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IN THIS ISSUE

1 Compliance Corner

5 New Considerations for Private Funds on Environmental, Social and Governance Issues

9 Investment Adviser Cybersecurity: Understanding What is at Stake and How to Prevent Cyber Attacks

12 FamilyOfficesUndertheAdvisers Act: Key Concepts and Requirements

17 Fall Events

PRIVATE FUNDS PRACTICE

NewsWireCompliance CornerOver the past few months, the Securities and Exchange Commission (“SEC”) has been active both in pursuing enforcement actions and releasing guidance updates on its various rules and initiatives. READ ARTICLE ON PAGE 1

New Considerations for Private Funds on Environmental, Social and Governance IssuesThe private equity industry, both sponsors (“GPs”) and investors (“LPs”) alike, is increas-ingly realizing that investment decisions can meaningfully impact investee companies and the communities in which they operate. This awareness has sparked a movement among GPs and LPs towards “impact investing” based on the view that effective management of environmental, social and governance (“ESG”) issues is both the “right thing to do” and can be fundamental to creating value over the long term. Within the industry there is a growing belief that companies which are successful in avoiding ESG risks while capturing ESG opportunities will outperform over the long term. READ ARTICLE ON PAGE 5

Investment Adviser Cybersecurity: Understanding What is at Stake and How to Prevent Cyber AttacksThe SEC’s Cybersecurity Roundtable in March 2014 demonstrated that the SEC views cybersecurity as an integral part of investor protection. As part of an ongoing cybersecu-rity initiative, the SEC has since announced in a Risk Alert that the Office of Complaince Inspections and Examinations (“OCIE”) will perform cybersecurity preparedness exami-nations. Many investment advisers understand the importance of cybersecurity but are uncertain about how they can best implement policies and procedures to protect their systems and address investor and SEC concerns. READ ARTICLE ON PAGE 9

FamilyOfficesUndertheAdvisersAct: Key Concepts and RequirementsCertain investment advisers to families may be able to avoid being classified as an “investment adviser” pursuant to Rule 202(a)(11)(G)-1 (the “Family Office Rule”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), thereby allowing such advisers to operate without SEC registration. Although many advisers characterize them-selves as family offices, the SEC has published limited guidance on the Family Office Rule’s definition of a “family office.” This article presents certain issues that a “family office” should consider in connection with seeking to provide investment advisory services pur-suant to the narrow Family Office Rule. READ ARTICLE ON PAGE 12

FALL 2014

© 2014, Chadbourne & Parke LLPThis material may constitute Attorney Advertising in some jurisdictions. Prior results do not guarantee a similar outcome.

PRIVATE FUNDS PRACTICE

NewsWireFALL 2014

Beth R. Kramer+1 (212) [email protected]

Morton E. Grosz+1 (212) [email protected]

Scott W. Naidech+1 (212) [email protected]

Talbert I. Navia+1 (212) [email protected]

Garrett Lynam+1 (212) [email protected]

TO OUR READERS

Private Funds Practice NewsWire is published by Chadbourne & Parke LLP for general information purposes only. It does not constitute the legal advice of Chadbourne & Parke LLP and it is not a sub sti tute for fact-specific legal counsel and does not represent the view of the firm or its clients.

Beth R. Kramer+1 (212) [email protected]

Alex M. Herman+1 (212) [email protected]

Garrett Lynam+1 (212) [email protected]

Scott W. Naidech+1 (212) [email protected]

Cole Beaubouef+1 (212) [email protected]

CONTRIBUTORS

EDITORS

ADVISORS

FALL 2014 | PRIVATE FUNDS PRACTICE NEWSWIRE 1

Compliance CornerBy Beth R. Kramer and Alex M. Herman1

Over the past few months, the Securities and Exchange Commission (“SEC”) has been active both in pursuing enforcement actions and releasing guidance updates on its various rules and initiatives. The following summary highlights recent compliance updates regarding:

I. WhistleblowersThe SEC is placing increased emphasis on its whistleblower program. Under the

“whistleblower program” authorized by the Dodd-Frank Wall Street Reform and Consumer Protection Act,2 the SEC may award between 10% and 30% of the mon-etary sanctions collected in an SEC regu-latory action to individuals who provide original information about the underly-ing federal securities law violations. In June 2014, SEC Chair Mary Jo White en-couraged corporate directors to function as gatekeepers in preventing, detecting and stopping securities law violations.3 Contemporaneously with this speech, the SEC issued awards of US$875,000 on June 3, 2014 to two whistleblowers for their tips and assistance in an enforcement action (representing 30% of the sanctions and the second largest total award given to date), and US$400,000 to another whistle-blower on July 31, 2014.

The SEC also has expanded authority to protect whistleblowers from retaliation by their employers. Under this power, the

SEC brought its first anti-retaliation action against Paradigm Capital Management, an Albany, New York-based hedge fund advisory firm, which settled with the SEC on June 16, 2014 for retaliating against an employee who reported prohibited trans-actions to the SEC. After reporting poten-tially illegal activity to the SEC, Paradigm stripped the employee of his head trader position and reduced his job functions. The firm further marginalized the em-ployee by removing all of his supervisory responsibilities. The trader later resigned. Paradigm Capital Management and its owner will pay US$2.2 million to settle the charges.

Firms should review their policies in light of this action, and can consider:

• Offering training programs on com-pliance topics to spread awareness of policies and procedures and securities laws;

• Regularly updating policies and proce-dures to reflect updated guidance and rules issued by the SEC; and

• Reviewing internal policies and pro-cedures to safeguard any employee who reports a company action to the SEC from being discharged, demoted, threatened, harassed or otherwise dis-criminated against.

II. Special Purpose Vehicles and the Custody RuleThe SEC’s Division of Investment Management published recent guidance clarifying how the “Custody Rule,” Rule 206(4)-2 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) applies to advisers of pooled invest-ment vehicles.4 The Custody Rule delin-eates a number of requirements that will apply when an adviser has custody of client funds or securities. For purposes of the Custody Rule, pooled investment ve-hicles are considered to be advisory clients (“PIVCs”) of the fund manager, and the fund manager generally is considered to have custody of their assets. Fund manag-ers are exempt from many Custody Rule requirements if they comply with the

“audit provision,” which generally requires

• whistleblowers

• the custody rule as it applies to special purpose vehicles (“SPVs”)

• the custody rule as it applies to escrow accounts

• disclosure for mutual funds

• evidence of the “Broken Windows” policy

• registration relief for certain commodity pool operators (“CPOs”)

• advisersretainingproxyadvisoryfirms

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the fund to (a) be audited at least annu-ally and (b) distribute financial statements to all beneficial owners within a specified period of time. Fund managers and ad-visers relying on the audit provision may sometimes consider an SPV to be an asset of a PIVC and include that asset in the fi-nancial statements of the PIVC. However, fund managers and advisers must distrib-ute separate financial statements for the SPV when it is treated as a separate client.

This guidance specifically addresses when an adviser may consider the SPV to be an asset of the PIVC for purposes of comply-ing with the audit provision. Generally, an adviser may treat the following types of SPVs as assets of the PIVC, so long as the assets are considered within the scope of the client’s financial statement audit and the SPV has no owners other than the adviser, the adviser’s employees or the PIVC:

• A single PIVC that creates an SPV to invest in one asset;

• Multiple PIVCs invest in an SPV which in turn invests in a single investment; or

• An adviser to one or more PIVCs uses an SPV to purchase multiple investments.

Generally, the adviser should treat the assets of the SPV as a separate client for Custody Rule purposes where the adviser uses an SPV to purchase one or more in-vestments for a PIVC and third parties, because the SPV has owners in addition to the adviser, the adviser’s employees or the PIVC.

III. Escrow Accounts and the Custody RuleThe SEC’s Division of Investment Management issued guidance under the Custody Rule for advisers using escrow accounts in connection with a sale of a portfolio company owned by one or more pooled investment vehicles.5 This guid-ance was released in response to inquiries regarding the application of the Custody Rule where, as part of a sale or merger, the adviser establishes an escrow account to

hold a portion of sale proceeds and satisfy post-closing pricing adjustments. The Staff indicated that the SEC would not object if an adviser maintains client funds in an escrow account with other client and non-client assets, so long as the following quali-fications are met:

• The client is a pooled investment fund relying on the audit provision of the Advisers Act6 and includes the portion of the escrow account attributable to the client in its financial statements;

• The escrow account is created in con-nection with a sale or merger of a port-folio company;

• The amount of money in escrow and the term of the escrow period have been agreed upon in bona fide negotia-tions between the buyer and seller;

• The escrow is maintained with a qualified custodian as defined by the Advisers Act;7 and

• The sellers’ representatives are contrac-tually obligated to promptly distrib-ute the funds at the end of the escrow period based on a predetermined formula.

IV. Mutual Fund Enhanced Disclosure8 Mutual funds may need to revisit their disclosure procedures for Form N-1A.9 In June 2014, the SEC’s Division of Investment Management published a guidance update clarifying the 2009 amendments to Form N-1A regarding mutual fund disclosures.

The original amendments were intended to simplify and clarify mutual fund dis-closures for clients, but were optional for funds to adopt. While over 80% of mutual funds already follow this practice, the SEC reiterated the intent of the disclosure form changes and highlighted certain rules and requirements. To meet these standards, mutual funds should:

• Ensure the “Summary Sections” sum-marize the required information and do not contain unnecessarily duplica-tive information;

• Write Form N-1A responses in plain English as required by Rule 421(d) of the Securities Act of 1933, as amended;10

• Omit information regarding non-principal strategies and risks, or clearly distinguish these items from principal strategies and risks; and

• Minimize complexity by avoiding cross-references to shareholder reports.

V. Broken Windows Enforcement ActionsIn our Spring 2014 Newswire, we drew attention to the SEC’s “Broken Windows” policy,11 which emphasizes enforcement of relatively minor securities law infractions in an effort to create a culture of compli-ance. This September, the SEC demon-strated its continued commitment to the policy charging 19 firms and an individual trader with violations under Rule 105 of Regulation M of the Securities Exchange Act of 1934, as amended (the “Exchange

Fund managers and advisers must distribute separate financial statements for the SPV when it is treated as a separate client.


Act”), charging 28 officers, directors and shareholders with violations under Section 16 of the Exchange Act as well as charging six public companies for failure to report their insiders’ delinquencies.

• Rule 105 of Regulation M makes it unlawful for any person to purchase equity securities in a public offering from an underwriter, broker or dealer participating in the offering if the person has sold short the same equity security during the “Restricted Period” provided for in Regulation M. The SEC began an initiative to enhance enforce-ment of Rule 105 in 2013, and issued the settled orders in September 2014, requiring each violator to pay disgorge-ment, interest and penalties.

• Under Section 16 of the Exchange Act, insiders (directors, officers and major shareholders) of public companies are required to promptly report informa-tion about their holdings and transac-tions in company stock. In charging the insiders and the companies that failed to report their insiders’ delin-quencies, the SEC used quantitative data sources and ranking algorithms to identify insiders as filing late Form 4s and Schedules 13D and 13G.

VI. Registration Relief for Certain CPOsUnder guidance released by the Commodity Futures Trading Commission (“CFTC”) in May 2014 (the “May Letter”),12 certain CPOs (including certain directors of a non-U.S. fund formed as a corpora-tion) could delegate their CPO duties and obligations to a CPO registered with the CFTC (typically the investment manager of the commodity pool). This “stream-lined” delegation process required the sub-mission of a short no-action letter with the CFTC.

However, in October 2014 the CFTC issued Letter 14-126 (the “October Letter”)13 to provide self-executing relief to delegating CPOs and to replace the May Letter.

To qualify for the self-executing relief under the October Letter, the delegating CPO must, among other things:14

• delegate all of its investment manage-ment authority with respect to a fund in a legally binding document;

• not participate in soliciting pool par-ticipants, subject to certain exceptions;

• not manage any property of the commodity pool, subject to certain exceptions;

• have its books and records with respect to the commodity pool maintained by the designated CPO;

• delegate its CPO rights and obligations to a registered CPO; and

• if the delegating CPO and designat-ed CPO are both entities, one must control, be controlled by, or be under common control with the other.

Any no-action letters issued under the May Letter are still valid, but the CFTC will no longer consider requests for relief under the May Letter and encourages CPOs instead to rely on the self-executing relief under the October Letter. If a CPO delegation does not meet the criteria in the October Letter, then the delegating CPO may prepare its own request for no-action relief and submit it to the CFTC staff for consideration.

VII. New Guidance for Advisers Retaining Proxy Advisory Firms15 Investment advisers, in addition to being bound by their fiduciary duties of care and loyalty, are also bound by the Proxy Voting Rule in Rule 206(4)-6 under the Advisers Act. This rule provides that investment advisers cannot exercise voting authority over client securities unless they adopt and implement certain policies and procedures that are reasonably designed to ensure that the investment adviser votes proxies in the best interests of its clients. On June 30, 2014, the Division of Investment Management and the Division of Corporation Finance of the SEC released guidance regarding proxy voting, which in part addressed voting client proxies and retaining proxy advisory firms.16 Investment advisers should consider the following advice con-tained in this newly released guidance:

• Cast proxy votes in compliance with the investment adviser’s proxy voting policies and procedures. An investment adviser should (a) periodically review a sample of proxy votes to confirm they were voted in compliance with their proxy voting policies and proce-dures and (b) review their proxy voting

The SEC used quantitative data sources and ranking algorithms to identify insiders as filing late Form 4s and Schedules 13D and 13G.

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1 The authors thank Chadbourne summer associ-ate Katherine Onyshko for her contributions to this article.

2 Dodd-Frank Wall Street Reform and Consumer Protection Act, 111 Pub. L. No. 203, 124 Stat. 1381, § 922.

3 Mary Jo White, Chair, Securities and Exchange Commission, Stanford University Rock Center for Corporate Governance Twentieth Annual Stanford Directors’ College, A Few Things Directors Should Know About the SEC (Jun. 23, 2014) avail-able at http://www.sec.gov/News/Speech/Detail/Speech/1370542148863#.VEcANfldXQg.

4 Investment Management Guidance Update, No. 2014-07, “Private Funds and the Application of the Custody Rule to Special Purpose Vehicles and Escrows” (June 2014), available at http://www.sec.gov/investment/im-guidance-2014-07.pdf.

5 Id.

6 See Investment Advisers Act of 1940, 112 Pub. L. No. 90; Securities and Exchange Commission Rule, 17 CFR Parts 275 and 279 (2004); Rule 206(4)-2(b)(4).

7 A qualified custodian is defined as (i) a bank; (ii) a registered broker-dealer; (iii) a registered futures commission exchange; or (iv) a foreign financial in-stitution holding assets for its clients. See Investment Advisers Act of 1940, 112 Pub. L. No. 90; Securities and Exchange Commission Rule, 17 CFR Parts 275 and 279 (2004); Rule 206(4)-2.

8 Investment Management Guidance Update, No. 2014-08, “Guidance Regarding Mutual Fund Enhanced Disclosure” (June 2014), available at http://www.sec.gov/investment/im-guidance-2014-08.pdf.

9 Form N-1A is used for mutual fund registration pursuant to the Investment Company Act of 1940. It is available at https://www.sec.gov/about/forms/form1-a.pdf.

10 See General Instruction B.4.(c) of Form N-1A; 17 CFR 230.421(d) (2011).

11 The Spring 2014 Newswire is available at http://www.chadbourne.com/files/Publication/c84f9 aca-02cc-47f8-8ffa-d2c19164faf b/Presentation/PublicationAttachment/c8f49cf9-7195-4506-8cb7-d2f0ef2d7130/PrivateFundsNewsWire_Spring14.pdf.

12 CFTC Staff Letter No. 14-69 (May 12, 2014) avail-able at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-69.pdf.

13 CFTC Staff Letter No. 14-126 (Oct. 15, 2014) avail-able at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-126.pdf. If the conditions in the letter are not met, then the CPO must still obtain its own no-action letter.

14 These criteria are substantially similar to the cri-teria in the May Letter. However, the October Letter provided important clarifications with respect to “insiders” who are affiliated with the delegat-ing and designated CPO. For an in-depth discus-sion of the May Letter criteria, see our Spring 2014 Newswire available at http://www.chadbourne.com/files/Publication/c84f9aca-02cc-47f8-8ffa-d2c19164fafb/Presentation/PublicationAttachment/c 8 f 4 9 c f 9 -719 5 - 4 5 0 6 - 8 c b7- d 2 f 0 e f 2 d 713 0 /PrivateFundsNewsWire_Spring14.pdf.

15 For further information regarding this new guid-ance, see our July 11, 2014 Client Alert : “SEC Staff Offers Guidance on Proxy Voting”, available at http://www.chadbourne.com/files/Publication/309b8e67-0431-4e34-a662-dc33e94e49df/Presentation/PublicationAttachment/083de927-4225-4031-ac7b-c4d30fc3dbe1/SEC_Staff_Offers_Guidance_on_Proxy_Voting_071114.pdf.

16 Proxy Voting: Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms, Staff Legal Bulletin No. 20 Division of Investment Management and Division of Corporation Finance (June 30, 2014), available at http://www.sec.gov/interps/legal/cfslb20.htm.

policies and procedures at least once a year to ensure they effectively serve the best interests of their clients;

• Thoroughly research a third-party proxy advisory firm before retaining them. Some factors to consider are whether the firm has the capacity and com-petency to adequately analyze proxy issues, the number and quality of the firm’s staffing and personnel and the firm’s policies and procedures regard-ing basing voting recommendations on current and accurate information and identifying and addressing conflicts of interest, among others;

• Oversee the retained proxy advisory firm. An investment adviser can fulfill its ongoing duty to oversee a retained proxy advisory firm by implementing policies and procedures concerning such oversight, including establishing and implementing measures reason-ably designed to identify and address the proxy advisory firm’s conflicts that can arise on an ongoing basis (i.e. requiring the proxy advisory firm to update the investment adviser of rel-evant business changes or conflict poli-cies and procedures); and

• Take reasonable steps to investigate errors and prevent future recurrences. If a retained proxy advisory firm makes a recommendation based on a material factual error, the investment adviser should (a) take reasonable steps to in-vestigate the error, taking into account, among other things, the nature of the error and the recommendation, and (b) seek to determine whether the proxy advisory firm is taking reason-able steps to reduce similar errors in the future.

Any necessary changes in light of this advice should be made promptly, and in advance of next year’s proxy season. n


New Considerations for Private Funds on Environmental, Social and Governance IssuesBy Scott W. Naidech1

The private equity industry, both sponsors (“GPs”) and investors (“LPs”) alike, is increasingly realizing that investment decisions can meaningfully impact investee companies and the com-munities in which they operate. This awareness has sparked a movement among GPs and LPs towards “impact investing” based on the view that effective management of environmental, social and governance (“ESG”) issues is both the “right thing to do” and can be fundamental to creating value over the long term. Within the industry there is a growing belief that companies which are successful in avoiding ESG risks while capturing ESG opportunities will outperform over the long term.

I. What is ESG?“ESG” is a broad term used to describe a range of non-financial considerations related to sustainable development, envi-ronmental stewardship, social equity and corporate governance. These categories can include, for example:

• Environmental: Carbon and CO2 emissions; waste management; envi-ronmental degradation; energy effi-ciency; pollution; water conservation; sustainable agriculture and resource scarcity; and biodiversity.

• Social: Health and safety; labor con-ditions and employee rights; human rights; supply chains; socio economic impact; and community and consumer protection.

• Governance: Environmental and social issue management; board ef-fectiveness; internal financial control; quality assurance; risk management; anti-bribery; anti-fraud and corrup-tion; business ethics; and transparency.

Similarly, “impact investing” has been generally described as an investment ap-proach that seeks to create both a financial and measurable positive social or environ-mental impact.

II. A Growing TrendAccording to the United Nations Principles for Responsible Investment (“UNPRI”), over US$34 trillion (approximately 15%) of the world’s investable assets are managed by signatories to the UNPRI who have committed to adopting policies and pro-cedures that factor ESG issues into invest-ment decisions. The UNPRI private equity work stream was launched in 2008 by a handful of GPs and funds of funds and has now grown to include more than 130 LP members.2 Further, recent surveys indicate that ESG and impact investing is rapidly becoming a fundamental part of the in-vestment approach of many private equity firms. For example, a 2013 PitchBook survey of GPs and LPs across the U.S. and Europe yielded the following results:3

• LPs are more concerned about ESG issues than ever before – 84% of LP

respondents said ESG issues are at least somewhat important when deciding whether or not to commit to a private equity fund, and 18% said they are essential.

• A majority of GP respondents (60% of GP respondents) indicated that they now work at a firm with an established ESG program, and a significant minor-ity (26%) expects to have a program in development or plan to create one in the near future.

• More GPs are taking steps to make ESG a fundamental part of their investment approach – 28% of GP respondents produce a corporate social responsibil-ity (“CSR”) report. 4

In addition, many LPs who are the largest contributors to private equity funds (public plans, endowments, foundations and sovereign wealth funds) have an image to maintain and can be expected to be a driving force for ESG policies and reporting.5 Depending on the fund strat-egy, GPs may consider ESG integration as a means to enhance portfolio company

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of strategy might consider ESG in their investment decisions, and subscribe to international standards of governance, transparency and regulatory improve-ments. Also, because short selling, ex-cessive leverage and derivatives trading may have destabilizing effects, ESG-focused investors may inquire about a manager’s approach to these practices.

• Quantitative Analysis Strategy. Fund managers that rely on computerized quantitative models to determine in-vestment decisions may be able to in-tegrate ESG data in advanced optimi-zation strategies and in relative value, arbitrage and volatility strategies.

• Distressed and Restructuring Strategies. The long-term impact of

M&A takeovers of distressed or failing companies is a key consideration for ESG investing. Operational restructur-ings (as opposed to financial restruc-turings) may lead to job losses from reorganizations. ESG-focused inves-tors might also inquire about coercive tactics such as acquiring shareholder rights through derivatives.

• Global Asset Allocation and Foreign Exchange Strategies. In addition to the considerations discussed above, global strategies might require a manager to consider ESG factors on a country-by-country basis, as well as currency exchange risks and foreign exchange positions that could potentially have destabilizing effects.

Hedge fund managers that can evidence ESG commitments (through side letters, investment restrictions or by enacting responsible investment policies) may be well-positioned to attract capital from ESG-focused investors.

III. Adopting a FrameworkEffective ESG integration is supported by appropriate policies, proper governance and committed senior management. Two of the leading frameworks for adopting ESG policies include:

• UNPRI. Developed by a group of inter-national investors in conjunction with the United Nations, the UNPRI is a set of six principles that provide practical guidance on how GPs can develop a framework for the integration of ESG factors within their organization and investment cycle.7

• Private Equity Growth Capital Council’s (“PEGCC’s”) Guidelines for Responsible Investment. The PEGCC guidelines grew out of a dia-logue between PEGCC members and a group of the world’s major institutional investors, which took place under the umbrella of the UNPRI.8

In addition, on March 25, 2013 a group of more than 40 LPs, 20 private equity asso-ciations, and leading GPs collaborated to publish the “ESG Disclosure Framework for Private Equity.” The framework in-cludes eight diligence questions that LPs might ask GPs about their ESG integra-tion and explains the objective of each question. The framework also summa-rizes the types of information GPs could include in a response. The stated goals of the framework include: providing guid-ance on the rationale behind ESG-related questions; facilitating an informed discus-sion between GPs and their LPs; and being a practical tool (and not as a prescriptive rule). The latter goal is important to note, as there can be no one-size-fits-all frame-work for implementing and measuring ESG initiatives.

Adopting a policy tailored to the fund’s business can provide a platform for en-gagement on ESG issues by GPs with their

value and risk management, as well as attract capital from LPs who care deeply about these issues.

A primary challenge in implementing ESG initiatives involves finding metrics to monitor ESG performance. Finding effective valuation metrics, along with standardized industry benchmarks and uniform guidance, could lead to higher prioritization by GPs. Another challenge, particularly for smaller and mid-sized GPs, involves the potential costs involved in implementing and monitoring ESG ini-tiatives and performance, particularly in light of ever-increasing regulation in the U.S. and Europe, fundraising constraints and market competition.

Hedge funds face a unique scenario when approaching ESG investments. Private equity managers are in a comparatively advantageous position to effect ESG in-vestments due to the long-term, control-oriented nature of their investments. Nevertheless, hedge fund managers may also be in a position to consider ESG al-ternatives in their strategies. The practices they deploy will vary widely depending on their investment strategies. For example:6

• Fundamental Selection Strategies. Funds that employ strategies based on fundamental analysis may be best po-sitioned to integrate ESG issues into their evaluation processes. Fund man-agers interested or involved in this type

Effective ESG integration is supported by appropriate policies, proper governance and committed senior management.


LPs, investee companies, firm personnel and other key stakeholders (which can be deemed to include trade unions and em-ployees, civil society and the public). The adoption of an ESG policy has been more traditionally associated with funds that have ESG-related investment mandates (or where such mandates are expected to be a significant part of their portfolio), such as clean energy, microfinance and certain emerging market and frontier funds (typi-cally associated with population growth and resulting infrastructure and resource needs).

Finally, although some GPs may be reluc-tant to adopt additional requirements to their processes and procedures, many GPs already incorporate risk management and some level of ESG diligence into their in-vestment decisions. For these sponsors, it may not be a big step to take a more struc-tured approach to integrating and report-ing on ESG issues.9

IV. Implementation and TransparencyDiligence. Many ESG guidelines call for adoption of ESG considerations into dili-gence of investee companies. Among other things, the UNPRI calls for the incorpora-tion of ESG issues into investment analysis and decision-making processes, and the PEGCC guidelines call for the consid-eration of environmental, public health, safety and social issues associated with target companies when evaluating a port-folio investment.

Enhanced ESG diligence can include, among other things:10

• Creating geography and sector-specific ESG policies;

• Integrating ESG opportunities into 100-day plans;

• Creating ESG guidelines at the invest-ment committee-level;11

• Standardizing procedures for integrat-ing ESG into due diligence;

• Adopting sector-specific ESG due diligence criteria; and

• Conducting legal compliance and con-tamination diligence.

Operations. From an operations perspec-tive, private equity firms typically are po-sitioned to identify and capture opportu-nities to improve ESG performance across investee companies. This can include, among other things:12

• Creating an ESG community and building platforms to share best prac-tices among portfolio companies;

• Measuring results and sharing lessons learned across the portfolio; and

• Partnering with individual companies to identify opportunities for operation-al improvements and value creation.

Measuring Value. Choosing appropriate metrics for ESG performance enables GPs to understand the impact of ESG issues on investments and to structure programs that create additional value. Action items can include:13

• Leveraging industry forums and case studies to showcase accomplishments;

• Measuring the impact of ESG initia-tives on investments;

• Establishing value-oriented ESG goals;

• Benchmarking ESG metrics across the portfolio; and

• Adopting standards and a process for identifying and measuring ESG metrics.

To justify investment into establishing and managing ESG initiatives, GPs must be able to quantify and demonstrate the ef-fectiveness of their programs. Quantifying the impact of ESG initiatives is a common challenge, although new tools are emerg-ing.14 As a general matter, industry par-ticipants expect standardized metrics to develop over time that will permit GPs to more easily quantify the value of ESG pro-grams and track them against investment returns.

Communication and Transparency. Effective communication of ESG initia-tives and accomplishments can support fundraising efforts and bolster investor and community relations. Effective com-munication can include, among other things:15

• Participating in collaborative re-search, peer communication and tool development;

• Integrating ESG programs and accom-plishments into fundraising materials and investor communications;

• Developing CSRs and participating in industry forums; and

• Developing ESG case studies for pro-motional materials.

Reporting can take on different forms depending on the audience, which can include both LPs and a more general au-dience made up of internal and external stakeholders (including trade unions,

Evidence demonstrates that ESG is a growing trend, based in part on LP demands and general public pressure on the private equity industry for increased accountability and transparency.

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employees, civil society and the media).16

Each of these groups has distinct needs; whereas communications to external stakeholders will involve one-way public reporting, LPs benefit from two-way dia-logue with their GPs.

V. Needs and Future ExpectationsEvidence demonstrates that ESG is a growing trend, based in part on LP demands and general public pressure on the private equity industry for increased accountability and transparency. In re-sponse, frameworks and industry stan-dards for ESG investing are emerging. Increasingly, ESG is being viewed as a driver for financial value and fund man-agers are being asked to report on their ESG processes and performance. In re-sponse, GPs are beginning to adopt (or consider adopting) a long-term strategy to address and report on ESG guidelines. Implementing such a strategy will neces-sarily involve a tailored approach to re-porting that considers the strategy of the fund, the demands of its LPs and the needs of all stakeholders. n

1 The author thanks Ariel Meyerstein for his contri-butions to this article.

2 The website for this work stream can be ac-cessed here: http://www.unpri.org/areas-of-work/implementation-support/private-equity/

3 2013 PE ESG Survey Environmental Social Governance, PitchBook (2013).

4 The contents of these reports vary, but they gener-ally include objectives, general approach to ESG issues, how ESG performance is measured and updates on specific ESG initiatives at portfolio companies and at the firm.

5 For example, see How can GPs Integrate ESG? An LP’s Perspective, Maaike van der Schoot, AlpInvest Partners, available at: http://alpinvest.com/assets/pdfs/How_can_GPs_integrate_ESG_-_AlpInvest_Partners.pdf.

6 United Nations White Paper Explains How Hedge Fund Investors can Layer Environmental, Social and Governance Factors into Manager Selection, Alessia Bell, The Hedge Fund Law Report (December 6, 2012).

7 See Note 2.

8 The PEGCC guidelines are available at: http://www.pegcc.org/issues/guidelines-for-responsible- investment.

9 See Note 5.

10 ESG in Private Equity: Perspectives and Best Practices for Managing Environmental, Social and Governance Issues, Malk Sustainability Partners and the Environmental Defense Fund (2012). Examples cited include the ESG code of Actis Capital, which provides guidance on managing ESG issues through-out the investment cycle and the Carlyle Group’s EcoValuScreen, which is a due diligence framework that helps identify value creation opportunities throughout the diligence cycle and through environ-mental innovation.

11 Impact investing need not conflict with the fidu-ciary responsibilities of investment committees. See From the Margins to the Mainstream, Assessment of the Impact Sector and Opportunities to Engage Mainstream Investors, World Economic Form Investors Industries and Deloitte Touche Tohmatsu, pg. 8 (Sept. 2013). “For most institutional investors, accepting social returns that imply long-term finan-cial concessions will not be acceptable. However…impact investing does not imply a trade-off between social outcomes and financial returns, but rather sup-ports the simultaneous dual objective of both social impact and financial impact. In certain instances, social objectives may in fact create long-term sustain-able financial returns.”

12 See Note 10. Other examples cited include TPG collaborating with one of its portfolio companies on energy management and waste reduction initiatives, and KKR partnering with one of its portfolio compa-nies to save fuel and energy costs from eco-efficiency initiatives.

13 See Note 10.

14 Id. The study also notes that integration of environ-ment-oriented management programs can be tracked through programs such as ISO 14001 (environmental management systems) or ISO 50001 (energy manage-ment systems), or by asking portfolio companies to report on aspects of their environmental footprint such as energy consumption or carbon emissions. Social and governance metrics can be more difficult to quantify, although new tools are emerging such as SA8000 (social accountability) and International Finance Corporation (IFC) guidance.

15 Id. For example, KKR, the Carlyle Group and Actis all publicly report and publish citizenship materials.

16 See Reporting on Environmental, Social and Governance Considerations in the Private Equity Sector, a Report for General Partners, Business for Social Responsibility (BSR) (August 2012), available at: https://www.bsr.org/en/our-insights/report-view/reporting-on-environmental-social-and-gover-nance-consideration-in-the-priva.


Investment Adviser Cybersecurity: Understanding What is at Stake and How to Prevent Cyber AttacksBy Beth R. Kramer and Garrett Lynam1

The Securities and Exchange Commission’s (“SEC’s”) Cybersecurity Roundtable in March 2014 demonstrated that the SEC views cybersecurity as an integral part of investor protec-tion.2 As part of an ongoing cybersecurity initiative, the SEC has since announced in a Risk AlertthattheOfficeofComplianceInspectionsandExaminations(“OCIE”)willperformcy-bersecurity preparedness examinations.3 Many investment advisers understand the impor-tance of cybersecurity but are uncertain about how they can best implement policies and procedures to protect their systems and address investor and SEC concerns.4 This article highlights the types of cyber threats that investment advisers may face and discusses how they may enhance their preparedness.

I. OCIE Risk AlertOCIE’s April 2014 Risk Alert stated that the SEC will examine over 50 registered broker-dealers and registered investment advisers in order to assess their cyberse-curity preparedness. OCIE’s examiners will focus on cybersecurity governance, identification and assessment of cyberse-curity risks, protection of networks and information, risks associated with remote customer access, fund transfer requests, vendors and other third parties, detection of unauthorized activity, and past experi-ences with cybersecurity threats. This Risk Alert is the latest installment of a contin-ued focus by the SEC to review investment advisers’ cybersecurity preparedness.

The April 2014 Risk Alert contained a 28-item sample request list attached as an exhibit requesting, among other things, policies and procedures related to the items set forth below. Several items on the sample request list were not entirely ap-plicable to investment advisers (especially those that only advise private funds), but

it is possible that the SEC may request an examined investment adviser to:

• provide a written information security policy and business continuity of op-erations plan;

• identify any published cybersecurity risk management process standards the firm has modeled its processes on;

• identify specific practices and controls regarding protection of networks and information that the firm utilizes, and provide any relevant policies and pro-cedures regarding those items;

• provide policies, procedures and train-ing materials regarding information securities procedures for vendors and business partners authorized to access the firm’s network; and

• provide an affirmation that the firm updated its written supervisory proce-dures to reflect the “Identity Theft Red Flags Rules,”5 or an explanation of why it did not.

Additionally, the sample request list asked for detailed information regarding:

• vendors, business partners and third parties who conduct remote maintenance;

• cybersecurity risk assessments of vendors and partners that have access to firm networks, data and sensitive information;

• certain practices the firm uses to assist in detecting unauthorized activity on networks and devices, including how and by whom the practice is carried out;

• information security compliance audits;

• if the firm provides online account access, information regarding the service provider, functionality of the platform, customer authentication, deletion software, customer PIN secu-rity measures and information given to customers regarding reducing cyberse-curity threats; and

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• whether the firm has experienced certain types of cybersecurity breaches since January 1, 2013, including infor-mation regarding the duration, fre-quency and severity of such breaches, as well as the remediation efforts.

II. What is a Cybersecurity Threat?Although its exact definition varies, a “cy-bersecurity threat” is generally interpreted to mean “any action that may result in un-authorized access to, manipulation of, or impairment to the integrity, confidential-ity or availability of an information system or information stored on or transiting an information system, or unauthorized exfiltration of information stored on or transiting an information system.”6 With respect to investment advisers, examples of specific threats include:

•“Ransomware” through which a third party “locks out” users of the invest-ment adviser’s system. Ransomware is a form of malware that can be down-loaded without knowledge. Once implemented, Ransomware prevents access to affected files unless a “ransom” is paid to obtain an access code.

•“Insiders” of the investment adviser who download harmful software. Firm personnel may inadvertently infect or block systems that are vital for the investment adviser’s day-to-day operations.

• Network attacks that originate through links on the investment adviser’s systems with third-party service pro-viders. In this situation, the cybersecu-rity threat originates from vulnerabili-ties in a service provider’s network and the interconnectedness between such system and the investment adviser’s systems.

• Fraudulent e-mails. “Spam” is a well-known cybersecurity threat that can include e-mails disguised as legitimate or customary requests. For example, a hacker may use a disguised e-mail address that appears to be a name fa-miliar to the investment adviser. This

e-mail may request details on investor custodial accounts or direct wire trans-fers to a new account controlled by the hacker.

Investment advisers that implement a high-speed trading strategy are particularly vul-nerable to threats that impede an adviser’s ability to relay trade information to service providers and counterparties. This threat is demonstrated by a recently disclosed cyber attack on a hedge fund manager that was reported through several major news sites, including CNBC.7

III. Consequences of a Cybersecurity BreachApart from a possible deficiency with respect to cybersecurity during an SEC examination, investment advisers should understand how a cybersecurity breach can affect their business and standing with investors:

• Trust: The cornerstone of an invest-ment adviser’s business is the trust it earns from its investors. A cyberse-curity breach may jeopardize this im-portant asset by raising questions as to the robustness of the adviser’s internal compliance.

• Operations: Most investment advisers are highly dependent on computer net-works. A crippling cyber attack could prohibit the adviser from trading or conducting other day-to-day opera-tions. If networks go down, the firm may be unable to operate at normal

capacity. In this sense, cybersecurity should be viewed similarly to the con-cepts of business continuity and disas-ter recovery.

IV. How to Prepare Cybersecurity is a serious matter that in-vestment advisers should address if they have not already done so. There is no “one size fits all” approach to cybersecurity, as different advisers will face various threats depending on their clientele and strategy. For example, an investment adviser to a managed account may have information about a client’s custodial account that hackers could seek to steal. Additionally, advisers to hedge funds may have confi-dential information regarding proprietary trading strategies and advisers to private equity funds may have confidential in-formation concerning portfolio company operations.

Still, certain best practices are consistent across most types of advisers. Even if a firm already has a cybersecurity plan in place (either through internal systems or oversight by a third-party service provid-er), it should:

• evaluate and assess its supervisory, compliance and/or other risk manage-ment systems, policies, and procedures on an ongoing basis as cybersecurity threats evolve;8

• implement firm-wide training ses-sions on how to enhance the firm’s cybersecurity;

Cybersecurity is a serious matter that investment advisers should address if they have not already done so.


• install and regularly update robust an-ti-virus software on the firm’s systems;

• make appropriate changes to address or strengthen systems, policies and proce-dures as weaknesses are identified and new cybersecurity threats arise;

• ask relevant service providers to provide a copy of their cybersecurity policies and procedures (any perceived deficiencies in the service provider’s policies and procedures should be flagged);

• require that passwords meet minimum requirements and be updated regularly;

• follow-up an e-mail request to update client or investor information with a phone call to ensure that the request is legitimate;

• retain back-up documentation of its efforts to review and enhance its cybersecurity;

• review whether cyber insurance is suit-able for the enterprise;9

• restrict personnel from accessing files and programs that are not within the scope of their day-to-day activities; and

• prohibit former personnel from access-ing any firm systems.

As mentioned above, cybersecurity can be viewed as an extension of business continuity and disaster recovery plan-ning. However, cybersecurity is not a static threat; rather, cybersecurity threats evolve frequently and quickly. Therefore, a vital part of a robust cybersecurity program is to regularly review and understand how existing and new cybersecurity threats can impact the adviser’s operations. n

1 The authors thank Chadbourne summer associate Li Litombe for her contributions to this article.

2 See Chair Mary Jo White, “Opening Statement at SEC Roundtable on Cybersecurity” (March 26, 2014), available at: http://www.sec.gov/News/PublicStmt/Detail/PublicStmt/1370541286468.

3 National Exam Program Risk Alert: OCIE Cybersecurity Initiative (April 15, 2014), available at http://www.sec.gov/ocie/announcement/Cybersecurity+Risk+Alert++%2526+Appendix+-+4.15.14.pdf.

4 The U.S. Federal Trade Commission has long-standing rules concerning the protection of private information concerning U.S. individual inves-tors. Such privacy rules are not discussed in this article even though they overlap with cybersecurity preparedness.

5 See Identity Theft Red Flags Rules: A Small Entity Compliance Guide, available at http://www.sec.gov/info/smallbus/secg/identity-theft-red-flag-secg.htm.

6 See Cybersecurity Regulatory Framework for Covered Critical Infrastructure Act, avail-able at http://www.whitehouse.gov/sites/default/f iles/omb/legislative/letters/cybersecurity-reg-ulatory-framework-for-covered-critical-infra-structure-act.pdf. For additional information regarding government cybersecurity programs, please see “Companies Need to Take Notice of the Government’s Cybersecurity Program” written by Chadbourne Counsel James Stenger and published in Chadbourne’s TMT Perspectives blog (http://www.tmtperspectives.com/2013/09/26/companies-need-to-take-notice-of-the-governments-cybersecurity-program/).

7 See Cybersecurity Firm Says Large Hedge Fund Attacked (June 19, 2014), available at http://www.cnbc.com/id/101770396.

8 The Securities Industry and Financial Markets Association has published a helpful webpage to assist businesses establish a cybersecurity framework. See Guidance for Small Firms, available at http://www.sifma.org/issues/operations-and-technology/cybersecurity/guidance-for-small-firms/

9 Although cyber insurance can mitigate losses caused by a cyber attack, it is not a substitute for cybersecurity awareness and preparedness. Merely acquiring a cyber insurance policy would likely not establish that the adviser is continuously analyzing how it can enhance its cybersecurity based on evolv-ing threats.

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Family Offices Under the Advisers Act: Key Concepts and RequirementsBy Beth R. Kramer and Garrett Lynam1

Certaininvestmentadviserstofamiliesmaybeabletoavoidbeingclassifiedasan“invest-mentadviser”pursuanttoRule202(a)(11)(G)-1(the“FamilyOfficeRule”)undertheInvestmentAdvisers Act of 1940, as amended (the “Advisers Act”), thereby allowing such advisers to operate without Securities and Exchange Commission (“SEC”) registration. Although many adviserscharacterizethemselvesasfamilyoffices,theSEChaspublishedlimitedguidanceontheFamilyOfficeRule’sdefinitionofa“familyoffice.”Thisarticlepresentscertainissuesthata“familyoffice”shouldconsiderinconnectionwithseekingtoprovideinvestmentadvi-soryservicespursuanttothenarrowFamilyOfficeRule.2ThefirstpartofthearticleanalyzestheFamilyOfficeRule’sdefinitionof“familyoffice.”Thesecondhalfofthearticlediscussesseveralongoingrequirementsthatfamilyofficesshouldunderstand.

I. What is a “Family Office”? On July 21, 2011, the Dodd-Frank Wall Street Reform and Consumer Protection Act created a new exclusion from registra-tion under the Advisers Act.3 Pursuant to section 202(a)(11)(G), “family offices” (as defined by the SEC in the Family Office Rule) are excluded from the definition of

“investment adviser” in the Advisers Act. An investment adviser that qualifies as a “family office” under the Family Office Rule is not subject to the provisions of the Advisers Act because it is not deemed to be an “investment adviser.”

The premise of the Family Office Rule is to allow families to manage their own wealth without extensive oversight by the SEC. In its final release accompanying the Family Office Rule, the SEC stated that the rule’s guiding principle is that disputes among family members concerning the opera-tion of the family office could be resolved within the “family unit” or, if necessary, through state courts under laws designed

to govern family disputes. Therefore, the SEC does not consider family offices that advise a single family to present the same regulatory concerns as investment advis-ers that advise multiple families and other third-party clients.

Generally, the Family Office Rule con-tains three primary conditions that an adviser must meet in order to be a “family office.” First, the investment adviser can only provide investment advice about securities to “family clients” of a single family. Second, family clients must exclusively own the family office and “family members” and/or their wholly-owned “family entities” must ex-clusively control the family office. Third, the family office cannot hold itself out to the public as an investment adviser. If a condition is not met, the family office ex-clusion under the Family Office Rule is unavailable and the investment adviser must analyze if it is otherwise required to register with the SEC.4

Condition 1: The Family Office Must Exclusively Advise “Family Clients” of a Single Family.

Family advisers must provide advice about securities only to “family clients” of a single family and cannot advise multiple families. The SEC emphasized this condi-tion both in the Family Office Rule’s ac-companying release (the “Final Release”)5 and in a 2012 no-action letter.6 The 2012 no-action letter also reminds family ad-visers that “if several unrelated families established separate family offices staffed with the same or substantially the same employees, such employees would be man-aging a de facto multifamily office,” and consequently fall outside the scope of the Family Office Rule.7

A “family client” is defined in perti-nent part to mean “family members,”

“key employees” and entities through which family members of a single family and their key employees invest.


Each of these defined terms is discussed below:

• Family Members: “Family members” are all lineal descendants (includ-ing by adoption and stepchildren) of a common ancestor and such lineal descendants’ spouses or spousal equivalents. The definition of “family member” in the Family Office Rule is broad but the common ancestor must be no more than 10 generations removed from the youngest generation of family members. The Final Release contains a chart to demonstrate how to count generations. Recently, the SEC published notices of two exemptive order applications seeking to narrowly expand who may be considered “family members” (and therefore “family clients”) under the Family Office Rule.8 The applicants argued that providing investment advice to a sister-in-law and a mother-in-law of a lineal descen-dant of each family office’s common ancestor should not require an entity that otherwise qualifies as a “family office” to register as an investment adviser. These exemptive orders would only benefit the applicants if granted but they illustrate that determining whether a person is a “family client” may not be intuitive.

• Key Employees: The Family Office Rule treats certain “key employees” of the family office, their estates, and certain entities through which key employees

Although many advisers characterize themselves as family offices, the SEC has published limited guidance on the Family Office Rule’s definition of a “family office.”

may invest as “family clients” (but not as “family members”). A “key em-ployee” is generally an executive officer, director, or person serving in a similar capacity at the family office or its affili-ated family office.

• Entities: To allow the family office to structure its activities through typical investment structures, the Family Office Rule treats as a family client any entity wholly owned (directly or indirectly) exclusively by, and oper-ated for the sole benefit of, one or more other family clients, including a pooled investment vehicle that is excluded from the definition of an “invest-ment company” under the Investment Company Act of 1940, as amended (e.g., a private equity fund or hedge fund).

Condition 2: The Family Office Must Be Owned by Family Clients and Controlled by Family Members.

A family office must be (i) wholly owned by family clients (which term includes key employees, as discussed above) and (ii) ex-clusively controlled, directly or indirectly, by one or more family members or “family entities.”9 The SEC has issued guidance re-garding what it means for a family office to be “exclusively controlled” by one or more family members or family entities.10

The SEC clarified in this guidance that a family office may have a board of direc-tors with seven directors, of which four may be family members and three may be

non-family members.11 However, under the governing documents of the family office, each director must have equal voting power and no minority veto power. Additionally, there cannot be any special shareholders agreements or other arrange-ments that would give someone who is not a family member ultimate control over the family office.

Perhaps unexpectedly, the right to appoint, terminate, or replace board members, by itself, does not satisfy the “exclusively con-trolled” standard. For example, the SEC also stated in its guidance that the “exclu-sively controlled” standard is not satis-fied if all members of the board of direc-tors of the family office are neither family members nor family entities, but they are all appointed by family members that have the right to appoint, terminate, or replace the directors (assuming that the govern-ing documents of the family office do not provide that matters relating to the man-agement or policies of the family office must be decided by shareholders that are family members or family entities).12

Condition 3: The Family Office Cannot Hold Itself Out to the Public as an Investment Adviser.

The Family Office Rule prohibits a family office from holding itself out to the public as an investment adviser, which suggests that the family office is seeking to enter into typical advisory relationships with non-family clients, and thus is inconsistent with the Family Office Rule’s objectives.

II. Selected Ongoing Requirements for Family Offices

A. SEC Regulations Family offices need to assess whether they are subject to reporting requirements under the Securities Exchange Act of 1934 (the “Exchange Act”).

Section 13(f) Reporting Requirements

Under Section 13(f) of the Exchange Act, an “institutional investment manager” that exercises investment discretion over

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US$100 million or more in Section 13(f) securities must publicly report such hold-ings on Form 13F with the SEC. Generally, a family office is an “institutional invest-ment manager” if it invests in, or buys and sells, securities for its own account or exercises investment discretion over the account of any family client.

Form 13F (which is a public filing) is filed electronically with the SEC within 45 days after the end of each calendar quarter. Generally, the Form 13F report requires disclosure of the name of the “institutional investment manager” that files the report, and, with respect to each Section 13(f) se-curity over which it exercises investment discretion, the name and class, the CUSIP number, the number of shares as of the end of the calendar quarter for which the report is filed, and the total market value.

Schedule 13D and 13G Reporting Requirements

Sections 13(d) and 13(g) of the Exchange Act generally require that any person who directly or indirectly acquires beneficial ownership of more than 5% of a class of publicly traded equity securities must pub-licly report such ownership to the SEC on Schedule 13D or 13G, as discussed below. Family offices with investment discretion over a family client’s assets are typically deemed to “beneficially own” the client’s securities. Additionally, family offices may have beneficial ownership of securities in

nondiscretionary accounts if the family office has or shares power to direct the voting or disposition of such securities.

If a reporting obligation exists under Section 13(d), the family office generally must file a Schedule 13D within 10 days of first exceeding the 5% ownership thresh-old.13 Schedule 13D requires the filing person to disclose extensive information, including information about its officers, directors and principal business, details of all transactions by it in the reportable securities during certain periods and its future intentions regarding the issuer.

A family office may be able to report on a “short form” Schedule 13G instead of Schedule 13D in certain circumstances. Schedule 13G is available to beneficial owners of more than 5% of a class of secu-rities that the SEC considers to be “passive investors.” An investment adviser may be eligible to file a Schedule 13G if, among other things, it did not “acquire” the re-portable securities with the intent to influ-ence the control of the issuer. Generally, the initial Schedule 13G must be filed within 10 days after the adviser crosses the reporting threshold.14

Rule 13h-1 “Large Trader” Reporting Requirements

Rule 13h-1 under the Exchange Act re-quires a “large trader,” generally defined as a person (including a family office) whose

transactions in “NMS securities”15 equal or exceed two million shares or US$20 million during any calendar day, or 20 million shares or US$200 million during any calendar month, to identify itself as such to the SEC and its registered broker-dealers, and make certain non-public dis-closures to the SEC on Form 13H.

The large trader reporting requirements have two primary components:

• SEC Registration: First, large traders must register with the SEC by filing (and periodically updating) Form 13H, which provides contact informa-tion and reports general information concerning their business, regula-tory status, affiliates, governance, and broker-dealers. Upon receipt of an initial Form 13H, the SEC will assign and issue to a large trader an identifi-cation number (an “LTID”). The large trader must disclose its LTID to all of its registered broker-dealers and must highlight to each such broker-dealer all accounts to which the LTID applies.

• Registered Broker-Dealer Requirements: Second, registered broker-dealers must: (1) maintain specified records of transactions effected by or through accounts of large traders as well as

“Unidentified Large Traders;” (2) elec-tronically report all transactions by such persons to the SEC upon request; and (3) perform a limited monitoring function to promote awareness of and foster compliance with Rule 13h-1.

Rule 105 of Regulation M

Rule 105 of Regulation M generally pro-hibits a purchaser from acquiring equity securities in a “firm commitment” under-written offering when it has effected short sales in such securities within a specified amount of time prior to pricing (gener-ally five days before pricing). Subject to narrow exceptions, family clients there-fore cannot purchase equity securities in a

The premise of the Family Office Rule is to allow families to manage their own wealth without extensive oversight by the SEC.


covered offering if they have also shorted those securities during the relevant period. In 2013 the SEC announced an initiative to enhance enforcement of Rule 105.16 Since then, the SEC has brought multiple enforcement actions, including 23 such actions in September 2014.17 In addition to this enforcement initiative, the SEC’s National Examination Program has issued an alert to highlight risks of non-compli-ance with Rule 105.18 In light of the SEC’s focus on reviewing compliance with Rule 105, family offices should adopt policies and procedures to prevent violations of the rule.

B. Commodity Futures Trading Commission RegulationsIf an entity will invest in commodities traded on a U.S. commodities exchange or enter into interest rate or currency hedging arrangements (including, for example, swaps), its investment adviser and/or con-trolling person may need to register as a commodity pool operator (a “CPO”) or a commodity trading advisor (a “CTA”) with the U.S. Commodity Futures Trading Commission (the “CFTC”), unless such person(s) meet an exemption in each case. CPO and CTA registration requirements are in addition to SEC investment adviser registration requirements (i.e., a family office needs to review that it is in compli-ance with CFTC registration exemptions in addition to the Family Office Rule).

In 2012 the CFTC eliminated the exemp-tion that most family offices that qualify as CPOs historically relied upon to avoid CPO registration. However, another exemption from registration exists for the CPOs of entities that engage in only a de minimis amount of commodities trading so long as a notice filing is made with the CFTC and reaffirmed each year. Additionally, family offices under the Family Office Rule may be exempt from CPO registration if they make a short notice filing with the CFTC.

As a general matter, CTA exemptions are typically available for CPOs that qualify as “family offices” under the Family Office Rule (and notify the CFTC of their status as such, as mentioned above) or that provide commodity trading advice to a small group of clients. For example, CFTC Regulation 4.14(a)(10) is a self-executing exemption from CTA registration that can be relied upon by family offices that have not furnished commodity trading advice to more than 15 persons during the course of the preceding 12 months and do not hold themselves out generally to the public as a commodity trading advisor. A single “person” includes an entity that re-ceives commodity interest trading advice based on its investment objectives rather than the individual investment objectives of its owners. Therefore, an entity’s owner would be counted in its own capacity if the CTA provides advisory services to the owner separate and apart from the advi-sory services provided to the entity. n

1 The authors thank Chadbourne summer associ-ate Sarahi Uribe for her contributions to this article.

2 Although this article does not address U.S. state laws, Section 203A(b)(1)(B) of the Advisers Act exempts “family offices” under the Family Office Rule from state-level investment adviser registration, licensing and qualification requirements.

3 The Family Office Rule is an exclusion from SEC investment adviser registration (as opposed to an exemption). Therefore, an adviser that is a “family office” under the Family Office Rule is not subject to the Advisers Act, whereas an adviser that is exempt from SEC investment adviser registration will remain subject to certain provisions of the Adviser Act notwithstanding its exempt status. This distinc-tion illustrates the regulatory benefit of being classi-fied as a “family office” under the Family Office Rule.

4 The Advisers Act provides a number of exemp-tions from registration, including the following that are most typically relied upon by investment advis-ers to private equity funds and hedge funds:

• Private Fund Adviser Exemption: Available to an adviser solely to “private funds” that has less than US$150 million in regulatory assets under management (“Regulatory AUM”) in the United States. Although exempt from SEC registration, an adviser relying on the Private Fund Adviser Exemption is deemed to be an

“exempt reporting adviser” by the SEC. Exempt reporting advisers are still subject to examina-tion by the SEC and must submit an annual filing with the SEC and, in some instances, with U.S. state regulators.

• Foreign Private Adviser Exemption: Available to an adviser that (i) has no place of business in the United States, (ii) has, in total, fewer than 15 clients and investors in the United States in private funds advised by the adviser, (iii) has Regulatory AUM attributable to these clients and investors of less than US$25 million, and (iv) does not hold itself out generally to the public in the United States as an investment adviser. Unlike the Private Fund Adviser Exemption, the Foreign Private Adviser Exemption is self-executing (i.e., it does not require a filing).

• Venture Capital Adviser Exemption: Available to an adviser that solely advises one or more

“venture capital funds” as defined by SEC rule (regardless of the amount of assets managed). This exemption is narrow and, like the Private Fund Adviser Exemption, requires that the adviser makes a filing with the SEC as an exempt reporting adviser (and, in some in-stances, with U.S. state regulators).

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Investment advisers that are exempt from SEC regis-tration may still have registration requirements with one or more U.S. states.

5 See Investment Advisers Release No. 3220, at note 114 (June 22, 2011), available at http://www.sec.gov/rules/final/2011/ia-3220.pdf.

6 Peter Adamson III, SEC No-Action Letter, 2012 WL 1134775 (Apr. 3, 2012).

7 Id.

8 Gruss & Co., Advisers Act Release No. 3866 (July 1, 2014); Duncan Family Office, Advisers Act Release No. 3867 (July 1, 2014).

9 A “family entity” is generally an entity through which a family member (but not a key employee) invests.

10 Staff Responses to Questions About the Family Office Rule (Updated as of April 27, 2012), available at http://www.sec.gov/divisions/investment/guidance /familyofficefaq.htm.

11 Id. at FAQ I.1.

12 Id. at FAQ I.2.

13 Additionally, the investment adviser must file an amendment to Schedule 13D if there is a material change to the information described therein. An acquisition or disposition of beneficial ownership of securities in an amount equal to 1% or more of a class is deemed to be “material” (lesser acquisitions may still be “material” depending on the facts and circumstances).

14 Additionally, an eligible filer will thereafter, in ad-dition to filing any required amendment within 45 days after the end of the year, file an amendment on 13G within 10 days after the end of the first month in which its direct or indirect beneficial ownership increases or decreases by more than 5% of the class of equity securities.

15 “NMS Security” is defined in Rule 600(b)(46) as “any security or class of securities for which trans-action reports are collected, processed, and made available pursuant to an effective transaction re-porting plan, or an effective national market system plan for reporting transactions in listed options.” See Staff Responses to Frequently Asked Questions Concerning Large Trader Reporting, available at http://www.sec.gov/divisions/marketreg/large-trad-er-faqs.htm.

16 See SEC Charges 23 Firms with Short Selling Violations in Crackdown on Potential Manipulation in Advance of Stock Offerings, available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539804376#.VCnlo_ldWBR.

17 Id.

18 Rule 105 of Regulation M: Short Selling in Connection with a Public Offering, available at http://www.sec.gov/about/offices/ocie/risk-alert-091713-rule105-regm.pdf.


Fall EventsPrivate Equity Structuring: The Basics

On September 12, 2014, Partner Scott Naidech co-chaired a New York City Bar program that highlighted key aspects of corporate, securities, M&A, real estate and tax matters for private equity structures. The program covered the basics of private equity fund formation and deal making at both

the fund level and with the fund’s portfolio companies. It also discussed crowd funding, the new general solicitation regulations and ethics pertaining to new public and private offering regulations.

Private Fund Compliance in 2014: Issues, Trends and SEC Guidance

On October 1, 2014, Partners Beth Kramer and Scott Naidech led a Regulatory Compliance Association (RCA) webcast that focused on key elements and current trends in

private fund compliance, including compliance for private equity and hedge funds, SEC examination priorities and managing risk.

Compliance, Risk & Enforcement (CRE) – New York 2014

On November 4, 2014, Partner Beth Kramer will serve on the speaking faculty for the Regulatory Compliance Association’s (RCA) annual New York symposium. The event will bring together regulators and practice leaders to discuss key insights regarding cybersecurity for fund

managers and registered investment advisers, the latest de-velopments in SEC and NFA processes, 2015 enforcement initiatives, examination priorities in 2015 and emerging issues in regulatory reporting.

Private Equity Fund Formation in 2014: Navigating Broker-Dealer Developments, SEC Focus on Fund Expenses, Tax Issues, Fundraising and the EU’s AIFM Directive

On November 12, 2014, Partner Scott Naidech and Counsel Edouard Markson will participate in a Strafford-hosted CLE webinar that will focus on identifying the most signifi-cant trends in private equity fund formation from a capital

raising, regulatory and negotiations standpoint. The panel will discuss the changing landscape of private equity fund formation and provide an update and overview of terms and negotiating points.

2015 ISS Updates and Proxy Season Insights for Companies and Investment Managers

On November 20, 2014, Partners Beth Kramer and Kevin Smith will join ISS Corporate Solutions Vice President Peter Kimball to discuss the ISS 2015 benchmark voting policy updates, along with developments of interest to public com-panies, investment managers and institutional investors.

Topics will include ISS 2015 policy updates and what they mean for the upcoming proxy season, a look at the ISS policy update process, shareholder proposals and activism and recent SEC guidance applicable to proxy advisory firms and investment managers.

NEW YORK

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