London Hedge Fund
Summit
Tuesday 29 April 2014
© Copyright 2014 by K&L Gates LLP. All rights reserved.
Issues for CTAs and Managed
Futures Firms
Sean P Donovan-Smith, Partner (London)
Michael W. McGrath, CFA, Partner (Boston)
© Copyright 2014 by K&L Gates LLP. All rights reserved.
Overview
 Regulation of OTC Derivatives in the US: DoddFrank Title VII
 Regulation of OTC Derivatives in the EU: EMIR
 MiFID II
 Commodity Pool Operator / Commodity Trading
Advisor Registration
klgates.com
3
Regulation of OTC Derivatives
in the US: Dodd-Frank Title VII
April 2014
© Copyright 2014 by K&L Gates LLP. All rights reserved.
Dodd-Frank Title VII Objectives
 Key Dodd-Frank objectives for derivative regulation:
 Improve transparency
 Reduce the potential for defaults, excessive risk taking, and
systemic risks
 Minimize unfair dealing, fraud, and manipulation
 Dodd-Frank rulemaking is an ongoing process
 Different regulators proceed according to different schedules
klgates.com
5
Dodd-Frank Title VII – U.S. Regulators

SEC



CFTC



Regulate standards of conduct of and regulatory requirements for banks and related entities
in swaps, SB Swaps, and mixed swaps
FSOC


Swaps (everything that is not an SB Swap) and mixed swaps (with security and non-security
characteristics)
Swap dealers, major swap participants, futures commission merchants, swap clearing
organizations, exchanges, and swap data repositories
Banking Regulators (“Prudential Regulators”)


Security-based swaps (“SB Swaps”) and mixed swaps
SB Swap Dealers, major SB Swap participants, broker-dealers, SB Swap clearing agencies,
SB Swap exchanges, SB Swap facilities, SB Swap data repositories
Mediates jurisdictional disputes between CFTC and SEC
FERC

Potentially overlapping jurisdiction with CFTC for natural gas and electric power markets
klgates.com
6
Dodd-Frank – Scope of Regulation
Scope - “Swaps” and “Security Based Swaps”
 CFTC regulates Swaps
 Interest rate swaps
 FX
 Covered under Dodd Frank: FX options,
swaptions and non-deliverable forwards
 Not covered under Dodd Frank (except for
Business Conduct): FX swaps, FX forwards
 Not covered at all under Dodd-Frank: FX spot;
securities transactions




Broad Index CDS and equity derivatives
Commodity derivatives
 SEC regulates Security-Based Swaps
 Single name CDS
 Narrow index CDS (9 names or less)
 Single name equity TRS
 Narrow index equity TRS (9 names or less)
 Guarantees of security-based swaps are considered
to be securities subject to federal securities law
regulation
 Security-Based Swaps are “securities” under the ‘33
and ‘34 Acts
Guarantees of swaps are considered to be swaps
Not covered under Dodd-Frank:
 Forward contracts (for nonfinancial
Compare to scope of EMIR!
commodity or security; intended to be
physically settled)
 Futures and exchange-traded options
7
Summary of Dodd-Frank Changes to
Swaps Regulation in the U.S.
 Market Structure:
 Swap Data Repositories (all swaps)
 Central Clearing Counterparties
 Interest rate swaps and certain CDS
 More classes to be added over time
 Swap Execution Facilities
 Position Limits
 Entity Regulation: Swap Dealers (entities that make
markets in swaps) and Major Swap Participants (entities
that engage in significant swap trading)
 Business conduct requirements
 Reporting and recordkeeping requirements
klgates.com
8
Dodd Frank Act – Key Derivatives Provisions
9
Impact on the Buy-Side
 Reporting obligations (unless SD or MSP reports)
 Relationship with SD and MSP counterparties
 Provide information that allows SDs and MSPs to comply with
regulations
 Define settlement and dispute process
 Typically achieved through adherence to the DF Protocol
 “Commercial End-Users” are exempt from most requirements
 Business Impact:





Reporting
Position limits
New trading documentation
Margin requirements for cleared swaps
Margin requirements for uncleared swaps (look for these in 2014)
klgates.com
10
Bilateral and Centrally-Cleared Markets
klgates.com
11
New Documentation for Swaps Trading
Cleared Swaps

Futures & Options Agreement

OTC cleared addendum (FIA/ISDA
form (product/clearinghouse neutral)

Give-up agreement (FIA/ISDA
execution agreement)

Potential master netting arrangement to
net futures, cleared and uncleared
swaps

Clearinghouse Rules

SEF User Agreement and/or SEF
rulebook
Both
DF Protocol

Swap Dealer must
comply with Business
Conduct Rules when
they face a customer
for a swap, whether
cleared or not
Uncleared Swaps

Schedule to the ISDA Master Agreement

Credit Support Annex

If segregation of IA is elected, then
Account Control Agreement with third party
custodian and CSA amendments
Off-SEF

Give-up agreement
(FIA/ISDA execution
agreement)

Schedule to the ISDA
Master Agreement

Credit Support Annex

If segregation of IA is
elected, then Account
Control Agreement
with third party
custodian and CSA
amendments
klgates.com
12
Swap Reporting
Real-time post-trade reporting and Swap Data Repository (SDR) reporting
 Dodd-Frank mandates Real Time Reporting for price forming transactions and
Regulatory Reporting (SDR Reporting) of Positions and Valuations
 One party to the trade is designated the Reporting party per the following hierarchy:
 Swap Dealer (regardless of whether it is a US person or not)
 Major Swap Participant
 End User
 Parties that share the same registration status must agree on the reporting party;
however, a U.S. party is the reporting party when trading with a non-U.S. party.
 Trades executed on a SEF or cleared through DCO are reported by the SEF/DCO
 All parties need to obtain a legal entity identifier - “CICI” / “GMEI”
13
Extraterritorial Application of Dodd-Frank
CFTC Cross-Border Guidance
 Commodity Exchange Act § 2(i)
 Title VII of Dodd-Frank “shall not apply to activities outside the United States unless those
activities have a direct and significant connection with activities in, or effect on, commerce of the
United States as the Commission may prescribe or promulgate as are necessary or appropriate
to prevent the evasion of any provision of this Act that was enacted by the Wall Street
Transparency and Accountability Act of 2010.”
 CFTC approach clarified in July 12, 2013 Guidance Statement
 Swap Dealer (or MSP) category
 Counterparty category
 Category of requirement
 Entity Level (1st and 2nd)
 Transactional Level (1st and 2nd)
 Legal challenge to CFTC Guidance Statement
14
Extraterritorial Application of Dodd-Frank
U.S. Person Definition – selected issues
 8 prongs to U.S. Person Definition, including:
 A “legal entity” (e.g., corporation, partnership, LLC, fund…or any similar form of
enterprise) that (A) is organized or incorporated under US law or (B) has its principal
place of business in the United States.
 Principal place of business – “nerve center” – where high-level officers direct, control and
coordinate the entity’s activities
 For collective investment vehicles- location of senior personnel responsible for
formation/promotion of vehicle implementation of investment strategy, depending on facts and
circumstances
 “The Commission generally believes that [a non-U.S.] person would not come within the “U.S.
person” interpretation solely because it retains an asset management firm located in the United
States…” (see FR 45312)
15
Extraterritorial Application of Dodd-Frank
U.S. Person Definition – selected issues (continued)
 Any commodity pool, pooled account, investment fund, or other collective investment
vehicle not described in the “legal entity” prong that is “majority-owned” by one or
more US persons, unless it is publicly offered only to non-U.S. persons and not
offered to U.S. persons
 Majority ownership test

Direct beneficial owners and “looking-through” the beneficial ownership of entities controlled by or
under common control with the fund

May rely on representations of an unrelated investor entity unless formed for the purpose of avoiding
“looking through”

Reasonable due diligence
 “Publicly offered”

Not defined but the publicly offered vehicle “could be a UCITs” (see FN 224)

Exception is intended to address comments that ownership verification would be particularly difficult for
publicly offered vehicles
16
Non-U.S. Persons That Raise Issues
SEC
CFTC

Non-US affiliates of US persons
 Guaranteed by a US person
 Acting as a conduit (whether or not
guaranteed for a US person)

Non-US registered SD/MSPs

Non-US aggregated affiliates

Non-US person guaranteed by a US person

Non-US person “conducting” a transaction
in the US

Non-US registered SB/MSPs

Non-US aggregated affiliates

Limited importance today, but expect
differences between CFTC and SEC
positions to cause problems in the future
17
Key Takeaways
 Presently concerned with a limited universe of
transactions – “swaps”
 Only one party to a trade is the reporting party
 “U.S. Person” definitions require analysis; end-users
should:
 Know their treatment for representations / DF protocol
adherence
 Be aware of clearing / execution mandates
18
Current / Upcoming Issues
 SEF trading mandates
 Recordkeeping issues
 Collateral requirements for uncleared swaps
 New position limit regulations
19
Regulation of OTC Derivatives
in the EU: EMIR
April 2014
© Copyright 2014 by K&L Gates LLP. All rights reserved.
European Market Infrastructure Regulation (“EMIR”)
Key Provisions
1
Clearing
• Connection to affirmation
platform has to be established
Collateral and Margin
• Connection to at least two clearing
• Margin requirements for non-cleared
members has to be established
swaps
• Daily variation calls
• Eligible collateral has to be
2
transferred as initial margin
Reporting
• Collateral management process to
• All derivatives (OTC and ETD)
be updated
will start to be reported from 12
February 2014 onwards
• Backlog derivative transactions
have to be reported
6
5
Customers
• Portfolios’ OTC
derivative activities
have to be mapped
and monitored
• Portfolios have to be
assessed in the light
of collateral eligibility
3
EMIR
4
Agreements
• Existing legal documentation with
counter- parties, custodian bank and
collateral manager has to be updated
• New contractual relation-ships with
clearing members and affirmation
platforms providers have to be set up
Risk Management &
Valuation
• New capital requirements
have to be fulfilled
• Risk mitigation techniques
for non- standard OTC
derivatives have to be
implemented
• Risk valuation method
has to be aligned
with requirements
EU Regulation of OTC Derivatives
 MiFID II and CRD IV
 EMIR: Derivative contracts existing on August 16, 2012
 Regulatory Technical Standards
 March 15, 2013
 September 15, 2013
 November 18, 2013 - Direct, substantial and foreseeable effect
in the EU and non-evasion
 Expected later 2014 - Margin and capital for non-centrally
cleared OTC derivatives
22
Overview of EMIR
 Central counterparty (“CCP”) and trade
repository (“TR”) requirements
 Clearing of standardised OTC derivative
contracts
 Risk mitigation for uncleared trades
 Trade repository reporting
23
Key Elements of EMIR
 Meaning of “Derivatives”
 Counterparty categorisation
 Financial Counterparties (“FCs”)
 Non-Financial Counterparties (“NFCs”)
 Third country entities (“TCEs”)
 Clearing thresholds
 NFC and NFC+
24
The clearing obligation
The clearing obligation under EMIR will apply:
Between two FCs
Between an FC and an NFC+ entity
Between two NFC+ entities
Between an FC or an NFC+ entity and a TCE (only where the TCE would be
subject to clearing obligation if it was established in the EU)
Between two TCEs if the contract has a “direct, substantial or foreseeable
effect” in the EU (or where it is necessary or appropriate to prevent the evasion
of EMIR’s requirements)
25
Extra-territorial effect
 Direct, substantial and foreseeable
 the contract is guaranteed by an FC; or
 the transaction is executed via the EU branches of the two TCEs
 Anti-Evasion Rule
 “Primary purpose” test
 Artificial arrangements
26
Risk mitigation techniques
 Uncleared OTC trades
 FCs and NFCs (all)
 From March 25, 2013: Timely confirmations
 From September 15, 2013: Reconciliation, portfolio compression
and dispute resolution
 Additional requirements for FC and NFC+ counterparties


Initial and variation margin (see April 2014 RTS consultation)
Daily valuation
 Extraterritorial effect of risk mitigation requirements
27
Trade Reporting
 All contracts entered into on or after August 16,
2012
 Timing T+1
 Back-loading
 If outstanding on February 12, 2014: 90 days
 If no longer open, but outstanding on August 16,
2012: 3 years
28
Key Takeaways
 Applies to all OTC derivatives
 Note issues with definition and treatment of “spot”
contracts
 Exact requirements drive by party classification and
location
 Trade reporting for ETD and OTC contracts
 Trade reporting applies to both parties if in the EU
 No equivalence yet between DFA and EMIR for reporting
 Central clearing and collateral requirements to
commence 2015
29
Timings
August 2012
EMIR in force
March 2013
Technical standards on OTC derivatives, Trade Repositories and
requirements for Trade Repositories and CCPs
NFC+ notification requirement in force
Timely confirmation requirement in force
August 2013
Draft technical standards on format and frequency of trade reports
September 2013
Risk management of non-cleared OTC derivatives
November 2013
Draft technical standards on “direct, substantial or foreseeable effect”
February 12, 2014
Reporting of derivatives (OTC and ETD) commences
April 2014
Non-Cleared Collateral and Margin RTS Consultation (to be finalised
December 2014)
Q4 2014 / Q1 2015
Clearing obligation comes into effect
Late 2015 to 2019
Margin requirements for non-cleared trades come into effect
30
MiFID II
April 2014
© Copyright 2014 by K&L Gates LLP. All rights reserved.
The MiFID Review




Mandated review
Greater competition / pan-European trading
Exchange consolidation
Advances in technology (smart order routing,
algo/HFT trading, latency and co-location)
 Rise of dark pools
 Liquidity incentives
klgates.com
32
Market Issues








Broker Crossing Networks
Pre-trade transparency waivers
Regulation of exchanges vs OTC markets
Systematic Internalisers
Fragmentation
Quality of execution
Access to post-trade infrastructure
Extension of post-trade transparency to nonequity markets
klgates.com
33
Key Changes








Trading and clearing access
Introduction of OTFs
Expansion to commodity markets
Automated trading
Introduction of position limits
Consolidated tape
Amendments to Article 2 exemptions
Timings
klgates.com
34
Commodity Pool Operators /
Commodity Trading Advisors
April 2014
© Copyright 2014 by K&L Gates LLP. All rights reserved.
Registration of CPOs and CTAs
 Commodity Pool Operators (CPOs) and Commodity
Trading Advisers (CTAs) operate and advise funds or
“commodity pools” that trade certain derivatives or
“commodity interests”
 CPOs and CTAs (the managers—not the funds) must
register with the CFTC, unless exempt
 Limited exemptions for non-U.S. operators
 If you solicit U.S. investors, you are likely a CPO or a CTA
 If you trade derivatives with U.S. counterparties, you are likely a
CPO or a CTA
36
What is a “Commodity Pool”
 An investment trust, syndicate, or similar enterprise that
invests in the following “commodity interests”:




futures contracts (including “security futures”)
options on futures
“retail forex”
and as of December 31, 2012: CFTC-regulated swaps (not
“security-based swaps”)
 A fund falls into the commodity pool definition even if it
invests in commodity interests indirectly through another
fund
37
What is a “Commodity Pool”
 SWAPS (including swaptions)
 on commodities, interest rates, currencies, etc.
 on broad-based securities indices, government
securities, and municipal securities
 “Mixed Swaps”
 on one or more components of a security-based swap and one
or more components that are not within the security-based swap
definition
 excluded: “security-based swaps”
 excluded: “FX swaps” and “FX forwards”
38
What is a CPO?
 Someone who operates a commodity pool and who solicits
assets from investors for the purpose of trading commodity
interests
 CFTC reads the definition broadly to include any person “that
handles or exercises control over” the commodity pool assets,
regardless of whether or not they engage in solicitation
 CFTC also looks at the person who has the authority to hire
and fire the pool’s CTA and select and change the pool’s FCM
 Generally is the GP or Managing Member, but could be the
adviser
39
What is a CTA?
 Someone who provides trading advice with respect to
futures and swaps
 The investment adviser to a fund is usually both the CPO
and the CTA
 A sub-adviser to a fund generally is a CTA but not a CPO
 A sub-adviser that does not provide derivatives trading
advice to a fund is not a CTA
 In a separate account, the investment adviser is a CTA
40
Changes to Exemptions – 4.13(a)(4)
 Rule 4.13(a)(4) – Exemption for Pools with Highly
Sophisticated Investors and non-U.S. Investors
 In 2012, the CFTC rescinded Rule 4.13(a)(4), which
contained a broad exemption from most of the CPO
requirements
 Rule 4.13(a)(4) did not contain any limit on the amount of
a pool’s trading in commodity interests
 As a result of the rescission of Rule 4.13(a)(4), private
fund managers must either comply with Rule 4.13(a)(3),
or register as a CPO
41
Changes to Exemptions – 4.13(a)(3)
 Rule 4.13(a)(3) – Unchanged, but now “commodity
interests” include swaps
 Rule 4.13(a)(3) requires that pool investors either be
non-U.S. persons or meet a sophistication standard
 Pool must trade a de minimis amount of commodity
interests; either:
 the aggregate initial margin and premiums cannot be more than
5% of the pool’s NAV; or
 the aggregate net notional value of such positions may not
exceed 100% of the pool’s NAV
42
Questions for Non-U.S. Managers
 Do you trade in the U.S. and/or market to U.S.
investors?
 Are you a CPO or a CTA?
 Have you filed an appropriate exemption with the U.S.
National Futures Association?
 Do you meet the requirements of CFTC Rule 4.13(a)(3)
 Taking into account swaps trading?
 Immediately after each commodity interest transaction?
43
Cross-Border Fund-raising
Sean P. Donovan-Smith, Partner (London)
Nicholas S. Hodge, Partner (Boston)
Philip J. Morgan, Partner (London)
© Copyright 2014 by K&L Gates LLP. All rights reserved.
Overview
 AIFMD and EU Private Placements
 UK Crowd-funding
 U.S. Fund-raising and JOBS Act
klgates.com
45
AIFMD and EU Private
Placements
April 2014
© Copyright 2014 by K&L Gates LLP. All rights reserved.
Cross-border Marketing (1)
 What is an “offering”?
 Directive does not apply if no marketing into EU, or only
“reverse solicitation” (i.e., no direct or indirect offering or
placement at the initiative of the AIFM or on its behalf)
 How will this be understood/interpreted in different EU
Member States?
Cross-border Marketing (2)
 Local private placement exemptions in EU
Member State where fund marketed allow it;
and
 Any local application procedure has been
followed in each EU Member State where fund
is to be marketed
Cross-border Marketing: Fund and
Manager Non-EU (1)
Can privately place if:
 Manager complies with Art 22 (Annual Report), Art 23
(Disclosure to Investors) and Art 24 (Reporting to
Regulator)
 Also need three-way co-operation agreements among
regulators (including regulator in each Member State
where fund marketed)
Cross-border Marketing: Fund and
Manager Non-EU (2)
Regulator Co-operation Agreements
 Must be in writing
 Specific framework for consultation, co-operation and
exchange of information for supervisory and
enforcement purposes
 Procedures to ensure EU regulators have access to
everything they need to perform their duties under
AIFMD
 Must enable on-site inspections (which can be carried
out by non-EU regulator with assistance from EU
regulator)
Cross-border Marketing: Fund and
Manager Non-EU (3)
 If considering EU AIFM managing EU AIF to get
passport, does not work if feeding into a non-EU fund
(85% + investment)
 Also cannot invest in parallel masters with “identical
investment strategies”
End of AIFMD Transitional Arrangements
 Transitional relief assists many up to July 21, 2014
 Note possible different interpretations in other EU
Member States
 UK firms must be fully compliant with AIFMD from July
22, 2014
 Marketing provisions only apply once authorised as
an AIFM
 Pass-porting only available post-authorisation
 Non-EU firms must submit notification forms by July 21,
2014 to continue marketing in the UK after that date
klgates.com
52
UK Crowd-funding
April 2014
© Copyright 2014 by K&L Gates LLP. All rights reserved.
Crowd-funding: UK Regulatory Change


FCA Policy statement issued in March 2014 (PS 14/4)
Where crowd-funding platforms allow investment in units in unregulated collective
investment schemes (“UCIS”) or other non-mainstream pooled investments, the
existing marketing restrictions applying to NMPIs will apply (a possible bear trap).

FCA: loan-based crowd-funding


Platforms have been regulated from April 1, 2014 as ‘peer-to-peer’ lending
platforms; considered to be lower risk than equity-based platforms (but market
may become riskier).
Minimum Prudential Requirements - Requirement for firms to maintain
adequate capital buffers – this is the higher of a fixed capital amount (£50,000)
and a percentage of a volume-based measure (e.g. 0.2% of the volume of
loaned funds up to £50m – i.e. £100,000 at £50m). The volume-based
measure is a percentage of the total amount of loaned funds on the platform.
Transitional regime until April 1, 2017.
klgates.com
54
Crowd-funding: UK Regulatory Change



Client Money Rules - CASS rules already apply to investment-based crowdfunding platforms. FCA now requiring that CASS rules be applied to loanbased crowd-funding platforms insofar as the firm holds money on behalf of
clients. No FSCS protection.
FCA Reporting Requirements - Requirement to provide FCA with client
money reports, financial position reports, complaints reports.
FCA: loan-based crowd-funding
 Requirements for firms to take reasonable steps to ensure that existing loans
continue to be managed and administered in accordance with contract terms in
the event of platform failure.
 Communications, clear, fair and not misleading and investors to be provided with
all the information they need to make informed investment decisions.
klgates.com
55
Crowd-funding: UK Regulatory Change

FCA: investment-based crowd-funding
 New rules also from April 1, 2014.
 Firms continue to be subject, for example, to prudential requirements.
 Now, new requirements upon all firms that promote and sell non-readily
realisable shares or debt securities whether web-based or not.
 Requirements apply to authorised firms and their appointed representatives.
 Apply to firms that use internet, telephone, meetings, mailings or any other media
to communicate and transact with customers.
 Overarching goal is consumer protection.
 FCA has “no evidence to show that the wrong type of investor is investing in
unlisted shares or debt securities” and acknowledges possibility that prior
approach worked. However, FCA has historically identified instances of noncompliant promotion of unlisted shares by firms using mailings or telephonebased business models and expects its proposals to minimise the risk of such
promotions in future.
klgates.com
56
Crowd-funding: UK Regulatory Change

FCA: investment-based crowd-funding
 FCA now restricts direct offer financial promotion of non-readily realisable shares
or debt securities (which excludes NMPI) by firms to one or more of the following
retail clients:
 certified or self-certified sophisticated investors;
 self-certified high net worth investors;
 those who confirm that, in relation to the investment promoted, they will
receive regulated investment advice or investment management services
from an authorised person;
 Retail clients that are corporate finance contacts or venture capital contacts;
 A restricted investor – i.e. those who certify that they have not invested over
a 12 month period more than 10% of their net investment portfolio in unlisted
shares or unlisted debt securities (excluding their primary residence,
pensions and life cover).
 In fact means crowd-funding investment opportunities are available to more retail
investors than previously (because previously restrictions were being imposed at
the point of FCA authorisation of the platform firm).
klgates.com
57
Crowd-funding: UK Regulatory Change
FCA: investment-based crowd-funding


“Appropriateness Test”
 Where advice is not provided, the FCA expects firms to apply an
“appropriateness test” to clients before issuing to them promotions for unlisted
equity or debt securities. This may involve firms needing to design automated
systems to assess client knowledge and experience and to check clients’
understanding of risks.
 Firms will need to ensure compliance with the FCA’s rules on appropriateness.
FCA plans to conduct a formal review of the crowd-funding regime in 2016.
klgates.com
58
U.S. Fund-raising and JOBS
Act
April 2014
© Copyright 2014 by K&L Gates LLP. All rights reserved.
How to Market Investment Funds Into the
United States
 Any investment fund organized outside the U.S.
that wishes to market its securities into the U.S.
must do so pursuant to the private placement
exemption in Section 4(a)(2) of the Securities
Act of 1933.
60
klgates.com
Section 4(A)(2)
 Section 4(a)(2) provides in its entirety:
“The provisions of Section 5 shall not apply to:
Transactions by an issuer not involving any public
offering.”
61
klgates.com
Rule 506 of Regulation D



Rule 506 of Regulation D was adopted by the SEC in 1982 to provide a
safe harbor: if an issuer of securities complies with the requirements of
Rule 506, it is deemed to have made a valid Section 4(a)(2) offering.
The essence of an offering under Section 4(a)(2) is that the investors
should be sufficiently sophisticated that they do not need the protections
that the Securities Act of 1933 was intended to afford. However, whether
any given investor is sophisticated is a highly subjective determination.
One of the cornerstones of Regulation D is the definition of “Accredited
Investor” in Rule 501. Accredited Investors include individuals with a net
worth in excess of $1 million (exclusive of primary residence), individuals
with an annual income in excess of $200,000 in the last two years who
expect to have income in excess of $200,000 in the current year, entities
that were not formed for the purpose of making the investment with at least
$5 million in assets, etc. When the SEC adopted Regulation D, it intended
Accredited Investor status to serve as a relatively objective proxy for
sophistication. Regulation D simplifies the process of meeting the
requirements of the Section 4(a)(2) exemption.
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General Solicitation
 Rule 506 has always forbidden general
solicitation and general advertising. That
changed on September 23, 2013, when new
Rule 506(c) became effective.
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Effect of New Rule 506(c)-General
Solicitation and General Advertising
Permitted
 This is an extraordinary shift in public policy brought
about by the JOBS Act.
 Any issuer relying on Rule 506(c) may solicit the public
to purchase the issuer’s securities.
 Issuers may publicly advertise their offerings through
any form of advertising, such as on their websites, or
through newspapers, magazines, Internet, T.V., radio or
other media.
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Rule 506(c) Required Elements
 Offerings by general solicitation may be made to
anyone, but all purchasers must be “accredited
investors.”
 The issuer must take reasonable steps to verify that
each purchaser is an “accredited investor” before the
sale.
 Rule applies a “principles-based” approach to
verification.
 Must continue to comply with other Regulation D
conditions
 Resale restrictions apply
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The Verification Process is Burdensome (1)
 In order for a private fund to verify an
individual’s income, the individual must usually
provide copies of his or her tax returns.
 In order for a private fund to verify an
individual’s net worth, the individual must
usually provide bank statements, brokerage
statements and credit reports.
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The Verification Process is Burdensome (2)
 Although new Rule 506(c) of Regulation D
permits general solicitation, most private funds
are not taking advantage of it because of the
requirement to verify the accredited status of
each investor. The requirement imposes a
burden not only on the private fund but also on
potential investors. Consequently, most private
funds are conducting private placements as
they have in the past, pursuant to Rule 506(b) of
Regulation D.
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Crowd-funding (1)
 The JOBS Act also added the Section 4(a)(6)
exemption from registration under the Securities
Act to provide a foundation for crowdfunding.
Crowdfunding is the raising of relatively small
amounts of capital from a large number of
investors, generally using the Internet or social
media.
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Crowd-funding (2)
 Until the SEC adopts final rules, no one can rely
on new Section 4(a)(6). More importantly,
however, companies that rely on Section 3(c) of
the Investment Company Act of 1940 (the “1940
Act”) to be excepted from registration under the
1940 Act cannot rely on new Section 4(a)(6).
Because any investment fund organized outside
the U.S. that wishes to offer its securities into
the U.S. must rely on the Section 3(c)(1) or
Section 3(c)(7) exception from registration
under the 1940 Act, Section 4(a)(6) is not
helpful to our private fund clients.
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Conclusion About the JOBS Act
 The opportunities that have been created by the
JOBS Act thus far are not likely to be helpful to
you either because they impose onerous
requirements or because they are not available
to you.
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Considerations Under the U.S. Investment
Advisers Act Of 1940
 If a non-U.S. investment adviser sells interests
in a private fund into the U.S. or enters into an
investment management contract with a client in
the U.S., it must register as an investment
adviser under the Investment Advisers Act of
1940 (“Advisers Act”) unless an exemption is
available.
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Foreign Private Adviser Exemption
 An exemption that might be available to a non-U.S.
manager is the Foreign Private Adviser Exemption in
Section 203(b)(3) of the Advisers Act. This is a
complete exemption from registration under the
Advisers Act. That exemption is available to a manager
that has no place of business in the U.S., has fewer that
15 clients and investors in the U.S., has aggregate
assets under management attributable to clients and
investors in the U.S. of less than $25 million, has no
place of business in the U.S., and does not act as an
adviser to a registered investment company or a
business development company. Because this
exemption is so restrictive, very few of our clients have
found it to be helpful.
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Private Fund Adviser Exemption (1)
 A non-U.S. manager that sponsors an
investment fund that is privately-offered into the
U.S. may be able to rely on the Private Fund
Adviser Exemption in Section 203(m) of the
Advisers Act. That Section exempts an adviser
whose only clients in the U.S. are Qualifying
Private Funds and who manages less than $150
million from a place of business in the U.S. If a
non-U.S. manager has no place of business in
the U.S., the dollar amount of its assets under
management from a place of business in the
U.S. will be zero. Funds that rely on the Section
3(c)(1) or Section 3(c)(7) exceptions are
Qualifying Private Funds.
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Private Fund Adviser Exemption (2)
 A non-U.S. manager may take advantage of this
exemption regardless of the type or number of
its non-U.S. clients or the amount of assets it
manages outside the U.S. The Private Fund
Adviser Exemption has therefore been very
helpful to our non-U.S. investment adviser
clients that sponsor private funds.
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Private Fund Adviser Exemption (3)
 The Private Fund Adviser Exemption is not a
complete exemption from registration under the
Advisers Act. An adviser wishing to rely on that
exemption must make a filing with the SEC and
become an Exempt Reporting Adviser.
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Risk and Claims Issues
Robert Hadley, Partner (London)
Robert Kelly, Baronsmead
Philip Morgan, Partner (London)
Sarah Turpin, Partner (London)
© Copyright 2013 by K&L Gates LLP. All rights reserved.
AIFMD Insurance Requirements
 AIFM should cover professional liability risks by
either:
 Maintaining an amount of additional own funds
(equivalent to 0.01% of total AUM)
 Buying professional indemnity insurance (equivalent
to 0.7% of total AUM for individual claims and 0.9% of
total AUM in aggregate per year) with the amount of
any policy excess and any exclusions fully covered by
additional own funds
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AIFMD Insurance Requirements (2)
 Professional liability risks defined as including:
 Loss of documents evidencing title of assets
 Misrepresentations or misleading statements made to
the AIF or investors
 Acts, errors or omissions resulting in breach of:






Legal and regulatory obligations
Duty of skill and care towards the AIF and its investors
Fiduciary duties
Obligations of confidentiality
AIF rules or instruments of corporation
Terms of appointment of the AIFM by the AIF
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AIFMD Insurance Requirements (3)
 Failure to establish, implement and maintain
appropriate procedures to prevent dishonest,
fraudulent or malicious acts
 Improperly carried out valuation of assets or
calculation of unit share/price
 Losses arising from business disruption, system
failures, failure of transaction processing or process
management
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AIFMD Insurance Requirements (4)
 Deadline for compliance: July 22, 2014
 Options
 Additional capital v PI insurance
 What does it really mean in practice?
 PI insurance as part of overall risk management
 Real question is whether that cover is effective
 Benefits of stand-alone v composite PI and D&O
policies
 Adequacy of cover for system failures/cyber attacks
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Common Types Of Claim
 Purely contractual claims
 Negligence claims
 Operational errors e.g. trading errors or “fat
finger” losses
 May need to be settled pre-claim
 Voluntarily or required by FCA
 Mitigation costs cover
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Common Types Of Claim (2)
 Fraud or dishonesty
 Often result in collapse of Fund
 May impact PI and D&O cover
 Beware fraud and dishonesty exclusions
Investor claims
multiple claim scenarios
potential aggregation issues
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Regulatory And Enforcement Issues
 FCA supervisory function – exposure of
individuals/approved persons
 Closer regulatory scrutiny – FCA, SEC, CFTC
 Co-operation between regulators worldwide eg
LIBOR




Significant legal costs
In several jurisdictions
PI and D&O cover may not be triggered from outset
Fines and penalties not recoverable
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Regulatory And Enforcement Issues (2)
 May lead to civil claims and proceedings
 Additional legal costs
 Beware notification issues
 Intervention of criminal investigators eg SFO
 Scope of cover for criminal proceedings
 Which individuals are covered?
 Internal investigations
 AML/Anti-bribery controls
 Data breaches and cyber attacks
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Points To Keep In Mind
 Claims and regulatory activity may well increase
 The driver behind AIFMD is investor protection
 Make sure you have proper controls and
procedures in place
 Make sure you have sufficiently broad PI and
D&O cover (regardless of AIFMD)
 Review your policies to avoid what could be very
costly gaps in cover
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Operations and Compliance
Issues for Private Funds
Sean P. Donovan-Smith, Partner (London)
Nicholas S. Hodge, Partner (Boston)
Michael W. McGrath, CFA, Partner (Boston)
Philip J. Morgan, Partner (London)
© Copyright 2014 by K&L Gates LLP. All rights reserved.
Summary
 Registration and entity-level obligations
 Reporting obligations and how to manage them
 Trading issues
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Registration and Entity-level Obligations
 AIFMD / remuneration
 U.S. adviser registration obligations for non-U.S.
advisers


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
Activities requiring registration
“Participating Affiliates”
Dual-registrants
Exempt Reporting Advisers
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Reporting Obligations




U.S. Form PF and CPO-PQR
AIFMD Annex IV
EMIR
Additional requirements?
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Trading Issues




Cross trades and principal trades
SEC expectations regarding best execution
Transaction and trade reporting
Use of dealing commissions from the view of the
FCA and SEC
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April 2014
Exempt Reporting Adviser
Status
Additional materials
© Copyright 2014 by K&L Gates LLP. All rights reserved.
Exempt Reporting Adviser (“ERA”) Status:
Initial Requirement
File a “truncated” initial Form ADV Part 1A





Item 1 (Identifying Information)
Item 2.B. (SEC Reporting by ERAs)
Item 3 (Form of Organization)
Item 6 (Other Business Activities)
Item 7 (Financial Industry Affiliations and Private
Fund Reporting)
 Item 10 (Control Persons); and
 Item 11 (Disciplinary Information)
 Any corresponding schedules
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ERA Status:
Ongoing Obligations After Initial Filing
 Amendments to Form ADV
 File an “annual updating amendment” to Form
ADV within 90 days after the end of the adviser’s
fiscal year
 Update Form ADV Part 1A promptly if any of the
following items becomes inaccurate in any way:
 Item 1 (Identifying Information)
 Item 3 (Form of Organization)
 Item 11 (Disciplinary Information)
 Update Form ADV Part 1A promptly if Item 10
(Control Persons) becomes materially
inaccurate.
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ERA Status – Ongoing Obligations After
Initial Filing
 Prevention and Misuse of Nonpublic
Information
 Implement procedures to prevent the misuse of
material nonpublic information by the ERA and any
persons associated with the ERA
 Prevention and Misuse of Nonpublic
Information
 Make any applicable filings under the U.S. Securities
Exchange Act of 1934 (e.g., Schedule 13G and 13D
filings, Section 16 filings, Form 13F and 13H filings)
 Antifraud Requirements
 Subject to Section 206 of the U.S. Investment
Advisers Act of 1940
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ERA Status – Ongoing Obligations After
Initial Filing (Cont’d)
 Recordkeeping Requirements
 Subject to recordkeeping requirements, although the
scope of these requirements has not been
specifically articulated by the SEC
 SEC “Cause” Inspections
 SEC has indicated that it does not expect to inspect
ERAs routinely
 SEC may, however, conduct “cause” examinations
(e.g., pursuant to a tip, complaint or referral from
another agency or self-regulatory organization)
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Registration Requirements
What can advisers expect if they do not qualify
as ERAs and must register as investment
advisers under the U.S. Investment Advisers
Act of 1940?
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Investment Adviser Registration - Impacts
 Preparation, maintenance and delivery of Form ADV
(including full Part 1A, as well as Parts 2A and 2B)
 Preparation, maintenance and filing of Form PF
 Regulation of client communications/advertisements
 Compliance Program




Appointment of Chief Compliance Officer
Implementation of a comprehensive compliance program
Annual compliance review
Code of ethics (including regulation and reporting of
personal securities holdings and transactions) and insider
trading policies
 Record keeping
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Investment Adviser Registration – Impacts
(Cont’d)
 Strict safeguards regarding custody
 Contractual provisions (e.g., change of
control of manager requires client consent)
 Routine SEC examinations and strict
enforcement
klgates.com
This presentation is for informational purposes and does not contain or convey legal advice. The information
herein should not be used or relied upon in regard to any particular facts or circumstances without first
consulting a lawyer.
©2014 K&L Gates LLP. All Rights Reserved.