In the wake of MF Global, it can be tempting to suggest myriad rules, which, if followed, would protect investors from similar debacles in the future. Of course, the key words here are: if followed. As Ananda Radhakrishnan, the CFTC’s Director of the Division of Clearing and Intermediary Oversight, put it, “If people are determined to misuse customer funds, they will misuse them.”

No matter how numerous the rules, they can still be broken. And in my experience, the more complex the rules are, the easier it is to break them without detection.  Complexity itself gives moral weight to the details of the rules, rather than their spirit.

Instead of creating a maze of regulations, let’s at least start by equipping investors with the tools to know exactly where their assets are going and what might happen while assets are in the custody of a particular third party.  Investors need to be crystal clear on the following points:

Contracting Entity – The contracting party should be clearly identified. This identification affects who can use assets and the purposes for which the assets may be used. For example, dealing with “affiliates” nudges the door of ambiguity ajar, and it could swing wide open later. The same goes for allowing the use of sub-custodians. If sub-custodians are used, the issues discussed below will also apply to assets left with them and need to be understood just as completely as they are for assets left directly with the custodian.

Location – In which jurisdiction(s) are the investor’s assets being held? Not all jurisdictions provide the same protection for custodied assets. An investor should be clear on where assets are being held and which regulatory authority has oversight of the legal entity that is holding its assets. Without this knowledge, the investor can’t answer the key questions discussed below.

Use of custodied assets – Knowing the legal entity a custodian uses and how that entity is regulated allows the investor to determine meaningful answers to the following questions: Can the investor’s assets be comingled with those of the custodian or of other customers? If so, what protection is afforded by local law? Who bears the loss if investments decline in value – the investor or the custodian? (History has shown that while the custodian makes the decisions on permitted investments, customers are left to deal with the results if there is a shortfall.) These questions shouldn’t be riddles for a potential investor to solve on its own. Each custodian should be prepared to address these matters with its customers and prospective customers in a clear and concise manner.

Third party creditors – A related set of questions involve whether, and in what circumstances, the custodian’s third-party creditors can gain access to the investor’s assets. What happens in the event of the custodian’s insolvency? How quickly can the investor reach its funds? Will the local regulatory authorities seek to “ring-fence” all assets to protect local creditors before assets are released generally to other creditors? An investor should be clear on its ability to access assets so that it can make contingency plans if access will be delayed.

The contract – Legal rules are the baseline for the relationship between an investor and its custodian, but a contract does not have to merely meet minimum legal requirements. It can set a different standard. An investor might consider an agreement that limits custodian control of its assets. One with enough bargaining position might even consider a more active way to monitor its positions.

The clearing process – Funds and financial assets are rarely left statically with a custodian; funds are used to purchase financial assets and financial assets are sold for funds. If this process occurs through a clearing house, the precise transaction details will differ depending on the country, the instrument traded, and the specific clearing house used. Many customers of MF Global had a rude awakening to the fact that clearing houses are focused on protecting trade performance between their direct members, not access to assets by customers of their members. Unfortunately, it is difficult to master the rules in this area and the associated risks they might pose to investors. For this reason, each clearing and settlement organization should be proactive in communicating to third-party users exactly how its practices impact access to assets. If transparency is required any place in the financial services industry, it is certainly sorely needed to help investors understand the clearing and settlement process and the risks they run in this regard.

Only once investors understand the legal framework surrounding their custodians and the clearing and settlement process can they make meaningful decisions about how to manage risks. Let’s help them get there before the next “surprise” occurs.

In your opinion, are there any other steps firms can take to protect themselves against these enforcement actions?

The Dodd Frank Blueprint to Registration
for Alternative Asset Managers

September 23^rd,
8:30 am – 12:30 pm
New York Law School
185 West Broadway
New York, NY 10013

Attendees Will Take Away:

• A framework for tailoring legal requirements to your unique business model.
• A specific list of risks to consider when designing your compliance program and preparing Form ADV.
• A list of key guidelines and policies for your compliance program.
• A firm understanding of how to manage your governance program on an ongoing basis.

You Should Attend If:

• You want to quickly understand the key issues.
• You are overseeing the SEC registration process.
• You are new to the role of Chief Compliance Officer or compliance reports to you.

 This event is free, but registration is limited. Register by email: information@RegFG.com

THE AGENDA

8:30 am
Event Registration and Light Snacks.

9:00 am
Opening Remarks

Deborah Prutzman, CEO of The Regulatory Fundamentals Group LLC

9:05 am
Surveying the Landscape
The pros and cons of filing as an SEC registered investment adviser or an exempt reporting adviser. Also, how structural changes can affect your status under the Advisers Act. You will learn some surprising facts that are essential to your decision.

Stephen H. Cohen, Partner at Loeb & Loeb LLP
Ronald H. Filler, Director of the Center on Financial Services Law

9:55 am
The Regulatory Foundation
You will learn to use a simple tool to sketch out the regulatory framework applicable to your unique business model. This is the first step in building a compliance program, whether registered or exempt.

Deborah Prutzman, CEO of The Regulatory Fundamentals Group LLC

10:15 am
Q & A & Coffee

10:25 am
A Roof over Your Head: The Compliance Manual
You will learn how a compliance manual can serve your business needs and will take away a list of key issues to consider.

Moderated by Kenneth L. Seiler
Michael Asher, Director of Production Services at Richard Fleischman & Associates 
Chris Franzek, Managing Director of Duff &Phelps

11:05 am
Maintaining the Structure: Staying Current under Dodd-Frank
You will take away a list of upcoming issues to watch out for, pitfalls to avoid (including director and officer exposures), and an approach to help you tackle these issues.

Moderated by Bailey E. Somers
Michael Asher, Director of Production Services at Richard Fleischman & Associates 
Kim Patlis, Managing Director at Corporate Risk Solutions, LLC

11:45 am
Keynote speech: Self-Registration Versus SEC Registration
Roberta Karmel, Centennial Professor of Law at Brooklyn Law and Former SEC Commissioner

Due to recent press, a number of these firms are reevaluating their current policies and monitoring systems with respect to insider trading and expert networks or research consultants that interact with portfolio management or trading personnel. Many of them are also interested in learning about what others advisers are considering.

If you’re one of these firms, you can click here to take it, or contact us to see the results.

RFG has received many updates about the meeting, but we didn’t feel as if they had sufficiently addressed the overall impact of these developments in a comprehensible manner. That said, we’ve prepared the following memo to help you better understand the impact of yesterday’s meeting, which can also be found here.

 SEC Commissioners Delay Private Adviser Registration Date to March 30, 2012

 Until the passage of the Dodd Frank Act, advisers to private funds were not required to register with the SEC if they had fewer than 15 “clients.”  Each fund counted as a single “client” regardless of the number of investors in the funds.  The Dodd Frank Act repealed this exemption and requires registration with the SEC if AUM reach $100 million.  AUM includes all assets, regardless of whether the assets are family or proprietary assets, assets managed for no compensation, or assets of foreign clients, and must be calculated on a gross basis, without deduction of fees, expenses, or leverage.  Private fund advisers must include uncalled capital commitments in their AUM and must use market value or, if unavailable, fair value to value their investments.

As a consequence of the Dodd-Frank Act, many previously exempt private fund advisers will need to register with the SEC (or state regulatory authorities), and will be subjected to examinations and reporting requirements.  Other private fund advisers will be able to avoid SEC registration because of newly-approved exemptions; however, some of these advisers will still be subject to reporting requirements albeit less stringent than the reporting requirements originally proposed.

Yesterday, the SEC approved rules that exempt certain types of advisers from federal registration and reallocate the line between federal and state registration.  These exemptions are effective July 21, 2011.  Also, advisers now have until March 30, 2012 to comply with the new registration requirements and advisers that are required to switch to state registration now have until June 28, 2012 to make the switch.  All advisers registered with the SEC on January 1, 2012 must file new form ADVs by March 30, 2012.  The final rules have been released by the SEC and are available on their website at http://sec.gov/rules/final.shtml.

In this memo, we provide a quick overview of the registration landscape for advisers affected by these new rules and facing the prospect of SEC registration for the first time.

Registration Requirements for Firms with AUM Under $100M:

 Prior to Dodd-Frank, advisers were required to register with the SEC if AUM exceeded $30 million (unless an exemption from registration was available) and were permitted to register with the SEC if their AUM exceeded $25 million.  Section 410 of the Dodd-Frank Act raised the threshold for SEC registration to $100 million in AUM.  Thus, firms with less than $100 million in AUM may face registration at the state level.  Notably, the SEC included a small buffer range for advisers with AUM close to $100 million:  an adviser must register with the SEC if AUM reach $110M and need not withdraw its SEC registration until it has less than $90M of AUM.

However, pursuant to the rules adopted yesterday, an adviser that has between $25 million and $100 million in AUM should register with the SEC if one of the following three conditions is met:

1. Multiple Registrations. The adviser may register with the SEC if it otherwise would be required to register in 15 or more states.

1. No Home State Examination. An adviser with $25M or more in AUM must register with the SEC if its home state does not examine the adviser (unless another federal exemption applies).  Based on comments at the meeting, it appears that the SEC will treat advisers based in New York as not subject to examinations, and therefore New York advisers may be required to register with the SEC if AUM exceeds $25 million.  Advisers in Minnesota and Wyoming may also be required to register with the SEC if AUM exceeds $25 million.

1. No Home State Registration. If the adviser’s home state does not require registration, advisers with over $25 million in AUM must register with the SEC (unless another federal exemption applies).

Registration Requirements for Firms with AUM at or above $100M:

As stated above, even those advisers that hit the $100 million AUM threshold may be exempt from SEC registration if they fall into an applicable exemption, including one of the newly-adopted exemptions described below.

            Advisers to Private Fund: If the adviser solely advises private funds, that is funds exempt from Investment Company Act registration under §3(c)(1) or §3(c)(7), and has AUM in the US of under $150 million, then the adviser does not need to register with the SEC.  For US advisers, all private fund assets must be included in the AUM calculation, even if the adviser has offices outside the US.  This exemption is available to non-US advisers with a place of business in the US as long as all of the adviser’s clients that are US persons are qualifying private funds; that is, the type or number of non-US clients and the amount of AUM managed outside the US will not affect availability of this exemption.

            Advisers to Venture Capital Funds:  If an adviser solely advises venture capital funds, the adviser does not need to register with the SEC.  A venture capital fund is defined as a private fund, i.e., §3(c)(7) or §3(c)(1) fund, that (i) invests in qualifying investments (essentially equity securities of a qualifying portfolio company (as defined in newly adopted Rule 203(l)-1(c)(4)) that are directly acquired by the fund) and holds no more than 20% of the fund’s capital commitments in non-qualifying investments (other than certain short term holdings of cash and cash equivalents); (ii) does not borrow or otherwise incur leverage (other than short term borrowing); (iii) does not offer redemption or other liquidity rights except in extraordinary circumstances; (iv) represents itself as pursuing a venture capital strategy; and (v) is not registered under the Investment Company Act and has not elected to be treated as a business development company. A grandfathering provision is included for funds that (a) have represented to investors that the fund pursues a venture capital strategy; (b) has sold securities prior to December 31, 2010; and (c) does not sell securities to any person after July 21, 2011.

            Family Offices:  The final rule implementing the exclusion from the definition of investment adviser is for family offices.  Under this rule, an investment adviser need not register with the SEC if it provides investment advice only to family clients as defined under the rule, is wholly-owned by family clients, controlled by family members or entities, and does not hold itself out to the public as an investment adviser.   The final rule expands the types of family members and family client entities that can obtain advice from the family office.  Family offices can petition the SEC for a determination of their status.

            Foreign Private Advisers:  Foreign Private Advisers are not required to register with the SEC, and are not subject to any examination or reporting requirements.  A Foreign Private Adviser is an adviser that has no place of business in the United States, has fewer than 15 clients in the US and US investors in private funds advised by the adviser, and has less than $25 million in AUM from these clients and investors.  Other conditions apply, including that such an adviser may not hold itself out generally in the US as an investment adviser.

Clearly, this framework raises a variety of strategic and tactical issues that advisers will need to consider on a case-by-case basis.  For example, advisers that may claim one of the above exemptions may decide to register with the SEC to address investor issues or eliminate the possibility of multiple state registrations.

Reporting Requirements:

Advisers relying on the exemption from registration for venture capital funds and for private funds with AUM in the U.S. of less than $150 million do not fully escape new federal regulatory burdens.  Such advisers will be required to prepare and file certain periodic reports that the SEC determines are in the public interest or for the protection of investors. Reports filed by these so-called “exempt reporting advisers” will become publicly available. Reporting information will focus on conflicts of interest, investment strategies, critical gatekeepers, and size of the fund.  The reporting requirements will be reassessed in one year.  The SEC indicated that certain proposed reporting requirements, particularly information that may be competitively sensitive, were omitted from the final rule. Also, the SEC indicated that it contemplates only limited exams for such exempt reporting advisers.

How RFG Can Help:

The registration and reporting process is highly complex and can often become overwhelming. For those advisers subjected to registration for the first time, RFG offers comprehensive templates as well as one-on-one consulting.  Our senior-level team includes a former national law firm partner, a senior operating officer at a fund of hedge funds, senior compliance and risk officers and a former SEC Commissioner.  For more information on our templates for registration, please visit us online.

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