Are You Ready? A Guide to SEC Registration Preparedness

Jul 21 2009 | 5:15am ET

By John Brunjes, Genna Garver and Kevin O'Connor -- President Barack Obama's administration has spoken—all private investment fund advisers with client assets exceeding $30 million are facing SEC registration.  States, such as Connecticut, are also considering closing regulatory gaps to regulate fund advisers that fall below the threshold for SEC registration. Although the details need to be hammered out through the legislative process, required registration for fund advisers with either the SEC or their home state securities regulator seems imminent. Are you ready? This article provides an approach to registration preparedness for fund advisers currently unregistered with the SEC and their home state securities regulator.

Current SEC Requirements for Unregistered Advisers

Unregistered fund advisers are certainly not unregulated. Many unregistered fund advisers are currently subject to certain provisions of the Investment Advisers Act of 1940, as amended, including provisions regarding: prohibitions on certain performance-based fees; contract assignments; prohibitions on engaging in any fraudulent, deceptive or manipulative acts; and the prevention of the misuse of material, nonpublic information. However, SEC registration would subject fund advisers to all of the provisions of the Advisers Act and the rules adopted thereunder. Although this article focuses on SEC registration preparedness for fund advisers, fund advisers that are not subject to SEC registration most likely will be subject to similar provisions under state law.

Implications of SEC Registration

Advisers subject to SEC registration are required to comply with all of the applicable provisions of the Advisers Act and the rules adopted thereunder. A summary of the material provisions of the Advisers Act is set forth below.

Genna GarverGenna GarverForm ADV. Every applicant for registration with the SEC as an adviser must file a Form ADV, which has two parts. Part 1 contains information about the adviser's education, business, disciplinary history and ownership (if the adviser is an entity). Part II includes information on an adviser's services, fees, and investment strategies. Form ADV must be filed annually by every adviser to amend its registration and must also be filed promptly during the year to reflect material changes. 

Maintenance of Books and Records. Advisers must maintain a number of records for the protection of clients, and to ensure compliance with the Advisers Act. Generally, advisers must maintain records relating to their advisory business, including financial statements, code of ethics, agreements with clients and other third parties, trade orders, correspondence, advertisements and proxy voting.

Custody. Advisers must maintain fund assets with a qualified custodian and notify the fund's investors where those assets are held. Unless the fund distributes annual financial statements audited in accordance with GAAP within 120 days of the end of the fund's fiscal year (within 180 days of the end of the fund's fiscal year for fund of funds), the adviser must also arrange for the fund's account statements to be sent to the fund's investors. The SEC recently proposed amendments to the custody provisions of the Advisers Act that would, among other requirements, require an annual surprise examination by an independent public accountant to verify client assets. 

Compliance Policies and Procedures. Advisers must adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules adopted thereunder. On at least an annual basis, those policies and procedures must be reviewed for their adequacy and effectiveness. Advisers must also designate a chief compliance officer to be responsible for administering the policies and procedures. Although the chief compliance officer is not prohibited from serving in multiple capacities for the adviser, investors are increasingly looking for a chief compliance officer with no other responsibilities.

Code of Ethics. Advisers must adopt a code of ethics designed to prevent fraud by adviser personnel, which also addresses the adviser's standard of business conduct, compliance with federal securities laws, personal securities reporting, pre-approval of certain transactions and reporting of violations of the code of ethics.

Restrictions on Advertising. The Advisers Act prohibits (with certain exceptions) advertisements that: use testimonials; reference past specific advisory recommendations; suggest that a graph, chart, formula or other device can assist investors in determining which investments to buy or sell; indicate that a report, analysis or other service will be provided free of charge; or contain any untrue statement of a material fact, or which is otherwise false or misleading.

SEC Examinations. Advisers are subject to examination by the SEC, which can occur on an announced or unannounced basis. During exams, SEC staff may interview adviser personnel, review the books and records, and analyze the adviser's operations to test the adviser's compliance with federal securities laws and regulations. The SEC may even reach out to third parties, including adviser clients, for independent verification of assets. SEC staff is familiar with and likely to review some or all of the following "hot" exam issues:

  • Custody.
  • Controls over valuation.
  • Performance claims.
  • Supervision and compliance.
  • Trading—including controls to prevent the intentional creation or spreading of false information intended to affect securities prices, or other potentially manipulative conduct.
  • Soft dollar practices.
  • Controls over material, non-public information/Insider trading.
  • Revenue sharing.
  • Side letters/Preferential treatment on redemptions.

Kevin O'ConnorKevin O'ConnorThe SEC recently announced plans to strengthen its examination oversight of advisers that will sharpen examiners' ability to detect fraud and other types of violations. The SEC has also announced a change in leadership in its Office of Compliance Inspections and Examinations (OCIE). 

President Obama's Administration recently proposed the Private Fund Investment Advisers Registration Act of 2009 to the U.S. Congress, which includes additional requirements for registered fund advisers, as well as requirements for the funds they manage. Notably, President Obama's proposal would subject all funds advised by SEC-registered advisers to recordkeeping requirements; requirements with respect to disclosures to investors, creditors, and counterparties; regulatory reporting requirements, and SEC examinations to monitor compliance with these requirements. Certain funds deemed to require greater regulation for financial stability purposes would be subject to heightened supervision and regulation by the Federal Reserve. At a minimum, those funds would be required to meet certain capital, liquidity and risk management requirements to account for the greater risks that their potential failure would impose on the financial system. 

Plan Ahead

The Private Fund Investment Advisers Registration Act of 2009 or similar legislation could be enacted at any time. Effective dates may approach with little warning. Advisers should, therefore, prepare now and consider the following actions:

Gather Information. Advisers should review Form ADV and its instructions and begin gathering information needed to complete the form. Advisers should also review the entitlement process for establishing an IARD account and access to the IARD system for online filing.  

Identify a Chief Compliance Officer. Advisers should identify and designate a chief compliance officer, which may require hiring additional personnel or providing additional training to existing personnel.

Develop a Compliance Program. Advisers should perform a risk-based assessment of their own compliance issues and practices so as to identify key compliance issues. The SEC staff has expressed on numerous occasions that compliance procedures should not be "off-the-shelf," but must result from specific internal analysis and be tailored to the adviser's specific circumstances. Compliance procedures should be "risk-based," meaning focused on those areas in which the adviser has or may have the highest risk exposure. Areas of highest risk exposure are not necessarily areas in which compliance problems have in fact occurred or are necessarily likely to occur, but rather the areas which from the perspective of the adviser's own situation should be singled out for special compliance oversight. In conducting the risk-based assessment, advisers should review their business — identify conflicts of interest, business practices, arrangements, and other factors creating risk for the adviser and its clients in relation to its operations. Then advisers should review existing compliance policies and procedures (if any) and begin drafting additional policies and procedures (if necessary), that specifically address those factors and the controls to be implemented to supervise and mitigate those areas of concern and to prevent violations of the Advisers Act. This process of establishing policies and procedures should be ongoing, in a state of constant improvement and flexible enough to identify and address new issues and risks as they emerge. 

Establish a Culture of Compliance. The chief compliance officers must assure that the conduct of the adviser and its employees meets fiduciary standards owed to clients and that the adviser is preventing problems, misdeeds and misconduct. The SEC staff has emphasized the importance of establishing a "Culture of Compliance." From the top of the organization down, a Culture of Compliance requires an overall environment that fosters ethical behavior and decision-making. 

Mock Audit. Once an adviser has established a compliance program, a "mock audit" can help assess its adequacy and effectiveness. Outside counsel and certain consultants offer this service to advisers looking to identify and remedy compliance issues before the SEC knocks on their door. 

Advisers should discuss with their legal counsel whether or not they may be required to register with the SEC or their home state securities regulator. Even in the unlikely event that the Obama Administration is unsuccessful in enacting SEC registration for fund advisers, implementing the actions discussed in this article are sound practices that will enhance investor confidence.

John Brunjes, Genna Garver and Kevin O'Connor are in the Private Investment Funds Group of Bracewell & Giuliani, LLP, representing hedge funds, private equity funds and venture capitalists in connection with fund formation and operations issues and illiquid investment transactions, with particular emphasis on advising private domestic and offshore capital pools and their stakeholders. Brunjes is head of the Fund Formation practice and a member of the Board of Directors of the Connecticut Hedge Fund Association. O'Connor previously served as the Associate Attorney General of the United States and served as the United States Attorney for the District of Connecticut for over five years.


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