Building an investment advisory business and onboarding new clients

Transcription

1 Vol. 20, No. 4 April 2013 Compliance Issues for Establishing New Client Relationships: Part 1 of 2 By Heather Traeger, Kris Easter, and Matthew Cohen Building an investment advisory business and onboarding new clients comes with a cadre of regulatory and compliance issues under the Investments Advisers Act of 1940 (Advisers Act) and other federal and state laws. We will identify and discuss herein some of the compliance issues that advisers face when beginning new client relationships, including solicitation arrangements, disclosure documents, and investment management agreements. Part 2 of this article, to appear in an upcoming issue of The Investment Lawyer, will discuss custodial relationships, ERISA related regulations, voting proxies, and other issues. We will also address some of the issues faced by advisers that operate or solicit funds for a commodity pool (CPOs) and/or advise as to the trading of commodity interests (CTAs) and must therefore register with, and be subject to regulation by, the Commodity Futures Trading Commission (CFTC). In addition, we will provide a few questions to consider while thinking through the compliance issues. Our goal is to Ms. Traeger is a partner, Ms. Easter is counsel, and Mr. Cohen is an associate, in the Washington, DC office of O Melveny & Myers LLP.

2 provide a general overview of relevant compliance issues, not an in-depth discussion of all regulatory and compliance requirements. 1 I. Solicitation To recruit new clients, investment advisers often rely on the use of solicitors, a group that can include employees, advisory affiliates, third-party placement agents and broker-dealers. However, because solicitors are compensated by an adviser for their referrals to the adviser, the Securities and Exchange Commission (SEC) has long been concerned with conflicts of interest and a risk of fraud associated with such fee arrangements. Instead of prohibiting cash referral fees, the SEC adopted rules under the Advisers Act to protect and inform prospective clients of the compensatory nature of a solicitor s activities. A. Cash Solicitation Rule Under Rule 206(4)-3 of the Advisers Act, an investment adviser may not pay cash fees to a solicitor unless four conditions are satisfied. The first three conditions apply to all cash referral fee payments subject to the rule. First, an investment adviser entering into a cash referral fee arrangement must be registered under the Advisers Act. The rule prohibits cash payments to a solicitor by an investment adviser that is required to register with the SEC but has not done so. Although the rule generally does not apply to persons excluded from the definition of an investment adviser, it would apply to an affiliate of the adviser paying a referral fee on the adviser s behalf. Second, the solicitor retained by the adviser must not be statutorily disqualified under the Advisers Act. Statutory disqualification includes, inter alia, having been convicted of certain felonies or being subject to an order, judgment, or decree under certain sections of the Advisers Act. Third, the fee must be paid via a written agreement to which the adviser is a party. Having satisfied the first three conditions, an adviser may still be prohibited from paying cash referral fees under the rule unless the fourth condition is satisfied. The fourth condition requires solicitors to make certain disclosures, which vary depending on the type of services provided and the relationship between the adviser and the solicitor. A solicitor is not required to provide clients with any particular information regarding a fee referral arrangement with an adviser whose activities are limited to impersonal advisory services. 2 Similarly, where the adviser offers both comprehensive and impersonal advisory services, the solicitor would not have to disclose any information regarding the referral fee arrangement as long as the solicitor recommends solely the impersonal advisory services of the adviser. 3 The solicitor could not, however, recommend the adviser s comprehensive advisory services without fulfilling certain disclosure obligations under the rule. In addition, a solicitor who is a partner, officer, director, or employee of the adviser or an affiliate of the adviser must disclose the status of the solicitor s relationship with the adviser or the adviser s affiliate at the time of the referral. The most comprehensive disclosure obligation under the rule is placed on third-party solicitors that are not associated with the adviser or one of the adviser s affiliates, and on solicitors that recommend an adviser for advisory services other than impersonal advisory services. Such solicitors must, at the time of solicitation, provide a prospective client with a current copy of the adviser s brochure (discussed below) and a separate written disclosure document containing the information prescribed by the rule. This information includes basic information about the fee referral arrangement, such as the terms of compensation, whether the client will pay a specific charge or a higher advisory fee because of the solicitation arrangement, and the parties to and nature of the relationship. The rule also imposes heightened requirements on an adviser in such instances. The adviser must receive from the client a signed and dated acknowledgement of receipt of the adviser s brochure and the solicitor s written disclosure document no later than inception of the advisory relationship. In addition, an adviser s written agreement with a solicitor in such instances must contain specific provisions, including one requiring the solicitor to THE INVESTMENT LAWYER 2

3 perform all solicitation activities in a manner consistent with the Advisers Act and rules thereunder. Further, the adviser must (1) make a bona fide effort to determine that the solicitor is in compliance with the fee referral agreement and (2) have a reasonable basis for such belief. The SEC and its Staff have provided guidance regarding the application of Rule 206(4)-3 to certain situations that present unique circumstances or are not squarely addressed by the rule. For example, the rule does not apply to sponsors of wrap fee programs who receive part of the wrap fee. It also does not apply to a cash solicitation agreement between a registered adviser and a solicitor solely for solicitation of investors into an investment pool managed by the adviser. 4 Although there is no explicit prohibition on the payment of non-cash referral fees to solicitors, the SEC has questioned the practice absent disclosure of the referral fee arrangement. The SEC Staff has suggested that solicitors would not otherwise be subject to the Advisers Act if such solicitors received fees as directed by Rule 206(4)-3. Independent of compliance with the rule, advisers should be aware of other rules that may be implicated by fee referral arrangements. The written agreement and other documentation created or received pursuant to Rule 206(4)-3 must be retained for an adviser s books and records requirements under Rule 204-2(a)(10) and (a)(15). Depending on the solicitor s activities and its relationship to the adviser, the solicitor may need to be registered as an investment adviser or brokerdealer at the federal or state level. In addition, solicitation of government or foreign officials may implicate pay to play as well as Foreign Corrupt Practices Act (FCPA) regulations, as discussed below. B. Pay to Play Registered investment advisers, exempt reporting advisers, and foreign private advisers as defined in Section 203(b)(3) of the Advisers Act are subject to Rule 206(4)-5, the SEC s pay to play rule. 5 Generally, the pay to play rule prohibits an adviser or its employees from directly or indirectly making contributions or other payments to public officials with the intent of generating investment advisory business. It does so by imposing a two-year ban on an adviser s acceptance of compensation for conducting advisory services for a government client from when an impermissible contribution is made. 6 The rule further prohibits an adviser from compensating third parties to solicit government entities for advisory services, unless such solicitor is a registered investment adviser, broker-dealer, or municipal advisor, in each case subject to pay to play restrictions. The pay to play rule also makes it unlawful for an adviser to solicit or coordinate (1) contributions for a government official to whom the adviser is seeking to provide advisory services or (2) payments to a political party of a state or locality where the adviser is providing or seeking to provide advisory services to a government entity. Advisers should closely review the numerous definitions found in the rule to ensure proper compliance. Under the rule, advisory services include (1) directly managing or advising government funds or (2) managing or advising through an investment pool. Government funds include, among others, all public pension plans and other collective government funds, including participant-directed plans such as 403(b), 457, and 529 plans. Covered investment pools include mutual funds, hedge funds, private equity funds, venture capital funds, and other collective investment pools. Mutual funds, however, are subject to the rule only to the extent that the funds are an investment option of a participant-directed plan or program of a government entity. 7 A contribution includes any gift, subscription, loan, advance, deposit of money, or anything of value made for the purpose of influencing an election for a federal, state, or local office, including any payments for debts incurred in such an election. In addition to the adviser, employees covered by the rule, called covered associates, are defined as the adviser s general partners, managing members, executive officers, and other individuals with a similar status or function; any employee who solicits a government entity for the investment adviser, and any person who supervises, directly or indirectly, such 3 Vol. 20, No. 4 April 2013

4 employee; and any political action committee (PAC) controlled by the investment adviser or by another covered associate. Rule 204-2(a)(18) of the Advisers Act requires investment advisers to keep certain records of contributions. 8 These records are required to be listed in chronological order identifying, among other items, each contributor and recipient and the amount and dates of the contributions. An adviser must document all government entities for which it has provided advisory services, or which were investors in an investment pool to which the adviser has provided advisory services, in the past five years. In addition, an adviser must document each regulated person to whom it agrees to provide payment to solicit a government entity for advisory services on its behalf. In addition to the SEC s pay to play rule, advisers may be subject to restrictions on solicitation of investment advisory business at the state and municipal level. These limitations may extend to the adviser, its employees, affiliates, and third-party solicitors. Advisers should be attuned to the likelihood of different pay to play, gift, and lobbying laws from federal, state, and municipal sources, as well as public pension plans, and they should regularly monitor for changes in applicable regulations and policies. While similar to the SEC s pay to play rule, the CFTC version of a pay to play rule targets only swap dealers and, to a limited extent, major swap participants. 9 CFTC Regulation restricts swap dealers from engaging in swap business with a government entity if they (or a covered associate) made or solicited political contributions to an official of such government entity during the preceding two years. The regulation also requires that swap dealers and major swap participants have a reasonable basis to believe that third-party representatives of government special entity counterparties are subject to pay to play restrictions imposed by the CFTC, SEC, or a self-regulatory organization subject to CFTC or SEC jurisdiction. Among other departures from the SEC s rule, the CFTC Regulation includes an exemption for swaps that are initiated on an exchange and for which the swap dealer does not know the identity of the counterparty prior to execution. It also prohibits a swap dealer from offering to engage in covered swap business following an impermissible contribution, going beyond the SEC s prohibition on receipt of compensation during the two-year ban. C. FCPA The use of solicitors may trigger obligations under the FCPA. Pursuant to the FCPA, advisers and solicitors are prohibited from giving payments or other benefits, such as entertainment, to a foreign official in return for the official s influence within his or her government. The FCPA most affects advisers and solicitors obtaining investments by sovereign wealth funds or foreign state-owned pension plans. D. Enforcement Actions In late 2012, Goldman, Sachs & Co. (Goldman) reached a $12 million settlement with the SEC in connection with alleged pay to play violations. 10 According to the SEC s charges, a vice-president in Goldman s Boston office solicited underwriting business from the Massachusetts treasurer while working on the treasurer s campaign for governor. The vicepresident conducted such campaign activities during work hours and used Goldman resources. Such use of Goldman work time and resources constituted in-kind campaign contributions to the treasurer that were attributable to Goldman and disqualified the firm from engaging in municipal underwriting business with certain Massachusetts municipal issuers for two years. Goldman, however, participated in 30 prohibited underwritings with Massachusetts issuers. The SEC also settled pay to play litigation involving New York s largest pension plan fund. 11 The SEC charged an investment management firm with entering into undisclosed financial arrangements that benefited two principals of the New York State Common Retirement Fund in order to win investment business. One of the allegations implicated an executive at the investment management firm paying more than $1 million in sham THE INVESTMENT LAWYER 4

5 finder fees to one of the Retirement Fund s principals. In another case, Hutchens Investment Management, Inc. (HIM), 12 the SEC entered an order censuring the investment adviser and suspending for three months the investment adviser s principal for violations of Section 206(4) and Rule 206(4)-3 after finding that the investment adviser paid a cash fee to a solicitor that was not paid pursuant to a written agreement to which HIM was a party and made no bona fide effort to ascertain whether the solicitor provided a separate written disclosure document to the clients. The SEC found that the investment adviser violated Section 206(4) of the Advisers Act and Rule 206(4)-3 thereunder and that its principal aided and abetted such violations. Questions to consider: 1. Do you review your solicitor s disclosures for compliance with Rule 206(4)-3 before the solicitor provides a copy to prospective clients? 2. Is your relationship with, and compensation of, a solicitor consistent with the disclosures provided to prospective clients? If your arrangement has changed, have you re-evaluated the disclosures and asked the solicitor to modify them as necessary? 3. Do you have written pay to play policies and procedures in place and are they reasonably designed to prevent violations of the rule? Do you train your employees on the policies and procedures? 4. If your policy permits contributions, what process do you have in place to test compliance with the de minimis provisions in the pay to play rule? II. Disclosure A. Brochure Rule Rule under the Advisers Act requires a registered investment adviser to provide current and potential clients with written disclosure document(s). 13 This is achieved by providing a copy of Part 2 of an adviser s Form ADV, commonly known as the adviser s brochure (i.e., Part 2A) and the brochure supplement (i.e., Part 2B). The information in the brochure will vary, depending on the adviser s business, but the brochure should be, at a minimum, informative about the adviser s practices, services, fee structure, and other mandatory items prescribed by the General Instructions to Form ADV. 14 Advisers should adhere closely to these instructions when drafting their brochure, including instructions that the information must not be materially inaccurate. 15 Registered advisers must also provide current and prospective investors with brochure supplements that disclose the education, business background, and other information about certain supervised advisory personnel. 16 Pursuant to Rule 204-3, an adviser must cause its brochure and brochure supplements to be delivered initially, and annually thereafter. The initial delivery must occur before or at the time an advisory contract is entered into with a client. Similarly, the brochure supplements must be delivered before or at the time the advisory personnel begin providing services to the client. Thereafter, within 120 days after the adviser s fiscal year-end, the adviser must deliver (1) a copy of the adviser s updated brochure or (2) a summary of any material changes to the brochure that also includes information on how the client can obtain a copy of the updated brochure and where the client can obtain information about the adviser through the Investment Adviser Public Disclosure (IAPD) system. Separate from the annual requirement, if there is a new disciplinary event related to the adviser or a supervised person that requires disclosure, or a material change in the legal and disciplinary disclosure information, an adviser must promptly deliver to each client an amended brochure or brochure supplement, as applicable, or a statement describing the material facts of the changed information. 17 Similar rules apply when there is a material change in the information about the disciplinary portion of the brochure supplement. Delivery may be accomplished through paper or electronic media. There are several exceptions to the brochure and brochure supplement delivery requirements. An adviser is not required to deliver a brochure to a client that is a registered investment company or a business development company or who receives only impersonal 5 Vol. 20, No. 4 April 2013

6 investment advice for which the adviser charges less than $500 per year. An adviser does not have to deliver a brochure supplement to a client: for which it does not have to deliver a brochure; who receives only impersonal advice; or who is an officer, employee, or other person related to the adviser that would be a qualified client of the adviser. 18 Rule 204-2(a)(14) under the Advisers Act requires advisers to maintain a copy of each disclosure document, and each amendment or revision, that was given or sent to clients or prospective clients as well as the dates on which the document(s) were distributed to a client or prospective client who later became a client. Importantly, Rule is not the only rule governing advisers disclosure obligations. An adviser must comply with any disclosure obligations it has under other federal or state laws. In particular, it must disclose all material facts about the advisory relationship. The CFTC also incorporates disclosure and recordkeeping obligations into its regulatory requirements for advisers, found in CFTC Regulations 4.21 through 4.26 with respect to CPOs and Regulations 4.31 through 4.36 with respect to CTAs. Generally, a CPO must deliver a comprehensive Disclosure Document to a prospective pool investor prior to or when it delivers the subscription agreement to the participant, and must obtain an acknowledgement of receipt of the Disclosure Document signed and dated by the participant. While the intent and delivery requirements for a Disclosure Document are similar to the SEC s rules, the CFTC arguably is more prescriptive in its regulation of the content of the Disclosure Document, prescribing specific text for a number of the disclosures as dictated by the types of activity undertaken by the pool and the CPO. Among other topics, the Disclosure Document must provide background information related to the pool, CPO, and other entities providing services to the fund, information on the investment program, use of proceeds, fee disclosures, risk factors, conflicts of interest, the break-even point, related party transactions and principal trading, ownership interests, and performance information. The CFTC s recordkeeping obligations for CPOs require, among other records, retention of books and records prepared in connection with the activities as a CPO, including written materials distributed to the pool or prospective pool participants. A CPO may qualify for an exemption under CFTC Regulations 4.7 or 4.12 from certain disclosure and recordkeeping obligations. Regulation 4.7 provides relief to CPOs who manage pools that are offered or sold solely to persons that meet the definition of Qualified Eligible Persons (QEPs) in a private offering that qualifies for an exemption from the registration requirements of the Securities Act of A QEP is conceptually similar to a qualified client or qualified purchaser as used in the Advisers Act and associated rules and, in fact, does include qualified purchasers as that term is defined in the Company Act. Certain QEPs must meet portfolio threshold requirements, while others have no such requirement; CPOs must maintain records of their determination that a pool investor is a QEP. Having satisfied the QEP requirement, a CPO does not have to satisfy the general Disclosure Document requirements. Instead, the CPO must provide specified disclosure on the cover page of its offering memorandum, or above the signature line in its subscription document if no offering memorandum is used, that notifies investors of the CPO s use of the exemption. Further, it must ensure that all necessary disclosures have been made to ensure the information in the memorandum or subscription document is not misleading. CPOs must claim the exemption by making an electronic filing with the National Futures Association (NFA). If the CPO does not know with certainty that it will qualify for the exemption once it has completed sales of interests in the fund, the CPO should satisfy the Disclosure Document requirements to ensure compliance with CFTC and NFA regulations. Regulation 4.12 provides another opportunity for relief from certain disclosure and recordkeeping obligations for CPOs that are unable to meet the QEP requirement in Regulation 4.7. This may include CPOs to funds that rely on the exclusion from the definition of investment company found in Section 3(c)(1) of the Company Act. Pool operators should be mindful that Regulation 4.12 THE INVESTMENT LAWYER 6

7 includes more conditions for availability and fewer exemptions from the disclosure and recordkeeping obligations associated with Regulation 4.7. CPOs must electronically file with the NFA to claim the exemption. CTAs generally must provide a Disclosure Document to each prospective client no later than the time the CTA delivers an advisory agreement to the prospective client. The disclosures required of CTAs, similar to those required of CPOs, include information about the CTA and each of its principals, information about the trading program pursuant to which the CTA will direct the client account, risk factors, fees, conflicts of interest, related party transactions and principal trading, and performance information. Similar to SEC-regulated investment advisers, CFTCregulated CTAs also must disclose all material information to existing or prospective clients even if such information is not specifically required by CFTC regulations. The CFTC s recordkeeping obligations for CTAs require the retention of records concerning the CTA s clients and any powers of attorney executed by such clients, written agreements entered into by the CTA, transactions effected for clients and related trade confirmations, and advertisements, among other records. Similar to the relief provided to CPOs, CFTC Regulation 4.7 provides relief from certain disclosure and record retention requirements for CTAs with respect to the accounts of QEPs. When relying on the exemption in this regulation, CTAs also must disclose above the signature line of the advisory agreement, if no brochure or other disclosure document is prepared and provided, that the CTA is relying on an exemption and must disclose certain other limited information. Such disclosures may be made in a brochure rather than the advisory agreement if the CTA prepares and provides one to the QEP client. Like CPOs, CTAs must electronically file a claim for such exemption with the NFA before relying on the relief provided in it. B. Privacy Rules The SEC s privacy rules are contained in Regulations S-P and S-AM, and the CFTC s privacy rules are contained in Regulations Part 160 and Part 162. The SEC s Regulation S-P and the CFTC s Part 160 apply, respectively, to SEC-registered investment advisers and to CTAs and CPOs subject to CFTC regulation, whether or not registered with the CFTC (referred to collectively as advisers ). 19 These regulations govern advisers treatment of consumer nonpublic personal information. The regulations make it unlawful to disclose nonpublic personal information about consumers to nonaffiliated third parties unless certain conditions imposed by the regulations have been satisfied, with certain limited exceptions. In addition, the regulations include a Safeguard Rule that requires advisers to adopt written policies and procedures to safeguard nonpublic personal information. The SEC s regulation further contains a Disposal Rule that requires advisers to take reasonable measures to protect such information when disposing of customer records and information. The details of these requirements are discussed more fully below. An adviser must adhere to the regulations with respect to nonpublic personal information about its consumers and customers, which the regulations currently define to be individuals. A consumer is defined as an individual who obtains or has obtained a financial product or service from a financial institution primarily for personal, family, or household purposes, or that individual s legal representative. A customer is defined as a consumer who has an ongoing relationship with the financial institution. As a result, an entity such as a pension plan or a fund that solicits advisory services would not be a consumer or a customer of the adviser, and its nonpublic personal information would not be protected under the regulations. 20 When onboarding new clients, advisers should be aware that certain categories of clients with whom they form advisory relationships are subject to federal privacy rules as well. In particular, the SEC s privacy rules apply to investment companies, as defined in Section 3 of the Company Act, and, although the SEC s rules do not extend to private funds that are excluded from the definition of an investment company, such funds are subject to privacy rules imposed by the FTC Vol. 20, No. 4 April 2013

8 Depending upon the nature of the relationship between the adviser and a fund client, the adviser may need to ensure the registered investment company or private fund client satisfies its regulatory obligations under SEC or FTC privacy rules. Advisers must understand when they have a customer relationship with an individual because the regulations apply different protections to the information of consumers that are customers than to those who are not customers. 22 Both SEC and CFTC regulations require advisers to adopt written policies and procedures to safeguard customer records and information. The procedures must address administrative, technical, and physical safeguards. In addition, under SEC regulations, an investment adviser s procedures must be reasonably designed to safeguard the confidentiality of customer records and information, to protect against anticipated threats to their security or integrity, and to protect against unauthorized access to or use that could result in substantial harm or inconvenience to any customer. Both SEC and CFTC regulations impose different privacy policy notice requirements with respect to consumers and customers, as described more fully below. Rule 10 of SEC Regulation S-P and Part of CFTC Regulations make it unlawful for an adviser to disclose any nonpublic personal information about a consumer to a nonaffiliated third party unless four conditions are satisfied: (1) the adviser provides the consumer an initial privacy policy notice; (2) the notice describes the consumer s right to opt out of the adviser s information disclosure practices; (3) the adviser provides a reasonable opportunity for the consumer to opt out; and (4) the consumer does not opt out. Rules 4 through 6 of SEC Regulation S-P, and Parts through of CFTC Regulations, prescribe when a privacy policy notice must be provided to a consumer or customer and identify what must be included in the content of such notices. Rule 8 of SEC Regulation S-P and Part of CFTC Regulations further provide that if an adviser alters its disclosure practices, it must provide a revised privacy policy notice to a consumer before disclosing that consumer s nonpublic personal information, either directly or through an affiliate, to any nonaffiliated third party. In addition, the SEC s Regulation S-AM and CFTC Part 162 further restrict the use of certain consumer information received from an affiliate to make marketing solicitations, subject to similar notice and opt out requirements as those contained in SEC Regulation S-P and CFTC Part 160. While the regulations require advisers to provide a privacy policy notice to both consumers that are not customers and those that are customers, the timing of delivery differs. An adviser must provide an initial privacy policy notice to a customer no later than the time at which they establish the customer relationship. 23 In addition to the initial notice, an adviser must provide customers with an annual privacy policy notice that accurately reflects its privacy policies and practices. Advisers generally may define their own 12-month period that forms the basis of their annual notification, but must apply the period on a consistent basis. In contrast, an adviser only must provide an initial privacy policy notice to a consumer that is not a customer before disclosing nonpublic personal information about the consumer to a nonaffiliated third party. If the adviser does not share such consumer information (except as otherwise permitted by law), it does not need to provide a privacy policy notice to consumers that do not establish a customer relationship with the adviser. Advisers do not have to provide an annual privacy policy notice to consumers that are not customers. All privacy policy notices must describe the categories of nonpublic personal information collected by the adviser, the categories of nonpublic personal information disclosed to nonaffiliated third parties (which may be a sub-set of the information collected), the categories of nonaffiliated third parties with which the adviser shares such information (for example, financial institutions, non-financial companies, or others), and a description of the adviser s policies and procedures with respect to protecting the confidentiality and security of such information, along with certain other disclosures. 24 The notices must also advise consumers and customers of their right to opt out of such disclosure of their THE INVESTMENT LAWYER 8

9 nonpublic personal information to nonaffiliated third parties. The SEC, in conjunction with the federal bank regulators, adopted a Model Privacy Form to assist financial institutions in providing disclosures clearly and conspicuously as required by the various privacy regulations. Advisers should consider using this model form. Further, when developing its policies and procedures, an adviser should clearly define its expectations of how advisory personnel and representatives handle nonpublic personal information and make sure such expectations are disclosed in its privacy notices as necessary. For example, does the adviser permit advisory representatives who have successfully brought in new clients to take such clients information with them if they terminate employment with the adviser? If so, the adviser must disclose this practice in its privacy policy notices. C. Electronic Delivery Investment advisers are permitted to distribute their brochure and brochure supplements by electronic media, provided advisers make it known to clients that the information is available electronically and any requisite software is available for free. Furthermore, clients must have the ability to access and retain such information. Investment advisers should also obtain informed consent from clients regarding electronic delivery, as well as evidence of receipt. Similarly, under both SEC and CFTC regulations, an adviser may provide its written privacy policy notices electronically if it can reasonably expect the consumer or customer to actually receive the notice via the particular electronic delivery mechanism used. However, an SEC-regulated adviser must take care in posting its privacy policy notice to its website as the sole method of delivery. The SEC has stated that an institution cannot reasonably expect that all of its customers will receive actual notice in writing of a privacy notice that is posted at a particular location, whether that location is an advertising site, the institution s premises, or the institution s web site. 25 Whether an adviser can reasonably expect a website posting of its notice to provide actual notice to a consumer or customer will depend on the particular facts and circumstances. D. Enforcement Actions Recent enforcement actions focused on violations of Regulation S-P. In Merriman Curham Ford & Co., 26 the SEC alleged, among other things, that an investment manager violated Rule 10(a) of Regulation S-P by sending confidential account statements to a certain customer so that said customer could fraudulently pledge the securities of other customers accounts to obtain personal loans. The SEC also prosecuted a broker for gaining illegal profits by selling the names and other confidential personal information of over 500 of his customers to insurance agents. 27 Questions to consider: 1. Are your disclosures consistent with your actual practices? 2. Do you evaluate your disclosures periodically to identify information that may have become inaccurate? 3. Have you adequately tracked privacy notices and opt-outs? 4. Have you evaluated your written policies and procedures to ensure proper safeguarding of nonpublic information based on the particular activities in which your firm engages (for example, electronic access to account statements or other information maintained by the firm)? 5. Do you provide training for employees on your privacy policies? III. Investment Advisory Contracts There are numerous regulations and rules that apply to advisers when forming new client relationships. Among those most critical for consideration are regulations and rules in connection with investment advisory contracts, many of which are set forth pursuant to Section 205 of the Adviser Act. Advisers should be aware of what generally needs to be in an advisory contract, as well as provisions applicable to particular clients. An adviser must carefully monitor its advisory contracts to stay on top of each client s rights, and the various legal obligations associated with 9 Vol. 20, No. 4 April 2013

10 those rights, and its client base as a whole. Although not statutorily required by the Advisers Act, many of the Advisers Act s rules are premised on advisory contracts being in writing. 28 A. Legal Requirements Section 205 of the Advisers Act dictates a number of contractual provisions related to an advisory contract. First, pursuant to Section 205(a)(2) of the Advisers Act, an advisory contract must include a provision prohibiting the investment adviser from assigning the advisory contract without the client s consent. 29 The term assignment is interpreted broadly, meaning any direct or indirect transfer of an advisory contract or of a controlling block of the adviser s outstanding voting securities by a security holder of the adviser. To address the breadth of the definition, Rule 202(a)(1)-1 under the Advisers Act provides that certain transactions that do not involve a transfer of actual control or management of the adviser, despite falling within the scope of the definition of assignment, are not an assignment. The SEC Staff has provided some guidance through no-action letters on the meaning of control and controlling influence and the types of transfers and transactions that would not qualify as an assignment. In the case of an assignment, however, an adviser should seek client consent by providing clients with written notice a reasonable amount of time before the assignment. 30 Second, if the adviser is organized as a partnership, the advisory contract must require the adviser to notify the client of any change in the membership of such partnership within a reasonable time after any such change. 31 Third, an advisory contract cannot provide for compensation to an adviser based on a share of capital gains or the appreciation of a client s funds or any portion of such funds (that is, performance fees), except in certain limited circumstances. Such limited circumstances include those in which the client is a qualified client. The definition of qualified client includes a qualified purchaser, (as defined in the Company Act), knowledgeable employee, and persons meeting certain net worth and assets under management tests. Additionally, there are exceptions to the limitations on performance fees related to business development companies, non-u.s. residents, private investment companies excepted from the definition of investment company under Section 3(c)(7) of the Company Act, certain sophisticated clients, and fulcrum fees for registered investment companies, among others. Significantly, Rule under the Advisers Act requires an adviser to look through certain clients to the equity owners to ensure that each owner satisfies the definition of qualified client before assessing a performance fee. 32 This requirement applies to registered investment companies, business development companies, and private investment companies excepted from the definition of investment company under Section 3(c)(1) of the Company Act. The requirement does not apply to the adviser entering into the contract or to owners that obtain their interest through certain transfers by, for example, gift or bequest. Finally, with respect to fees, advisers should be aware of client consent and written disclosure obligations related to recommendations that clients invest part of their assets in a mutual fund managed by the adviser or an affiliate. The Advisers Act also regulates certain indemnification provisions in an advisory contract. For example, under Section 215(a), any provision binding any person to waive compliance with the Advisers Act or its rules is void. Section 215(b) further limits an adviser s ability to enforce an advisory contract that violates the Advisers Act. However, in Transamerica Mortgage Advisors, Inc., et. al. v. Lewis, 33 the Supreme Court ruled that clients have a limited private remedy under [Section 215 of ] the Investment Advisers Act of 1940 to void an investment advisers contract, but that the Act confers no other private causes of action, legal or equitable, with monetary damages reduced to solely fees paid to the adviser. More recent no-action relief from the SEC Staff provides that a clause in an advisory contract that purports to limit liability, but that also contains a non-waiver clause, would not per se violate the anti-fraud provisions in Section 206 of the Advisers Act if the contract is with sophisticated clients, the terms accurately and clearly state the adviser s intent, THE INVESTMENT LAWYER 10

11 and an intermediary explains the provision to the client. 34 Staff further commented that whether a hedge or indemnification clause would violate Section 206 turns on the form and content of the particular hedge clause (for example, its accuracy), any oral or written communications between the investment adviser and the client about the hedge clause, and the particular circumstances of the client (for example, the client s sophistication level). 35 B. Suggested Provisions Similar to having advisory contracts in writing, many advisers typically include provisions that, while not required by law, are matters of best business practice in light of the adviser s business operations. Such suggested provisions address: the scope of the adviser s authority; brokerage matters; delivery of documents; whether the adviser is also a broker-dealer; confidentiality of information; standard of care; use of sub-advisers; indemnification; proxy voting responsibility; custody; fees, charges, and expenses; aggregation and allocation issues; exclusivity; termination or assignment of contracts; severability; governing law; and representations, warranties, waivers of breaches and dispute resolution. Many advisory contracts also include investment guidelines and restrictions, as well as instructions for how the adviser will manage the client s account. If an adviser includes investment guidelines in its advisory contracts with clients, such guidelines should be clear and include a process for amending. Questions to consider: 1. If you charge a performance fee, do you have a process in place to determine if each client charged the fee satisfies the definition of qualified client and, if necessary, that each beneficial owner of the client also satisfies the definition? 2. Do you have written policies and procedures in place to ensure adherence to any investment guidelines and restrictions? IV. Side Letters Side letters are agreements that fund advisers enter into with certain new investors to accommodate their tax status (for example, a tax-exempt investor), regulatory needs (for example, a benefit plan investor), and/or legal status (for example, a state administered fund). Side letters are also used to provide receiving investors with more favorable rights and privileges than other investors, as well as more favorable economic terms like lower management fees. Such partisan treatment, like liquidity preferences or more access to portfolio information, has spurred scrutiny by the SEC. Accordingly, investment advisers should disclose in the fund s marketing and disclosure documents whether side letters will be utilized and create any conflicts of interest because of preferential treatment. Conflicts of interest may also arise from the adviser s internal compliance with side letters. One investor may request a side letter provision relating to its tax status that cannot be complied with when compared to a side letter provision previously given to another investor. Side letters also commonly include a most favored nations provision that gives the receiving investor the ability to review and elect provisions from side letters entered into with other investors. The administrative aspect of fulfilling such side letters may create compliance issues. Investment advisers should, therefore, develop and implement a record keeping and compliance procedure when entering into side letters. Questions to consider: 1. Have you adequately disclosed your use of side letters and the possible conflicts of interest created by such use? 2. Do you have a process in place to fulfill most favored nations elections that reduces the risk of conflicts of interest? 3. Have you implemented a system to track all side letter agreements and terms, and to monitor your practices to ensure they are consistent with such agreements? Notes 1. Application of the regulatory and compliance information in this article may vary depending upon specific facts and circumstances and should not be relied upon without specific legal advice based on particular situations. 2. Advisers Act Rule 206(4)-3(d)(3) provides that impersonal advisory services mean: (1) written materials or oral 11 Vol. 20, No. 4 April 2013

12 statements which do not purport to meet the objectives or needs of specific clients; (2) statistical information containing no expression of opinions as to the investment merits of particular securities; or (3) any combination of the foregoing services. 3. See Requirements Governing Payments of Cash Referral Fees by Investment Advisers, Investment Advisers Act Release No. 688 (July 12, 1979), note 12 and accompanying text. 4. An investment pool is an investment company, as defined under Section 3(a)(1) of the Investment Company Act of 1940 (Company Act), or a company that would be an investment company but for an exclusion from the definition of investment company provided by Section 3(c) of the Company Act. Mayer Brown LLP, SEC No-Action Letter (July 28, 2008). 5. See generally Political Contributions by Certain Investment Advisers, Release No. IA-3043 (Jul. 1, 2010); see also Rules Implementing Amendments to the Investment Advisers Act of 1940, Release No. IA-3222 (Jun. 22, 2011); Political Contributions by Certain Investment Advisers, Release No. IA-3418 (Jun. 8, 2012). The rule applies to subadvisers but does not apply to small advisers that are registered with the state securities authorities and certain other advisers that are exempt from SEC registration. 6. Rule 206(4)-5 includes a de minimis provision allowing contributions of up to $350 per election per candidate if the contributor is entitled to vote for the candidate and up to $150 per election per candidate if the contributor is not entitled to vote for the candidate. 7. If an adviser is selected by a government entity to advise a government-sponsored plan, regardless of whether the plan selects one of the pools the adviser offers or manages as an option available under its plan, the prohibitions of the rule directly apply to the adviser. 8. Advisers to mutual funds may employ an alternative set of recordkeeping requirements to the extent a government entity s participation in an investment pool is through an intermediary. See Investment Company Institute, SEC No-Action Letter (Sept. 12, 2011). 9. Depending on their swap activities, advisers may qualify as a swap dealer or major swap participant or be associated therewith. 10. In the Matter of Goldman, Sachs & Co. (Sep. 27, 2012), Securities Exchange Act Release No , available at SEC v. Quadrangle Group LLC, et al., 10-CV-3192 (S.D.N.Y. Apr. 15, 2010); SEC Litigation Release No (Apr. 15, 2010), available at litreleases/2010/lr21487.htm. 12. Hutchens Investment Management, Inc. and William Hutchens, Investment Advisers Act Release No (May 9, 2006). 13. See Amendments to Form ADV, Release No. IA-3060 (Jul. 28, 2010); see also Investment Adviser Requirements Concerning Disclosure, Recordkeeping, Applications for Registration and Annual Filings, Release No. 664 (Jan. 30, 1979). 14. Advisers to wrap fee programs must furnish a written disclosure document that contains the information identified in Part 2A, Appendix I, of Form ADV instead of the brochure. The timing requirements related to delivery of the disclosure document are the same as those for the brochure and brochure supplements. 15. To the extent an adviser offers substantially different types of advisory services to different types of clients, it may use a tailored brochure for each category of client. 16. When advisory services are provided by a team of more than five supervised persons, Rule provides that a current brochure supplement need only be delivered for the five supervised persons with the most significant responsibility for the day-to-day advice provided to the client. 17. For example, an adviser may disclose in a supplement delivered electronically that the supervised person has a disciplinary event and provide a hyperlink to either FINRA s BrokerCheck system or the IAPD system. See Amendments to Form ADV, Release No. IA-3060 (Jul. 28, 2010), note 219 and accompanying text. 18. An adviser does not have to deliver a brochure to investors in private funds. 19. Investment advisers that are not required to register with the SEC must comply with the Federal Trade Commission s (FTC s) Privacy Rules. The rules issued by the FTC are substantially similar to those issued by the SEC and CFTC. 20. This could change should the SEC adopt certain amendments to Regulation S-P as proposed several years ago. See generally Part 248 Regulation S-P: Privacy of Consumer Financial Information and Safeguarding Personal Information, Investment Advisers Act Release No (March 4, 2008) (proposing to amend - among other amendments - the safeguard and disposal rules to cover personal information, which would be defined as information that is handled by the adviser that is identified with any consumer, or with any employee, investor, or security holder who is a natural person). 21. Staff Responses to Questions about Regulation S-P, Question 1, available at investment/guidance/regs2qa.htm. 22. For an example of the SEC s interpretation of customer, a wrap account client is considered to be a customer of the wrap account s investment adviser even if the client s written contract is with the wrap account sponsor and not with the wrap account s investment adviser. In addition, an individual that buys investment company shares and holds them in his or her own name is a customer of that investment company even if the shares are purchased through a broker-dealer. Id., Question The SEC has stated that an adviser may provide the initial privacy policy notice at the same time it satisfies its brochure delivery obligation, and an investment company may provide its initial privacy notice to investors with the prospectus, no later than the trade date. THE INVESTMENT LAWYER 12

13 24. See Rule 6 of SEC Regulation S-P and CFTC Part Staff Responses to Questions about Regulation S-P, supra n.21, at Question In the Matter of Merriman Curham Ford & Co. et. al., Securities Exchange Act Release No (Nov. 10, 2009). 27. SEC v. Sidney Mondschein, No. cv si (N.D. Cal., Apr. 14, 2008); SEC Litigation Release No (Apr. 17, 2008), available at litreleases/2008/lr20531.htm. 28. The Company Act, in contrast, requires an advisory contract with a registered investment company be in writing, among other enumerated requirements. 29. This rule does not apply to investment advisory contracts with registered investment companies. 30. The Advisers Act does not address the method of obtaining consent but SEC Staff have granted no-action relief for negative consent letters provided written notification (paper or electronic) was given to clients in a reasonable timeframe, such as 60 days. 31. The SEC has not required such a notification when a limited partnership has changed its limited partners, to the extent the change was not an assignment. 32. An owner does not have to be a qualified client if it is not charged a performance fee, but it must be notified by the adviser if other owners have performance fee arrangements. See generally Exemption to Allow Registered Investment Advisers to Charge Fees Based upon a Share of Capital Gains upon or Capital Appreciation of a Client s Account, Investment Advisers Act Release No. 996 (Nov. 14, 1985); see also Investment Adviser Performance Compensation, Release No. IA-3372 (Feb. 15, 2012) U.S. 11, 24 (1979). 34. Heitman Capital Management, LLC, SEC No-Action Letter (Feb. 12, 2007). 35. The SEC Staff has said that an advisory contract cannot have any provision, including a mandatory arbitration clause, that would lead a client to believe it had waived any available right of action against the adviser because such a provision may violate the antifraud rules of the Advisers Act. Copyright 2013 CCH Incorporated. All Rights Reserved Reprinted from The Investment Lawyer April 2013, Volume 20, Number 4, pages, 1, 12 23, with permission from Aspen Publishers, Wolters Kluwer Law & Business, New York, NY, ,