Hedge Fund Alert. Authors: J. Matthew Mangan

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1 October Authors: J. Matthew Mangan Alexandra C. Sparling California Proposes Rule Change that Will Require Certain Hedge Fund Advisers to Register with the State and Proposes New Rules Affecting Licensed California Advisers Generally K&L Gates comprises approximately 1,400 lawyers in 22 offices located in North America, Europe and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities. For more information, please visit The Commissioner of the California Department of Corporations ( Commissioner ) recently announced a series of proposed new rules and amendments to current rules under the California Corporate Securities Law of 1968 ( CSL ). 1 If adopted, certain unregistered investment advisers will be required to register with the California Department of Corporations ( Department ) (unless they elect to register with the Securities and Exchange Commission ( SEC ) instead) and licensed California investment advisers will be subject to a number of new and revised rules that are proposed to increase uniformity with other states investment adviser regulations, as set forth in model rules adopted by the North American Securities Administrators Association ( NASAA ), and with certain SEC rules and interpretations. Proposed Rule Change to Require Certain Unregistered Hedge Fund Advisers and Other Investment Advisers to Register with the Department As described in more detail below, this proposed rule change will impact investment advisers that do business in California, including advisers to hedge funds, that are currently not registered with the SEC and are not registered in California in reliance on California s version of the private adviser exemption, Section of the California Code of Regulations, 2 which the Commissioner now proposes to amend. The General Registration Requirement Under California Law. Section of the CSL prohibits any investment adviser from doing business as an investment adviser in California without first obtaining an investment adviser certificate from the Department, unless the investment adviser is exempt from registration either directly under the CSL or under a rule adopted by the Commissioner. SEC registered investment advisers, including SEC registered investment advisers with places of business in the state, are not required to register with the Department by virtue of the federal preemption of state licensing requirements under Section 203A(b)(1)(A) of the Investment Advisers Act of 1940, as amended ( Advisers Act ). Exemptions from the Registration Requirement. For investment advisers not registered with the SEC and with clients located in California, there are two main exemptions from the CSL registration requirements. First, out-of-state investment advisers (i.e., those without a place of business in the state) with fewer than six clients resident in California 1 California Corporations Code Section et seq. For copies of the proposals, see PRO 41/06 and PRO 27/03 on the California Department of Corporations website at rm.htm#proposed%20rules C.C.R. Sec

2 in the preceding 12-month period are not required to register with the state. 3 Second, California s parallel provision to Section 203(b)(3) of the Advisers Act ( Private Adviser Exemption ), set forth in Reg. Section ( California Exemption ), provides an exemption from registration with the Department to any person who: (1) does not hold itself out generally to the public as an investment adviser; (2) has fewer than 15 clients; (3) is exempt from registration with the SEC pursuant to the Private Adviser Exemption; and (4) either has assets under management of $25 million or more or provides investment advice only to venture capital companies. The Proposed Rule Change. The Commissioner now proposes to revise the California Exemption to remove the reference to investment advisers having 15 or fewer clients and having $25 million or more in assets under management, such that the California Exemption will now specifically relate only to advisers to venture capital companies (as defined in the rule). As a result, many unregistered investment advisers with offices and/or clients located in California, including those who are not registered with the SEC because they rely on the Private Adviser Exemption and are not registered with the Department because they currently rely on the California Exemption, would be required to register either with: (1) the Department, thus becoming subject to additional obligations and restrictions (including a host of new proposed and updated rules, as discussed below); or (2) the SEC. In particular, this proposed rule is likely to affect unregistered investment advisers to hedge funds with more than $25 million in assets under management. Thus, if this rule change is enacted as proposed, unregistered investment advisers should consider, if registration with the SEC is an option, whether they would prefer to register with the Department or the SEC. As a result, we are summarizing below some additional rule changes proposed by the Department and contrasting them with the SEC s requirements to assist such advisers in making this decision. The written comment period for this proposed rule ends at 5:00 p.m. on November 26, See Section of the CSL. Proposed New Rules to Increase Uniformity with NASAA Model Rules and SEC Rules and Interpretations The Commissioner also proposes to adopt, repeal, and amend a number of rules generally applicable to investment advisers registered with the Department in order to bring the rules and regulations applicable to California registered investment advisers into conformity with those of other states and to officially adopt a number of unwritten policies observed by the Commissioner s examination staff but never officially adopted. Electronic Filing of Form ADV Part II (Reg. Section ). Under the existing rules, an investment adviser must file Part 1 of Form ADV with the Commissioner through the Investment Adviser Registration Depository ( IARD ), but Part II of that form may currently be filed in paper as opposed to electronically. The proposed amendment would incorporate the recent upgrade to the IARD system and require investment advisers to file Part II of Form ADV electronically through the IARD system. Performance-Based Advertising (Reg. Section ). The existing rule sets forth various advertising practices by an investment adviser that constitute fraudulent, deceptive, or manipulative acts. The proposed amendment would permit the advertisement of past performance (both actual performance or model results) only if the advertisement discloses all material facts necessary to avoid any unwarranted inference and sets forth certain required disclosures to be made in connection with an advertisement of past performance. The stated purpose of the proposal is to increase uniformity with investment adviser regulation at the federal level by incorporating the principles set forth in the SEC No- Action Letter Clover Capital Management, Inc. (pub. avail. Oct. 28, 1996), by setting forth certain required disclosures for the advertisement of past performance data. Under the proposed amendment, model and actual performance results may not be advertised if they: (1) fail to disclose the effect of material market or economic conditions on the results portrayed; October

3 (2) include model or actual results that do not reflect the deduction of advisory fees, brokerage, or other commissions, and any other expenses that a client would have paid or actually paid; (3) fail to disclose whether and to what extent the advertised results reflect the reinvestment of dividends and other earnings; (4) suggest or make claims about the potential for profit without also disclosing the possibility of loss; (5) compare model or actual results to an index without disclosing all material facts relevant to the comparison; and (6) fail to disclose any material conditions, objectives, or investment strategies used to obtain the results advertised. 4 In addition, model performance results may not be advertised if they: (1) fail to disclose prominently the limitations inherent in model results, particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser s decision-making if the adviser were actually managing a client s money; (2) fail to disclose, if applicable, that the conditions, objectives or investment strategies of the model portfolio changed materially during the time period portrayed in the advertisement and, if so, the effect of any such change on the results portrayed; (3) fail to disclose, if applicable, that the adviser s clients had investment results materially different from the results portrayed in the model; and (4) fail to disclose that the advertised results involve model performance rather than actual performance. And, finally, actual performance results may not be advertised if they fail to disclose prominently, if applicable, that the results portrayed relate only to a select group of the adviser s clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material. Notably, the proposed rule amendment includes an Internet site within the definition of an advertisement under the rule. Written Disclosures (Reg. Section ). Existing rules do not require investment advisers to provide clients or prospective 4 Gross performance information should still be permitted to be shown to prospective clients in one-on-one presentations where participants have an opportunity to discuss and ask questions concerning the type of fees charged, provided certain disclosures, including the impact of fees on performance, are made at the time of the presentation. See SEC No-Action Letter Investment Company Institute (pub. avail. September 23, 1988). clients with a written disclosure statement. Under the proposed rule, however, which incorporates NASAA model rule 203(b) commonly known as the Brochure Rule an investment adviser would be required to deliver Part II of its Form ADV to each prospective and actual advisory client: (1) not less than 48 hours prior to entering into any investment advisory contract with such client or prospective client; or (2) at the time of entering into any such contract, if the advisory client has a right to terminate the contract without penalty within five business days after entering into the contract. In addition, the investment adviser must deliver or offer to deliver Part II of its Form ADV annually to its clients. Custody Definitions and Provisions (Reg. Sections and ). Current rules prescribe requirements for investment advisers with custody or possession of a client s funds or securities. The proposed amendment would provide a definition of what constitutes custody for purposes of those rules. The definition of custody offered by the proposed rule is designed to mirror the NASAA model rule s definition, which was put into place after the SEC redefined the term in 2003 with respect to federally registered investment advisers. Additionally, the proposed amendment would require that advisers with custody of client assets maintain those assets with a qualified custodian and have a reasonable belief that the qualified custodian that holds the assets is providing periodic account statements to the clients. Investment advisers with custody of client funds would be required to maintain a positive current ratio and investment advisers with custody of or discretion over client funds would be required to prepare a trial balance and compute the minimum financial requirements required by the rule on a monthly basis. The amendment would also provide that the failure to maintain books and records does not relieve the investment adviser of the minimum financial requirements and would clarify that the failure to meet the minimum financial requirements of this rule will result in reporting requirements. Finally, under the proposed rule an investment adviser would be required to disclose deficiencies in its financial condition to its clients. Pooled investment vehicles, including hedge funds, may comply with the custody rule by engaging an independent party to review all fees, expenses and October

4 capital withdrawals, to determine that the payment is in accordance with the pooled investment vehicle s controlling documents (generally, the partnership agreement or operating agreement), and to inform the qualified custodian, with a copy to the investment adviser, of the independent representative s approval of the request for payment of fees or reimbursement of expenses. Alternatively, if the pooled investment vehicle is audited at least annually and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year, the pooled investment vehicle will not be required to have its fees and expenses reviewed and approved by an independent party. 5 The proposed rule does not contain a provision permitting fund of funds to distribute audited financial statements to investors within 180 days of its fiscal year end, as is provided under the SEC s custody rule (see Rule 206(4)- 2(b)(3)). Unethical Business Practices (Reg. Section ). California law currently requires investment advisers to adhere to such rules as the Commissioner may prescribe to promote fair, equitable and ethical principles (see Section of the CSL) but does not define that phrase. The proposed amendment confirms that [a] person who is an investment adviser or an investment adviser representative is a fiduciary and has a duty to act primarily for the benefit of his or her clients. In addition, the proposed amendment adds several categories of activities that do not promote the fair, equitable or ethical principles identified in Section 25238, including (1) churning an account; (2) disclosing confidential information of any client to a third party unless required by law or with consent of the client; 6 (3) failing to adopt procedures designed to 5 The proposed rule appears to have a typographical error in a cross-reference to the exception from the independent representative approval requirement for delivery of audited financial statements. We assume that the Department intends to follow the NASAA model rule, Rule 102(e)(1)-1, which provides for the exception noted above. 6 Read literally, this portion of the proposed rule would not permit disclosure of confidential information to affiliated third parties or to unaffiliated third parties, such as administrators, without client consent, which is in contrast to Gramm-Leach- Blilely Act Section 502(b)(2), which generally permits sharing of information with both affiliated and unaffiliated third party service providers without customer consent. prevent the misuse of material nonpublic information; (4) indicating in any agreement, condition, stipulation or binding provision that compliance with any of the rules may be waived; or (5) engaging in any conduct indirectly or through any other person that would be unlawful for such person to do directly under these rules. Code of Ethics Requirement (Reg. Section ). The proposed rule, which is modeled after the SEC s Investment Adviser Code of Ethics requirements set forth in SEC Rule 204A-1 of the Advisers Act, would require investment advisers to establish, maintain, and enforce policies and procedures designed to prevent the misuse of material nonpublic information, and to adopt reporting procedures concerning personal securities transactions by supervised persons. Soft Dollar Practices (Reg. Section ). The proposed rule would essentially adopt the language of Section 28(e) of the Securities Exchange Act of 1934, as amended, which establishes a safe harbor that allows investment advisers to use client funds to purchase brokerage and research services under certain circumstances without breaching their fiduciary duties to clients. The proposed rule incorporates portions of SEC Release No in defining the scope of acceptable brokerage and research services. Payments for Client Solicitations (Reg. Section ). This proposed rule generally follows SEC Rule 206(4)-3, commonly referred to as the Cash Solicitation Rule. Investment advisers would be prohibited under the proposed rule from paying compensation to any solicitor unless that compensation were to be paid pursuant to a written agreement and unless the solicitor were to make certain disclosures to the clients. Although this places an additional obligation on solicitors, investment advisers would also be affected in that the investment adviser would have a corresponding obligation to make a bona fi de effort to ascertain whether the solicitor has complied with these requirements. Business Continuity Plans (Reg. Section ). The proposed rule would require an investment adviser to create and maintain a written business continuity plan that must specify how an investment advisory business would respond to various emergencies and to provide safeguards for clients in October

5 the event of death or incapacity of the investment adviser or of any of its representatives. The proposed rule would require the investment adviser to update its plan in the event of any material change to the investment adviser s operations, structure, business or location, and to conduct an annual review of its business continuity plan to determine whether any modifications are necessary in light of changes to the investment adviser s operations, structure, business or location. Recordkeeping (Reg. Section ). Proposed amendments to recordkeeping rules mirror NASAA s model rule 203(a)(2), which is based on the SEC s 2001 rule regarding the preservation and maintenance of an investment adviser s books and records. Specifically, the proposed amendments require the retention of (1) written communications involving litigation regarding a written customer complaint, (2) information regarding clients that is the basis for making any investment recommendations to such clients, (3) documents of each initial Form U-4 and each amendment to the disciplinary pages of Form U-4, (4) certain documents where the investment adviser inadvertently held or obtained a client s securities, (5) documents that grant the investment adviser the authority to withdraw a client s fund or securities maintained with a custodian, (6) specific documents that are acquired by the investment adviser from the issuer in a transaction not involving any public offering, (7) certain documents in situations where an investment adviser has custody of securities or funds and (8) documents showing what securities were purchased and sold and the amount and price of each purchase and sale. The amendment would also change the provisions of the existing rule involving the retention of circulars or advertisements sent to individuals to lower the number of persons that would trigger the retention requirement from 10 individuals to 2 individuals. Investment advisers would also be required to maintain written policies to supervise employees. Financial statements required to be maintained under the existing rule would be required to be prepared in accordance with generally accepted accounting principles and all records would be required to be arranged and indexed, and to be promptly provided upon request, and duplicates would be required to be stored separately from originals. The written comment period for these proposed rules and amendments ends at 5:00 p.m. on October 30, K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name Kirkpatrick & Lockhart Preston Gates Ellis LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin, and in Beijing (Kirkpatrick & Lockhart Preston Gates Ellis LLP Beijing Representative Office); a limited liability partnership (also named Kirkpatrick & Lockhart Preston Gates Ellis LLP) incorporated in England and maintaining our London office; a Taiwan general partnership (Kirkpatrick & Lockhart Preston Gates Ellis) which practices from our Taipei office; and a Hong Kong general partnership (Kirkpatrick & Lockhart Preston Gates Ellis, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Data Protection Act 1998 We may contact you from time to time with information on Kirkpatrick & Lockhart Preston Gates Ellis LLP seminars and with our regular newsletters, which may be of interest to you. We will not provide your details to any third parties. Please london@ klgates.com if you would prefer not to receive this information Kirkpatrick & Lockhart Preston Gates Ellis LLP. All Rights Reserved. October