Category: Investment Advisers Act

Dodd’s Solo View on Private Investment Funds

Senator Dodd

Senator Dodd did not forget about private investment funds. Tucked into page 366 of his 1366 page Restoring American Financial Stability Act of 2010 is the Private Fund Investment Advisers Registration Act.

This is largely the same language in the Private Fund Investment Advisers Registration Act of 2009 contained in Dodd’s draft Restoring American Financial Stability Act of 2009. He circulated that draft back in November to start negotiations with Republicans.

Venture Capital Fund Advisers

There is an exemption from registration for the “provision of investment advice relating to a venture capital fund.” The bill gives the SEC the responsibility for defining a “venture capital fund.”

Private Equity Fund Advisers

Unlike the bill passed by the House, Dodd proposes an exemption from registration or reporting requirements with respect to advice given to private equity funds. The SEC is tasked with defining the term “private equity fund.”  Unlike venture capital funds, private equity funds will be subject to SEC record-keeping requirements to the extent the SEC determines it is “necessary and appropriate in the public interest and for the protection of investors.”

State versus Federal Registration of Investment Advisers

Section 410 of the bill raises the federal registration level to $100 million from $25 million. So investment advisers and funds of less than $100 million will be subject to state regulators instead of federal regulators. David Tittsworth, executive director of the Investment Adviser Association, said the change would shift about 4,200 of the 11,000 money managers now registered at the SEC to state regulation.

Accredited Investors

The Dodd bill would change the threshold for “accredited investor.” Currently, the threshold is $200,000 income for a natural person (or $300,000 for a couple) or $1,000,000 in assets. The SEC would have the power to increase those levels  as “appropriate and in the public interest, in light of price inflation since those figures were determined.”

The Comptroller General is also directed to study the financial thresholds for investor eligibility in private funds.

Regulation D Offerings

Separately in the bill, Senator Dodd is proposing to tinker with exemption from registration under Rule 506. Section 926 of his bill, gives the SEC the power to designate certain Rule 506 offerings to not be “covered securities.”  That would get the states more involved in the review and regulation of private offerings, including private fund offerings.

Now What?

This bill still has a long way to go in the Senate. Most reports indicate that private funds are not one of the hotly contested issues in the bill. Assuming the Senate passes the bill, they will need to negotiate the differences between the House and Senate. Assuming it passes, it looks like a big chunk of work would be dropped onto the SEC to define the fund types.

Sources:

Dodd Goes Solo

Senator Dodd

After months of negotiation, Senator Dodd gave up on his negotiations with Republicans and decided to introduce a financial industry reform bill all by himself.

To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘‘too big to fail’’, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.

Now what?

Well, there’s a lot of reading. The Restoring American Financial Stability Act of 2010 is a whopping 1,336 pages. That’s a hundred or so pages longer the House’s Wall Street Reform and Consumer Protection Act passed in December.

Apparently none of the 10 Republicans on the Senate Banking Committee endorse Dodd’s Restoring American Financial Stability Act of 2010. I assume he can muster the Democrats on the committee to pass the bill. Then he has to get the votes lined up in the full Senate. That will likely mean having to make some changes to the bill. Assuming he can gather that many votes, then they need to negotiate a compromise law with the House so that the bill is in a final form that both legislative bodies will approve (or vote down).

I wouldn’t get too attached to anything in the Restoring American Financial Stability Act of 2010. One thing that’s certain: the bill will look different.

How will it be different? I’m not even going to guess.

Sources:

Custody of Funds or Securities of Clients by Investment Advisers

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The SEC released the final version of its new custody rule (.pdf). The Commissioners had announced their approval of the rule on December 17 and then released the final text on December 30. The rule goes into effect 60 days after publication in the Federal Register.

The amendments are designed to provide additional safeguards under the Advisers Act when a registered adviser has custody of client funds or securities by requiring such an adviser, among other things: to undergo an annual surprise examination by an independent public accountant to verify client assets; to have the qualified custodian maintaining client funds and securities send account statements directly to the advisory clients; and unless client assets are maintained by an independent custodian (i.e., a custodian that is not the adviser itself or a related person), to obtain, or receive from a related person, a report of the internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board. Finally, the amended custody rule and forms will provide the Commission and the public with better information about the custodial practices of registered investment advisers.

This new custody rule is designed to catch a Madoff fraud.

The rule is limited in scope. Only SEC-registered investment advisories that control custody of their client’s assets – as Madoff did — are subject to the rule. Independent RIAs with client assets in custody with unaffiliated third parties are exempt from the final version of the rule.

The difference is that the SEC exempted investment advisers who were deemed to have custody merely because they had the authority to deduct their advisory fees from client accounts from the surprise audit requirement. The SEC also exempted pooled investment vehicles from the requirement if they have an annual GAAP audit by an independent public accountant.

Between 1,500 and 1,900 SEC-registered investment advisories provide in-house custody of securities and most of these are either broker-dealer affiliates or alternative-investment managers. This leaves well over 9,000 SEC-regulated RIAs and at least that many state-registered investment adviser firms free from the burdens of the rule. The SEC estimates the annual cost of compliance at about $8,000 a year, but TD Ameritrade estimates the cost is closer to $25,000 per year.

References:

SEC Approves New Custody Rule

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The Securities and Exchange Commission adopted the proposed Custody Rule for investment advisers originally proposed last May. (See: SEC Releases Proposed Custody Rules for Investment Advisers)

As is typical with the SEC, they announced the rule was approved before they made the final version of rule available. The rule amendments will be effective 60 days after their publication in the Federal Register.

The SEC press release highlights the two biggest changes:

Surprise Exam

“The adviser is now required to engage an independent public accountant to conduct an annual “surprise exam” to verify that client assets exist. Such a surprise examination would provide another set of eyes on the client’s assets, and provide additional protection against theft or misuse. The accountants would have to contact the SEC if they discovered client assets were missing.”

Custody Controls Review

“When the adviser or an affiliate serves as custodian of client assets, the adviser is now required to obtain a written report — prepared by an accountant that is registered with and subject to regular inspection by the PCAOB — that, among other things, describes the controls in place at the custodian, tests the operating effectiveness of those controls and provides the results of those tests. These reports are commonly known as SAS-70 reports. Requiring that the accountant be registered with and subject to inspection by the PCAOB provides greater confidence regarding the quality of these reports.”

The rules are amendments to Rule 206(4)-2 [17 CFR 275.206(4)-2], Rule 204-2 [17 CFR 275.204-2] under the Investment Advisers Act of 1940 [15 U.S.C. 80b] (the “Advisers Act” or “Act”), to Form ADV [17 CFR 279.1], and to Form ADV-E [17 CFR 279.8].

References:

Review of SEC’s Process for Selecting Adviser Examination Targets

Review of the Commission’s Processes for Selecting Investment Advisers and Investment Companies for Examination

To continue the Madoff dogpile on the SEC, the SEC’s Office of Inspector General released a report criticizing the SEC’s process for selecting investment advisers and investment companies for examination.

Review of the Commission’s Processes for Selecting Investment Advisers and Investment Companies for Examination pdf-icon

As a result of OCIE never having examined Madoff’s investment firm, the Inspector General conducted this review to determine OCIE’s rationale for not performing an examination of Madoff’s investment advisory business. They came up with 11 recommendations:

Recommendation 1:

The Office of Compliance Inspections and Examinations (OCIE) should implement a procedure requiring, as part its process for creating a risk rating for an investment adviser, that OCIE staff perform a search of Commission databases containing information about past examinations, investigations, and filings related to the investment adviser.

Recommendation 2:

The Office of Compliance Inspections and Examinations (OCIE) should change the risk rating of an investment adviser based on pertinent information garnered from all Divisions and Offices of the Commission, including information from OCIE examinations and Enforcement investigations, regardless of whether the information was learned during an examination conducted to look specifically at a firm’s investment advisory business.

Recommendation 3:

The Division of Enforcement and the Office of Compliance Inspections and Examinations should establish and adhere to a joint protocol providing for the sharing of all pertinent information (e.g., securities laws violations, disciplinary history, tips, complaints and referrals) identified during the course of an investigation or examination or otherwise.

Recommendation 4:

The Office of Compliance Inspections and Examinations (OCIE) should establish a procedure to thoroughly evaluate negative information that it receives about an investment adviser and use this information to determine when it is appropriate to conduct a cause examination of an investment adviser. OCIE should ensure its procedure provides for timely opening of a cause examination.

Recommendation 5:

When the Office of Compliance Inspections and Examinations (OCIE) becomes aware of negative information pertaining to an investment adviser, OCIE should examine the investment adviser’s Form ADV filings and document and investigate discrepancies existing between the adviser’s Form ADV and information that OCIE previously learned about the registrant.

Recommendation 6:

The Office of Compliance Inspections and Examinations (OCIE) should establish a procedure to thoroughly evaluate an investment adviser’s Form ADVs when OCIE becomes aware of issues or problems with an investment adviser. OCIE should document areas where it believes a Form ADV contains false information and initiate appropriate action, such as commencing a cause examination.

Recommendation 7:

The Office of Compliance Inspections and Examinations (OCIE) should re-evaluate the point scores that it assigns to advisers based on their reported assets under management. OCIE should assign progressively higher risk weightings to firms that have greater assets under management.

Recommendation 8:

The Office of Compliance Inspections and Examinations (OCIE) should re-evaluate the point scores that it assigns to firms based on their reported number of clients to which they provide investment advisory services. OCIE should assign progressively higher risk weightings to investment advisers that serve a larger number of clients.

Recommendation 9:

The Office of Compliance Inspections and Examinations (OCIE) should recommend to the Chairman’s office that it institute a Commission rulemaking that would require the following additional information to be reported as part of Form ADV:
• Performance information;
• A fund’s service providers, custodians, auditors and administrators, and applicable information about these entities;
• A hedge fund’s current auditor and any changes in the auditor; and
• The auditor’s opinion of the firm.

Recommendation 10:

The Commission should finalize the proposed rule titled Amendments to Form ADV [Release No. IA-2711; 34-57419]. In finalizing this rule, the Commission should consider what, if any, additional information investment advisers should include in Part II of Form ADV by consulting with the Office of Compliance Inspections and Examinations (OCIE) and the Division of Investment Management (IM). Further, the Commission, in consultation with OCIE and IM, should consider provisions that would assist OCIE to efficiently and effectively review and analyze the information in Part II of Form ADV.

Recommendation 11:

The Office of Compliance Inspections and Examinations (OCIE) should develop and adhere to policies and procedures for conducting third party verifications, such that OCIE verifies the existence of assets, custodian statements, and other relevant criteria.

This is now the fourth report the SEC’s OIG has issued as a result of Madoff, following up on:

Fund Registration Act Will Cost the SEC $140 Million

CBO Congressional budget office

The Congressional Budge Office released a cost estimate of H.R. 3818, the Private Fund Investment Advisers Registration Act of 2009. Obviously, there will be an additional cost to fund managers that need to register with the SEC and operate under the SEC rules and oversight. There is also a real cost to the SEC (and therefore the taxpayers) for supervision of the newly regulated fund advisers.

The CBO estimates that the SEC will need an additional $140 million over the 2010-2014 period to implement the provisions of H.R. 3818. That means 150 employees new SEC employees by fiscal year 2011 to write regulations and undertake the additional examination and enforcement activities required by the bill. That’s about a 4 percent increase over the SEC’s 2009 staffing levels. The $140 million is to cover the cost of salaries and benefits, overhead, preparation of reports, and upgrades to information technology systems for the new employees.

The CBO report estimates that H.R. 3818 would result in 1,300 new registrations. That excludes venture capital funds which are exempted under this bill, but does include private equity firms that are exempted under the Senate version of the Private Fund Investment Advisers Registration Act. Doing the math, that results in $108,000 in additional costs for each new fund manager that registers.

On the manager side, the CBO estimates that it will only cost $30,000 for each fund manager to comply with Private Fund Investment Advisers Registration Act of 2009.

References:

Amendments to the Private Fund Investment Advisers Registration Act

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Enacting legislation is often compared to making sausage. I don’t think that the Private Fund Investment Advisers Registration Act is exception. I spent some time watching the House Financial Services Committee hearing on passing the Private Fund Investment Advisers Registration Act.

There were 13 proposed amendments, 8 of which were agreed to by the Committee. I tried incorporating these amendments into the text to see what happened earlier this week.

You can see my attempt hosted on JD Supra

Here are some quick thoughts:

  • The exemption for venture capital funds was retained.
  • There is a new exemption for investment advisers of private funds with less than $150 million. (There was a rejected amendment trying to have this level at $500 million.)
  • There is a one year transition rule, postponing the registration requirement until one year after the Act is passed.

References:

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Capital Markets Regulatory Reform: Enhancing Oversight of Private Pools of Capital

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Today, the House Committee on Financial Services heard testimony on Enhancing Oversight of Private Pools of Capital. This seems to be is response to the draft Private Fund Investment Advisers Registration Act. Congressman Paul E. Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, released a discussion draft of the bill.

This was likely to be a battle over who gets regulated. Congressman Kanjorski opened that door by including a registration exemption for “Venture Capital” funds, with no definition of what that means.

Panel Two—Enhancing Oversight of Private Pools of Capital

Rep. Paul E. Kanjorski emphasized that the committee wanted to works with the industry to impose regulations that would not burden the industry with lots of compliance costs.  His audience of fellow Congressmen was limited. There were more empty seats than Congressmen.

The panelists emphasized that the full burden of the Investment Advisers Act would inhibit the private fund industry. They also pointed out that many of the types of private pools of capital (other than hedge funds) do not have systemic risk and were not part of the cause of the financial industry issues.

The hearing did include a battle over whether there should be registration and who should be registered. “We only deal with sophisticated investors, we think we should be treated differently than retail investments.”

Schwarzman Stands up for Placement Agents

blackstone

“Eliminating placement agents as a group because there were a few bad actors who have tarnished the industry is analogous to eliminating Major League Baseball because several of its players behaved illegally.”

Steven Schwarzman, The Blackstone Group’s chairman and chief executive, has submitted a comment letter on the SEC’s proposed ban on placement agents interacting with public pensions.  He comes squarely down on the side of placement agents. In fact, he credits placement agents with being essential to his fund-raising success.

The proposed SEC rule is fallout from investigations by the SEC and the New York District Attorney into a pay-to-play scandal involving “fixers” and prior scandal in New Mexico

References:

Reasons Why the SEC Wants to Regulate Political Contributions

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The SEC has proposed a New Rule on Political Contributions by Certain Investment Advisers to prevent advisers from participating in pay to play practices affecting the management of public pension plans. They had proposed a similar rule in 1999. Many of the comments to that rule said that pay to play was not a problem in the management of public funds.

Now, the SEC thinks that pay to play is a significant problem in the management of public funds by investment advisers. In recent years, the SEC and criminal authorities have brought a number of actions charging investment advisers with participating in pay to play schemes. Here are some of the incidents they cite in the proposed pay to play rule. http://www.sec.gov/rules/proposed/2009/ia-2910.pdf

Alabama

  • The SEC brought a case against the mayor of Birmingham and other defendants, alleging that while the mayor served as president of the County Commission of Jefferson County, he accepted undisclosed cash and benefits through a lobbyist as a conduit from the chairman of a Montgomery, Alabama-based broker-dealer, in return for awarding municipal bond business and swap transactions to the broker-dealer. See SEC v. Larry P. Langford et al., Litigation Release No. 20545 (Apr. 30, 2008).

California

Connecticut

  • Paul J. Silvester, the former Treasurer of the State of Connecticut, agreed to invest $200 million of state pension funds in return for the investment adviser providing consulting contracts valued at approximately $1 million each to two of his friends.SEC v. Paul J. Silvester et al., Litigation Release No. 16759 (Oct. 10, 2000); Litigation Release No. 20027 (Mar. 2, 2007); Litigation Release No. 19583 (Mar. 1, 2006); Litigation Release No. 18461 (Nov. 17, 2003); Litigation Release No. 16834 (Dec. 19, 2000);
  • Sanctions against William A. DiBella, the former Majority Leader of the Connecticut State Senate, and his consulting firm, North Cove Ventures, L.L.C. for their roles in aiding and abetting then Treasurer of the State of Connecticut, Paul J. Silvester in a fraudulent investment scheme.SEC v. William A. DiBella et al., Litigation Release No. 20498 (Mar. 14, 2008). See also
  • A judgment against Ben F. Andrews, Jr. in connection with a fraudulent scheme involving the investment of Connecticut state pension fund money. U.S.. v. Ben F. Andrews, Litigation Release No. 19566 (Feb. 15, 2006);
  • In November 1998, the then-Connecticut Treasurer invested $75 million of the Connecticut state pension fund with Thayer IV. In connection with this investment, Thayer, through Malek, agreed to hire a consultant at the Treasurer’s request. This consultant, who was paid nearly $375,000 by TC Management IV, had no previous involvement with the proposed investment and ultimately performed no meaningful work on the deal. In the Matter of Thayer Capital Partners, TC Equity Partners IV, L.L.C., TC Management Partners IV, L.L.C., and Frederick V. Malek, Investment Advisers Act Release No. 2276 (Aug. 12, 2004);
  • The principal of an investment adviser provided $2 million in consulting contracts to associates of the Connecticut State Treasurer to secure the decision to invest $200 million in state pension funds in his funds. In the Matter of Frederick W. McCarthy, Investment Advisers Act Release No. 2218 (Mar. 5, 2004);
  • An aide to the Connecticut State Treasurer received a $1 million consulting contract from an investment adviser with whom the Treasurer had invested $200 million in Connecticut state pension funds. In the Matter of Lisa A. Thiesfield, Investment Advisers Act Release No. 2186 (Oct. 29, 2003).
  • The indictment of the former mayor of Bridgeport, Connecticut, in connection with his conviction for, among other things, requiring payment from an investment adviser in return for city business. U.S. v. Joseph P. Ganim, 2007 U.S. App. LEXIS 29367 (2d Cir. 2007)

Florida

  • A partner at Lazard Freres & Co. was found liable for conspiracy and wire fraud for fraudulently paying $40,000 through an intermediary to Fulton County’s independent financial adviser to secure an assurance that Lazard would be selected for the Fulton County underwriting contract. United States v. Poirier, 321 F.3d 1024 (11th Cir.), cert. denied sub nom., deVegter v. United States, 540 U.S. 874 (2003)

Georgia

  • A broker-dealer, two of its officers and a city official were involved in a scheme to defraud the City of Atlanta in connection with the purchase and sale of certain securities while providing substantial, undisclosed monetary benefits to the city’s investment officer who was authorized to select a broker-dealer for the transactions. See In the Matter of Pryor, McClendon, Counts & Co., Inc. et al., Securities Act Release No. 7673 (Apr. 29, 1999); Securities Act Release No. 8062 (Feb. 6, 2002); Exchange Act Release No. 48095 (June 26, 2003); Securities Act Release No. 8245 (June 26, 2003); Securities Act Release No. 8246 (June 26, 2003).

Illinois

New Mexico

  • An investment adviser was barred from association with any broker, dealer or investment adviser for paying kickbacks to the Treasurer of the State of New Mexico. In the Matter of Kent D. Nelson, Investment Advisers Act Release No. 2765 (Aug. 1, 2008);  I
  • Conviction of the former treasurer of New Mexico for requiring that a friend be hired by an investment manager in return for accepting a proposal from the manager for government business.
  • Conviction for attempted extortion of the former treasurer of New Mexico’s successor for requiring that a friend be hired by an investment manager at a high salary in return for the former treasurer’s willingness to accept a proposal from the manager for government businessU.S. v. Vigil, 523 F. 3d 1258 (10th Cir. 2008)

New York

  • The deputy comptroller and a “placement agent” engaged in corruption and securities fraud for selling access to management of public funds in return for kickbacks and other payments for personal and political gain. SEC v. Henry Morris, et al, Litigation Release No. 21036 (May 12, 2009).

North Carolina

  • Alleged pay to play activities involving North Carolina’s state treasurer. Moore Defends Pension System, by Rick Rothacker & David Ingram for the Charlotte Observer (Feb. 25, 2007) (discussing )

Ohio

  • Reginald Fields, Four More Convicted in Pension Case: Ex-Board Members Took Gifts from Firm, CLEVELAND PLAIN DEALER (Sept. 20, 2006) (addressing pay to play activities of members of the Ohio Teachers Retirement System).

Pennsylvania

That is a big list of bad behavior is short period of time.

Maybe the SEC has a point.

Although I am not sure if the proposed SEC rule will stop it.