Investment advisers registered with the Securities and Exchange Commission (SEC) (each, an RIA) are subject to certain annual requirements under the Investment Advisers Act of 1940 (the Advisers Act); some of these requirements also either apply to exempt reporting advisers (each, an ERA) or warrant consideration as best practices for ERAs. This Sidley Update reminds investment advisers about certain annual regulatory and compliance obligations, including a number of significant 2018 reporting or filing deadlines.
This Sidley Update also reminds advisers that are registered as commodity pool operators (CPOs) or commodity trading advisors (CTAs) with the Commodity Futures Trading Commission (CFTC) and members of the National Futures Association (NFA) of certain CFTC and NFA reporting requirements.
This Sidley Update provides important information regarding:
- selected recent regulatory developments that may affect an adviser’s filing obligations and compliance program, including changes to Form ADV and new recordkeeping requirements
- SEC guidance published in 2017 related to the Advisers Act “Custody Rule,” advertising restrictions and managing cybersecurity risks
- SEC examination priorities for 2018
- recent SEC enforcement proceedings that reflect SEC concerns relevant to advisers
This Sidley Update does not purport to be a comprehensive summary of all of the compliance obligations to which advisers are subject; please contact your Sidley lawyer to discuss these and other requirements under the Advisers Act, the Commodity Exchange Act and other regulations that may be applicable to investment advisers, CPOs and/or CTAs.1
Form ADV Annual Updating Amendment for RIAs; Brochure Delivery to Clients
Recently Effective SEC Amendments to Form ADV Part 1A
In August 2016, the SEC adopted substantial amendments to Form ADV Part 1A.2 As of October 1, 2017, any adviser filing an initial Form ADV or an ADV amendment must use the revised version of Form ADV. The amendments, among other things,
- require RIAs, state-registered advisers and applicants for registration to provide specific information about separately managed accounts (SMAs) (i.e., advisory accounts that are not pooled investment vehicles), including the types of assets held and the use of derivatives and borrowings in SMAs
- streamline and standardize the process of “umbrella” registration on one Form ADV of related private fund advisers that conduct a single advisory business
- require new disclosure regarding social media, outsourced compliance officers and multiple office locations
- revise or add certain other Form ADV items and instructions
Most of the substantive changes to Form ADV Part 1A appear under Item 1 and Item 5 or relate to umbrella registration. Only certain of the revisions affect ERAs.
Most RIAs and ERAs have a fiscal year end of December 31 and will likely first address the revised Part 1A requirements when preparing and filing their annual updating amendment in the first quarter of 2018. Advisers should allocate additional time and resources for completion of the revised form.
Annual Updating Amendment
Each RIA must file an annual updating amendment to its Form ADV within 90 days of its fiscal year end. Accordingly, an adviser with a December 31, 2017, fiscal year end must file its annual amendment by March 31, 2018 (even though that date falls on a Saturday). Part 1A and Part 2A (the adviser’s brochure) are filed electronically with the SEC via the Investment Adviser Registration Depository (IARD) and are publicly available. Part 2B, the brochure supplement, is not required to be filed with the SEC but must be preserved by the adviser and made available, if requested, to the SEC for examination.
IARD will not accept an annual Form ADV updating amendment without (a) an updated Part 2A brochure, (b) a representation by the adviser that the brochure on file does not contain any materially inaccurate information or (c) a representation that the adviser is not required to prepare a brochure because it is not required to deliver it to any clients. In addition, IARD collects annual fees associated with Form ADV filings. An adviser should ensure proper funding is set up electronically prior to filing its annual amendment.
An RIA must update its Form ADV Part 1A more frequently if required, as specified in General Instruction 4 to Form ADV,3 by filing an other-than-annual amendment. The adviser also must update (and file) its Part 2A brochure promptly when any information in the brochure becomes materially inaccurate.
Annual Delivery of Brochure to Clients
Within 120 days of its fiscal year end, an RIA must deliver to each client for which delivery is required either
- its updated Part 2A brochure and a summary of material changes to the brochure, if any, or
- a summary of material changes, if any, accompanied by an offer to provide the updated brochure, which, if requested, must be mailed within seven days or delivered electronically in accordance with SEC guidelines
The brochure is required to be delivered to “clients,” which the SEC staff has acknowledged does not include fund investors; however, many fund advisers voluntarily deliver the brochure to fund investors. An adviser with a December 31, 2017, fiscal year end must deliver its updated brochure to clients by April 30, 2018.
Importance of Accurate and Complete Form ADV Disclosure
Inaccurate, misleading or omitted Form ADV disclosure is a frequently cited deficiency in SEC examinations. Moreover, Form ADV and Form PF are linked electronically, and disclosure in the two forms must be consistent.
Disclosure points of particular importance include:
- An adviser must accurately calculate its regulatory assets under management (RAUM). RAUM must be calculated on a gross basis, including proceeds of leverage and uncalled capital commitments and without deduction of any outstanding indebtedness or other accrued but unpaid liabilities, according to specific instructions provided in Instruction 5.b of Form ADV: Instructions for Part 1A (Part 1A Instructions).4
- An adviser to private funds (i.e., funds that rely on the exclusion from the definition of investment company provided by Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940) must provide specific information regarding those funds on Form ADV. Correct classification of the funds advised, according to the specific definitions provided in Instruction 6 of the Part 1A Instructions, is necessary to determine an adviser’s Form PF filing category (see Form PF Reporting Requirements — Determining an Adviser’s Filing Category below).
- An adviser that has added a new private fund as a client since its last Form ADV annual updating (or other) amendment may need to amend Form ADV to add the new fund before information regarding the new fund can be reported on Form PF. An adviser in this situation may need to file its annual Form ADV amendment early or file an other-than-annual amendment.5
Form ADV Annual Updating Amendment for ERAs
Advisers relying on the “private fund adviser” exemption or the “venture capital fund adviser” exemption from SEC registration are ERAs and are required to file reports on Form ADV Part 1A with the SEC through IARD. An ERA, like an RIA, must amend its Form ADV at least annually, within 90 days of its fiscal year end, and more frequently if required, as specified in General Instruction 4 to Form ADV. Hence, an ERA with a December 31, 2017, fiscal year end must file its annual updating amendment by March 31, 2018.
An ERA relying on the private fund adviser exemption must calculate annually the private fund RAUM that it manages and report the amount in its annual Form ADV amendment. If a U.S.-based ERA reports in its annual amendment that it has U.S. $150 million or more of private fund RAUM or has accepted a client that is not a private fund, the adviser is no longer eligible for the private fund adviser exemption.6 A private fund adviser that has complied with all ERA reporting requirements but is no longer eligible for the private fund adviser exemption because its RAUM meets or exceeds U.S. $150 million must apply for registration with the SEC within 90 days after filing the annual amendment and may continue advising private fund clients during this period. This transition period is not available to an adviser that otherwise would not qualify for the private fund adviser exemption, such as an adviser that accepts a managed account. Rather, an adviser relying on this exemption must be registered with the SEC (or, if pertinent, with one or more states) prior to accepting a non-private fund client. The transition period also is not available to advisers relying on the venture capital fund adviser exemption; such an adviser (whether based in or outside of the United States) must register under the Advisers Act before accepting a client that is not a venture capital fund, unless the adviser is eligible for another exemption from registration.
Annual Compliance Program Review
Rule 206(4)-7 under the Advisers Act (the Compliance Rule) requires an RIA to designate a Chief Compliance Officer (CCO) and adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder by the adviser and its supervised persons. The Compliance Rule does not enumerate specific elements that must be included in the compliance policies and procedures.7 Rather, the SEC staff has indicated that it expects an RIA’s policies and procedures to be based on an assessment of the regulatory and compliance risks present in the adviser’s business that may result in violations of the Advisers Act (a risk assessment) and a determination of controls needed to manage or mitigate these risks.
A February 2017 Risk Alert issued by the SEC’s Office of Compliance Inspections and Examinations (OCIE) described examples of deficiencies or weaknesses in connection with the Compliance Rule frequently identified in OCIE examinations.8 Examples include:
- Compliance manuals are not reasonably tailored to the adviser’s business practices. The staff noted that certain compliance programs did not take into account important individualized business practices, such as the adviser’s particular investment strategies, types of clients, trading practices, valuation procedures and advisory fees.
- Annual review was not performed or did not address the adequacy of the adviser’s policies and procedures. The staff also observed that some advisers did not address or correct problems identified in their annual reviews.
- Adviser does not follow its compliance policies and procedures.
- Compliance manuals are not current. The staff noted that certain compliance manuals contained information or policies that are no longer current.
Periodic and Annual Review
The Compliance Rule also requires an RIA to review at least annually the adequacy of its policies and procedures and the effectiveness of their implementation. The required annual review may be conducted in stages throughout the year or all at once, depending on what works best for the adviser; as a matter of “best practices,” however, it is recommended that an adviser conduct periodic reviews throughout the year. The SEC staff has stated that an adviser’s compliance program should continue to evolve in conjunction with an ongoing risk assessment (and re-evaluation) process.
The annual review should include consideration of any developments during the year that might suggest a need to revise the adviser’s compliance program, including, among other things:
- the results of any SEC examinations of the adviser
- review of material compliance matters that arose
- changes in the adviser’s business activities or operations (e.g., entering a new line of business)
- recent enforcement actions
- changes to applicable laws, rules or regulations
The review process should incorporate reasonable “forensic” (i.e., looking at trends over time) and “transactional” (i.e., spot) tests to detect gaps in the compliance program or instances in which the adviser’s policies and procedures may have been circumvented or are not operating effectively. Any issues identified in the testing process should be accompanied by a strategy for remediation and the results of any remediation efforts.
The adviser should document the annual review as well as steps taken to revise or enhance the compliance program to reflect the results of the review. Upon examination, the SEC will require the adviser to produce documentation evidencing the required annual review. Failure to conduct a timely annual review is an often-cited violation in addition to other charges brought by the SEC’s Division of Enforcement.
Report to Management
As a best practice, an adviser’s senior management, at least annually, should convene a special meeting to review the effectiveness of the adviser’s compliance policies and procedures. A formal written report summarizing the conclusions of senior management should be filed in the adviser’s compliance records, together with a memorandum summarizing the responses, if any, made to perceived deficiencies or inadequacies as well as evaluating the approach taken to any specific compliance problems during the year. The failure to escalate compliance issues to senior management properly may lead to individual liability for compliance professionals. Senior management should be engaged as frequently as necessary during the year to assist in establishing and maintaining a culture of compliance within an adviser’s organization.
Training and Annual Certification
The SEC staff has emphasized the importance of advisers educating their supervised persons concerning the general principles as well as the specific requirements of the adviser’s compliance program. Pertinent training should take place on at least an annual basis and more frequently as convenient or necessary, such as when an employee joins the firm or when the testing of policies and procedures demonstrates a lack of understanding of the policies and procedures.
An adviser’s compliance policies and procedures should be documented in a compliance manual distributed to all supervised persons. All supervised persons should be required to execute and deliver, at least annually, a certificate stating that they have read (or re-read) and understand the provisions in the compliance manual (including any revisions or updates), including the code of ethics and the adviser’s policies and procedures designed to detect and prevent insider trading. Many firms also use an annual certification to remind supervised persons of their specific disclosure obligations, such as the obligation to disclose outside business activities, that assists the adviser with complying with its fiduciary duties under the Advisers Act.
An ERA, as an unregistered adviser, is not required to adopt a comprehensive compliance program pursuant to the Compliance Rule or to comply with most other rules under the Advisers Act. Unregistered advisers, however, are still subject to the antifraud provisions of the Advisers Act. An ERA, therefore, should adopt reasonable compliance policies, procedures and oversight to avoid even the appearance of a violation of the antifraud provisions or the ERA’s fiduciary duty to clients. Like an RIA, an ERA is subject to the pay-to-play rule under the Advisers Act as well as the Advisers Act requirement that an adviser adopt policies and procedures reasonably designed to prevent insider trading. As a best practice, an ERA should review at least annually the adequacy of its policies and procedures and make any needed revisions.
Advisers Registered as CPOs and/or CTAs — NFA Self-Examination and Attestation
NFA believes that all NFA members should regularly review the adequacy of their supervisory procedures. To satisfy their continuing supervisory responsibilities, NFA members must review their operations yearly using NFA’s Self-Examination Questionnaire, which includes a general questionnaire that must be completed by all NFA members and supplemental questionnaires (i.e., CPO and CTA) that must be completed as applicable.
After reviewing the annual questionnaires, an appropriate supervisory person must sign and date a written attestation stating that he or she has reviewed the NFA member’s operations in light of the matters covered by the questionnaire. A separate attestation must be made for each branch office, and if the branch office reviews its own operations, the main office must receive a copy of the questionnaire’s signed attestation. A branch office is an office of the NFA member other than the main office, not a separate entity affiliated with the NFA member. These attestations should be readily available for the most recent two years and retained for the most recent five years.
Other Annual Reminders for RIAs and ERAs
Other annual obligations, as pertinent, include (nonexclusive list):
Review of Disclosure and Offering Documents. An adviser should review all disclosure documents (including fund offering materials) at least annually to ensure that content and disclosure are accurate, up-to-date and consistent across documents (including filings with the SEC and other regulators) and with the adviser’s compliance policies and procedures. Advertising materials, pitch books and standard due diligence questionnaire responses should also be reviewed.
Annual Personal Securities Holdings Report. On an annual basis, an RIA must collect from each “access person” (by a date specified by the adviser) an annual personal securities holding report containing certain required information regarding securities holdings and all securities accounts. The information must be current as of a date no more than 45 days prior to the date the report is submitted.
Annual Delivery of Privacy Notice. An adviser must provide clients and fund investors who are natural persons with a privacy notice disclosing the adviser’s practices for maintaining privacy of non-public personal information, both at or before the establishment of the customer relationship and annually thereafter. This privacy notice should provide clients and fund investors with the right to “opt out” from the sharing of non-public personal information with unaffiliated third parties, if applicable. An adviser is not required to make an annual distribution of its privacy notice if the adviser (a) only provides non-public personal information to unaffiliated third parties for limited, non-marketing-related purposes and (b) has not changed its policies and practices from those disclosed in the adviser’s most recent privacy notice provided to clients and fund investors.
Annual “Bad Actor” Recertification. Private funds and other issuers are not permitted to rely on the exemption from Securities Act of 1933 (the Securities Act) registration provided by Rule 506 of Regulation D if the pertinent offering involves certain “bad actors.” For continuous or other offerings of long duration, an adviser must update, with reasonable care, its factual inquiries (i.e., by email or questionnaire) to determine whether any covered persons have “disqualifying events,” which may also require disclosure in Form ADV.
Annual Eligibility for “New Issues.” An adviser should verify annually the eligibility of clients and fund investors to participate in new issues of publicly offered securities (i.e., initial public offerings or IPOs) to make sure “restricted persons” are properly identified and their participation is appropriately restricted.
Form D and “Blue Sky” Filings. Form D filings for private funds with ongoing offerings lasting longer than one year must be amended annually, on or before the first anniversary of the initial Form D filing. On an annual basis, an adviser also should review blue sky filings for each state to ensure that any renewal requirements are met.
Distribution of Audited Financials to Private Fund Investors. An adviser relying on the “audit provision” of the Advisers Act Custody Rule with respect to its private fund clients must deliver audited financial statements of each pertinent private fund to fund investors within 120 days of the fund’s fiscal year end (by April 30, 2018, if the fiscal year ends on December 31) or within 180 days of the private fund’s fiscal year end, if the private fund is a fund-of-funds (by June 29, 2018, if the fiscal year ends on December 31).
Annual Affirmation of CFTC Exemptions. Advisers claiming an exemption from registration under CFTC Rules 4.13(a)(1), 4.13(a)(2), 4.13(a)(3) or 4.13(a)(5) or exclusion from the definition of “commodity pool operator” under Regulation 4.5, and CTAs claiming an exemption from CTA registration under Regulation 4.14(a)(8), must affirm the applicable notice of exemption or exclusion within 60 days of each calendar year end — March 1, 2018 — or be deemed to have requested a withdrawal of the applicable exemption or exclusion.
Confirming Affirmation of Investors/Clients Claiming Exemptions. In a January 9, 2018, Notice to Members, NFA noted that persons claiming an exemption from CPO registration under CFTC Rule 4.13(a), an exclusion from CPO registration under CFTC Rule 4.5 or an exemption from CTA registration under CFTC Rule 4.14(a)(8) have until March 1, 2018 to file their annual affirmation of the exemption and that, therefore, it may be difficult for an NFA member to determine whether a CPO or CTA that previously claimed an exemption continues to be eligible for the exemption. Accordingly, NFA indicated that a registered CPO or CTA that takes reasonable steps to determine the registration and membership status of investors/clients claiming an exemption or exclusion under these CFTC rules will not be in violation of NFA Bylaw 1101 or Compliance Rule 2-36(d) if, between January 1 and March 31, 2018, it transacts customer business with a previously exempt person that fails to (a) become registered and a member of NFA, (b) file a notice affirming its exemption from CPO/CTA registration or (c) provide a written representation as to why the person is not required to register or file the notice affirming the exemption.9
BEA and TIC Reporting Requirements for Cross-Border Investments. Investment advisers and other financial institutions may be required to file reports with the U.S. Bureau of Economic Analysis (BEA) for surveys of cross-border “direct investments” (generally, voting interests of 10% or more) by or in U.S. entities, among other things,10 and with the U.S. Treasury Department, for Treasury International Capital (TIC) surveys of cross-border “portfolio investments” (generally, nonvoting interests and voting interests of less than 10%).11
Firms should routinely review the reporting requirements and applicable thresholds and exemptions to determine whether and when they must proactively file reports or claims for exemption with the BEA or the Treasury Department. In addition, firms may be required to submit reports for certain surveys, even if filing thresholds have not been met or exceeded, if contacted by the BEA or the Treasury Department.
Recent developments include a BEA change, in cooperation with the Treasury Department, to its direct investment surveys applicable for investment surveys conducted beginning in 2017. Under these changes, cross-border voting investments of 10% or more in, or by, private funds are subject to BEA reporting only if such investments involve, directly or indirectly, a direct investment in an “operating company,” which the BEA defines as “companies that are not other private funds or holding companies.” The BEA expects that some hedge fund firms that were subject to BEA direct investment reporting as a result of cross-border voting interests are now subject to TIC reporting, to the extent that their total cross-border investments exceed the generally much higher TIC reporting thresholds. Many private equity funds, however, remain subject to BEA direct investment reporting.12
The BEA Form BE-12 benchmark report on foreign direct investment in the United States will be due by May 31, 2018. The BE-12 requires proactive filing with respect to domestic operating entities directly owned by foreign persons. Detailed instructions have not yet been released.
SEC Exam Initiatives and Priorities for 2018
The number of investment advisers examined by OCIE has increased significantly in recent years. The OCIE National Exam Program examined 15% of RIAs during FY 2017, exceeding its target level of 13% for the period and up from 11% in FY 2016.13 Just five years ago, 8% of RIAs were examined.14 In 2016, the SEC reassigned approximately 100 broker-dealer examiners to conduct investment adviser exams.
On February 7, 2018, OCIE released its list of examination priorities for 2018 (Exam Priorities), highlighting certain concerns and risks SEC officials have expressed over the past few years. The Exam Priorities can serve as a roadmap for advisers to assess their policies, procedures and compliance programs; test for and remediate any suspected deficiencies related to the Exam Priorities; and prepare for OCIE exams.
OCIE’s current examination priorities, as outlined in the February 7th release, are organized around five themes: (a) retail investors, including seniors and those saving for retirement; (b) compliance issues and risks associated with entities that provide critical market infrastructure, including clearing agencies, national securities exchanges, transfer agents and Regulation Systems Compliance and Integrity (SCI) entities; (c) SEC oversight of the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB); (d) cybersecurity; and (e) anti-money laundering programs of financial institutions that are required by regulations adopted under the Bank Secrecy Act to establish such programs.
Exams are Risk-Based and Data-Driven
The Exam Priorities make clear that the use of technology and rapidly advancing data analysis is integral to OCIE’s risk-based exam approach. OCIE uses data in such areas as risk assessment; decisions regarding which firms to examine and the scope of exams; and exam planning and execution. For example, OCIE notes, the staff is rapidly advancing in its capacity to use data to analyze regulatory filings and trading activity. Among other things, this has included use of OCIE’s proprietary National Examination Analytics Tool (NEAT), developed by its Quantitative Analytics Unit, to facilitate the analysis of trading blotters. OCIE also uses data analysis to more efficiently analyze information during examinations.
Continued Focus on Retail Investors
In the past, OCIE often focused on investor-related themes, including conflicts of interest, investment adviser fees and expenses, and the adequacy and accuracy of disclosures. The Exam Priorities continue this trend. OCIE states in the release that it will continue “to prioritize protecting retail investors, particularly seniors and those saving for retirement, and pursue examinations of firms that provide products and services directly to them.” OCIE also notes that it will continue to examine RIAs associated with wrap fee programs, reviewing whether advisers are acting in a manner consistent with their fiduciary duty and are meeting their contractual obligations to clients.
OCIE states in the Exam Priorities that it also will focus on firms that have practices or business models that may create increased risks that investors will pay inadequately disclosed fees, expenses or other charges, including private fund advisers that manage funds with a high concentration of investors investing for the benefit of retail clients, such as nonprofit organizations and pension plans.
Other Relevant Focus Areas
Certain of the topics covered in the Exam Priorities are relevant not only to advisers with retail clients but also to advisers that advise other types of clients, including institutional clients and private funds. Focus areas include:
Disclosure of the Costs of Investing. OCIE states in the Exam Priorities that the proper disclosure and calculation of fees, expenses and other charges investors pay is critically important. It is also important for financial professionals to inform investors of any conflicts of interest that might provide incentives for the financial professionals to recommend certain types of products or services to investors, including any higher cost or riskier products. Examiners will review, among other things:
- whether fees and expenses are calculated and charged in accordance with the disclosures provided to clients and investors
- fees charged to advisory accounts, particularly where the fee is dependent on the value of the account, to assess whether assets are valued in accordance with investor agreements, disclosures and the firm’s policies and procedures
- in firms where advisory personnel may receive financial incentives to recommend investments in particular share classes of mutual funds with higher sales loads or distribution fees, whether the conflict of interest is adequately disclosed to investors
Electronic Investment Advice. OCIE will continue to examine investment advisers that offer investment advice through automated or digital platforms, including “robo-advisers” and other firms that interact primarily with clients online. Examinations will focus on the adviser’s compliance program, including the oversight of algorithms that generate recommendations, marketing materials, investor data protection and disclosure of conflicts of interest.
Cryptocurrency, Initial Coin Offerings, Secondary Market Trading and Blockchain. The cryptocurrency and initial coin offerings (ICO) markets have grown rapidly, and the number of investment advisers engaged in this space continues to expand as well. According to the Exam Priorities, OCIE will continue to monitor the sale of these products and, where the products are securities, examine for regulatory compliance. Areas of focus will include whether financial professionals are (a) maintaining adequate controls and safeguards to protect these assets from theft or misappropriation and (b) providing investors with disclosure about the risks associated with these investments, including the risk of investment losses, liquidity risks, price volatility and potential fraud.
Never-Before-Examined Investment Advisers. Once again, included within the goal of protecting retail investors is continued OCIE focus on never-before-examined investment advisers and examination of advisers that have “elevated risk profiles.” Since the implementation in 2012 of adviser registration requirements mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), the examination of both newly registered advisers and advisers that have not been examined in some time continues to be high on the OCIE priority list.
Cybersecurity. OCIE will continue to work with firms in all sectors to identify and manage cybersecurity risks and encourage other market participants to engage in this effort as well. OCIE’s examinations will focus on cybersecurity governance, risk assessment, access rights and controls, data loss prevention, vendor management, training and incident response. Given the attention that the SEC has paid to cybersecurity in speeches, congressional testimony and stated priorities, registrants should expect cybersecurity to be a component of any SEC exam.
Preparing for an SEC Examination
OCIE is examining more advisers than in recent years and using augmented technological resources, so it is crucially important that advisers be prepared for the possibility of an exam, including possibly on short notice.
As noted above, OCIE generally follows a risk-based examination strategy. According to an October 2017 SEC staff report,15 before a private fund adviser examination begins, the staff generally reviews the adviser’s Form ADV and Form PF filings as part of a routine pre-examination evaluation. This review, in combination with other data sources, provides SEC staff with an understanding of the adviser’s current business, operations and investment strategy. The staff has developed automated analyses known as “flag reports” that summarize and combine Form ADV data with key Form PF data about an adviser’s private funds and advisory business. These reports are designed to assist staff in identifying potential reporting errors, compliance issues or other issues of interest (“flags”) for the examination team to consider.
The books and records of all RIAs, including the records of any private funds to which the adviser provides investment advice, are subject to examination. Generally, an adviser being examined is required to provide the SEC with access to all books and records related to its advisory business, whether or not they are required to be kept. ERAs also are subject to SEC examination, although the SEC has indicated that it does not expect to examine ERAs on a routine basis.
Depending on the nature of the examination, OCIE often will contact an adviser in advance and provide a document request list before commencing the examination. Initial document request lists vary depending on the nature and focus of the examination and may be followed by one or more subsequent request lists. The scope of recent exams has varied greatly. In some cases, the scope is relatively narrow, with an emphasis on several higher risk areas. Certain exams are conducted primarily by document submission and review and telephone interviews, sometimes followed by an on-site visit.
Certain proactive steps should be taken to prepare for the contingency of an examination. For example, an adviser should:
- obtain and review sample SEC document request lists to anticipate likely staff requests
- ensure that its disclosure documents (including filings with the SEC and other regulators), compliance policies and procedures and actual business and compliance practices are all consistent
- review results from periodic and annual compliance reviews to make sure that findings have been addressed
- review previous SEC examination findings (if any) to make sure that past deficiencies have been remedied
- consider conducting a mock examination or gap analysis
Most advisers that are examined receive an “exam findings” letter, outlining technical and/or more serious compliance weaknesses or violations. It is critically important that the adviser address all deficiencies, including revisions (as needed) to its compliance program and/or disclosure documents. SEC staff may consider even minor deficiencies, if not corrected, as serious when the next exam occurs, and the staff may take administrative or other enforcement action against such “recidivist” behavior.
Continued SEC Focus on Cybersecurity
Cybersecurity remains one of the SEC’s top focus areas, and OCIE will continue to examine for cybersecurity compliance procedures and controls, including testing the implementation of those procedures and controls at firms.
Observations from OCIE Cybersecurity Examinations
A Risk Alert issued in August 201716 reported on OCIE’s second round of exams of certain broker-dealers, investment advisers and investment companies registered with the SEC to assess industry practices and legal and compliance issues associated with cybersecurity preparedness. This round of exams involved more validation and testing of procedures and controls surrounding cybersecurity preparedness than was previously performed.
In general, the staff observed increased cybersecurity preparedness since OCIE’s first cybersecurity initiative in 2014. However, the staff also observed areas where compliance and oversight could be improved, noting that a majority of the firms’ information protection policies and procedures appeared to have issues. Examples include:
- policies and procedures were not reasonably tailored because they provided employees with only general guidance; identified limited examples of safeguards; were very narrowly scoped; or were vague, as they did not articulate procedures for implementing the policies
- firms did not appear to adhere to or enforce policies and procedures, or the policies and procedures did not reflect the firms’ actual practices
The staff also observed Regulation S-P-related issues among firms that did not appear to adequately conduct system maintenance, such as the installation of software patches to address security vulnerabilities and other operational safeguards to protect customer records and information.
Cyber Unit Created in Division of Enforcement
In September 2017, the SEC announced the creation of a Cyber Unit in the SEC’s Enforcement Division to target, for example, (a) market manipulation schemes involving false information spread through electronic and social media, (b) violations regarding ledger technology and initial coin offerings, (c) misconduct perpetrated using the dark web, (d) intrusions into retail brokerage accounts and (e) cyber-related threats to trading platforms and other critical market infrastructure.17 Creation of the Cyber Unit is part of an effort to create a cybersecurity working group to coordinate information sharing, risk monitoring and incident response efforts throughout the SEC.
According to Stephanie Avakian, Co-Director of the Enforcement Division,18 the Division sees its potential enforcement interest in cyber-related issues as falling generally into three types of cases:
- cases where cyber-related misconduct is used to gain some sort of unlawful market advantage
- cases involving failures by registered entities to take appropriate steps to safeguard information or ensure system integrity and
- cases where there may be a cyber-related disclosure failure by a public company
With respect to the second type, Avakian noted that the SEC has adopted rules — such as Regulations S-P, S-ID and SCI —that require registered entities to have reasonable safeguards in place to address cybersecurity threats. These rules are risk-based and flexible, she stated, and require firms to understand the risks they face and take reasonable steps to address those risks.
Avakian also noted that included within the responsibility of the Cyber Unit is the SEC’s focus on the emerging issues presented by blockchain technology, which can be an “attractive vehicle” for fraudulent conduct. On December 4, 2017, the Cyber Unit announced its first charges,19 filing a complaint in federal court alleging violations of the antifraud provisions and the registration provision of the federal securities laws. In connection with the charges, the SEC obtained an emergency asset freeze to halt an ICO that raised money from investors by falsely promoting a 13-fold profit in less than a month.
Custody Rule Developments
Common Deficiencies Found in OCIE Exams
The February 2017 Risk Alert20 included the Custody Rule as one of the five most frequent compliance topics identified in OCIE adviser exams. Typical examples of deficiencies or weaknesses identified with respect to the Custody Rule included:
- Advisers did not recognize that they may have custody as a result of certain authority over client accounts or due to online access to client accounts.
- Advisers with custody obtained surprise examinations that did not meet the requirements of the Custody Rule. Certain advisers, for example, did not provide independent public accountants performing surprise exams with a complete list of accounts over which the adviser has custody. The staff also observed indications that surprise examinations may not have been conducted on a surprise basis.
SEC Custody Rule Guidance
In February 2017, the SEC’s Division of Investment Management released guidance in three parts — an update to the SEC’s FAQs about the Custody Rule, a no-action letter response and a Guidance Update — to address an RIA’s obligations under the Custody Rule where the RIA has authority to transfer client assets from a client’s custodial account, as follows:
- To the client’s own account(s) with the same or different custodian(s). Updated Custody Rule FAQ II.4 clarifies that an RIA’s authority regarding such transfers will not establish custody if (a) the client provides a written and signed authorization to effect such transfers and (b) a copy of the authorization, specifying certain details regarding the client’s account(s) (except where the transfer involves accounts at a single custodian or at related custodians and both custodians already have access to this information) is provided to the sending custodian(s).21
- To a third party based on a standing letter of instruction or similar authorization (SLOA) from a client to its custodian. The no-action letter response clarifies that (a) an RIA’s authority under a SLOA to transfer assets to a third party for any purpose other than authorized trading constitutes “custody,” but (b) the SEC staff would not recommend enforcement if the RIA did not obtain a surprise examination, provided the arrangement meets certain conditions.22
- Based on broad authority indicated in the client’s agreement with its custodian to which the RIA is not a party (“inadvertent custody”). The Guidance Update states that a custodial agreement between a client and its custodian that permits the custodian to accept instructions from an RIA to transfer assets from the custodial account for any purpose other than authorized trading establishes the RIA’s custody of such assets. The staff suggested that a separate and clear written understanding between the RIA and the custodian limiting the RIA’s authority to “delivery versus payment” trading is one way an RIA could avert this result.23
The Guidance Update regarding inadvertent custody has been widely criticized within the industry as unworkable, since where an RIA has no contractual relationship with the custodian, the custodian has little incentive to accept or acknowledge the RIA’s limitations on its own authority. Adviser industry groups have engaged the SEC staff in extensive discussions regarding this issue and understand that the staff may be seeking another approach.
Other Recent Regulatory Developments and Guidance That May Affect an Adviser’s Compliance Program
The following selected regulatory developments may affect the compliance programs of certain advisers. Advisers should review these and other changes in applicable laws, rules, regulations and/or SEC staff guidance to determine whether compliance policies and procedures need to be added or revised.
Recordkeeping Rule Amendments
Amendments to Advisers Act Rule 204-2 (the Books and Records Rule) that the SEC adopted in August 2016 became effective as of October 1, 2017, requiring RIAs to maintain additional documentation related to the calculation and distribution of performance information. In accordance with the amended rule, any adviser subject to the rule that distributes performance-related communications after October 1, 2017 must maintain additional records as follows:
- Rule 204-2 historically required advisers subject to the rule to maintain records supporting performance claims in communications that were distributed or circulated to 10 or more persons. The amendments remove the “10 or more persons” condition, requiring advisers to retain the required materials demonstrating the calculation of the performance or rate of return in any communication that is circulated or distributed, directly or indirectly, to any person.
- Rule 204-2 historically required advisers subject to the rule to maintain certain categories of written communications received and copies of written communications sent. The amendments add a new category of communications that must be maintained — i.e., originals of all written communications received and copies of written communications sent by the adviser relating to the performance or rate of return of any or all managed accounts or securities recommendations. The release noted that the SEC staff believes most advisers currently maintain this information.
These changes require an adviser subject to the Books and Records Rule that circulates or distributes any communication after October 1, 2017, that includes performance information generated prior to that date to maintain the materials listed in the Books and Records Rule that are necessary to form the basis for, or demonstrate the calculation of, such prior performance or rate of return.
Advertising Rule Guidance
A Risk Alert issued in September 201724 highlights the topic areas related to Advisers Act Rule 206(4)-1 (the Advertising Rule) most frequently associated with deficiencies identified in OCIE examinations of RIAs. The topic areas include misleading performance results; misleading one-on-one presentations; misleading claims of compliance with voluntary performance results, such as Global Investment Performance Standards (GIPS®); cherry-picked profitable stock selections; misleading selection of recommendations; and failure to implement compliance policies and procedures in connection with advertising practices and materials.
Documenting Participating Affiliate Arrangements
An Information Update issued in March 201725 addressed how multinational advisory firms can document their reliance on a series of no-action letters dating back to the 1990s, often referred to as the Unibanco letters (the Letters). In the Letters, the staff agreed not to recommend enforcement action to the SEC if a non-U.S. advisory affiliate of an RIA (a “participating affiliate”) shares personnel with, and provides certain services to U.S. clients through, the RIA without the participating affiliate registering under the Advisers Act, subject to certain conditions.While the Information Update did not alter nor add to the requirements set forth in the Letters, the staff noted that it periodically receives questions regarding what information, if any, should be submitted to the SEC in connection with participating affiliate arrangements.
In the Information Update, the staff summarized the types of documentation it generally believes address most clearly the concerns raised in the Letters regarding the staff’s ability to monitor the conduct of participating affiliates. The Information Update did not specifically require advisers relying on the Letters to submit the documentation to the SEC. However, a note at the end of the Information Update indicating that the information can be submitted to the staff by e-mail suggests that the staff expects advisers to do so. In any case, the Information Update provides useful clarity regarding staff expectations for the documentation of participating affiliate arrangements.
Recent Enforcement Initiatives and Proceedings
In September 2017, the SEC announced the establishment of a Retail Strategy Task Force,26 which will leverage data analytics and technology to identify large-scale misconduct affecting retail investors. The task force will include SEC Enforcement Division personnel from around the country and will work with staff across the SEC, including from the National Exam Program and the Office of Investor Education and Advocacy.
The Enforcement Division issued a report in November 201727 highlighting its priorities for the coming year and quoting SEC Chairman Jay Clayton’s statement that the SEC’s mission “starts and ends with the long-term interests of the Main Street investor.” However, the report also included a message from the Enforcement Division’s Co-Directors, who stated that “[a]s we enhance our focus on retail investors, we will continue to vigorously pursue cases against financial institutions and intermediaries.We do not face a binary choice between protecting Main Street and policing Wall Street.”
The following is a summary of a number of recent enforcement actions of relevance to investment advisers.
Improper Allocation of Fees and Expenses
Unauthorized and Undisclosed Use of Fund Assets. The SEC settled an enforcement action involving the improper allocation by an RIA of fees and expenses to two private equity fund clients.28 The SEC found that the adviser:
- improperly used the assets of a fund client to pay for services provided by the adviser’s affiliates to a portfolio company of the fund. The adviser was not authorized to charge these fees to the fund and failed to disclose this use of fund assets to the fund’s investors. After the portfolio company subsequently reimbursed the cost of the fees, the adviser failed to offset the portfolio company fees against the management fees it charged to the fund as required by the fund’s limited partnership agreement.
- improperly used the funds’ assets to pay for adviser-related expenses, including to compensate a member of the adviser’s investment team, pay rent and other expenses and pay costs associated with the adviser’s regulatory obligations. The use of the funds’ assets in this manner was neither authorized by nor disclosed in the funds’ governing documents. The funds’ audited financial statements also failed to disclose these payments as related party transactions. According to the SEC’s order, because the audited financial statements did not reflect the related party relationships and material transactions, they were not prepared in accordance with Generally Accepted Accounting Principles. As a result, the adviser, which had custody of client assets, was unable to rely on the “audit provision” as a means of complying with the Custody Rule.
- failed to adopt and implement policies and procedures regarding the allocation of portfolio company fees and certain adviser-related expenses between the adviser and the funds, in violation of the Compliance Rule.
Broken Deal Expenses. The SEC settled an enforcement action alleging improper allocation of broken deal expenses by an RIA that manages private equity funds.29 During the pertinent period, related persons of the RIA co-invested in each consummated portfolio company through separate co-investment vehicles that the RIA managed. According to the SEC’s order, the RIA allocated all broken deal expenses to the funds without adequately disclosing to fund investors that the funds would pay the broken deal expenses for the portion of each investment that would have been allocated to the co-investors. The SEC also found that the adviser failed to adopt and implement written compliance policies or procedures governing its expense allocation practices, in violation of the Compliance Rule.
“Cherry-Picking” Profitable Trades for Personal Accounts
The SEC settled charges against two investment advisers for allegedly engaging in separate fraudulent trade allocation schemes.30 Through data analysis, the SEC found that the principals of the two firms each cherry-picked profitable trades for their personal accounts to the detriment of client accounts. The SEC’s orders arose from an enforcement initiative to combat cherry-picking led by the SEC’s Los Angeles Regional Office and supported by the SEC’s Division of Economic and Risk Analysis. According to an Administrative Summary, the SEC’s analysis showed that for a certain time there was (a) less than a one-in-a-trillion chance that the outsized performance of the personal account of one of the advisers, compared to that of his clients’ accounts, was due to chance and (b) less than a one-in-a-billion chance that the difference between the return of the other adviser’s account and those of his clients was due to chance.
Failure to Implement Adequate Policies and Procedures to Prevent the Misuse of MNPI
In a settled administrative proceeding,31 the SEC found that an RIA violated Section 204A of the Advisers Act by failing to “establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such investment adviser’s business, to prevent the misuse … of material non-public information (MNPI).” On behalf of its advisory clients, the adviser engaged in extensive research regarding the healthcare industry. These efforts encompassed hiring third-party experts, expert networks and research firms, including research firms that specialized in providing “political intelligence” regarding upcoming regulatory and legislative decisions.
According to the SEC’s order, the adviser had no procedures that required (a) a research firm to undergo due diligence to evaluate its compliance controls, (b) the adviser's employee consulting with the research firm to provide an oral reminder to the firm’s personnel not to disclose MNPI or (c) the employee to enter a report of the discussion into the adviser’s database for retaining and organizing investment research.With respect to information received from research firms, the adviser’s employees were basically responsible for policing themselves, identifying their potential receipt of MNPI and raising concerns with their superiors. The SEC found that the adviser failed to detect or act upon “red flags” signaling the possible receipt and/or improper use of MNPI, and certain communications that contained MNPI resulted in trading by the adviser.
Adviser Not Entitled to Rely on Exemption from SEC Registration; Custody Rule and Compliance Rule Violations
The SEC settled an enforcement action involving multiple charges that reflect several current SEC compliance concerns.32 The proceeding involved an RIA (the Registered Adviser) that advises individuals, an affiliated adviser that claimed to be exempt from registration (the Affiliated Adviser) and the principal of both firms (collectively, the Respondents).
- The Affiliated Adviser advised two private funds with regulatory assets under management of less than $150 million and filed with the SEC as an ERA relying on the private fund adviser exemption. The SEC found that the Affiliated Adviser was not entitled to rely on the exemption because the two advisers were under common control and operationally integrated, sharing the same principal office and place of business and the same technology systems. According to the SEC’s order, the principal formed the Affiliated Adviser because he thought that the Affiliated Adviser, as an ERA, could advise private funds without incurring the expense of complying with certain Advisers Act rules, including the Custody Rule. However, the SEC found that the Affiliated Adviser was required to be registered with the SEC and to comply with all pertinent Advisers Act rules.
- The SEC found that both advisers failed to comply with the Custody Rule. The Registered Adviser had custody of certain clients’ assets, and some of those assets were not maintained by a qualified custodian. The Registered Adviser had access to certain clients’ log-in and password information related to client accounts, providing the Registered Adviser with the ability to make withdrawals or transfer assets in those accounts. Despite having custody of those client assets, the Registered Adviser did not obtain surprise exams during the pertinent period. The SEC also found that the Affiliated Adviser had custody of fund assets but did not subject the funds to an annual audit or obtain a surprise exam.
- The SEC found that as an investment adviser required to be registered with the SEC, the Affiliated Adviser was required to adopt a compliance program in accordance with the Compliance Rule but failed to adopt such policies and procedures. The Registered Adviser had a compliance manual, but had adopted an off-the-shelf manual that was not tailored to the type of business that it conducted. In addition, the Registered Adviser failed to conduct an annual review of the adequacy and effectiveness of its compliance policies and procedures.
- The SEC also found that the Respondents improperly used fund assets to pay legal fees that the Respondents incurred in connection with the SEC’s investigation. Such use of fund assets was not authorized by the pertinent fund’s operating agreement.
Failure to Properly Oversee Third-Party Pricing Vendor
The SEC settled charges that an RIA materially misstated the value of assets in five private funds, resulting in the funds’ paying excessive management fees and incorrectly calculating redemptions from the funds.33 The adviser used a third-party pricing service to value municipal bonds held in the funds. However, during the pertinent period, the methodology used by the pricing service violated the adviser’s own valuation policy and disclosure documents. According to the SEC’s order, (a) by almost exclusively using values provided by the pricing service and not using substantial available observable inputs, the adviser failed to follow its own valuation policy and (b) the adviser continued to rely on the pricing service values even when there existed relevant observable and unobservable inputs indicative of fair value. The proceeding illustrates the critical importance of initial and ongoing due diligence with respect to service providers to ensure that their practices are consistent with the adviser’s own policies and procedures and disclosure to investors.
Improper Share Class Selection
The SEC continues to scrutinize adviser selection of share classes and Rule 12b-1 fees. The SEC recently settled charges with two advisory firms alleging that the firms improperly invested clients in more expensive Class A shares of mutual funds rather than less expensive institutional shares for which the clients were eligible.34 The proceedings arose out of alleged breaches of fiduciary duty, inadequate disclosures and compliance deficiencies and follow a series of similar cases previously brought by the SEC in connection with its focus on alleged share class abuses.
Form PF Reporting Requirements
Most RIAs that advise private funds are required to file Form PF on either a quarterly or an annual basis; advisers that are exempt from SEC registration, including ERAs, are not required to file Form PF. Form PF, which is a joint form between the SEC and the CFTC with respect to Sections 1 and 2 of the form, is filed with the SEC via the Private Fund Reporting Depository (PFRD) electronic filing system and is not publicly available.
Given the volume and complexity of the work involved, many private fund advisers face a number of challenges in preparing Form PF, including making decisions regarding (and documenting) assumptions and methodologies, due to the ambiguous or subjective nature of a number of Form PF’s instructions, definitions and questions. The SEC staff has provided assistance with respect to these issues and other Form PF questions, both directly in response to private inquiries and in FAQs posted (and periodically updated) on the SEC’s website.35
Who Must File
An RIA is required to file Form PF if it (a) advises one or more private funds and (b) collectively, with related persons (other than related persons that are separately operated), had RAUM of $150 million or more (calculated in accordance with Form PF aggregation requirements) attributable to private funds as of the end of its most recently completed fiscal year.
CFTC-registered CPOs that are dually registered with the SEC and are required to file Form PF must submit information with respect to each advised commodity pool that also is a private fund. Because commodity pools are considered hedge funds for purposes of Form PF, the filing adviser must complete the sections of the form applicable to hedge funds for each commodity pool reported on Form PF. For a dual registrant, filing Form PF can serve to satisfy certain CFTC Form CPO-PQR reporting requirements. Dual registrants also have the option of using Form PF to satisfy certain CFTC reporting requirements with respect to commodity pools that are not private funds in lieu of completing certain sections of Form CPO-PQR.36
To avoid duplicative reporting, Form PF information regarding subadvised funds should be reported by only one adviser. The adviser that completes information in Form ADV Schedule D Section 7.B.1 with respect to any private fund is also required to report that fund on Form PF. If, however, the adviser reporting the private fund on Form ADV in Section 7.B.1 is not required to file Form PF (i.e., because it is an ERA), then another adviser, if any, to the fund, if required to file Form PF, must report the fund on Form PF.
Determining an Adviser’s Filing Category
The scope of required Form PF disclosure, the frequency of reporting and filing deadlines differ based on the RAUM of the adviser attributable to different types of private funds (in particular, hedge funds, liquidity funds and private equity funds). Accurately determining an adviser’s filing category is a critical first step. Specific definitions of fund types are provided in the Form ADV Part 1A Instructions and the Form PF: Glossary of Terms.
The RAUM thresholds applicable to different categories of Form PF filers are summarized in the chart below. An adviser meeting only the minimum $150 million private fund RAUM reporting threshold, as well as a large private equity fund adviser, must file Form PF annually within 120 days of its fiscal year end. A large liquidity fund adviser or large hedge fund adviser must file quarterly, within 15 days (for large liquidity fund advisers) and 60 days (for large hedge fund advisers) of its fiscal quarter end.
Advisers are required to follow certain aggregation instructions for purposes of determining whether they meet the de minimis $150 million private fund asset threshold for reporting on Form PF as well as the pertinent large private fund adviser thresholds. Aggregation also is required for large hedge fund advisers to determine whether any hedge fund is a “qualifying hedge fund” subject to additional reporting requirements. The aggregation instructions (and, conversely, certain netting instructions for fund-of-funds advisers and others whose funds invest in other private funds) may raise challenging interpretive issues for many advisers.
Frequency of Reporting and Filing Deadlines
The reporting frequency and upcoming filing deadlines for different categories of Form PF reporting advisers are summarized below. The filing deadlines set forth in the following table are for advisers with a December 31 fiscal year end.
|Large Hedge Fund Adviser||Large Liquidity Fund Adviser||Large Private Equity Fund Adviser||Smaller Private Fund Adviser|
|RAUM Threshold||$1.5 billion or more attributable to hedge funds as of the end of any month during the preceding fiscal quarter||$1.0 billion or more in combined liquidity fund and registered money market fund assets as of the end of any month during the preceding fiscal quarter||$2.0 billion or more attributable to private equity fund assets as of the end of the most recent fiscal year||$150 million or more (but less than the applicable “large” adviser threshold) attributable to private funds as of the end of the most recent fiscal year|
|Reporting Deadline*||60 days from end of fiscal quarter||15 days from end of fiscal quarter||120 days from fiscal year end||120 days from fiscal year end|
|Applicable Form PF Sections||Sections 1 and 2||Sections 1 and 3||Sections 1 and 4||Sections 1|
|Upcoming Filing Deadline||March 1, 2018
(for fourth quarter 2017)
|April 16, 2018
(for first quarter 2018)
|April 30, 2018
|April 30, 2018
*If the filing due date falls on a holiday, a weekend or a day when the PFRD system is closed, the Form PF filing will be considered timely filed with the SEC if filed no later than the following business day.
How the SEC Staff Uses Form PF Data
While the primary aim of Form PF was to create a source of data for the Financial Stability Oversight Council’s assessment of systemic risk, the SEC also is using the data to support its own regulatory programs, including examinations, investigations and investor protection efforts. As noted above, the OCIE staff generally reviews an adviser’s Form PF filing as a part of its pre-exam evaluation and reviews information contained in the filing for inconsistencies with other information obtained during an exam, such as due diligence reports, pitch books, offering documents, operating agreements and books and records. In addition, the OCIE staff typically looks for discrepancies between an adviser’s Form PF filing and any publicly available documents related to the adviser, including the adviser’s Form ADV Part 1A and its Part 2A brochure. Division of Enforcement staff also obtains and reviews Form PF filings in connection with ongoing adviser investigations.
A recent SEC staff report describes a number of ways the staff is using Form PF data to identify and monitor private fund industry trends, identify emerging compliance risk areas, inform policymaking and prioritize the use of exam and enforcement resources.37 According to the report, for example:
- The staff has developed a variety of analytical tools that combine Form PF data with other SEC databases to support the SEC’s monitoring and analytical activities.
- The staff’s analyses of Form PF data include risk-based analysis and monitoring initiatives that facilitate staff efforts to allocate limited exam resources efficiently in setting objectives and priorities for examinations of private fund advisers. For example, the staff uses Form PF data to identify as potential examination candidates those private fund advisers whose activities involve areas of specific examination focus or that may present heightened compliance risks.
- “Flag reports,” which can be rapidly and automatically generated using internally developed code and metrics, expedite the staff’s preparation for and conduct of exams by summarizing key information from Form PF and identifying potential reporting errors, compliance issues and other issues of interest.
It recently has been reported that the SEC has been identifying and making inquiries of certain private fund advisers with RAUM of $150 million or more that have not filed a Form PF.
Reporting Requirements for Certain Investment Advisers on CFTC and NFA Form CPO-PQR and/or Form CTA-PR
Many advisers to privately offered funds and registered investment companies are required to register as CPOs and/or CTAs with the CFTC with respect to certain commodity pools that they advise and to become members of the NFA. CFTC-registered CPOs and CTAs must report certain information on CFTC and NFA Form CPO-PQR (also referred to herein as CFTC Form PQR and NFA Form PQR, as applicable) and Form CTA-PR and NFA PR, respectively. The forms must be filed electronically using the NFA’s EasyFile System.
CFTC and NFA Reporting Requirements on Form CPO-PQR
The scope of required disclosure, the frequency of reporting and whether a given Form CPO-PQR filing is required by the CFTC and/or NFA is determined generally by the CPO’s aggregated gross pool assets under management (Gross AUM). As in the case of Form PF, Form CPO-PQR filers are required to follow certain aggregation instructions for purposes of determining the applicable filing category. The CFTC’s Division of Swap Dealer and Intermediary Oversight has posted FAQs regarding Form CPO-PQR, while the NFA has posted FAQs regarding Form PQR.38
Based on the information that the CPO enters on the cover page of Form CPO-PQR, all subsequent screens of the form will be dynamically generated to present only required schedules.39
As noted above, advisers that are dually registered with the SEC and the CFTC can satisfy certain CFTC Form PQR filing requirements by filing Form PF.40 For example, a large CPO that is a quarterly Form PF filer can file Form PF Sections 1 and/or 2 in lieu of CFTC Form PQR Schedules B and C. Each of these filings is due within 60 days of quarter end. Similarly, a mid-size CPO that is an annual Form PF filer can file Form PF Sections 1.b and 1.c in lieu of CFTC Form PQR Schedule B. A dual registrant is required only to submit Schedule A of CFTC Form PQR annually; however, a dual registrant will still be subject to quarterly NFA reporting requirements pursuant to NFA Form PQR. Note, however, that whereas a mid-size CPO must meet its CFTC Form PQR reporting obligation within 90 days of calendar year end, the filing deadline for an annual Form PF filer is 120 days from fiscal year end. Hence, a mid-size CPO that wishes to meet a portion of its CFTC reporting requirements through Form PF may need to file its Form PF within 90 days (rather than 120 days) of its year end (assuming a calendar year fiscal year).
With respect to co-CPOs, the CPO with the greater Gross AUM is required to report for the pool. If a pool is operated by co-CPOs and one of the CPOs is also a dual registrant that files Form PF Sections 1 and/or 2 (and thus is only required to file CFTC Form PQR Schedule A), the non-investment adviser CPO must nevertheless file the applicable sections of CFTC Form PQR.
Each CPO that is an NFA member must file NFA Form PQR quarterly within 60 days of the quarters ending in March, June and September and a year-end report within 60 or 90 days (depending on the size of the CPO) of the calendar year end. Large CPOs that file the required CFTC Form PQR schedules quarterly satisfy their NFA Form PQR filing requirements through filing CFTC Form PQR.41
CPOs that file Form PF with the SEC in lieu of certain portions of CFTC Form PQR are required to file NFA Form PQR with the NFA quarterly within 60 days of the quarter end, except for the December 31 quarter, when the filing will be due within 90 days.42
CFTC Form PQR and NFA Form PQR filing requirements are summarized in the following chart.
|Gross AUM Threshold|
|Filing Requirements||Large CPO*
||CPO That Files Form PF in Lieu of CFTC Form PQR Schedules B and C
||CFTC Form PQR Schedules A, B, C# (within 60 days of quarter end)##
||NFA Form PQR (within 60 days of quarter end)
||NFA Form PQR (within 60 days of quarter end)||NFA Form PQR (within 60 days of quarter end)|
||CFTC Form PQR Schedules A, B, C# (within 60 days of quarter end)##||NFA Form PQR (within 60 days of quarter end)||NFA Form PQR (within 60 days of quarter end)||NFA Form PQR (within 60 days of quarter end)|
||CFTC Form PQR Schedules A, B, C# (within 60 days of quarter end)##||NFA Form PQR (within 60 days of quarter end)||NFA Form PQR (within 60 days of quarter end)||NFA Form PQR (within 60 days of quarter end)|
||CFTC Form PQR Schedules A, B, C# (within 60 days of quarter end)##||CFTC Form PQR Schedules A, B (within 90 days of calendar year end)##||CFTC Form PQR Schedule A + NFA Form PQR (within 90 days of calendar year end)||CFTC Form PQR Schedule A + NFA Form PQR (within 60 or 90 days, depending on the size of the CPO)|
* $1.5 billion or more attributable to aggregated pools as of the close of business on any day during the most recent calendar quarter.
** $150 million or more (but less than the applicable “large” CPO threshold) attributable to aggregated pools as of the close of business on any day during the most recent calendar year.
*** Less than $150 million attributable to aggregated pools as of the close of business on each day during the most recent calendar year.
# Schedule C Part 2 is only applicable to any pool that has a net asset value individually, or in combination with any parallel pool structure, of at least $500 million.
## Satisfies the NFA filing requirement.
Each registered CTA is required to file an annual Form CTA-PR with the CFTC within 45 days of the calendar year end and a quarterly NFA Form CTA-PR within 45 days of the calendar quarter end.43 The same form is used for both the CFTC and the NFA filings. All Form CTA-PR filings are made through the NFA’s EasyFile System. The CFTC and the NFA have posted FAQs regarding Form CTA-PR.44
1 This Sidley Update does not address non-U.S. regulatory developments. For example, on January 3, 2018, the second EU Markets in Financial Instruments Directive and the Markets in Financial Instruments Regulation (together “MiFID II”) came into effect across the EU. MiFID II reforms the way in which EU markets and their participants operate. Non-EU investment advisers, even if they do not have any direct EU presence, should consider the direct and indirect obligations and resulting changes to their compliance programs based on the MiFID II framework. Non-EU investment advisers already may have received new documentation from their brokers and requests for information from distribution partners as a result of changes introduced by MiFID II. See Sidley Austin LLP, Sidley Update, “MiFID II – Implications for EU and Non-EU Investment Managers” (May 5, 2017), https://www.sidley.com/en/insights/newsupdates/2017/05/mifid-ii. In addition, the EU PRIIPs Regulation (on Packaged Retail and Insurance-based Investment Products) came into effect on January 1, 2018. The PRIIPs Regulation introduces an EU-wide regime for the promotion of investment products to retail investors in the EU. Non-EU investment advisers may fall within the scope of the PRIIPs Regulation if they allow their products to be made available to retail investors (even if as a result of a “reverse solicitation”). The principal requirement under the PRIIPs Regulation is to publish a “key information document” (KID) for retail investors. Non-EU investment advisers should consider whether the time and costs associated with producing a KID make it unviable to promote their investment products to retail investors in the EU. If so, such firms should take steps to ensure that their products are not distributed to retail investors. See Sidley Austin LLP, Sidley Update, “EU PRIIPs Regulation – Impact on EU and Non-EU Fund Managers” (November 27, 2017), https://www.sidley.com/en/insights/newsupdates/2017/11/eu-priips-regulation.
2 See Sidley Austin LLP, Sidley Update, “SEC Adopts Form ADV Amendments to Require Reporting on Separately Managed Accounts and Clarify ‘Umbrella’ Registration” (September 9, 2016), http://www.sidley.com/en/news/2016-09-09-investment-funds-update.
3 Form ADV: General Instructions, http://www.sec.gov/about/forms/formadv-instructions.pdf.
4 Form ADV: Instructions for Part 1A, http://www.sec.gov/about/forms/formadv-instructions.pdf.
5 See Form PF: General Instructions, https://www.sec.gov/about/forms/formpf.pdf. A private fund must have an identification number for both Form ADV and Form PF reporting. The instructions state, “If you need to obtain a private fund identification number [obtained by filing Form ADV] and you are required to file a quarterly update of Form PF prior to your next annual update of Form ADV, then you must acquire the identification number by filing an other-than-annual amendment to your Form ADV …. [and] must complete and file all of Form ADV Section 7.B.1 for the new private fund.”
6 An ERA based outside of the United States will lose the exemption if it (i) manages private fund assets of U.S. $150 million or more at a place of business in the United States; (ii) advises a U.S. client other than a private fund (e.g., a managed account for a U.S. institution or pension plan); or (iii) manages any non-private-fund assets at a place of business in the United States. For purposes of this exemption, a single investor fund or “fund of one” generally will be deemed to be a managed account.
7 In the adopting release for Rule 206(4)-7, “Compliance Programs of Investment Companies and Investment Advisers,” IA-2204 (December 17, 2003), the SEC staff stated that an adviser’s policies and procedures, at a minimum, should address the following issues to the extent they are relevant: portfolio management processes; trading practices; proprietary and personal trading; accuracy of disclosures; safeguarding of client assets; recordkeeping; marketing advisory services; valuation; privacy; and business continuity plans.
8 National Exam Program Risk Alert, “The Five Most Frequent Compliance Topics Identified in OCIE Examinations of Investment Advisers” (February 7, 2017), https://www.sec.gov/ocie/Article/risk-alert-5-most-frequent-ia-compliance-topics.pdf.
9 NFA Notice I-18-01, “Member obligations under NFA Bylaw 1101 and Compliance Rule 2-36(d) with respect to CPOs/CTAs exempt from registration” (January 9, 2018), https://www.nfa.futures.org/news/newsNotice.asp?ArticleID=4979.
10 These include both surveys of foreign direct investment in the United States such as BE-13, BE-605, BE-12 and BE-15, and surveys of U.S. direct investment abroad, such as BE-577, BE-10 and BE-11.
11 These TIC surveys include the TIC Form S, TIC Form SLT, and for 2017, the TIC Form SHC.
12 Further information on these changes is available on the BEA website. See also Sidley Austin LLP, Sidley Update, “BEA Implements Changes to Direct Investment Survey Reporting Requirements for Certain Private Funds” (January 10, 2017), http://www.sidley.com/en/news/2017-01-10-investment-funds-update.
13 SEC, Agency Financial Report, Fiscal Year 2017 (November 13, 2017), https://www.sec.gov/files/sec-2017-agency-financial-report.pdf.
14 SEC, Office of Compliance Inspections and Examinations, 2018 National Exam Program Examination Priorities (February 7, 2018), https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2018.pdf.
15 SEC Annual Staff Report Relating to the Use of Form PF Data (October 16, 2017), https://www.sec.gov/files/im-private-fund-annual-report-101617.pdf.
16 SEC National Exam Program Risk Alert, “Observations From Cybersecurity Examinations” (August 7, 2017), https://www.sec.gov/files/observations-from-cybersecurity-examinations.pdf.
17 SEC Press Release, 2017-176, “SEC Announces Enforcement Initiatives to Combat Cyber-Based Threats and Protect Retail Investors” (September 25, 2017), https://www.sec.gov/news/press-release/2017-176.
18 Speech, Stephanie Avakian, Co-Director, SEC Division of Enforcement, “The SEC Enforcement Division’s Initiatives Regarding Retail Investor Protection and Cybersecurity” (October 26, 2017), https://www.sec.gov/news/speech/speech-avakian-2017-10-26.
19 SEC Press Release 2017-219, “SEC Emergency Action Halts ICO Scam” (December 4, 2017), https://www.sec.gov/news/press-release/2017-219.
20 See Note 8 above.
21 SEC Division of Investment Management, “Staff Responses to Questions About the Custody Rule,” Question II.4 (modified February 21, 2017), https://www.sec.gov/divisions/investment/custody_faq_030510.htm.
22 Investment Adviser Association, SEC Staff No-Action Letter (February 21, 2017), https://www.sec.gov/divisions/investment/noaction/2017/investment-adviser-association-022117-206-4.htm.
23 SEC Division of Investment Management, IM Guidance Update: “Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority,” No. 2017-01 (February 2017), https://www.sec.gov/investment/im-guidance-2017-01.pdf.
24 SEC National Exam Program Risk Alert, “The Most Frequent Advertising Rule Compliance Issues Identified in OCIE Examinations of Investment Advisers” (September 14, 2017), https://www.sec.gov/ocie/Article/risk-alert-advertising.pdf.
25 SEC Division of Investment Management, IM Information Update: “Information Update for Advisers Relying on the Unibanco No-Action Letters,” No. 2017-03 (March 2017), https://www.sec.gov/investment/im-info-2017-03.pdf.
26 SEC Press Release, 2017-176, “SEC Announces Enforcement Initiatives to Combat Cyber-Based Threats and Protect Retail Investors” (September 25, 2017), https://www.sec.gov/news/press-release/2017-176.
27 SEC Division of Enforcement, “Annual Report: A Look Back at Fiscal Year 2017” (November 15, 2017), https://www.sec.gov/files/enforcement-annual-report-2017.pdf.
28 SEC Administrative Proceeding File No. 3-18168 (September 11, 2017), https://www.sec.gov/litigation/admin/2017/ia-4766.pdf.
29 SEC Administrative Proceeding File No. 3-18194 (September 21, 2017), https://www.sec.gov/litigation/admin/2017/ia-4772.pdf.
30 SEC Administrative Proceeding Files No. 3-18171 and 3-18172, Administrative Summary (September 12, 2017), https://www.sec.gov/litigation/admin/2017/34-81584-s.pdf.
31 SEC Administrative Proceeding File No. 3-18120 (August 21, 2017), https://www.sec.gov/litigation/admin/2017/ia-4749.pdf.
32 SEC Administrative Proceeding File No. 3-18073 (July 25, 2017), https://www.sec.gov/litigation/admin/2017/ia-4733.pdf.
33 SEC Administrative Proceeding File No. 3-17891 (March 29, 2017), https://www.sec.gov/litigation/admin/2017/ia-4672.pdf.
34 SEC Administrative Proceeding File No. 3-18164 (September 8, 2017), https://www.sec.gov/litigation/admin/2017/ia-4764.pdf; SEC Administrative Proceeding File No. 3-18178 (September 14, 2017), https://www.sec.gov/litigation/admin/2017/34-81611.pdf.
35 See Form PF Frequently Asked Questions, http://www.sec.gov/divisions/investment/pfrd/pfrdfaq.shtml (most recently updated on January 18, 2017). FINRA, as administrator for the PFRD filing system, also posts information to assist Form PF filers, including PFRD System Frequently Asked Questions, http://www.iard.com/pfrd/pdf/PFRD_System_FAQs.pdf (most recently updated on March 18, 2017).
36 Regardless of any reporting on Form PF, however, all registered CPOs and CTAs are required to file at least Schedule A of CFTC Form PQR and Form CTA-PR, as applicable, and comply with the requirements of NFA Form PQR.
37 See Note 15 above.
38 See CFTC, “CFTC Division of Swap Dealer and Intermediary Oversight Responds to Frequently Asked Questions Regarding Commission Form CPO-PQR” (November 5, 2015), http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/faq_cpocta110515.pdf; see also NFA, “CPO FAQs: Form PQR” (February 6, 2018), https://www.nfa.futures.org/electronic-filing-systems/CPOFAQsFormPQR.pdf.
39 See Form CPO-PQR Filing System Overview (on the NFA website), https://www.nfa.futures.org/electronic-filing-systems/PQR-Help.pdf.
40 Form PF filing deadlines are based on the adviser’s fiscal year (or quarter), while Form CPO-PQR/Form CTA-PR filing deadlines are based on the calendar year (or quarter). Note that dual registrants with a fiscal year that differs from the calendar year may have difficulty using Form PF to satisfy their CFTC Form PQR filing obligations.
41 As noted above, all registered CPOs must file CFTC Form PQR Schedule A. Quarterly CFTC Form PQR filers also file Schedule B, which contains a Schedule of Investments.
42 While Form PF may fulfill certain CFTC filing requirements, it does not fulfill the NFA quarterly filing requirements.
43 See Form CTA-PR Filing System Help (on the NFA website), http://www.nfa.futures.org/electronic-filing-systems/CTA-PR-System-Help.pdf.
44 See NFA, “CTA FAQs: Form PR,” https://www.nfa.futures.org/NFA-electronic-filings/CTAFAQsFormPR.pdf. CFTC’s FAQs on Form CTA-PR are in the same release as the FAQs regarding Form CPO-PQR.
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