Financial Services Alert - November 15, 2011 November 15, 2011
In This Issue

SEC and CFTC Adopt Joint Final Rules for Confidential Reporting of Private Fund Information by SEC-Registered Advisers and Certain Jointly Registered Advisers

The SEC and the CFTC adopted joint rules and new Form PF (collectively, the “Private Fund Reporting Rules”) that implement a mandate under the Dodd-Frank Act to gather information from federally registered investment advisers regarding their private funds (i.e., funds that rely on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940) for use by the Financial Stability Oversight Council in assessing and monitoring systemic risk.  The Private Fund Reporting Rules will require periodic, confidential submission of private fund information to the SEC in electronic form on Form PF by SEC-registered advisers whose private fund assets under management exceed certain thresholds (discussed in greater detail below).  The Private Fund Reporting Rules do not apply to exempt reporting advisers (e.g., advisers that rely on the registration exemption for venture capital fund advisers, see the June 30, 2011 Goodwin Procter Alert for more on exempt reporting advisers). 

The Private Fund Reporting Rules direct CFTC-registered commodity pool operators (CPOs) and commodity trading advisers (CTAs) that are also registered with the SEC to file any required private fund information with the SEC on Form PF.  The joint rules also allow jointly registered advisers to use Form PF to report information to the SEC with respect to commodity pools that would otherwise have to be reported to the CFTC.  (The CFTC has proposed, but taken no further action on, its own systemic risk reporting requirements.)

Frequency and Substance of Reports.  A registered adviser with more than $150 million in assets under management attributable to private funds will be required to file Form PF (see “Calculating Private Fund Assets under Management” below).  However, the content and frequency of an adviser’s reports on Form PF will depend in large part on whether the adviser is a “large private fund adviser” or a “smaller private fund adviser.”  Large private fund advisers are divided into the following three categories, each with its own particular reporting requirements:

  • A large hedge fund adviser (at least $1.5 billion in assets under management attributable to “hedge funds”) must make quarterly Form PF filings.  Each filing is due within 60 days of the adviser’s fiscal quarter‑end.  The information to be provided in these filings regarding hedge funds the adviser manages includes (1) aggregate information regarding exposures by (i) asset class, (ii) geographical concentration, and (iii) turnover by asset class and (2) for each hedge fund with a net asset value of $500 million or more, information relating to (A) exposures, (B) liquidity, (C) risk metrics, (D) borrowings and derivatives positions, (E) side pockets and (F) investor withdrawals/redemptions (but no position-level information).
“Hedge fund” as defined in Form PF sweeps more broadly than the term on its face suggests.  A “hedge fund” is any private fund (other than a securitized asset fund as defined below) that (i) with respect to which one or more advisers (or their related persons) may be paid a performance fee or allocation calculated by taking into account unrealized gains; (ii) may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net asset value (including any committed capital); or (iii) may sell securities or other assets short or enter into similar transactions (other than for the purpose of hedging currency exposure or managing duration). 

The joint adopting release notes that a private fund is not a “hedge fund” solely because its organizational documents do not “prohibit the fund from borrowing or incurring derivative exposures in excess of the specified amounts or from engaging in short selling so long as the fund in fact does not engage in these practices (other than, in the case of clause [(iii) above], short selling for the purpose of hedging currency exposure or managing duration) and a reasonable investor would understand, based on the fund’s offering documents, that the fund will not engage in these practices.”

  • Large liquidity fund advisers (at least $1 billion in combined assets under management attributable to “liquidity funds” and registered money market funds) must make quarterly Form PF filings.  Each filing is due within 15 days of the adviser’s fiscal quarter-end.  These filings must provide information for each liquidity fund with respect to (1) types of assets, (2) risk profile‑related matters, and (3) the extent to which the liquidity fund complies with conditions in Rule 2a-7 under the Investment Company Act of 1940 governing registered money market funds.
A “liquidity fund” is any private fund that seeks to generate income by investing in a portfolio of short-term obligations in order to maintain a stable net asset value per unit or minimize principal volatility for investors.

  • Large private equity fund advisers (at least $2 billion in assets under management attributable to “private equity funds”) must make annual Form PF filings within 120 days of their fiscal year-ends responding to questions focused primarily on portfolio company leverage and industry and geographical breakdowns.

A “private equity fund” is any private fund that is not a hedge fund, liquidity fund, venture capital fund, real estate fund or securitized asset fund (each as defined in Form PF) and does not provide investors with redemption rights in the ordinary course. 

Venture capital fund” has the same meaning as in Rule 203(l)-1 under the Advisers Act, which defines the term for purposes of the new venture capital fund adviser exemption created by the Dodd-Frank Act (as discussed in the June 30, 2011 Goodwin Procter Alert).

A real estate fund is any private fund that is not a “hedge fund” (as defined above), that does not provide investors with redemption rights in the ordinary course and that invests primarily in real estate and real estate related assets. 

A securitized asset fund is any private fund whose primary purpose is to issue asset backed securities and whose investors are primarily debt‑holders.

Any other adviser required to file Form PF is a “smaller private fund adviser” that will have to file Form PF annually within 120 days of its fiscal year-end, reporting only limited information for the adviser’s private funds including (a) fund type (selected from among those noted above and an “other private funds” category), (b) size, (c) borrowings, (d) derivatives positions, (e) investor types and concentration and (f) performance.  A smaller private fund adviser managing hedge funds will also have to report information for those funds regarding (1) fund strategy, (2) counterparty credit risk and (3) use of trading and clearing mechanisms

Calculating Private Fund Assets under Management.  In determining whether any of the reporting thresholds discussed above is met, Form PF requires a private fund adviser to use the new “regulatory assets under management” calculation that will be mandatory for amendments to Form ADV Part 1A beginning January 1, 2012 (as discussed in the June 28, 2011 Financial Services Alert).  In broad terms, regulatory assets under management include all “securities portfolios” (i.e., those portfolios 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 determining whether Form PF reporting thresholds are met, a private fund adviser must also aggregate with its private funds its managed accounts that pursue substantially the same investment objective and strategy and invest in substantially the same positions (“parallel managed accounts”) unless the value of those accounts exceeds the value of the private funds with which they are managed.  An adviser must also treat assets of private funds and parallel managed accounts advised by each of its “related persons” as if they were the adviser’s own unless the related person is separately operated.  “Related person” is defined as in Part 1A of Form ADV and includes an adviser’s control persons.  

A related person is separately operated if (1) the adviser has no business dealings with the related person in connection with the adviser’s advisory business; (2) the adviser and related person do not conduct shared operations; (3) there is no referral of clients or business between the adviser and related person; (4) the adviser and related person do not share premises or supervised persons; and (5) the adviser has no reason to believe that its relationship with the related person otherwise creates a conflict of interest with the adviser’s clients.

Compliance Dates. The following advisers are required to begin filing Form PF following their first fiscal year or fiscal quarter, as applicable, ending on or after June 15, 2012:

  • Advisers with at least $5 billion in assets under management attributable to hedge funds
  • Advisers with at least $5 billion in combined assets under management attributable to liquidity funds and registered money market funds
  • Advisers with at least $5 billion in assets under management attributable to private equity funds

All other private fund advisers are required to begin complying with Form PF requirements following the end of their first fiscal year or fiscal quarter, as applicable, ending on or after December 15, 2012.

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Form PF is a substantial new reporting obligation.  This article conveys only a very broad sense of the kinds and amount of information Form PF requires, which can vary significantly depending on a private fund adviser’s particular circumstances.  Given the potential complexities of producing the required information in a timely manner, each private fund adviser should carefully review Form PF with an eye towards developing (i) procedures to monitor its filing obligations on an ongoing basis and (ii) if needed, a plan for collecting/generating appropriate data for its Form PF filings.

Financial Stability Board Announces Policy Measures to Address Global Systemically Important Financial Institutions

The Financial Stability Board (“FSB”) announced policy measures to address the risks to the global financial system posed by certain large, complex financial institutions known as global systemically important financial institutions (“G-SIFIs”).  The FSB also identified the initial group of 29 G-SIFIs, including eight U.S.‑headquartered institutions.  The policy measures for G-SIFIs include:

  • A new international standard as a point of reference for reforms of national resolution regimes, to strengthen authorities’ powers to resolve failing financial firms in an orderly manner and without exposing the taxpayer to the risk of loss;
  • Requirements for resolvability assessments, recovery and resolution plans and institution-specific cross-border cooperation agreements for G-SIFIs;
  • Requirements for additional loss absorption capacity above the Basel III minimum for global systemically important banks; and
  • More intensive and effective supervision through stronger supervisory mandates, and higher supervisory expectations for risk management functions, risk data aggregation capabilities, risk governance and internal controls.

G-SIFIs will be subject to an additional capital requirement to hold between 1% to 2.5% of risk-weighted assets, above the minimum requirements set under the Basel III capital accord, with the amount of additional capital depending on each institution’s systemic importance.  In addition, any G-SIFI which becomes larger in the future, posing an even bigger threat to the stability of the global financial system, may be subject to a higher 3.5% additional capital requirement.  The additional capital requirements will be based on G‑SIFIs identified in November 2014, not on the current list released by the FSB, and will be phased in starting in January 2016 with full implementation by January 2019.  G‑SIFIs must also meet higher supervisory expectations for data aggregation. The FSB stated that the FSB and Basel Committee on Banking Supervision have assessed the macroeconomic impact of higher loss absorbency requirements for G‑SIFIs, and that the benefit of greater resilience of these institutions is expected to exceed the temporary decline of GDP during the implementation process.

FINRA Issues Guidance on Advertising Issues

FINRA issued Regulatory Notice 11-49 (the “Notice”) providing guidance to members related to the application of NASD Rule 2210 (Communications with the Public) and the filing of communications for review with FINRA’s Advertising Regulation Department.  The Notice states that FINRA intends to periodically issue guidance to the industry concerning significant interpretive issues or other issues related to FINRA rules governing communications with the public.  The issuance of the Notice appears to respond to a recommendation in the July 2011 report on mutual fund advertising issued by the Government Accountability Office (which was discussed in the August 2, 2011 Financial Services Alert) that the SEC take steps to ensure that FINRA develops mechanisms to ensure industry-wide notification of new interpretive positions for its mutual fund advertising rules.  In addition to the following topics, the Notice also addresses the use of FINRA’s name in trademarks and members’ identification of related prior filings when submitting new materials for review:

Exchange Traded Funds.  The Notice reminds FINRA members that NASD Rule 2210(c)(2), which requires FINRA members to file advertisements and sales literature concerning registered investment companies with FINRA within 10 business days of first use or publication, applies to advertisements and sales literature, including research reports, concerning exchange traded funds (“ETFs”) and to exchange traded products that meet the definition of a “direct participation program” under FINRA rules.

Treasury Inflation-Protected Securities Funds.  The Notice states that a number of mutual funds, including ETFs, invest heavily in Treasury Inflation-Protected Securities (“TIPS”) Funds and that because SEC rules governing the calculation of a mutual fund’s current yield do not prescribe a method for treating the inflation adjustment component of TIPS, various treatments of the inflation adjustment component of TIPS for purposes of disclosing the mutual funds’ yield have evolved.  To address the inconsistencies among these treatments, FINRA has interpreted NASD Rule 2210(d) to include the following requirements for advertisements and sales literature that include the current yield of a mutual fund that invests in TIPS: (1) if the fund’s current yield is adjusted monthly based on changes in the rate of inflation, then the communication must explain that these changes can cause the yield to vary substantially from one month to the next; and (2) if an advertisement or item of sales literature includes an exceptionally high current yield for a fund that invests in TIPS, it must disclose that the yield is attributable to the rise in the inflation rate, which might not be repeated.

Massachusetts Issues Revised Proposal to Amend Investment Adviser Registration Exemptions

The Massachusetts Securities Division (the “Division”) published for public comment a revised proposal that would phase out a commonly-used exemption from registration as an investment adviser with the Commonwealth and create a new private fund adviser registration exemption.  The Division is seeking to adjust the Commonwealth’s regulation of investment advisers to accommodate the Dodd-Frank Act’s elimination of the federal registration exemption for advisers with fewer than 15 clients and the related creation of new federal registration exemptions.  (See the June 30, 2011 Goodwin Procter Alert for a discussion of rules adopted by the SEC to implement the registration exemptions under the Investment Advisers Act of 1940 (the “Advisers Act”) created by the Dodd‑Frank Act.)  The revised proposal is designed to address public comment on an initial proposal issued by the Division in April 2011 (as discussed in the April 26, 2011 Financial Services Alert).

Definition of Institutional Buyer.  The revised proposal would modify the definition of “institutional buyer” under Massachusetts regulations to limit the extent to which investment advisers are exempt from registration with the Commonwealth because their only clients are “institutional buyers.”  The revised proposal would carve back the existing category of institutional buyer that consists of any investing entity that accepts only “accredited investors,” each of whom has invested at least $50,000.  The revised proposal would make that category available only to funds that (i) existed prior to March 30, 2012 (the date the SEC’s new rules regarding investment adviser exemptions are to take effect) and (ii) have not accepted new investors since that date.  The revised proposal would, however, allow an adviser to continue to treat such a fund as an “institutional buyer” if the fund accepted additional investments from pre‑March 30, 2012 investors going forward.

Proposed Private Fund Adviser Exemption.  The revised proposal would also create a new Massachusetts registration exemption for advisers whose only clients are funds excluded from the definition of “investment company” under either Section 3(c)(1) (a “3(c)(1) fund”) or Section 3(c)(7) of the Investment Company Act of 1940.  An adviser seeking to rely on this exemption would be subject to additional conditions to the extent it advises a 3(c)(1) fund that is not a “venture capital fund” within the meaning of SEC Rule 203(l)-1 under the Advisers Act, which defines the term for purposes of the new venture capital fund adviser exemption created by the Dodd-Frank Act (as discussed in the June 30, 2011 Goodwin Procter Alert).  The adviser would have to (a) limit the investors in such a non-venture capital 3(c)(1) fund to “qualified clients” as defined in SEC Rule 205-3 under the Advisers Act (subject to a grandfathering provision for pre-March 30, 2012 funds with non-qualified client investors); and (b) provide the fund’s investors with (i) certain disclosures at the time of purchase and (ii) annual audited financial statements for the fund.  All advisers relying on the proposed Massachusetts exemption would be required to file in Massachusetts any reports they file with the SEC as “exempt reporting advisers.”  (The reporting requirements for exempt reporting advisers are discussed in the June 30, 2011 Goodwin Procter Alert.)  The proposed exemption is subject to additional conditions, including the absence of any disqualification based on certain disciplinary matters.

Hearing and Public Comment.  The Division will hold a public hearing on the revised proposal at 10:00 a.m. on December 6, 2011.  Comments on the revised proposal may be submitted to the Division through December 7, 2011.

CFPB to Provide Advance Warning Prior to Most Enforcement Actions

The CFPB issued a release informing institutions and individuals that it will provide an early warning notice before initiating a formal legal proceeding for an alleged violation of a consumer financial protection law.  The CFPB noted that the early warning notice is not required by law and its use will be discretionary.  Enforcement staff will have the ability to bypass providing a notice when prompt action is deemed necessary.  An advance notice will be accompanied by evidence of the alleged violation, and the recipient of such notice will have 14 days to submit a written response to the CFPB, which may include any relevant legal or policy arguments and facts in response to the alleged violation.  Factual assertions included in any written response must be made under oath by someone with personal knowledge of such facts, and responses will be discoverable by third parties.  The CFPB will decide whether to proceed with an enforcement action following its review of a written response.

Federal Savings Associations to be Subject to Standard OCC Appeals Process

Pursuant to Section 316 of the Dodd-Frank Act, the OCC issued a bulletin (the “Bulletin”), revising its procedures for national banks to appeal OCC actions and decisions to include federal savings associations.  The Bulletin  provides for a uniform appeals process for national banks, federal savings associations, and federal branches and agencies.  The Bulletin replaces the prior OCC appeals guidance relating to national banks and repeals the existing OTS appeals guidance.

CFTC Adopts Final Rules for Core Principles Governing Derivatives Clearing Organizations

The CFTC adopted final rules that establish the regulatory standards for compliance with the Core Principles for derivatives clearing organizations (“DCOs”) set forth in Section 5b of the Commodity Exchange Act.  Among other things, the CFTC’s action also updates and adds related definitions; adopts implementing rules for DCO chief compliance officers (“CCOs”); revises procedures for DCO applications including the required use of a new Form DCO; adopts procedural rules applicable to the transfer of a DCO registration; and adds requirements for approval of DCO rules establishing a portfolio margining program for customer accounts carried by a futures commission merchant that is also registered as a securities broker‑dealer.  The final rules generally become effective January 12, 2012 with delayed compliance dates in certain instances.