Recommended Annual Review for Hedge Fund and Other Private Fund Advisers

December 04, 2012

In 2012, we again saw a number of significant changes regarding how advisers to hedge funds and other private funds are regulated. The following is a summary of some of the significant changes that occurred in 2012 and certain “best practices” that you should consider in preparing for 2013. This summary is general in nature and does not constitute legal advice for any specific situation.

Table of Contents

Form ADV

As a result of the repeal of the “private adviser” exemption1 from registration under the Investment Advisers Act of 1940 (the “Advisers Act”), many investment advisers to private funds were required to be registered with the SEC by March 30, 2012.2 Certain other exemptions from registration were made available, but many advisers have been made subject to reporting requirements on Form ADV. For more information on registration as an investment adviser with the SEC, please see our guide to registration here.

Each investment adviser that is currently registered with the SEC must update its Form ADV Part 1 and Part 2A and file them with the SEC on an annual basis within ninety (90) days after the end of its fiscal year (by April 1 in 2013 for advisers with a December 31 fiscal year-end). In addition, certain Form ADV information must be amended promptly if it becomes inaccurate, or upon any change in the disciplinary history of an investment adviser and/or its personnel. Exempt reporting advisers are subject to similar updating requirements for the parts of Form ADV that are applicable to them. Investment advisers should refer to the Form ADV instructions (which can be found on the SEC’s website) or contact counsel to determine whether any of their Form ADV information must be updated.

If there are any material changes to Part 2A during an adviser’s fiscal year, that document or a summary of material changes must be delivered to clients within one hundred twenty (120) days after the end of the fiscal year (by April 30 in 2013). An update of each of Part 2A and 2B of Form ADV (or a statement summarizing material changes) must generally be delivered to clients upon the disclosure of any additional disciplinary event or upon a material change to the description of any disciplinary event already disclosed. Although “clients” under the Advisers Act are technically the funds advised by an investment adviser rather than the investors in those funds, we suggest that Part 2 be delivered to these underlying investors on an annual basis.

The updates to Form ADV Part 1 and Part 2A must be filed on the SEC’s electronic IARD system. Although Part 2B is not filed with the SEC, it is required to be maintained in the investment adviser’s files.

If an exempt reporting adviser relying on the private fund adviser exemption reports in its annual updating amendment that it has “regulatory assets under management” (“RAUM”)3 attributable to private fund assets of $150 million or more, the exempt reporting adviser must register with the SEC unless it qualifies for another exemption from registration. The adviser has up to ninety (90) days after filing the annual updating amendment to apply for SEC registration, and must submit its final report as an exempt reporting adviser and apply for SEC registration in the same filing.

In addition, certain states also require that investment advisers “notice file” by filing their Form ADV with state regulatory authorities, and some states require a paper filing. In general, special attention should be paid to the requirements of any state in which the investment adviser has a place of business or more than five non-exempt clients. State-registered investment advisers should also consider any other requirements in the states in which they are registered.

Form PF

In late 2011, the SEC and the Commodity Futures Trading Commission (the “CFTC”) jointly adopted final rules requiring reporting on Form PF by certain SEC-registered investment advisers and investment advisers that are registered with the CFTC as commodity pool operators (“CPOs”) and/or commodity trading advisors (“CTAs”). Data collected from Form PF is supposed to assist the Financial Stability Oversight Committee in monitoring systemic risk. The SEC and CFTC, however, may use Form PF information in examinations, enforcement actions and for investor protection efforts. Information reported on Form PF will otherwise remain confidential.

Advisers Act Rule 204(b)-1 requires SEC-registered investment advisers that advise one or more private funds and have at least $150 million in RAUM attributable to private funds to file Form PF with the SEC. As discussed below, CFTC Rule 4.27 outlines Form PF reporting obligations for dual SEC-CFTC-registered investment advisers.

Investment advisers reporting on Form PF are required to disclose certain information regarding their advisory business and the private funds they advise, including their assets under management. Generally, investment advisers must file Form PF within one hundred twenty (120) days after each fiscal year. Investment advisers with at least $1.5 billion in RAUM attributable to hedge funds as of the end of any month in the adviser’s prior fiscal quarter must file Form PF within sixty (60) days after each quarter and are required to complete additional portions of the form. Investment advisers with at least $2 billion in RAUM attributable to private equity funds as of the last day of the adviser’s most recently completed fiscal year must also complete additional portions of the form.

Advisers that have at least $5 billion of RAUM attributable to hedge funds, private equity funds, or liquidity funds and registered money market funds were required to make an initial filing after the first fiscal year or quarter end (as applicable) occurring after June 15, 2012. All other advisers must make an initial filing after the first fiscal year or quarter end (as applicable) occurring after December 15, 2012. A more detailed explanation of Form PF may be found here. Additionally, the SEC has released Frequently Asked Questions relating to Form PF, which may be found here.

CFTC Regulatory Updates

Rescission of the CPO Exemption under Rule 4.13(a)(4). On February 9, 2012, the CFTC rescinded Rule 4.13(a)(4). This rule provided a widely used exemption from registration as a CPO4. Absent another available exemption or exclusion from the CPO definition, operators of “commodity pools”5 must register with the CFTC effective December 31, 2012. The rescission of Rule 4.13(a)(4) may prevent an adviser from relying on a related exemption from registration as a CTA, Rule 4.14(a)(8); accordingly, the adviser may be required to identify an alternative exemption or otherwise register with the CFTC as a CTA.

De Minimis Trading Exemption under Rule 4.13(a)(3). In light of the rescission of Rule 4.13(a)(4), advisers have been evaluating whether they can rely on the Rule 4.13(a)(3) exemption from CPO registration. Under Rule 4.13(a)(3), an adviser is not required to register with the CFTC as a CPO with respect to a fund if the fund engages in limited trading of commodity interests. Pursuant to this Rule, a fund must satisfy at least one of the following limits:

  • Initial Margin Limit. The aggregate initial margin, premiums and required minimum security deposit for retail forex transactions required to establish the fund’s positions in commodity interests (determined at the time the most recent position was established) must not exceed 5% of the liquidation value of the fund’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions into which it has entered.6
  • Aggregate Net Notional Value Limit. The aggregate net notional value of a fund’s positions in commodity interests, determined at the time the most recent position was established, must not exceed 100% of the liquidation value of the fund’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions into which it has entered.7

To make use of this exemption, each fund investor must meet certain sophistication criteria, and the fund cannot be marketed as a vehicle for trading in commodity interests. The adviser must also file a notice of exemption with the National Futures Association (the “NFA”) and must affirm at the end of each calendar year that it is conducting its activities in accordance with the terms of the exemption. The de minimis exemption is difficult to apply in the fund of funds context.

CPO Registration. The CPO registration process is administered by the NFA. An adviser files for registration as a CPO by filing Form 7-R through the NFA Online Registration System. In general, the registration process takes three to four months.

Individuals who are “associated persons” of a registered CPO or CTA must themselves register with the CFTC. This process will generally involve taking and passing the Series 3 exam. An associated person will not need to pass the Series 3 exam if he or she can rely on an exception or can obtain a waiver. Under NFA Registration Rule 401(e)(2)(ii), a waiver can be requested pursuant to NFA Registration Rule 402 if the adviser would be eligible for the exemption from CPO registration under Rule 4.13(a)(3) but for the trading of swaps subject to the CFTC’s jurisdiction. The NFA may also determine, upon request pursuant to NFA Registration Rule 402, to waive the examination requirement for certain individuals associated with a CTA who are required to register solely because their securities advisory services include advice on the use of futures and options for risk management purposes. For more information, please see our alert here. In addition, individuals who are “principals” of an adviser must make certain filings in connection with their adviser’s registration. Both principals and associated persons must submit their fingerprints to the NFA, and they are subject to criminal background checks by the FBI as part of this process.

As part of the registration process, CPOs are required to design and implement a program for complying with the rules and regulations of the CFTC and the NFA. Key topics that must be covered by an adviser’s compliance program include ethics training for employees, annual compliance reviews, inspections of branch offices, registration of new employees and disaster recovery planning.

In addition, advisers typically include in their compliance manuals procedures for complying with other CFTC/NFA requirements, particularly any applicable disclosure, reporting and recordkeeping requirements relating to commodity pools found in Part 4 of the CFTC’s regulations. Advisers that are registered with the SEC as investment advisers may be able to incorporate these separate procedures in their existing manuals.

Rule 4.7 – Relief Available under the “CFTC Lite” Regime. A registered CPO may be able to rely on the “CFTC Lite” regime under Rule 4.7, which substantially reduces the disclosure, recordkeeping and reporting requirements discussed above. The CFTC Lite regime is available with respect to a fund in which each investor is a “qualified eligible person” and the offering of interests therein is exempt from registration under the Securities Act of 1933 (the “1933 Act”). Note that qualified purchasers are automatically qualified eligible persons, so any funds relying on the 3(c)(7) exemption from registration as an investment company under the 1940 Act should be eligible for the CFTC Lite regime. A registered CPO would need to file a notice of exemption with the NFA in connection with relying on the CFTC Lite regime.

NFA Bylaw 1101. One of the key NFA compliance obligations facing new CFTC registrants and NFA members arises out of NFA Bylaw 1101, which generally prohibits an NFA member, such as a CPO, from conducting business with or on behalf of a non-NFA member that is otherwise required to register with the CFTC. To ensure compliance with this rule, we recommend that investment advisers obtain representations from fund investors, counterparties and others with whom they conduct business to determine such parties’ CFTC registration and/or exemption status. For example, a fund adviser should ensure that CPOs of any fund of fund investors are either registered as a CPO and an NFA member or that the operator is exempt from registration.

Reporting on Form CPO-PQR. Under Rule 4.27, registered CPOs are required to report information on Form CPO-PQR. This Form mirrors the reporting that SEC-registered investment advisers must make on Form PF.

Large CPOs are required to file Form CPO-PQR quarterly, within sixty (60) days of the end of each calendar quarter, with their first Form CPO-PQR due by November 29, 2012. Smaller and mid-sized CPOs must file Form CPO-PQR annually, within ninety (90) days of the end of each calendar year. The filing deadlines for Form CPO-PQR and Form PF are not the same.

Form CPO-PQR is divided into: (i) Schedule A, which requests basic identifying and performance information and must be filed by all registered CPOs; (ii) Schedule B, which requests detailed information about commodity pools managed by “midsized CPOs”8 and “large CPOs”9; and (iii) Schedule C, which requests additional detailed pool information from large CPOs.

An adviser that is both an SEC-registered investment adviser and a registered CPO will not need to file Schedules B and C if the adviser includes information on all relevant pools in the Form PF it files with the SEC.

Reporting on Form CTA-PR. CFTC Rule 4.27 requires registered CTAs to file basic identifying and performance information on new Form CTA-PR annually, within forty-five (45) days of the end of each calendar year. CTAs are required to submit Form CTA-PR to the NFA, even if the CTA reports on Form PF. A registered CTA must file its first Form CTA-PR based on information as of December 31, 2012.

For more information on these CPO/CTA developments and how they affect investment advisers, please see our earlier alerts from February, March and June 2012 in this area.

Swaps Regulation under the Dodd-Frank Act. Title VII of the Dodd-Frank Act provides a detailed framework for regulating the swaps market and market participants. On October 12, 2012, the rules defining the term “swap” came into effect. Under these rules, the SEC has regulatory authority over security-based swaps, which generally are swaps based on a narrow-based security index (such as an index with nine or fewer component securities), a single security or certain events relating to a single issuer or narrow group of issuers. The CFTC has regulatory authority over swaps, which is broadly defined to include most swaps, options and similar products, the value of which relates to, among other things, rates, currencies, commodities, indices and other financial or economic interests. The SEC and CFTC will jointly regulate mixed swaps, which is a product that has elements of both a swap and a security-based swap. The SEC will continue to have antifraud authority over certain CFTC-regulated instruments, including security-based swap agreements.

The swap definitions affect certain entity registration requirements (including the Rule 4.13(a)(3) exemption test), as well as clearing, trading, reporting, recordkeeping, margin and business conduct requirements. For example, certain swaps may need to be cleared through derivatives clearing organizations and/or must be executed on a designated contract market or a swap execution facility. These requirements may apply even if a fund sponsor or adviser is not required to register with the CFTC in any capacity. In addition, swap market participants, including funds, will be required to retain and report data relating to swap transactions.

For more information on swaps regulation under the Dodd-Frank Act, please see our earlier alert in October 2012 in this area.

TIC Form SLT and Other Forms

TIC Form SLT. An investment adviser may be required to complete Form SLT, a reporting form that is part of the Treasury International Capital (TIC) data reporting system and designed to gather information on cross-border ownership of long-term securities by U.S. and foreign residents‚ for use in forming U.S. international financial and monetary policies.

All U.S. individuals or entities (i) who qualify as U.S.-resident custodians‚ issuers and/or end-investors (e.g.‚ funds), and (ii) whose consolidated long-term reportable securities10 exceed $1 billion as of the last business day of the reporting month‚ will be required to file Form SLT. Securities that must be reported on Form SLT are foreign-resident holdings of U.S. securities and U.S.-resident holdings of foreign securities. Equity interests or other securities issued by funds (such as interests issued by a non-U.S. master fund to a U.S. feeder fund, interests issued by a U.S. fund to a non-U.S. investor or interests issued by a U.S. master fund to a non-U.S. feeder fund) would generally qualify as reportable securities. Where securities reportable on Form SLT are held by a U.S.-resident custodian‚ however, a Form SLT report covering these securities would be due from the custodian and not the beneficial owner of the securities.

Form SLT must be filed as of the last business day of the month in which the $1 billion threshold is exceeded and monthly thereafter for the remainder of the calendar year.11 Reporters must submit Form SLT to the Federal Reserve Bank of New York no later than the 23rd calendar day of the month following the applicable reporting date (or the next business day‚ if the filing date falls on a weekend or holiday).

Advisers should be aware that it may take substantial work to determine whether an adviser is required to file Form SLT on behalf of entities it manages and subsequently to complete the form. More information on Form SLT may be found here. Advisers also should be aware that the U.S. Treasury and Commerce Departments (which includes the Bureau of Economic Analysis) may impose additional reporting obligations on investment advisers, including, without limitation, with respect to cross-border transactions involving long-term securities, derivatives, currencies and direct investment12. We suggest that you contact outside counsel with any questions relating to Form SLT or such other reporting obligations.

Other Forms. Investment advisers also should consider whether other regulatory filings are required based on their operations and investments, including, but not limited to, annual filings that may be required under federal, state or foreign law, as applicable. For example, an investment adviser may be required to file a large position report with the Department of Treasury if it holds or controls a significant amount of certain U.S. Treasury securities or may be required to file forms with the Bureau of Economic Analysis if it has direct investment. An investment adviser that is considering acquiring a large amount of voting securities of an issuer should consider Hart-Scott-Rodino requirements that may apply, depending on the value of the acquisition and/or the size of the parties involved. Also, investment advisers that invest in securities in foreign jurisdictions should consider the filing requirements in each jurisdiction in which they invest.

European Union Regulatory Updates

European Union AIFMD. The European Union Alternative Investment Fund Managers Directive (the “AIFMD”)13 will be transposed into the national laws of EU Member States, and will have to be complied with, by July 22, 2013.

The AIFMD regulates the hedge, private equity and alternative investment fund industry in Europe. It imposes organizational, management and systems requirements on alternative investment fund advisers that are either domiciled in the EU or that manage investment funds domiciled in the EU (“AIFM”).

The AIFMD permits AIFM that are authorized in accordance with the requirements of the directive and that manage EU-domiciled investment funds (and from July 2015, non-EU domiciled investment funds) to market those funds to “professional investors” on a pan-European basis. From 2015, AIFMD will permit investment advisers domiciled outside of the EU but that are registered with an EU “reference state” and comply with the requirements of the directive, to market those funds to “professional investors” on a “passported” pan-European basis.

The AIFMD allows (but does not compel) each EU Member State to permit (until July 2018) a non-EU investment adviser (that is, an adviser that is not domiciled in the EU and that does not manage a fund domiciled in the EU) to market its fund to professional investors in that Member State on a private placement basis, but only where the non-EU investment adviser (and fund) complies with certain pre- and post-sale transparency requirements, including the requirement for the fund to have an audited annual report (the “AIFMD Private Placement Regime”). Where an EU domiciled sub-advisor advises an adviser in the U.S. (and does not directly advise a fund), the AIFMD will not directly affect that sub-advisor, although any marketing of the fund will have to comply with the AIFMD Private Placement Regime.

Investment advisers should consider how they will strategically respond to the AIFMD. Questions that investment advisers should be asking include the following:

  • If the adviser (or a fund that it manages) is domiciled in the EU, is it ready to become authorized pursuant to the AIFMD?
  • If the adviser is not domiciled in the EU, does it intend to market its funds to investors in the EU after July 2013? If so, will the advisers be willing and able to make the required disclosures to investors and regulators, and will the fund have a compliant audited annual report?
  • Does the adviser have any mandates that have been delegated from an AIFM subject to the AIFMD? If so, have the delegation arrangements been amended to reflect the AIFMD outsourcing requirements?

More information on the AIFMD may be found here.

European Union Short Selling Regulation. The EU Regulation on Short Selling and Certain Aspects of Credit Default (the “SSR”)14 was implemented on November 1, 2012. For the six-month period following implementation, current national disclosure regimes can run in tandem with the SSR (although some Member States, including the United Kingdom, have not opted to use this transition period). The SSR introduces a pan-European framework for the regulation of short selling and will, to a large degree, remove discrepancies between the Member States (as is currently the case). However, the SSR does allow individual Member States to impose additional restrictions on short selling in “exceptional circumstances”. For example, Spain took advantage of this emergency power and has prohibited all short selling of shares listed on Spanish exchanges.

The SSR requires the following disclosures:

  • private disclosure of net short positions in shares of a company admitted to trading on a regulated European exchange (a “European Company”) when the net short position reaches, exceeds or falls below 0.2%, 0.3% or 0.4% of the issuer’s share capital;
  • public disclosure of net short positions in shares of a European Company when the net short position reaches, exceeds or falls below 0.5% of the issuer’s share capital; and
  • private disclosure of “significant” net short positions in EU sovereign debt.

Net short positions must be calculated as at 11:59p.m. at the end of each trading day. Disclosure must be made by 3:30p.m. on the following trading day in the Member State in which the notification is to be made. Investment advisers should be aware that each Member State has a slightly different process for notifications, with some regulators using a web-based notification system whereas others are using an email-based system. It should also be noted that registration for these new systems may take a few days in certain jurisdictions, particularly Germany and France.

Information to be contained in the disclosure includes identifying: (i) the person that holds the position; (ii) the size of the relevant position; (iii) the issuer in respect of which the position is held; and (iv) the date on which the position was created, changed or ceased to be held.

The SSR also prohibits (i) uncovered/naked short sales of shares in European Companies; (ii) uncovered/naked short sales of EU sovereign debt; and (iii) uncovered/naked credit default swaps (“CDS”) relating to EU sovereign debt.

Amendments to Accredited Investor Standard

On December 21, 2011, the SEC published a final rule amending the definition of an “accredited investor”. Pursuant to the final rule, in calculating whether an individual’s net worth exceeds the $1 million minimum requirement for qualifying as an accredited investor,

  • the individual’s primary residence cannot be included as an asset;
  • indebtedness that is secured by the individual’s primary residence (e.g., a mortgage), up to the estimated fair market value of the primary residence at the time of the sale of securities, will not be subtracted as a liability; and
  • indebtedness that is secured by the individual’s primary residence in excess of the estimated fair market value of the primary residence at the time of the sale of securities must be subtracted as a liability.

Additionally, indebtedness secured by the primary residence that is incurred in the sixty (60) days prior to the sale of the securities must be subtracted as a liability, unless the indebtedness is a result of the acquisition of the primary residence. This provision applies even if the total indebtedness secured by the individual’s primary residence is less than the estimated value of the primary residence.

Investment advisers that have not already done so should update the subscription documents of the funds they manage to include the amendments to the accredited investor definition. More information on the amendments may be found here.

Amendments to the “Qualified Client” Definition

On February 15, 2012, the SEC issued a final rule that amends the definition of “qualified client”.15 The final rule: (i) codifies the order issued by the SEC on July 12, 2011, that increased the dollar amounts of the asset under management test to $1 million and the net worth test to $2 million in the definition of qualified client (the previous thresholds were $750,000 and $1.5 million, respectively); (ii) requires that the value of a natural person’s primary residence and certain debt secured by the residence be excluded for purposes of determining whether a client meets the net worth test; (iii) modifies the transition provisions of the rule to take into account existing client and investor arrangements; and (iv) requires the SEC to issue subsequent orders to adjust the dollar amounts of the net worth test and the asset under management test every five years to account for inflation.

Investment advisers that have not already done so should update the subscription documents of the funds they manage to include the change in the threshold for qualified clients. More information may be found here.


On April 5, 2012, President Obama signed the Jumpstart Our Business Startups Act (the “JOBS Act”) into law. The JOBS Act directed the SEC to remove the prohibition against general solicitation and general advertising for private offerings under Rule 506 of Regulation D under the 1933 Act no later than July 4, 2012. The SEC was not able to adopt rules removing the prohibition by that date and, in fact, as of the date of this Alert, final rules eliminating the restrictions on general solicitation and general advertising have not yet been adopted. The JOBS Act also enacts other reforms designed to increase the shareholder threshold required for reporting under the Securities Exchange Act of 1934 (the “1934 Act”) and to reduce regulatory burdens on initial public offerings of emerging companies and offerings conducted under Rule 144A of the 1933 Act.

Amendment to Rule 506 on General Solicitation and General Advertising. On August 29, 2012, the SEC proposed amendments to Rule 506 of Regulation D under the 1933 Act, one of the most commonly relied upon safe harbors from 1933 Act registration by private fund issuers, to eliminate the existing prohibitions on general solicitation and general advertising in Rule 506. If adopted, Rule 506(c), which will permit the use of general solicitation in connection with an offering of securities, would provide that (i) all purchasers of securities in such offering are accredited investors; (ii) the issuer in such offering takes reasonable steps to verify that all purchasers of the securities are accredited investors16; and (iii) all terms and conditions of Rule 501 and Rules 502(a) and 502(d) are satisfied17.

If the SEC adopts final rules eliminating the restrictions on general solicitation and general advertising, it could have a significant impact on the way that hedge funds, private equity funds and other private funds raise capital. Until final rules are adopted (and it is uncertain when this will occur), issuers and persons acting on their behalf should not engage in any general solicitation in connection with Rule 506 or Rule 144A offerings. More information on the proposed rules may be found here.

Increased Threshold for 1934 Act Reporting. The JOBS Act significantly increased the number of investors that a private fund may have before it is required to file periodic reports under the 1934 Act. Prior to the passage of the JOBS Act, Section 12(g) of the 1934 Act required reporting by an issuer that had more than $10 million in assets and a class of equity securities that was held of record by 500 or more persons (or, in the case of a non-U.S. issuer, held of record by 300 or more U.S. persons).

The JOBS Act increased this threshold by requiring periodic reporting only when an issuer has more than $10 million in assets and a class of securities that is held of record either by (i) 2,000 or more persons or (ii) 500 or more persons who are not accredited investors. Employees who received their securities pursuant to exempt transactions under employee compensation plans will not be counted as holders of record for purposes of these calculations.

Our alert summarizing the JOBS Act and discussing its impact may be found here.

Certain Tax Considerations

FATCA Implementation Dates Delayed. On March 18, 2010, President Obama signed into law H.R. 2847, the Hiring Incentives to Restore Employment Act (the “HIRE Act”), which incorporates the measures of the Foreign Account Tax Compliance Act of 2009 (“FATCA”) designed to stop tax evasion. For taxable years beginning after December 31, 2012, FATCA imposes new reporting and withholding rules designed to induce a “foreign financial institution” (an “FFI”) and other foreign entities to report information to the Internal Revenue Service (the “IRS”) regarding their U.S. accountholders and investors. Under these rules, an FFI will have to enter into an agreement (an “FFI Agreement”) with the IRS agreeing to certain covenants, and provide evidence of such agreement to payors of certain income from U.S. sources, including U.S.-source interest and dividends, as well as the gross proceeds from the sale of instruments that would generate such income. Generally, offshore funds, whether treated as corporations or partnerships for U.S. federal income tax purposes, will be treated as FFIs and subject to these rules unless guidance is issued exempting them.

While the FATCA provisions are effective beginning in 2013 under the HIRE Act, the IRS intends to issues regulations providing for a phased implementation of the various FATCA provisions. Pursuant to IRS guidance issued late this year, the first possible date on which an FFI Agreement will be effective will be January 1, 2014. Accordingly, an FFI should enter into an FFI Agreement by that date, to ensure that it will be identified as a participating FFI in sufficient time to allow U.S. withholding agents to refrain from withholding on new obligations beginning on January 1, 2014. With respect to preexisting obligations, i.e., those issued prior to January 1, 2014, withholding will be delayed for up to two years—until January 1, 2016. Moreover, withholding with respect to the gross proceeds from the sale of obligations that produce U.S.-source interest and dividends will be delayed until January 1, 2017 (regardless of when those obligations were issued).

Sunsetting of Lower Individual Tax Rates. Under present law, the maximum marginal federal income tax rate for individuals is 35% with respect to ordinary income, and 15% with respect to most types of long-term capital gains. In addition, “qualified dividends” currently are subject to the lower capital gains rates rather than the ordinary income rates.

Under the terms of current law, the favorable rates described above will expire for taxable years beginning after December 31, 2012. If no action is taken by Congress and the President, the maximum marginal federal income tax rate for individuals will rise to 39.6%, most types of long-term capital gains will be subject to tax at a maximum rate of 20% and dividends will no longer qualify for the lower capital gains rates. In addition, for taxable years beginning after December 31, 2012, itemized deductions of individuals, estates and trusts will be subject to a limitation generally in an amount equal to the lesser of 3% of such taxpayer’s adjusted gross income over a threshold level or 80% of the taxpayer’s otherwise allowable total itemized deductions.

Additional Medicare Tax. Effective in 2013, the Health Care and Education Reconciliation Act of 2010 will subject some individuals to a 3.8% Medicare contribution tax on their unearned income. This new tax will apply to single taxpayers with a modified adjusted gross income (MAGI) in excess of $200,000 and to married taxpayers with a MAGI in excess of $250,000 if filing a joint return, or $125,000 if filing a separate return. For most individuals, their MAGI will be their adjusted gross income, unless they are U.S. citizens or residents living abroad and have foreign earned income. The tax is equal to 3.8% of the lesser of the individual’s “net investment income” or the amount by which the individual’s MAGI exceeds the threshold for application of the tax.

An individual’s “net investment income” generally includes interest, dividends, annuities, royalties and rents, other than such income that is derived in the ordinary course of a trade or business, less allocable deductions. It also includes income from a passive activity or a trade or business of trading in financial instruments or commodities, net gain from the disposition of property (other than property held in an active trade or business), gains from trading in financial instruments or commodities, and gain on the sale of a personal residence in excess of the amount permitted to be excluded from income under Section 121 of the Internal Revenue Code (the “IRC”). It generally does not include distributions from qualified retirement plans or tax-exempt interest.

Although Medicare tax assessed on self-employment income generally is deductible, the Medicare tax on net investment income is not deductible when computing income taxes. The tax is subject to the individual estimated tax provisions.

New York Attorney General Investigating Management Fee Waivers. In September of this year, the press reported that the New York Attorney General’s office was investigating the so-called “management fee waiver” structure used by many advisors to private equity funds. Under the management fee waiver structure, the advisor waives some or all of its fees in exchange for future fund profits up to the amount that would have been received if the waived fee were actually invested in the fund. The results of the investigation, including whether it has been concluded or expanded, has not been publicly reported.

Proposed Carried Interest Legislation. As the “fiscal cliff” approaches at the end of this year, legislators in Congress and the President may again consider proposals to tax the “carried interest” received by advisers or their affiliated entities as ordinary income. Such proposals have been discussed since 2007, and versions of the proposal were reintroduced in the American Jobs Act of 2011 (which was not enacted) and in proposed legislation introduced in February of this year by Representative Sander Levin.

Although the carried interest proposals introduced in Congress since 2007 vary in their drafting and scope, they all share certain key features. In particular, all of the proposals do the following: (i) substantially increase the tax rate paid by advisers and other partnership service providers on their carried interest share of a partnership’s profits, either during the life of the fund or on exit, because some percentage, or all, of the profits derived from ownership of a carried interest would be taxed as ordinary income, rather than capital gain; (ii) subject these recharacterized gains to self-employment (Medicare) tax, the rate for which is scheduled under existing law to increase from 2.9% to 3.8% in 2013; (iii) tax gains from a “qualified capital interest”, i.e., that portion of a partnership interest acquired by the service partner in exchange for capital contributions, at capital gain rates, and excluded from self-employment tax, provided that such capital contributions are properly structured; and (iv) exclude interests received in a domestic corporation for services.

China Regulatory Updates

QFII Regulation. In July 2012, the China Securities Regulatory Commission published new regulations that addressed and eased barriers to market entry for qualified foreign institutional investors (“QFIIs”) in China by relaxing market entry criteria and operational constraints, expanding the scope of permitted investment and simplifying and facilitating administrative processes. For more information, please see our alert from August 17, 2012, which may be found here.

RQFII Pilot Program. In December 2011, China launched a pilot program for RMB Qualified Foreign Institutional Investors (“RQFII”) that allows Chinese yuan raised in Hong Kong by Hong Kong subsidiaries of Chinese fund management companies and securities companies to be invested in China’s domestic securities markets. Under the pilot program, the initial investment quota was RMB 20 billion ($3.1 billion). The investment quota was increased to RMB 70 billion ($11.1 billion) in April 2012, as the demand from overseas markets is strong. Media recently reported that the Chinese authorities have approved a further increase in the quota to RMB 270 billion ($42.8 billion) and will amend the current RQFII regulations to expand the scope of institutions eligible for the RQFII program and relax restrictions on RQFII investments.

QFLP Program. In December 2010, Shanghai launched the foreign invested equity investment enterprises (“FIEIE”) program (commonly known as the QFLP program), which allows foreign enterprises and individuals to establish private equity funds registered in Shanghai in order to raise local capital for investment in unlisted Chinese companies. Some other cities (such as Beijing, Tianjin, Chongqing and Shenzhen) have also implemented local rules, which are similar to the Shanghai rules in terms of content. A number of foreign funds have established FIEIEs and invested in Chinese unlisted companies. Initially, the local authorities deemed FIEIEs to be domestic entities as long as not more than 5% of the total amount of an FIEIE’s registered capital (or committed capital) was foreign capital. In April 2012, however, the National Development and Reform Commission issued a notice (“NDRC Notice”) stating that, for investment restriction purposes, all FIEIEs will be deemed to be foreign funds regardless of their percentage of foreign capital. The immediate impact of the NDRC Notice is that FIEIEs may not invest in industries where foreign investments are “prohibited” in the Foreign Investment Catalogue. The long-term impact of the NDRC Notice remains unclear.

Shanghai’s QDLP Program. In March 2012, the Shanghai government approved the overseas investment fund enterprises program (commonly known as the “QDLP Program”), the purpose of which is to attract international recognized hedge fund advisers to establish hedge funds in Shanghai. The program allows selected international hedge fund advisers to establish investment funds in Shanghai to raise local capital for investment in offshore secondary markets. Although the QDLP Program was begun and select hedge funds were invited to apply for licenses and capital quotas more than six months ago, the regulations governing the QDLP program (e.g., qualifications for eligible advisers) have still not been publicly released.

Hong Kong Regulatory Updates

Amendment to Code of Conduct for Licensed and Registered Persons by Hong Kong SFC. The Hong Kong Securities and Futures Commission (“SFC”) announced on May 21, 2012 that the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the “Code of Conduct”) was to be amended.

The main amendments to the Code of Conduct were as follows:

(i) licensed persons must comply with the new Financial Dispute Resolution Scheme pursuant to which unresolved complaints may be referred to the Financial Dispute Resolution Centre Ltd (the “FDRC”) for mediation and arbitration;

(ii) licensed persons must report to the SFC suspected breaches by clients of market misconduct provisions in Parts XIII and XIV of the Securities and Futures Ordinance (this is a controversial provision);

(iii) the severe restriction of the use of mobile phones to accept client orders and the retention period for telephone recordings of orders has been extended to six months;

(iv) licensed persons, as a firm, must permit their employees to provide expert witness services to the SFC and the Hong Kong Monetary Authority when they wish to, unless there is a reasonable basis to prevent them; and

(v) a review of operations must take place where a client makes a complaint that also has an impact on other clients.

The FDRC-related amendments took effect on June 19, 2012, and the other changes took effect on December 1, 2012.

Additionally, with respect to the authorization and operation of a discretionary account, licensed corporations will only be permitted to accept orders from a third party designated by the client (including employees of the client) where such designation is made by the client in writing18. Any existing verbal authorizations must be replaced with written authorizations before the implementation date of December 1, 2012.

Licensed corporations will need to amend their systems, controls and compliance/operations manuals to implement these changes, and staff will need to be provided with relevant training.

Hong Kong Securities and Futures (Short Position Reporting) Rules. On February 10, 2012, the SFC published its Conclusions on Further Consultation on the Securities and Futures (Short Position Reporting) Rules, which came into effect on June 18, 2012. Under the Rules, a report must be filed with the SFC by any person who has a net short position at the close of trading on The Stock Exchange of Hong Kong Limited (the “Exchange”) on the last trading day of the week that equals to or exceeds the lower of (i) HK$30 million (approx. $3.9 million) or (ii) 0.02% of the value of the issued share capital of the corporation.19 Short positions established through derivatives or off exchange trading are excluded from the reporting requirement.

Generally, the person/entity who beneficially owns the short position has the obligation to report. In relation to investment funds where it is not practicable for each of the beneficiaries of a fund who owns a short position to file a separate report with the SFC, the fund itself (if it is a corporate entity) is responsible to notify the SFC of its net short position. If the fund is established as a partnership, a partner or any person authorized by all those partners of the partnership can report to the SFC on behalf of the partnership. In the case of an “umbrella” fund or a group of sub-funds under common management that has a reportable short position, the short positions and the long positions (if any) in any specified shares held by each of the sub-funds within an “umbrella” fund are to be treated separately and not to be aggregated for reporting purposes. Each sub-fund must report separately. It is permissible for an agent of the fund (e.g., an adviser or a prime broker) to make a report on behalf of a fund but the fund as principal remains responsible.

Any person who has a reportable short position in respect of any specified shares at the close of trading on the Exchange on the last trading day of the week must notify the SFC of the reportable short position within two business days. Additionally, the SFC may publish a daily reporting requirement notice in respect of any specified shares in accordance with the Rules.

Any person who, without reasonable excuse, breaches the Rules is liable, on conviction on indictment, to a fine at level 6 (HK$100,000, equivalent to $12,900) and a term of imprisonment for two years, and on summary conviction, to a fine at level 3 (HK$10,000, equivalent to $1,290) and a term of imprisonment for six months.

ERISA Considerations

Avoiding “Plan Asset” Status. Each investment adviser that manages funds that accept investments from employee benefit plans, IRAs and other benefit plan investors, but that does not want the funds it manages to become subject to ERISA, should take the opportunity to confirm that the funds satisfy the requirements of ERISA’s “significant participation” exemption. Under the exemption, a fund is only subject to ERISA and to certain prohibited transaction provisions of the IRC if 25% or more of any class of the fund’s equity interests is held by “benefit plan investors” (“BPIs”). Only benefit plans subject to ERISA (primarily private domestic employer and union plans) or to the prohibited transaction provisions of the IRC (such as IRAs and Keogh plans), or entities that themselves are treated as holding the “plan assets” of such plans, will count as BPIs for purposes of the 25% test. Governmental and foreign benefit plans are not BPIs. The 25% test should be conducted each time there is a new investment or any transfer or redemption of interests in the fund. A pro rata rule applies where a fund (such as a fund of hedge funds) that exceeds the 25% test and is therefore a BPI invests in a lower-tier fund. The lower-tier fund in which the fund of funds invests will consider the fund of funds to be a BPI only to the extent that the fund of funds’ equity interests are held by BPIs. However, an investing fund that is a common or collective bank trust or an insurance company separately managed account that has any level of BPI investment is generally treated as holding BPI money. Each year, a fund should reconfirm the BPI status of its investors. The BPI status of fund of funds investors, whose BPI status, and the percentage of whose equity interests are held by BPIs, can change over time, should be confirmed more frequently.

Becoming a Plan Asset Vehicle. Since many investment advisers are now required to register with the SEC, investment advisers may wish to reconsider their policy of maintaining benefit plan investment below the 25% threshold. Once registered under the Advisers Act, a well-capitalized investment adviser with more than $85 million of assets under management may qualify as a “qualified professional asset manager” or “QPAM”, which will greatly enhance its ability to operate a fund that contains “plan assets” in accordance with the prohibited transaction provisions of ERISA and the IRC. Depending upon the fund’s investor base, trading strategy and geographical area of activity, compliance with these rules may be reasonably practicable. Advisers that advise ERISA and other BPI client funds though separately managed accounts will generally be treated as investment fiduciaries under ERISA. Advisers who accept ERISA fiduciary status should establish, as part of their written compliance policies and procedures, clear operational guidelines to ensure that employees dealing with plan assets comply with ERISA, including its “prudent expert” standard of care and bonding, disclosure and indicia of ownership rules, and with the related party and self-dealing prohibited transaction rules of ERISA and the IRC. However, private equity funds, for a number of reasons, cannot generally operate as plan asset vehicles; these funds must remain under the 25% threshold or seek to qualify under the exemptions for “venture capital operating companies” or “real estate operating companies.”

Recent Department of Labor Developments.

  • New Advance Disclosures to ERISA Pension Plan Clients Under Section 408(b)(2). New rules under Section 408(b)(2) of ERISA became effective on July 1, 2012. Designed to give plan fiduciaries sufficient information to assess whether a service arrangement is “reasonable,” the rules impose significant new advance written disclosure obligations on certain service providers to ERISA-covered pension plans, including advisers who provide investment management or investment advisory services through separately managed accounts or through “plan asset” funds. The new regulations require a covered service provider to disclose to a responsible fiduciary of the plan, a reasonable time before the service arrangement is entered into or the fund investment made, the scope of the services to be provided and the direct and indirect compensation the adviser and its affiliates and subcontractors expect to receive. Advisers are typically providing the disclosure in a separate short document; in the fund context, it will likely be provided at the subscription stage along with the fund’s offering memorandum, subscription document and financial statements. A typical adviser’s disclosure will cover management and performance compensation, gifts and entertainment received from brokers and the like, soft dollars, the fund’s expense ratio and any subadvisory arrangements and placement fees. The failure of a covered service provider to timely provide the necessary information may technically result in the service arrangement becoming a “prohibited transaction” under ERISA, with the consequence that the service provider may have to disgorge some or all of its compensation to the plan and pay excise taxes to the IRS. Further, an ERISA pension plan is required to terminate a covered service provider who does not timely respond to a request for information under Section 408(b)(2). Disclosures to existing ERISA pension plan clients were due by July 1, 2012, the effective date of the rules.
  • Schedule C Reporting. Since the 2009 plan year, ERISA plans filing an annual Form 5500 report with the Department of Labor must include an expanded Schedule C which identifies certain service providers to the plan who received $5,000 or more in direct and indirect compensation during the year and the services for which the compensation was received. Consequently, investment advisers to separately managed ERISA plan accounts, and to private funds with any ERISA plan investors (including, significantly, funds, other than venture capital operating companies or real estate operating companies, that do not hold plan assets) may now expect annual compensation information requests from ERISA clients. Unlike the Section 408(b)(2) regulations, which require prospective information, Schedule C looks back to compensation received and services provided in the prior year. We recommend that a fund complex with a number of ERISA investors prepare a standard Schedule C response each year that can be automatically provided to those investors.
  • Expanded Definition of Fiduciary. In October 2010, DOL proposed a significant expansion of its regulation that describes when a person provides “investment advice” to an ERISA plan or an IRA, and thus is treated as a fiduciary of the plan under ERISA and/or the prohibited transaction rules of the IRC. As drafted, the rule would have recharacterized many consultants, broker-dealers and appraisers as fiduciaries. Many industry participants feared that, under the rule as proposed, broker-dealers might no longer be able to recommend affiliated hedge funds, and advisers of funds (even those that keep under the 25% BPI threshold) might become fiduciaries as a result of providing current net asset valuations to plan investors. The proposed rule met with considerable opposition, and was withdrawn for reproposal in September 2011. We understand that the DOL is close to finalizing a reproposed rule which may, along with expanded and new prohibited transaction exemptions designed to permit certain industry practices to continue, be released in early 2013.

Deferred Fee and Incentive Compensation Arrangements

Section 457A. IRC Section 457A effectively prevents investment advisers from deferring the taxation of fee income earned in 2009 and subsequent years from funds established in tax havens. Compensation deferred in 2008 and earlier years may only remain deferred until the end of the 2017 tax year, when it must be “repatriated” and taken into income by the adviser. Section 457A does not, however, prevent an offshore hedge fund from issuing options or stock-settled (but not cash-settled) stock appreciation rights to an adviser if the exercise price equals or exceeds the fair market value of the fund’s shares on the date of grant. However, advisers interested in such an incentive compensation approach should consider the various tax issues, including those relating to passive foreign investment companies or “PFICs,” carefully with counsel. Section 457A also impacts incentive fees (but not incentive allocations from partnerships) on side-pocketed investment assets, payment of which is usually postponed until the asset is realized, becomes liquid or acquires a readily available market value. Such an incentive fee may be considered “deferred” under Section 457A, in which case the adviser may be subject to an additional 20% penalty tax, plus interest, when the amount of the incentive fee is finally determinable in the year in which the side pocket is realized or deemed realized. Section 457A may also significantly complicate the design of a multiyear fee—whether structured as a fee or a partnership allocation—if the earnings period exceeds two years. Section 457A does, however, permit very limited short-term deferrals of up to a year following the end of the year in which the compensation is earned. Until further notice, Section 457A will not apply to carried interests in a partnership. Therefore, many investment advisers of funds (particularly those with funds that generate long-term capital gains) have changed the form of their incentive for services performed from a fee to a partnership allocation.

Section 409A. IRC Section 409A compliance is still important for hedge funds. Investment advisers who retain a fee (as opposed to a partnership allocation) structure with their offshore fund(s) and wish to defer fees for up to one year, as permitted by Section 457A, must continue to comply with Section 409A, which generally requires deferral elections to be made by the end of the year before the fee income is earned. Investment advisers and funds must also structure their deferred bonus, phantom carry and other incentive compensation arrangements with employees to either avoid or comply with the requirements of Section 409A. Finally, all surviving pre-2009 deferred fee arrangements with offshore funds must be administered in accordance with the final Section 409A regulations until the end of 2017.

Redeferral of Pre-2008 Deferred Fees Past 2017. Under Section 457A, pre-2009 deferred fees owing by an offshore fund to an adviser will be taxable to the adviser in the fund’s 2017 tax year, even if payable in a later year under the terms of the deferral arrangement. Section 409A permits amounts to be redeferred only for a minimum period of five years, and does not generally allow parties to a deferred compensation arrangement to accelerate payment dates once they have been fixed. Therefore, if an adviser wishes to redefer pre-2009 deferred fees that fall due in 2013, 2014, 2015 or 2016, it must push the payment dates out beyond 2017. Unless further transition relief is granted, an adviser who does so will have taxable income under Section 457A in 2017, but will not ordinarily be able to take a distribution of the deferred fees without a Section 409A violation. However, under a plan termination exception in the 409A regulations, an adviser may be able to defer amounts past 2017 and then access the funds earlier by terminating the deferral arrangement (and all similar deferral arrangements) during 2016 and paying out all remaining deferred amounts in 2017.

Application of CFTC Business Conduct Rules to “Special Entities”. The CFTC’s final external business conduct rules impose significant new obligations on swap dealers and major swap participants in their dealings with counterparties, effective January 1, 2013. Additional requirements apply where the counterparty is a “special entity,” a term that includes ERISA plans and governmental plans, but not hedge funds or other collective investment vehicles, even those treated as holding “plan assets” under ERISA. It is expected that swap dealers and major swap participants will comply with their obligations to special entities largely through reliance on disclosures to, and representations from, counterparties and their advisers. Investment advisers to ERISA and governmental plan separately managed accounts may need to update their existing compliance policies and procedures and, in some cases, their investment management or similar agreements with special entity clients, to take into account the representations they will be asked to make to swap dealers and major swap participants on their clients’ behalf.

The Pay-to-Play Rule

The SEC extended the compliance date for the ban in Rule 206(4)-5 (the “Pay-to-Play” rule) on advisers paying third parties to solicit government entities from June 13, 2012 to nine (9) months after the compliance date of a final rule adopted by the SEC by which municipal advisor firms must register under the 1934 Act (which has not yet occurred). In 2011, the SEC added “registered municipal advisors” to the categories of regulated entities exempt from the ban on third-party solicitation. To qualify for the exemption, the registered municipal advisor is required to register with the SEC pursuant to Section 15B of the 1934 Act and be subject to a Municipal Securities Rulemaking Board’s pay-to-play rule. An overview of the Pay-to-Play rule may be found here. For more information on the amendment to the Pay-to-Play rule, please see our alert on the final rules implementing the Dodd-Frank Act provisions, which may be found here.

Electronic Communications and Social Media

The ubiquitous use of electronic communications and social media in the workplace means that advisers should consider establishing policies and procedures that govern their use. Such policies and procedures may regulate, without limitation, email communications and employer-provided electronic devices, prohibited communications using the employer’s electronic facilities, permitted disclosures on social and business media websites, electronic delivery of required disclosures, electronic security, reporting breaches of information security and electronic monitoring. For more information, please see our alert on the position of the staff of the Office of Compliance Inspections and Examinations of the SEC concerning investment advisers’ use of social media, and our alert on a report issued by the Office of General Counsel of the National Labor Relations Board that examines social media policies and provides specific examples of employer policies that both violated and did not violate the National Labor Relations Act. Advisers may also need to consider state-specific regulations.

State Regulatory Updates

In the past year, a number of states enacted a variety of laws, rules and regulations that impact investment advisers. For example, New York passed a law that requires New York employers, between January 1 and February 1 of each year, to furnish all New York employees with a written notice of: (1) their rate of pay including, for non-exempt employees, their overtime rate; (2) how the employee is paid (hourly, salary, commission, etc.); (3) their regular payday; (4) the official name of the employer and any other names used for business (DBA); (5) the address and phone number of the employer’s main office; and (6) if applicable, any allowances taken as part of the minimum wage (i.e., tip, meal and lodging deductions) (our December 22, 2011 alert may be found here). In February, Massachusetts approved a number of regulations relating to investment advisers, including the elimination of a frequently relied-on exclusion from the definition of investment adviser, and the adoption of a new exemption from the registration requirements for investment advisers to solely “private funds,” subject to certain conditions. Also in February, the Massachusetts Securities Division issued a report dealing with regulatory issues raised by investment advisers’ use of social media (our February 17, 2012 alert may be found here). In September, California joined Maryland and Illinois in passing social media privacy laws that restrict employers and colleges from demanding access to the social media accounts of applicable employees/students, except under limited circumstances (our October 11, 2012 alert may be found here). This summary of state regulatory updates is not exhaustive and we recommend investment advisers seek guidance from counsel with respect to compliance with applicable state statutes, rules and interpretations.

Annual Compliance Review

Offering Document Updates. An investment adviser should review the offering documents (e.g., private placement memoranda, subscription documents, marketing materials, etc.) of the funds it manages to determine whether the investment adviser’s and/or a fund’s business has undergone any material changes (including, but not limited to, changes to investment objectives/strategies, risk factors, conflicts of interest and/or service provider relationships), or if there have been any regulatory changes (including tax and ERISA) since the documents were last updated. If so, the investment adviser should consider updating the offering documents to reflect any such changes or developments. Given the events in the markets during the past few years, investment advisers should pay particular attention to whether or not their stated investment strategies and related risk factors are still accurate. Consideration should be given as to whether any changes require consent from investors or directors.

Compliance Policies and Procedures. Each SEC-registered investment adviser is required to review its compliance policies and procedures on an annual basis and should maintain written evidence of the review. The annual review should consider, among other things, any compliance matters that arose during the previous year, any changes in the business activities of the investment adviser and any changes in the Advisers Act or other regulations that might require changes to the policies and procedures.20

In light of the SEC’s focus on investment advisers’ controls regarding material non-public information, we have found that it is useful to have outside counsel (together with in-house counsel, if applicable) provide training with respect to the prevention of insider trading to all of the investment adviser’s personnel. If you would like us to provide such training for your personnel, please contact your Bingham counsel.

SEC-registered investment advisers, among other things, should also be sure that each of their access persons21, and possibly certain other personnel, provides to the investment adviser’s chief compliance officer a quarterly transactions report and annual holdings report listing such person’s personal security transactions or holdings, as applicable. SEC-registered investment advisers should also consider their other obligations under the Advisers Act, including, but not limited to, considering the effectiveness of their codes of ethics and conducting any necessary training that may be associated therewith, as well as the effectiveness of any disaster recovery contingency plans and systems that they have in place.

Employee Training. In order to encourage a culture of compliance in the work environment, an investment adviser should consider instituting training and/or programs to promote better understanding of the investment adviser’s compliance policies and procedures and employee handbook. An investment adviser’s fiduciary duties and obligations, avoiding potential conflicts of interest, and the prevention of insider trading and employee harassment are just a few topics for training that investment advisers should consider.

Form D and Blue Sky Filings. Form D must be electronically filed with the SEC on its filer management system, EDGAR, within fifteen (15) days of the initial sale of securities in an offering. If a Form D was filed as of September 15, 2008 or later, and it relates to an offering that is still on going, it must be amended annually, on or before the first anniversary of the most recent previously filed notice. Form D must also be amended as soon as practicable after a change in information on the previously filed notice, or to correct a material mistake of fact or error.

The blue sky laws of many states require that a hard copy of Form D be filed with the relevant state authority within fifteen (15) days following the initial sale of interests or shares in that state. In addition, the blue sky laws generally require that filings previously made be updated from time to time to reflect certain changes, and some states require filings on a periodic basis. In considering blue sky filings, investment advisers should pay special attention to: (i) new states where they intend to sell (or recently sold) interests or shares; (ii) states where they have sold interests or shares but did not file a Form D; and (iii) states from which investors have made additional investments. The regulatory penalties for failing to make filings on time can be significant and may also result in a requirement to offer rescission to each investor in a state.

Custody Rule Compliance. SEC-registered investment advisers that have custody of client securities or assets22 are subject to Rule 206(4)-2 under the Advisers Act. Unless an investment adviser has account statements delivered to the investors in the funds it manages on a regular quarterly basis from qualified custodians, the rule requires that a copy of each fund’s audited financial statements, prepared in accordance with generally accepted accounting principles, be delivered to fund investors within one hundred twenty (120) days (or one-hundred-eighty (180) days for funds of funds) after the end of the fund’s fiscal year.23

Other Regulatory Filings. There are several regulatory filings that investment advisers (whether SEC-registered or not) may be required to make in light of certain activities, which may include:

  • Form 13F. An investment adviser is required to file a Form 13F with the SEC if it exercised investment discretion over $100 million or more in Section 13(f) securities on the last trading day of any month in the prior calendar year. Form 13F must be filed within forty-five (45) days after the last day of the calendar year (for the coming year, not later than February 14, 2013) and again within forty-five (45) days after the last day of each of the three (3) calendar quarters thereafter.
  • Schedule 13D/13G. If an investment adviser directly or indirectly “beneficially owns” (through fund(s), client account(s) or proprietary account(s)) more than 5% of a class of publicly traded securities, the investment adviser (and possibly others) is required to file either a Schedule 13D or Schedule 13G with the SEC. “Beneficial ownership” generally means the direct or indirect power to vote and/or dispose of such securities. Unless qualified to file a Schedule 13G, an investment adviser (and possibly others24) must file a Schedule 13D within ten (10) days of the acquisition of more than 5% of such securities, which must be amended promptly to reflect material changes, including, but not limited to, an acquisition or disposition equal to 1% or more of such securities.

Schedule 13G may generally be filed by a person or entity that beneficially owns less than 20% of the outstanding shares of a class of such securities in the ordinary course of business and not for the purpose of changing or controlling the management of the issuer of such securities. A “passive investor” must file Schedule 13G within ten (10) days of crossing the 5% beneficial ownership threshold. Certain eligible institutions (including SEC-registered investment advisers) also are permitted to file on Schedule 13G.25 An SEC-registered investment adviser must file a Schedule 13G within forty-five (45) days after the end of the calendar year in which more than 5% beneficial ownership of such securities was obtained (if the beneficial ownership remains above 5% as of year-end), or within ten (10) days of month end if beneficial ownership exceeds 10% at such month end. A non-SEC registered investment adviser must file Schedule 13G within ten (10) days of the acquisition of more than 5% of such securities. Schedule 13G must be amended periodically per rules that vary based on the type of filer. In addition, each registered and non-registered investment adviser that has previously filed a Schedule 13G must file a Schedule 13D within ten (10) calendar days if its passive investment purpose changes and a non-SEC registered investment adviser that has previously filed a Schedule 13G must file a Schedule 13D within ten (10) calendar days after acquiring more than 20% of the class of such securities. The statutes, rules and SEC and court interpretations regarding Schedule 13D and Schedule 13G are very complicated, and we urge investment advisers to seek guidance from counsel with respect to compliance with applicable statutes, rules and interpretations.26 Investment advisers should also note that in some cases, one may need to consider non-equity investments in evaluating your filing requirements.

  • Form 13H. Rule 13h-1 of the 1934 Act27 imposes initial and ongoing filing obligations on “large traders”28 and subjects the U.S.-registered broker-dealers that service large traders to certain recordkeeping, monitoring and reporting requirements. A trader may also voluntarily file Form 13H. The purpose of Rule 13h-1 is to assist the SEC in its efforts to identify the most significant participants in the U.S. securities markets and to gather information quickly on their trading activity.

Those who meet the “large trader” definition must file Form 13H “promptly” after meeting the threshold (generally within ten (10) days). Thereafter, a large trader must submit an annual filing on Form 13H within forty-five (45) days of the end of the calendar year (by February 14 in 2013) and must submit any amendments promptly after the end of any calendar quarter in which information previously provided becomes inaccurate. As of May 1, 2013, or November 30, 2012 (depending on the broker-dealer), broker-dealers must maintain the required records, monitor large trader activity and be able to respond to requests from regulators with required information, including with respect to “unidentified large traders.”29 More information on Form 13H may be found here.

  • Forms 3, 4 and 5. An investment adviser (and possibly others) may be required to file certain forms if it directly or indirectly beneficially owns more than 10% of any publicly registered class of equity security of an issuer, or if it (or an employee acting on behalf of the investment adviser) serves as an officer or director of the issuer. Form 3 must be filed within ten (10) days after exceeding the 10% threshold or becoming an officer or director of the issuer; Form 4 generally must be filed by the end of the second business day after executing a transaction in any equity securities of the issuer; and Form 5 must be filed within forty-five (45) days after the end of the issuer’s fiscal year to report exempt and other transactions that were not previously reported. These rules also apply to securities that are exchangeable or convertible into the issuer’s equity securities. Securities held by certain specified types of institutions in the ordinary course of business, and not for the purpose of changing or influencing control of an issuer, need not be counted in determining if an investment adviser has reached the 10% threshold and, accordingly, certain investment advisers may not be required to file these forms. Investment advisers and others who are required to file these forms are subject to disgorgement of profits (or deemed “profits” calculated in accordance with a rigid formula) resulting from purchases and sales (or other opposite-direction transactions) within any six-month period. We suggest that such persons to seek guidance from counsel prior to becoming subject to these reporting requirements.

Liability Insurance. In light of the increasing number of investor lawsuits in recent years, as well as the increasing review and scrutiny by regulatory and governmental authorities of the hedge fund industry generally, investment advisers may want to consider whether management liability insurance should be obtained, depending on the exposure of their current business. Management liability insurance generally includes coverage for directors’ and officers’ liability, fiduciary liability, errors and omissions liability and employment practices liability.

Other Annual Requirements. SEC-registered and unregistered investment advisers are subject to several other annual requirements and obligations, including those set forth below. Although these obligations need not be completed immediately, investment advisers should confirm that these activities are on their annual compliance calendar.

  • Privacy Policy. A copy of an investment adviser’s privacy policy must be sent to each of its individual clients once within every twelve-month period, even if the privacy policy has not changed. In addition, if an investment adviser’s policies and procedures relating to maintaining privacy of client information have changed and such changes lead to the disclosure of information not described in previous policies or lead to the delivery of information to a third party not previously disclosed, the privacy policy must be updated.
  • New Issues. If funds managed by an investment adviser invest in “new issues” (whether directly or through an investment in another fund), the investment adviser must obtain an annual representation from all investors in the funds it manages as to their eligibility to participate in profits and losses from new issues. This can be accomplished by requesting that each investor inform the investment adviser of any changes in the investor’s status from its representation in its subscription agreement with the fund. The investment adviser must keep a record of all information relating to whether an investor is eligible to purchase new issues for at least three years.

* * *

This summary is not intended to provide a complete list of an investment adviser’s obligations relating to its compliance with applicable rules and regulations or to serve as legal advice and, accordingly, has not been tailored to the specific needs of a particular investment adviser’s business. We encourage you to contact us if you would like to discuss whether there are additional items that you should consider or if you have any questions about any of the items covered herein. This summary does not purport to be comprehensive and should be used for information purposes only.


If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:


1 The private adviser exemption was available to an investment adviser if, during the preceding twelve (12) months, the investment adviser advised fewer than fifteen (15) clients and neither held itself out to the public as an investment adviser nor acted as an investment adviser to any investment company registered with the Securities and Exchange Commission (the “SEC”) under the Investment Company Act of 1940 (the “1940 Act”) or any entity electing to be treated as a business development company under the 1940 Act.

2 See June 22, 2011 SEC Final Rules, Release No. IA-3221, “Rules Implementing Amendments to the Investment Advisers Act of 1940” and Release No. IA-3222, “Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers with Less than $150 Million in Assets Under Management, and Foreign Private Advisers”.

Effective July 21, 2011, “private fund” is defined under Section 202(a)(29) of the Advisers Act as “an issuer that would be an investment company, as defined in section 3 of the [1940 Act], but for section 3(c)(1) or 3(c)(7) of that Act.”

3 An adviser determines its RAUM by calculating “the securities portfolios with respect to which an investment adviser provides continuous and regular supervisory or management services”. Advisers are required to include in their RAUM (i) proprietary assets; (ii) assets managed without receiving compensation; and (iii) assets of foreign clients. Advisers are not permitted to subtract outstanding indebtedness in determining RAUM. All advisers are required to use the current market value (or fair value) of private fund assets rather than their cost in determining RAUM.

The rule also requires an adviser to a private fund to include in its RAUM (i) the value of any private fund it manages regardless of the nature of the assets held by the private fund and (ii) the amount of any uncalled capital commitments made to the fund. The method for calculating RAUM is set out in Instruction 5.B. to Part 1A of Form ADV.

4 The term “commodity pool operator” includes any person engaged in a business that is in the nature of a commodity pool and who, in connection therewith, solicits, accepts or receives from others, funds, securities or property, either directly or through capital contributions, the sale of stock or other forms of securities, or otherwise, for the purpose of trading in commodity interests, including any future, security futures product or swap; authorized commodity option or leverage transaction; or retail forex or commodity transactions as further defined in the Commodity Exchange Act (the “CEA”). The definition also includes any entity or person that registers with the CFTC as a CPO for whatever reason.

5 A “commodity pool” is an enterprise in which funds contributed by a number of persons are combined for the purpose of trading futures or options contracts, including swaps.

6 In the case of an option that is in-the-money at the time of purchase, the in-the-money amount, as defined in Rule 190.01(x) of the CFTC’s regulations, may be excluded in computing this percentage.

7 “Notional value” is calculated for each futures position by multiplying the number of contracts by the size of the contract in contract units (taking into account any multiplier specified in the contract), then multiplying that number by the current market price per unit; for each option position by multiplying the number of contracts by the size of the contract, adjusted by its delta, in contract units (taking into account any multiplier specified in the contract), and then multiplying that number by the strike price per unit; for each retail forex transaction, by calculating the value in U.S. Dollars of such transaction, at the time the transaction was established, excluding for this purpose the value in U.S. Dollars of offsetting long and short transactions, if any; and for any cleared swap by the value as determined consistent with the terms of Part 45 of the CFTC Rules. Futures contracts with the same underlying commodity across designated contract markets and foreign boards of trade and swaps cleared on the same designated clearing organization may be netted where appropriate.

8 Form CPO-PQR defines a “mid-sized CPO” as any CPO that had at least $150 million in aggregated pool assets under management as of the close of business on any day during the “reporting period.” Note that “assets under management” in this context is net asset value, not the RAUM that the SEC uses for Form ADV and Form PF purposes. For a mid-sized CPO, the “reporting period” is the calendar year end.

9 Form CPO-PQR defines a “large CPO” as any CPO that had at least $1.5 billion in aggregated pool assets under management as of the close of business on any day during the reporting period. Note that “assets under management” in this context is net asset value, not the RAUM that the SEC uses for Form ADV and Form PF purposes. For a large CPO, the “reporting period” is any individual calendar quarter ending March 31, June 30, September 30 or December 31.

10 Long-term reportable securities include equity securities, including common stock, preferred stock, limited partnership interests and debt securities. The following are not long-term reportable securities: direct investments, derivatives, currencies, short-term securities (original maturity date of one calendar year or less), loans (directly negotiated between lender and borrower), repos and securities lending arrangements.

11 Investment advisers should note that, even if an investment adviser were to cease managing at least $1 billion in aggregated reportable securities at some point after filing Form SLT‚ it nevertheless will be required to submit a report for each remaining reporting date in that calendar year‚ regardless of the total fair market value of the consolidated reportable securities on any such date.

12 Direct investment is the ownership or control, directly or indirectly, by one person of 10% or more of the voting securities of an incorporated or unincorporated business enterprise.

13 See Directive 2011/61/EU.

14 See Regulation (EU) No 236/2012.

15 Rule 205-3 under the Advisers Act exempts an investment adviser from the prohibition against charging a client performance fees in certain circumstances, including when the client is a qualified client.

16 The SEC has, to date, provided little guidance on the “reasonable steps” that should be taken by an issuer to verify that the purchaser of its securities are accredited investors. The release issued by the SEC with respect to the proposed amendments stated that whether the steps actually taken by an issuer in this regard are reasonable would be “an objective determination, based on the particular facts and circumstances of each transaction”. Currently, it is common practice for many private funds to have each prospective investor complete a qualification questionnaire in which the investor certifies, among other things, that it is an accredited investor. Private funds that wish to rely on proposed Rule 506(c) if and when it is adopted should note that, depending on all the facts and circumstances of an offering, this practice by itself may not constitute sufficient reasonable steps toward verifying the investor’s accredited status for purposes of proposed Rule 506(c).

17 Rule 501 contains definitions of the terms used throughout Regulation D, including the term “accredited investor.” For purposes of determining whether the conditions of a Regulation D safe harbor are met, Rule 502(a) requires the integration of all offerings by an issuer that occur within six months of each other. Rule 502(d) imposes limitations on the resale of securities acquired in a transaction under Regulation D.

18 Section 7.1(a) of the Code of Conduct.

19 The reporting requirement only applies to specified shares in a corporation, namely, those that are listed or admitted to trading on the Exchange and are designated: (i) as a constituent of the Hang Seng Index; (ii) as a constituent of the Hang Seng China Enterprises Index; or (iii) by the Exchange to be a “designated security” according to the rules of the Exchange and classified by the Hang Seng Indexes Company Limited as “financial” stocks. The SFC publishes a list of specified shares that will be caught by the Rules.

20 Newly-registered advisers generally have eighteen (18) months after the adoption or approval of their compliance policies and procedures to complete the initial review.

21 An “access person” is any partner, officer, director (or other person occupying a similar status or performing similar functions), or employee of the investment adviser, or any other person who provides investment advice on behalf of the investment adviser and is subject to the supervision and control of the investment adviser, who has access to nonpublic information regarding any client’s purchase or sale of securities, or nonpublic information regarding the portfolio holdings of any reportable fund, or who is involved in making securities recommendations to clients, or who has access to such recommendations that are nonpublic.

22 “Custody” is defined broadly under Rule 206(4)-2 as holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.

23 The custody rule further requires that the auditor performing such annual audit be registered with, and subject to inspection by, the Public Company Accounting Oversight Board.

24 The requirement to file Schedule 13D or Schedule 13G is applicable to any beneficial owner of more than 5% of a class of publicly-traded securities, not just investment advisers. This means that a fund that such investment advisers may advise or a group of funds that acts in concert may have its own filing obligation.

25 This does not mean that a fund or group of funds advised by the investment adviser and that may have an independent requirement to file are permitted to file as eligible institutions.

26 Please see our alert summarizing the CSX decision (CSX Corporation v. The Children’s Investment Fund Management (UK) LLP et al. (S.D.N.Y. No. 08 Civ. 2764)) for further details, which may be found here.

27 See July 26, 2011, SEC Final Rule, Release No. 34-64976, “Large Trader Reporting”, which may be found here.

28 A “large trader” is a person that “[d]irectly or indirectly, including through other persons controlled by such person, exercises investment discretion over one or more accounts and effects transactions for the purchase or sale of any NMS security for or on behalf of such accounts, by or through one or more registered broker-dealers, in an aggregate amount equal to or greater than the identifying activity level.” “Identifying activity level” is defined as aggregate transactions in NMS securities of at least 2 million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month.

29 Upon receiving a large trader’s Form 13H, the SEC will assign the large trader a unique large trader identification number (“LTID”). The large trader will be required to provide its LTID to each of its broker-dealers and identify to the broker-dealers all of its accounts to which the LTID applies.

This article was originally published by Bingham McCutchen LLP.