Inside The Beltway─
Report From Washington
DC 9882109 v1
Diane E. Ambler
Mary Burke Baker
Cary J. Meer
Kara Ward
December 11, 2014
Agenda
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New Republican Congress
Commodity Exchange Act Reauthorization
Tax Legislation and Tax Reform
Agency Action
 Financial Stability Oversight Council (“FSOC”)
 Commodity Futures Trading Commission (“CFTC”)
 Securities and Exchange Commission (“SEC”)
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New Republican Congress
Changes in the Congress*
* As of December 4, 2014
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Republican Congress and Democratic
President─ Confrontation Before Cooperation
 “Moderate Middle” is absent
 Each party must first play to its base
 Obama’s executive actions
 The young (net neutrality)
 Environmentalists (climate change)
 Hispanics (immigration)
 Republican Congress
 Oversight/Overturning Obama actions
 Dodd-Frank “fixes”
 CFTC reauthorization
4
114th Congress:
Senate Banking Committee
Tim Johnson
(D-SD)
Chairman,
113th Congress
Richard Shelby (R-AL)
Sherrod Brown (D-OH)
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Mike Crapo (R-ID)
Ranking Member,
113th Congress
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Financial Services Bills Did Pass the House
with Bipartisan Support in 113TH Congress…
1. Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification
Act of 2013 (H.R. 2274)
2. Capital Access for Small Community Financial Institutions Act of 2014 (H.R.
3584)
3. Business Risk Mitigation and Price Stabilization Act of 2013 (H.R. 634)
4. Mortgage Choice Act of 2013 (H.R. 3211)
5. Swaps Regulatory Improvement Act (H.R. 992)
6. Retail Investor Protection Act (H.R. 2374)
7. Disclosure Modernization and Simplification Act of 2014 (H.R. 4569)
8. SBIC Advisers Relief Act of 2014 (H.R. 4200)
9. Commodity Exchange Act and the Securities Exchange Act of 1934 to
specify how clearing requirements apply to certain affiliated transactions
(H.R. 5471)
…and are Likely to be Enacted in the 114th Congress
6
Commodity Exchange Act
Reauthorization
Commodity Exchange Act
Reauthorization
 Industry Priorities
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Additional funding
Repeal of changes to CFTC Regulation 4.5
U.S. person definition/cross-border guidance
Reinstate CFTC Regulation 4.13(a)(4)
Exemptions for non-U.S. commodity pool operators (“CPOs”) operating
non-U.S. funds (similar to foreign private adviser and private fund
adviser exemptions)
Exempt non-deliverable forwards and compo-equity swaps from “swap”
definition
Relief for listed non-U.S. commodity pools
Clarification of CFTC Regulation 3.10(c)(3)
 Chance of Success?
8
Tax Legislation and Tax Reform
114th Congress:
House Ways and Means Committee
Paul Ryan (R-WI)
Chairman
Sander Levin (D-MI)
Ranking Member
Dave Camp (R-MI)
Chairman, 113th
Congress
10
114th Congress:
Senate Finance Committee
Orrin Hatch (R-UT)
Chairman
Ron Wyden (D-OR)
Ranking Member
11
Financial-Related Tax
Issues at Risk
 Taxation of Financial
Instruments (Camp)
 FTT (Tobin Tax)
 Bank Tax
 Taxation of Mobile/Passive
Income
 Inversions
 REITs
 PFICs
 Commodities
 Carried Interest
 Hedge Funds
Active Financing Exception
Retirement Security
New Markets Tax Credit
Tax-Exempt Interest
Mortgage Interest Deduction
Mortgage Insurance
Deduction
 Cancellation of Indebtedness
 Mega-IRAs
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Virtual Currency─Emerging Issue
 IRS Notice 2014-21
 Property, not Currency
 Realization of Income
 When “earned”
 When “used”
 Information Reporting
 Impact on Exchangers
 SEC Actions
 Security?
 Ponzi Schemes
 Bitcoin ETF
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FATCA
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Status of IRS Implementation
Status of IGAs
Influence on OECD-AEOI
Congressional Concerns
 Impact on Treaty Ratification
 Nonresident Alien Information Reporting
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Agency Action ― FSOC
What is the FSOC?
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Designation….not just for Banks
Non-Bank SIFI Designation Framework
- Size
- Interconnectedness
- Lack of substitutes
- Leverage
- Liquidity Risk & maturation mismatch
- Existing regulatory scrutiny
17
What is the FSOC Worried About
When it Comes to Asset Managers?
 2013: Office of Financial Research Study
 2014: FSOC Conference on Asset Management
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The Role of the SEC
 SEC moves to try to keep FSOC at bay
 “ . . . since the enactment of Dodd-Frank . . . the
Commission has consistently faced encroachments on its
regulatory purview from prudential regulators and, even
more concerning, pressure to join the prudential regulators
in adopting the defense against “systemic risk” as part of our
mission.” – Commissioner Gallagher
 What could SEC regulations/enforcement look
like?
 Large asset managers stress tests
 Requirement for more cash or cash equivalent holdings
 Enhanced reporting
 Timeline? Unclear, but likely a year or more
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Agency Action ― CFTC
Industry Priorities
 Recordkeeping
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Cross-Border Issues
Listed Foreign Funds
Reform of CFTC Regulation 3.10(c)(3)
Disclosure Document/Account Statement/Annual Report Delivery
Changing Reporting Periods in CFTC Regulation 4.7(b)
Netting of over-the-counter swaps under CFTC Regulations 4.5/4.13(a)(3)
Compo Equity Swaps
FAQs─Forms CPO-PQR and CTA-PR and NFA Forms PQR and PR
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CFTC Regulation 1.31
CFTC Regulation 1.35
International Financial Reporting Standards
Regulation 4.20(c)/Section 17
Funds of Funds
21
Recent Successes
 JOBS Act
 CPO Delegation Relief
 Family Office Relief
22
Agency Action ― SEC
SEC Initiatives
 Rulemaking
 “ . . . many, if not most, of the 100 mandates imposed upon the
Commission by the Dodd-Frank Act do not by any measure represent the
best use of the Commission’s time and resources.” – Commissioner
Gallagher
 Cost-Benefit Analysis Hurdles
 Regulation by Enforcement
 Asset Management Unit
 Morgan Keegan
 Regulatory Fiat
 IM Guidance Updates─Fixed-Income Markets
 Valuation “Guidance”
 Congressional Pressures and Self-Funding
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Open Issues for Funds
and Advisers
 New Product Development
 ETFs, ETMFs
 Old Product Reform
 Money Market Funds
 What’s next?
 Oldies but Goodies
 FINRA as SRO for Advisers?
 Fiduciary Duty Debate
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QUESTIONS?
Key Issues Affecting Investment
Managers
DC 9880933 v1
Matt T. Morley
Anthony R. G. Nolan
Andras P. Teleki
Craig A. Ruckman
Cybersecurity and the
Securities Industry
Cybersecurity Threat
Environment and Business Risks
Risks to Data and Systems
 Risks to data and systems can be classified into four
general categories:
 Risk of Disclosure
 Risk of Modification
 Risk of Unavailability
 Risk of Destruction
 Risk events may be triggered either intentionally
(malicious) or unintentionally (accidental).
 Risks event may come from internal or external sources.
3
External Threats
 Most common external cyber threats to financial
services firms are hackers and organized
criminals.
 Other external threats include:
 Competitors
 Activists/Hacktivists
 Terrorists
 Foreign Organizations
 Foreign Nation States
4
Internal Threats
 Most common internal cyber threats to financial
services firms are current and former employees.
 Other internal threats include:
 Current Service Providers/Contractors
 Former Service Providers/Contractors
 Suppliers/Business Partners
 Information Brokers
5
Risks of Cybersecurity Event
 Clients or employees may suffer identity theft,
fraud, and financial impacts.
 Firm may suffer fraud and financial impacts.
 Firm reputation may suffer.
 Firm may incur regulatory fines and/or litigation
expenses.
 Strategic business plans or intellectual property
may be compromised.
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Types of Sensitive Information
 Client Information
 Personal Identifying Information (PII)
 Name, Address, Social Security Number, Birth Date, Usernames,
Passwords
 Personal Financial Information (PFI)
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Account Numbers
Account Balances and Investments
Bank Routing and Account Numbers
Credit Card Numbers
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Types of Sensitive Information
 Company Information
 Portfolio Strategy Information
 Investment Process, Trading Strategies and Algorithms, Quantitative
Models and Proprietary Research
 Company Financial Information
 Bank and Other Accounts, Revenues and Earnings, and Other Material
Non-Public Information
 Confidential Business Information
 Strategic Plans, Intellectual Property, Board Documents, Legal Matters,
Personnel Information
 Company Systems Information
 Systems Architecture, Trade Execution and Information Storage
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Cybersecurity Legal and
Regulatory Requirements
Noteworthy Regulatory
Requirements
 Reg. S-P “Safeguards Rule”
 Reg. S-ID (Identity Theft Red Flags)
 15c3-5 – Risk management controls for brokers or dealers with
market access
 Business Continuity Plans
 Rule 38a-1 and Rule 206(4)-7 Testing
 Suspicious Activity Reporting
 Mass. Information Security Regulation
 State Breach Notification Laws
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SEC/OCIE Cybersecurity Sweep
Announced in April 2014
(The SEC/OCIE Sweep Requests Information on the Following Data Security Protection
Activities)
 providing written guidance and periodic training to 
employees concerning information security risks
and responsibilities;
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 maintaining controls to prevent unauthorized
escalation of user privileges and lateral movement 
among network resources;
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 restricting users access to those network resources
only as necessary for their business functions;
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 maintaining a segregated environment for testing
and development of software and applications;
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 preventing users from altering the baseline
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configuration of hardware and software without
authorization;
 managing IT assets and performing regular system
maintenance;
maintaining controls to secure removable and
portable media against malware and data leakage;
maintaining protection against DDoS attacks for
critical internet-facing IP addresses;
maintaining a written data destruction policy;
maintaining a written cybersecurity incident
response policy;
periodically testing the functionality of the firm’s
backup system;
use of encryption;
conducting periodic audits of compliance with the
firm’s information security policies.
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State Law Regulatory Trends
 Standards for the Protection of Personal
Information of the Residents of the
Commonwealth of Massachusetts.
 State notification requirements in the event of a
data breach or loss of customer-related
information (notification thresholds and
requirements vary state by state; any loss of data
must be reviewed on a state-by-state basis).
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State Breach Notification Laws
 Forty-seven states, the District of Columbia, Guam, Puerto Rico and
the Virgin Islands have enacted legislation requiring private or
government entities to notify individuals of security breaches of
information involving personally identifiable information.
 Security breach laws typically have provisions regarding:
 who must comply with the law (e.g., businesses, data/ information brokers,
government entities, etc.);
 definitions of “personal information” (e.g., name combined with SSN, drivers license
or state ID, account numbers, etc.);
 what constitutes a breach (e.g., unauthorized acquisition of data);
 requirements for notice (e.g., timing or method of notice, who must be notified);
 and exemptions (e.g., for encrypted information).
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The Dodd-Frank Whistleblower
Program: Recent Developments
Dodd-Frank Whistleblower
Provisions
 Effective August 2011 (Exchange Act §21F)
 Fourteen awards to date
 Nine in SEC’s FY 2014
 10 to 30 percent of recovery to be paid to:
 Persons who supply original information that enables a successful
securities enforcement action
 Where enforcement action yields sanctions of over $1 million
 Almost anyone can be a whistleblower: employee,
customer, competitor, or others
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SEC’s Office of the
Whistleblower
 ~ 3000 tips per year
 Increase ~10% per year since start of program
 Full range of potential securities violations
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Corporate disclosure and financial statement issues
Offering fraud
Market manipulation
Insider trading
FCPA
 Sources: 90% domestic, 10% non-U.S.
 60 different countries, highest from U.K., Canada, China, Russia,
India, Ireland, Australia, and Germany
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Dodd-Frank Whistleblower
Awards
 Largest payout to date: $30 million
 To foreign national (unknown)
 Nature of case not disclosed
 Information concerning an “ongoing fraud that would have been very difficult to
detect.”
 Award reduced from the maximum level because whistleblower had
failed to come forward earlier
 Purportedly due to uncertainty as to whether the SEC would take action in the
matter.
 SEC found this delay “unreasonable.”
 October 2013: $14 million for tip that led to substantial
recovery of investor funds
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Dodd-Frank Whistleblower
Awards (continued)
 $300,000 payout to (unknown) individual employed in
corporate compliance function (August 2014)
 Had reported the concerns internally
 Compliance and internal audit personnel are ordinarily ineligible for
awards
 BUT Company took no action for 120 days
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Anti-Retaliation Provisions
 Paradigm Capital Management (“PCM”)
 First anti-retaliation case brought by SEC under the rules
 PCM allegedly engaged in prohibited principal transactions
 PCM’s head trader reported these violations directly to SEC
 No suggestion that he sought to report them internally
 Four months later disclosed to PCM that he had done so
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Anti-Retaliation Provisions
(continued)
 Relieved of duties, directed to:
 Prepare a report detailing the facts relating to his allegations.
 Review 1,900 pages of hardcopy data to identify any potential wrongdoing.
 Consolidate PCM’s multiple trading procedure manuals into one comprehensive
policy.
 Ultimately resigned.
 PCM charged with violation of anti-retaliation provisions
 PCM and its owner/president fined $300,000, plus disgorgement and interest of
$1,900,000, forced to retain compliance consultant to review trading procedures.
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Proactive Measures
 Encourage employees to report internally in the first
instance
 No requirement to first report internally – can go directly to SEC
 Actively encourage reporting of genuine concerns
 Guarantee that reporting employees will not suffer
adverse consequences
 Prompt investigation and resolution of reports
 Visible to the extent consistent with confidentiality needs
21
SEC Sweep of Alternative Funds
Growth of Alternative Funds
 Rapid growth
 Press reports estimate
 December 2008: $38 billion in assets, 172 funds
 February 2014: $160 billion in assets, 429 funds
 SEC estimates
 September 2014: $282 billion in assets and $95 billion of cash inflows in
2013
 Drivers
 Offering the investment profile of an alternative investment
vehicle (e.g., hedge funds, PE funds) in a structure that provides
daily pricing, liquidity, transparency and low investment
thresholds
 Low correlation to traditional equity and fixed-income
investments
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What is an Alternative
Mutual Fund?
 No single, universally accepted definition exists
 SEC – An alternative mutual fund’s primary investment
strategy falls into one or more of the following buckets:
 Non-traditional asset classes (e.g., currencies, etc.);
 Non-traditional strategies (e.g., long/short equity, managed
futures, etc.); and
 Illiquid assets (e.g., private debt).
 Generally, alternative mutual funds can be understood to
seek a low correlation to the returns of traditional asset
classes such as equity and fixed-income markets.
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SEC Shift to Proactive Regulator
 Rapid growth draws the attention of the SEC
 SEC seeks to be perceived as more proactive regulator following
2008 crisis
 SEC staff identifies “alternative investment companies”
as a national exam priority in January 2014
 SEC staff launches alternative funds sweep exam during
Summer 2014
 Initial reports indicated that approximately 15-20 fund companies
would be contacted
 Subsequent reports suggested that number may have grown to
approximately 35-40 fund companies
 Latest comments from staff members indicate that the exam is
“ongoing”
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SEC Areas of Concerns
Focus Issues
 Leverage, liquidity and valuation
 Policies and procedures for managing non-traditional investments and strategies
within the requirements of the 1940 Act
 Stress testing and liquidity backstops (i.e., standby letters of credit)
 Board governance and compliance programs
 Ensuring that Boards of Directors are sufficiently informed regarding alternative
investments and the requirements of the 1940 Act
 Conflicts of Interest
 Registered fund investors vs. private fund investors
 Disclosure
 Traditional retail fund investors may not have experience with alternative
strategies and asset classes
 SEC staff is stressing clear and concise disclosure to promote investor
understanding
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SEC Areas of Concerns
Focus Issues (continued)
 Experience of Investment Advisers
 Private fund advisers entering the registered fund space and managing issues
under the 1940 Act
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Daily pricing and valuation
Maintaining sufficient liquidity
Leverage constraints
Board reporting
Compliance programs
 Traditional fund advisers launching alternative funds and dealing with issues
associated with managing alternative investments
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Requisite experience and skill
Full understanding of the risks involved
 Traditional fund adviser overseeing a private fund adviser managing an
alternative fund on a sub-advised basis
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Appropriate due diligence, oversight, and compliance controls
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Sample Request Items
 Board materials and presentations
 Compliance policies and procedures (especially as they
relate to liquidity, leverage, and valuation)
 Compliance reviews
 Valuation policies
 Liquidity analyses and reports
 Leverage / senior debt analyses and reports
 Holdings analyses and reports
 Stress testing
 Trade blotters
 Risk analyses
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U.S. Swaps Regulation After the Crisis:
Emergence of the New Normal
Agenda
 2014 Swap Documentation Initiatives
 Recent CFTC Developments
 Other Regulatory Developments
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2014 Swap Document Initiatives
Overview
 2014 ISDA Resolution Stay Protocol
 2014 Credit Derivatives Definitions
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2014 ISDA Resolution
Stay Protocol
Background
 At the 2013 G-20 summit, the G-20 leaders committed to make progress
towards ending “too big to fail” and implementing principles developed by the
FSB on key attributes of effective resolution regimes.
 In November 2013, regulators from six major economies asked ISDA to
revise ISDA Master Agreement documentation to eliminate close-out rights
triggered by the resolution of a SIFI.
 In September 2014 the FSB issued a consultative paper on Cross-border
recognition of resolution action.
 ISDA subsequently developed the Protocol to provide a contractual approach
to cross-border recognition until comprehensive regulations are adopted.
 The protocol was opened for adherence in November 2014 in coordination
with the 2014 G-20 Summit; 18 large global banks adhered at opening.
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2014 ISDA Resolution
Stay Protocol (continued)
What the Protocol does:
 Adhering parties can opt in to resolution regimes that stay (or override)
certain cross-default and direct-default rights in swaps contracts upon
receivership, insolvency, liquidation, resolution, or the like.
 The Protocol also introduces similar stays and overrides under certain U.S.
insolvency regimes where none exist.
 The Protocol amends existing ISDA Master Agreements and Credit
Enhancements. Future ISDA Master Agreements and Credit Enhancements
are not amended unless the parties agree to incorporate the Protocol.
 The Protocol is subject to sunset revocation from time to time. The idea is
that while a contractual approach is a useful short-term solution it must be
replaced by uniform cross-border regulations for a longer-term fix.
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2014 ISDA Resolution
Stay Protocol (continued)
Impact on Investment Funds:
 Adhering to the Protocol would disadvantage fund investors at the expense
of bank creditors and violate the fiduciary duty owed by investment advisers
to their clients.
 As a result of these concerns being aired, buy-side adherence to the Protocol
was separated from bank adherence.
 The FSB has proposed that national regulators introduce rules in 2015 to
create a level playing field to encourage buy-side firms to adopt stays. ISDA
has indicated it expects sunset revocations if regulations are not enacted.
 In the meantime, the question is whether non-adhering firms will be locked
out of trading by sell-side firms.
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2014 Credit Derivatives Definitions
Radical overhaul of 2003 definitions; effective September 22, 2014
Amendments generally include the following:
 Upgrades provisions for successor reference entities;
 Expanded scope of guarantees that can be hedged with CDS;
 Rationalizes treatment of contingent debt and guarantee obligations;
 Addressing currency redenomination issues;
 Adjusts restructuring settlement mechanism;
 Integrates auction settlement into the definitions
 Significantly affects timelines relevant to settlement:
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Whether a credit event has occurred;
When credit event notices must be given;
When settlement is required; and
When settlement fallbacks apply.
36
2014 Credit Derivatives Definitions
(continued)
Some specific changes include the following:
 Governmental Intervention Credit Event.
 Triggered by government-initiated bail-in;
 Can deliver proceeds of bailed-in debt or a restructured ref. obligation;
 More delineation between senior and subordinated CDS.
 New deliverable obligations.
 Sovereign CDS asset package delivery permits settlement by delivery of assets into
which sovereign debt is converted.
 CoCo Supplement permits delivery of contingent convertible bonds issued by
financial entities.
 Standard reference obligation:
 Allows for adoption of a standardized ref. obligation across all market-standard CDS
contracts on the same reference entity and seniority level.
37
Recent CFTC Developments
Overview
 Third-Party Recordkeeping
 Remaining Recordkeeping Issues
 CPO Delegation
 Staff Letters – Conditions
 Staff Letters - Issues
 Other Issues
39
Third-Party Recordkeeping
 The CFTC’s “harmonization rules” allowed CPOs to maintain
records in locations other than their main business office
 But third-party recordkeepers were limited to specified entities (fund
administrators, custodians, distributors, banks, and broker-dealers)
 The CFTC issued an exemptive letter dated September 8,
2014 that discarded these categories and permitted CPOs to
use any third-party as a recordkeeper, so long as:
 The CPO has timely access to such records, so that the CPO will satisfy
the obligations of the applicable CFTC regulations, particularly with regard
to providing such records for inspection; and
 The CPO complies with existing requirements under CFTC Rules 4.7(b)(5)
and 4.23(c) requiring that the CPO file a statement to identify the thirdparty to the CFTC.
40
Remaining Recordkeeping Issues
 CTAs are still not permitted to delegate recordkeeping duties to
any third parties.
 The CFTC has acknowledged that its electronic recordkeeping
requirements have not kept pace with technology.
 For example, the CFTC rules contain a requirement that CPOs and CTAs
engage a “technical consultant” if only electronic storage media is used for
some records.
 Anecdotal evidence suggests that neither the CFTC nor the NFA
enforce these antiquated requirements very rigorously.
41
Remaining Recordkeeping Issues
(continued)
 Potential relief ahead?
 AIMA/IAA/MFA petitioned for more comprehensive recordkeeping
relief this summer (including to address the points referenced on
the preceding slide).
 In the September 8, 2014 letter, the CFTC stated that it intends to
review the current CFTC recordkeeping requirements and their
applicability to the current technological environment.
42
CPO Delegation
 The CFTC staff takes the view that the CPO of
 A corporate fund (for example, a Cayman company) is its board members;
 A limited partnership or limited liability company fund is its general partner
or managing member/manager;
 This position does not apply to registered investment companies.
 Under CFTC Staff Letter 14-69 (May 12, 2014), delegating
CPOs were able to seek individualized no-action relief to
delegate the CPO function to the designated CPO (usually the
investment manager).
 CFTC Staff Letter 14-126 (October 15, 2014) replaced Letter
14-69.
43
Staff Letters – Conditions
 CFTC Letter 14-126 now makes no-action relief “self-executing” and
also modifies certain of the conditions in the prior letter
 The CFTC will consider granting individualized no-action relief where there are
circumstances that are not addressed in Letter 14-126
 These conditions, as modified by Letter 14-126, include the following:
 The CPO function and investment management function must be delegated to the
designated CPO pursuant to a legally binding document
 The delegating CPO may not participate in solicitation of investors for the pool
unless (i) the delegating CPO is registered as an associated person (AP) of the
designated CPO, or is exempt from such registration and (ii) such solicitation is
conducted only in the delegating CPO’s capacity as an AP
44
Staff Letters – Conditions (continued)
 The delegating CPO may not manage any property of the pool,
unless the delegating CPO: (i) is a principal or employee of the
designated CPO or of a CTA of the pool, (ii) has management
responsibilities over pool property, (iii) exercises these
management responsibilities solely in the capacity of a principal
or employee of the designated CPO or as a CTA of the pool (and
not as the delegating CPO of the pool) and (iv) is subject to
supervision as a principal or an employee by either the
designated CPO or a CTA of the pool
 For purposes of this condition, management does not include administrative or
clerical responsibilities
 The designated CPO must be registered as a CPO
 Therefore, the no-action relief is not available if the CPO is exempt
45
Staff Letters – Conditions (continued)
 The delegating CPO must not be subject to a statutory
disqualification
 There must be a legitimate business purpose for having
separate delegated and designated CPOs
 Books and records of the delegating CPO must be maintained by the
designated CPO in accordance with CFTC recordkeeping rules
 If the delegating and designated CPOs are not natural persons, they
must be affiliates
 There must be joint and several liability, established by a legally binding
contract, between delegating and designated CPOs
 But this requirement does not apply to unaffiliated natural person delegating CPOs (such
as independent directors)
46
Staff Letters – Issues
 Now that CFTC Letter 14-126 has been issued to provide for
“self-executing” CPO registration relief, there is a question for
the industry as to whether the conditions in the letter should be
complied with in all cases
 For example, should there always be a written agreement providing for
joint and several liability?
 If there is no such agreement, does that create an implication that there is
a registration obligation?
 It is possible that further relief/guidance may be forthcoming
 MFA and other industry groups have requested more comprehensive rulemaking on delegation issues
47
Other Issues
 The NFA has stated that CPOs of registered funds do not need
to conduct NFA Bylaw 1101 diligence on fund investors
 However, this appears to be a temporary position
 NFA guidance is expected; timing remains uncertain
 Funds-of-funds guidance

The CFTC has stated that it will provide the fund of funds industry with
guidance on how the de minimis thresholds in CFTC Rules 4.5 and
4.13(a)(3) should be computed in a fund of funds

There is still no concrete indication of when this guidance will be provided

It is also unclear whether it will be provided as part of a rule proposal or
as staff guidance
48
Other Issues (continued)
 JOBS Act
 CFTC Staff Letter 14-116 (Sept. 9, 2014) harmonizes Regulations
4.7(b) and 4.13(a)(3) with Rule 506(c) of SEC Regulation D, which
permits general solicitation
 This relief is not self-executing, meaning that a notice filing is
required
49
Other Regulatory Developments
Overview
 Key derivatives provisions of the Dodd-Frank Act
 Central clearing of derivatives
 Swap Execution Facilities (SEFs)
 Various margin issues
 Documentation
 Challenges Ahead
51
Dodd Frank Act – Key Derivatives Provisions
52
Dodd-Frank Product Definitions and Registration Requirements
Dodd Frank regulations generally cover any transactions done under an ISDA Master
Agreement, with limited exclusions

“Swaps” and “Security Based Swaps” defined

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), subject to final
determination by US Treasury Dept.: FX swaps,
FX forwards
Not covered at all under Dodd-Frank: FX spot;
securities transactions

SEC regulates Security Based Swaps





Single name CDS
Narrow index CDS (9 names or less)
Single name equity swaps
Narrow index equity derivatives (9 names or less)
Guarantees of security-based swaps are considered
to be securities subject to federal securities law
regulation
Index CDS
Index equity derivatives
Commodity derivatives
Guarantees of swaps are considered to be swaps
53
Dodd-Frank Product Definitions and Registration Requirements
(continued)
Registration requirements for Swap Dealers and Major Swap Participants

Swap Dealer (SD) / Security-Based SD (SBSD)



Statutory definition: a person who
 Holds itself out as a dealer in swaps
 Makes a market in swaps
 Regularly enters into swaps with counterparties in
the ordinary course of business for its own account,
or
 Engages in activity causing it to be commonly
known in the trade as a dealer or market maker in
swaps

Major Swap Participant (MSP) / Security-Based MSP
(SBMSP)

An MSP/SBMSP needs to meet one of several tests


Liquidity providers on SEFs/exchanges may be required
to be registered as SDs/SBSDs
The final regulation sets out a de minimus exception to
SD/SBSD status: $8bn in gross notional of swaps
executed over preceding 12-months, scaling down,
after a phase-in period of 30 months, to $3bn in gross
notional executed.

Maintain a “substantial position” in any asset category
(excluding transactions that hedge or mitigate
commercial risk), i.e. >$3bn in current, uncollateralized
outward exposure in rates or >$1bn in other swaps OR
>$6bn in current exposure + potential future exposure in
rates or >$2bn in other swaps
Creates “Substantial counterparty exposure” across all
asset classes (incl. transactions that hedge or mitigate
commercial risk), i.e. for swaps, >$5bn in current
exposure or >$8bn in current + potential future exposure
, for security-based swaps, >$2bn in current exposure or
>$4bn in current + potential future exposure
Is a “highly leveraged” financial entity and maintains a
“substantial position” in any asset category (incl.
transactions that hedge or mitigate commercial risk)
54
Reporting
Real-time post trade reporting and Swap Data Repository (SDR) reporting



Dodd-Frank mandates Real Time Reporting for public dissemination of price forming transactions and Regulatory Reporting (SDR
Reporting) of New Transactions and Lifecycle events, 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) in preference to a Major Swap Participant, in preference to an End User. Where both parties share the same registration
status, the two parties to the trade will agree the reporting party. Where trades are executed on a SEF or cleared through DCO, these
bodies will provide reporting to an SDR on behalf of the reporting party
All parties need to obtain a legal entity identifier, called a CICI, which can be obtained at www.ciciuitlity.org
Requirement for the Reporting Party
Real Time
Reporting
Primary
Economic
Terms
Confirm
Data
Position
Valuation

Requirement for the SDR
Send summary trade details as soon as technologically practicable
for public dissemination (in any case within 15 mins).
Assign a unique trade identifier (Unique Swap Identifier – USI) and
legal entity identifier

Publicly disseminate information on price forming events.
Within 15 mins for electronic execution, 30 mins for voice execution
but electronic confirmation, and 24 hours for paper confirmation:
Send the SDR economic terms of the trade, sufficient to allow the
price to be calculated by a 3rd party. Both new trades and lifecycle
events

Store primary economic terms linked to original real time
(RT) report
Send confirmation data to the SDR (likely to be electronic
confirmation providers).
Send PDF copies of the confirmation for paper confirmed trades.


Link confirmation data record to RT and PET reports
Store PDF copies of confirmation linked to the RT and
PET messages


Send lifecycle events or daily position snapshot in order to maintain
outstanding positions of all live trades to the SDR.
CFTC rules require lifecycle events for Credit and Equities and snap
shot reporting for other asset classes.
SDR to calculate the position for Credit and Equities and
to receive and store positions from the reporting party
other asset classes.


Send the SDR a daily valuation of each live transaction.
Send collateral information for each trade.

Record daily valuation of live transactions






55
Basic Distinctions between non-cleared
bilateral and centrally cleared market
56
Clearing of swaps
Client
SEF
FCM
Dealer
FCM
Swap Trade
Clearinghouse
Matching, settlement,
clearance
FCM
LSOC
Reporting
FCM
 Parties execute swap in an anonymous market through a SEF or board of trade
 Clearinghouse steps in between each Client and Dealer to be universal counterparty
 Clearinghouse requires both “initial” (up front) and “variation” margin (based on market moves and volatility
changes) from FCM, and FCM requires same of Client and Dealer
 Margin required by FCM (house margin) can exceed Clearinghouse required margin
 SEF and LSOC Reporting are the main differences from futures clearing model above
57
Documentation: Cleared vs Uncleared Swaps
Cleared Swaps


Futures & Options Agreement

Give-up agreement (FIA/ISDA execution
agreement)

Potential master netting arrangement to
net futures, cleared and uncleared
swaps


OTC cleared addendum (FIA/ISDA form
(product/clearinghouse neutral)
Both
DF Protocol




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
Clearinghouse Rules
SEF User Agreement and/or SEF
rulebook
Swap Dealer must
comply with Business
Conduct Rules when
they face a customer
for a swap, whether
cleared or not
Uncleared Swaps
If segregation of IA is
elected, then Account
Control Agreement
with third party
custodian and CSA
amendments
58
Swap Execution Facilities
Standardized OTC derivatives must be traded on exchanges or SEFs, where appropriate
Swap Execution Facility (SEF) was introduced in the Dodd-Frank Act in response to the G20 commitment to trade standardized
OTC derivatives “on exchanges or electronic platforms where appropriate”. SEFs will be a type of electronic execution platform
intended to be suitable for trading of OTC derivatives
SEF rule and definitions




All trades must be executed on a SEF if:
 required to be cleared;
 are made “available for trading” (MAT) on a SEF; and
 are not “block” trades (CFTC has issued a final rule defining what is a “block” trade)
CFTC Final Rule (applies to Swaps)
 2 types of execution methods: request for quote (RFQ) or order book (similar to an exchange); a SEF must provide for
order book execution in order to provide RFQ
 If RFQ, request must go to 2 or more market participants during the first year, then 3 or more
 Any responsive resting quotes from the order book must be transmitted to RFQ requester as well
 SEF submits determination that a swap is MAT to CFTC, which then reviews
SEC proposal (applies to Security-based Swaps)
 RFQ or central limit order book
 If RFQ, request can go to 1 market participant so long as SEF allows client the choice to RFQ more than 1
Other SEF obligations
 Surveillance and C ompliance obligations
 Supply post-trade transparency and reporting to SDRs, electronic confirmation and STP
59
Swap Execution Facilities
Industry Developments

Market Fragmentation

Split in EUR interest rate swaps between US and non-US counterparties



European dealers reluctant to trade with US dealers
Trade compression spikes

Significant increase in volume due to compression and compaction


Pre-MAT volumes for interdealer trades was 25%; declined to 9% post-MAT
May 2014 to June 2014 increased $1.8 trillion
SEF Rulebook review

CFTC updating “provisionally registered” status to full registration


Could result in significant changes to operations and other processes
Attrition resulting from reputational shifts
60
Swap Execution Facilities
Beyond the Numbers





Five Factors for long-term success
Liquidity

investors need trades done in the right size and price
Distribution

Direct access, agency models, sponsored-access
Functionality

Compression tools, innovative order types – more streamlined wins
Pricing

Total cost of trades- ticket fees, spreads, agency fees
Service

Investors want the ability to call and talk to about the system and market
61
Margin Re-proposals
“Prudential Regulators” Proposal (the Federal Reserve, the FDIC, the OCC, the Farm Credit Administration
and the Federal Housing Finance Authority)
On September 3, 2014, U.S. banking regulators re-proposed margin, capital and segregation requirements applicable to
SDs/MSPs in light of the Basel Committee on Banking Supervision’s and the International Organization of Securities Commissions’
issuance of their 2013 final policy framework on margin requirements for uncleared derivatives and the comments received on
the original proposal. The revised proposal:





provides for a compliance deadline of December 1, 2015 for variation margin and a phased compliance schedule for initial
margin, running from December 1, 2015 to December 1, 2019, with compliance timing dependent on the uncleared swaps
exposures of a swap entity’s affiliated group and each counterparty’s affiliated group for the June to August period of each
prior year;
does not require initial or variation margin for a swap entity’s transactions with non-financial end users;
includes a revised, and very complex, definition of “financial end user,” which differs significantly from the original proposal
and existing definitions used by the CFTC and SEC;
outlines the specific collateral eligible to be used to satisfy the margin requirements and related “haircuts,” expanding the
list of collateral for initial margin and limiting variation margin to cash;
does not provide an exemption from the margin requirements for uncleared swap transactions between affiliates; and
The revised proposal would apply to swap entities that are regulated by one of the “Prudential Regulators”. The CFTC and SEC
have previously issued proposed rules for margin, capital and segregation requirements that would apply to swap entities not
regulated by a Prudential Regulator, which differ in some respects from the Prudential Regulators’ proposal.
62
Margin Re-proposals
CFTC Proposal
On September 17, 2014, the CFTC re-proposed rules for uncleared swap margin requirements. The CFTC’s re-proposal would
apply to CFTC-registered swap dealers and major swap participants that are not US or foreign banks, which includes non-bank
subsidiaries of bank holding companies. The CFTC re-proposal is largely consistent with the re-proposal issued by the Prudential
Regulator’s, except that unlike the Prudential Regulators’ re-proposal:




the CFTC specifically seeks comment on whether it is appropriate to allow SDs/MSPs to rely upon a foreign counterparty’s
certification as to whether it is a financial end user. The CFTC’s re-proposal permits the CFTC to designate additional entities
as financial end users if it identifies additional entities whose activities and risk profile would warrant inclusion;
the CFTC’s re-proposal requires control mechanisms for the calculation of variation margin. SDs/MSPs must:
 create and maintain documentation setting forth its calculation methodology with sufficient specificity to allow the
counterparty, the CFTC and any applicable Prudential Regulator to calculate a reasonable approximation of the
margin requirement independently; and
 evaluate the reliability of its data sources at least annually, and make adjustments, as appropriate
the CFTC’s re-proposal requires a SD/MSP to have in place alternative methods for determining the value of an uncleared
swap in the event of the unavailability or other failure of any input required to value a swap and may at any time require a
SD/MSP to provide further data or analysis concerning the methodology or a data source used to value a swap for variation
margin purposes.
the CFTC’s re-proposal does not include a concrete proposal for how margin requirements would apply extraterritorially.
Instead the CFTC’s re-proposal includes an advance notice of proposed rulemaking that offers three potential alternative
approaches for industry comment.
63
Margin Calculations
64
The road ahead…





CFTC approves rule amendment for government-owned utilities


Excludes “utility operations-related swaps” from counting against special entity “de minimis”
Trades still subject to general de minimis threshold ($3billion w/initial phase-in level of $8billion)
CFTC Reauthorization Bill

Provides for significant end-user relief from Dodd-Frank requirements
ISDA Resolution Stay Protocol

Industry initiative to address “too big to fail”
Clearing Non-deliverable forwards

CFTC staff currently considering a proposal for mandating clearing for 12 currency pairs
Bitcoin derivatives

TeraExchange completed first bitcoin derivatives trade on regulated exchange
65
Key Dates In 2014
Effective Date of
CFTC final rule on
exclusion of utility
operations-related
swaps w/special
entities from de
minimis threshold
Oct 27
Comment
deadline for
Prudential
Regulator and
CFTC proposed
margin rules
Nov 3
Effective date for
rules for segregation
of initial margin
under uncleared
swaps w/existing
counterparties
End of Nov/Start of Dec
SEC cross-border guidance
finalization?
End December/Year -end
Expiration of CFTC No-Action relief under
CFTC letters 13-44, 13-73, 13-81, 14-07, 1425, 14-26, 14-60, 14-68, 14-74, 14-85, 1486, 14-87, 14-107
66
QUESTIONS?
Enforcement Developments
DC 9880531 v2
Stephen J. Crimmins
Jonathan N. Eisenberg
Shanda N. Hastings
Kermitt Brooks, AXA Equitable Life Insurance U.S.
Major Changes in the
SEC Enforcement Program
New SEC Decision-Makers
 SEC Chair Mary Jo White:




First SEC chair who was a criminal prosecutor.
Get-tough stance (Madoff, financial crisis).
“First and foremost a law enforcement agency.”
“Broken windows.”
 Enforcement Director Andrew Ceresney:
 Also a criminal prosecutor.
 Longtime colleague of White.
2
New SEC Decision-Makers
(continued)
 Case production during White and Ceresney’s
first year (FYE 9/30/2014):
 755 cases (up from 686), with $4.2B awarded (up from
$3.4B).
 Asset Management Unit:
 Continuing huge case production since creation in
2010.
 What used to be deficiency letter matters can now be
enforcement cases.
3
New SEC Decision-Makers
(continued)
 AMU leadership change. Promotions from within
(former deputy chiefs), so expect the aggressive
enforcement approach to continue.
 Julie Riewe (DC-based, joined SEC in 2005, JD Duke, 8th Cir.
clerk).
 Marshall Sprung (LA-based, joined SEC in 2003, JD NYU, ND
Tex. clerk).
4
New Enforcement Approaches
 Risk identification initiatives – e.g. aberrational
performance.
 Partnerships with other divisions:
 DERA for risk assessment;
 OCIE for surveillance; and
 Investment Management for theory.
 No more silos.
 Gatekeeper focus: attorneys, accountants,
compliance professionals.
5
Requiring Admissions
in Settlements
 Started by Mary Jo White. Outlier among federal
agencies.
 Problem: Require admissions in what kinds of
cases? Criteria still unclear.
 Jenson (7/28/2014):
 COO of Harbinger (Falcone).
 Aiding and abetting.
 Assisted Falcone to take related-party loan on favorable
terms.
6
Whistleblower Program
Gaining Momentum
 Relatively new tool resulting from Dodd-Frank.
 In cases where SEC collects over $1M, can
award up to 30% as bonus to whistleblower.
 Retaliation protections.
 Record award $30M this year. Previous record
was $14M. Up from five-figure awards not long
ago.
7
Whistleblower Program
Gaining Momentum (continued)
 First case charging retaliation against
whistleblower:
 Paradigm Capital Management (6/16/2014).
Charged that head trader was demoted
following whistleblowing. Settled for $1.7M
disgorgement, $300K penalty.
8
Shift to In-House
Administrative Proceedings
 Dodd-Frank substantially expanded SEC’s power
to bring cases before its own ALJs instead of in
federal court.
 Already happening:
 For FYE 9/30/2014, 57% in court versus 43% as
administrative cases, so approaching 50-50.
9
Shift to In-House
Administrative Proceedings
(continued)
 Problems for litigating defendants:





Limited discovery.
Time to trial.
No jury.
No evidence rules (hearsay allowed).
Appeal is to SEC commissioners, now aggressive on
enforcement, and further federal court of appeals review
is limited.
10
Shift to In-House
Administrative Proceedings
(continued)
 SEC cases often charge fraud and seek serious
penalties, including lifetime professional bars and
large monetary penalties.
 Based on quasi-criminal nature, do these cases
inherently belong before juries?
 Defense usually needs jury (federal court) in
circumstantial cases.
 Also in cases where witness credibility is important.
11
Recent Enforcement Focus Areas
Pay-to-Play
 Rule adopted in 2010.
 First pay-to-play case against an adviser –
TL Ventures (6/20/2014):
 Associate contributed $2500 to Philadelphia mayor
(appointed three of nine on city pension board), $2,000
to Pennsylvania governor (appointed six of eleven on
state retirement board).
 Settled for almost $300K.
13
Allocation of Expenses
 Clean Energy Capital (2/25/2014): Fees and
expenses charged by PE adviser firm. Advisers’
rent, salaries, other employee benefits, bonuses.
When funds were short paying expenses, adviser
loaned at 17%. Antifraud provisions. Litigated.
 Lincolnshire (9/22/14): Integrated portfolio
companies operationally. Owned by different
managed funds. Some payments benefitted both, or
just one, yet not fairly allocated. Settled for $1.5M
disgorgement and $450K penalty.
14
Custody Rule
 Standards when maintaining custody for clients.
Majority do not and, instead, use bank or brokerdealer for custody.
 2010 amendments require annual “surprise”
exam to verify assets or have an audit by
PCAOB-registered auditor.
15
Custody Rule (continued)
 Three settled cases (10/28/13): Negligence
C&Ds.
 Further Lane (and CEO): Failed to arrange annual
surprise exam. Disgorgement $347K. Penalty for CEO
$150K, plus one-year industry bar.
 GW & Wade: Failed to identify itself as a custodian to
investors or auditors. $250K penalty.
 Knelman (and CEO and CCO): Funds were not subject
to annual surprise exams and did not audit financial
statements. Firm $60K penalty. CEO/CCO $75K
penalty, plus three-year bar as CCO.
16
Custody Rule (continued)
 Litigated case:
 Sands (10/29/2014): Allegedly late for each of three
years in providing audited financials. Also, claim
against co-founders and CCO/COO.
17
Undisclosed Compensation
Arrangements
 Robare Group (9/2/2014): Received a
percentage of funds that its clients invested in
certain mutual funds. Approximately $440K over
eight years. Fraud charges. Litigating.
18
Cherry-Picking in Performance
Advertising
 Grimaldi / Navigator (1/30/2014): Selectively
touted past performance of a fund. Fraud
charges. Settled for censure, $100K penalty
and compliance consultant.
19
Charging Rule 206(4)-7 as a
Standalone Violation
 Adopted in 2003.
 Requires written policies and procedures
“reasonably designed to prevent violation” of the
Advisers Act and rules.
 Must review effectiveness annually.
 Must designate a CCO.
20
Charging Rule 206(4)-7 as a
Standalone Violation (continued)
 Must reflect changes in business:
 Barclays Capital (9/23/2014). Failed to enhance
compliance infrastructure to integrate and support
acquisition and growth of Lehman’s advisory business.
Settled for $15M penalty and compliance consultant.
21
Other Policies and
Procedures Cases
 Valuation:
 GLG Partners (12/12/2013). Hedge fund adviser’s
valuation policy required monthly determination of
25% PE stake in portfolio company by independent
pricing committee. Employees got info raising
questions on valuation. Inadequate P&Ps to ensure
provided to independent pricing committee.
Confusion regarding who was supposed to elevate.
Charged internal controls violations. Settled for
disgorgement of $4.4M and penalty of $750K.
22
Other Policies and
Procedures Cases (continued)
 Insider trading:
 Wells Fargo (9/22/2014): Broker learned from customer
about a takeover and traded. Indications the broker
was misusing customer information. However, lacked
coordination of assigned responsibilities, so failed to
act. Charged Exchange Act § 15(g). Settled for $5M
penalty, censure and independent consultant.
23
Where Are We With State
Enforcement?
 Breadth of New York’s Martin Act
 Tenth anniversary of NYAG Spitzer’s late-trading and market-timing
initiative
 Formation of New York DFS: Reach to add enforcement powers
 Evolving New York focus: Fairness trumps contractual provisions?
 Particular areas to watch at this point?
24
QUESTIONS?
Marketing and Trading
DC 9881456 v2
K. Susan Grafton
C. Dirk Peterson
Joshua O’Melia
Rebecca Sheinberg, The Carlyle Group
Discussion Overview
 Cross-Border Fund-Raising
 Trading and Markets Issues Including
Best Execution and Market Structure
Developments
 Advertising and Marketing, Including Use
of Social Media and the Impact of the
JOBS Act
1
Cross-Border Fund-Raising
Cross-Border Fund-Raising
 All the world’s a stage, and all the men and
women merely players . . . .” -- As You Like It,
By William Shakespeare
3
Primary Considerations
 Issuer Considerations – Registration requirements
of the offering itself or available exemptions, as well
as, in the case of a pooled investment fund, the
extent to which the adviser has a regulatory status
in a particular jurisdiction as a result of providing
advice
 Marketer Considerations – Status of the marketer in
a particular jurisdiction when promoting a fund and
whether registration requirements apply or
exemptions may be available
4
Offshore Offerings – U.S.
 The United States has a relatively seasoned regulatory regime for
offshore fundraising into the U.S.




Private offering regime pursuant to Regulation D of the Securities Act – since 1985,
Regulation D has prescribed a nonexclusive safe harbor to Section 4(a)(2) of the
Securities Act to determine the private status of an offering that is exempt from the
registration requirements of Section 5 of the Securities Act
JOBS Act
Private funds exception – For pooled investment funds that are not intending to
register, or may not qualify for registration (e.g., foreign issuers), Section 3(c)(1) and
Section 3(c)(7) of the Investment Company Act exclude issuers from registration
requirements of the Investment Company Act to the extent that an issuer would be an
investment company within the meaning of the Investment Company (the private fund
exclusion ties with Rule 506 of Regulation D to ensure private status under the
Investment Company Act)
Rule 15a-6 under the Securities Exchange Act – since 1989 provides an exemption
from broker-dealer registration for “foreign broker-dealers” that solicit securities
transactions with U.S. institutional investors and major U.S. institutional investors
5
Offshore Offerings – Asia Pacific
 Australia
 A person that conducts a “financial services business” in
Australia could be subject to regulation by Australia’s financial
services laws
 “Financial services business” can include providing financial product advice,
dealing in a financial product, and performing custodial or depository
services in respect of a financial service product.
 The extent of engaging in a financial services business is factual and
depends on the depth of contacts in Australia. Potentially, a “fly-over” visit to
Australia is not sufficient to be a “business” for these purposes.
 Solicitation of subscription interests and other fund-raising efforts can trigger
requirements for an Australian financial services (AFS) license regardless of
the status of the issuer or manager in the United States.
 Potential Exemptions – Australian Securities and Investment
Commission (ASIC) Class Order 03/1100
6
Asia Pacific (continued)
 Available to SEC-registered investment advisers that may be fund-raising in
their own right.
 Exemption is not self-executing, and an SEC-registered investment adviser
must obtain an exemption from ASIC by applying for the exemption with
supporting documentation and by appointing a local agent or, if the activities
are substantial in Australia, register as a foreign company.
 Limited exemption in the scope of potential investors that could be solicited.
Marketing is limited to “wholesale” investors (non-retail investor)
characterized as follows:



Purchases an interest in the issuer (fund) in excess of (AU)$500K
Investor (as certified by an accountant) has net assets of at least (AU) $2.5 million or gross
income for each of the past two financial years of at least (AU)$250K
Falls within a category of “professional investor”
 Disclosure on offering documents relating to the adviser’s exempt status and
its regulatory status as an SEC-registered adviser under U.S. laws, which
differ from Australian laws.
7
Asia Pacific (continued)
 Japan
 Two types of licensing considerations arise in Japan in connection with the
marketing of a fund to Japanese investors and the management of a fund in
which Japanese investors hold interests.
 The Financial Instruments and Exchange Act of Japan (FIEA) regulates
investment management functions of foreign investment partnerships in which
advice is given indirectly to Japanese investors – e.g., advice to a fund in which
Japanese investors hold interests.
 Registration is burdensome and impractical for offshore managers. Accordingly,
exemptions are sought.
 Two exemptions exist─one is self-executing and the other is obtained by notice
filing with the Japan Financial Services Agency (JFSA).
8
Asia Pacific (continued)
 Self-Executing Exemption

Extends to the General Partner of the Fund (not the adviser), although a fund adviser may permissibly
“piggyback” off the exemption obtained by the General Partner insofar as an appointment exists from
the General Partner allocating advisory functions to the fund adviser.

All Japanese investors must be “qualified institutional investors,” as defined by the FIES (e.g., banks,
securities companies, Japanese-registered investment managers, certain high-net-worth individuals
who, among other requirements, have obtained status as a “qualified institutional investor.”

The number or Japanese “qualified institutional investors” is less than ten.

The total amount of contributions by all Japanese “qualified institutional investors” is less than onethird of the total amount of investment in a fund.
 Article 63 Exemption

Requires notification to the JFSA and requires disclosure of, among other things, the capital formation
of the General Partner, the business activities of the General Partner, and identities of Japanese
“qualified institutional investors.”
9
Asia Pacific (continued)

At least one Japanese investor must be a “qualified institutional investor,” and there are less than 50
Japanese non-qualified institutional investors.
 Solicitations – In addition to the advisory regulatory and exemption requirements,
the solicitation of investors triggers the second of the licensing considerations in
Japan.

Very generally, soliciting subscriptions from Japanese investors requires the services of a Type 2
financial instruments dealer.

A limited exemption may extend to the General Partner of a fund permitting it to fund-raise in its own
right or permitting a placement agent, which has been engaged by the General Partner, to fund-raise
in the absence of a Type 2 registration.

If the fund is working through a placement agent that is SEC-registered and does not otherwise hand
off fund-raising to a Type 2 licensed dealer in Japan, the placement agent could engage in limited
fund-raising, as follows:

Contacts are made outside Japan (inbound calls would be permitted)

Contacts are made solely to (i) banks, (ii) insurance companies, (iii) credit unions, credit cooperatives etc. and
(iv) Japanese-registered
10
Asia Pacific (continued)
 If the General Partner (not the adviser) seeks to fund-raise directly, a narrow
exemption exists, as follows:
 The fund must contain at least one “qualified institutional investor” and
may have no more than 49 non-qualified institutional investors among
Japanese investors.
 The fund’s Limited Partnership Agreement must contain transfer
restrictions tailored to address transfers by and among “qualified
institutional investors” and non-qualified institutional investors.
 The General Partner makes a notice filing to the JFSA, which contains
background on the offering, including (among other things) the
business activities of the General Partner, capital formation, and
identities of Japanese “qualified institutional investors.”
11
Asia Pacific (continued)
 Hong Kong
 Consideration in Hong Kong must be given to the regulatory status of those
engaged in fund-raising and the offering itself.
 Direct fund-raising, as well as advice regarding the merits of a fund investment,
raise “Type 1” and “Type 4”) licensing issues (Dealing in Securities and Advising
on Securities, respectively).

Marketing in Hong Kong would require the intermediation of a Type 1-licensed dealer, at a minimum.

Generally speaking, a Type 1-licensed dealer could give advice as to the merits of fund investment
absent also having a Type 4 license to render investment advice on the theory that the advice was
incidental to the offering of fund interests.

Offering would need to focus on “professional investors” in order to ensure that the offering itself would
not be subject to registration in Hong Kong.
12
Asia Pacific (continued)
 Regulation of “Collective Investment Schemes” (CIS) – a CIS very generally is an
arrangement where investors have no day-to-day control over fund operations
(they are passive), having delegated such control to a fund manager to manage
the business of the fund for the purpose of receiving profits.

Exemptions from authorization of a CIS or prospectus approvals apply to offerings to “professional
investors” in Hong Kong.

Very generally, a “professional investor” includes (among others) (i) specified financial intermediaries
and institutions, (ii) certain trusts that satisfy a HK$40 million (or foreign currency equivalent) asset
threshold (documentary evidence required), (iii) high-net-worth individuals who satisfy a HK$8 million
(or foreign currency equivalent) asset threshold (documentary evidence required), (iv) corporation and
partnerships with a portfolio of at least HK$8 million or assets of HK$40 million (or foreign currency
equivalent)(documentary evidence required), and (v) any corporation whose sole business is to own
investments and is owned solely by persons described in (iii).

The offering, however, must be marketed by a dealer authorized by the Hong Kong Securities and
Futures Commission (SFC) as a Type 1 dealer.

Assuming reliance on the “professional investor” exemption, and the absence of filing for approvals of
a fund and its offering memorandum, the OM would nonetheless need to contain disclosure tailored to
an exempt Hong Kong offering.
13
Offshore Offerings – E.U.
 Alternative Investment Fund Managers Directive
(AIFMD)
 Slightly more than one year in effect (July 22, 2013)
 Regulates alternative fund managers rather than the funds
themselves
 Established to close perceived regulatory gaps in the alternative
asset management and investments space, which was argued to
have contributed to the global financial crisis of 2008
 Contains many points of regulatory application including (but not
limited to) applying to the marketing of non-E.U.-domiciled funds
offered by non-E.U. asset managers (or their agents) to E.U.
investors (e.g., U.S. advisers to Delaware and/or Cayman
pooled investment funds)
14
Offshore Offerings – E.U. (continued)
 Key concepts related to marketing of non-E.U.-domiciled funds in the E.U. by
non-E.U.-domiciled advisers (or their agents):

“Reverse Solicitation” – The AIFMD will not apply to offers of pooled investment funds by reverse
solicitation. Not entirely clear on scope and fact-intensive, but clearly may not be at the initiation or
marketing on the part of the adviser (or agent). Factors that may be of guidance include (i) preexisting business relationship between adviser and investor; (ii) the extent to which the investor’s
approach was general (more likely that the adviser would be deemed to have solicited during the
course of the communication) or more specific as to fund offering (less likely there would be no
solicitation because the investor was specifically informed, assuming that neither the adviser nor its
agent was responsible for informing the investor. Just how practical is the reverse solicitation
carve out anyway?

Passporting – Since July 2013, AIFMD passporting permits E.U.-domiciled asset managers to market
pooled investment funds (deemed AIFs) throughout the E.U., as well as manage AIFs wherever
domiciled in the E.U. Passport marketing currently is not available to non-E.U.-domiciled asset
managers, although 2015 may mark a potential program to permit passporting to non-E.U.-domiciled
asset managers and AIFs. Currently, private placement regimes, to the extent provided in a member
state, provide the only option for marketing AIFs sponsored by non-E.U.-domiciled asset managers.
The earliest member states may consider the continuation of a private placement regime is 2018.
15
Offshore Offerings – E.U. (continued)
 Germany
 Germany takes a restrictive approach.
 As of July 21, 2014, Germany requires persons that actively fund-raise for
investment in a pooled investment fund to obtain an authorization from the
Financial Supervisory Authority (BaFin), which is the German equivalent to the
SEC.
 BaFin authorization is required even if the marketing is limited exclusively to
“professional investors.” BaFin imposes ongoing reporting obligations for the
adviser:

Disclosure to BaFin of: (i) the principle markets and instruments in which the fund/adviser trades; (ii)
the primary holdings of the fund, markets transacted in by the fund, risk exposure of the fund and
concentrations of the fund; (iii) the percentage of illiquid assets; (iv) the fund’s risk profile and riskmanagement systems; (v) asset categorization; (vi) stress test results, as prescribed by the Capital
Investment Act; (vii) annual report (at BaFin’s request); (viii) leverage information; and (ix) other
information BaFin believes necessary to monitor systemic risk.
16
Offshore Offerings – E.U. (continued)
 As a condition to authorization, an unaffiliated depository is required to satisfy
specified obligations, as follows:

Monitoring of fund cash flows and audit functions ensuring custody of investor assets in a custodian
deemed subject to effective prudential regulation and supervision comparable to the laws of the E.U.

Verification of ownership of fund assets

Make assurances of (i) the permissibility of sales, issues, re-purchases, redemptions and cancellations
of fund interests; (ii) asset valuations; (iii) directions/instructions of the adviser to the extent the
directions/instructions do not conflict with national law, the fund’s rules or fund’s formation documents;
(iv) remittances to the fund are timely; and (v) the application of fund income consistent with national
law, the fund’s rules or the fund’s formation documents
 The adviser must comply with investor disclosure requirements, including the
following:
17
Offshore Offerings – E.U. (continued)
 Provide an annual report.
 Describe (i) the investment strategy and objectives of the
fund; (ii) asset types for potential investment; (iii) investment
methods and risks; (iv) the use of leverage and collateral
use; (v) investment restrictions; and (vi) other material
disclosures that relate to, among other things, fees, risk
management, valuations process, and material business
arrangements relevant to fund management and investment.
 Reportings to investors are at the initial investment stage,
which could be addressed in the offering memorandum, but
also on an ongoing basis.
18
Offshore Offerings – E.U. (continued)
 United Kingdom
 Like Germany, marketing of fund interests by a non-E.U.-domiciled asset
manager would be subject to AIFMD restrictions.
 The Financial Conduct Authority (FCA) regulates, among other things, firms that
are in the business of “arranging deals,” an activity which includes the active
promotion of investment funds in the U.K.
 A single “flyover” visit or de minimis contact may not rise to the level of “arranging
deals” in the U.K., but the extent of FCA regulatory jurisdiction would depend on
frequency of visits, length of time spent in the U.K. marketing, and the extent of
fund promotion as a business at the particular adviser. Alternatively, all contacts
that are made outside the U.K. could avoid FCA regulatory jurisdiction.
 Use of an FCA-authorized intermediary to market a fund could permit a U.S.
adviser to participate in fund road shows absent FCA authorization, provided the
FCA-authorized intermediary handled investment recommendations and
subscriptions.
19
Offshore Offerings – E.U. (continued)
 Scope of offering should be limited to “investment professionals” to avoid FCAauthorization requirements.
 “Investment professionals” include among others: (i) FCA-authorized firms, (ii)
companies that have share capital or assets of £500,000 or £5 million or more,
depending on the number of shareholders; (iii) partnerships or unincorporated
associations with assets of £5 million or more; or (iv) a trustee having an
aggregate value of cash and investments (before liabilities) of £10 million or
more presently or that has been £10 million or more during the prior year.
 The AIFMD would impose additional obligations that are required at the initial
investment and ongoing (see Germany example). A notice filing with the FCA
would be required, as would ongoing reporting that related to the fund’s
investment and risk management similar to the SEC’s Form PF reporting.
20
Offshore Fund-Raising –
Middle East
 Bahrain
 Direct marketing of fund interests raises licensing issues and authorization from
the Bahrain Ministry of Industry and Commerce (MOCI) and the Central Bank of
Bahrain (CBB).
 Thus, if actively marketing fund interests, efforts should proceed through an
intermediary authorized by the CBB to distribute securities.
 An adviser could participate in road shows with an authorized intermediary, but
those participations should be vetted and subject to guidelines to protect the
adviser from acting as an unauthorized distributor of securities.
 Very generally, a pooled investment fund would be a “Collective Investment
Undertaking” (CIU), which would impose cross-border restrictions on the CIU
sponsor.
21
Offshore Fund-Raising –
Middle East (continued)
 Although a CIU could be offered on a private-placement (non-retail) basis in
Bahrain, it is still subject to authorization by the CBB via Form 1 and must be
marketed by a securities distributor authorized by the CBB.
 Offering circulars will need to contain legends tailored to an offering in Bahrain in
addition to specific disclosure prescribed by the CBB.
 Generally, the offering must be limited in scope – (i) minimum investment of
$100,000; and (ii) offering to “accredited investors,” as established by Bahrain
law (e.g., financial assets of $1 million or more).
22
Market Structure Developments
Tick Size Pilot Program
 One-year pilot program to be developed and filed jointly by FINRA
and the exchanges (Release No. 34-573511; File No. 4-657 (Nov. 3,
2014)
 Comments due: December 22, 2014
 Pilot Securities
 NMS common stocks with (a) a market capitalization of $5 billion or less; (b) a
closing price of at least $2.00 on the last day of the 3-month measurement
period; (c) a closing price of at least $1.50 on every day of the measurement
period; (d) a consolidated average daily volume of one million shares or less;
and (e) a volume weighted average price of at least $2.00 per share during the
measurement period
 No recent (i.e., within 6-months) IPO stocks
 The Pilot Securities will be grouped into 27 categories based on
price, market capitalization and trading volume, and each of those
three categories will be further subdivided into low, medium or high
subcategories.
24
Tick Size Pilot Program
 A random sample of Pilot Securities from each of the 27 categories
will be placed into three Test Groups in a number proportional to the
category's size relative to the population of Pilot Securities.
 Pilot Design: Each test group will 400 securities
 Test Group One: Minimum quote increment of $0.05 minimum; trade at any
currently permitted increment
 Test Group Two: Minimum quote and trade increments of $0.05; applicable to
brokered cross-trades. Exceptions for: (1) trades at the midpoint, (2) retail
investor trades that provide price improvement of at least $0.005, and (3)
negotiated trades (e.g., VWAP and TWAP)
 Test Group Three: Same as Test Group Two, plus a “trade-at” requirement to
prevent price matching protected quotations by a trading center not displaying
the NBBO, and to permit a trading center that was quoting at a protected
quotations to execute orders at that level, but only up to the amount of its
displayed size
 Control Group: Current quote and trade increments
25
Regulation SCI



Regulation SCI supersedes and replaces the SEC’s current Automation
Review Policy (“ARP”), established through two policy statements, each
titled “Automated Systems of Self-Regulatory Organizations,” issued in
1989 and 1991.
Compliance dates are phased based on the type of entity and requirement
Applies to “SCI entities”:
 “SCI self-regulatory organizations”: national securities exchanges, national
securities associations (FINRA and the MSRB) and registered clearing agencies
 “SCI ATSs”: alternative trading systems that meet certain average daily volume
thresholds (e.g. , at least 5% in any National Market System (“NMS”) security
and 0.25% in all NMS securities, or 1% in all NMS securities
 Exempt clearing agencies
 Plan processors
26
Regulation SCI
 Regulation SCI will require “SCI entities” to:





Establish written policies and procedures reasonably designed to ensure that their
systems have levels of capacity, integrity, resiliency, availability, and security adequate
to maintain their operational capability and promote the maintenance of fair and
orderly markets, and that they operate in a manner that complies with the 1934 Act.
Mandate participation by designated members or participants in scheduled testing of
the operation of their business continuity and disaster recovery plans, including
backup systems, and to coordinate such testing on an industry- or sector-wide basis
with other SCI entities.
Take corrective action with respect to SCI events (e.g., systems disruptions, systems
compliance issues and systems intrusions), and notify the SEC of such events.
Disseminate information about certain SCI events to affected members or participants
and, for certain major SCI events, to all members or participants of the SCI entity.
At least an annually, conduct a review of their systems by objective, qualified
personnel at least annually, submit quarterly reports regarding completed, ongoing,
and planned material changes to their SCI systems to the Commission, and maintain
certain books and records.
27
Pending Developments
 Regulation of high-frequency traders
 Guidance on “traders exception” from the definition of
“dealer” in Section 3(a)(5) of the Securities Exchange Act
of 1934
 Elimination of exception from FINRA membership
 Increased Disclosure




Institutional investor order routing information
Order types
Payment for order flow and rebates
Alternative trading systems
28
Disruptive Trading Practices
 In re Athena Capital Research, LLC,
Release No. 73369 (Oct. 16, 2014)
 First-high speed trading manipulation case
 “Marking the Close”
 Development of anti-disruptive trading rule
 Risk management of algorithmic trading
29
Best Execution
Duty of Best Execution
 Generally, best execution is the duty to obtain the best
price given the portfolio manager’s objective
 Derives from common law and the anti-fraud provisions
of the federal securities laws, particularly Section 206 of
the Investment Advisers Act of 1940
 SEC v. Capital Gains Research Bureau, 375 U.S. 180
(1963):
 Section 206 imposes a fiduciary duty on investment advisers
 Duty of loyalty and duty of care
31
Factors in Evaluating Execution
Quality; Not Just Price

Price and price improvement

Access to market centers and
other market participants

Speed

Certainty of execution

Low trading errors and willingness
to correct mistakes

Responsiveness

Commission and commission
equivalent rates

Value of research

Confidentiality

Order handling capabilities, such
as block and complex trades

Reputation

Capital adequacy

Expertise with relevant markets or
securities

Back-office capabilities, including
automation and trade reporting

Assistance in finding liquidity and
willingness to commit capital

Past experience
32
Establishing a Compliance Program
 Implement and update written compliance policies and procedures
addressing best execution:



Broker selection
Methods and measures for evaluating execution quality
Allocation of desk or trader responsibility for particular funds, investing style,
and geographic and industry sectors
 Establish a best execution committee with appropriate procedures


Committee meetings should be periodic and systematic
Minutes should be made and maintained under direction of legal
 Implement and test systems for monitoring executions

Determine tools that will be used
 Broker-dealers’ “dash reports” (Exchange Act Rules 605 and 606)
 Vendor services
 Provide periodic training to relevant personnel
33
Trading Desk Compliance
 Focus should be on obtaining the best price given the portfolio
manager’s objective
 Trading desks should have the necessary tools, including:





Effective execution management system
Timely and accurate market data as needed to determine the best price of a
security
Protocols and mechanisms for handling trade aggregation, trade allocation, and
trade sequencing
Procedures for complying with regulatory requirements relating to cross and
agency-cross trades and principal transactions
Client account instructions, including account objections, use of soft dollars, and
disallowed brokers
 Guidance should be provided regarding the number of dealers that
should be contacted to obtain a price, particularly for illiquid and
thinly traded securities
34
Post-Trade Review and Analysis
 Periodic and systematic meetings of the best execution committee
to review execution quality





Analyze execution quality based on statistical information
Review executing brokers, including with respect to the reasonableness of
commissions and commission equivalents, soft-dollar arrangements, potential
conflicts of interest, any credit or other financial issues regarding the broker,
news relating to litigation, regulatory investigations, and other qualitative factors
Desk errors or mistakes
Systems issues
Available third-party data
 Determine and assign responsibility for pre-meeting preparation
 Assign responsibility for implementing any needed changes based
on review
 Make and keep relevant records
35
Advertising and Marketing
Marketing and Performance
 SEC examinations – recurring problems:
 Cherry-picking composites
 Comparing performance to inappropriate indices
 Representing model or back-tested performance as actual
performance
 Portability
 Submission of misleading information to publications or
consultants
 Inaccurate assets under management
 False or improper GIPS claims
 Not presenting net-of-fees performance (especially on website)
 Use of superlatives
37
In the Matter of Navigator Money Management, Inc.
and Mark Grimaldi (Jan. 30, 2014)

The SEC charged a New York money manager and his firm with making misleading
claims about the success of their investment advice, the performance of a mutual
fund they managed, and the performance of model portfolios they recommended

For example, they stated that their Sector Rotation Fund was ranked No. 1 out of 375
World Allocation funds tracked by Morningstar; but the time period they
picked─October 13, 2010, to October 12, 2011─was “cherry-picked” and did not
reflect its performance in other periods

Alleged that the adviser’s claim that it was a “five-star (Morningstar) money manager”
was misleading because Morningstar rates funds not investment managers

Alleged that the adviser’s model portfolios “doubled the S&P 500 in the last 10 years”
was misleading because the adviser was not involved in the model portfolio
performance for the first three years

Failed to comply with rules about advertising past performance recommendations

SEC staff alleged that the adviser did not have any written policies and procedures
specifically tailored to address the kinds of advertisements made; rather, the policies
and procedures simply “parroted” the SEC’s advertising rule
38
Compliance Considerations
 Customize written policies and procedures
 Ad preparation process







Consider use of checklist for each advertisement
Track SEC requirements and include appropriate disclosures
Describe dates, benchmarks, indexes, and sources
Document sign-off by all involved in preparation and review
Verify that performance data is accurate, and keep records
Attach support to verify factual claims
Attach checklist to approved advertisement
 Consider the facts and circumstances
 Consider the sophistication of audience
 If you can’t substantiate it – don’t say it!
39
Social Media Guidance Update
SEC Investment Management Guidance
on Social Media (March 28, 2014)
 Addresses the interactive nature of social media
 Prior to guidance, an advertisement with noninvestment-related client commentary could be a
prohibited testimonial under Rule 206(4)-1(a)(1)
 Testimonial – any explicit or implicit statement of a client’s
experience with, or endorsement of, an investment adviser
 Problems:
 Advertising guidance for print and email
 Businesses are using social media
 Certain functionalities on social media cannot be disabled
41
Guidelines for Third-Party Postings
 Adviser that maintains or links to a social media
site with public commentary (which may include
client commentary) is not in violation of the
testimonial rule if:




Independent social media website
Independent third-party commentary
Completeness of content
No modification of content
42
Client Lists
 Contacts or “friends” on a social media website
of an adviser or its personnel would not be an
impermissible testimonial even if a partial client
list
 May be a misleading advertisement if:
 Inference that contacts or “friends” have experienced
favorable investment results
 Manipulate or present the list in a misleading manner
43
Policies and Procedures
 Advisers with a social media presence should
consider policies and procedures that:
 Expressly identify permissible social media websites
that the adviser and its personnel may use for
business purposes
 Prohibit personnel from asking clients or the public to
post comments about the adviser or its personnel
 Prohibit personnel from posting unauthorized
comments on the adviser’s social media sites
 Prohibit manipulation of third-party posts
44
Compliance Considerations
 Training related to social media
 Record-keeping requirements
 Monitor compliance
 Employee privacy concerns
 Follow up any potential violations
45
Accredited Investor Standards
Accredited Investor Definition
 On October 9, 2014, SEC met with its “Investor Advisory Committee”
(IAC) to discuss possible changes to the “accredited investor” (AI)
definition
 Dodd-Frank established the IAC and also requires the SEC to revisit the Al
definition every four years
 The purpose of the IAC and its subcommittees is to advise and consult with the
SEC on, most notably, investor protection issues
 The IAC proposed several key recommendations to change the AI
definition, particularly as it relates to individuals
 First, the IAC argued that the SEC should revise the Al definition to
enable investors to qualify based on financial sophistication, rather
than financial thresholds
47
Accredited Investor Definition
(continued)
 The IAC argued that financial thresholds have various shortcomings,
including notably the fact that some investors may be wealthy but
lack financial sophistication
 The IAC suggested that financial sophistication could be
demonstrated through:




Professional certificates
Professional and investments experience
Membership in relevant groups
Standardized tests
 To the extent that financial thresholds are retained in the Al
definition, the IAC suggested that some restrictions be added
 One suggestion was limiting individuals who meet the thresholds to investing up
to [10] percent of their income or net worth in private offerings in aggregate in a
[12-month] period
48
Accredited Investor Definition
(continued)
 The IAC acknowledged that any change to the accredited investor
definition that increases its complexity will ultimately increase the
burden on issuers to verify accredited investor status
 Therefore, the IAC urged the SEC to take steps to develop an
alternative means of verifying accredited investor status that shifts
the burden away from issuers
 The IAC suggested third-party verification provided by securities professionals,
such as brokers, accountants, and attorneys
 The SEC has received similar feedback on the verification issue in connection
with Rule 506(c) offerings
 The IAC recommendations are, unsurprisingly, focused on the
interests of investors, particularly individuals
 Different constituencies, including issuers of private fund securities will have an
opportunity to share their own perspectives during any rule-making process
49
Rule 506(c), (d)
Update on Rule 506(c)
 Since Rule 506(c) of Regulation D became effective in
September 2013, private fund managers have been
permitted to raise capital through general solicitation and
advertising
 Some industry observers predicted that the adoption of
Rule 506(c) would unleash a torrent of private fund
advertising
 This has not happened
 Vast majority of private offerings by hedge funds continue to be
conducted pursuant to Rule 506(b), which is to say without
general solicitation
 Only about 10% of all Rule 506 offerings are conducted pursuant
to Rule 506(c)
51
Deterrence to Use of 506(c)
 Requirement to take reasonable steps to verify accredited investor
status of investors
 Concern about the “burden” of verifying accredited investor status, particularly
because some prospective investors do not want to provide confidential
materials to managers
 But the burden of verifying status may not be significantly greater than the
burden of establishing a “reasonable belief” that an investor is accredited in a
traditional Rule 506(b) offering
 Private funds may use an institutional sales process─long
investment process, personal meetings, and a small number of
investors
 Don’t want to be the first one to use a new process and be a “test
case”
 Resistance to change in the manager and investor communities
52
Safe Harbors
 Four safe harbors for the verification requirement




Income Test (obtaining copies of tax returns)
Net Worth Test (reviewing bank and brokerage statements, credit reports, etc.)
Third-Party Verification (e.g., Broker-Dealers, RIAs, attorneys, CPAs)
Existing Investors
 In a speech to the Angel Capital Association on March 28, 2014,
Keith Higgins, the Director of the Division of Corporation Finance of
the SEC, reminded the investment community that the safe harbors
are nonexclusive
 An issuer of securities is not required to obtain tax returns or securities
statements in order to verify accredited investor status
 An issuer can properly verify accredited investor status by any number of means,
depending on the particular facts and circumstances
 The investment amount itself may be indicative of accredited investor status
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Safe Harbors (continued)
 Mr. Higgins went on to say that while the SEC
Staff may not be in a position to provide
guidance on what constitutes reasonable steps
in particular circumstances
 “I also believe that staff will not be quick to
second-guess decisions that issuers and their
advisers make in good faith that appear to be
reasonable under the circumstances”
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CFTC Update on Rule 506(c)
 Another barrier to the use of Rule 506(c) has
been that fund managers relying on CFTC
Regulation 4.7(b) or 4.13(a)(3) have been
prohibited from marketing their funds publicly
 On September 9, 2014, the CFTC issued an
exemptive letter that harmonized Regulations
4.7(b) and 4.13(a)(3) with Rule 506(c)
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Rule 506(d)
 Adopted by the SEC on July 10, 2013, pursuant to Section 926 of
the Dodd-Frank Act
 Limits the availability of the Rule 506 safe harbor to offerings not
involving a Covered Person that is subject to an enumerated
Disqualifying Event (a “Bad Actor”)
 Issuers must conduct an inquiry and exercise “reasonable care” to
determine whether a Bad Actor is involved in the offering
 Effective for all Rule 506 offerings conducted after September 23,
2013
 Disclosure to investors prior to subscription required for any
disqualifying event occurring prior to September 23, 2013, involving
a Covered Person
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Rule 506(d) – Disqualifying
Events
 “Disqualifying Events” include (among other
things):
 Felony or misdemeanor convictions relating to
securities or false SEC filings
 SEC disciplinary orders
 Being subject to an order, judgment, decree,
suspension, expulsion, or bar of any court or state
securities commission that restrains a Covered
Person from participating in securities and other
finance-related activities
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Rule 506(d) – Covered Persons
 “Covered Persons” include:
 The issuer, any predecessor of the issuer, or any affiliated issuer
 Any director, executive officer, or other officer participating in the
offering
 A general partner or managing member of the issuer
 Beneficial owners of 20 percent or more of the issuer’s
outstanding voting equity securities (calculated on the basis of
voting power)
 Any promoter connected with the issuer in any capacity at the
time of sale
 Any person that has been paid or will be paid for solicitation of
purchasers in connection with the sale and any director, officer,
general partner, or managing member of any such solicitor
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Update on Rule 506(d) of
Regulation D
 One year has passed since the adoption of
Rule 506(d)
 The SEC published “Compliance and Disclosure
Interpretations” clarifying a number of
interpretive matters
 Confirmed a lookthrough for beneficial owners
 Defined “affiliated issuer”
 Interpretive issues remain
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Rule 506(d) – 20% Beneficial
Owners
 SEC guidance requires that the issuer look through an investor to
determine beneficial ownership of securities
 Look-through considerations include:
 Voting power – includes the power to vote, or direct the voting of, the investor’s
interests in the issuer (e.g., a voting agreement)
 Investment power – includes the power to dispose of, or to direct the disposition
of, the investor’s interests in the issuer (e.g., discretionary investment
management relationships)
 Issuers cannot assume that there is no 20% beneficial owner simply
because no single investor holds 20% or more of the issuer’s
outstanding voting securities
 Issuers should require each investor to disclose the existence of
voting and investment power relationships
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Rule 506(d) – Reasonable Care
 Requires that the issuer make a factual inquiry into whether any
Covered Person is subject to a Disqualifying Event on an ongoing
basis
 SEC guidance indicates that the following would satisfy the
reasonable care standard:
 Representations regarding Bad Actor status
 Contractual covenants to update Bad Actor representations
 Periodic renewal of Bad Actor representations and covenants through negative
response letters
 Absent cooperation from Covered Persons, responsibility falls upon
the issuer to verify Bad Actor status
 Research vendors offer background check tools, but, absent guidance from the
SEC, it is uncertain whether these tools would satisfy the reasonable care
standard
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Rule 506(d) – Best Practices
 Identify all Covered Persons and those likely to become Covered
Persons
 Integrate Bad Actor representations into placement agreements and reserve the
right to terminate the agreement and payment of fees if placement agent and/or
sub-agent becomes subject to a Disqualifying Event
 Obtain Bad Actor representations from the fund’s “Covered Persons”
 Integrate Bad Actor representations into subscription materials and obtain Bad
Actor representations from existing shareholders
 If any existing investor refuses to provide beneficial ownership
and/or Bad Actor representations, consider consulting legal counsel
to evaluate Rule 506(d) implications
 Obtain annual renewal of Bad Actor representations by negative
consent
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Rule 506(d) – Practical Guidance
 Depending on the issuer’s structure, the 20% beneficial
owner test may not apply
 Cayman funds that delegate voting rights to STAR Trusts are
typically exempt because shareholders do not own “voting
securities”
 Some domestic funds have adopted provisions in their
organizational documents that prevent investors from acquiring
20% of the fund’s voting securities by shifting a portion of their
investment into a class with no voting rights
 Act quickly upon notice that a Bad Actor is involved in an
offering
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Rule 506(d) – Practical Guidance
 SEC and State Regulatory Orders and Settlements
 Funds and investment advisers continue to struggle with the
506(d) implications of regulatory orders and settlements
 In light of the look-through guidance, all orders and settlements,
where an issuer, its investment adviser, its GP, or any of their
affiliates is a party, require a 506(d) analysis
 If the settlement or order would result in disqualification, request
waiver from the SEC or state regulator as part of the negotiations
 Or: not have that person participate in the offering, depending on that person’s
category
 Or: remove the person
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Rule 506(d) – Outstanding
Interpretive Issues
 Recertification
 The SEC indicated periodic recertification of 506(d)
representations is necessary, but has not provided guidance on
the frequency. Many industry participants view annual
affirmation by negative consent to be sufficient
 Ongoing Disciplinary Obligations
 The SEC considers a Disqualifying Event that limits the activities
of an entity to terminate when the obligation terminates or the
required action is accomplished. Ongoing obligations (e.g.,
requiring a compliance specialist to review procedures
periodically) may result in indefinite reporting under Rule 506(e)
or indefinite disqualification, if not waived
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QUESTIONS?