February 2012 Archives | Securities Law & Corporate Counsel Blog
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February 2012 Archives

Take Note of New Qualified Client Thresholds

On February 15, 2012, the SEC announced the final adoption of amendments to Rule 205-3 of the Investment Advisers Act of 1940 ("Advisers Act"). The amendment results from the Dodd-Frank Wall Street Reform and Consumer Protection Act's change to section 205 of the Advisers Act, which requires the SEC to make inflationary adjustments to any dollar amount thresholds used to exempt investors from the provision's prohibition on registered investment advisers collection of performance based fees. Section 205(a)(1) of the Advisers Act was originally enacted in 1940 to protect advisory clients from compensation arrangements that Congress believed would encourage advisers to take undue risks with client's funds to increase their own fees. The law was later amended to authorize the SEC to exempt any advisory contract from the performance fee prohibition if the contract is "with any person that the Commission determines does not need the protections of subsection (a)(1), on the basis of such factors as financial sophistication, net worth, knowledge of and experience in financial matters, amount of assets under management, [and] relationship with a registered investment adviser...." 15 U.S.C.§80b-5. As a result, in 1985 the SEC adopted Rule 205-3, which allowed advisers to charge performance fees to certain qualified investors who had at least $500,000 of assets under management with the adviser or if the adviser reasonably believed the client had a net worth of more than $1 million at the time the contract was entered into. In 1998 these amounts were adjusted upwards by the Commission to $750,000 and $1.5 million, respectively. The new amendment to Rule 205-3 adjusts the dollar thresholds for the assets under management test to $1 million and the net worth test to $2 million. The rule also is amended to: (1) state that the SEC will adjust the thresholds for inflation every five (5) years; (2) exclude the value of a person's primary residence from the net worth test just as it has done for the definition of accredited investors (although not required by Dodd-Frank); and (3) institute grandfathering provisions to allow investment advisers charging performance fees to clients who were qualified under the prior thresholds to maintain those agreements. Perhaps the biggest impact of the new rule will be on previously unregistered private fund managers who, as a result of Dodd-Frank's mandate, must register as investment advisers and are subject to Advisers Act requirements. Such managers, who previously could solicit investments from accredited investors (with a net worth requirement of only $1 million), are now restricted to soliciting investments from qualified clients (with assets under management of $1 million or a net worth above $2 million) pursuant to Rule 205-3. In sum, the amended rule may now result in the reduction of the number of potential investors who are eligible to invest in private funds that charge a performance-based fee. For additional information please contact Sarah Weber, Associate Attorney at Jacko Law Group, at sarah.weber@jackolg.com or (619) 298-2880.

Update on CA Private Fund Advisers' Registration

On February 6th the California Department of Corporations announced a 45-day extension of the comment period for its proposed rule aligning California's exemption for private fund advisers to the federal exemption. Interested parties now have until 5 p.m. March 26, 2012 to provide commentary on the proposed rulemaking. As reported by Core Compliance and Legal Services, Inc.,  on December 21, 2011, the DOC released its initial notice of proposed rulemaking concerning private fund adviser exemption. The overhaul of federal financial services and securities laws resulting from Dodd-Frank included the elimination of the "private adviser" exemption set forth in Section 203(b)(3) of the Investment Adviser Act of 1940 and the creation of a new regulatory regime for advisers to private funds. The new provisions adopted by the SEC under Dodd-Frank exempt advisers to private funds from registration if they (1) exclusively advise venture capital funds or (2) manage less than $150 million of assets. The proposed California rule would likewise exempt advisers from state registration if they advise only "qualifying private funds" (defined by SEC Rule 203(m)-1). The California rule also includes several investor protection safeguards, including requiring that the exempt adviser not be subject to statutory disqualifications (also known as "bad boy" provisions) and requiring the adviser to file periodic reports on Form ADV containing the information required by exempt reporting advisers under SEC Rule 204-4. If the proposal is adopted, California firms that solely manage qualifying funds (and meet the additional requirements) with under $150M in AUM may not be required to register with any regulatory agency. For additional information on the proposed regulation, please contact Sarah Weber at (619) 298-2880 or sarah.weber@jackolg.com.

B-D Corner: Helpful Guidance for Supervision of Complex Products

Many opine the financial crisis was hastened by the financial industry’s use of byzantine and risky securities. FINRA recently released more specific guidance concerning supervision by broker dealers over the sale of complex products:  Regulatory Notice 12-03, Complex Products: Heightened Supervision of Complex Products.The Notice provides helpful guidance for determining whether products require heightened supervision, as well as specific supervisory and compliance procedures firms should have in place.Characteristics of Complex ProductsFINRA notes that “any product with multiple features that affect its investment returns differently under various scenarios is potentially complex” and provides a non-exclusive list of characteristics to consider, including:
  • Asset-backed securities secured by a pool of collateral (i.e. mortgages or consumer credit card payments) whose risks are not readily apparent;
  • Any product with an embedded derivate component that is difficult to understand (i.e. structured notes with an embedded derivative); and
  • Investments tied to the performance of markets not readily understood (i.e. an exchange traded product with exposure to futures on the CBOE Volatility Index).
If there is any question firms are cautioned to “err on side of applying their procedures for enhanced oversight to the product.”Best Practices for Heightened SupervisionBroker-dealers and their registered representatives (RRs) must perform a reasonable basis suitability determination before recommending complex securities, which provides “an understanding of the potential risks and rewards associated with the recommended security or strategy.” Further, firms should have formal written procedures to ensure that reps do not recommend a complex product before it has been thoroughly vetted.Broker-dealers also should ensure that their RRs are adequately knowledgeable about the complex products they offer. Ideally the RR “should be competent to develop a payoff diagram of a structured product to facilitate his or her analysis of its embedded features and recognize that such a product typically can be decomposed into bond and derivative parts.” The RR must also be fully knowledgeable on the risks associated with each part of the complex product. Importantly, “[r]egistered representatives should consider whether less complex or costly products could achieve the same objectives for their customers” as the contemplated complex product.For additional information on FINRA Regulatory Notice 12-03, please contact sarah.weber@jackolg.com or by phone at (619)298-2880.