As financial reform has made its way through Congress there have been several proposed changes to the standard of what it takes to be an accredited investor.

In 1982, the SEC prescribed the standard in Rule 501 of Regulation D:

5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;

6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

The Senate version of the bill would have increased both amounts. If you use the CPI index, the amounts would more than double.

Although the bill has not passed yet, but it looks like the accredited investor standard is going to change. Section 413 of the bill is Adjusting the Accredited Investor Standard.

The net worth standard will stay at $1 million for at least the next four years, but the value of the primary residence will be excluded from net worth. Otherwise the SEC will be tasked with a review of the definition of “accredited investor” and has a clean slate to develop its own definition. The SEC can revisit the definition every four years. The only standard is that the definition be “appropriate for the protection of investors, in the public interest, and in light of the economy.”

Looking into my crystal ball, I expect the SEC to adjust the income standards based on inflation. That would put them at around $459,000 if single and $688,000 if married. I would also expect the standard to include some sort investment expertise and knowledge standard. Having a big pile of cash or a big paycheck will likely no longer be the only standard.  At least that’s my guess.

Sources:

• Text of Title IV:Private Fund Investment Advisers Registration Act of 2010
• Accredited Investors under the Restoring American Financial Stability Act – prior post

Image: three horsemen of the apocalypse, greenspan, et al by daveeza

If you are running a private investment fund, do you need a chief compliance officer?

If you are not registered with the SEC, it’s a gray area. If you are registered with SEC, then “yes.”

Rule 206(4)-7 requires a registered investment adviser to “[d]esignate an individual (who is a supervised person) responsible for administering the policies and procedures that you adopt under paragraph (a) of this section.”

Since the financial reform bill is going to remove the small adviser exemption from registration, hundreds (thousands?) of private fund managers will need to register with the SEC once the bill is finalized and signed by the president.

Do you need to hire a new person to serve as CCO? The rule does not require advisers to hire an additional executive to serve as compliance officer. [See Footnote 74 of SEC Release No. IA-2204] You merely have to designate someone to serve in the role.

What are the requirements for a CCO for private equity fund?

• Must be competent and knowledgeable regarding the Advisers Act.
• Must be empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the firm.
• Must have sufficient seniority and authority within the organization to compel others to adhere to the compliance policies and procedures.

Having the knowledge about the act is going have many firms look toward their general counsel to act as CCO.

A dual role of general counsel and CCO may put the individual into conflict with their obligations to maintain attorney-client privilege.

Sources:

• Rule 206(4)-7
• SEC Release IA-2204 Compliance Programs of Investment Companies and Investment Advisers

Image is Yes from Administration by Ranken Jordan

As I wrote about yesterday on the code of ethics for an investment adviser, one of the requirements of registering with SEC as an investment adviser is implementing a code of ethics. The most involved part of the code is the extensive reporting requirement on securities activities to the chief compliance officer.

Rule 204A-1 under the Investment Advisers Act of 1940 takes the approach that extensive reporting of trading activities by employees of an investment adviser will been a strong deterrent from getting involved in insider trading.The rule breaks the reporting into two baskets: holdings report and transaction report.

Holding Report Under Rule 204A-1

Annually, each access person needs to submit a report of their securities holdings. The report needs to include the following:

• title of the security;
• type of security
• as applicable, the exchange ticker symbol or CUSIP number
• number of shares
• principal amount of each reportable security
• The name of any broker, dealer or bank
• The date of the report

The rule does not require this to be a calendar year.

Transactions Report Under Rule 204A-1

Quarterly, each access person needs to submit a report of their securities trading activity. The report needs to include the following:

• date of the transaction
• title of the security
• as applicable the exchange ticker symbol or CUSIP number
• interest rate and maturity date for bonds and debt instruments
• number of shares
• principal amount
• nature of the transaction (i.e., purchase, sale or any other type of acquisition or disposition)
• price of the security
• name of the broker, dealer or bank who effected the trade
• submission date of the report

The report is due within 30 days after the end of the calendar quarter.

Access Person Under Rule 204A-1

The reporting obligations are limited to “access persons” at the investment adviser. These are every employee that

1. has access to nonpublic information regarding any clients’ purchase or sale of securities
2. has access to nonpublic information regarding the portfolio holdings of any reportable fund
3. is involved in making securities recommendations to clients
4. has access to securities recommendations that are nonpublic

Those are some very broad categories. For most private funds, I would guess that most of their employees could be considered “access persons.” It’s probably easier and less likely to get you in trouble if you consider all employees to be access persons and require all employees to submit reports. Not easier on the compliance officers, but easier on employee understanding.

Exceptions From Reporting Requirements

Rule 204A-1 has some exceptions to personal securities reporting. No reports are required:

• With respect to transactions effected pursuant to an automatic investment plan.
• With respect to securities held in accounts over which the access person had no direct or indirect influence or control.

Plus there is also a group securities that are not reportable:

• Direct obligations of the Government of the United States;
• Bankers’ acceptances, bank certificates of deposit, commercial paper and high quality short-term debt instruments, including repurchase agreements;
• Shares issued by money market funds;
• Shares issued by open-end funds other than reportable funds; and
• Shares issued by unit investment trusts that are invested exclusively in one or more open-end funds, none of which are reportable funds

Preclearance for IPOs and Limited Offerings

Rule 204a-1 requires an access person to obtain approval before they any security in an initial public offering or in a limited offering. A “limited offering” is a private placement and would include the purchase of an interest in a private investment fund.

What About Alternative Investment Fund Advisers?

These rules make sense for an adviser focusing on tradable securities, but make much less sense for advisers to funds that focus on alternative investments. Venture capital is an obvious example, but it seems they have escaped from the registration requirement imposed on other private equity firms under the financial reform bills.

Sources:

• Section 204A of the Investment Adviser Act
• Rule 204A-1 – Investment Adviser Code of Ethics
• Final Rule Release for Rule 204A-1 IA-2256
• Webinar: Code of ethics Compliance from Compliance Avenue featuring William G. Mulligan

Image of 100 dollar bill is by mokra from RGBstock.com

With the financial reform bill set to eliminate the 15 client rule exemption for registration under the Investment Advisers Act, the only remaining exemption for fund companies with over $150 million in assets under management will be for venture capital. The Congressional conference decided to not include the Senate’s exemption for private equity.

The bill would leave it up to the Securities and Exchange Commission to define “venture capital.” So what do you think that definition will be?

Wikipedia provides a nice overview, but lacks much in the way of a definition for regulators.

Venture capital is provided as seed funding to early-stage, high-potential, growth companies and more often after the seed funding round as growth funding round in the interest of generating a return through an eventual realization event such as an IPO or trade sale of the company. Venture capital investments are generally made in cash in exchange for shares in the invested company.

Next I turned to a trade group’s definition of venture capital. So I went to the website for the National Venture Capital Association. I had a hard time finding a comprehensive definition. Although I’m sure that they are working on some proposals for the SEC. Here are some tidbits:

Venture capitalists invest mostly in young, private companies that have great potential for innovation and growth.

Venture capitalists are long-term investors who take a very active role in their portfolio companies. When a venture capitalist makes an investment he/she does not expect a return on that investment for 7-10 years, on average.

Venture capital is a subset of the larger private equity asset class. The private equity asset class includes venture capital, buyouts, and mezzanine investment activity. Venture capital focuses on investing in private, young, fast growing companies. Buyout and mezzanine investing focuses on investing in more mature companies. Venture capitalists also invest cash for equity. Other private equity investors tend to use debt as part of their transactions.

Venture capital is more like a different business model for investing than a legally definable industry. Since the SEC is going to come up with a definition, that means that there will be a legal definition.

That also means that the SEC definition will most likely affect the types of investments by venture capital firms, the nature of their capital investment, and the exit strategy from their investments.

Here are some guesses:

• Prohibition or limitation on holding debt
• Limitation on holding preferred shares
• Restricted to holding common shares in operating companies
• Prohibitions or limitations on holding publicly-traded securities
• Limitations on holding shares in companies that have debt obligations
• Restrictions on the type of operating companies they can invest in

They are just guesses. But the industry should be very worried about the eventual definition. The SEC has expressed a desire to regulate all private investment funds so I would expect their eventual definition to be very narrow.

I’m sure that the venture capital industry views the exemption as a victory. But the exemption could end up being a heavy weight around their necks. They may need to change their operating approach and investing style to stay within the boundaries of the definition and the exemption.

In the end, it may just be easier to register and regain the flexibility for a wider variety of investment approaches.

Sources:

• Frequently Asked Questions About Venture Capital from the National Venture Capital Association
• Regulation of Advisers to Private Funds -prior post

You can get the “Trust Me, I’m a Venture Capitalist” hat at Cafe Press.

With the impending removal of the 15 Client Rule exemption from registration with the SEC, I was scratching my head trying to figure how to make the SEC’s new custody rule work for private equity.

The SEC recently updated its guidance on custody rule compliance truing to add clarity for advisers to pooled investment vehicles.

Here is one:

Question II.3

Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

A: No. Rule 206(4)-2 applies only to clients’ funds and securities. (Posted 2003.)

Actually that does not help. A private equity fund will hold interests in private companies. Those interests may be stock, LLC interests or partnership interests.  Just because the company is private, those interests may still be securities.

For real estate private equity, the deeds to the underlying property would fall outside the custody rule. The intermediate entities, REITs and joint ventures may not fall outside the custody rule.

§ 275.206(4)-2(b)(2) has an exemption for certain privately offered securities, if the securities are:

(A) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;
(B) Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client;
and
(C) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

This exemption is available only if the fund is audited, and the audited financial statements are distributed, as described in paragraph (b)(4) of this section.

The “uncertificated” requirement can be a problem. It is common practice for lenders relying on private company interests to require they be certificated to get better priority under the UCC.

The limits on transfer are a problem because as the holder of the interests, you want the flexibility to transfer interests.

The financial statements requirement is another extra burden, although may not be a problem for many funds. This requires:

• annual audit
• in accordance with GAAP
• within 120 days of the end of the fiscal year
• independent accountant registered and subject to inspection by PCAOB

(I’m not sure how quickly the SEC can change this rule if the Supreme Court rules PCAOB unconstitutional.)

In looking towards Capitol Hill, the Senate’s Restoring American Financial Stability Act would exempt private equity firms from having to comply with the custody rule since they would not have to register. The House’s Wall Street Reform and Consumer Protection Act would not exempt private equity firms from registration and they would be subject to the custody rule.

One interesting aspect of the bills is that fund advisers that are currently registered because they have more than 15 clients/funds may no longer have to be registered if they fall under the venture capital fund advisers exemption or private equity fund advisers exemption. (Assuming those exemptions survive in the final bill.)

Sources:

• SEC Release No. IA-2968: Custody of Funds or Securities of Clients by Investment Advisers
• SEC Staff Responses to Questions About the Custody Rule
• SEC Staff issues additional guidance on amended Custody Rule compliance for advisers to pooled investment vehicle by Compliance Avenue
• Custody of Funds or Securities of Clients by Investment Advisers – prior post

Image of Old West Bank – It’s a beautiful bank is by oddsock

Shearman & Sterling put together a great client publication on private fund manager registration requirements being considered by Congress: Private Fund Manager Registration as U.S. Financial Reform Legislation Approaches the Finish Line.

Among the many provisions to be reconciled in the 1,600+ pages of each bill are those that would require private fund managers to register as investment advisers with the U.S. Securities and Exchange Commission. The registration provisions would strike the existing registration exemption on which many fund managers now rely, that being the so-called “private adviser” or “fourteen or fewer clients” exemption. The result is that many fund managers that are currently exempt from SEC investment adviser registration will be forced to register in due course. With that background, this alert highlights differences between the Senate and House treatment of these registration requirements.

It looks like much of that is going to be wiped out of the bill. Senate Amendment 4056, proposed by Senator Bond, was passed by a voice vote.

The amendment directs the SEC to adjust the net worth needed to attain accredited investor status to $1,000,000, excluding the value of the primary residence. Within the period of four years after enactment, however, the net worth standard must be $1,000,000, excluding the value of the primary residence. The proposal would give the SEC the power to adjust the the definition of “accredited investor” every four years.

Senate Amendment 4056 also removed the 120 review period for private placements.

I have found Senate process for dealing with financial reform bill to be incredibly opaque and fast moving. There have been almost 400 amendments proposed since the bill was submitted last month, with the text of most of the amendments not being available until after vote has taken place.

Sources:

• Text of Senate Amendment 4056
• Bond Amendment Adjusts Accredited Investor and Reg. D Provisions in Senate Reform Bill in Jim Hamilton’s World of Securities Regulation
• Accredited Investors under the Restoring American Financial Stability Act – prior post

If you have ERISA plan investors in your private investment fund you should know that they have new reporting requirements this year.

There is a new rule that requires greatly expanded disclosure of monetary and non-monetary compensation paid by the ERISA plan. On Schedule C to Form 5500, the plan will need to identify any service provider who received more than $5,000 in compensation. In prior years, ERISA plan administrators were only required to identify the plan’s 40 most highly compensated service providers who received at least $5,000.

Mutual funds, hedge funds, private equity funds and funds of funds are all considered service providers. If you have an ERISA plan invested in your fund, expect a request for information on fees.

In the case of registered mutual funds, compensation paid to persons who rendered services to the plans investing in the fund is reportable. These expenses include investment management fees and fees related to the purchase or sale of interests in the fund. Amounts charged against the fund for “other ordinary operating expenses,” such as brokerage commissions paid to a broker in connection with a securities transaction within the fund’s portfolio, would not be deemed indirect compensation to a service provider and would not be reportable.

Fees received by third parties from an operating company in which a plan invests, including a venture capital operating company (VCOC) or a real estate operating company (REOC), generally would not be reportable indirect compensation according to the DOL’s FAQ on Form 5500 Schedule C:

Q7: Is compensation received in connection with the management and operation of venture capital operating companies (VCOCs), real estate operating companies (REOCs), and other operating companies reportable indirect compensation?

No. Although the requirement to report indirect compensation is not limited to fees received by persons managing plan assets, unlike investment funds (e.g., mutual funds, collective investment funds), fees received by third parties from operating companies, including real estate operating companies (REOC) or venture capital operating companies (VCOC), in connection with managing or operating the operating company, generally would not be reportable indirect compensation. Fees or commissions received by an investment manager or investment adviser in connection with a plan investment in a VCOC, REOC, or other operating company would, however, be reportable indirect compensation. This answer would not be affected by whether the VCOC, REOC, or other operating company were wholly owned by a plan such that the assets of the entity would be deemed to be plan assets.

ERISA is a complicated law. Make sure you find someone to help you answer these questions.
Sources:

• DOL’s Form 5500 Series webpage
• DOL’s FAQs About The 2009 Form 5500 Schedule C
• DOL’s Supplemental FAQs About The 2009 Schedule C
• Pension Benefit Guaranty Corporation Annual Reporting and Disclosure; Revision of Annual Information Return/Reports; Final Rule and Notice (November 16, 2007)

The SEC censured and fined an investment adviser for due diligence lapses. Yosemite Capital Management, LLC and its managing director, Paul H. Heckler, got a wrist slap for failing to disclose to clients that they had encountered substantial problems when attempting to perform the due diligence.

The big problem is that Yosemite had made a promise to at least two clients prior to placing his clients into the investment. They had promised to conduct due diligence. We saw a similar action by the SEC against the Hennessee Group for their failure to conduct their promised due diligence.

Yosemite ended up putting their clients’ money into a Ponzi scheme. Yosemite placed $3.25 million of four clients’ funds through a feeder fund, Ashton Investments LLC which was supposed to make bridge loans arranged by Norman Hsu and Next Components, Ltd. Heckler’s clients’ funds became part of a Hsu’s $60 million Ponzi scheme.

Yosemite missed some bright red flags:

• The business cards from Ashton’s representatives that listed their position as “Represenative” [sic].
• Ashton gave Yosemite a brochure riddled with spelling errors and mostly general, unverified information.
• In addition to the business cards and the brochure, the only other written information concerning Ashton and Hsu that Yosemite received were emails, without any identifying information, that summarized a few of the loans.
• Heckler was told that he could not contact Hsu’s lawyers or accountants because Hsu was a  private person.
• Heckler was told that the bridge loans were safer than stocks or bonds.
• When Heckler requested a disclaimer in the loan agreement, he was told that it was unnecessary because the investment was not risky.
• Because Ashton had no offices, Heckler met the Ashton representatives at local restaurants to discuss the investment.

Heckler and Yosemite willfully violated Section 206(2) of the Advisers Act, which prohibits any investment adviser from engaging in any transaction, practice, or course of business, which operates as a fraud or deceit on any client or prospective client, and Heckler caused Yosemite’s violations of Section 206(2) of the Advisers Act.

The “wrist slap” was a disgorgement of the fee earned ($26,000), prejudgment interest and a $50,000 fine. Heckler invested $275,000 of his own money in the scheme and lost $150,000 of it.

Of the $3.25 million of the clients’ money invested, they lost $1.95 million when Hsu’s Ponzi scheme collapsed.

Sources:

• SEC Administrative Proceeding 3-13821 Paul H. Heckler and Yosemite Capital Management, LLC
• Davis Polk Investment Management Regulatory Update – May 10, 2010
• Failure to Conduct Diligence Can Lead to SEC Sanctions – prior post

They’re looking at you.

Rob Kaplan and Bruce Karpati, co-chiefs of the Asset Management Unit of the SEC enforcement division, held their first full staff meeting last week. This new unit will be focusing on misbehavior by private-equity funds, hedge funds, buyout firms, mutual funds and other asset managers. The unit is one of the five specialty units the SEC formed earlier this year.

Side Pockets

Hedge funds use side pockets to protect new investments, long term investments and other assets that they do not want to liquidate in the face of redemptions in the fund. In the Great Panic of 2008 funds used side pockets to limit redemption.

Valuations

One issue related to the side pocket is valuation of the assets. One reason for keeping the assets is because the fund managers feel the assets are not being properly valued in the market. On the bad side, the fund may be charging fees against the inflated value of those side pockets assets. Most side pocket assets are illiquid, which makes valuations difficult to determine.

Management Investment

One surprising priority for the unit is evaluating whether fund managers really have their own wealth invested in the fund when they are saying so in the prospectus and marketing materials.

It sounds like some enforcement proceedings are likely to appear in this area in the next few months.

Sources:

• SEC Probes ‘Side Pocket’ Arrangements by Jenny Strasburg for the Wall Street Journal
• SEC Probes Hedge Funds’ Use Of Side Pockets by by Joseph A. Giannone (Reuters) in the New York Times
• S.E.C. Enforcers Focus on Avoiding Madoff Repeat by Jenny Anderson and Zachery Kouwe for the New York Times
• SEC Probing of Side Pockets in Compliance Avenue
• SEC sets up fund investigation unit By Peter Ortiz in the Financial Times
• SEC Rearranges its Enforcement Program – prior post

Picture is by Daniel Rosenbaum for The New York Times