Investment Advisers Prep for New SEC Registration Rules

Now that the Dodd-Frank Reform Act has been signed into law, managers of hedge funds, private equity funds and other similar investment vehicles can expect some big compliance changes ahead.

The time to prepare is now, experts say.

One particular provision in the law, the Private Fund Investment Advisers Registration Act, “will significantly change the scope of investment adviser registration,” Patrick Shea, executive vice president of HedgeOp Compliance, a provider of compliance software and consulting services for asset managers, said during a recent Webcast.

Most importantly, the Dodd-Frank Act eliminates the so-called “private adviser exemption,” which many advisers, historically, have used to avoid registration with the Securities and Exchange Commission. Under the current exemption, through the Investment Advisers Act of 1940, advisers do not have to register with the SEC if they have fewer than 15 clients and do not hold themselves out generally to the public as investment advisers.

“In our view, the composition of SEC registered advisers is going to change, and it’s pretty clear that the SEC is concentrating efforts on managers with larger holdings and larger assets under management,” said Shea.

More specifically, the Dodd-Frank Reform Act raises the assets under management threshold for SEC registration to $100 million from the prior level of $25 million. The Act creates a limited exception from SEC registration for private fund advisers that solely advise private funds (i.e., they do not accept managed accounts) and have aggregate assets under management in the United States of less than $150 million.

From a practical perspective, the law will generally require investment advisers to hedge funds and private equity funds with assets under management of $100 million or more to register with the SEC, whereas small- and mid-size private fund advisers with assets between $25 million and $100 million will have to look into registering with a state regulator.

However, even those exempted from SEC registration must still maintain records and reports, as the Commission deems appropriate in the interest of the public or investors. In developing registration requirements and examination procedures for “mid-sized” private fund advisers, the SEC is required to take into account fund size, governance, investment strategy, and the level of systemic risk posed by the fund.

“In our view, the composition of SEC registered advisers is going to change, and it’s pretty clear that the SEC is concentrating efforts on managers with larger holdings and larger assets under management.”

—Patrick Shea,

Executive Vice President,

HedgeOp Compliance

The Act also creates a limited exemption from registration for foreign investment advisers. A foreign private adviser is defined as an investment adviser that:

Has no place of business in the United States;

Has fewer than 15 clients and investors in the United States;

Has aggregate assets under management of less than $25 million; and

Neither holds itself out generally to the public as an investment adviser nor acts as an adviser to any investment company registered under the Investment Company Act of 1940 or any business development company.

Others exempt from registration include advisers to “venture capital funds” and “family offices,” both terms the SEC has yet to define.

Key Considerations

Investment advisers can take many steps to prepare for such compliance changes. William Mulligan, CEO of HedgeOp, who also spoke during the Webcast, outlined ten important considerations to keep in mind as they work toward SEC compliance with the Act.

1. One size does not fit all. “In our experience, people using off-the-shelf manuals that have not been customized or thought through can be very dangerous,” warned Mulligan. Your program needs to be unique to your firm and investment activities.

2. Talk to others who have gone through the process. Start with colleagues in the business. How did they do it? Who did the work (a law firm, an outside consultant firm, someone else)? “Get an idea of how it worked well for other people,” as well as where they experienced surprises or hiccups in the process, said Mulligan.

STEPS FOR REGISTRATION

Mechanics of SEC Registration:

STEP ONE

Establish Investment Advisers Registration

Depository (“IARD”) User Account

Complete and submit forms contained in the IARD

Entitlement Packet

Designate Super Account Administrator (“SAA”)

Upon receipt of completed entitlement form, FINRA

will create an SAA account for your firm and provide

IARD access by sending confirmation e-mails

containing user ID and initial password

STEP TWO

Complete Form ADV Part 1 on-line via the IARD

system

—Input information regarding your firm,

including the firm’s business practices,

persons who own and control the firm,

persons who provide investment advice on

behalf of the firm, the firm’s affiliates and the

firm’s regulatory disciplinary history.

STEP THREE

Deposit funds into your financial account

—You will NOT be able to submit an electronic

filing until funds are deposited into your

financial account.

—Submit either by Web E-pay, wire transfer, or

check

STEP FOUR

Develop your Firm’s Form ADV Part 2 (“Brochure”)

—Principal document that advisers must provide to clients and

prospects

Includes descriptions of qualifications, investment strategy, fees,

business practices and important disclosures

—SEC recently adopted significant amendments to the Part 2

Generally effective Q1 2011

Moving from: check-the-box to a “plain English” narrative approach

Electronically filed and publicly available

Expanded content

New updating requirements

Brochure supplements about key personnel (resume-like

disclosures)

STEP FIVE

Develop a Compliance Infrastructure that meets Adviser’s Act requirements

Compliance Manual

—Must have a Compliance Manual in place as soon as you become registered

—Must be customized for your business and include detailed policies, such as:

Maintaining Form ADV

Portfolio management processes

Trading and brokerage practices

Custody of advisory client assets

Record keeping

Marketing activities

Valuation practices

Annual compliance review

Proxy voting

Oversight of political contributions by the firm and its employees

Source

Registration and

Compliance for Private Funds (July 28, 2010)

3. Assign ownership from the start. “We find that it’s absolutely key as part of a client’s program development process to create a matrix, or calendar, of what needs to be done each month,” and then to assign responsibly of who is going to do what, said Mulligan. Having a calendar also can serve as a useful review tool, he said.

Schwartz

Better yet, an electronic compliance calendar let’s you track, monitor, and archive your compliance program, said Jordan Schwartz, vice president of HedgeOp. Further, an electronic calendar can help you create an audit trail and document archive so you can easily retrieve and evidence various compliance tasks, he said.

4. Culture is immensely important. You want the SEC to see you have a very strong compliance culture, “and that’s got to come from the top,” said Mulligan. “Senior management has got to buy into the process.”

Mulligan

In general, adviser firms are much more successful when senior management is involved right out of the gate. “They don’t have to be involved in the minute details, but should participate in the training, sign off on the procedures, demonstrate to the rest of the firm that, for this to work, the firm has to follow the system,” Mulligan added.

5. Disclosure can protect you. “Disclosure is a very important shield,” said Mulligan. He recommended considering the following questions: How are you going to disclose to the SEC how certain procedures work? What are your proxy voting procedures? Are there gaps between what you say you’re going to do and what you’re actually doing? A common example is conflicts of interest, such as personal trading, receipt of gifts, business or entertainment, and transactions between affiliates.

6. Open up the process and create a dialogue regarding the person trading rules and restrictions. Get your people to understand why restrictions and prohibitions are in place. Explain the ”rhyme and reason” behind the rule, advised Mulligan. Why are strict rules better for the firm? Think about what you would expect if you were an investor, he said.

7. Think about the importance of IT controls. Set up an electronic mail retention system. Similarly, you should feel “rock solid” about your recordkeeping, said Mulligan. Are you backing everything up? Are the backups safe? Are you testing the backups to make sure that they’re safe?

Also, think about information security controls. If your employees use laptops, blackberries, or other mobile devices, are passwords and locking devices in place? Think of all the ways investors’ data can be accessed and how that data is transported when it’s outside the firm.

8. Adopt a system of reminders and regular checks. Make sure you identify what employees need to perform compliance requirements and “create that system upfront,” said Mulligan. Check in with employees on a regulator basis; you want to be able to demonstrate that your firm is adequately supervising its people. “By going through this very organized detail of reminders and check-ins, that helps the cause that you’re checking in as much as you need to check in,” said Mulligan.

9. Train your staff about the parameters of the compliance program. “Don’t just roll out a manual in the Code.” Walk through examples of what needs to be done. Do an annual review that identifies any weak areas, and what needs to be focused on during training. “From a practical standpoint, have everyone sign in sheets and attestations so that you can easily demonstrate to the SEC that you’re holding these training sessions,” advised Mulligan.

10. Be ready to prove that you do what you say you’re doing. “You want to make sure you’re able to back up all those statements,” said Mulligan. “That’s especially true for an audit.” Every six months or once a year, make like you’re getting audited. How do we monitor training? How do we handle marketing, the trade allocation process, etc …?

“Where we see problems, and where things really go downhill, is when people let a mole hill turn into a mountain,” said Mulligan. “That doesn’t need to be the case.” If you stay on top of small problems and address them as they occur, “you don’t let these problems get out of control.”