Financial Services Alert - June 28, 2011

The SEC issued three releases that contain final rules and form amendments related to changes in federal adviser regulation effected by the Dodd-Frank Act.

• The first release addresses rules designed to implement new exemptions from registration under the Investment Advisers Act of 1940 (“Advisers Act”) created by the Dodd-Frank Act, including exemptions for advisers to “venture capital funds,” “private fund advisers” with less than $150 million in assets under management and “foreign private advisers.” 


• The second release describes rule and Form ADV changes that principally address (a) information that registered advisers and certain advisers that are exempt from registration (“exempt reporting advisers”) must provide in Form ADV Part 1 regarding “private funds” they advise, (b) other changes to Form ADV requirements designed to assist SEC compliance risk assessment, (c) changes in the boundaries between federal and state registration, and related transition matters, and (d) adjustments to various Advisers Act rules, e.g., the “pay to play” rule, to accommodate changes effected by the Dodd-Frank Act.
• The third release, which relates to a new SEC rule implementing an exemption from registration under the Advisers Act of 1940 for “family offices,” is the subject of a June 23, 2011 Goodwin Procter Alert.

Following the SEC open meeting at which the final rules and form amendments were adopted, Goodwin Procter issued an Alert summarizing the description of these changes provided at the meeting.  This edition of the Alert includes a discussion of how the SEC’s action, particularly the changes made to Form ADV Part 1A, will affect advisers that are already registered with the SEC.  Later this week, Goodwin Procter will provide a detailed Alert analyzing the new exemptions and discussing the final rules’ implementation provisions, with a focus on how the final rules affect advisers to private funds and non-U.S. advisers.

The SEC issued final rule and form changes (the “Implementing Amendments”) that will (a) require advisers who are exempt from registration under the new exemptions from adviser registration created by the Dodd-Frank Act for advisers to venture capital funds and advisers to private funds with less than $150 million in assets under management, as discussed in the July 23, 2010 Goodwin Procter Alert (collectively, “Exempt Reporting Advisers”), to file certain information with the SEC, and (b) give effect to other provisions of the Dodd‑Frank Act.  Although the Implementing Amendments focus to a significant extent on Exempt Reporting Advisers, the changes they make to Form ADV Part 1A also apply to registered investment advisers, and set forth new, detailed reporting requirements regarding private funds managed by registered investment advisers.  This article provides an overview of the principal changes to Form ADV under the Implementing Amendments.  The Implementing Amendments also include amendments to Rule 206(4)‑5, the so‑called “pay to play” rule, which was adopted in July 2010 (as discussed in the July 9, 2010 Goodwin Procter Client Alert) and is not fully effective; these amendments (1) make Exempt Reporting Advisers subject to the rule, (2) create an additional exception to allow payments to a registered municipal advisor for soliciting a government entity, subject to certain conditions, and (3) push back the compliance date for the Rule’s provision limiting payment for third-party solicitation of government entities from September 30, 2011 to June 13, 2012.

Calculating Assets Under Management

The Implementing Amendments create the defined term “regulatory assets under management,” which is used to determine whether an adviser is eligible to be registered with the SEC.  Regulatory assets under management include all “securities portfolios” (i.e., the total value of each portfolio at least 50% of whose total value consists of securities) for which an adviser provides continuous and regular supervisory or management services (without any deduction for leverage or other accrued but unpaid liabilities, but including uncalled capital commitments).  In calculating this amount, an adviser must include proprietary assets, assets managed without receiving compensation, and assets of foreign clients in the regulatory assets under management calculation; currently an adviser may, but is not required to, include these amounts in calculating its assets under management for Form ADV Part 1A.  Regulatory assets under management also include the value of any private fund over which an adviser exercises continuous and regular supervisory or management services regardless of the nature of the assets held by the fund.  (The Implementing Amendments define “private fund” as an investment company that relies on the exclusion in Section 3(c)(1) or 3(c)(7) under the Investment Company Act of 1940 (the “1940 Act”).)  The SEC will require advisers to use the market value, or the fair value if market value is unavailable, (not cost) of private fund assets in determining their regulatory assets under management.  The Implementing Amendments do not mandate the use of GAAP or any other accounting standard.

Private Fund Reporting

The Implementing Amendments significantly increase the amount of information that an adviser is required to report on its private funds under Item 7.B. of Form ADV Part 1A.  These amendments in part, reinstate Form ADV Part 1A amendments that the SEC adopted in 2004 as part of its “hedge fund adviser registration” rulemaking, but which were vacated by the 2006 decision in Goldstein v. Securities and Exchange Commission. 

Under the Implementing Amendments, the SEC will no longer require an adviser to report funds that are advised by affiliates, and will allow a sub-adviser to exclude private funds for which an adviser is already reporting on Schedule D to Form ADV Part 1A.  In addition, an adviser sponsoring a master‑feeder arrangement may submit information on an aggregate basis for the master fund and all of the feeder funds that would otherwise be submitting substantially identical data.

Section 7.B.1.A. of Schedule D to Form ADV Part 1A will require identifying information for each private fund, including the fund’s name, as well as the state or country where the fund was organized, and the name of its general partner, directors, trustees or persons occupying similar positions.  The adviser will also need to provide information about its regulatory status and the regulatory status of the fund, including the exclusion from the 1940 Act on which the fund relies, whether the adviser is subject to a foreign regulatory authority, and whether in offering its securities the fund relies on an exemption from registration under the Securities Act of 1933. 

The adviser will be required to disclose the fund’s gross assets and identify in which of the following categories the fund falls based on its investment strategy: (i) hedge fund; (ii) liquidity fund; (iii) private equity fund; (iv) real estate fund; (v) securitized asset fund; (vi) venture capital fund; or (vii) other private fund.  An adviser that is a sub-adviser to a private fund will be required to identify by name and SEC file number any other advisers to the fund.  The SEC chose not to adopt amendments that would require an adviser to (a) disclose a private fund’s net assets; (b) report private fund assets and liabilities by class and categorization in the fair market hierarchy established under GAAP; and (c) provide the percentage of each private fund owned by specified types of beneficial owners (e.g., individuals, broker-dealers, pension plans, state and local governments).  This information may nevertheless ultimately be required in reports to the SEC and Financial Stability Oversight Council on Form PF.  (The SEC and CFTC’s proposal regarding Form PF was discussed in the February 1, 2011 Alert.)  Finally, an adviser must disclose the number and the types of investors in a private fund, as well as the minimum amounts required to be invested by fund investors.  

Information Regarding Service Providers

Section 7.B.1.B. of Schedule D to Form ADV Part 1A will require an adviser to provide information regarding five types of service providers that the SEC perceives as “gatekeepers” for private funds: auditors, prime brokers, custodians, administrators and marketers.  For each private fund, an adviser must identify each of these service providers, provide their locations, and state whether they are related persons.  Form ADV will require specific information for each service provider regarding its services and registration status, including the following:

• Auditors: whether the they are independent, registered with the PCAOB and subject to its regular inspection, whether audited statements are distributed to fund investors, and whether the auditor’s report contains an unqualified opinion.
• Prime Brokers: whether they are SEC-registered and whether they act as custodian for private fund assets. 
• Custodians: whether they are related persons of the adviser. 
• Administrators: whether they prepare and send account statements to fund investors and what percentage of the fund assets are valued by a person, such as an administrator, that is not a related person of the adviser. 
• Marketers: whether they are related persons of the adviser, their SEC file number (if any), and the address of any website they use to market the fund.

Information about an Adviser’s Business

The Implementing Amendments revise Item 5 of Form ADV Part 1A, which requires an adviser to provide basic information regarding its business, including the types of services it provides, and clients.  Among other things, the Implementing Amendments expand the list of client types and require an adviser to provide the approximate amount of assets under management attributable to each client type using the new regulatory assets under management calculation and state the approximate percentage of its clients that are not United States persons.  An adviser that discloses that it has a registered investment company client must provide that investment company’s SEC file number under the 1940 Act, which will enable SEC examination staff to cross check Form ADV disclosures against corresponding disclosures in investment company filings.

Other Business Activities and Financial Industry Affiliations

The Implementing Amendments expand the range of other financial services that if provided by an adviser or one of its affiliates must be identified in both Items 6 and 7 of Form ADV Part 1A to also include acting as trust company, registered municipal advisor, registered security-based swap dealer, and major security-based swap participant, the latter three of which are new SEC registrants created by the Dodd-Frank Act. The Implementing Amendments also require additional reporting in the corresponding sections of Schedule D, which will entail disclosure relating to the use of other business names and identifying information for each related person listed in Item 7.A., including more details about the relationship between the adviser and the related person, whether the related person is registered with a foreign financial regulatory authority, and whether the adviser and related person share personnel or the same physical location.  

In response to public comment, the SEC scaled back the Schedule D disclosure requirements from those it had originally proposed so that an adviser will be able omit disclosure for a related person if:

(1) the adviser and related person have no business dealings related to the adviser’s advisory business;

(2) the adviser and related person do not conduct shared operations;

(3) the adviser and related person do not refer clients or business to each other;

(4) the adviser does not share its supervised persons or premises with the related person; and

(5) the adviser has no reason to believe that its relationship with the related person otherwise creates a conflict of interest with its clients.

The adopting release provides the following examples of how these conditions will apply: an adviser may omit Schedule D disclosure for (a) an offshore adviser with which the adviser has no business dealings; (b) a bank that merely provides it with payroll services; (c) an accounting firm that prepares the adviser’s annual tax return filings; or (d) a real estate broker that represents the adviser in securing office space; but an adviser may not omit an affiliated adviser with whom the adviser shares information technology  infrastructure, which would be considered sharing operations.

Participation in Client Transactions

Under Item 8 of Form ADV Part 1A an adviser is required to indicate if it has discretionary authority to determine the brokers or dealers for client transactions and if it recommends brokers or dealers to clients.  The Implementing Amendments require additional disclosure as to whether any of the recommended brokers or dealers are related persons of the adviser.  In addition, an adviser that indicates that it receives “soft dollar benefits” must also report whether all those benefits qualify for the safe harbor under Section 28(e) of the Securities Exchange Act of 1934 for eligible research or brokerage services.  Finally, an adviser must indicate whether it or any of its related persons receives compensation for client referrals.

Reporting $1 Billion in Balance Sheet Assets

Pursuant to Section 956 of the Dodd-Frank Act, the SEC and certain other federal regulators have proposed a joint rule that addresses certain excessive incentive-based compensation arrangements, including those of any registered investment adviser with $1 billion or more in assets on its own balance sheet.  (See the March 8, 2011 Alert for a discussion of the proposed rule.)  Under the Implementing Amendments each adviser must indicate in Item 1 of Form ADV Part 1A whether or not the adviser had $1 billion or more in assets on its balance sheet as of the last day of the adviser’s most recent fiscal year. 

Compliance Date for Form ADV Changes

The SEC currently anticipates that beginning in November 2011 the IARD, which receives electronic filings on Form ADV, will have been re-programmed to accept the changes to Form ADV adopted in the Implementing Amendments.  After January 1, 2012, any adviser filing an amendment to Form ADV will be required to provide responses to revised Form ADV.  As part of the transition process for Dodd-Frank Act related changes to Advisers Act exemptions, all advisers registered on January 1, 2012, regardless of their fiscal year end, will be required to file an amendment to their Form ADV on revised Form ADV by March 30, 2012.  An investment adviser filing an initial application for registration after the IARD is re-programmed to accommodate filing of the revised Form ADV must complete the revised form.

The November 2, 2010 Alert reported that the U.S. District Court for the Northern District of California granted a motion to dismiss the amended complaint in a derivative suit brought by a mutual fund shareholder against the fund’s distributor and trustees alleging (a) a violation of Section 47(b) of the Investment Company Act of 1940, as amended (the “1940 Act”), by the distributor, and (b) state law claims of (i) breach of contract by the distributor, (ii) breach of fiduciary duty by the defendant trustees, and (iii) waste of fund assets by the defendant trustees.  The suit claimed that because the fund’s Rule 12b-1 payments to brokers to sell and service fund shares are calculated on the fund’s net asset value, such asset-based compensation constitutes “special compensation” with respect to brokerage accounts and is unlawful under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).  Smith v. Franklin/Templeton Distributors, No. C 09-4775 PJH (N.D. Cal. Oct. 22, 2010).

Recently, two other federal district courts dismissed similar complaints brought by the same plaintiff’s counsel and asserting the same claims.  The United States District Court for the District of Massachusetts held that the Rule 12b-1 payments are not illegal, finding that the SEC’s rulemaking effort and the rejection of that effort in Financial Planning Association v. SEC, 482 F.3d 481 (D.C. Cir. 2007), was not dispositive with respect to the interpretation of “special compensation.”  The court therefore declined to find that the Trust’s payment of the asset-based Rule 12b-1 fees automatically disqualified use of the broker-dealer exemption.  It found “no facts alleged that would demonstrate that the 12b-1 fees at issue here constitute special compensation for advisory services,” and said that even if broker‑dealers were required to treat accounts as advisory accounts, “[t]he Trust has no legal obligation to ensure that these actions are taken.”  The court further held that even if the Rule 12b-1 payments somehow violated the Advisers Act, they did not constitute a violation of Section 36(a) or Rule 38a-1 of the 1940 Act.  Even though the court said that a private right of action exists under Section 47(b) of the 1940 Act for a party to a contract to void or rescind a contract for a violation of the 1940 Act, it dismissed that claim here because no predicate violation existed.  Lastly, the court concluded that the state law claims for breach of contract, breach of fiduciary duty and waste likewise failed because the Rule 12b-1 payments were not illegal.  Wiener v. Eaton Vance Distributors, Inc., No. 10‑10515‑DPW (D. Mass. March 30, 2011). 

The United States District Court for the Southern District of New York also dismissed the plaintiff’s complaint, but for different reasons.  It held that in order to seek rescission under Section 47(b), the plaintiff must assert a predicate violation of a substantive provision of the 1940 Act which itself has a private right of action.  The court cited Second Circuit precedent in concluding that neither Section 36(a) of the 1940 Act – which gives the SEC authority to bring an action for breach of fiduciary duty – nor Rule 38a-1 provides a private right of action.  Therefore, the court dismissed the Section 47(b) claim, and declined to exercise jurisdiction over the state law claims.  Smith v. Oppenheimer Funds Distributor, Inc., Nos. 10 Civ. 7387 (LBS) and 10 Civ. 7394 (LBS) (S.D.N.Y. June 6, 2011). 

The plaintiffs in Smith v. Franklin/Templeton Distributors and in Wiener v. Eaton Vance Distributors, Inc. initially appealed dismissal of their complaints, but now have voluntarily dismissed both appeals.

Goodwin Procter LLP represented the independent trustees in the Wiener and Franklin/Templeton proceedings.

In an unpublished opinion, the U.S. Court of Appeals for the Fourth Circuit (the “Court of Appeals”) upheld a 2007 decision of the U.S. District Court for the Southern District of West Virginia (the “District Court”) that an audit by Grant Thornton LLP (“Grant Thornton”) of First National Bank of Keystone (the “Bank”) was the proximate cause of losses sustained by the Bank after the audit.  Grant Thornton was hired by the Bank in 1998 after the OCC ordered the Bank to hire a nationally recognized independent auditor to scrutinize the Bank’s operations.  Grant Thornton issued an audit report of the Bank on April 21, 1999 that the District Court concluded was negligent and that, among other things, failed to report that the Bank was carrying over $400 million of loans on its books that were not owned by the Bank.  The FDIC, as receiver, closed the Bank on September 1, 1999.  The District Court concluded that Grant Thornton’s negligent behavior cost the FDIC’s insurance fund approximately $750 million.

On appeal, Grant Thornton did not contest that its actions had been negligent, but argued that they were not the proximate cause of the losses to the Bank or the FDIC’s insurance fund.  The Court of Appeals disagreed and stated that a “reasonably prudent auditor” should have identified the Bank’s true losses and its insolvent position and have foreseen that they could lead to further losses at the Bank.  The Court of Appeals took special note of the fact that when Grant Thornton was hired, it was aware that the Bank was under a high level of regulatory scrutiny and that Grant Thornton was being hired because of that high level of regulatory concern. 

In its opinion, the Court of Appeals stressed that this case presented a unique set of facts, that it was not setting a new standard of auditor liability and that, as an unpublished opinion, the decision does not serve as precedent for future cases.

On June 23, 2011, the SEC issued Release No. 34-64736 concerning FINRA’s rule filing to adopt FINRA Rule 3110 (Supervision) and FINRA Rule 3120 (Supervisory Controls) and certain related rules.  These rule changes are intended to consolidate existing NASD and NYSE rules and guidance relating to supervision and supervisory controls of member firms into FINRA rules.  Although many of the consolidated provisions are identical or nearly identical to those in the original rules, there are some substantive changes, including new guidance in Supplementary Material appended to the end of Rule 3110.  A table prepared by Goodwin Procter showing the origins of the consolidated rule provisions and discussing substantive changes is available here.

The OCC, FRB, FDIC, Farm Credit Administration and the Federal Housing Finance Agency extended the comment period until July 11, 2011 on proposed joint rulemaking that would establish minimum margin and capital requirements for swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants as required by the Dodd-Frank Act. The comment period had originally been set to end on June 24, 2011 (as discussed in the May 31, 2011 Alert).

The Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, issued a statement providing that the capital surcharge that will be imposed on global systemically important banks will be in the range of 1% to 2.5%, depending on the bank’s systemic importance.  This capital surcharge, which was smaller than feared by many in the industry, must be met with Common Equity Tier 1 capital, and is in addition to the 7% Common Equity Tier 1 capital ratio requirement generally imposed on all banks by Basel III.  In addition, to “provide a disincentive for banks facing the highest charge to increase materially their global systemic importance in the future, an additional 1% surcharge would be applied in such circumstances.”