Investment Management

Posted on Monday, May 8 2017 at 10:38 am by

General Solicitations of Certain Regulation D “Private” Securities Offerings:  SEC Affirms Zero-Tolerance Policy.

By Paul Foley and John I. Sanders

On March 29, 2017, the Securities and Exchange Commission (the “SEC”) issued a noteworthy opinion in In re KCD Financial Inc.,[i] a review of a FINRA disciplinary action.[ii]  While the opinion affirmed FINRA’s disciplinary action,[iii] it also affirmed the SEC’s zero-tolerance policy regarding general solicitations made in the course of certain Regulation D offerings.  Those relying on or contemplating relying on Regulation D exemptions from registration should review the SEC’s opinion.

Factual Background

KCD Financial, Inc. (“KCD”) is an independent broker-dealer.[iv]  In 2011, KCD signed an agreement with one of its affiliates (“Westmount”) under which it would solicit accredited investors for a particular private fund (the “Fund”) sponsored by Westmount.[v]  Westmount did not plan to register the offering.  Westmount instead planned to rely on a Rule 506(b) exemption from registration.[vi]

Prior to KCD selling any interest in the Fund, Westmount issued a press release describing the Fund.[vii]  Two Dallas newspapers published articles based on the press release and made the articles available on their respective public websites.[viii]  One of those newspaper articles was then posted on a public website belonging to a Westmount affiliate.[ix]  Westmount’s outside counsel informed Westmount that the newspaper articles constituted general solicitations, which are prohibited in Rule 506(b) offerings.[x]

After KCD and Westmount officers were told that the articles were general solicitations prohibited under Rule 506(b), they did not end the offering, register the securities, or seek to rely on an alternative exemption.  Instead, KCD’s CCO and Westmount’s Vice President of Capital Markets instructed the representatives to sell interests in the Fund only to (i) those with an existing relationship to KCD or Westmount and (ii) accredited investors who had not learned of the offering through the general solicitations.[xi]  Under those guidelines, at least one person was refused an opportunity to purchase interests in the Fund.[xii]

During a FINRA examination of KCD, the examiner found that the newspaper article about the offering had not been removed from a Westmount-affiliated website.[xiii]  Subsequently, FINRA filed a complaint against KCD alleging that the firm’s registered representatives sold securities that were unregistered and not qualified for an exemption from registration, thereby violating FINRA Rule 2010.[xiv]  FINRA also alleged that KCD failed to reasonably supervise the offering, thereby violating FINRA Rule 3010.[xv]  FINRA’s Hearing Panel found that KCD violated those rules.[xvi]  FINRA censured KCD and imposed a fine of $73,000.[xvii]  The National Adjudicatory Counsel affirmed FINRA’s decision.[xviii]  KCD then requested an SEC review.[xix]

SEC Review

KCD admitted that the Fund interests it offered were not registered, but argued that offers were made pursuant to Rule 506(b).[xx]  The SEC rejected KCD’s contention,[xxi] finding that where a party relying on the Rule 506(b) exemption makes a general solicitation, the exemption then is unavailable “regardless of the number of accredited investors or the knowledge and experience of the purchasers who were not accredited investors.”[xxii]  In this context, whether purchasers were accredited or had prior relationships with KCD and Westmount was “irrelevant to whether or not the newspaper articles constituted a general solicitation” and precluded reliance on Rule 506(b).[xxiii]

KCD also argued, assuming the newspaper articles constituted general solicitations, it could still rely on a Rule 506(b) exemption because “KCD did not generally solicit any of the actual investors in the [Westmount] Fund.”[xxiv]  This argument confused the notion of what is prohibited under Rule 506(b).  It is making an offer by general solicitation which precludes reliance on a Rule 506(b) exemption.[xxv]  Whether a sale results directly from the general solicitation is irrelevant.[xxvi]

Practical Implications

The SEC’s opinion affirms its view that exemptions from registration in securities offerings are narrowly construed and must be adhered to strictly.[xxvii]  Where, as here, the exemption prohibits a general solicitation, any general solicitation forever forfeits the issuer’s ability to rely on the exemption in making the offering (i.e., the toothpaste cannot go back into the tube).

Those making exempt offerings in reliance on Rule 504,[xxviii] Rule 505,[xxix] and Rule 506(b)[xxx] should review their sales practices in light of the KCD opinion.  In reviewing practices, issuers should look beyond the obvious means of making a general solicitation (e.g., a press release that is published by a widely-circulated newspaper).  Websites and social media accounts of those participating in the offerings are equally capable of precluding use of a valuable registration exemption.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem, North Carolina offices.  John I. Sanders is an associate based out of the firm’s Winston-Salem office.

[i] In re KCD Financial, Inc., SEC Release No. 34-80340 (March 29, 2017), available at www.sec.gov/litigation/opinions/2017/34-80340.pdf (hereinafter, SEC Opinion).

[ii] In re KCD Financial, Inc., FINRA Complaint No. 2011025851501 (Aug. 3, 2016), available at http:www.finra.com (hereinafter, FINRA Opinion).

[iii] SEC Opinion, supra note 1, at p. 1.

[iv] Id., at p. 2.

[v] Id.

[vi] Id.

[vii] Id, at p. 3.

[viii] Id.

[ix] Id. at p. 4.

[x] Id.

[xi] Id.

[xii] Id.

[xiii] Id.

[xiv] Id.

[xv] Id.

[xvi] FINRA Opinion, supra note 2, at p. 4.

[xvii] Id.

[xviii] Id.

[xix] Id.

[xx] SEC Opinion, supra note 1, at 2.

[xxi] Id.

[xxii] Id. at 7.

[xxiii] Id. at 9.

[xxiv] Id at 10.

[xxv] Id.

[xxvi] Id. at 11

[xxvii] Id. at 7.

[xxviii] 17 CFR 230.504 (2017).

[xxix] 17 CFR 230.505 (2017).

[xxx] 17 CFR 230.506(b) (2017).

Posted on , May 8 2017 at 9:59 am by

SEC Amends Crowdfunding Rules

By Paul Foley and John I. Sanders

Under the Jumpstart our Business Startups Acts of 2012 (the “JOBS Act”), the Securities and Exchange Commission (the “SEC”) adopted rules allowing for securities-based crowdfunding in 2015.[i]  The JOBS Act required the SEC to adjust dollar limits placed on the amount that could be invested or raised through securities-based crowdfunding at least every five years to account for inflation.[ii]  On April 5, 2017, the SEC issued a final rule adjusting those limits for the first time.[iii]  We encourage those interested in issuing securities through a securities-based crowdfunding offering to review the final rule and call us with any questions you may have.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem, North Carolina offices.  John Sanders is an associate based out of the firm’s Winston-Salem office.

[i] SEC, Release No. 33-9974 (Oct. 9, 2015), available at https://www.sec.gov/rules/final/2015/33-9974.pdf.

[ii] Id. at 15.

[iii] SEC, Release No.33-10332 (April 5, 2017), available at https://www.sec.gov/rules/final/2017/33-10332.pdf.

Posted on Wednesday, April 19 2017 at 8:48 am by

SEC Issues Guidance to Robo-Advisers

Robo-advisers are a fast-growing segment of the investment advisory industry.  In fact, they now account for an estimated $71.5 billion in assets under management.[1]  In response to their explosive growth, the SEC has made robo-advisers an examination priority[2] and has issued regulatory guidance to them.[3]  The SEC’s guidance is summarized below.

  • Disclosures to potential clients should explain the: (i) robo-adviser’s business model and how it differs from traditional investment adviser models; and (ii) limitations in the scope of the robo-adviser’s services.[4]  The robo-adviser should also consider whether its delivery of the disclosures is clear and conspicuous enough to be effective in the context of the relationship, which may be entirely web-based.[5]
  • Questionnaires used to gather client information should be designed to obtain sufficient information to support the robo-adviser’s suitability obligation.[6] Where the client can select investments other than those the adviser recommends, the robo-adviser should provide commentary supporting its recommendations.[7]
  • Internal compliance programs should address the unique aspects of the robo-adviser business model, including limited human interaction and heightened cybersecurity risks.[8]

Advisers who have replaced or supplemented their advisory services with robo-adviser technology in recent years may have questions after reviewing the SEC’s guidance.  Please feel free to contact us with any questions you may have.

Paul J. Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

 

[1] Daisy Maxey, Spotlight on Robo Advisers’ Returns, Wall Street Journal (Nov. 1, 2016), https://www.wsj.com/articles/spotlight-on-robo-advisers-returns-1478018429.

[2] SEC, National Exam Program Examination Priorities for 2017 (Jan. 13, 2017), www.sec.gov/about/offices/ocie/national-examination-program-priorities-2017.pdf.

[3] SEC, IM Guidance Update No. 2017-02 (Feb. 2017), www.sec.gov/im-guidance-2017-02.pdf.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

Posted on Wednesday, April 5 2017 at 11:50 am by

SEC Issues Custody Rule Guidance

By Paul Foley and John I. Sanders

In February, the Securities and Exchange Commission (SEC) issued two significant pieces of guidance on arrangements that may result in an investment adviser having “custody” of its client assets as that term is defined in Rule 206(4)-2 (Custody Rule)[1] of the Investment Advisers Act of 1940 (Advisers Act).[2] The first piece of guidance was a Guidance Update issued by the SEC’s Division of Investment Management. The second came in the form of a no-action letter (Letter) issued to the Investment Adviser Association (IAA) on February 21, 2017. This article discusses both and offers practical insight into compliance with the Custody Rule.

Background

Under the Custody Rule, an investment adviser is deemed to have custody of client assets when it or a related person “holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services” it provides to its clients.[3] Additionally, the term custody includes any arrangement under which an investment adviser is “authorized or permitted to withdraw client funds or securities maintained with a custodian upon [its] instruction to the custodian.”[4] When an investment adviser is deemed to have “custody,” a number of regulatory requirements are triggered, including an independent verification by an accountant (a “surprise examination”).[5] Accordingly, investment advisers must understand when they have custody of client assets. The SEC’s recent guidance addresses instances in which investment advisers may not know that they have custody and, therefore, are subject to the various regulatory requirements of the Custody Rule.

Guidance Update

An IM Guidance Update published by the SEC’s Division of Investment Management stated that investment advisers may “inadvertently have custody of client funds or securities because of provisions in a separate custodial agreement entered into between its advisory client and a qualified custodian.”[6] The Division of Investment Management found that some custodial agreements grant an adviser the broad power “to instruct the custodian to disburse, or transfer, funds or securities.”[7] Where the adviser has that power, it may be deemed to have custody of the assets even though it did not intend to have such power and its contractual agreement with the client directly prohibits it from taking such action.[8]

The Division of Investment Management found that inadvertent custody arose from some commonly observed custodial agreement provisions:[9]

  • A custodial agreement that grants the client’s adviser the right to “receive money, securities, and property of every kind and dispose of same.”
  • A custodial agreement under which a custodian may rely on the “[adviser’s] instructions without any direction” from the client and asks the client to “ratify and confirm any and all transactions with [the custodian]” made by the adviser.
  • A custodial agreement that provides authorization for the client’s adviser to “instruct us to disburse cash from your cash account for any purpose . . . .”

After describing how advisers might have inadvertent custody of client assets, the SEC cautioned that rectifying inadvertent custody could not be accomplished through a bilateral agreement between the adviser and the client as the custody stems from the custodian’s perception of the adviser’s power.[10] The adviser can alter that perception by: (i) delivering a letter to the custodian that limits the adviser’s authority to “delivery versus payment” notwithstanding a greater grant of power in the custodial agreement; and (ii) obtaining written acknowledgement of the limitation from the client and custodian.[11]

After providing common custodial agreement provisions that may create inadvertent custody, the Guidance Update specified one common provision which does not, in itself, create custody. The SEC stated that where a custodial agreement permits merely the deduction of advisory fees, “an adviser may have custody but not need a surprise examination, provided it otherwise complies with the exception under Rule 206(4)-2(b)(3) available to advisers with limited custody due to fee deduction.”[12] A broader grant of power, however, likely constitutes custody.

We believe the Guidance Update may place a substantial burden on investment advisers. It will not be enough for investment advisers to review their own advisory agreements and other form documents. Instead, an adviser must work with all custodians holding its clients’ assets to obtain and examine any custodial agreement provisions that might create inadvertent custody for the adviser. Moreover, the adviser would need to monitor those agreements for material changes in perpetuity. Of course, the simpler, but still burdensome, path to compliance may be to send letters to all clients and their custodians and obtain their acknowledgement of the adviser’s limited power as a preventative measure.

The IAA No-Action Letter

Dovetailing the Guidance Update, in a letter dated February 15, 2017, the IAA asked the SEC staff to clarify that an investment adviser does not have custody under the Custody Rule “if it acts pursuant to a standing letter of instruction or other similar asset transfer authorization arrangement established by a client with a qualified custodian.”[13] In the alternative, the IAA asked the SEC to state it would not recommend an enforcement action under Section 206(4) of the Act and the Custody Rule against an investment adviser acting pursuant to a standing letter of authorization (SLOA), as described in the Letter, without obtaining a surprise examination of the custodied assets as required by the Custody Rule.[14]

The IAA stated that it is common for an advisory client to grant its registered investment adviser the power, through a SLOA, to disburse funds to specifically-designated third parties. Granting such power to an investment adviser is especially helpful where the client owns multiple accounts with different purposes across multiple custodians. Under such an arrangement, the client grants authority to the adviser, then the client instructs the custodian to transfer assets to the designated third parties on the adviser’s command. After issuing a SLOA, the client retains the power to change or revoke the arrangement, and the adviser’s authority is limited by the specific terms of the SLOA.[15] It was the IAA’s positon that such an arrangement did not constitute custody.[16]

The SEC determined that a SLOA, as described by the IAA may, in fact, lead to an investment adviser having custody of its client assets as contemplated by the Custody Rule. The general rule, as articulated by the SEC, is that an “investment adviser with the power to dispose of client funds or securities for any purpose other than authorized trading has access to the client’s assets” and thus has custody of those assets.[17] Because the SLOA or other similar authorization would permit the investment adviser “to withdraw client funds or securities maintained with a qualified custodian upon its instruction,” an investment adviser entering into an SLOA or similar arrangement would have custody of client assets and would be required to comply with the Custody Rule.

The SEC then stated that it would not recommend enforcement action under Section 206(4) of the Adviser Act or the Custody Rule against an investment adviser that enters into a SLOA that meets the following requirements and does not obtain a surprise examination:[18]

  1. The client provides an instruction to the qualified custodian, in writing, that includes the client’s signature, the third-party’s name, and either the third-party’s address or the third-party’s account number at a custodian to which the transfer should be directed.
  2. The client authorizes the investment adviser, in writing, either on the qualified custodian’s form or separately, to direct transfers to the third party either on a specified schedule or from time to time.
  3. The client’s qualified custodian performs appropriate verification of the instruction, such as a signature review or other method to verify the client’s authorization, and provides a transfer of funds notice to the client promptly after each transfer.
  4. The client has the ability to terminate or change the instruction to the client’s qualified custodian.
  5. The investment adviser has no authority or ability to designate or change the identity of the third party, the address, or any other information about the third party contained in the client’s instruction.
  6. The investment adviser maintains records showing that the third party is not a related party of the investment adviser or located at the same address as the investment adviser.
  7. The client’s qualified custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.

We believe few SLOAs or similar arrangements currently in place would satisfy these extensive requirements. The SEC seems to agree. It noted that investments advisers, qualified custodians, and their clients would need “a reasonable period of time” to comply with the relief provided by the no-action letter.[19] Further, the SEC stated that any investment adviser that is party to a SLOA that results in custody would not need to include the affected client assets in its response to Item 9 of Form ADV until the next annual updating amendment after October 1, 2017.[20]

The Letter, on its face, could be construed broadly to cover a number of common arrangements. However, the Letter was limited by a SEC statement published the same day.[21] In that statement, the SEC explained that the limited authority to transfer assets between accounts, whether with the same custodian or different custodian, provided that the client has authorized the adviser to make the transfers between specified accounts and has provided the custodians a copy of the authorization, does not constitute custody.[22] The SEC also noted that an adviser’s ability to transfer client assets between accounts at the same custodian or between affiliated custodians that have access to both account numbers and client account name does not amount to custody.[23] Therefore, the Letter seems to directly affect only SLOAs and similar arrangements under which the adviser has the authority to withdraw and disburse clients assets.

Despite the limiting effect of the SEC’s statement, advisers who are currently parties to a SLOA or similar arrangement should carefully review the terms of those arrangements. Where the arrangements do not meet the seven conditions for relief stated in the Letter, the adviser should work to either: (i) change the terms of the arrangement; or (ii) comply with the terms of the Custody Rule and disclose those assets in the next annual amendment to Form ADV after October 1, 2017.

Conclusion

The SEC’s recent guidance may generate significant anxiety among investment advisers concerned about becoming subject to the requirements of the Custody Rule. In particular, the SEC’s recent guidance raises the specter of custody arising from longstanding SLOA arrangements or even from contracts the investment advisers have not seen or do not regularly review. Please feel free to contact us with any questions you may have.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices. John I. Sanders is an associate based in the firm’s Winston-Salem office.

13776971v.4

[1] 17 CFR 275.206(4)-2 (2017).

[2] 15 USC 80b et al (2017).

[3] 17 CFR 275.206(4)-2(d)(2) (2017).

[4] 17 CFR 275.206(4)-2(d)(2)(ii) (2017).

[5] 17 CFR 275.206(4)-2 (2017). Under the Custody Rule, among other things, an investment adviser must: maintain client funds and securities with a “qualified custodian” either under the client’s name or under the investment adviser’s name as agent or trustee for the client; notify its clients promptly upon opening a custodial account on their behalf and when there are changes to the information required in the notification; and have a reasonable basis, after due inquiry, for believing that the qualified custodian sends quarterly account statements directly to the client.

[6] SEC, IM Guidance Update: Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority (Feb. 2017), available at www.sec.gov.

[7] Id.

[8] Id.

[9] Id.

[10] Id.

[11] Id.

[12] Id.

[13] SEC, Investment Advisers Act of 1940 – Section 206(4) and Rule 206(4)-2; Response to the Investment Adviser Association (Feb. 21, 2017), available at https://www.sec.gov/divisions/investment/noaction/2017/investment-adviser-association-022117-206-4.htm.

[14] Id.

[15] Id.

[16] Id.

[17] Id.

[18] Id.

[19] Id.

[20] Id.

[21] SEC, Staff Responses to Questions About the Custody Rule (Feb. 21, 2017), available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm.

[22] Id.

[23] Id.

Posted on Wednesday, March 8 2017 at 10:41 am by

SEC Issues Guidance to Ease Fund Implementation of “Clean Shares”

By Andrew Sachs and John I Sanders

In January, we authored a post[i] discussing an SEC no-action letter, dated January 11, 2017, to Capital Group (the “Capital Group Letter”), the parent company of American Funds.[ii]  In the Capital Group Letter, the SEC agreed that Section 22(d) of the Investment Company Act of 1940 (the “Act”), which prohibits selling securities except at “a current public offering price described in the prospectus”, does not apply to brokers when acting as agent on behalf of its customers and charging customers commissions for effecting transactions in so-called “Clean Shares”.[iii]

Clean shares are mutual fund shares stripped of any front-end load, deferred sales charge, or other asset-based fee for sales or distribution that are sold by brokers who set their own commissions in connection with such sales.[iv]  We noted in January that the ability to replace the distribution fees typically charged by its mutual funds with commissions charged by a broker would give funds a new measure of flexibility to meet the demands of the Fiduciary Rule and competition generally, and we anticipated that many mutual fund companies would explore the concept of Clean Shares.

On February 15, 2017, just a month after publication of the Capital Group Letter, the SEC was compelled to issue guidance (the “FAQ”) addressing some of the questions it had received from mutual fund companies to-date.[v]  Below, we summarize FAQ as it relates to Funds seeking to implement Clean Shares.

Initial Implementation of Clean Shares

A mutual fund company issuing Clean Shares must, of course, amend its registration statement to include disclosure of the new share class.  Such an amendment might be affected through a Rule 485(a) filing or through a Rule 485(b) filing, depending on whether the amendment is “material”.[vi]  Typically, funds prefer Rule 485(b) filings because they become effective immediately,[vii] while Rule 485(a) filings are subject to a 60 day review.[viii]

In the FAQ, the SEC confirmed that “Funds should create these new Clean Shares, like any new class, by making a filing under Rule 485(a).”  To minimize the burdens of filing under Rule 485(a), if the only disclosures being amended are those describing the new share class, we advise mutual fund companies to seek selective review of the Rule 485(a) filing.  The request for a selective review should be made in the cover letter accompanying the 485(a) filing and must include (i) a statement as to whether the disclosure in the filing has been reviewed by the staff in another context; (ii) a statement identifying prior filings that the registrant considers similar to, or intends as precedent for, the current filing; (iii) a summary of the material changes made in the current filing from the previous filings; and (iv) any specific areas that the registrant believes warrant the SEC staff’s particular attention.[ix]

Adding Clean Shares to Multiple Funds

A mutual fund family adding Clean Shares to multiple funds need not file Rule 485(a) filings for each fund.  Instead, the FAQ confirms that mutual funds companies introducing Clean Shares across multiple funds can request Template Filing Relief pursuant to Rule 485(b)(i)(vii).  A registrant requesting Template Filing Relief would make a single Rule 485(a) filing with a Template Filing Relief request for all other funds with “substantially identical disclosure”.[x]

We note, however, that a request for Template Filing Relief must include (i) the reason for making the post-effective amendment; (ii) the identity of the Template filing;[xi] (iii) the identity of the registration statements that intend to rely on the relief (“Replicate filings”).[xii]  Additionally, the registrant must represent to the SEC that (i) the disclosure changes in the template filing are substantially identical to disclosure changes that will be made in the replicate filings; (ii) the replicate filings will incorporate changes made to the disclosure included in the Template filing to resolve any staff comments thereon; and (iii) the replicate filings will not include any other changes that would otherwise render them ineligible for filing under rule 485(b).[xiii]  Selective Review and Template Filing Relief can save registrants adding Clean Shares to existing funds time and money.

Existing Share Classes Qualify as Clean Shares

One of the more interesting aspects of the FAQ was the acknowledgement by the SEC that certain existing share classes of funds (such as institutional class shares) might already meet the requirements of Clean Shares, thereby offering a path to offering Clean Shares to many registrants without a Rule 485(a) filing.[xiv] In such a case, the SEC noted that a 485(a) filing would not be necessary “solely to add the prospectus disclosure described in the [Capital Group Letter]”[xv] where the fund already offers a share class that meets the requirements of the Capital Group Letter.[xvi]  Instead, a Rule 485(b) or Rule 497 filing will suffice.

Conclusion

The introduction of Clean Shares to the mutual fund industry presents an opportunity for mutual fund companies to improve the competitive position of their products, and we anticipate that there will be continued interest in Clean Shares even if the Department of Labor’s Conflict of Interest Rule does not become effective.[xvii]  If you have questions about Clean Shares of the SEC’s recent guidance, we encourage you to contact us.

 

[i] Andrew Sachs and John I. Sanders, Effects of the DOL Fiduciary Rule Reach Mutual Fund Industry, Kilpatrick Townsend: Investment Management News and Notes (Jan. 27, 2017), http://blogs.kilpatricktownsend.com/investmentmanagement/.

[ii] SEC, Response of the Office of Chief Counsel Division of Investment Management, available at https://www.sec.gov/divisions/investment/noaction/2017/capital-group-011117-22d.htm (“Capital Group Letter”).

[iii] Id.

[iv] John Waggoner, Brace for Thousands of New DOL Fiduciary-Friendly Mutual Fund Share Classes, INVESTMENT NEWS (Jan. 6, 2017), http://www.investmentnews.com/article/20170106/FREE/170109955/brace-for-thousands-of-new-dol-fiduciary-friendly-mutual-fund-share.

[v] SEC, Frequently Asked Questions on IM Guidance Update 2016-06 (Mutual Fund Fee Structures, available at https://www.sec.gov/divisions/investment/guidance/frequently-asked-questions-mutual-fund-fee-structures.htm (“FAQ”).

[vi] 17 CFR 230.485(a)-(b) (2017).

[vii] 17 CFR 230.485(b) (2017).

[viii] 17 CFR 230.485(a) (2017).

[ix] SEC: IM Guidance 2016-06, available at https://www.sec.gov.

[x] Id.

[xi] This identifying information should include the name of the Fund and the registrant, the Securities Act file number, and the filing date of the rule 485(a) filing.

[xii] This identifying information should include the name of the registrant, the Securities Act file number, and the series and class name for each of the Funds that intend to rely on the relief.

[xiii] SEC: IM Guidance 2016-06, available at https://www.sec.gov.

[xiv] FAQ, supra note 7.

[xv] Id. at Question 5.

[xvi] See, Capital Group Letter, supra note 2 (Listing the registrant’s representations to the SEC:  The broker will represent in its selling agreement with the fund’s underwriter that it is acting solely on an agency basis for the sale of Clean Shares; The Clean Shares sold by the broker will not include any form of distribution-related payment to the broker; The fund’s prospectus will disclose that an investor transacting in Clean Shares may be required to pay a commission to a broker, and if applicable, that shares of the fund are available in other share classes that have different fees and expenses; The nature and amount of the commissions and the times at which they would be collected would be determined by the broker consistent with the broker’s obligations under applicable law, including but not limited to applicable FINRA and Department of Labor rules; and Purchases and redemptions of Clean Shares will be made at net asset value established by the fund (before imposition of a commission).

[xvii] Paul Foley and John I. Sanders, Department of Labor Set to Eliminate the Fiduciary Rule, JD SUPRA (March 3, 2017), http://www.jdsupra.com/legalnews/department-of-labor-set-to-eliminate-92801/.

Posted on Thursday, March 2 2017 at 3:13 pm by

Department of Labor Set to Eliminate the Fiduciary Rule

On March 2, 2017, the DOL proposed to extend the applicability date of the Department of Labor (“DOL”) Conflict of Interest Rule (the “Fiduciary Rule”) from April 10, 2017 for 60 days.[1]  The proposal states that the extension will make it possible for the DOL to take additional steps (e.g., propose rescission of the Fiduciary Rule) without the Fiduciary Rule becoming applicable.[2]  The DOL states that this approach is being taken so that “advisers, investors and other stakeholders would be spared the risk and expense of facing two major changes in regulatory environment.”[3]  This delay follows the Presidential Memorandum, sent by President Trump on February 3, 2017, that directed the DOL to examine whether the Fiduciary Rule would “adversely affect the ability of Americans to gain access to retirement information and financial advice.”[4]  Considering the language contained in the Presidential Memorandum and the text of DOL’s release, we do not believe the Fiduciary Rule is long for this world.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices. John I. Sanders is an associate based in the firm’s Winston-Salem office.

[1] Department of Labor,  Conflict of Interest Rule – Retirement Investment Advice; Proposed Rule; Extension of Applicability Date (March 1, 2017), available at https://www.dol.gov/agencies/ebsa/laws-and-regulations/rules-and-regulations/completed-rulemaking/1210-AB32-2.

[2] Id.

[3] Id.

[4] Id.  The DOL was instructed to consider the following three questions in the course of its examination:  (1) whether the anticipated applicability of the final rule has harmed or is likely to harm investors due to a reduction of Americans’ access to certain retirement savings offerings, retirement product structures, retirement savings information, or related financial advice; (2) whether the anticipated applicability of the final rule has resulted in dislocations or disruptions within the retirement services industry that may adversely affect investors or retirees; and (3) whether the final rule is likely to cause an increase in litigation, and an increase in the prices that investors and retirees must pay to gain access to retirement services.  President Trump directed that if the DOL makes an affirmative determination as to any of the three inquiries or otherwise finds the Fiduciary Rule is incompatible with President Trump’s desire “to empower Americans to make their own financial decisions,” then the DOL is to publish for notice and comment rulemaking a proposal to revise or rescind the Fiduciary Rule.

Posted on Friday, January 27 2017 at 10:34 am by

Effects of the DOL Fiduciary Rule Reach Mutual Fund Industry

By Andrew Sachs and John I. Sanders

The Department of Labor finalized the so-called “Fiduciary Rule” in April 2016 and announced it would go into effect in April 2017.[i]  Since the finalization of the Fiduciary Rule, the annuities,[ii] brokerage,[iii] and advisory industries[iv] have all seen substantial changes to products or fee structures.  Now, the effects of the rule have reached the mutual fund industry as well, with the SEC’s recent approval of American Funds’ “Clean Shares” – shares stripped of any front-end load, deferred sales charge, or other asset-based fee for sales or distribution that are sold by brokers who set their own commissions in connection with such sales.[v]

On January 11th, the SEC issued a no-action letter to Capital Group, the parent company of American Funds.[vi]  The no-action letter stated that the SEC concurred with Capital Group’s view that Section 22(d) of the Investment Company Act of 1940 (the “Act”), which prohibits selling securities except at “a current public offering price described in the prospectus,” does not apply to brokers when acting as agent on behalf of its customers and charging customers commissions for effecting transactions in Clean Shares.[vii]

At least one publication predicts that thousands of mutual funds will create similar classes of shares.[viii]  We believe that the ability to replace the distribution fees typically charged by its mutual funds with commissions charged by the broker will give funds a new measure of flexibility to meet the demands of the Fiduciary Rule and competition generally.  For those wishing to more fully understand the costs and benefits of adopting a similar share class, we are here to help.

Andrew Sachs is a partner with Kilpatrick Townsend & Stockton’s Winston-Salem office. John I. Sanders is an associate in the firm’s Winston-Salem office.

 

[i] Department of Labor, Fact Sheet: Department of Labor Finalizes Rule to Address Conflicts of Interest in Retirement Advice, Saving Middle Class Families Billions of Dollars Every Year, https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/fact-sheets/dol-final-rule-to-address-conflicts-of-interest.

[ii] Greg Iacurci, Insurers Developing Fee-Based Fixed-Index Annuities Post-DOL Fiduciary Rule, INVESTMENT NEWS (July 14, 2016), http://www.investmentnews.com/article/20160714/FREE/160719964/insurers-developing-fee-based-fixed-indexed-annuities-post-dol.

[iii] Katherine Chiglinsky and Margaret Collins, AIG CEO Blames Obama Retirement Rule for Broker-Dealer Exit, BLOOMBERG (Jan. 27, 2016), http://www.bloomberg.com/news/articles/2016-01-27/aig-broker-dealer-exit-fueled-by-obama-retirement-rule-ceo-says.

[iv] Darla Mercado, How the New “Fiduciary” Rule Will Actually Affect You, CNBC (Oct. 13, 2016), http://www.cnbc.com/2016/10/13/how-the-new-fiduciary-rule-will-actually-affect-you.html.

[v] John Waggoner, Brace for Thousands of New DOL Fiduciary-Friendly Mutual Fund Share Classes, INVESTMENT NEWS (Jan. 6, 2017), http://www.investmentnews.com/article/20170106/FREE/170109955/brace-for-thousands-of-new-dol-fiduciary-friendly-mutual-fund-share.

[vi] SEC, Response of the Office of Chief Counsel Division of Investment Management, available at https://www.sec.gov/divisions/investment/noaction/2017/capital-group-011117-22d.htm.

[vii] Id.

[viii] Waggoner, supra note 5.

Posted on Tuesday, January 24 2017 at 3:08 pm by

Constitutionality of SEC Judges Questioned

By Paul Foley and John I. Sanders

Among the many provisions of the Dodd-Frank Act were some that gave the SEC greater ability to hear cases and levy punishments in internal administrative courts without resort to ordinary federal courts.[i]  These provisions resulted in alarming results, including a 90% success rate for the SEC in front of its own newly-minted administrative law judges.[ii]  For comparative purposes, the SEC’s previous success rate was below 70%.[iii]

A legal challenge brought against the SEC argued that these judges are “inferior officers” that, pursuant to the Appointments Clause of the U.S. Constitution,[iv] must be appointed by an executive branch member and approved by the Senate.  Because such steps were never taken, the judges’ actions would be unconstitutional if they are, in fact, found to be “inferior officers”.  The 10th Circuit has agreed with the plaintiffs, but the SEC is expected to appeal.[v]

If the challenge is ultimately successful, there will be two significant impacts.  First, the cases decided by the SEC’s judges may be void.  Second, the SEC will be forced to use the old, less certain procedure of bringing enforcement actions in federal district court.  If you’d like to know more, I encourage you to read a succinct review of the matter in today’s Wall Street Journal.[vi]

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem, North Carolina offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

[i] Giles D. Beal IV, Judge, Jury, and Executioner:  SEC Administrative Law Judges Post-Dodd Frank, 20 N.C. Banking Inst. 413 (2016), available at https://litigation-essentials.lexisnexis.com/webcd/app?action=DocumentDisplay&crawlid=1&doctype=cite&docid=20+N.C.+Banking+Inst.+413&srctype=smi&srcid=3B15&key=e7ef73edd6e64a6ec56e122360340a35.

[ii] Jean Eaglesham, SEC Wins with In-House Judges, Wall St. Journal (May 6, 2015), http://www.wsj.com/articles/sec-wins-with-in-house-judges-1430965803.

[iii] Id.

[iv] U.S. Const. art. II, sec. 2, cl. 2.

[v] Alison Frankel, 10th Circuit Strikes Down SEC ALJ Regime, Debates Reach to Other Agencies, Reuters (Dec. 28, 2016), http://www.reuters.com/article/otc-sec-idUSKBN14H1S3.

[vi] David B. Rivkin Jr. and Andrew M. Grossman, When is a Judge Not Really a Judge?, Wall St. Journal (Jan. 23, 2017), http://www.wsj.com/articles/when-is-a-judge-not-really-a-judge-1485215998.

Posted on Thursday, December 15 2016 at 9:28 am by

Supreme Court Confirms Expansive View of Insider Trading

By Paul Foley, Clay Wheeler, and John Sanders

Perhaps the most serious charge that could be leveled against a reader of this blog is that of being engaged in or associated with “insider trading.”  The allegation alone is enough to derail or end a promising career.  Successful compliance requires an understanding of the law and your obligations under it.  In light of recent developments regarding insider trading, including the first Supreme Court decision to address the crime in 20 years,[1] we encourage you to read this article in its entirety and contact us with any questions you may have.

Insider Trading:  The Tradition

Section 10(b) of the Securities Exchange Act of 1934[2] and Rule 10b-5[3] promulgated thereunder prohibit insider trading.  The basic elements of insider trading are:  (i) engaging in a securities transaction, (ii) while in possession of material, non-public information, (iii) in violation of a duty to refrain from doing so.

The paradigm case discussing the so-called “classical” theory of insider trading is Chiarella v. U.S.[4]  In Chiarella, an employee of a publishing firm was charged with insider trading after using advance notice of a takeover bid to trade.  Chiarella’s conviction was reversed by the Supreme Court after the Court focused on the requirement of a duty running from the trader to the shareholders of the corporate entity “owning” the material, non-public information.  Thus, a successful prosecution under the classical theory usually involves a corporate insider trading in shares of his or her employer while in possession of material, non-public information (e.g., advance notice of a merger).

After Chiarella, an important development in the law has been the extension of liability to persons who receive tips from insiders, i.e., individuals whose duty to refrain from trading is derived or inherited from the corporate insider’s duty.  Thus, not only may insiders be liable for insider trading under rule 10b-5, but those to whom they pass tips, either directly (tippees) or through others (remote tippees) may be liable if they trade on such tips.  Because tippee and remote tippee liability is more difficult to grasp and more likely to affect our readers, this article will primarily, but not exclusively, focus on individuals in those circumstances.

In a pattern that has repeated itself over the years, courts broadened the scope of insider trading by developing a second, “complementary”[5] theory of insider trading – the “misappropriation” theory.  This theory “targets person[s] who are not corporate insiders but to whom material non-public information has been entrusted in confidence and who breach a fiduciary duty to the source of the information to gain personal profit in the securities market.”[6]  The seminal case in the articulation of the misappropriation theory is U.S. v. O’Hagan.  In O’Hagan, a partner at a large law firm (but not ours) obtained and traded on information given to attorneys in the firm who were representing a client in a tender offer.  The Supreme Court held that “A person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of the information, may be held liable for violating § 10(b) and Rule 10b-5.”[7]  In practical terms, under the misappropriation theory, individuals who come into possession of material, non-public information while providing services to corporate clients, such as the attorney in O’Hagan [8] may be held liable.

Joining Chiarella and O’Hagan in making up the traditional core of insider trading law is Dirks v. SEC.[9]  In Dirks, the Supreme Court attempted to set a limit on the scope of insider trading.[10]  Dirks was a securities analyst who learned from a former insurance company insider that the company was committing fraud and was on the verge of financial ruin.[11]  Dirks investigated and disclosed this information to several people, including a reporter and clients who traded on the information.[12]  Dirks was held liable for insider trading, but appealed.[13]  The overturning of Dirks’s liability centered on the fact that the corporate insider had disclosed the fraud to Dirks purely by a desire to expose the fraud, rather than to obtain any financial or other personal benefit.  The Court held:

In determining whether a tippee is under an obligation to disclose or abstain, it is necessary to determine whether the insider’s “tip” constituted a breach of the insider’s fiduciary duty.  Whether disclosure is a breach of duty depends in large part on the personal benefit the insider receives as a result of the disclosure.  Absent an improper purpose, there is no breach of duty to stockholders.  And absent a breach by the insider, there is no derivative breach.[14]

Furthermore, Dirks introduced the idea that a tippee has to be actually aware of the tipper’s breach or presented with sufficient facts so that the tippee will be deemed aware.  In this way, Dirks created a “personal benefit” element related to the tipper.  After Dirks, prosecutors were generally confident they could prove this benefit existed as long as there was a quid pro quo or a moderately close relationship between tipper and tippee.

Newman:  A Disruption

Chiarella, O’Hagan, and Dirks guided the law of insider trading largely uninterrupted for nearly 20 years.  Then came a decision from the Second Circuit, the so-called “Mother Court”[15] of securities law, but an underling of the Supreme Court, called U.S. v. Newman.[16]

Newman involved a hedge fund portfolio manager who was part of an information-sharing cohort of analysts and portfolio managers.[17]  By the time Newman received the tip, he was “four levels removed from the insider tippers,” (i.e., a remote tippee).[18]  The tippers were insiders at technology companies who had provided information to what the court termed “casual acquaintances,” who in turn passed those tips on.  Citing Dirks repeatedly for support, the U.S. 2nd Circuit Court of Appeals emphasized that government must prove the tipper received “a personal benefit” and that the tippee knew of that benefit.[19]

In Newman, the Second Circuit concluded that “the mere fact of friendship” was insufficient to give rise to the required personal benefit to the tipper.  Instead, the court required “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”  Despite the fact that the 2nd Circuit cited its adherence to Dirks in overturning Newman’s conviction, it was clear to all that by raising the bar for the evidence required to meet the Dirks “personal benefit” requirement, the opinion suggested a serious new limitation on insider trading law.  Moreover, the prosecutors were denied a rehearing en banc and a Supreme Court writ of certiorari.  This meant Newman would remain law in the most significant federal circuit for securities law until further notice.

One attorney called Newman “a well-deserved generational setback for the Government.”[20]  The predicted effect of Newman was that the government would be forced to prove that someone charged with insider trading knew that she was trading on non-public, material information and that “the tipper’s goal in disclosing information is to obtain money, property, or something of tangible value.”[21]  This heightened burden led to the reversal of more than a dozen insider trading convictions,[22] and pending cases were dropped.[23]

Salman:  The Expansive View of Insider Trading Strikes Back

Newman’s holding concerning what qualifies as a personal benefit to the tipper was reversed last week when the Supreme Court issued its opinion in Salman v. United States.[24]  Before the Supreme Court issued its opinion, in Salman, only the most ardent securities law gurus followed the case.  So, some background may be helpful.  Salman was convicted after trading on material, non-public information received from a friend, who had received the information from Salman’s brother-in-law.  Thus, Salman was prosecuted as a remote tippee.  He argued that he could not “be held liable as a tippee because the tipper (his brother-in-law, who worked on M&A matters at an investment bank) did not personally receive money or property in exchange for the tips.”[25]

In a strong rebuke, the Supreme Court held, “To the extent that the Second Circuit in Newman held that the tipper must also receive something of a “pecuniary or similarly valuable nature” in exchange for a gift to a trading relative, that rule is inconsistent with Dirks.[26]  Justice Alito succinctly explained “a tippee’s liability for trading on inside information hinges on whether the tipper breached a fiduciary duty” and that duty is breached “when the tipper discloses the inside information for a personal benefit.”[27]  Such a personal benefit can be inferred where the tip is made “to a trading relative or friend.”[28]

Why Salman Matters

By allowing a generous inference of a benefit to the tipper based on a personal relationship alone, the Supreme Court in Salman reestablished the old order of things – an expansive scope for insider trading prosecutions.  We understand that investment advisers are more likely than others to come into contact with corporate insiders, as well as those with whom corporate insiders speak in confidence.  You know these individuals as professionals, former schoolmates, and even friends and family members.  In discussing your work, it is quite possible that non-public, material information may be intentionally or inadvertently tipped to you.  Your livelihood and liberty may depend on how well you understand your legal obligations when that happens.  Fortunately, when you have questions about the rules regarding insider trading, we’re here to assist.

 

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices. Clay Wheeler is a partner in Kilpatrick’s Raleigh and Winston-Salem officesJohn Sanders is an associate based in the firm’s Winston-Salem office.

 

[1] Greg Stohr and Patricia Hurtado, The Supreme Court Will Hear Its First Insider-Trading Case in 20 Years, Bloomberg (Oct. 4, 2016), https://www.bloomberg.com/politics/articles/2016-10-04/wall-street-watching-as-u-s-high-court-tackles-insider-trading.

[2] 15 U.S.C. 78j (2016).

[3] 17 CFR 270.10b-5 (2016).

[4] Chiarella v. U.S., 445 U.S. 222 (1980).

[5] U.S. v. O’Hagan, 521 U.S. 642, 643 (1997).

[6] SEC v. Obus, 693 F.3d 276, 284 (2d Cir. 2012).

[7] O’Hagan, at 642.

[8] Id.

[9] Dirks v. SEC, 463 U.S. 646 (1983).

[10] Id. at 646.

[11] Id.

[12] Id.

[13] Id.

[14] Id. at 647.

[15] James D. Zirin, American Bar Association, The Mother Court: A.K.A., the Southern District Court of New York, http://www.americanbar.org/publications/tyl/topics/legal-history/the-mother-court-aka-southern-district-court-new-york.html

[16] U.S. v. Newman, 773 F.3d 438 (2d Cir. 2014)

[17] Id. at 443.

[18] Id.

[19] Id. at 450.

[20] Jon Eisenberg, How the United States v. Newman Changes the Law, Harvard Law School Forum on Corporate Governance and Financial Regulation (May 3, 2015), https://corpgov.law.harvard.edu/2015/05/03/how-united-states-v-newman-changes-the-law/.

[21] Salman v. U.S., available at https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0ahUKEwihloXYvu_QAhVBjpAKHflsCIIQFggjMAE&url=https%3A%2F%2Fwww.supremecourt.gov%2Fopinions%2F16pdf%2F15-628_m6ho.pdf&usg=AFQjCNGY28IXIk-a-h-Nuvi5EXSHC6XW6g&sig2=Ydo5oy44CzIMDuCxjMluzA&bvm=bv.141320020,d.eWE (The opinion presents and rejects this argument from Salman before stating that the rule from Newman is inconsistent with precedent)

[22] Greg Stohr and Patricia Hurtado, The Supreme Court Will Hear Its First Insider-Trading Case in 20 Years, Bloomberg (Oct. 4, 2016), https://www.bloomberg.com/politics/articles/2016-10-04/wall-street-watching-as-u-s-high-court-tackles-insider-trading.

[23] Patricia Hurtado, SAC Capital’s Steinberg Gets Insider Trading Charges Dropped, Bloomberg (Oct. 23, 2015), https://www.bloomberg.com/news/articles/2015-10-22/u-s-drops-charges-against-sac-capital-s-michael-steinberg.

[24] Salman, supra note 21.

[25] Id.

[26] Id.

[27] Id.

[28] Id.

Posted on Thursday, November 10 2016 at 2:03 pm by

Revised Form ADV: What CCOs Need to Know

By Paul Foley and John Sanders of Kilpatrick Townsend & Stockton

On Aug. 25, 2016, the Securities and Exchange Commission adopted final rules intended to update and enhance the disclosure requirements promulgated under the Investment Advisers Act of 1940—primarily by revising Form ADV. The final rules, which became effective on October 31, 2016 and have a compliance date of Oct. 1, 2017, are substantial and wide-ranging, and chief compliance officers should take note both of their provisions and the potential implementation issues they raise.

INCREASE IN SMA DISCLOSURES

Among the most significant amendments to Form ADV are those related to the disclosure of assets held in separately managed accounts. Advisers will now be required to disclose the approximate percentage of SMA assets that are invested in 12 broad asset categories, including exchange-traded equity securities, U.S. government bonds and derivatives.

This classification requirement presents a practical concern as certain SMA assets may not fit squarely within a single category. The SEC will allow advisers to use their own classification methodology for such assets, “so long as their methodologies are consistently applied and consistent with information the advisers report internally.” But what sounds like well-intentioned deference may not be as beneficial to advisers as it seems. In fact, it may trap unwary advisers, leaving them unable to change internal classification methodologies later.

Perhaps more surprisingly, the new SMA disclosure requirements may be of marginal utility with respect to SMAs holding significant interests in funds, such as exchange-traded funds, mutual funds, hedge funds and private equity funds. Indeed, despite the wide variations among fund asset allocations, the amendments only require advisers to disclose the amount of fund assets held in SMAs. Advisers are expressly told not to look through such funds with respect to the underlying exposure to the various asset categories.

The lack of a look-through mechanism means that the SEC and current and potential advisory clients may garner little information from the new disclosure requirements. This is particularly true with respect to advisers that primarily use funds in SMAs.

For example, if nearly all of an adviser’s SMA assets are invested in funds, the new disclosure requirements will provide almost no meaningful insight regarding the risk, diversification or strategies used by the adviser in SMAs. This issue will only grow more pronounced as advisers increasingly use ETFs and other fund-based strategies.

UMBRELLA REGISTRATION

Another noteworthy amendment to Form ADV tries to make umbrella registration more efficient. The SEC first allowed umbrella registration through no-action letter guidance in response to the new adviser registration requirements set forth in the Dodd-Frank Act. Today, around 743 filing advisers and 2,587 relying advisers are using umbrella registrations. The SEC believes this represents nearly all advisers entitled to use umbrella registration.

With umbrella registration already in extensive use, the true effect of these amendments is to codify the conditions that must be met before it can be employed. According to the SEC, this was done “to limit eligibility for umbrella registration to groups of private fund advisers that operate as a single advisory business.”

The Commission received a number of comment letters regarding umbrella registration that favored relaxing the requirements. Specifically, some objected to the condition that the filing adviser and relying advisers operate under a single code of ethics and a single set of written policies and procedures administered by a single CCO. But the SEC did not alter its position.

The agency’s focus on limiting the applicability of umbrella registration did not address a surprisingly popular practice whereby one or more advisers under common control, but organized as distinct entities, avoid registration entirely. In such circumstances, advisers specifically do not meet the requirements for umbrella registration and each adviser tries to rely on its own exemption from registration. This seems like a missed opportunity by the SEC to address a practice that one could argue is simply doing indirectly what is prohibited from being done directly.

SOCIAL MEDIA DISCLOSURE

Nestled among the amendments that will impact advisers immediately is one that, although somewhat significant today, will likely become even more important over time. Form ADV now requires disclosure of the adviser’s social media accounts and the address of each of the adviser’s social media pages. The SEC plans to use this information to prepare for examinations of advisers and compare information that advisers disseminate across different platforms.

We anticipate that SEC examiners will have heightened interest in advisers’ use of social media. Moreover, we believe this additional disclosure will lead to significantly more deficiencies and, potentially, enforcement related to the adviser recordkeeping and performance marketing rules.

CLARIFYING AMENDMENT AND TECHNICAL CHANGES

In addition to the changes discussed above, the SEC has made numerous amendments designed to clarify Form ADV and its instructions. Although the clarifying and technical amendments are too numerous to cover adequately here, an overview of the changes to Item 7, which the SEC revised significantly, provides an illustrative example.

Item 7.A., which requires advisers to disclose whether their related persons fall within certain financial industry categories, will now state that advisers need not disclose that some of their employees perform investment advisory functions or are registered representatives of a broker/dealer, since this information is reported elsewhere in Form ADV.

In a similar vein, Item 7.B asks whether an adviser serves as an adviser to a private fund and Section 7.B.(1) is where further information is provided. The SEC has added an explanation that Section 7.B.(1) of Schedule D should not be completed for a fund if another registered adviser or SEC-exempt reporting adviser reports the information. These amendments are likely to improve the overall quality of disclosure in Form ADV by making it more consistent among advisers.

BOOKS AND RECORD RULES

The SEC has also amended Rule 204-2, the books and records rule, under the Advisers Act. Rule 204-2(a)(16), which at present requires advisers to maintain records supporting performance claims in communications that are distributed to 10 or more persons, will now require records to be maintained for any performance claims distributed to any person.

In addition, Rule 204-2(a)(7) will now require advisers to maintain originals of all written communications received and copies of all written communications sent by an adviser relating to the performance or rate of return of any managed accounts or other securities recommendations. We believe these amendments to the books and records rule will have a limited impact on advisers because most advisers already maintain this information.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York office. John Sanders is an associate based in the firm’s Winston-Salem, North Carolina office.

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