1	Countdown To The New Reality in Hedge Fund Compliance Presented By: RSM McGladrey and TurboCompliance
2	Adviser Registration Requirements Section 202(a)(11) and related state law defines the term “investment adviser” as any person who for compensation is engaged in the business of providing advice to others regarding securities. Generally, 203(b)(3) of the Advisers Act of 1940 requires registration if a firm renders investment advice to: more than 14 clients (within one calendar year); with $30 million or more in Assets Under Management.
3	Adviser Registration Requirements Offshore Advisers (or with principle office in WY) with more than 14 clients must register with the SEC regardless of Assets Under Management (IA 2333 Foot Note 190) Assets Under Management (principle office in US) Under $25 million, registration required by the state where PRINCIPLE OFFICE IS LOCATED (exception WY) Between $25 and $30 Million, YOU MAY ELECT SEC Registration At $30 million or more, YOU MUST REGISTER with the SEC.
4	Private Adviser Exception (Hedge Funds) Since 1985, under the Private Adviser Exemption, a “Private Fund” only constituted 1 investor, NOT the sum of participants. Therefore, an LP or LLC with 99 participants only counted as 1 client toward the “14 client” threshold. A Private Fund under Rule 203(b)(3)-1 comprises ANY company that: would require registration under the Investment Company Act of 1940, but for the exemptions provided by Section 3(c)(1) or 3(c)(7) provides for LESS THAN a 2 year lock up offers interests based on investment advisory skills, ability or expertise of the investment manager Note: Look Through requirements do NOT apply to Insurance Companies, Broker Dealers, Banks
5	14 Client Threshold – Counting Rules Rule 203(b)(3)-2 requires Advisers to count each investor in a “Private Fund” towards the 14 client threshold. RESULT: an Adviser to a “Private Fund” MUST COUNT EACH PARTICIPANT IN A PRIVATE FUND OR ANY INDIVIDUAL CLIENT TOWARD THE 14 CLIENT THRESHOLD. (IA 2333 Foot Note 185 and 186). Treatment of Fund of Funds investor…An Adviser managing a Private Fund with an investor who is a Private Fund must “look through” the Private Fund investor, and count each of the participants in the Private Fund investor toward the 14 client threshold. Treatment of Offshore Investors…Domestic Advisers must count all clients, even offshore investors.
6	14 Client Threshold – Counting Rules Treatment of Family and Relatives…Spouses, children and relatives in the same principal residence can be counted as one client. Treatment of Investments in Multiple Funds…Advisers managing multiple Private Funds may count a person as one client who invests in multiple funds Treatment of Adviser employees An beneficial owner (aka Manager) of the Adviser does not count (regardless of form of ownership) Certain Knowledgeable Employees do not count (i.e., insiders generally those with investment related duties, non-clerical).
7	Offshore Advisers – 14 Client Threshold An Offshore Adviser managing a domestic or offshore Private Fund must “look through” the Private Fund to count each US resident investor toward the 14 client threshold. The Offshore Adviser shall determine residency at the time of initial investment. Therefore, a non-US investor retains this status even upon relocation to the US.
8	Bona fide Offshore Funds – 14 Client Threshold An bona fide Offshore Fund is NOT treated as a Private Fund, PROVIDED (meet all three): principal office and place of business is outside the US; Public Offering of its securities occurs outside the US; AND subject to regulation as a public investment company in the country where Public Offering occurs Therefore NONE of the investors of a bona fide Offshore fund count toward the 14 client threshold.
9	"Post Registration Compliance" Post Registration Compliance Requirements
10	Post Registration Compliance Requirements Written Compliance Program Designate CCO & Required Annual Review of Compliance Procedures System of Internal Controls & Conflicts of Interest Supervision Books and Records Advertising, Performance Fees and Solicitation Trading Issues (Allocations, Best Execution, Soft Dollars) Code of Ethics (Personal Securities Transactions/ Insider Trading) Business Continuity Plan Custody and AML Proxy Voting and Privacy Other Relevant Requirements
11	Indicators of New SEC Trend Complete Shift Evidenced By Requirements For: Formal & Comprehensive Internal Control Structure WRITTEN: Compliance Manual - October 5, 2004, new rule 206(4)-7, IA Act (www.sec.gov/rules/final/ia-2204.htm) Code of Ethics – February 1, 2005, new rule 204A-1 , 1940 IA Act (www.sec.gov/rules/final/ia-2256.htm) Anti-Money Laundering Procedures Actions Demonstrate That New Regulatory Environment Is A SECULAR Trend
12	Post-October 5, 2004 SEC Request List Describe the specific risk management, control and compliance processes and procedures used in achieving Portfolio management processes Trading practices Proprietary and personal trading Accuracy of disclosures Safeguarding of client assets Recordkeeping Processes to value client holdings Safeguards for the protection of client records and information Business continuity plans
13	Post-October 5, 2004 SEC Request List Any documents that demonstrate the effectiveness of the control processes. These documents should include: Exception reports together with documentation of follow-up work; Completed compliance check lists; Completed reconciliation files; Management reports; Documents containing supervisory approval of overrides in various areas. Warning or sanction notices to staff that did not follow procedure; Periodic analyses of transactions by compliance staff that are searching for patterns or “what if” situations that may need further follow up and results of any such follow up activities; Periodic self assessments of the effectiveness of control processes such as internal audit reports.
14	Post-October 5, 2004 SEC Request List Any policies, procedures, and compliance manuals, which describe operating and control procedures that the Registrant uses. Provide information on each significant regulatory/disclosure breach or issue… on Registrant’s letterhead, signed by the Chief Compliance Officer or President. Provide ALL email for the following individuals for the following 3 months…(requested approximate 50% of firm personnel’s email)
15	206(4)-7 COMPLIANCE PROGRAM MINIMUM REQUIREMENTS 12/17/2003 Changed the Landscape of the Regulatory Environment Forever, with the issuance of Rule 206(4)-7 under the Investment Advisers Act of 1940 (“Advisers Act”) and Rule 38a-1 under the Investment Company Act of 1940 (“1940 Act”).1 These rules require RIAs and ICs to: Prevent, detect, and correct violations of securities laws “to the extent that they are relevant.”—i.e. an Internal Control Structure specific to your firm Failure to implement adequate compliance policies and procedures constitutes an independent violation of the securities laws, even where no other violation results from the inadequate procedures.
16	206(4)-7 COMPLIANCE PROGRAM MINIMUM REQUIREMENTS Policies and Procedures must, at a minimum, address: portfolio management processes trading practices proprietary trading of the adviser and personal trading activities of supervised persons accuracy of disclosures made to investors, clients and regulators safeguarding client assets the accurate creation and maintenance of required records in a manner that secures them from unauthorized alteration or use, and protects them from untimely destruction. marketing advisory services, including the use of solicitors; processing to value client holdings and assessment of fees; safeguarding privacy of client records and information; business continuity plans.
17	206(4)-7 COMPLIANCE PROGRAM MINIMUM REQUIREMENTS Annually review policies and procedures to determine their adequacy, and the effectiveness of their implementation, taking into account: any compliance matters that arose during the previous year, any changes in the business activities of the advisers or its affiliates, and any changes in the Advisers Act or applicable regulations Designate a Chief Compliance Officer (“CCO”) “competent and knowledgeable regarding the Advisers Act . . . empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the firm.” Maintain in an easily accessible place, for a “rolling” period of 5 years copies of ALL compliance policies and procedures
18	Internal Control Structure Examination experience shows that Advisers with effective system of compliance controls are: much less likely to violate Securities Laws and if violations occur…found quickly…with less harm In contrast…weak controls: indicate undetected violations exist with higher risk to investors new emphasis on “Risk Based” Examinations Examining firms controls and procedures Evaluating the EFFECTIVENESS of internal controls
19	Internal Control Structure Where controls are found to be weak and ineffective or non-existent firm deemed a higher risk More frequent and in-depth exams Important area for firms to focus on Perfection is not the goal of your compliance program and internal controls. Pro-active compliance is the goal, NOT reactive compliance. Internal controls are the heart and soul of any policy or procedure. Internal controls = the process by which policies and procedures are checked to ensure implementation.
20	Duty To Supervise Sanctions imposed for failure to reasonable supervise…view toward preventing securities violations Factors contributing to Supervisory Status Requisite degree of responsibility, ability or authority to affect conduct or behavior Sufficient if individual “plays a significant role, even if shared May be liable—even absent unilateral disciplinary authority SEC actions against Hedge Fund Advisers shall continue to escalate—for an example, reference IA Rel. No. 2203 (12/15/2003) Admin Proc File No. 3-11357 In Re Robert T. Littell and Wilfred Meckel
21	Communications with the Public Advisers MUST preserve all written communication regarding Advice provided or proposed Receipt, disbursement or delivery of funds/securities Purchase or sale of securities Retention NOT required for Unsolicited market letters Similar communications of General Public Distribution NOT prepared by Adviser
22	Communications - Retention Advisers must retain required records for at least 5 years from the year end of the date of last entry Information distributed to 10 or more people must be retained for 5 years from the year end of the year of last distribution Calc of performance fees, rates of return, circulars, advertisements, news articles, investment letters, bulletins
23	Communications - Supervision OCIE GC John Walsh recommends Advisers seek guidance from NASD Rule 3010 Procedures for review of Email must be described in firms WSP Tailored to the firm’s structure Adequate to supervise activities of all firm personnel Monitor and test to ensure effectiveness Provide education & training Maintain records documenting incompliance, resolution, sanctions and modification procedures, as appropriate
24	Communications - Supervision WSP must specify in writing: Firm’s policies and procedures for reviewing electronic communications Identify how supervisory reviews conducted and documented Identify whether electronic communications pre or post reviewed Identify the organizational position responsible Specify minimum frequency of reviews Monitor implementation and compliance Periodically re-evaluate effectiveness/ consider revision
25	Books and Records – Rule 204-2 Books and Records Requirements generally fall into 2 broad categories: general business and advisory operations. An Adviser must retain records for the first 2 years in the Adviser’s Office (unless disclosed) and for 3 years thereafter in an easily accessible location. Generally, Hedge Fund Managers should begin retaining ALL required performance-related records as of Feb 10, 2005—in order to use performance records in advertisements after registration. (IA Rel 2333 FN 256-258)
26	Advertising – Rule 206(4)-1 The Advisers Act places many restrictions on advertising Adviser can hold itself out to the public as an Investment Adviser The Adviser can NOT “market” Unregistered Funds (aka Hedge Fund) No Testimonials No Cherry-Picking
27	Performance Fees – Rule 205-3 The Advisers Act and the Investment Adviser legislation of most states prohibits Performance Fees unless the client is a “Qualified Client” which requires either: $1.5 million in net worth has $750,000 under management with the Adviser is a knowledgeable employee Practice Note: A Registrant with pre-existing Performance Fee Arrangements may continue to charge performance fees to Private Fund participants or Separately Management Accounts who do NOT constitute Qualified Clients, provided the investment initiated PRIOR TO February 10, 2005.
28	Solicitation – Rule 206(4)-3 An Adviser may compensate a person for soliciting clients, provided a written Solicitation Agreement exists and the Solicitor possesses a clean disciplinary history. the Solicitor must provide to the prospective client: the Adviser’s Form ADV Part II; and A written disclosure statement regarding the Solicitor's relationship with the Adviser (Solicitor Disclosure Statement), detailing: the terms of the Solicitor's compensation and any additional fees the client will pay Adviser must obtain from client: signed acknowledgement of Form ADV Part 2 and the Solicitor Disclosure Statement.
29	Trading Issues Aggregation & Allocation SEC expects advisers to have internal controls in place which ensure FAIR allocation…consistent with rules and Adviser disclosure Adviser allocation policies and procedures must be CLEARLY disclosed IN ADVANCE SEC concern = “potential for client to be harmed or defrauded if allocations are contrary to client expectations”
30	Trading Issues – IPO Allocations SEC Examinations focus on: Any indication of preferential allocations Internal controls to ensure fair allocation Disclosure of internal controls Whether ACTUAL PRACTICES ARE CONSISTENT WITH WRITTEN POLICIES AND PROCEEDURES Enforcement actions typically involve Failure to disclose a preferential allocation No system of internal controls Failure to disclose impact of IPO allocation on reported performance results
31	Trading Issues – IPO Allocations NASD Rule 2790 replaces the “Free Riding and Withholding Interpretation” Rule 2790 applies to ALL new issues Narrows the category of “restricted persons” Adopts a “de minimis” exemption…accounts containing restricted persons may purchase IPO provided beneficial interest of same < 10% Standardizes records keeping requirement to evidence compliance with rule
32	Trading Issues – Best Execution Important DISCLOSURE issues include: Effects of client-imposed limitations on Adviser’s DISCRETIONARY AUTHORITY for brokerage If AFFILIATE of Adviser = Broker-Dealer who executes transactions for RIA clients Under what circumstances Adviser uses an UNAFFILIATED Broker Dealer to obtain the best price and execution for a particular transaction Effects of Adviser’s decision to use affiliated Broker-Dealers Geman v. SEC 334 F.3d 1183 In Re Jamison, Eaton & Wood, Inc. Rel No. IA-2129 In Re Renberg Capital Management, Inc and Daniel H Renberg Rel. No IA-2064
33	Trading Issues – Soft Dollars Section 28(e) provides a “safe harbor” allowing Advisers to “pay up” use Broker Dealers charging more than the lowest available commission Soft Dollar services categories Research Non-Research Mixed use Research = “proprietary” or 3rd party, investment related publications, analysis and data Non Research requires full disclosure of Adviser’s conflicts of interest AND client consent.
34	Fund Directed Brokerage New Definition = Paying for the distribution of mutual fund shares managed with brokerage commissions Funds or their Advisers are prohibited from directing brokerage to pay for the distribution of fund shares Prohibition includes performing or arranging to perform any function related to the processing of a transaction Transmission of an order for execution Execution of an order Clearance and settlement of a transaction Prohibition includes “step outs” Arrangement designed to compensate selling brokers for selling mutual funds
35	Code of Ethics 7/2/2004 SEC adopted Rule 204A-1 amended Rule 204-2 and Rule 17j-1 of the 40 Act Advisers must adopt and implement a Code of Ethics regardless of number or types of clients serviced. Review Personal Securities Transactions of Access Persons Firm’s “Standards of Conduct”: Reflect Access Person’s Fiduciary Duties CLEARLY require compliance with ALL securities laws
36	Ethics Code – Persons Covered Access Persons: Adviser’s Officers, Directors, Partners (individuals possessing a similar status or function) Employees Person subject to Adviser’s supervision and control The Personal Securities Transaction requirements of Rule 204 include a spouse or other family member who resides in the same household as an Access Person
37	Ethics Code - ADV Disclosure Rule 204A-1 requires Part 2, Schedule F to include Description of Adviser’s Code of Ethics Offer to provide Clients or Prospective Clients a copy of Adviser’s Code of Ethics upon request Must REVIEW and UPDATE Part 2 to reflect ANY changes in Code of Ethics
38	Ethics Code MINIMUM Requirements STRICT COMPLIANCE with Personal Securities Transactions Procedures and Reporting for ALL access persons Pre-clearance for IPOs and Limited Offering or Private Placement Pre-clearance for any other area if “necessary” or “appropriate” Procedures or Restrictions on Acceptance of Gifts Service on Board of publicly traded company Procedures for REVIEW of Code and REPORTS generated pursuant to Code
39	Ethics Code MINIMUM Requirements Holdings Reports – Access Persons MUST report personal security holdings: Initially - Within 10 days, with information current as of 45 days prior Yearly, thereafter, with information current when submitted Quarterly Transaction Reports – Access Persons MUST report personal trading activities each quarter, within 30 days of close Quarterly Brokerage Account Reports – Institutional Advisers ONLY, Access Person disclose account opened during quarter where possess direct or indirect benefit
40	Ethics Code MINIMUM Requirements Record Keeping – Advisers required to maintain for 5 years Copies of Each Code of Ethics Records of ANY violations, and actions taken Written acknowledgement of receipt of Code and amendments Holdings and Transaction Reports Name of each Access Person Personal Securities Reports and records of decisions to approve participation in IPO or Private Placements Person(s) responsible for reviewing each Access Person's reports
41	Ethics Code – CCO Duties/ Sanctions Personal Securities Transactions and Holdings MUST be reported to CCO or other designated person VIOLATIONS of Code MUST be reported to CCO, even if Adviser designated another person to receive reports ENFORCEMENT - SEC expects CCO to possess PRIMARY RESPONSIBILITY for Enforcement of Code CCO should establish sanctions, including: warnings, fines, disgorgement, suspension, demotion or termination Violations should result in referral to civil or criminal authorities where appropriate
42	Custody & AML Requirements Rule 206(4)-2 (establishing requirements for Advisers with custody of client assets) An Adviser (or a related party thereof) serving as the General Partner of a Private Fund is DEEMED to have Custody by virtue of the ambit of “control” over the Fund Must provide Audited Financials within 120 days of Fiscal Year End (180 days for Fund of Funds) Patriot Act & AML laws and regulations. Office of Foreign Asset Control, Specially Designated Nationals Reporting—AKA OFAC SDN Reporting Know Your Customer or KYC
43	Privacy and Proxy Rules Regulation S-P (requiring a Privacy Policy and governing disposal of Customer Information). Advisers must provide a copy of their Privacy Policy upon the inception of the client relationship, and annually thereafter Rule 206(4)-6 (requiring written proxy voting policies and procedures). Adviser should institute and maintain, regardless of whether a 3rd party service provider is used
44	Contingency Planning Purpose: to ensure business continuity despite Significant Disruptive Events SEC indicated that Adviser’s fiduciary obligation includes “protecting…against risk of Adviser’s inability to service client.” Interagency Paper on Sound Practices to strengthen the resilience of the US Financial Markets drafted by SEC, Federal Reserve and Office of Comptroller of the Currency Elements of Contingency Planning include: Sufficient geographic dispersion of critical resources Back-up facilities Response to relevant white paper recommendations
45	Additional Compliance Requirements Rule 204-1 (requiring advisers to update their Form ADV). Rule 204-3 (requiring advisers to provide a copy of their Form ADV Part II to new clients and make at least an annual offer to provide existing clients with a copy of the Form ADV Part II). Section 205 (requiring registered advisers to include “non-assignment” clauses in their advisory contracts and placing restrictions on charging performance fees).
46	Additional Compliance Requirements Rule 206(4)-4 (requiring special client disclosures for advisers facing an impaired financial condition and for advisers and their management persons who are subject to certain disciplinary actions). Section 208 (prohibiting an adviser from representing or implying that it is approved or qualified by the SEC and from using the name “investment counsel” unless meeting certain criteria).
47	SEC OCIE Inspections Former goal conduct routine examinations of each adviser every five years conducted a targeted review of various areas in firm Adopted “Risk-Based” and “Event-Driven” approach to determine the scope and frequency of adviser inspections Implemented a revised adviser examination request, adding several questions on the existence and effectiveness of compliance policies and procedures and the system of internal controls
48	OCIE Compliance Program Factors OCIE NEW criteria for a strong compliance program establishing internal control processes for problem areas; identifying special risks related to different business models; creating control points for both typical and special risk areas; creating and maintaining necessary documentation; designating a specific person to administer the compliance program. Trending…Advisers’ compliance policies and procedures should employ compliance tests that analyze information over time to identify unusual patterns.
49	NEW Penalty Regime Old Method = Disgorgement + Civil Penalty, usually of equal value New Method = Nature of Violation Drives Penalty Ratio, not 1 + 1 No mitigation of SEC Penalties from indemnification, reimbursement by insurers, or favorable tax treatments Recent settlements of Enforcement Actions included language that companies “shall not, in any Related Investor Action, benefit from any offset or reduction of any investor’s claim by the amount of any distribution to such investor in this proceeding that is proportionately attributable to the civil penalty paid.”
50	SEC’s New Examination Approach Places A Higher Burden and Cost on Firms
51	Step 1 – RSM McGladrey RSM McGladrey provides firms with CPAs who possess the requisite background, core competencies and skill sets to Analyze your business model and identify any unique issues Effect your SEC registration Draft, update and review your: Written Supervisory Procedures AML Procedures Ethics Code (Personal Securities Transactions & Insider Trading) Business Continuity Plan Privacy Policy
52	Step 2 – RSM McGladrey & TurboCompliance RSM McGladrey works in concert with one of the TurboCompliance development teams to build a version of TurboCompliance which automates the daily compliance workload produced your firm’s compliance policies and procedures. TurboComplianceTM installs a comprehensive, well organized Internal Control Structure to automate your compliance procedures which reduces your daily compliance workload and the related costs by 75% to 85%.
53	Step 3—Straight-Through ComplianceSM The TurboCompliance Platform provides Straight-Though Compliance for each chapter of your compliance policies and procedures manual, prepared by RSM McGladrey, including: Anti Money Laundering (OFAC & KYC Analysis/Reporting) Advertising & Marketing, e.g., Solicitors and Cap Intro Communications with the public (Email, IM & “hard copy”) Account Documentation and Disclosure ERISA Private Placement of Securities Compliance Code of Ethics (Personal Securities Transactions/ Insider Trading)
54	Step 3—Straight-Through ComplianceSM Portfolio Management & Trading Suitability Client Mandates/Restrictions Allocation of Opportunities Trade Errors Principal, Agency Cross & Cross Transactions Best Execution and Soft Dollars Proxy Voting and Valuation Books and Records Assessment of Fees SEC Filings and Reporting Business Continuity
55	Step 3—Straight-Through ComplianceSM TurboCompliance places a comprehensive, well organized Internal Control Structure around each business process to AUTOMATE the daily compliance workload required by your compliance policies and procedures, including: Monitoring and Supervising ALL members of the Firm Detecting and Preventing or Correcting incompliant activities Reporting up the chain of command Documenting ALL incompliance on each person’s Compliance ScoreCardSM Sanctioning each member of the firm, based upon the CCO customized compliance rules, formulas, schedules Preparing your Annual Review and Satisfying all documentation/record keeping requirements for Personnel
56	COST OF COMPLIANCE Manual vs TurboComplianceTM
57	COST OF COMPLIANCE Manual vs TurboComplianceTM
58	About Our Presentation This presentation is intended solely to provide general information and does NOT constitute legal advice. Attendance at the presentation or later review of these printed or electronic materials does not create any client relationship with the presenter. You should not take any action based upon any information in this presentation without first consulting your firm’s Chief Compliance Officer and legal counsel familiar with your particular circumstances. Copyright 1998 – 2005, NWT, all rights reserved. Trademark Owners retain ALL rights to their respective intellectual property. You may contact the Presentation Faculty as follows: Walter Zebrowski, JD, CPA – 800-530-7211 or wczebrowski@turbocompliance.com Sal (Kislay) Shah, CPA – 212-297-4846 or kislay.shah@rsmi.com Questions@turbocompliance.com altinvestments@rsmi.com