring sub-advisers is
disproportionate based on services provided by/responsibilities of the adviser
Fee charged for same strategy by managers acting in subadvisory capacity materially lower than those charged when serving as primary adviser
Complaints also contain allegations regarding board’s ability to devote necessary attention to negotiating advisory fees
Multiple firms have been targeted by excessive fee lawsuits, including BlackRock, J.P. Morgan and SEI
16
MONEY MARKET FUND REFORM AND RULE 2A-7
In July 2014, SEC adopted final money market fund rules Rules would impose a floating NAV on institutional prime money market
funds Boards will have discretion to impose temporary liquidity fees or
redemption gates in times of financial stress Rules also amended Rule 2a-7 under the 1940 Act Compliance dates for the various requirements are staggered, but most
will be effective by October 2016 Industry Responses
Industry groups (ICI, SIFMA) working on FAQs from the SEC Restructuring existing funds or creating new products, including private
money market funds seeking to operate under old regime Issues with technology solutions and service providers
17
SEC RULEMAKINGS The Dodd-Frank Act was signed into law on July 21,
2010 Rulemakings under the Dodd-Frank Act
Required 398 total rulemakings As of October 2014, 220 of those rulemakings have been finalized 115 rulemaking deadlines have been missed 95 rulemakings still to be proposed
Jumpstart Our Business Startups Act (JOBS Act) enacted in April 2012 Rulemakings under the JOBS Act
Elimination of ban on general solicitation and general advertising in Rule 506 and Rule 144A offerings
Amendments to Regulation D and Rule 156 under the Securities Act Proposed rules regarding Regulation A and crowdfunding
18
QUESTIONS?
SEC Asset Management Unit and Exam Program Areas of Focus for 2015Michael S. Caccese, Partner, K&L GatesLuke T. Cadigan, Partner, K&L GatesNicholas S. Hodge, Partner, K&L Gates
22
AGENDA
Trends in the SEC’s Exam program Office of Compliance Inspections and
Examinations (OCIE) priorities for 2015 Anticipating and preparing for SEC exams SEC Enforcement trends Asset Management Unit cases and initiatives Insider trading, municipal securities,
administrative proceedings, and whistleblowers
23
TRENDS IN THE OCIE EXAM PROGRAM Continued use of technology and data analytics National Exam Analytics Tool (NEAT) In FY 2014, Risk Analysis Examination Group analyzed 1.3
billion transactions from 350 firms Impact of Risk Assessment and Surveillance Group
Performs data analytics to identify firms and practices that present the greatest risks to investors
Virtually all exams based on identification of risk factors at respective firms
New hedge fund and private equity registrants still getting attention Establishment of Private Funds Unit
Implementation of National Examination Manual Rigorous pre-exam due diligence and aggressive examinations
24
OCIE BY THE NUMBERS – IA/IC EXAMS
Responsible for exams of nearly 11,000 investment advisers and 800 investment companies
Collectively, assets under management of nearly $55 trillion
Fewer than 460 staff members conducting IA/IC exams (SEC seeking 250 more)
Identification of higher-risk firms for examination OCIE conducted approximately 1,200 formal
examinations of IA/ICs in 2014 (1,850 overall) Represents 30% of assets under management and 10% of all
IA/ICs
25
ENHANCED COORDINATION WITH ENFORCEMENT AND INVESTMENT MANAGEMENT OCIE’s Risk Assessment & Surveillance Unit working to assess
risk with Enforcement’s Office of Market Intelligence OCIE reaching out to Enforcement more frequently and
informally when Exam staff sees potential issues Enforcement increasingly accompanying OCIE on exams Enforcement taking all referrals seriously
In FY 2014, OCIE made more than 200 referrals, resulting in more than $300 million in financial sanctions
Investment Management’s Risk and Examination Office also accompanying OCIE on exams to obtain information to help guide policymaking
OCIE’S GROWING ENFORCEMENT PERSPECTIVE
Regional offices, including OCIE staff, overseen by growing number of former prosecutors Boston, San Francisco, and Chicago
Boston OCIE now headed by former head of Boston’s Asset Management Unit
Other former Enforcement staff now in OCIE
26
NATIONAL EXAM PROGRAM (NEP)-WIDE INITIATIVES Fraud Detection and Prevention Corporate Governance, Conflicts of Interest, and
Enterprise Risk Management Technology Dual Registrants Relatively New Laws and Regulation Securities Act Rule 506(c) Municipal advisor rules Security-based swaps dealers
Retirement Vehicles and Rollovers27
OCIE CYBERSECURITY INITIATIVE SEC Cybersecurity Roundtable (March 26, 2014) NEP Risk Alert (April 15, 2014) Sweep of investment advisers and broker-dealers Focus on Cybersecurity governance Identification and assessment of cybersecurity risks Protection of networks and information Risks associated with vendors and other third parties Detection of unauthorized activity Experiences with cybersecurity threats
Risk Alert or other report of findings expected28
IA/IC PROGRAM CORE RISKS
Safety of Assets and Custody• Asset verification
Marketing/Performance Conflicts of Interest Inherent in Certain
Investment Adviser Business Models
29
IA/IC PROGRAM – ISSUES AND INITIATIVES Never-Before Examined Advisers Wrap Fee Programs Monitoring, conflicts of interest, best execution,
trading away from the sponsor, disclosures Quantitative Trading Models Presence Exams Newly registered advisers to private funds Deficiencies in allocation of expenses, hidden fees,
marketing, and valuation
30
IA/IC PROGRAM – ISSUES AND INITIATIVES
Payments for Distribution in Guise Fixed Income Investment Companies January 2014 IM Guidance Update suggests stress
tests involving liquidity and various other factors Disclosures regarding effects of rise in interest rates
• Exposure by Retail Investors to Lack of Liquidity
31
IA/IC PROGRAM – POLICY TOPICS
Money Market Funds Securities Lending Arrangements “Alternative” Investment Companies 2014 sweep focused on Valuation Liquidity Leverage Role of fund boards in oversight and compliance
32
CONFLICTS OF INTEREST A key area for SEC risk analysis “Conflicts of interest, when not eliminated
or properly mitigated, are a leading indicator of significant regulatory issues for individual firms, and sometimes even systematic risk for the entire financial system.”
-- Carlo di Florio, Director, OCIE, Speech to National Society of Compliance Professionals, October 22, 2012
33
IA/IC PROGRAM – 2015 PRIORITIES Elderly and Retirement Issues
Sales and marketing practices
Supervision of Information Technology Tracking Individuals with Disciplinary Histories Dual Registrants Enhanced Use of Form PF Data JOBS Act Role of Proxy Advisory Firms
June 2014 IM guidance about investment advisers’ responsibilities in voting client proxies and retaining proxy advisory firms
Risk Management Liquidity risk management, stress testing, use of derivatives, and
transition planning
34
ANTICIPATING SEC EXAMS AND ENFORCEMENT ACTIVITY SEC’s exam and enforcement programs are more
risk-based than ever You can predict the likelihood of your next exam by
looking at the risk areas identified by the SEC and determining whether they apply to you Consider a mock audit
SEC investigations at other firms into practices you engage in should prompt a review at your firm
35
ANTICIPATING SEC AREAS OF FOCUS Firms should consider:
Prior SEC exams, including deficiencies raised and actions taken Relevant topics identified by the SEC staff in speeches or releases
(e.g., IM Guidance Updates, Risk Alerts) Enforcement actions and investigations Analysis of new statutory/regulatory requirements that impact the
adviser’s business Any serious compliance issues that arose at the adviser or in the
industry in the past year Analysis of compliance implications of any new businesses,
discontinued businesses, and change in advisory operations during the past year
36
37
DIVISION OF ENFORCEMENT FY 2013 STATISTICS
686 enforcement actions $3.4 billion in penalties and disgorgement 140 cases against IA/ICs (20% of total) 121 cases against B/Ds (18% of total) 44 insider trading cases (6% of total)
38
DIVISION OF ENFORCEMENTFY 2014 STATISTICS 755 enforcement actions (20 more than
FY2011 record) $4.16 billion in penalties and disgorgement Number and nature of cases reflect the
SEC’s “Broken Windows” approach
39
THE SEC’S “BROKEN WINDOWS” APPROACH“Minor violations . . . can feed bigger ones, and . . . can foster a culture where laws are increasingly treated as toothless guidelines. And so, I believe it is important to pursue even the smallest infractions.”- SEC Chair Mary Jo White, “Broken Windows” Speech, October 9, 2013
40
“Broken Windows” approach Lower thresholds for intent and disgorgement/harm
Continued reliance on data analytics Continued focus on individuals Requiring admissions of guilt in specific cases Professed intent to take more cases to trial Increased use of administrative proceedings Increased urgency in wake of Gabelli holding (5-year
statute of limitations starts with fraud not discovery) Whistleblower program
Increased coordination with criminal authorities
ENFORCEMENT TRENDS
41
ENFORCEMENT FOCUS AREAS Investment advisers Hedge funds Private equity funds Mutual funds
Financial statement and accounting fraud Insider trading Microcap fraud Market structure violations Deficient gatekeepers
42
SPECIALIZED UNITS AND TASK FORCESEnforcement Specialized Units Asset Management Market Abuse Foreign Corrupt Practices Act Complex Financial Instruments Municipal Securities and Public Pension
Task Forces Financial Reporting and Audit Task Force Center for Risk and Quantitative Analytics (CRQA) Microcap Fraud Task Force
43
ASSET MANAGEMENT UNIT Largest of specialized units with more than seventy-five staff
members More than 20 staff in each of New York and DC Generally 3-4 staff in each other office
Staff experts include hedge fund portfolio manager, private equity analyst, and individuals with due diligence, mutual fund operations, and trading experience
Focus divided equally among 1) private funds, 2) registered investment companies, and 3) separately managed accounts
Works closely with OCIE and the Divisions of Investment Management and Economic and Risk Analysis in devising analytics and methodologies for targeting specific practices and firms
44
ASSET MANAGEMENT UNITCONTINUED AREAS OF FOCUS
Valuation issues (board oversight, side pockets, liquidity representations, marking the close, etc.)
Conflicts of interest (related party transactions, transactions between co-managed funds, cherry-picking, front-running, etc.)
Performance advertising (claims of back-tested or model performance, GIPS compliance, etc.)
Fee arrangements (board oversight, disguised distribution fees, adviser fees, wrap fees, etc.)
44
45
Custody Rule (failure to conduct surprise exams and to ensure quarterly account statements from custodian, etc.)
Private equity firms (valuation, conflicts of interest, fees, zombie funds, performance claims, etc.)
Small advisers (compliance programs, Ponzi schemes)
Sales practices (are products appropriate to investors?)
ASSET MANAGEMENT UNITCONTINUED AREAS OF FOCUS
46
VARIOUS ASSET MANAGEMENT UNIT INITIATIVES Compliance Program Initiative
Failure to correct compliance violations cited as deficiencies by staff in prior exams
Mutual fund fee initiative Board oversight of fees and valuation determinations
Preferential redemption initiative Investors permitted to redeem on preferential terms
Aberrational performance initiative Use of analytics to identify returns too good to be true at hedge
funds and mutual funds
Problem adviser initiative (“Operation ADV”) Scrutiny of misrepresentations as to education, experience,
strategy, and performance
47
NOTABLE CASES Cross-Trades: Firm charged with engaging in cross-
trades that failed to allocate cost savings equally between buying and selling clients (Western Asset Management)
Performance: SEC charged money manager with making false and misleading claims about the firm's past performance in newsletters and through Twitter. (Mark Grimaldi/Navigator Money Management)
Conflicts of Interest: SEC charged firm and its CEO used undisclosed revenue sharing agreements to pay themselves kickbacks and failed to disclose conflicts of interest (Total Wealth Management)
48
INSIDER TRADING Market Abuse Unit using computer-based tools to sift
through data to find aberrational trading and relationships
Significant collaboration with USAO SAC Capital, Galleon, Expert Network cases
SEC setbacks in attempting to prove insider trading Bauer: 7th Circuit reversed decision finding insider trading in
connection with redemption of mutual funds Cuban: SEC lost jury trial premised on supposed agreement not
to trade on information Obus: SEC lost jury trial against hedge fund manager accused of
selling on merger tip Moshayedi: SEC lost jury trial against former CEO who sold
before disclosure that customer would scale back sales
MUNICIPAL SECURITIES First financial penalty against a municipal issuer (The Greater
Wenatchee Regional Events Center Public Facilities District) First emergency action to halt a fraudulent municipal bond offering
(City of Harvey, Illinois) First case charging a firm with violating the pay-to-play rules for
investment advisors (TL Ventures Inc.) First case under the Municipalities Continuing Disclosure
Cooperation initiative (Kings Canyon Joint Unified School District) First case charging violations of Municipal Securities Rulemaking
Board Rule G-15(f), which establishes the “minimum denomination,” brought against a number of dealers related to Puerto Rico junk bond sales
First time the SEC has charged a municipal official under a federal statute that provides for “control person” liability (Gary Burtka)
49
50
INCREASED USE OFSEC ADMINISTRATIVE PROCESS This past year, SEC brought 43% of its litigated cases as APs SEC has indicated it will make greater use of its advantages in this
forum, where it has a higher winning percentage No right to jury Trial to SEC administrative law judge with first appeal to SEC de
novo No discovery generally
Exceptions: SEC investigative file, statements of witnesses, subpoenas for documents
Limited expert disclosures, but ALJ may order more No dispositive motions (with minor exceptions) All relevant evidence (including hearsay) is admitted Trial within 4-5 months; decision within 10 months Use of SEC administrative process has been subject to
constitutional challenges and public criticism
51
SEC WHISTLEBLOWER PROGRAM
SEC enforcement action with sanctions over $1 million SEC must pay 10-30% of recovery
To any eligible whistleblower Who has voluntarily provided the SEC with Original information about a possible violation of the federal
securities laws
SEC received 3,238 tips in FY13, nearly 9 each day Nearly 90% of whistleblower tips supposedly first made
to company
SEC Whistleblower Program 3,238 formal whistleblower tips received in FY2013 Since Office of Whistleblower opened by SEC in 2011, received more than 6,500 whistleblower tips Examples Corporate disclosures and financials – 17.2% Offering fraud – 17.1% Manipulation – 16.2% Insider trading – 6.1%
404 tips from 55 countries outside US E.g., United Kingdom (66 tips), Canada (62 tips), and China (52 tips)
52
SEC WHISTLEBLOWER PROGRAM
August 21, 2012: SEC issues $50,000 award to an unnamed tipster who helped uncover a fraud
June 12, 2013: SEC issues awards to three whistleblower of 5% of funds collected in connection with alleged sham hedge fund
September 30, 2013: SEC awards over $14 million to whistleblower whose tip led to recovery of investor funds
October 30, 2013: SEC awards to whistleblower 30% of funds collected in connection with action arising from ongoing fraudulent scheme
53
SEC WHISTLEBLOWER PROGRAM June 3, 2014: SEC awards $875,000 to be split
between two whistleblowers June 16, 2014: SEC brings action against
hedge fund adviser for retaliation against whistleblower
August 29, 2014: SEC awards $300,000 to compliance/internal audit professional
September 2014: SEC issues $30 million award
54
QUESTIONS?
CFTC and Derivative Developments
Michael W. McGrath, Partner, K&L Gates LLPSkanthan Vivekananda, Partner, K&L Gates LLP
58
AGENDA
CPOs and CTAs
Form 40 Amendments
Margin for Uncleared Swaps
ISDA Resolution Stay Protocol
EMIR
59
CPOS AND CTAS – HOW DID WE GET HERE? The Dodd-Frank Act and related rulemaking added
most swaps to the definition of “commodity interest”
2012: the CFTC significantly narrowed the exclusion for CPOs of Registered Funds by requiring the CPO to meet certain marketing requirements and meet one of two de minimis tests: 5% Test 100% Net Notional Test
2013: “Harmonization” rules provide a “substituted compliance” regime for most aspects of CFTC regulation (other than CPO registration)
60
CPOS AND CTAS – RECENT DEVELOPMENTS
Third-Party Recordkeeping: September 2014 letter permits allCPOs to use any third-party as a recordkeeper, provided: The CPO has timely access to such records
The CPO files a statement that identifies the third-party to the CFTC
CPO Delegation: October 2014 letter provides “self-executing” delegation subject to certain conditions, including: Delegation is pursuant to a legally binding document
The delegating CPO does not solicit investors for the pool or manage pool assets (with certain exceptions)
The designated CPO is registered
JOBS Act: September letter harmonizes Regulations 4.7(b) and 4.13(a)(3) with Rule 506(c) of Regulation D, but a notice filing is required
61
CPOS AND CTAS – OPEN ISSUES
CTA recordkeeping delegation
Recordkeeping rule modernization
Fund-of-funds guidance
Additional delegation guidance
62
OWNERSHIP AND CONTROL REPORTING
In 2013, the CFTC published new rules related to ownership and control reporting (Form 40 / 40S reporting for end-users)Substantive changes:
Expanded trader and account informationNew reporting obligations for DCMs and SEFsElectronic submissionObligation to update
Compliance Dates:February / March of 2015 for FCMs / clearing membersFebruary 2016 for reporting end-users
Reporting: FCMs / CFTC web portal / FIA Techthe CPO has timely access to such recordsthe CPO files a statement identify the third-party to the CFTC
CPO Delegation: October 2014 letter provides “self-executing” delegation subject to certain conditions, including:
Delegation is pursuant to a legally binding documentThe delegating CPO does not solicit investors for the pool or manage pool assets (with certain exceptions)The designated CPO is registered
JOBS Act: September letter harmonizes Regulations 4.7(b) and 4.13(a)(3) with Rule 506(c) of Regulation D, but a notice filing is required
MARGIN FOR NON-CLEARED SWAPS
63
Earlier this fall, the CFTC and U.S. prudential regulators re-proposed margin, capital and segregation requirements applicable to SDs/MSPs in light of the Basel Committee on Banking Supervision’s and the International Organization of Securities Commissions’ issuance of their 2013 final policy framework on margin requirements for uncleared derivatives and the comments received on the original proposal.
Proposals are not identical but share many similarities.
Prudential regulator rules apply to SD/MSPs regulated by them (Federal Reserve, the FDIC, the OCC, the Farm Credit Administration and the Federal Housing Finance Authority)
CFTC rules apply to other SD/MSPs. These are proposed rules. However, comment period recently expired. Perhaps final rules 1st/2nd quarter next year?
Both impose requirements on SD/MSPs to post and collect variation and initial margin for all un-cleared swaps with end users meeting certain criteria.
MARGIN FOR NON-CLEARED SWAPS
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Variation Margin SD/MSP must post/collect variation margin on all uncleared swaps with “financial
end-users.” Financial end user - long list of entities including:
registered investment companies 3(c)(1) and 3(c)(7) funds 3a-7 and 3(c)(5)(c) funds commodity pools ERISA plans wide variety of other entiities
must post an amount sufficient to cover a change in the value of obligations under the un-cleared swaps since the last time such payment was made (the “cumulative mark-to-market amount”)
Must post/collect each business day Only cash collateral is permissible (U.S. dollars or cash in the currency in which
payment obligations under the swap are required to be settled) Minimum Transfer Amount of up to $650,000 is OK (but in calculating, you look at
cumulative amount of initial and variation margin required) Proposed compliance date: December 1, 2015
MARGIN FOR NON-CLEARED SWAPS
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Initial Margin SD/MSP must post/collect initial margin on all un-cleared swaps with financial
end-users who have “material swaps exposure.” that entity and its affiliates have an average daily aggregate notional amount of non-
cleared swaps, non-cleared security based swaps, foreign exchange forwards and foreign exchange swaps with all counterparties for June, July and August of the previous calendar year that exceeds $3 billion (where such amount is calculated only for business days)
Calculation of the initial margin required can use a model based approach (based on model approved by regulators meeting certain criteria).
Alternatively, it can use a table based approach set forth in the rules. e.g., table requires initial margin of 2% of notional for interest rate swaps with 2 to 4 year
maturity Must post/collect each business day starting with the business day following the
trade date. Permissible collateral includes, among other things, cash in USD and certain
other major currencies, treasuries and certain other sovereign debt, certain agency securities, certain highly rated corporate debt, gold and equities on certain major indices . Collateral is subject to haircuts based on a table in the proposed rules.
MARGIN FOR NON-CLEARED SWAPS
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Initial Margin Cont’d Minimum Transfer Amount of up to $650,000 is OK (but in calculating, you look at
cumulative amount of initial and variation margin required). A Threshold of up to $65 million is OK, but this is applied at a consolidated entity
level (i.e., across all non-cleared swaps between the SD/MSP and its affiliates and the counterparty and its affiliates). Example: SD enters into three separate swaps with three counterparties part of the same
affiliated group. If initial margin amount would otherwise be $100 million for each entity and Threshold is $65 million, SP must collect at least $235 million ($100 + $100 + $100 - $65).
All initial margin posted/collected pursuant to this mandate must be held at a tri-party custodian pursuant to an account control agreement.
Phased in compliance between December 1, 2015 to December 1, 2019 based on notional amount of un-cleared swap trading activity by financial end-user and its affiliates $4 trillion December 1, 2015 $3 trillion December 1, 2016 $2 trillion December 1, 2017 $1 trillion December 1, 2018 otherwise December 1, 2019
MARGIN FOR NON-CLEARED SWAPS
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Right to Segregation of Initial Margin at a Tri-Party Custodian
CFTC rules require swap dealers/MSPs to notify counterparties of their right to require segregation of initial margin posted in connection with an unclearedswap at a tri-party custodian. Notice must provide a list of independent custodians and provide pricing information
Swap dealer must obtain confirmation from counterparty whether or not it wants to elect to segregate initial margin prior to confirming the terms of any unclearedswap. However, CFTC recently issued no action relief permitting a negative consent
procedure. If you elect to segregate initial margin in accordance with this new regime, your
control agreements must include certain additional terms. Collateral may only be released upon submission of a notice made under oath or
under penalty of perjury that the party is entitled to exercise control of the account. Funds in control account may only be invested consistent with CFTC Rule 1.25.
Don’t proposed un-cleared swap margin rules mandate that initial margin be held at a tri-party custodian? If so, what is the point of this?
RESOLUTION STAY PROTOCOL
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Fact pattern #1:
US bank holding company files for bankruptcy. You manage a Fund that is party to a swap with its U.S. subsidiary guaranteed by the holding company parent (in ISDA parlance, the parent is a “credit support provider”).
A bankruptcy refresher
The automatic stay Ipso Facto clauses (e.g., Section 365(e) of the Bankruptcy Code) Safe harbors for derivatives (e.g., Section 560 of the Bankruptcy Code)
contractual right to liquidate, terminate or accelerate a swap agreement because of a bankruptcy or insolvency event or to offset or net out any termination values shall not be stayed by other provisions of [the Bankruptcy Code].
Why? The Lehman Experience
A rush to the exits!
RESOLUTION STAY PROTOCOL
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Orderly Resolution Regimes Systemically Important Financial Institutions Title II Of Dodd-Frank and Orderly Liquidation Authority Short Stay on termination rights Other regimes: The European Union Bank Recovery and Resolution Directive
and other regimes
Fact pattern #2: Same as Fact Pattern #1 but now the holding company is located in United
Kingdom. As in Fact Pattern #1, your counterparty is its U.S. based subsidiary. If UK BHC files for bankruptcy and is subject to a stay resolution regime, will you be able to terminate your swap with the subsidiary? Would a New York court recognize the UK’s stay resolution regime?
Resolution Stay Protocol Purpose is to achieve by contract an agreement to these stay resolution
regimes on a cross-border basis. Implications for the buy side.
KEY ELEMENTS OF EMIR
Meaning of “Derivatives” Counterparty categorisation
Financial Counterparties (“FCs”) Non-Financial Counterparties (“NFCs”) Third country entities (“TCEs”)
Clearing thresholds NFC and NFC+
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EMIR - CLEARING
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The clearing obligation under EMIR will apply: Between two FCs Between an FC and an NFC+ entity Between two NFC+ entities Between an FC or an NFC+ entity and a TCE (only where
the TCE would be subject to clearing obligation if it was established in the EU)
Between two TCEs if the contract has a “direct, substantial or foreseeable effect” in the EU (or where it is necessary or appropriate to prevent the evasion of EMIR’s requirements)
EMIR – “RISK MITIGATION TECHNIQUES”
Uncleared OTC trades FCs and NFCs (all)
Timely confirmations Reconciliation, portfolio compression and dispute resolution
Additional requirements for FC and NFC+ counterparties Initial and variation margin Daily valuation
Effect of risk mitigation requirements on U.S. entities
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TRADE REPORTING Timing T+1 Delegated reporting and ongoing obigations Back-loading
If outstanding on February 12, 2014: 90 days If no longer open, but outstanding on August 16, 2012: 3 years
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Registered Alternative Products
Michael S. Caccese, Partner, K&L Gates LLPGeorge Zornada, Partner, K&L Gates LLP
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REGISTERED ALTERNATIVE PRODUCTS
RICs and Alternative Assets and Strategies Registered Funds of Hedge Funds
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RICS AND ALTERNATIVE INVESTMENTS
As markets have fallen, traditional fixed income investments have produced low interest income and most markets have exhibited more volatility; investor demand has increased for "alternatives."
Registered funds have expanded the borders of traditional investments as "average" investors are comfortable with traditional mutual fund form and advisers seek alternative exposure for their clients.
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TRADITIONAL REGISTERED FUNDS WITH ALTERNATIVE STRATEGIES Mutual funds with "hedge fund" strategies
Long/short funds Multi-strategy fund of funds Multi-manager funds Event-linked funds (catastrophe bond) Event-driven funds (special situations) Managed futures
Commodities Exposure (also ETPs that are not investment companies)
MLPs (open and closed-end funds) Closed-end funds and illiquid strategies Creativity at work, but registered funds do have distinct limits - there
always will be hedge funds
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MUTUAL FUNDS WITH "HEDGE FUND" STRATEGIES Long/short funds
purchase and short sale of equity securities With a long position, the fund purchases a stock outright; with a short position, the fund sells
a security that it does not own and must borrow to meet its settlement obligations. Asset coverage requirements, limit the amount of shorting a fund can do.
Multi-strategy fund of funds Access alternative investment strategies (e.g., convertible arbitrage, event driven (merger
arbitrage), fixed income relative value, equity market neutral, long/short equity, global macro, managed futures and emerging markets) by investing in other investment companies.
Multi-manager funds Access alternative investment strategies by hiring multiple sub-adviser to run specific sub-
strategies. Main Adviser allocates fund assets to distinct sleeves managed by separate (often
unaffiliated) sub-advisers.
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MUTUAL FUNDS WITH "HEDGE FUND" STRATEGIES Event-linked funds (catastrophe bonds)
Return of principal and payment of interest contingent on the non-occurrence of a specified trigger event(s) that leads to economic and/or human loss, such as an earthquake of a particular magnitude or a hurricane of a specific category.
The most common type of event-linked bonds is known as “catastrophe” or “CAT” bonds. In most cases, the trigger event(s) will not be deemed to have occurred unless the event(s) happened in a
particular geographic area and was of a certain magnitude or caused a certain amount of actual or modeled loss. If the trigger event(s) occurs prior to a bond's maturity, the fund may lose all or a portion of its principal and forgo additional interest.
Liquidity of the CAT bond market is biggest challenge, although becoming much more liquid. Uncorrelated to equity or bond markets.
Event-driven funds (special situations) Invests in the securities of publicly traded companies involved in mergers, takeovers, tender offers,
leveraged buyouts, spin-offs, liquidations, or similar events (“corporate reorganizations”). A variety of strategies can be employed to capitalize on the mispricing of corporate securities during
corporate reorganizations, including transactions involving common and preferred stock, debt instruments and derivative securities.
Strategies often involve the use of arbitrage, which involves taking advantage of small price differences between two otherwise equivalent assets.
Such strategies considered to be less dependent on the overall direction of stock prices.
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MUTUAL FUNDS WITH "HEDGE FUND" STRATEGIES
Managed futures To run as a RIC, must use offshore subsidiary for commodities
futures that produce “bad income.” Utilize inherent or “economic” leverage in futures typically with
programmatic trading Asset coverage requirements. CFTC has “harmonized” requirements for such funds, which
also are commodity pools.
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COMMODITIES EXPOSURE
Commodity RICs Frequently are the same as “managed futures” funds but focused on
commodities futures rather than financial futures. Offshore subsidiary structure. Asset coverage requirements. CFTC harmony.
■ Commodity ETPs Pool that holds only physical commodity (i.e., gold, silver, copper). Not investment company, not commodity pool. Exchange-traded issuer like a public company.
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MLPs Registered funds must diversify assets into MLPs, related companies or exposure to such
companies through other instruments. RIC limited to 25% direct holding of MLPs. Some MLPs are not RICs but are registered investment companies that operate as “C
corporations” rather than as a RIC. MLPs are “master limited partnerships.” MLPs are generally treated as partnerships for U.S. federal income tax purposes. To be treated as a partnership for U.S. federal income tax purposes, an MLP must derive at least
90% of its gross income for each taxable year from qualifying sources, including activities such as the exploration, development, mining, production, processing, refining, transportation, storage and certain marketing of mineral or natural resources.
MLPs are generally publicly traded, are regulated by the SEC and must make public filings like any publicly traded corporation.
Many MLPs operate oil, gas or petroleum facilities, or other facilities within the energy sector. Midstream MLPs may also operate ancillary businesses including marketing of energy products
and logistical services. The MLPs in which the Fund invests may also engage in owning, managing and transporting alternative energy assets, including alternative fuels such as ethanol, hydrogen and biodiesel.
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REGISTERED FUNDS OF HEDGE FUNDS
Closed-end. Continuously offered. Not exchange listed, use tender offers. Partnership or RIC structure. Provide exposure to potentially anything investable,
anywhere. Not generally available to all investors, even if
publicly offered, based on SEC staff policy.
Special Issues for Closed-End FundsClair E. Pagnano, Partner, K&L Gates LLPTrayne S. Wheeler, Partner, K&L Gates LLP
AGENDA Closed-End Fund Basics Taking Advantage of Trading Premiums: Shelf
Offerings Managing Trading Discounts Tender Offers for Preferred Shares Distribution Rates Open Market Share Repurchases Tender Offers for Common Shares
Closed-End Fund Litigation Overview Impact of the Volcker Rule
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CLOSED-END FUND BASICS Hybrid of a mutual fund and operating company Third-party underwritten IPOs Stable pool of assets – no redemptions – great for investing
in certain instruments (e.g., fixed income) Traded on an exchange (most often NYSE or AMEX) NAV of underlying portfolio is not anchored to market trading
price This presents challenges (discounts) and opportunities
(premiums) Most significant result of this is that the fund may trade at either
a premium or a discount to its market value Example – a fund with 10 million shares outstanding and a portfolio
worth $100 million would be expected to trade around $10/share Shares may be trading for a discount (e.g., $8) or premium (e.g.,
$12) to NAV
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TAKING ADVANTAGE OF TRADING PREMIUMS: SHELF OFFERINGS Permits Issuance Of Additional Shares Generally Into Existing Trading
Market Generally Employed Where Shares Are Trading at a Significant Premium General No-Action Relief Facilitates Funds Relying on General Shelf
Registration Rule Without Additional Reporting Requirements Issuer-specific No-Action Relief Permits Annual Updating under Rule 486(b) 1933 Act Rule 415
Fund Must be Reporting for At least one year Permits Delayed or Continuous Offering of Shares “At the market” offering must be on delayed Basis Need to File Shelf Registration Statement “Take Downs” Reflected in Supplements to Shelf Registration Statement
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TAKING ADVANTAGE OF TRADING PREMIUMS: SHELF OFFERINGS (CONT’D) Underwriting
Overnight Deals -- Third Party Brokers Will Underwrite – For a Price At-the-Market Offerings – Generally Use an Affiliated Broker (typically
mutual fund distributor) – Third-Party Broker Typically Used as Sales Agent Must be FINRA qualified to underwrite closed-end offerings May require amendment to FINRA membership agreement If there is no affiliated broker, a third-party broker may be used –
generally involves a more significant closing
Sales Loads Typically varies based upon amount of trading premium Section 23(b) Prohibits Issuance at Below NAV Revenue Sharing -- Some Brokers will Seek trail Payments from
Adviser in addition to load90
TAKING ADVANTAGE OF TRADING PREMIUMS: SHELF OFFERINGS (CONT’D) NYSE/Other Listing
Shares sold in shelf offerings must be subject to supplemental listing application
May be done once covering all shelf shares -- not required for each take down
FINRA filings All SEC shelf filings must be made with FINRA Same-day clearance
Board Considerations Board must conclude that Benefits of Program through
additional assets outweighs possible impact on premium
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MANAGING TRADING DISCOUNTS
Problem: Many Closed-End Funds’ Market Prices Trade at a
Discount to Net Asset Value
Consequences: Shareholder Value Diminished Attracts Activist Shareholders Seeking to Arbitrage
Discount Presents Difficulties in Attracting Underwriters for
Future Offerings
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METHODS FOR MANAGING DISCOUNTS
Enhancing Competitive Distribution Rates Open Market Share Repurchases Tender Offers for Outstanding Common
Shares Tender Offers for Preferred Shares
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ENHANCING DISTRIBUTION RATES Closed-End Funds Very Often Marketed and
Purchased for Income Produced Closely Monitoring Distribution Rates Relative
to Competitors is Very Important Section 19(a) Disclosures Section 19(b) Limitations 19(b) Exemptive Orders: Managed Distribution
Plans Possible Uniform Exemptive Rule
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OPEN MARKET SHARE REPURCHASES
1940 Act Section 23(c) Permits Must be Conducted Under 1934 Act Rule10b-18
Safe Harbor Single Broker Time - Near Close of Primary Trading Price
1. Maximum Highest Bid or Last Transaction2. Special Provisions for Share Where No bids of Transactions3. Generally not applicable to CEFs
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OPEN MARKET SHARE REPURCHASES (CONT’D) 1940 Act Section 23(c) Permits
1. Volume Maximum 25% of Average Daily Trading Volume Exception for Once Weekly Block Purchase
2. Notice of Program Repurchased Shares Generally must be Retired Governing Instruments Determine Resale or Reissuance Requires Re-Registration Affiliates of Fund May Also Make Open Market
Purchases
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TENDER OFFERS FOR COMMON SHARES 1940 Act Section 23(c) Permits Must Comply with 1934 Act Rule 13e-4 Governing Issuer
Self Tenders Volume -- No Limit - Board Determines Series Tenders -- Typically Small amounts 5% - 10% One Time Tenders Amounts may be Larger Impact may be time limited
Filing of Schedule TO Dissemination Long Form Publication Mailing to Shareholders -- Most Common Short Form Publication
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TENDER OFFERS FOR COMMON SHARES (CONT’D) Period -- Must be Open for 20 Business Days Price -- Not Prescribed -- Typically 95% to 98% of NAV
Depending on Current Discount Valuation -- Based Upon NAV at Expiration Date Amended Schedule TO Reflecting Results Must be Filed
with SEC Related Communications -- All Must be Filed Tenders By Affiliates -- Generally Subject to Same
Requirements Resale of Purchased Shares -- Must be Re-Registered
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TENDER OFFERS FOR PREFERRED SHARES Redeem auction rate preferred shares through
tender offers Typically done in connection with refinancing
transactions (i.e., issuances of private preferred shares, debt or tender option bonds) in order to give liquidity to ARPS holders and maintain the fund’s leveraged capital structure
Conditions on tender offers: Tender offer at some percentage below par Minimum participation percentage
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TENDER OFFER FOR PREFERRED SHARES – FACTORS BENEFITING THE FUND
Not readily quantifiable factors include: Providing ARPS shareholder an opportunity to
liquidate their shares Reducing risks associated with inaction Potential changes to Board structure Costs associated with proxy fights Litigation from preferred shareholders Risk new forms of refinancing will not be available
in the future
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FACTORS IMPACTING TENDER OFFER PRICES FOR PREFERRED SHARES Reasons why tender offers vary by fund: Variety of leverage options available (taxable
funds have more) Degree to which portfolio can support leverage
expenses Existence of a credit facility (reducing
transactional expenses) Extent to which the offer is subscribed
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CLOSED-END FUND LITIGATION OVERVIEW: DIRECT ACTIONSa. Direct suits relate to shareholders'
structural, financial, liquidity and voting rights
b. If numerous plaintiffs with similar or identical claims -- claim may be brought as a class action
c. Example -- disclosure actions
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CLOSED-END FUND LITIGATION OVERVIEW: DERIVATIVE ACTIONSa. Breach of fiduciary duty owed to the fundb. Demand letter must be sent to the fund's boardc. Fund board determines whether to pursue claims
Special Committee (SC -- independent directors)
SC must be independent, unbiased and act in good faith
Differing standards of review depending on applicable law
d. Example -- Challenges to board’s decision not to reorganize closed-end fund as open-end fund
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RISE OF AUCTION RATE PREFERRED SHARES LITIGATIONa. Demand letters on behalf of purported holders of funds’ common shares,
alleging that the funds’ investment adviser, officers and board of directors breached their fiduciary duties in connection with the redemption of the funds’ auction preferred shares at their liquidation preference.
b. Derivative actions filed (suits filed in New York, Illinois, Massachusetts)c. Standard approach
Establish Special Committee to investigate and respond to claim Stay proceeding pending Special Committee’s / Board's determination Special Committee evaluates demand If demand is rejected, Defendants move to dismiss proceeding relying on
Business Judgment Rule
d. SEC’s brief supports claims that Merrill Lynch & Co. rigged the ARPS market Failed to disclose its role in “propping up” auctions Goes against prior dismissals
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IMPACT OF THE VOLCKER RULE ON TOBS TOB programs have been historically used to provide a supply of
short-term tax-exempt municipal bonds to funds, including municipal bond closed-end funds
The Volcker Rule exempted federally insured depository institutions and affiliates from potential proprietary trading prohibitions on municipal bonds While the exemption covers most of the municipal market, tender option
bond (TOB) programs are not exempt Upon finalization of the Volcker rule, market participants began
attempting to restructure existing TOB programs or find feasible alternative structures Volcker-compliant TOB structures began appearing over the summer,
aiding municipal market liquidity Look for additional structures to develop in the coming months
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DOL, ERISA and Tax Developments
Mark J. Duggan, Partner, K&L Gates (with thanks to William P. Wade)Joel D. Almquist, Partner, K&L Gates
ERISA FAQs
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QUESTION 1
Why do we need to worry about ERISA and the Department of Labor, given that our firm already is SEC- and CFTC registered?Aren’t two regulators enough?!
ANSWER 1
ERISA and other Federal laws co-exist
ERISA preempts most State laws, except banking, insurance, securities laws
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QUESTION 2
My firm usually adopts a gross negligence exculpation and indemnification standard in our fund contracts, but I understand that ERISA has a “prudence” concept. How is that different from gross negligence?
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ANSWER 2
ERISA disallows exculpation or indemnity for breach of fiduciary duty
“Prudent expert” standard – process is important
Can a “prudent expert” be negligent (or grossly negligent)?
Liability for trade errors (i.e. WAMCo)
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QUESTION 3
I heard that an adviser needs insurance or a bond to manage ERISA money. Our firm has $XX million in D&O/E&O coverage. Is that sufficient?
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ANSWER 3
ERISA bond intended to protect the plan
Note: bond required for each plan in a plan-asset fund
D&O/E&O insurance protects the investment manager
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QUESTION 4
Does our firm really need to be a “QPAM” to manage ERISA money, either legally or practically?
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ANSWER 4
Legally, no – practically, expected
Broad prohibited transaction restrictions require exemptions
QPAM is broad exemption for “party-in-interest” transactions – requires status and other conditions; note exceptions
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ANSWER 4 (CONTINUED)
Other possible exemptions ERISA 408(b)(2) “Services” Exemption Allows services to plans by parties in interest; no
more than “reasonable compensation” permitted 408(b)(2) disclosure requirements
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ANSWER 4 (CONTINUED)
Other possible exemptions “Service Provider” Exemption – 408(b)(17) Allows transactions with a service provider to a plan Unlike QPAM, does not require SEC-registered
adviser status Plan must pay no more, and receive no less, than
“adequate consideration” Some market participants resist use
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QUESTION 5
ERISA has a 25% test for private funds that allow ERISA plans to invest (i.e., if ERISA plans hold less than 25% of any class of fund interests, ERISA does not apply). How does that work in a master-feeder or a fund of funds structure?
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ANSWER 5 – THE “25% TEST”
Private Fund assets are “plan assets” if:1) benefit plan investors2) hold 25% or more of3) any class of equity interests in the Fund4) not counting interests held by the Fund
manager or its affiliates for their own account.
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ANSWER 5 –“BENEFIT PLAN INVESTORS”
Defined in ERISA § 3(42):
ERISA Plans
Code Section 4975 Plans (IRAs, Keogh plans)
Other “plan asset” funds
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ANSWER 5 –25% TEST FORMULA
Numerator (“benefit plan investors”): ERISA plan $
plus Code 4975 plan $plus “Plan-asset” fund $
Denominator:Assets in class/fund $
less fund manager and “affiliate” $
= 25% or more? (per class)
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ANSWER 5 – SPECIAL RULES (FOFS, MASTER-FEEDER)
25% Test at Two Levels:
Level 1 Test Level 2 Test
Fund-of-funds Underlying Fund
Feeder Fund Master Fund
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ANSWER 5 – SPECIAL RULES (CONTINED)
Level 1 Test for FOF/Feeder –Standard “plan asset” computation
Level 2 Test for Underlying/Master –What part of investment of FOF/Feeder, if any, goes into the numerator? If Level 1 Test less than 25% – zero If Level 1 Test 25% or more – that portion of the investment by the
FOF/Feeder that is attributable to “Benefit Plan Investors”
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ANSWER 5 – EXAMPLE 1 (FUND OF FUNDS)
BENEFIT PLANINVESTORS
NON-BENEFIT PLANINVESTORS
$3,000 $2,000
FUND OF FUNDS
$5,000
UNDERLYINGFUND
“Plan Assets”?
$5,000
NON-BPIINVESTORSYes
“Plan Assets”? Yes
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ANSWER 5 – EXAMPLE 2 (FUND OF FUNDS)
BENEFIT PLANINVESTORS
NON-BENEFIT PLANINVESTORS
$3,000 $2,000
FUND OF FUNDS
$5,000
UNDERLYINGFUND
“Plan Assets”?
$10,000
NON-BPIINVESTORSYes
“Plan Assets”? No
126
QUESTION 6
What exactly are Taft-Hartley plans and are they the same as ERISA plans?
127
ANSWER 6
TH plans = collectively-bargained employee benefit plans
Jointly administered by labor-management trustees
TH plans are subject to ERISA
128
QUESTION 7
We have a fund that has a lot of IRA money, but no ERISA plans. We have another fund that has only state and local government retirement plans. In either case, do we need to worry about ERISA?
129
ANSWER 7
IRAs not subject to ERISA, but Code Section 4975
Government plans not subject to ERISA, but subject to state laws that may adopt ERISA principles
130
TAX DEVELOPMENTS
132
TAX DEVELOPMENTS
RIC Issues Proposed changes to regulations for purposes of RIC
asset diversification test Changes to Treas. Reg. § 1.851-5 to clarify the controlled
group rules under section 851(c) and add a new example to illustrate the application of the controlled group rules with respect to RIC investment in MLPs
133
TAX DEVELOPMENTS
Rev. Proc. 2014-45 : wash sale rules will not apply to purchases and redemptions of floating-NAV money market fund shares
Proposed regulations: simplified tax accounting rules for shareholders in floating-NAV money market fund
Proposed regulations: floating-NAV money market funds exempt from information-reporting requirements
133
Money Market Fund Tax Issues
TAX DEVELOPMENTS
Increased ability to recover taxes withheld by EU countries
Results in over-distribution of creditable foreign taxes to RIC shareholders in prior years
No good means of correcting prior year tax reporting
RIC Foreign Tax Reclaims
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TAX DEVELOPMENTS
Rev. Rul. 2014-18 affirms that a stock option or stock-settled SAR granted to a manager of an offshore fund is not a nonqualified deferred compensation plan subject to taxation under Section 457A
Hedge Fund Manager Stock Options
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Tax Developments
Cayman Islands currently has an intergovernmental agreement (IGA) with each of the United States and the United Kingdom. Financial account reporting to begin in 2015 under US-Cayman IGA.
Organization for Economic Cooperation and Development (OECD) introduces a standard of automatic account information exchange between 45 countries
In October 2014, the Cayman Islands joined the OECD-sponsored Multilateral Competent Authority Agreement and made a commitment to implement the new common reporting standard on automatic exchange of information with various countries by 2018. This means that there will be more IGAs in coming years, and more reporting obligations.
FATCA / GATCA
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