Financial Industry Developments
Nicholas S. Hodge, Partner K&L Gates
Sean P. Mahoney, Partner, K&L Gates
Paul J. Marnoto, Partner, K&L Gates
OCIE Cybersecurity Risk Alert
Background
 April 15, 2014 -- SEC OCIE published a
National Exam Program Risk Alert setting
forth OCIE expectations for RIAs and BDs
with respect to cybersecurity
 50 RIA’s and BD’s examined
 Alert includes a sample document request
 Request can be viewed (in part) as an indication of
what OCIE was expecting to see
4
Bases for Cybersecurity Exams
 Rule 15c3-5 (Exchange Act)
 requires broker-dealers with market access to
maintain policies and procedures to protect
“information and information systems from
unauthorized access, use, disclosure,
disruption, modification, perusal, inspection,
recording or destruction”
 Seems to be viewed as imposing a general
requirement to address cybersecurity
5
Bases for Cybersecurity Exams
 Rule 206(4)-7 (Advisers Act); Rule 38a-1
(’40 Act)
 Require compliance policies and procedures
 SEC noted in preamble to Rule 38a-1 that
business continuity obligations fall under
advisers’ fiduciary duties
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Specific Documents Requested
 Written information security policy
(Regulation S-P, Regulation S-ID)
 Documentation of responsibilities of
employees and managers for
cybersecurity
 Written guidance and periodic training for
employees and vendors
7
Specific Documents Requested
 Data destruction policy (Regulation S-P;
Massachusetts; FACT Act)
 Records management program is essential
for cybersecurity and for a number of other
reasons
 Written cybersecurity incident response
policy (i.e., “playbook”)
8
Specific Documents Requested
 Written policy and training addressing
removable and mobile media
 Vendor management
 information security questionnaires
 cybersecurity contractual requirements
 Written incident alert thresholds
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Other Requests or Expectations
 Written inventories and assessments
 Identification of standards (such as NIST)
used by firm
 Expectation that firm has process to keep up
with emerging best practices (e.g., FS-ISAC)
 Protection against DDoS attacks
 Cybersecurity insurance
10
Results of OCIE Reviews
 Ed Schmidt, Senior Technology Officer for
OCIE, commented on the results of
cybersecurity examinations at a
September 11-12 conference
11
Concerns of Firms Examined
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Network Breach
Employee misconduct
Social engineering
Mobile device security
Malware
Vendor management
Compromise of computers or clouds
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Attacks Experienced
 87% of firms experienced attacks
 20% of firms experienced attacks directly
and through vendors
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What Firms Are Doing
 Participating in industry information
sharing groups (e.g., FS-ISAC)
 Using various security frameworks
 COBIT (Control Objectives for Information and
Related Technology)
 Information Security Forum
 SANS Institute
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Private Equity Developments
Private Equity Developments
 SEC Presence Exams – Notes from the
Frontline
 Impact of SEC’s “Broken Windows”
Enforcement Approach
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Presence Exams
Three Primary Objectives:
 Introduce National Exam Program and
OCIE to new registrants
 Promote compliance with the Investment
Advisers Act and focus on certain areas of
particular importance
 Report observations from exams
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Presence Exams
Five Areas of Particular Focus
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Marketing
Portfolio Management
Conflicts of Interest
Safety of client assets
Valuations
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Presence Exams
Observations from the Front Lines
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Transaction-based compensation
Failure to comply with the Custody Rule
Misallocation of expenses among clients
Portfolio company fees
E-mails part of books and records
Transactions pre-dating registration
“Misleading” use of brand name
Untimely submission of personal securities holdings reports
19
“Broken Windows” Strategy
“Broken Windows”
SEC’s “tough cop” Approach
 Based on the premise that no securities
law violation is too small to prosecute and
that minor enforcement actions lead to
greater overall compliance.
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“Broken Windows”
Creating Culture of Fear?
 Lack of clear guidance as to the applicability of certain
rules (e.g., transaction-based compensation)
 Enforcement actions brought for even minor violations
 Risk of reputational harm due to SEC’s recent practice of
publicizing even minor enforcement actions
 When combined with focused Presence Exams, leading
the private funds industry to be more conservative.
22
“Broken Windows”
Effect of Strategy on Industry
 Greater transparency of portfolio company fees
 More disclosure of fees that are not subject to
management fee offsets (e.g., compensation of
operating partners and other consultants)
 Managers foregoing certain fees to avoid
engaging in potential broker activities.
23
Private Placement Developments
SEC Investment Advisory Committee
Recommendations of October 9, 2014
Regarding Accredited Investor
Definition
 The Committee noted that accredited investor status is
intended to define a class of investors who are able to
fend for themselves and therefore do not need the
protections that the Securities Act of 1933 was intended
to provide. The Committee expressed the view that the
“current definition is, at best, a highly imperfect proxy for
financial sophistication and access to information.”
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Committee recommendations to the SEC
 Rather than focusing on increasing the financial
thresholds in Rule 501, the Committee has urged the
SEC to consider alternative approaches, such as:
 Basing the definition on ownership of financial
assets or liquid assets.
 Enabling individuals to qualify as accredited
investors based on their financial sophistication, as
evidenced by the attainment of professional
credentials such as the series 7 securities license
or the Chartered Financial Analyst designation.
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 Enabling individuals to qualify as accredited investors
based on investment experience.
 Limiting private offerings to a percentage of assets or
income.
 Facilitating third-party verification of accredited status.
It is not clear at this time whether the SEC will
propose rules to implement any of these
recommendations.
27
Update on Rule 506(d) of Regulation D (the Bad
Actors Provision)
 Adopted by the SEC on July 10, 2013.
 Limits availability of the Regulation D Rule 506 safe harbors
to offerings not involving a Covered Person that is subject to
an enumerated Disqualifying Event (a “Bad Actor”).
 Issuers must conduct an inquiry exercising “reasonable care”
to determine whether a Bad Actor is involved in the offering.
 Effective for all Rule 506 offerings occurring 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; and
 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 of the issuer
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; and
 Any person that has been paid or will be paid for solicitation of
purchasers in connection with the offering and any director, officer,
general partner, or managing member of any such solicitor.
30
Rule 506(d) - 20% Beneficial Owners
 SEC guidance requires that the issuer look through
the 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).
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 Issuers cannot assume that a 20% beneficial
owner does not exist 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 a combination of the
following would satisfy the reasonable care standard:
 Representations regarding Bad Actor status;
 Contractual covenants to update Bad Actor
representations; and
 Periodic renewal of Bad Actor representations and
covenants through negative response letters.
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 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.
34
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 right to terminate the
agreement and payment of fees if the placement
agent and/or sub-agent becomes subject to a
Disqualifying Event.
 Obtain Bad Actor representations from the fund’s,
adviser’s, managing member’s, etc. officers,
executive officers and directors.
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 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
engaging 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
 Funds are wary of the 20% beneficial owner test.
 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 Regulator 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
or its GP or any of their affiliates is a party requires
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.
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Rule 506(d) – Outstanding Interpretive Issues
 Recertification
 The SEC indicated periodic re-certification 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.
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 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 506(e) or indefinite disqualification, if not
waived.
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Money Market Fund Rule Revisions
Clair E. Pagnano, Partner, K&L Gates LLP
George P. Attisano, Counsel, K&L Gates LLP
MONEY MARKET FUND RULE CHANGES
 On July 23, 2014, the SEC adopted revisions to Rule 2a7 under the Investment Company Act of 1940, and
related rules and forms
 All money funds, except retail and government funds,
must adopt a floating NAV structure
 Money funds will be permitted to impose liquidity fees
and redemption gates during times of market stress
 In certain cases, liquidity fee will be mandatory
 Government funds are exempt, but may voluntarily impose fees
and gates
 New disclosure requirements
 Revised diversification and stress-testing requirements
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FLOATING NAV
 Money funds must adopt a floating NAV structure unless they
are retail or government funds. Floating NAV funds must:
 Use market valuations (instead of amortized cost) to determine NAV
 Calculate NAV to the 4th decimal place, i.e., $1.0000 (or equivalent
for other stable value funds)
 Retail and government funds may continue to:
 Use amortized cost to value all holdings
 Calculate a stable $1 NAV (or equivalent)
 NOTE: all funds, including floating NAV money funds, may use
amortized cost to value securities with remaining maturities of 60
days or less
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FLOATING NAV
 Retail funds can be sold only to natural persons
 SEC expects funds to rely primarily on Social Security numbers
 Can establish procedures to determine that beneficial owners
investing through omnibus and tax-advantaged accounts are natural
persons
 Government funds must invest at least 99.5% of total assets
in cash, government securities, and/or repurchase
agreements that are collateralized solely by government
securities or cash
 Tax rules proposed to simplify accounting and exempt floating
NAV funds from wash sale rules
 Compliance date for floating NAV: October 14, 2016
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FEES & GATES: LIQUIDITY FEES
 If weekly liquid assets fall below 30%, a money fund may
impose a liquidity fee of up to 2% if the board (and a
majority of independent directors) determines this to be
in the best interests of the fund
 If weekly liquid assets fall below 10%, the fund will have
to impose a 1% liquidity fee on all redemptions
 However, the board (and a majority of independent directors)
may determine that the fee is not in the best interests of the fund,
or that a lower or higher fee (up to 2%) is in the fund’s best
interests
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FEES AND GATES: LIQUIDITY FEES
 Board considerations:
 Changes in spreads for portfolio securities (based
on actual sales; dealer quotes; pricing vendor,
mark-to-model, or matrix pricing; or otherwise)
 The maturities of the fund’s portfolio securities
 Actual or expected changes in the fund’s liquidity
profile in response to redemptions
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FEES AND GATES: LIQUIDITY FEES
 Board considerations, continued:
 The capability of the fund and its intermediaries to
rapidly impose a liquidity fee differing from a previous
or default fee
 For a floating NAV fund, the extent to which the fund’s
NAV reflect liquidity costs
 The fund’s past experience, if any, with imposing
liquidity fees
 Compliance date for liquidity fees: October 14, 2016
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FEES AND GATES: REDEMPTION GATES
 If weekly liquid assets fall below 30%, a money
fund may suspend redemptions for up to 10
business days, with the approval of the board
(and a majority of independent directors)
 Gate may be imposed for fewer than 10 days or lifted
before the 10th day
 Fund may not be gated more than 10 business days
in any 90-day period
 Compliance date for redemption gates: October
14, 2016
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DISCLOSURE: NEW FORM N-CR
 Triggered by:
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Imposition or removal of fees or gates
Financial support from sponsor
Security defaults
For retail and government funds, a decline in NAV
below $0.9975
 Must be filed within one business day of
triggering event
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DISCLOSURE: NEW FORM N-CR
 Financial support by the sponsor includes:
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Capital contribution
Purchase of a security in reliance on Rule 17a-9
Purchase of any defaulted or devalued security at par
Letter of credit or indemnity
Capital support agreements (whether or not the fund
ultimately receives)
 Performance guarantee
 Other similar action reasonably intended to increase
or stabilize the value or liquidity of the fund’s portfolio
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DISCLOSURE: NEW FORM N-CR
 Financial support does not include:
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Routine fee waiver or expense reimbursement
Routine inter-fund lending
Routine inter-fund fund share purchases
Other actions that the board considers not intended to
increase or stabilize the fund’s value or liquidity
 Compliance date for new Form N-CR: July 14,
2015
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DISCLOSURE: PROSPECTUS
 New standard prominent risk disclosure:
 Floating NAV or no guarantee that stable $1.00 will be
preserved
 Possibility of fees and/or gates (unless government
fund does not opt in)
 No guarantee of sponsor support (unless provided)
 Floating NAV funds: disclose tax and operational
issues
 Fees and gates: discuss circumstances in which
fees and gates may be imposed
 Compliance date for prospectus disclosure:
October 14, 2016
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DISCLOSURE: SAI
 Disclose occasions during past 10 years when:
 Weekly liquid assets fell below 10% or 30% and the
imposition of any fees or gates (but not for instances
before April 14, 2016)
 Fund sponsor provided financial support
 Compliance date for SAI disclosure: April 14,
2016
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DISCLOSURE: WEBSITE
 Daily updated posting of:
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Levels of daily and weekly liquid assets
Net shareholder inflows and outflows
Market-based NAVs
Sponsor support
Any imposition of fees and gates
 Maintain information for 6 months
 Compliance date for website disclosure related to
Form N-CR: July 14, 2015
 Compliance date for website disclosure not related
to Form N-CR: April 16, 2016
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DISCLOSURE: FORM N-MFP
 Information will become publicly available
immediately upon filing (instead of current 60-day
delay)
 New information required:
 NAV (and shadow price), daily and weekly liquid assets, and
shareholder flows on a weekly basis within the monthly filing
 NAV (and shadow price) to the fourth decimal place (or
equivalent for other stable value funds)
 Include exempt government and retail funds as a category option
 Compliance date for amended Form N-MFP: April
14, 2016
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STRESS TESTING
 Rule 2a-7 stress testing provisions revised to
require funds to test the ability to maintain
weekly liquid assets of at least 10% and
minimize principal volatility under certain
specified scenarios
 New rules increase board reporting
requirements
 Compliance date for stress testing: April 14,
2016
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DIVERSIFICATION
 Amendments to Rule 2a-7 diversification provisions:
 Affiliate Aggregation — Certain entities that are affiliated with
each other must be treated as single issuers for the 5% issuer
diversification test
 Removal of 25% Basket — Money funds, other than tax-exempt
funds, will have to meet the 10% diversification limit for
guarantors and demand feature providers. For tax-exempt funds,
the limit will be 15%
 Asset-Backed Securities — Sponsors of asset-backed securities
must be treated as guarantors subject to the 10% diversification
limit, unless the board (or its delegate) determines that the fund
is not relying on the sponsor to determine quality or liquidity
 Compliance date for diversification amendments: April
14, 2016
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NEXT STEPS
 Retail or Institutional?
 Assess to what extent existing shareholder base is retail or
institutional
 Determine whether to reorganize existing retail and institutional
share classes into separate funds or create new funds
 Review charter documents to assess if shareholder approval is
needed for various actions
 Consider establishing government funds, or amending
investment policies of existing funds to qualify as government
funds
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NEXT STEPS
 Revise Rule 2a-7 procedures to reflect floating NAV (if applicable),
fees and gates, new disclosure requirements, new stress testing
requirements, and new diversification standards
 Revise prospectus and SAI, Form N-MFP, and website disclosures
 For floating NAV funds, update systems to enable routine
transactions at floating NAV
 For retail funds, develop procedures to ensure that funds are sold
only to natural persons
 Develop procedures for filing Form N-CR on occurrence of triggering
event
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INTERPRETIVE ISSUES
 Retail funds
 Beneficial ownership: are “direct or indirect pecuniary
interest” and “sole or shared voting or investment
power” alternative tests?
 Can a managed account invest in retail funds?
 Does a forfeiture feature in a defined contribution plan
disqualify the plan from investing in a retail fund?
 Is an estate of a natural person a natural person?
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INTERPRETIVE ISSUES
 Retail funds, continued
 Can a retail fund permit a non-natural person (such
as a sponsor) to own shares of the fund to facilitate
operations (e.g., for seed money, merger or
liquidation costs)?
 In a master-feeder structure, if all the feeders qualify
as retail funds, does the master also qualify?
 Can a retail fund invest in another retail fund without
being considered a non-natural person shareholder of
the acquired fund?
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INTERPRETIVE ISSUES
 Retail funds, continued
 Outside the reorganization context, can a retail fund
involuntarily redeem non-eligible investors without
giving 60 days’ notice?
 Can insurance company separate accounts qualify as
intermediaries or omnibus account holders?
 Fees/Gates
 May an intermediary net purchases and redemptions
for purposes of applying a liquidity fee?
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INTERPRETIVE ISSUES
 Government funds
 May qualification be tested only upon each acquisition
of securities?
 Performance record
 If an existing fund with retail and institutional share
classes reorganizes into separate retail and floating
NAV funds, may both funds continue to show
performance of original fund?
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Broker-Dealer Regulatory Update
Michael S. Caccese, Partner, K&L Gates
Kenneth G. Juster, Partner, K&L Gates
AGENDA
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High Frequency Trading
Crowd Funding / Online Platforms
Marketing and Placement Agents
Broker-Dealer “Status” Issues for Private
Funds
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High Frequency Trading
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WHAT IS HIGH FREQUENCY TRADING?
 Use of low-latency tools, such as co-located servers, and
direct data feeds from exchanges
 Aggressive short-term trading using computer algorithms
 Typically used by proprietary trading firms and hedge
funds, though tools are also used by brokers to execute
customer trades
 Difference of opinion:
 Michael Lewis (“Flash Boys”) claims HFT disadvantages retail
investors
 Some industry commentators claim HFT adds liquidity to the
markets and lowers cost of execution
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HFT: REGULATORY LANDSCAPE
 SEC Chairwoman Mary Jo White is focused on
equity market structure issues and HFT
 Developing an anti-disruptive trading rule to address
the use of aggressive, destabilizing trading strategies
in vulnerable market conditions
 Two proposed registration rules:
 Clarify status of unregistered active proprietary traders as
“dealers” under the Exchange Act
 Eliminate exception from FINRA membership requirements
for dealers that trade in off-exchange venues
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REGULATION SCI
 Regulation Systems Compliance and Integrity
(“SCI”)
 Adopted November 19, 2014
 Designed to strengthen infrastructure of US securities
markets
 Requires SROs, clearing agencies, ATSs, plan
processors and exempt clearing agencies to establish
policies and procedures to ensure systems have
adequate capacity, integrity, resiliency, availability and
security
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RECENT HFT ENFORCEMENT ACTION
 In re Athena Capital Research, LLC (Oct. 16,
2014)
 First HFT manipulation case
 HFT firm used algorithmic trading and rapid fire orders to “mark
the close”
 Large purchases or sales in last two seconds before 4:00 close
to drive closing prices higher or lower
 Manipulative trading in violation of Section 10(b) of the
Exchange Act and Rule 10b-5
 Cease and desist, censure, and $1 million fine
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Crowdfunding
CROWDFUNDING – JOBS ACT
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Crowdfunding generally refers to the use of the Internet and social media to
raise capital, normally from a large number of people and in relatively small
amounts from each
JOBS Act – Crowdfunding is subject to SEC rulemaking
 SEC proposed Regulation Crowdfunding for comment in October 2013
 As proposed, not available to private fund issuers
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True “crowdfunding,” as contemplated by the JOBS Act is currently not
permitted until the SEC acts on regulations that were proposed last year
Because of a number of restrictions/conditions (including information
requirements, maximum fundraising amounts, and various mandatory
reports) that are either required by the JOBS Act or anticipated in SEC
regulations, it is unclear whether true “crowdfunding” will, in fact, prove to be
a popular way to raise assets
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CROWDFUNDING LOOK-ALIKES
 New and creative structures for capital formation emerge
and are tested against the realities of the market
 Many structures that are called “crowdfunding,” are
different than the crowdfunding contemplated by the
JOBS Act
 Rule 506(c) fundraising
 Community/Donation-Based Support
 Ex. Kickstarter and Indiegogo
 Human/Income-Contingent Capital
 Venture Fund Model
 Peer-to-Peer Lending
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Rule 506(c)
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“Crowdfunding,” as the term is colloquially used, more typically refers not to
JOBS Act “Crowdfunding,” but rather to Rule 506(c) private placements or,
even more broadly, to any online investment platform

Rule 506(c) allows for the public solicitation of investors to raise an
unlimited amount of capital so long as all of the investors are accredited.
There are few of the (anticipated) complexities associated with true
Crowdfunding and most of the advantages

Many of the existing online securities crowdfunding sources (e.g.,
EquityNet, CircleUp) are broker-dealers offering securities through a
Crowdfunding look-alike website that offers a capital formation tool based
on Rule 506(c), but are not “Crowdfunding” as contemplated by the JOBS
Act

From a securities law standpoint, many so-called “crowdfunding” sites are
merely a modern wrapper around an otherwise traditional Rule 506(b)
offering
76
ONLINE PLATFORMS – LENDING

Though sometimes labeled “crowdfunding,” these sites (including popular
peer-to-peer lending sites such as Lending Club and Prosper) are not true
Crowdfunding sites

With variations, these sites offer investors an opportunity to choose among
loan proposals from individuals and commercial entities

With some platforms, investors select the loans, or fractions thereof, in
which they want to invest

With other platforms, a sponsor selects the actual loans

Investors are typically issued a payment dependent note

Some platforms aggregate loans via an SPV structure such that an investor
actually receives an SPV interest
77
ONLINE PLATFORMS – REAL ESTATE
 Typically, these sites offer an opportunity to invest, on a debt
or equity basis, in a real estate project with a third-party
developer

In some cases, platforms have tried to acquire property directly, and hire
a developer afterward, but this approach can be very expensive, is far
more complicated to implement, and shifts enormous risks to the
platform sponsor
 Real estate platforms typically follow either a debt or equity
model


In the equity model, the sponsor creates an SPV to invest in a project
(or, more typically, an SPV related to the project)
In a debt model, similar to lending platforms, the sponsor issues a class
of its (or an affiliate’s) debt or preferred stock securities to investors, and
uses the proceeds to invest directly in the project (or project SPV)
78
ONLINE PLATFORMS – VENTURE
CAPITAL
 Based on no-action letters issued to AngelList and
FundingClub in March 2013.
 Platforms offer accredited investors investments in private
funds, each of which invests in a single private company (or
other asset(s))
 Investment adviser (or exempt reporting advisor) affiliated
with the platform provides investment advice and
administrative services to the investment vehicle
 Transaction-based compensation not permitted, but
investment adviser can receive incentive compensation (i.e.,
carried interest in private funds) without broker registration
79
ONLINE PLATFORMS – REGULATORY
ISSUES

Online platforms often create complicated U.S. federal and state securities
law issues, primarily around whether the sponsor of the site is acting as an
investment adviser and/or broker-dealer
 This analysis will typically turn on whether the platform is offering or selling
securities, the nature of the sponsor’s services, and the manner of compensation
 With many business models, a site sponsor will be deemed to be an investment
adviser and/or a broker-dealer
 Another common issue is whether the SPV or (with sponsors that issue debt) the
sponsor itself is an investment company
 Apart from the SEC, online platforms may invest in asset classes that are
themselves highly regulated:
 Lending platforms are subject to a variety of state and local lending laws
 Real estate platforms are subject to state and local real estate licensing and similar
laws
80
Marketing and Placement Agents
81
MARKETING AND PLACEMENT AGENTS
 David Blass, formerly Chief Counsel, SEC Division of
Trading and Markets (April 5, 2013)
 Raising awareness of broker-dealer status issues in the private
fund industry
 Two primary issues:
 Dedicated sales force may require broker-dealer registration
 Transaction-based compensation arrangements may trigger brokerdealer registration requirements
 Use of issuer’s exemption for private fund sales
 Failure to ensure fund marketers are appropriately
registered can create liability for sponsor/advisor
 Ranieri Partners case – “aiding and abetting” liability
82
THE “ISSUER EXEMPTION” – RULE 3A4-1
 Creates a safe harbor from federal broker-dealer registration
requirements.
 The safe harbor is available only to “associated persons” of an
issuer (as defined by Rule 3a4-1) who participate in the issuer’s sale
of its securities who can not:
 Be “statutorily disqualified” (e.g., barred, suspended from membership,
participation, or association with a member of any SRO, including
FINRA) during the time of participating in the sale;
 Receive transaction-based compensation for his or her participation in
the sale of the issuer’s securities; and
 Be an “associated person” of a broker-dealer
 Employees of adviser to a mutual fund are included in Rule 3a4-1
definition of “associated person of an issuer”
 BUT, 1940 Act restrictions generally prevent use of safe harbor for
distribution of mutual funds
83
ISSUER’S EXEMPTION
 If a fund’s associated persons meet all three factors,
they must then comply with one of the following three
alternatives:
 Limit solicitation to sophisticated purchasers such as various
financial institutions and intermediaries or limit sales to securities
exempt section 3(a)(7), 3(a)(9) or 3(a)(10) of the Securities Act of
1933
 Ensure that the employee who engages in sales activity
performs “substantial” duties other than selling securities
(“substantial” is measured in terms of work time and volume of
work performed in activities unrelated to selling interests in the
fund)
 Limit sales to purely passive activities such as written solicitation
84
ISSUER’S EXEMPTION
 David Blass: “As you all know, Rule 3a4-1 generally is
not used by private fund advisers.”
 The safe harbor would generally not be available to fulltime, internal marketing employees, including those
associated with funds in continuous distribution.
 The difficulty of remaining within the safe harbor limits its
usefulness and can create uncertainty.
 Open dialogue with industry on where the “brokerdealer” line should be drawn, but momentum has slowed
after Blass’ departure from the SEC (June 2014)
85
SELLING FUNDS THROUGH DUAL
EMPLOYEES
 Wearing “broker hat” vs. “adviser hat”
 No bright line test
 General guidelines:
 Broker:
 Marketing securities, participating in execution of trades, receipt of
transaction-based compensation
 Adviser
 Marketing strategies, providing investment advice, receipt of asset-based
compensation, no reference to broker-dealer or naming of particular
securities in marketing materials
86
DUAL EMPLOYEE COMPLIANCE ISSUES
 Outside business activity notifications
 Dual employment agreement
 Disclose correct firm on
 Letterhead/business cards
 General marketing materials
 Presentations, pitch books, sales literature, etc.
 All securities activities through BD – no selling away
 Compliance and supervision by both entities
87
IMPACTS OF MARKETING THROUGH
BROKER-DEALER






FINRA advertising rules apply
Potential filing requirement (retail materials)
No model, hypothetical, backtested performance
Limitations on related performance (3(c)(7) only)
Materials subject to FINRA inspection
Content standards of Rule 2210
 No superlatives, may not predict or project performance
 “Fair and balanced” standard
88
Broker-Dealer “Status” Issues
89
BROKER-DEALER STATUS ISSUES
 SEC remains focused on broker-dealer status
issues in the private fund industry
 Following Dodd-Frank, numerous private fund
advisers became RIAs
 As they are now being examined by the SEC,
they are being questioned about their business
practices
 Routine exam questions regarding fee structures
90
BROKER DEALER STATUS ISSUES
 Focus is on various fees received by fund sponsors or
their affiliates:





Compensation of sales people linked to successful investments
Acquisition or disposition fees
“Investment banking” fees
“Transaction structuring” fees
“Success” fees
 Some of these fees may raise “broker” registration
obligations
91
RECENT SEC RELIEF
 M&A Brokers No-Action Letter (Feb. 4, 2014)
 Provides an exemption from “broker” registration for an M&A
broker, if certain conditions are met:









No ability to bind parties to a transaction
No provision of financing for a transaction
No custody, control, possession or handling of funds/securities
No public offering, restricted securities, no shell companies
Consent required if representing both sides of transaction
May not form a group of buyers
Buyer will “control” and “actively operate” the target company
No passive buyers
Not barred or suspended from associating with a broker-dealer
92
M&A BROKERS LETTER
 Two key indicia that buyer is not passive:
 “Control”
 Power, directly or indirectly, to direct the management or policies of a
company
 Control will be presumed to exist if, upon completion of the transaction, the
buyer or group of buyers has 25% or more ownership
 “Actively Operate”
 May be demonstrated by the power to elect executive officers and approve
the annual budget or by service as an executive or other executive manager,
among other things.
93
Questions?
94
European Issues
C. Todd Gibson, Partner, K&L Gates
UCITS & AIFMD
 UCITS
 UCITS V
 Ireland Consultation on Effectiveness of Fund Management
Companies
 ESMA Guidelines on ETFs and other UCITS Issues
 Money Market Fund Reform Update
 AIFMD
 Summary and Scope
 Impact on US Managers
 Key Implementation Issues and Questions
97
UCITS
UCITS V - Timeline
 8/28/2014 - Directive published in the EU
Official Journal
 9/17/2014 – Directive came into force
 3/18/2016 – Deadline for transposition by
Member States into national law
98
UCITS
UCITS V
 Remuneration
 AIFMD-like rules that apply to senior management, risk takers
and control functions
 Will remuneration rules to extend to a delegate investment
manager?
 Proportionality applies
 ESMA to issue additional details in Level 2 guidelines regarding
applicability to staff
99
UCITS
UCITS V
 Remuneration (continued)
 Variable Remuneration - Shares
 50% paid in UCITS shares (or certain other), with vesting periods
 Does not apply if management of UCITS is less than 50% of the
total assets managed by the management company
 Variable Remuneration – Bonuses
 40% deferral over minimum of 3 years (or recommended holding
period of UCITS concerned)
 Deferral higher where variable compensation is a large component
of total compensation
100
UCITS
UCITS V
 Remuneration (continued)
 Disclosure of remuneration policy
 Annual report information regarding amounts
paid, split into fixed and variable components
101
UCITS
UCITS V
 Depositary Functions
 Single depositary
 Increased liability
 Liable for any assets held “in custody”
 Verification of ownership/recordkeeping
 Overarching duty of care for losses suffered by UCITS resulting from
depositary’s negligence or intentional failure to properly fulfill its
obligations
102
UCITS
UCITS V
 Depositary Functions
 New rules relating to delegation to sub-custodians –
depositary cannot discharge or transfer liability onto
sub-custodian with respect to the UCITS
 Limited exceptions relating to delegations in emerging
markets, subject to conditions
103
UCITS
Consultation on Effectiveness
 Irish consultation on the effectiveness of
management company supervision of
delegates (CP86) – comments due 12/12
 Covers variety of topics
 Delegate supervision
 Board composition/managerial functions
104
UCITS
Consultation on Effectiveness
 Delegate Supervision
 Draft version of “good practices” for directors
 Streamlining of managerial functions
 Combining financial-related, new “distribution” function
 Modifications to Irish residency requirement for directors
 2 directors in Ireland at least 110 days per year
 Can substitute for one of these directors a person (i) who can engage with
the Central Bank within 24 hours, (ii) “unconnected” to the depositary or a
service provider, and (iii) is “competent” in one of the managerial functions
105
UCITS
Consultation on Effectiveness
 Board composition rationale
 Document as part of authorization process
how board composition as a whole enables it
to fulfill its responsibilities
 Role of lawyers on Irish fund boards
106
UCITS
ESMA Guidance – ETFs and UCITS Issues
 Issued 2013 and currently effective, with subsequent updates,
ESMA issued guidance and related Q&A’s on various issues
impacting ETFs and UCITS funds
 ETFs & Financial Indices
 Guidance regarding names and disclosures applicable to UCITS
ETFs
 Guidance regarding use of a financial index and composition of
the index
 Commodity indices cannot relate to single commodity (including
sub-categories, such as crude oil, gasoline, heating oil)
107
UCITS
ESMA Guidance – ETFs and UCITS Issues
 Collateral Management for OTC and EPM techniques
(including repurchase agreements)
 Guidance regarding liquidity, issuer credit quality, valuation, etc.
 Collateral diversification
 “..sufficiently diversified in terms of country, markets, and issuers.”
 Issuer diversification – collateral basket has a maximum exposure to a given
issuer of 20% of the fund’s net asset value (multiple collateral pools are
aggregated)
 Per ESMA Q&A (Question 6(g)): For government bonds, applies to issuer,
and not issue
108
UCITS
Money Market Fund Reform Update
 Currently Two “Tracks”
 European Council (Italian Presidency)
 Debating numerous options (redemption fees, gates, prohibition of
sponsor support, capital requirements)
 European Parliament
 Reviewing proposals from ECON committee
 Modifies the European Commission text (no VNAV or capital buffer),
carve-outs for retail and government funds
 Debate continues with final proposals not expected until
late 2015
109
AIFMD
Summary & Scope
 What is the Alternative Investment Fund Managers
Directive?
 What is an Alternative Investment Fund (AIF)?
 Broadly defined, but exempts UCITS, securitization special purpose
entities; “family office” vehicles; joint ventures; funds restricted to only
having one investor (excluding master funds with one feeder);
separately managed accounts (no “pooled return”)
 Includes US investment companies, Cayman hedge funds, etc.
110
AIFMD
Summary & Scope
 Applies to (but different treatment):


EU-established manager of AIF (registered office in a
Member State)
Non-EU AIFMs actively marketing (directly or
indirectly) AIF into the EU

Does not apply, in most jurisdictions, to a “reverse
solicitation” (investment made at the sole initiation of the
investor
111
AIFMD
Summary & Scope
 Who is the “investor”?
 Nominee accounts, discretionary SMAs,
investors that are funds, etc.
112
AIFMD
Impact on US Managers
 How are US managers impacted?
 Cross-border marketing of AIFs to EU
investors
 Private offerings of US RICs
 Delegation (e.g., sub-advisory) relationships
113
AIFMD
Impact on US Managers
 Cross-border marketing permitted:
 Manager complies with Art. 22 (Annual Report), Art. 23
(Disclosure to Investors) and Art. 24 (Reporting to Regulator)
 Comply with local national private placement regime (NPPR) in
EU Member State where fund marketed
 Any local application procedure has been followed in each EU
Member State where fund is to be marketed
114
AIFMD
Impact on US Managers
 Delegation Arrangements/Multiple Advisers
 Who is the AIFM?




Only one per fund
Can be internal or external
Excludes firms providing advice only
Must engage in either portfolio management or risk management or both;
can delegate subject to limits
 Responsible to fund and investors for portfolio management and risk
management (and cannot delegate such responsibility)
 AIFM must have the expertise and resources to review delegate “on an
ongoing basis”
115
AIFMD
Impact on US Managers
 Delegation Arrangements (continued)
 AIFMD Remuneration Rules
 Similar to UCITS V Rules
 Although AIFMD may not apply to a US delegate,
expectation that they will extend to delegate to
some extent via “appropriate contractual
arrangements”
116
AIFMD
Final Thoughts

Identify what currently unknown information is critical to your organization’s business
plan – e.g., which EU Member States might you want to market into, and therefore,
which local versions of the AIFMD are most mission critical for you: take steps to
monitor how the AIFMD is being implemented in the relevant jurisdictions
 Heighten awareness of AIFMD internally
 If an AIF is proposed to be actively marketed into the EU:
 Perform a gap analysis in respect of the AIF’s annual report and offering
materials for additional disclosures required for EU marketing; and
 Review EU regulator disclosure form and registration process; assess
information required and additional processes (e.g., AIFMD version of a US
Form PF)
 Determine any restrictions or prohibitions on sales to EU investors and communicate
to distribution partners
117
Registered Fund Board of Directors
and Fund Governance Issues
Mark P. Goshko, Partner, K&L Gates LLP
Clair E. Pagnano, Partner, K&L Gates LLP
OVERVIEW







Organization of the SEC
SEC Examinations
Section 12(b) and Rule 12b-1
SEC Enforcement
Update on Section 36(b) Litigation
Money Market Fund Reform and Rule 2a-7
SEC Rulemakings
3
ORGANIZATION OF THE SEC
 SEC consists of 5 divisions and 23 offices, with approximately 4,100
total employees
 Division of Investment Management
 Employs approximately 200 staff
 Regulates the asset management industry, including investment companies
and registered investment advisers
 Division of Enforcement
 Nearly 1,300 employees
 For the 12-month period ended 9/30/14, brought 755 enforcement actions
and obtained sanctions totaling $4.16 billion
 Office of Compliance Inspections and Examinations (OCIE)
 Comprised of approximately 450 examiners, accountants and lawyers
 Administers the National Exam Program that oversees investment
companies and investment advisers
 Requested budget for 2015 is $1.7 billion (2014 - $1.46 billion; 2013
- $1.27 billion)
4
SWEEP EXAMS BY THE SEC
 Fixed-income funds
 Sweep is in response to expected volatility in the bond market
due to potentially rising interest rates
 SEC is also focused on disclosure about the impact from rising
interest rates and board oversight of bond funds
 Sweep is expected to cover 25 to 30 firms
 Focus of the sweep exam
 Policies and procedures related to liquidity risks and illiquid
assets
 Results of stress tests of portfolio liquidity
 Board oversight of liquidity management
5
SWEEP EXAMS BY THE SEC
 Liquid alternative funds
 Focused on those funds with non-traditional asset classes and/or
non-traditional strategies
 Risks posed by valuation, liquidity, leverage and disclosure
 SEC expects to examine 15 to 20 complexes
 Focus of the sweep exam





Use of derivatives (portfolio holdings and trade blotters)
Risk management regarding alternative funds and holdings
Pre-trade/post-trade compliance results
Liquidity (assessment of fund’s liquidity; stress testing)
Valuation
6
SWEEP EXAMS BY THE SEC
 Cybersecurity
 OCIE is conducting exams of 50 broker-dealers and investment
advisers to assess their cybersecurity preparedness
 Focus on the following areas:







Cybersecurity governance
Identification and assessment of cybersecurity risks
Protection of networks and information
Risks associated with remote customer access and funds transfer requests
Risks associated with vendors and other third parties
Detection of unauthorized activity
Prior experiences with certain cybersecurity threats
7
SWEEP EXAMS BY THE SEC
 “Distribution in guise”
 Begun in 2013, sweep focused on mutual fund distribution fees
 SEC staff recently indicated that it completed the sweep
 Several related enforcement actions are expected (“guidance through enforcement” like
Morgan Keegan for valuation)
 SEC assessed the payment amounts, services provided and the
“interaction of the service agreements”
 Focus
of the sweep exam
 Underlying notion that payments ostensibly for sub-transfer agency,
recordkeeping or other services were effectively for distribution
 SEC looked for link between payments and distribution not previously
disclosed and potential Rule 12b-1 violations
 Who is getting paid? For what?
 Particular focus on direct or indirect connections to a preferred fund
arrangement, marketing, promotion or access to investors
8
1940 ACT RESTRICTIONS ON FUND
PAYMENTS FOR DISTRIBUTION
 Section 12(b) of the 1940 Act
 Prohibits a mutual fund from acting as
distributor of its own shares
 Rule 12(b)-1 under the 1940 Act
 Mutual fund will not be deemed a distributor if it
makes payments for distribution in accordance
with the rule
 Paid pursuant to a written plan adopted in accordance
with the rule
 Annual, in-person board approval
9
1940 ACT RESTRICTIONS ON FUND
PAYMENTS FOR DISTRIBUTION
 Adviser payments for distribution and Rule 12b-1
 Fund is not permitted to indirectly act as distributor
 Violation of Section 12(b) and Rule 12b-1(a)(2)
 Adviser is not prohibited from paying for distribution (sound business
practice) and may pay for distribution using revenue from advisory fee
 Creates a potential inference that the mutual fund is making an indirect
use of fund assets to pay for distribution
 Advisory fee payments as “distribution in guise”
 Board has responsibility during 15(c) process to assess reasonableness
of advisory fee and contract in light of Gartenberg factors
 Advisers generally do not discuss their revenue sharing and distribution
arrangements during the 15(c) process
 Adviser’s position is that any revenue sharing and distribution payments are
separate and distinct from the advisory fee
10
1940 ACT RESTRICTIONS ON FUND
PAYMENTS FOR DISTRIBUTION
 SEC guidance on “indirect use of fund assets”1
 An adviser is permitted to use its legitimate resources to pay for
distribution
 SEC in “distribution in guise” sweep raised issues similar to
those outlined in its 1998 “Fund Supermarkets” Letter2
 There should not be allowances in an advisory fee for distribution payments
 Federated fees for shareholder services and recordkeeping are charged
separately from 12b-1 fees and are not paid pursuant to 12b-1 plans
 If the fee/advisory contract does not result in a breach of
fiduciary duty under Section 36(b) of the 1940 Act, adviser may
use revenue from the advisory fee to pay for distribution (even if
such amounts exceed profits on the contract)3
1 Bearing
of Distribution Expenses by Mutual Funds, Investment Company Act Release 11414 (Oct. 28, 1980)
Company Institute, Letter from Douglas Scheit (pub. avail. Oct. 30, 1998)
3 Payment of Asset-Based Sales Loads by Registered Open-End Management Investment Companies, Investment Company Act
Release No. 16431, at note 125 (Jun. 13, 1988)
2 Investment
11
TRENDS IN SEC ENFORCEMENT
 Market structure and exchanges
 Gatekeepers: attorneys, accountants and
compliance professionals and their roles in the
securities industry
 Insider trading and material non-public information
 Fair Valuation
12
RECENT ENFORCEMENT ACTIONS
 Insider Trading and Material Non-Public Information (MNPI)
 SEC v. Rengan Rajaratnam
 Manager actively tried to cultivate new insider sources for Galleon Managment and
played key role in what the SEC has dubbed “the most expansive insider trading
scheme ever perpetrated”
 Defendant is brother of primary defendant in the headliner Galleon insider trading case
 Manager was fined more than $840,000 and agreed to a 5-year industry ban
 SEC v. Lawson, Lawson & Cerullo
 Software company founders, relying on MNPI regarding the company’s prospective
merger, sold company shares in advance of share price decrease
 Sanctions totaled nearly $5.8 million in disgorgement and matching penalties
 SEC v. CITIC Securities & China Shenghai Investment Management
 Accounts managed by the two firms were frozen by the SEC as a result of suspicious
activity preceding a 50% spike in shares of Nexen, Inc.
 Enforcement action capped a series of related SEC proceedings recouping nearly $30
million in gains made due to insider trading
13
RECENT ENFORCEMENT ACTIONS
 Fair Valuation
 In late 2012, the SEC began proceedings against former Morgan
Keegan directors of Morgan Keegan’s registered funds




Board oversight of valuation procedures
Delegation of valuation responsibilities
Valuation methodologies
Insufficient valuation materials for Board review
 Morgan Keegan directors ultimately reached settlement with the SEC
 Industry responses to Morgan Keegan




No formal SEC guidance
Third-party assessment of fund valuation policies and procedures
Back-testing
Increased Board review of valuation issues
14
RECENT ENFORCEMENT ACTIONS

Money market fund manager charged with fraud and Rule 2a-7 violations
 Advisory firm and portfolio manager misled fund’s board and failed to comply
with Rule 2a-7’s risk-limiting provisions
 The manager misled the board about the credit risk posed by securities in the
portfolio, the fund’s exposure to Eurozone credit crisis of 2011 and the fund’s
diversification
 Enforcement action resulted when fund’s performance and gross yield were
identified as “consistently different” from the rest of the market

Adviser sanctioned for improper cross trading
 SEC alleged that the firm improperly allocated the savings resulting from these
affiliated transactions and denied certain clients approximately $6.2 million in
savings
 In its order, the SEC noted that cross trading can pose substantial risks due to
the adviser’s inherent conflict of interest in obtaining best execution for both the
buying and the selling client
15
UPDATE ON SECTION 36(B) LITIGATION
 Two approaches by plaintiffs bringing Section 36(b)
excessive fee cases
 Portion of fee retained by advisers hiring sub-advisers is
disproportionate based on services provided by/responsibilities
of the adviser
 Fee charged for same strategy by managers acting in
subadvisory capacity materially lower than those charged when
serving as primary adviser
 Complaints also contain allegations regarding board’s
ability to devote necessary attention to negotiating
advisory fees
 Multiple firms have been targeted by excessive fee
lawsuits, including BlackRock, J.P. Morgan and SEI
16
MONEY MARKET FUND REFORM AND
RULE 2A-7
 In July 2014, SEC adopted final money market fund rules
 Rules would impose a floating NAV on institutional prime money market
funds
 Boards will have discretion to impose temporary liquidity fees or
redemption gates in times of financial stress
 Rules also amended Rule 2a-7 under the 1940 Act
 Compliance dates for the various requirements are staggered, but most
will be effective by October 2016
 Industry Responses
 Industry groups (ICI, SIFMA) working on FAQs from the SEC
 Restructuring existing funds or creating new products, including private
money market funds seeking to operate under old regime
 Issues with technology solutions and service providers
17
SEC RULEMAKINGS
 The Dodd-Frank Act was signed into law on July 21,
2010
 Rulemakings under the Dodd-Frank Act




Required 398 total rulemakings
As of October 2014, 220 of those rulemakings have been finalized
115 rulemaking deadlines have been missed
95 rulemakings still to be proposed
 Jumpstart Our Business Startups Act (JOBS Act)
enacted in April 2012
 Rulemakings under the JOBS Act
 Elimination of ban on general solicitation and general advertising in Rule 506
and Rule 144A offerings
 Amendments to Regulation D and Rule 156 under the Securities Act
 Proposed rules regarding Regulation A and crowdfunding
18
QUESTIONS?
SEC Asset Management Unit and
Exam Program Areas of Focus for
2015
Michael S. Caccese, Partner, K&L Gates
Luke T. Cadigan, Partner, K&L Gates
Nicholas S. Hodge, Partner, K&L Gates
AGENDA
 Trends in the SEC’s Exam program
 Office of Compliance Inspections and
Examinations (OCIE) priorities for 2015
 Anticipating and preparing for SEC exams
 SEC Enforcement trends
 Asset Management Unit cases and initiatives
 Insider trading, municipal securities,
administrative proceedings, and whistleblowers
22
TRENDS IN THE OCIE EXAM PROGRAM
 Continued use of technology and data analytics
 National Exam Analytics Tool (NEAT)
 In FY 2014, Risk Analysis Examination Group analyzed 1.3
billion transactions from 350 firms
 Impact of Risk Assessment and Surveillance Group
 Performs data analytics to identify firms and practices that
present the greatest risks to investors
 Virtually all exams based on identification of risk factors at
respective firms
 New hedge fund and private equity registrants still getting attention
 Establishment of Private Funds Unit
 Implementation of National Examination Manual
 Rigorous pre-exam due diligence and aggressive examinations
23
OCIE BY THE NUMBERS – IA/IC EXAMS
 Responsible for exams of nearly 11,000 investment
advisers and 800 investment companies
 Collectively, assets under management of nearly $55
trillion
 Fewer than 460 staff members conducting IA/IC exams
(SEC seeking 250 more)
 Identification of higher-risk firms for examination
 OCIE conducted approximately 1,200 formal
examinations of IA/ICs in 2014 (1,850 overall)
 Represents 30% of assets under management and 10% of all
IA/ICs
24
ENHANCED COORDINATION WITH
ENFORCEMENT AND INVESTMENT
MANAGEMENT
 OCIE’s Risk Assessment & Surveillance Unit working to assess
risk with Enforcement’s Office of Market Intelligence
 OCIE reaching out to Enforcement more frequently and
informally when Exam staff sees potential issues
 Enforcement increasingly accompanying OCIE on exams
 Enforcement taking all referrals seriously
 In FY 2014, OCIE made more than 200 referrals, resulting in more
than $300 million in financial sanctions
 Investment Management’s Risk and Examination Office also
accompanying OCIE on exams to obtain information to help
guide policymaking
25
OCIE’S GROWING ENFORCEMENT
PERSPECTIVE
 Regional offices, including OCIE staff,
overseen by growing number of former
prosecutors
 Boston, San Francisco, and Chicago
 Boston OCIE now headed by former
head of Boston’s Asset Management Unit
 Other former Enforcement staff now in
OCIE
26
NATIONAL EXAM PROGRAM (NEP)-WIDE
INITIATIVES
 Fraud Detection and Prevention
 Corporate Governance, Conflicts of Interest, and
Enterprise Risk Management
 Technology
 Dual Registrants
 Relatively New Laws and Regulation
 Securities Act Rule 506(c)
 Municipal advisor rules
 Security-based swaps dealers
 Retirement Vehicles and Rollovers
27
OCIE CYBERSECURITY INITIATIVE
SEC Cybersecurity Roundtable (March 26, 2014)
NEP Risk Alert (April 15, 2014)
Sweep of investment advisers and broker-dealers
Focus on
 Cybersecurity governance
 Identification and assessment of cybersecurity risks
 Protection of networks and information
 Risks associated with vendors and other third parties
 Detection of unauthorized activity
 Experiences with cybersecurity threats
 Risk Alert or other report of findings expected




28
IA/IC PROGRAM CORE RISKS
 Safety of Assets and Custody
• Asset verification
 Marketing/Performance
 Conflicts of Interest Inherent in Certain
Investment Adviser Business Models
2
9
IA/IC PROGRAM – ISSUES AND
INITIATIVES
 Never-Before Examined Advisers
 Wrap Fee Programs
 Monitoring, conflicts of interest, best execution,
trading away from the sponsor, disclosures
 Quantitative Trading Models
 Presence Exams
 Newly registered advisers to private funds
 Deficiencies in allocation of expenses, hidden fees,
marketing, and valuation
30
IA/IC PROGRAM – ISSUES AND
INITIATIVES
 Payments for Distribution in Guise
 Fixed Income Investment Companies
 January 2014 IM Guidance Update suggests stress
tests involving liquidity and various other factors
 Disclosures regarding effects of rise in interest rates
• Exposure by Retail Investors to Lack of Liquidity
31
IA/IC PROGRAM – POLICY TOPICS
 Money Market Funds
 Securities Lending Arrangements
 “Alternative” Investment Companies
 2014 sweep focused on
 Valuation
 Liquidity
 Leverage
 Role of fund boards in oversight and compliance
32
CONFLICTS OF INTEREST
 A key area for SEC risk analysis
 “Conflicts of interest, when not eliminated
or properly mitigated, are a leading
indicator of significant regulatory issues for
individual firms, and sometimes even
systematic risk for the entire financial
system.”
-- Carlo di Florio, Director, OCIE, Speech to National Society
of Compliance Professionals, October 22, 2012
33
IA/IC PROGRAM – 2015 PRIORITIES
 Elderly and Retirement Issues
 Sales and marketing practices






Supervision of Information Technology
Tracking Individuals with Disciplinary Histories
Dual Registrants
Enhanced Use of Form PF Data
JOBS Act
Role of Proxy Advisory Firms
 June 2014 IM guidance about investment advisers’ responsibilities in
voting client proxies and retaining proxy advisory firms
 Risk Management
 Liquidity risk management, stress testing, use of derivatives, and
transition planning
34
ANTICIPATING SEC EXAMS AND
ENFORCEMENT ACTIVITY
 SEC’s exam and enforcement programs are more
risk-based than ever
 You can predict the likelihood of your next exam by
looking at the risk areas identified by the SEC and
determining whether they apply to you
 Consider a mock audit
 SEC investigations at other firms into practices you
engage in should prompt a review at your firm
35
ANTICIPATING SEC AREAS OF FOCUS
 Firms should consider:
 Prior SEC exams, including deficiencies raised and actions taken
 Relevant topics identified by the SEC staff in speeches or releases
(e.g., IM Guidance Updates, Risk Alerts)
 Enforcement actions and investigations
 Analysis of new statutory/regulatory requirements that impact the
adviser’s business
 Any serious compliance issues that arose at the adviser or in the
industry in the past year
 Analysis of compliance implications of any new businesses,
discontinued businesses, and change in advisory operations during the
past year
36
DIVISION OF ENFORCEMENT FY 2013
STATISTICS





686 enforcement actions
$3.4 billion in penalties and disgorgement
140 cases against IA/ICs (20% of total)
121 cases against B/Ds (18% of total)
44 insider trading cases (6% of total)
37
DIVISION OF ENFORCEMENT
FY 2014 STATISTICS
 755 enforcement actions (20 more than
FY2011 record)
 $4.16 billion in penalties and disgorgement
 Number and nature of cases reflect the
SEC’s “Broken Windows” approach
38
THE SEC’S “BROKEN WINDOWS”
APPROACH
“Minor violations . . . can
feed bigger ones, and . . .
can foster a culture where
laws are increasingly
treated as toothless
guidelines. And so, I
believe it is important to
pursue even the smallest
infractions.”
- SEC Chair Mary Jo White,
“Broken Windows” Speech,
October 9, 2013
39
ENFORCEMENT TRENDS
 “Broken Windows” approach
 Lower thresholds for intent and disgorgement/harm
Continued reliance on data analytics
Continued focus on individuals
Requiring admissions of guilt in specific cases
Professed intent to take more cases to trial
Increased use of administrative proceedings
Increased urgency in wake of Gabelli holding (5-year
statute of limitations starts with fraud not discovery)
Whistleblower program
 Increased coordination with criminal authorities






40
ENFORCEMENT FOCUS AREAS
 Investment advisers
 Hedge funds
 Private equity funds
 Mutual funds
 Financial statement and accounting fraud
 Insider trading
 Microcap fraud
 Market structure violations
 Deficient gatekeepers
41
SPECIALIZED UNITS AND TASK FORCES
Enforcement Specialized Units





Asset Management
Market Abuse
Foreign Corrupt Practices Act
Complex Financial Instruments
Municipal Securities and Public Pension
Task Forces
 Financial Reporting and Audit Task Force
 Center for Risk and Quantitative Analytics (CRQA)
 Microcap Fraud Task Force
42
ASSET MANAGEMENT UNIT
 Largest of specialized units with more than seventy-five staff
members
 More than 20 staff in each of New York and DC
 Generally 3-4 staff in each other office
 Staff experts include hedge fund portfolio manager, private
equity analyst, and individuals with due diligence, mutual fund
operations, and trading experience
 Focus divided equally among 1) private funds, 2) registered
investment companies, and 3) separately managed accounts
 Works closely with OCIE and the Divisions of Investment
Management and Economic and Risk Analysis in devising
analytics and methodologies for targeting specific practices
and firms
43
ASSET MANAGEMENT UNIT
CONTINUED AREAS OF FOCUS
 Valuation issues (board oversight, side pockets,
liquidity representations, marking the close, etc.)
 Conflicts of interest (related party transactions,
transactions between co-managed funds, cherrypicking, front-running, etc.)
 Performance advertising (claims of back-tested
or model performance, GIPS compliance, etc.)
 Fee arrangements (board oversight, disguised
distribution fees, adviser fees, wrap fees, etc.)
44
44
ASSET MANAGEMENT UNIT
CONTINUED AREAS OF FOCUS
 Custody Rule (failure to conduct surprise
exams and to ensure quarterly account
statements from custodian, etc.)
 Private equity firms (valuation, conflicts of
interest, fees, zombie funds, performance
claims, etc.)
 Small advisers (compliance programs, Ponzi
schemes)
 Sales practices (are products appropriate to
investors?)
45
VARIOUS ASSET MANAGEMENT UNIT
INITIATIVES
 Compliance Program Initiative
 Failure to correct compliance violations cited as deficiencies by
staff in prior exams
 Mutual fund fee initiative
 Board oversight of fees and valuation determinations
 Preferential redemption initiative
 Investors permitted to redeem on preferential terms
 Aberrational performance initiative
 Use of analytics to identify returns too good to be true at hedge
funds and mutual funds
 Problem adviser initiative (“Operation ADV”)
 Scrutiny of misrepresentations as to education, experience,
strategy, and performance
46
NOTABLE CASES
 Cross-Trades: Firm charged with engaging in crosstrades that failed to allocate cost savings equally
between buying and selling clients (Western Asset
Management)
 Performance: SEC charged money manager with
making false and misleading claims about the firm's
past performance in newsletters and through Twitter.
(Mark Grimaldi/Navigator Money Management)
 Conflicts of Interest: SEC charged firm and its CEO
used undisclosed revenue sharing agreements to pay
themselves kickbacks and failed to disclose conflicts of
interest (Total Wealth Management)
47
INSIDER TRADING
 Market Abuse Unit using computer-based tools to sift
through data to find aberrational trading and
relationships
 Significant collaboration with USAO
 SAC Capital, Galleon, Expert Network cases
 SEC setbacks in attempting to prove insider trading
 Bauer: 7th Circuit reversed decision finding insider trading in
connection with redemption of mutual funds
 Cuban: SEC lost jury trial premised on supposed agreement not
to trade on information
 Obus: SEC lost jury trial against hedge fund manager accused of
selling on merger tip
 Moshayedi: SEC lost jury trial against former CEO who sold
before disclosure that customer would scale back sales
48
MUNICIPAL SECURITIES
 First financial penalty against a municipal issuer (The Greater
Wenatchee Regional Events Center Public Facilities District)
 First emergency action to halt a fraudulent municipal bond offering
(City of Harvey, Illinois)
 First case charging a firm with violating the pay-to-play rules for
investment advisors (TL Ventures Inc.)
 First case under the Municipalities Continuing Disclosure
Cooperation initiative (Kings Canyon Joint Unified School District)
 First case charging violations of Municipal Securities Rulemaking
Board Rule G-15(f), which establishes the “minimum denomination,”
brought against a number of dealers related to Puerto Rico junk
bond sales
 First time the SEC has charged a municipal official under a federal
statute that provides for “control person” liability (Gary Burtka)
49
INCREASED USE OF
SEC ADMINISTRATIVE PROCESS
 This past year, SEC brought 43% of its litigated cases as APs
 SEC has indicated it will make greater use of its advantages in this
forum, where it has a higher winning percentage
 No right to jury
 Trial to SEC administrative law judge with first appeal to SEC de
novo
 No discovery generally
 Exceptions: SEC investigative file, statements of witnesses, subpoenas for
documents
 Limited expert disclosures, but ALJ may order more




No dispositive motions (with minor exceptions)
All relevant evidence (including hearsay) is admitted
Trial within 4-5 months; decision within 10 months
Use of SEC administrative process has been subject to
constitutional challenges and public criticism
50
SEC WHISTLEBLOWER PROGRAM
 SEC enforcement action with sanctions over $1 million
 SEC must pay 10-30% of recovery
 To any eligible whistleblower
 Who has voluntarily provided the SEC with
 Original information about a possible violation of the federal
securities laws
 SEC received 3,238 tips in FY13, nearly 9 each day
 Nearly 90% of whistleblower tips supposedly first made
to company
51
SEC Whistleblower Program
 3,238 formal whistleblower tips received in
FY2013
 Since Office of Whistleblower opened by SEC in 2011, received
more than 6,500 whistleblower tips
 Examples
 Corporate disclosures and financials – 17.2%
 Offering fraud – 17.1%
 Manipulation – 16.2%
 Insider trading – 6.1%
 404 tips from 55 countries outside US
 E.g., United Kingdom (66 tips), Canada (62 tips), and China (52
tips)
52
SEC WHISTLEBLOWER PROGRAM
 August 21, 2012: SEC issues $50,000 award to an
unnamed tipster who helped uncover a fraud
 June 12, 2013: SEC issues awards to three
whistleblower of 5% of funds collected in connection with
alleged sham hedge fund
 September 30, 2013: SEC awards over $14 million to
whistleblower whose tip led to recovery of investor funds
 October 30, 2013: SEC awards to whistleblower 30% of
funds collected in connection with action arising from
ongoing fraudulent scheme
53
SEC WHISTLEBLOWER PROGRAM
 June 3, 2014: SEC awards $875,000 to be split
between two whistleblowers
 June 16, 2014: SEC brings action against
hedge fund adviser for retaliation against
whistleblower
 August 29, 2014: SEC awards $300,000 to
compliance/internal audit professional
 September 2014: SEC issues $30 million
award
54
QUESTIONS?
CFTC and Derivative Developments
Michael W. McGrath, Partner, K&L Gates LLP
Skanthan Vivekananda, Partner, K&L Gates LLP
AGENDA
 CPOs and CTAs
 Form 40 Amendments
 Margin for Uncleared Swaps
 ISDA Resolution Stay Protocol
 EMIR
58
CPOS AND CTAS – HOW DID WE GET HERE?

The Dodd-Frank Act and related rulemaking added
most swaps to the definition of “commodity interest”

2012: the CFTC significantly narrowed the exclusion for
CPOs of Registered Funds by requiring the CPO to
meet certain marketing requirements and meet one of
two de minimis tests:
 5% Test
 100% Net Notional Test
 2013: “Harmonization” rules provide a “substituted
compliance” regime for most aspects of CFTC regulation
(other than CPO registration)
59
CPOS AND CTAS – RECENT
DEVELOPMENTS


Third-Party Recordkeeping: September 2014 letter permits all
CPOs to use any third-party as a recordkeeper, provided:

The CPO has timely access to such records

The CPO files a statement that identifies the third-party to the CFTC
CPO Delegation: October 2014 letter provides “self-executing”
delegation subject to certain conditions, including:
 Delegation is pursuant to a legally binding document
 The delegating CPO does not solicit investors for the pool or manage pool assets
(with certain exceptions)
 The designated CPO is registered
 JOBS Act: September letter harmonizes Regulations 4.7(b) and
4.13(a)(3) with Rule 506(c) of Regulation D, but a notice filing is
required
60
CPOS AND CTAS – OPEN ISSUES
 CTA recordkeeping delegation
 Recordkeeping rule modernization
 Fund-of-funds guidance
 Additional delegation guidance
61
OWNERSHIP AND CONTROL
REPORTING
In 2013, the CFTC published new rules related to ownership and control reporting (Form 40 / 40S
reporting for end-users)
Substantive changes:
Expanded trader and account information
New reporting obligations for DCMs and SEFs
Electronic submission
Obligation to update
Compliance Dates:
February / March of 2015 for FCMs / clearing members
February 2016 for reporting end-users
Reporting: FCMs / CFTC web portal / FIA Tech
the CPO has timely access to such records
the CPO files a statement identify the third-party to the CFTC
CPO Delegation: October 2014 letter provides “self-executing” delegation subject to certain conditions,
including:
Delegation is pursuant to a legally binding document
The delegating CPO does not solicit investors for the pool or manage pool assets (with certain exceptions)
The designated CPO is registered
JOBS Act: September letter harmonizes Regulations 4.7(b) and 4.13(a)(3) with Rule 506(c) of Regulation D,
but a notice filing is required
62
MARGIN FOR NON-CLEARED SWAPS
Earlier this fall, the CFTC and U.S. prudential 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.
 Proposals are not identical but share many similarities.
 Prudential regulator rules apply to SD/MSPs regulated by them (Federal
Reserve, the FDIC, the OCC, the Farm Credit Administration and the Federal
Housing Finance Authority)
 CFTC rules apply to other SD/MSPs.
 These are proposed rules. However, comment period recently expired.
 Perhaps final rules 1st/2nd quarter next year?
 Both impose requirements on SD/MSPs to post and collect variation and
initial margin for all un-cleared swaps with end users meeting certain criteria.
63
MARGIN FOR NON-CLEARED SWAPS
 Variation Margin
 SD/MSP must post/collect variation margin on all uncleared swaps with “financial
end-users.”
 Financial end user - long list of entities including:






registered investment companies
3(c)(1) and 3(c)(7) funds
3a-7 and 3(c)(5)(c) funds
commodity pools
ERISA plans
wide variety of other entiities
 must post an amount sufficient to cover a change in the value of obligations under
the un-cleared swaps since the last time such payment was made (the “cumulative
mark-to-market amount”)
 Must post/collect each business day
 Only cash collateral is permissible (U.S. dollars or cash in the currency in which
payment obligations under the swap are required to be settled)
 Minimum Transfer Amount of up to $650,000 is OK (but in calculating, you look at
cumulative amount of initial and variation margin required)
 Proposed compliance date: December 1, 2015
64
MARGIN FOR NON-CLEARED SWAPS
 Initial Margin
 SD/MSP must post/collect initial margin on all un-cleared swaps with financial
end-users who have “material swaps exposure.”

that entity and its affiliates have an average daily aggregate notional amount of noncleared swaps, non-cleared security based swaps, foreign exchange forwards and
foreign exchange swaps with all counterparties for June, July and August of the
previous calendar year that exceeds $3 billion (where such amount is calculated only
for business days)
 Calculation of the initial margin required can use a model based approach (based
on model approved by regulators meeting certain criteria).
 Alternatively, it can use a table based approach set forth in the rules.

e.g., table requires initial margin of 2% of notional for interest rate swaps with 2 to 4 year
maturity
 Must post/collect each business day starting with the business day following the
trade date.
 Permissible collateral includes, among other things, cash in USD and certain
other major currencies, treasuries and certain other sovereign debt, certain
agency securities, certain highly rated corporate debt, gold and equities on
certain major indices .

Collateral is subject to haircuts based on a table in the proposed rules.
65
MARGIN FOR NON-CLEARED SWAPS
 Initial Margin Cont’d
 Minimum Transfer Amount of up to $650,000 is OK (but in calculating, you look at
cumulative amount of initial and variation margin required).
 A Threshold of up to $65 million is OK, but this is applied at a consolidated entity
level (i.e., across all non-cleared swaps between the SD/MSP and its affiliates and
the counterparty and its affiliates).

Example: SD enters into three separate swaps with three counterparties part of the same
affiliated group. If initial margin amount would otherwise be $100 million for each entity and
Threshold is $65 million, SP must collect at least $235 million ($100 + $100 + $100 - $65).
 All initial margin posted/collected pursuant to this mandate must be held at a tri-party
custodian pursuant to an account control agreement.
 Phased in compliance between December 1, 2015 to December 1, 2019 based on
notional amount of un-cleared swap trading activity by financial end-user and its
affiliates
 $4 trillion  December 1, 2015
 $3 trillion  December 1, 2016
 $2 trillion  December 1, 2017
 $1 trillion  December 1, 2018
 otherwise  December 1, 2019
66
MARGIN FOR NON-CLEARED SWAPS
 Right to Segregation of Initial Margin at a Tri-Party Custodian
 CFTC rules require swap dealers/MSPs to notify counterparties of their right to
require segregation of initial margin posted in connection with an uncleared
swap at a tri-party custodian.

Notice must provide a list of independent custodians and provide pricing information
 Swap dealer must obtain confirmation from counterparty whether or not it wants
to elect to segregate initial margin prior to confirming the terms of any uncleared
swap.

However, CFTC recently issued no action relief permitting a negative consent
procedure.
 If you elect to segregate initial margin in accordance with this new regime, your
control agreements must include certain additional terms.


Collateral may only be released upon submission of a notice made under oath or
under penalty of perjury that the party is entitled to exercise control of the account.
Funds in control account may only be invested consistent with CFTC Rule 1.25.
 Don’t proposed un-cleared swap margin rules mandate that initial margin be
held at a tri-party custodian? If so, what is the point of this?
67
RESOLUTION STAY PROTOCOL
 Fact pattern #1:
 US bank holding company files for bankruptcy. You manage a Fund that is party
to a swap with its U.S. subsidiary guaranteed by the holding company parent
(in ISDA parlance, the parent is a “credit support provider”).
 A bankruptcy refresher
 The automatic stay
 Ipso Facto clauses (e.g., Section 365(e) of the Bankruptcy Code)
 Safe harbors for derivatives (e.g., Section 560 of the Bankruptcy Code)
 contractual right to liquidate, terminate or accelerate a swap agreement
because of a bankruptcy or insolvency event or to offset or net out any
termination values shall not be stayed by other provisions of [the
Bankruptcy Code].
 Why?
 The Lehman Experience

A rush to the exits!
68
RESOLUTION STAY PROTOCOL
 Orderly Resolution Regimes




Systemically Important Financial Institutions
Title II Of Dodd-Frank and Orderly Liquidation Authority
Short Stay on termination rights
Other regimes: The European Union Bank Recovery and Resolution Directive
and other regimes
 Fact pattern #2:
 Same as Fact Pattern #1 but now the holding company is located in United
Kingdom. As in Fact Pattern #1, your counterparty is its U.S. based subsidiary.
If UK BHC files for bankruptcy and is subject to a stay resolution regime, will
you be able to terminate your swap with the subsidiary? Would a New York
court recognize the UK’s stay resolution regime?
 Resolution Stay Protocol
 Purpose is to achieve by contract an agreement to these stay resolution
regimes on a cross-border basis.
 Implications for the buy side.
69
KEY ELEMENTS OF EMIR
 Meaning of “Derivatives”
 Counterparty categorisation
 Financial Counterparties (“FCs”)
 Non-Financial Counterparties (“NFCs”)
 Third country entities (“TCEs”)
 Clearing thresholds
 NFC and NFC+
70
EMIR - CLEARING
 The clearing obligation under EMIR will apply:
Between two FCs
Between an FC and an NFC+ entity
Between two NFC+ entities
Between an FC or an NFC+ entity and a TCE (only where
the TCE would be subject to clearing obligation if it was
established in the EU)
 Between two TCEs if the contract has a “direct, substantial
or foreseeable effect” in the EU (or where it is necessary or
appropriate to prevent the evasion of EMIR’s requirements)




71
EMIR – “RISK MITIGATION
TECHNIQUES”
 Uncleared OTC trades
 FCs and NFCs (all)
 Timely confirmations
 Reconciliation, portfolio compression and dispute resolution
 Additional requirements for FC and NFC+ counterparties


Initial and variation margin
Daily valuation
 Effect of risk mitigation requirements on U.S. entities
72
TRADE REPORTING
 Timing T+1
 Delegated reporting and ongoing obigations
 Back-loading
 If outstanding on February 12, 2014: 90 days
 If no longer open, but outstanding on August 16, 2012: 3 years
73
Registered Alternative Products
Michael S. Caccese, Partner, K&L Gates LLP
George Zornada, Partner, K&L Gates LLP
REGISTERED ALTERNATIVE PRODUCTS
 RICs and Alternative Assets and Strategies
 Registered Funds of Hedge Funds
76
RICS AND ALTERNATIVE INVESTMENTS
 As markets have fallen, traditional fixed income
investments have produced low interest income and
most markets have exhibited more volatility; investor
demand has increased for "alternatives."
 Registered funds have expanded the borders of
traditional investments as "average" investors are
comfortable with traditional mutual fund form and
advisers seek alternative exposure for their clients.
77
TRADITIONAL REGISTERED FUNDS
WITH ALTERNATIVE STRATEGIES
 Mutual funds with "hedge fund" strategies






Long/short funds
Multi-strategy fund of funds
Multi-manager funds
Event-linked funds (catastrophe bond)
Event-driven funds (special situations)
Managed futures
 Commodities Exposure (also ETPs that are not investment
companies)
 MLPs (open and closed-end funds)
 Closed-end funds and illiquid strategies
 Creativity at work, but registered funds do have distinct limits - there
always will be hedge funds
78
MUTUAL FUNDS WITH "HEDGE FUND"
STRATEGIES
 Long/short funds



purchase and short sale of equity securities
With a long position, the fund purchases a stock outright; with a short position, the fund sells
a security that it does not own and must borrow to meet its settlement obligations.
Asset coverage requirements, limit the amount of shorting a fund can do.
 Multi-strategy fund of funds

Access alternative investment strategies (e.g., convertible arbitrage, event driven (merger
arbitrage), fixed income relative value, equity market neutral, long/short equity, global macro,
managed futures and emerging markets) by investing in other investment companies.
 Multi-manager funds


Access alternative investment strategies by hiring multiple sub-adviser to run specific substrategies.
Main Adviser allocates fund assets to distinct sleeves managed by separate (often
unaffiliated) sub-advisers.
79
MUTUAL FUNDS WITH "HEDGE FUND"
STRATEGIES
 Event-linked funds (catastrophe bonds)






Return of principal and payment of interest contingent on the non-occurrence of a specified trigger event(s)
that leads to economic and/or human loss, such as an earthquake of a particular magnitude or a hurricane of
a specific category.
The most common type of event-linked bonds is known as “catastrophe” or “CAT” bonds.
In most cases, the trigger event(s) will not be deemed to have occurred unless the event(s) happened in a
particular geographic area and was of a certain magnitude or caused a certain amount of actual or modeled
loss. If the trigger event(s) occurs prior to a bond's maturity, the fund may lose all or a portion of its principal
and forgo additional interest.
Liquidity of the CAT bond market is biggest challenge, although becoming much more liquid.
Uncorrelated to equity or bond markets.
Event-driven funds (special situations)




Invests in the securities of publicly traded companies involved in mergers, takeovers, tender offers,
leveraged buyouts, spin-offs, liquidations, or similar events (“corporate reorganizations”).
A variety of strategies can be employed to capitalize on the mispricing of corporate securities during
corporate reorganizations, including transactions involving common and preferred stock, debt instruments
and derivative securities.
Strategies often involve the use of arbitrage, which involves taking advantage of small price differences
between two otherwise equivalent assets.
Such strategies considered to be less dependent on the overall direction of stock prices.
80
MUTUAL FUNDS WITH "HEDGE FUND"
STRATEGIES
 Managed futures
 To run as a RIC, must use offshore subsidiary for commodities
futures that produce “bad income.”
 Utilize inherent or “economic” leverage in futures typically with
programmatic trading
 Asset coverage requirements.
 CFTC has “harmonized” requirements for such funds, which
also are commodity pools.
81
COMMODITIES EXPOSURE
 Commodity RICs
 Frequently are the same as “managed futures” funds but focused on
commodities futures rather than financial futures.
 Offshore subsidiary structure.
 Asset coverage requirements.
 CFTC harmony.
■
Commodity ETPs
 Pool that holds only physical commodity (i.e., gold, silver, copper).
 Not investment company, not commodity pool.
 Exchange-traded issuer like a public company.
82
MLPs








Registered funds must diversify assets into MLPs, related companies or exposure to such
companies through other instruments. RIC limited to 25% direct holding of MLPs.
Some MLPs are not RICs but are registered investment companies that operate as “C
corporations” rather than as a RIC.
MLPs are “master limited partnerships.”
MLPs are generally treated as partnerships for U.S. federal income tax purposes.
To be treated as a partnership for U.S. federal income tax purposes, an MLP must derive at least
90% of its gross income for each taxable year from qualifying sources, including activities such
as the exploration, development, mining, production, processing, refining, transportation, storage
and certain marketing of mineral or natural resources.
MLPs are generally publicly traded, are regulated by the SEC and must make public filings like
any publicly traded corporation.
Many MLPs operate oil, gas or petroleum facilities, or other facilities within the energy sector.
Midstream MLPs may also operate ancillary businesses including marketing of energy products
and logistical services. The MLPs in which the Fund invests may also engage in owning,
managing and transporting alternative energy assets, including alternative fuels such as ethanol,
hydrogen and biodiesel.
83
REGISTERED FUNDS OF HEDGE FUNDS
Closed-end.
Continuously offered.
Not exchange listed, use tender offers.
Partnership or RIC structure.
Provide exposure to potentially anything investable,
anywhere.
 Not generally available to all investors, even if
publicly offered, based on SEC staff policy.





84
Special Issues for Closed-End Funds
Clair E. Pagnano, Partner, K&L Gates LLP
Trayne S. Wheeler, Partner, K&L Gates LLP
AGENDA
 Closed-End Fund Basics
 Taking Advantage of Trading Premiums: Shelf
Offerings
 Managing Trading Discounts




Tender Offers for Preferred Shares
Distribution Rates
Open Market Share Repurchases
Tender Offers for Common Shares
 Closed-End Fund Litigation Overview
 Impact of the Volcker Rule
87
CLOSED-END FUND BASICS
 Hybrid of a mutual fund and operating company
 Third-party underwritten IPOs
 Stable pool of assets – no redemptions – great for investing
in certain instruments (e.g., fixed income)
 Traded on an exchange (most often NYSE or AMEX)
 NAV of underlying portfolio is not anchored to market trading
price
 This presents challenges (discounts) and opportunities
(premiums)
 Most significant result of this is that the fund may trade at either
a premium or a discount to its market value
 Example – a fund with 10 million shares outstanding and a portfolio
worth $100 million would be expected to trade around $10/share
 Shares may be trading for a discount (e.g., $8) or premium (e.g.,
$12) to NAV
88
TAKING ADVANTAGE OF TRADING
PREMIUMS: SHELF OFFERINGS





Permits Issuance Of Additional Shares Generally Into Existing Trading
Market
Generally Employed Where Shares Are Trading at a Significant Premium
General No-Action Relief Facilitates Funds Relying on General Shelf
Registration Rule Without Additional Reporting Requirements
Issuer-specific No-Action Relief Permits Annual Updating under Rule 486(b)
1933 Act Rule 415





Fund Must be Reporting for At least one year
Permits Delayed or Continuous Offering of Shares
“At the market” offering must be on delayed Basis
Need to File Shelf Registration Statement
“Take Downs” Reflected in Supplements to Shelf Registration Statement
89
TAKING ADVANTAGE OF TRADING
PREMIUMS: SHELF OFFERINGS (CONT’D)

Underwriting
 Overnight Deals -- Third Party Brokers Will Underwrite – For a Price
 At-the-Market Offerings – Generally Use an Affiliated Broker (typically
mutual fund distributor) – Third-Party Broker Typically Used as Sales
Agent
 Must be FINRA qualified to underwrite closed-end offerings
 May require amendment to FINRA membership agreement
 If there is no affiliated broker, a third-party broker may be used –
generally involves a more significant closing

Sales Loads
 Typically varies based upon amount of trading premium
 Section 23(b) Prohibits Issuance at Below NAV
 Revenue Sharing -- Some Brokers will Seek trail Payments from
Adviser in addition to load
90
TAKING ADVANTAGE OF TRADING
PREMIUMS: SHELF OFFERINGS (CONT’D)

NYSE/Other Listing
 Shares sold in shelf offerings must be subject to
supplemental listing application
 May be done once covering all shelf shares -- not required for
each take down
 FINRA filings
 All SEC shelf filings must be made with FINRA
 Same-day clearance

Board Considerations
 Board must conclude that Benefits of Program through
additional assets outweighs possible impact on premium
91
MANAGING TRADING DISCOUNTS
 Problem:
 Many Closed-End Funds’ Market Prices Trade at a
Discount to Net Asset Value
 Consequences:
 Shareholder Value Diminished
 Attracts Activist Shareholders Seeking to Arbitrage
Discount
 Presents Difficulties in Attracting Underwriters for
Future Offerings
92
METHODS FOR MANAGING DISCOUNTS
 Enhancing Competitive Distribution Rates
 Open Market Share Repurchases
 Tender Offers for Outstanding Common
Shares
 Tender Offers for Preferred Shares
93
ENHANCING DISTRIBUTION RATES
 Closed-End Funds Very Often Marketed and
Purchased for Income Produced
 Closely Monitoring Distribution Rates Relative
to Competitors is Very Important
 Section 19(a) Disclosures
 Section 19(b) Limitations
 19(b) Exemptive Orders: Managed Distribution
Plans
 Possible Uniform Exemptive Rule
94
OPEN MARKET SHARE REPURCHASES
 1940 Act Section 23(c) Permits
 Must be Conducted Under 1934 Act Rule10b-18
Safe Harbor



Single Broker
Time - Near Close of Primary Trading
Price
1. Maximum Highest Bid or Last Transaction
2. Special Provisions for Share Where No bids of Transactions
3. Generally not applicable to CEFs
95
OPEN MARKET SHARE REPURCHASES
(CONT’D)
 1940 Act Section 23(c) Permits
1. Volume


Maximum 25% of Average Daily Trading Volume
Exception for Once Weekly Block Purchase
2. Notice of Program




Repurchased Shares Generally must be Retired
Governing Instruments Determine
Resale or Reissuance Requires Re-Registration
Affiliates of Fund May Also Make Open Market
Purchases
96
TENDER OFFERS FOR COMMON
SHARES
 1940 Act Section 23(c) Permits
 Must Comply with 1934 Act Rule 13e-4 Governing Issuer
Self Tenders
 Volume -- No Limit - Board Determines
 Series Tenders -- Typically Small amounts 5% - 10%
 One Time Tenders
 Amounts may be Larger
 Impact may be time limited
 Filing of Schedule TO
 Dissemination
 Long Form Publication
 Mailing to Shareholders -- Most Common
 Short Form Publication
97
TENDER OFFERS FOR COMMON
SHARES (CONT’D)
 Period -- Must be Open for 20 Business Days
 Price -- Not Prescribed -- Typically 95% to 98% of NAV
Depending on Current Discount
 Valuation -- Based Upon NAV at Expiration Date
 Amended Schedule TO Reflecting Results Must be Filed
with SEC
 Related Communications -- All Must be Filed
 Tenders By Affiliates -- Generally Subject to Same
Requirements
 Resale of Purchased Shares -- Must be Re-Registered
98
TENDER OFFERS FOR PREFERRED
SHARES
 Redeem auction rate preferred shares through
tender offers
 Typically done in connection with refinancing
transactions (i.e., issuances of private preferred
shares, debt or tender option bonds) in order to give
liquidity to ARPS holders and maintain the fund’s
leveraged capital structure
 Conditions on tender offers:
 Tender offer at some percentage below par
 Minimum participation percentage
99
TENDER OFFER FOR PREFERRED SHARES
– FACTORS BENEFITING THE FUND
 Not readily quantifiable factors include:
 Providing ARPS shareholder an opportunity to
liquidate their shares
 Reducing risks associated with inaction
 Potential changes to Board structure
 Costs associated with proxy fights
 Litigation from preferred shareholders
 Risk new forms of refinancing will not be available
in the future
100
FACTORS IMPACTING TENDER OFFER
PRICES FOR PREFERRED SHARES
 Reasons why tender offers vary by fund:
 Variety of leverage options available (taxable
funds have more)
 Degree to which portfolio can support leverage
expenses
 Existence of a credit facility (reducing
transactional expenses)
 Extent to which the offer is subscribed
101
CLOSED-END FUND LITIGATION
OVERVIEW: DIRECT ACTIONS
a. Direct suits relate to shareholders'
structural, financial, liquidity and voting
rights
b. If numerous plaintiffs with similar or identical
claims -- claim may be brought as a class
action
c. Example -- disclosure actions
102
CLOSED-END FUND LITIGATION
OVERVIEW: DERIVATIVE ACTIONS
a. Breach of fiduciary duty owed to the fund
b. Demand letter must be sent to the fund's board
c. Fund board determines whether to pursue claims

Special Committee (SC -- independent directors)

SC must be independent, unbiased and act in good faith

Differing standards of review depending on applicable law
d. Example -- Challenges to board’s decision not to
reorganize closed-end fund as open-end fund
103
RISE OF AUCTION RATE PREFERRED
SHARES LITIGATION
a.
Demand letters on behalf of purported holders of funds’ common shares,
alleging that the funds’ investment adviser, officers and board of directors
breached their fiduciary duties in connection with the redemption of the
funds’ auction preferred shares at their liquidation preference.
b.
Derivative actions filed (suits filed in New York, Illinois, Massachusetts)
c.
Standard approach




d.
Establish Special Committee to investigate and respond to claim
Stay proceeding pending Special Committee’s / Board's determination
Special Committee evaluates demand
If demand is rejected, Defendants move to dismiss proceeding relying on
Business Judgment Rule
SEC’s brief supports claims that Merrill Lynch & Co. rigged the ARPS
market


Failed to disclose its role in “propping up” auctions
Goes against prior dismissals
104
IMPACT OF THE VOLCKER RULE ON TOBS
 TOB programs have been historically used to provide a supply of
short-term tax-exempt municipal bonds to funds, including municipal
bond closed-end funds
 The Volcker Rule exempted federally insured depository institutions
and affiliates from potential proprietary trading prohibitions on
municipal bonds
 While the exemption covers most of the municipal market, tender option
bond (TOB) programs are not exempt
 Upon finalization of the Volcker rule, market participants began
attempting to restructure existing TOB programs or find feasible
alternative structures
 Volcker-compliant TOB structures began appearing over the summer,
aiding municipal market liquidity
 Look for additional structures to develop in the coming months
105
DOL, ERISA and Tax Developments
Mark J. Duggan, Partner, K&L Gates (with thanks to
William P. Wade)
Joel D. Almquist, Partner, K&L Gates
ERISA FAQs
QUESTION 1
Why do we need to worry about ERISA and
the Department of Labor, given that our firm
already is SEC- and CFTC registered?
Aren’t two regulators enough?!
109
ANSWER 1
 ERISA and other Federal laws co-exist
 ERISA preempts most State laws, except
banking, insurance, securities laws
110
QUESTION 2
My firm usually adopts a gross negligence
exculpation and indemnification standard in
our fund contracts, but I understand that
ERISA has a “prudence” concept. How is
that different from gross negligence?
111
ANSWER 2
 ERISA disallows exculpation or indemnity
for breach of fiduciary duty
 “Prudent expert” standard – process is
important
 Can a “prudent expert” be negligent (or
grossly negligent)?
 Liability for trade errors (i.e. WAMCo)
112
QUESTION 3
I heard that an adviser needs insurance or a
bond to manage ERISA money. Our firm
has $XX million in D&O/E&O coverage. Is
that sufficient?
113
ANSWER 3
 ERISA bond intended to protect the plan
 Note: bond required for each plan in a
plan-asset fund
 D&O/E&O insurance protects the
investment manager
114
QUESTION 4
Does our firm really need to be a “QPAM” to
manage ERISA money, either legally or
practically?
115
ANSWER 4
 Legally, no – practically, expected
 Broad prohibited transaction restrictions
require exemptions
 QPAM is broad exemption for “party-ininterest” transactions – requires status and
other conditions; note exceptions
116
ANSWER 4 (CONTINUED)
 Other possible exemptions
 ERISA 408(b)(2)
 “Services” Exemption
 Allows services to plans by parties in interest; no
more than “reasonable compensation” permitted
 408(b)(2) disclosure requirements
117
ANSWER 4 (CONTINUED)
 Other possible exemptions
 “Service Provider” Exemption – 408(b)(17)
 Allows transactions with a service provider to a plan
 Unlike QPAM, does not require SEC-registered
adviser status
 Plan must pay no more, and receive no less, than
“adequate consideration”
 Some market participants resist use
118
QUESTION 5
ERISA has a 25% test for private funds that
allow ERISA plans to invest (i.e., if ERISA
plans hold less than 25% of any class of
fund interests, ERISA does not apply). How
does that work in a master-feeder or a fund
of funds structure?
119
ANSWER 5 – THE “25% TEST”
Private Fund assets are “plan assets” if:
1) benefit plan investors
2) hold 25% or more of
3) any class of equity interests in the Fund
4) not counting interests held by the Fund
manager or its affiliates for their own
account.
120
ANSWER 5 –
“BENEFIT PLAN INVESTORS”
Defined in ERISA § 3(42):
 ERISA Plans
 Code Section 4975 Plans (IRAs, Keogh
plans)
 Other “plan asset” funds
121
ANSWER 5 –
25% TEST FORMULA
Numerator (“benefit plan investors”):
ERISA plan $
plus Code 4975 plan $
plus “Plan-asset” fund $
Denominator:
Assets in class/fund $
less fund manager and “affiliate” $
= 25% or more?
(per class)
122
ANSWER 5 – SPECIAL RULES
(FOFS, MASTER-FEEDER)
25% Test at Two Levels:
Level 1 Test
Level 2 Test
Fund-of-funds
Underlying Fund
Feeder Fund
Master Fund
123
ANSWER 5 – SPECIAL RULES
(CONTINED)
 Level 1 Test for FOF/Feeder –
Standard “plan asset” computation
 Level 2 Test for Underlying/Master –
What part of investment of FOF/Feeder, if any, goes into
the numerator?
 If Level 1 Test less than 25% – zero
 If Level 1 Test 25% or more – that portion of the investment by the
FOF/Feeder that is attributable to “Benefit Plan Investors”
124
ANSWER 5 – EXAMPLE 1
(FUND OF FUNDS)
“Plan Assets”?
“Plan Assets”?
BENEFIT PLAN
INVESTORS
NON-BENEFIT PLAN
INVESTORS
$3,000
$2,000
Yes
Yes
FUND OF FUNDS
NON-BPI
INVESTORS
$5,000
$5,000
UNDERLYING
FUND
125
ANSWER 5 – EXAMPLE 2
(FUND OF FUNDS)
“Plan Assets”?
“Plan Assets”?
BENEFIT PLAN
INVESTORS
NON-BENEFIT PLAN
INVESTORS
$3,000
$2,000
Yes
No
FUND OF FUNDS
NON-BPI
INVESTORS
$5,000
$10,000
UNDERLYING
FUND
126
QUESTION 6
What exactly are Taft-Hartley plans and are
they the same as ERISA plans?
127
ANSWER 6
 TH plans = collectively-bargained
employee benefit plans
 Jointly administered by labor-management
trustees
 TH plans are subject to ERISA
128
QUESTION 7
We have a fund that has a lot of IRA money,
but no ERISA plans. We have another fund
that has only state and local government
retirement plans. In either case, do we need
to worry about ERISA?
129
ANSWER 7
 IRAs not subject to ERISA, but Code
Section 4975
 Government plans not subject to ERISA,
but subject to state laws that may adopt
ERISA principles
130
TAX DEVELOPMENTS
TAX DEVELOPMENTS
RIC Issues
 Proposed changes to regulations for purposes of RIC
asset diversification test
 Changes to Treas. Reg. § 1.851-5 to clarify the controlled
group rules under section 851(c) and add a new example
to illustrate the application of the controlled group rules
with respect to RIC investment in MLPs
132
TAX DEVELOPMENTS
Money Market Fund Tax Issues
 Rev. Proc. 2014-45 : wash sale rules will not apply to
purchases and redemptions of floating-NAV money
market fund shares
 Proposed regulations: simplified tax accounting rules for
shareholders in floating-NAV money market fund
 Proposed regulations: floating-NAV money market funds
exempt from information-reporting requirements
133
TAX DEVELOPMENTS
RIC Foreign Tax Reclaims
 Increased ability to recover taxes withheld by EU
countries
 Results in over-distribution of creditable foreign
taxes to RIC shareholders in prior years
 No good means of correcting prior year tax
reporting
134
TAX DEVELOPMENTS
Hedge Fund Manager Stock Options
 Rev. Rul. 2014-18 affirms that a stock
option or stock-settled SAR granted to a
manager of an offshore fund is not a
nonqualified deferred compensation plan
subject to taxation under Section 457A
135
Tax Developments
FATCA / GATCA



Cayman Islands currently has an intergovernmental agreement (IGA) with
each of the United States and the United Kingdom. Financial account
reporting to begin in 2015 under US-Cayman IGA.
Organization for Economic Cooperation and Development (OECD)
introduces a standard of automatic account information exchange between
45 countries
In October 2014, the Cayman Islands joined the OECD-sponsored
Multilateral Competent Authority Agreement and made a commitment to
implement the new common reporting standard on automatic exchange of
information with various countries by 2018. This means that there will be
more IGAs in coming years, and more reporting obligations.
136