Regulatory Updates - March 2014 Publication


SEC Provides Further Guidance on "Knowledgeable Employees"


In a recently released No-Action Letter, the SEC expanded the scope of “knowledgeable employees” for purposes of their investment in 3(c)(1) funds and 3(c)(7) funds that are sponsored by their investment manager. The investment of a knowledgeable employee generally does not count towards the 100 investor limit of a 3(c)(1) fund and a knowledgeable employee is not required to be a “qualified purchaser” to invest in a 3(c)(7) fund.


Rule 3c-5 of the Investment Company Act states that the term “knowledgeable employee” with respect to an investment manager that manages a 3(c)(1) or 3(c)(7) fund generally means any natural person who fits into either of the following two general categories: (i) an executive officer of the investment manager; or (ii) an employee of the investment manager who, in connection with his or her regular functions or duties, participates in the investment activities of the investment manager for at least 12 months (this 12 month period may include employment with a different investment manager).


In the No-Action Letter, the SEC states that the definition of executive officer includes any officer who performs a policy-making function or any other person who performs similar policy-making functions on behalf of an investment manager. The rule does not require policy-making individuals to have a specific title and includes all employees that have the power to make policy on behalf of the investment manager. Accordingly, the SEC states that an employee who does not have a senior manager title may still be considered an executive officer under the rule if he makes policy through day-to-day involvement in the development and adoption of an investment manager’s policies. Further, the SEC agrees that the rule does not require that the policy-making function be concentrated in one individual and that employees serving as active members of a group or committee that develop and adopt an investment manager’s policies, such as the valuation committee, could be executive officers under the rule.


The No-Action Letter also broadens the types of employees who could be considered to be participating in investment activities. In the letter, the SEC takes the position that a research analyst who researches only a portion of the portfolio of a private fund and provides analysis or advice to the portfolio manager with respect to such portion of the private fund’s portfolio is participating in the investment activities of the fund for purposes of the rule, and that such a research analyst could be considered a knowledgeable employee.


Further, the No-Action Letter states that the following types of individuals could be considered as “knowledgeable employees” provided that they perform these functions or duties for the investment manager for at least 12 months: (i) a member of the analytical or risk team who regularly develops models and systems to implement a private fund’s trading strategies; (ii) a trader who regularly is consulted for analysis or advice by a portfolio manager during the investment process and whose analysis or advice is material to the portfolio manager’s investment decisions based on the trader’s market knowledge and expertise; (iii) a tax professional who is regularly consulted for analysis or advice by a portfolio manager typically before the portfolio manager makes investment decisions; and (iv) an attorney who regularly analyzes legal terms and provisions of investments and whose analysis or advice is material to the portfolio manager’s investment decisions.


While the SEC states that the determinations as to the employees described above will be determined on a case by case basis, the position taken by the SEC in the No-Action Letter may have a beneficial effect on employees who wish to invest in Covered Funds that are managed by their employer.


The No-Action Letter may be found via the following link.



SEC Provides Relief from Broker-Dealer Registration to M&A Brokers to Private Companies


The SEC recently released a No-Action Letter which pertains to “M&A Brokers” or, generally, persons engaged in the business of effecting securities transactions in privately-held companies through the purchase or sale (or other type of business transaction) to buyers that will actively operate such companies. In many instances, these M&A Brokers could have previously been viewed as falling within the term “broker” as defined in the Exchange Act which, absent an exception or exemption, could have required these M&A Brokers to register as a “broker-dealers” and to become members of FINRA. This registration process has been described as lengthy and expensive, often costing upwards of several hundred thousand dollars.


However, in this No-Action Letter, the SEC’s Division of Trading and Markets stated that it would not recommend enforcement action if an M&A Broker were to engage in the activities described above without being registered as a broker-dealer. Further, the Division of Trading and Markets stated that it would not recommend enforcement action against M&A Brokers who were to a) advertise a privately-held company for sale and b) receive transaction or other based compensation in connection with the activities described above.


The SEC’s position may have implications for private equity firms as these entities frequently engage in the activities described above while receiving transaction-based compensation for doing so. Some industry commentators had previously taken the position that these private equity firms would be required to register as broker-dealers based on these activities. This No Action Letter would seem to refute this notion.


The SEC’s No-Action Relief is subject to several conditions that are listed in the No-Action Letter which may be found via the following link.



SEC Announces Exam Priorities for 2014


The SEC recently released its exam priorities for calendar year 2014. The following generally summarizes this release as it relates to investment advisers:


A. Priorities across all types of entities:


First: Fraud detection and prevention.


Second: Corporate Governance, Conflicts of Interest, Enterprise Risk Management. The SEC will ask Senior Management and the Board of Directors how they identify and mitigate conflicts of interest and legal, compliance, financial and operational risks. SEC wants to evaluate the firm’s control environment and the “tone at the top.” The SEC would also like to understand the firm’s approach to conflicts and risk management.


Third: Technology. Governance and supervision of IT systems, operational capability, market access, IT security, preparedness to respond to malfunctions and system outages.


Fourth: New Laws such as Verification of Accredited Investor status under Rule 506(c) of the Securities Act. What due diligence is the firm performing in this area?


B. Priorities specific to Registered Investment Advisers


First: Safety of Assets and Custody Rule compliance Rule 206(4)-2. The release lists several significant cases in this area:


Second: Conflicts of Interest in RIA Business. Specifically, the SEC highlights instances where registrants put their own interests ahead of their clients. The SEC notes that too often the registrant fails to identify and mitigate the risks that arise from conflicts of interest. The release lists several significant cases in this area.


Third: Compensation Arrangements, particularly where the compensation is undisclosed. What effect do these arrangements have on recommendations to clients?


Fourth: Investment Allocation


Fifth: Controls around side-by-side management arrangements


Sixth: Risk Controls—especially around illiquid investments and leveraged investments.


Seventh: Marketing/Performance. The SEC will test the accuracy and completeness of performance numbers used in marketing materials. What records are kept? What compliance oversight exists over marketing materials? Significant cases in this area include In re Modern Portfolio Management, Inc. (Oct. 23, 2013).


C. Presence Exams


The SEC cites five key areas on which they will focus during presence exams including 1) Marketing, 2) Portfolio Management, 3) Conflicts of Interest, 4) Safety of Clients Assets, and 5) Valuation.


The list of exam priorities can be found via the following link.



SEC Market Data for Fiscal Year 2013


The SEC recently released its “Select SEC and Market Data Fiscal 2013” report which highlights the Commission’s Enforcement Actions, Enforcement Cases, Investigations, Investor Complaints and Questions, Financial Information and Transaction Activity during Fiscal Year 2013.


In particular, this report stated that as to enforcement actions, the SEC obtained orders requiring securities violators to disgorge illegal profits of approximately $2.257 billion and to pay penalties of approximately $1.167 billion, sought orders barring 81 defendants and respondents from serving as officers or directors of public companies and filed 12 actions to enforce investigative subpoenas. The report also disclosed that in SEC-related criminal cases, prosecutors filed 126 indictments or related actions in Fiscal Year 2013.


The report also disclosed the ten most common complaints made by investors to the SEC. Common topics included those related to advance fee fraud, manipulation of securities/prices, account administration and processing, retirement or 401(k) plans, and ponzi/pyramid schemes.


The Market Data can be found via the following link.


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