Compliance Corner

Publication August 9, 2016

By Chadbourne & Parke LLP’s Fund Formation and Investment Management Group*

The following summary highlights certain recent significant investment management industry updates:

  • The SEC Issues a Proposed Rule Requiring Registered Investment Advisers to Adopt and Implement Written Business Continuity and Transition Plans;
  • The SEC Issues Order Approving Inflation Adjustment for “Qualified Client” Threshold;
  • Brexit’s Potential Effects on US Investment Advisers;
  • Private Equity Fund Adviser Settles Charges for Acting as an Unregistered Broker;
  • Private Equity Funds Found Liable for Portfolio Company’s Withdrawal Liabilities;
  • FinCEN Clarifies Customer Due Diligence Requirements in Final Rule;
  • The NFA Issues an Interpretive Notice Regarding Information Systems Security Programs;
  • OCIE Introduces Share Class Initiative; and
  • The SEC’s Spring 2016 Agency Rule List Published by the Office of Information and Regulatory Affairs Targets Numerous Regulatory Actions for 2017.

The SEC Issues Proposed Rule Requiring Registered Investment Advisers to Adopt and Implement Written Business Continuity and Transition Plans

On June 28, 2016, the Securities and Exchange Commission (the “SEC”) issued a proposal that, if adopted, would implement a new Rule 206(4)-4 of the Investment Advisers Act of 1940 (the “Advisers Act”) that would require investment advisers registered with the SEC (or required to be registered) to adopt and implement written business continuity and transition plans reasonably designed to address operational and other risks related to a significant disruption in the investment adviser’s operations. [1] The proposed rule would require advisers to tailor their business continuity and transition plans to the specifics of their own businesses. According to the SEC, the goal of the proposal is to protect investors from certain fundamental operational risks that may impact the ability of an investment adviser and its personnel to continue operations, provide services to clients and investors or, in certain circumstances, transition the management of accounts to another adviser. [2]

Among other things, the proposed rule would require advisers to identify how they would respond to disruptive incidents, such as cyber-attacks or technological failures, natural disasters, or the departure of top personnel. In order to mitigate the risks in the event of such disturbances, investment advisers would be required to adopt measures for maintaining systems and alternative work locations, protecting data, and identifying and assessing the use of third-party providers’ systems. Additionally, advisers would be required to have plans in place to contact clients, employees, service providers, and regulators in the event of a disruption or discontinuation of service.

Under the proposal, advisers also would need to adopt a plan of transition or winding down of the adviser’s business in the event that the adviser can no longer provide services at all. Such transition plans would be required to consist of measures for safeguarding and transferring client assets and facilitating the prompt distribution of client information to transfer accounts. Additionally, the transition plan would be required to include information about the corporate governance structure of the adviser and identify the adviser’s financial resources. Finally, the plan would be required to include an assessment of the laws and obligations applicable to the adviser and clients that would be relevant to the transition.

Under the proposal, advisers would be required to review their business continuity and transition plans annually and maintain certain related records, such as all business continuity and transition plans during the previous five years, and documents pertaining to annual reviews and compliance in connection therewith.

SEC Chair Mary Jo White explained the rationale for the proposal, stating, “[w]hile an adviser may not always be able to prevent significant disruptions to its operations, advance planning and preparation can help mitigate the effects of such disruptions and in some cases, minimize the likelihood of their occurrence, which is an objective of this rule.” Chair White also described the proposal as “the latest action in the Commission’s efforts to modernize and enhance regulatory safeguards for the asset management industry.” [3] The proposal itself states that disruptions in service may harm investors’ interests by preventing trades, interrupting access to assets or accounts, or halting communication between investors and advisers. Thus, the proposal is designed to require advisers to have “sufficiently robust plans” to mitigate the potential adverse effects of disruptions or transitions.

The Chadbourne & Parke LLP Fund Formation and Investment Management Group will continue to follow the SEC’s actions in connection with the proposal and provide updates as they occur. The comment period for the proposed rule expires on September 6, 2016.

The SEC Issues Order Approving Inflation Adjustment for “Qualified Client” Threshold

On June 14, 2016, the SEC issued an order (the “Order”) approving an increase of the dollar amount threshold under the “net worth test” in the definition of “qualified client” under the Advisers Act from $2,000,000 to $2,100,000. [4] Currently under Sections 205(a)(1) and 205(e) and Rule 205-3 of the Advisers Act, an investment adviser cannot enter into an advisory contract under which the adviser’s payment is collected from a share of the capital gains of the client’s managed fund (also known as performance compensation or performance fees), unless the client meets the “qualified client” threshold under which either (i) the client has at least $1,000,000 in assets under management with the adviser; or (ii) the adviser reasonably believes, immediately prior to entering into the contract, that the client’s net worth is at least $2,000,000. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) amended Section 205(e) of the Advisers Act to allow for the qualified client threshold amounts to be adjusted for inflation, to the nearest $100,000, at five year intervals. The Order took into account calculations based on the PCE price index that reflected inflation from 2011 to the end of 2015 and adjusted the “net worth test” qualified client threshold from $2,000,000 to $2,100,000; the “assets-under-management test” threshold remains unchanged. Investment advisers are encouraged to review and amend their subscription documents accordingly. The Order is effective as of August 15, 2016.

Brexit’s Potential Effects on US Investment Advisers

On June 23, 2016, British citizens voted in the widely-anticipated United Kingdom referendum on European Union membership, with a majority voting to leave the European Union (commonly known as “Brexit”). At this time, it is not certain what steps will need to be taken to facilitate the UK’s exit from the European Union or the length of time that this may take, as well as what implications, if any, the departure may have for EU and non-EU investment advisers. Article 50 of the Treaty on the European Union guarantees that there will be a two-year negotiation period between its activation and the UK’s actual exit from the EU. Little change will occur during this period while the UK is still bound by the EU and its regulations. However, negotiations during this period regarding exit parameters will determine whether Brexit is a “hard” or “soft” departure. A hard departure is unlikely because it would involve the UK surrendering all cross-border relations. More likely is a soft departure, which could take one of many forms, with perhaps the smoothest transition provided by a potential UK membership in the European Economic Area (the “EEA”).

If the UK were able to negotiate an EEA membership, similar to the agreement Norway has with the EU, the Markets in Financial Instruments Directive (“MiFID”), Alternative Investment Managers Directive (“AIFMD”), and Undertakings for Collective Investment in Transferable Securities (“UCITS”) would all still apply. However, seeking EAA membership may inspire pushback from the UK constituency because the agreement would require the UK to provide a monetary payment to the EU in addition to allowing EU laborers the opportunity to work within the UK, two factors that spurred Brexit in the first place.

The Chadbourne & Parke LLP Fund Formation and Investment Management Group will continue to follow and provide updates in connection with the AIFMD, the EU Directive on UCITS and other programs and statutes that may be affected by Brexit.

Private Equity Fund Adviser Settles Charges for Acting as an Unregistered Broker

On June 1, 2016, the SEC announced that Blackstreet Capital Management, a Maryland-based private equity fund advisory firm, and its owner had agreed to pay a settlement of more than $3.1 million in the form of fines, interest and disgorgement. [5] An SEC investigation found that the firm had performed brokerage services in-house rather than using investment banks or broker-dealers to handle the acquisition and disposition of portfolio companies without registering as a broker-dealer with the SEC. Additionally, the SEC found that the firm and its owner engaged in conflicted transactions and did not adequately disclose fees and expenses. In one instance, the SEC found that the firm compensated itself with fund assets for brokerage services; in another, the SEC found that the firm purchased shares in a portfolio company owned by one of its funds without disclosing its financial interest or obtaining appropriate consent to engage in such a transaction. The SEC also alleged that the firm used fund assets to make political contributions and for other unauthorized purposes. Additionally, the SEC found that the firm violated one of their fund’s governing documents by having an entity acquire a fund interest from certain limited partners and having the fund’s general partner waive any obligation to satisfy future capital calls. Finally, the SEC charged the firm with failure to adopt and implement policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules, such as violations associated with the improper use of fund assets, undisclosed receipt of fees or purchase of LP interests.

The SEC’s order found that Blackstreet violated Section 15(a) of the Securities Exchange Act of 1934, and Sections 206(2) and 206(4) of the Investment Advisers Act of 1940.

Private Equity Funds Found Liable for Portfolio Company’s Withdrawal Liabilities

On March 28, 2016, the District Court for the District of Massachusetts held on remand that two separate, but affiliated, private equity funds within Sun Capital Partners were jointly and severally liable under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), for the $4.5 million multiemployer pension plan withdrawal liability of a bankrupt portfolio company. [6]

The Court ruled that the funds had formed a “partnership-in-fact” between them, were in common control with the portfolio company and were engaged in a “trade or business” under ERISA. This decision, if not overturned on appeal, may change traditional methods of structuring private equity investments in portfolio companies with pension plans or potential pension liabilities.

For ERISA’s controlled group liability doctrine to apply, the entities in the group must be under “common control” and engaged in a “trade or business” under ERISA. A corporation owning 80 percent or more of a bankrupt portfolio company is deemed to be in “common control” with such company and is generally liable for 100 percent of such company’s unpaid defined benefit pension obligations, including multiemployer plan withdrawal liability. However, if a corporation owns less than 80 percent of a bankrupt portfolio company, and is organized as a partnership or LLC, like most private equity funds, then the ERISA doctrine does not apply unless the entities in the group are engaged in a “trade or business.” Private equity funds organized as a partnership or LLC have traditionally not been considered to be engaged in a “trade or business.” Thus, in order to avoid the controlled group liability doctrine, private equity funds, organized as partnerships or LLCs, often structure investments so that no single fund owns more than 80% of a portfolio company.

The District Court in Sun Capital found that, despite separately owning less than 80% of the portfolio company, the two funds created a deemed “partnership-in-fact” and should be held jointly and severally liable for the bankrupt entity’s multiemployer withdrawal liability. Unless overturned, this decision may materially impact the potential liability to which private equity funds may be at risk when investing in a portfolio company with pension liabilities. Even unrelated co-investors who engage in normal pre-transaction joint activities may unintentionally create a “partnership-in-fact” with unlimited liability among its partners. It is unclear whether other circuit courts will adopt the same conclusions and how broadly this decision will be applied.

To prepare for the potential outcomes of Sun Capital, consider the following guidelines:

  • Continue reviewing fund documents and focus on fee offset arrangements and general partner authorities that permit the direct or indirect provision of management services or that could support a ruling that the fund actively manages its investments;
  • Be cautious of the risk underlying investments held by two separate, but affiliated, funds in a single portfolio investment, despite the percentage of ownership separately held by each fund; and
  • When evaluating new investment opportunities in portfolio companies with pension plans or potential pension liabilities, consider the possibility that pension liability may reach beyond the portfolio company and to the private equity fund.

The private equity industry will closely monitor the status of this novel decision, which is being appealed, and the extent to which other courts consider and analyze these same issues and adopt a similar approach.

FinCEN Clarifies Customer Due Diligence Requirements in Final Rule

On May 11, 2016, the Financial Crimes Enforcement Network (“FinCEN”) of the U.S. Department of Treasury published a final rule regarding customer due diligence requirements under the Bank Secrecy Act. [7] Specifically, the rule requires banks, securities broker-dealers, mutual funds, futures commission merchants and introducing commodities brokers to meet and include four standards within their anti-money laundering (AML) programs: (1) customer identification and verification; (2) identification and verification of beneficial owners of legal entity customers; (3) creation of a customer risk profile, based upon the nature and purpose of customer relationships, to identify suspicious activity; and (4) ongoing monitoring for reporting suspicious transactions and, on a risk basis, maintaining and updating customer information.

Standards one, three and four are already either explicit or implicit AML requirements; standard two is a new addition. The final rule excludes registered investment advisers and registered investment companies from the definition of “legal entity customer”. Institutions must be in compliance with the rules by May 11, 2018.

The NFA Issues an Interpretive Notice Regarding Information Systems Security Programs

On March 1, 2016, the National Futures Association’s (the “NFA”) interpretive notice that includes guidance on enhancing information systems security programs (“ISSPs”) became effective. [8] The notice requires NFA member firms (“Members”)—namely futures commission merchants, commodity trading advisors, commodity pool operators, and introducing brokers—to diligently supervise the futures activities of their employees and agents. [9] Likewise, swap dealers and major swap participants must diligently supervise their businesses. [10] Aside from these specific demands, Members are encouraged to implement flexible, tailored ISSPs; however, they should keep in mind that the framework of any ISSP should be based on five guidelines: (1) a written program; (2) security and risk analysis; (3) deployment of protective measures against the identified threats and vulnerabilities; (4) response and recovery from events that threaten the security of the electronic systems; and (5) employee training relating to information security. [11]

OCIE Introduces Share Class Initiative

On July 13, 2016, the Office of Compliance Inspections and Examinations (the “OCIE”) published a risk alert introducing an initiative aimed at addressing the risk that registered advisers may potentially make conflicted investment recommendations to their clients (the “Share Class Initiative”). [12] Specifically, the Share Class Initiative is seeking to identify conflicts of interest tied to advisers recommending mutual fund and 529 plan share classes with loads or distribution fees that may benefit either the adviser or its affiliates. Advisers have an obligation to act in their clients’ best interests and disclose material conflicts of interest, and adopt written policies and procedures that are reasonably designed to prevent violations of the Advisers Act, including those that govern their mutual fund share class selection process. The SEC will focus on advisers’ practices related to share class recommendations and compliance oversight, and will conduct focused, risk-based examinations of high-risk areas, including fiduciary duty and best execution, disclosures and compliance programs.

The SEC’s Spring 2016 Agency Rule List Published by the Office of Information and Regulatory Affairs Targets Numerous Regulatory Actions for 2017

According to the SEC’s Spring 2016 Agency Rule List, [13] published by the Office of Information and Regulatory Affairs and the Office of Management and Budget, the agency intends to promulgate numerous regulatory actions that may be of importance to the investment management industry.

Agency Rule Lists generally are published on a semi-annual basis and provide insight into pending and planned regulatory initiatives of various federal agencies. While there are no guarantees that actions will be taken in respect of the regulatory proposals set forth on the lists, the lists do provide useful guidance in respect of regulators’ plans.

Based on the SEC’s regulatory plans set forth in its Agency Rule List, the SEC intends to act on the following regulatory initiatives, among others: (1) amendments to Regulation D and Form D under the Securities Act of 1933 (proposed rules have been pending since 2013); (2) a uniform fiduciary standard of conduct for broker-dealers and investment advisers; (3) stress testing requirements for large asset managers and large investment companies; (4) amendments to Form ADV (proposed rules have been pending since 2015); and (5) transition plans for registered investment advisers (proposed rules were issued in June 2016).

 

[1] See Securities and Exchange Commission, Proposed Rule, Adviser Business Continuity and Transition Plans, 17 CFR Part 285 (June 28, 2016).

[2] For information on business continuity planning for registered investment companies, see IM Guidance Update, Securities and Exchange Commission, Division of Investment Management, Business Continuity Planning for Registered Investment Companies (June 2016).

[3] See Securities and Exchange Commission, Proposed Rule, Adviser Business Continuity and Transition Plans (June 28, 2016) and Securities and Exchange Commission, Press Release, SEC Proposes Rule Requiring Investment Advisers to Adopt Business Continuity and Transition Plans (June 28, 2016).

[4] See Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, No. 10-10921 (D. Mass. 2016).

[5] See In the Matter of Blackstreet Capital Management, LLC and Murry N. Gunty, Investment Advisers Act of 1940, Release No. 4411 (June 1, 2016).

[6] See Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, No. 10-10921 (D. Mass. 2016).

[7] See Customer Due Diligence Requirements for Financial Institutions; Final Rule, 81 Fed. Reg. 91 (May 11, 2016) (to be codified at 31 C.F.R. pt. 1010, 1020, 1023, et al.).

[8] See National Futures Association, Interpretive Notice, NFA Compliance Rules 2-9, 2-36, and 2-49: Information Systems Security Programs (August 20, 2015).

[9] See NFA Compliance Rule 2-9.

[10] See NFA Compliance Rule 2-49.

[11] For more information on cybersecurity and information security, please refer to Investment Adviser Cybersecurity: Principles and Effective Practices in Chadbourne & Parke LLP’s Fund Formation and Investment Management NewsWire (Winter 2015).

[12] See Securities and Exchange Commission: Office of Compliance Inspections and Examinations, National Exam Program Risk Alert, OCIE’s 2016 Share Class Initiative (July 13, 2016).

[13] See Office of Information and Regulatory Affairs, Agency Rule List – Spring 2016.

*Nadia Bryan, a Summer Associate with Chadbourne, assisted with the preparation of this article.

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