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A Compliance Guide to the Investment Advisers Act of 1940

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Part III: The Registered Investment Adviser’s Relationship with Its Clients

This article is the third in a series I have designed to give guidance to managers of hedge funds for complying with regulations proposed by the Securities and Exchange Commission. If the proposed regulations are adopted, they will require the managers and advisers to most hedge funds to register as investment advisers with the SEC. Registration will subject the advisers to the compliance standards set forth under the Investment Advisers Act of 1940. This series provides a description of the proposed regulations and registration requirements and addresses the key aspects of Advisers Act compliance. Use of defined terms, statutory references, while at times unavoidable, will be kept to a minimum.

As discussed in prior articles, under current law, many managers and advisers to hedge funds qualify for an exemption from registration under the Advisers Act. The SEC’s proposed rule, if made final, would modify this exemption as it applies to hedge funds. Previous articles have reviewed the proposed rules and how to register as a registered investment adviser. In this article, I examine the effect that registration with the SEC would have on an investment adviser’s relationship with its clients. The fourth and final article will analyze the registered investment adviser’s ongoing relationship with the SEC.

Form ADV Part II and other Client Disclosure Requirements

All registered investment advisers must file Form ADV, which consists of two parts. The adviser must file Part I with the SEC. The requirements for filing Part I of Form ADV were provided in the second article in this series. Part II of Form ADV, also known as the “brochure” contains the information that the adviser must disclose to all clients and potential clients. Part II is not formally filed with the SEC but is deemed filed if it is maintained on file at the adviser’s offices. Part II also must be provided to each of the adviser’s clients and potential clients. The SEC requires that Part II include the following information about the adviser: types of clients; types of investments; methods used to analyze investments; sources of information and investment strategies; education, business standards and business background required of those making investment decisions; other business activities; other financial industry activities or affiliations; participation or interest in client transactions; conditions for managing accounts; additional compensation; and a balance sheet. An adviser may distribute Form ADV Part II to its clients in the form provided by the SEC. As an alternative, an adviser may reformat the information and present it as a real brochure to its clients that will be in compliance with SEC requirements so long as the brochure contains all information required on Part II. Under the Advisers Act it is unlawful to willfully make any untrue statement of material fact or to willfully omit a material fact on Form ADV. Since SEC Chairman William Donaldson has stated that a primary purpose of the new rule is to reduce fraud in the hedge fund industry, special care should be taken to confirm that the information provided on both Part I and Part II is thorough and complete.

In addition to the information required under Form ADV Part II, SEC rules impose additional disclosure requirements that must be met upon the occurrence of certain events. This includes information about the adviser’s financial state and any disciplinary action to which it becomes subject. There is no clear guidance on the type of financial information that should be provided. For example, an adviser is required to disclose any material facts about any financial condition that is reasonably likely to impair its ability to meet its contractual commitments to clients. With respect to disciplinary disclosures, the rules provide some but not exhaustive guidance. In short, an adviser must disclose information on any legal or disciplinary event that involves an adviser or a management person of the adviser that is not resolved in favor of the adviser or management person.

Notwithstanding the vagueness of the financial and disciplinary disclosure rules, these disclosures must be made promptly. The disclosure rules are even more stringent with respect to prospective clients, who must receive all required disclosures not less than 48 hours prior to entering into an advisory contract. The SEC has deemed that the financial conditions and disciplinary events that will trigger the rule’s disclosure requirements will depend on the facts and circumstances of each situation. Further, the SEC has discretion to determine, based on special facts and circumstances that additional disclosures should have been made. Given the SEC’s heightened scrutiny of the hedge fund industry, a registered hedge fund adviser will be wise to err on the side of over disclosure if there is any question of whether or not to disclose a fact or circumstance.

Antifraud Rules and Fiduciary Duties

The SEC’s antifraud rules lay the regulatory foundation of the adviser’s relationship with its clients. All investment advisers, registered or not, are governed by the SEC’s antifraud requirements. Rules promulgated under the Advisers Act prohibit an adviser from defrauding, deceiving or manipulating any client or prospective client in its business practices. The Supreme Court has held that the antifraud rules impose a fiduciary duty on investment advisers by operation of law. As a fiduciary, since the investment adviser has been entrusted with client assets it must therefore act in the utmost good faith, solely in the best interest of its client and make full and fair disclosure of all material facts. In particular, the adviser must disclose any interests that may conflict with the client’s. The adviser must be sensitive to the possibility of rendering less than disinterested advice, whether consciously or unconsciously. An adviser may be held liable even if it did not intend to injure a client and even if a client does not suffer a monetary loss. The SEC has deemed that an adviser’s fiduciary obligations require that an adviser have a reasonable, independent basis for its investment advice, obtain best execution for client’s securities transactions where the adviser is in a position to direct brokerage transactions, and refrain from effecting personal securities transactions that are inconsistent with client interests.

The standards for compliance with the antifraud rules are high. An adviser may be found liable for violations of the antifraud rules even if the adviser was not acting with intent or recklessness. The disclosure of material information relating to an adviser’s business practices may not be sufficient to protect the adviser from liability under the antifraud rules. A wide range of activities has led to findings of violation of the antifraud rules. These have included misrepresenting internal controls and overstating performance results. The following have also been considered violations of the antifraud rules: failure to disclose to investors that a large portion of a fund’s superior performance was due to investments in initial public offerings; failure to disclose commission-splitting arrangements; misrepresentation of a pricing methodology; failure to follow disclosed valuation methods; deliberate mispricing of portfolio holdings; manipulating market prices to inflate valuations; compensating a third party for referring a client without disclosing the material terms of the fee arrangement; and taking an opposite position on securities purchased for a client.

Limitations on Fees

The Advisers Act prohibits a registered investment adviser from charging fees of its clients that are based on a share of the capital gains or capital appreciation in a client’s account. The purpose of this prohibition is to prevent advisers from engaging in excessive speculation or from making significant high risk investments to offset losses. The analysis of what constitutes capital gains or capital appreciation is not clear and very likely a moving target for regulators. For example, a performance fee based on interest, ordinary income or dividends is permissible. Fees based on premiums received from writing options are capital gains and impermissible but capital appreciation in the value of futures and related options may form the basis for a performance fee. The SEC also prohibits contingent fees that are tied to the adviser realization of a target capital gain or appreciation in a client’s account. Exceptions to the prohibition on performance fees are fees based on assets under management and fees charged to “qualified clients”. Qualified clients include natural persons that have invested at least US$750,000 with the adviser or that have a net worth in excess of US$1,500,000. The rules governing fee arrangements are complex and are subject to change.

Custody Rule

Rules under the Advisers Act state that an adviser has “custody” of client assets if it holds the client funds or securities or has the authority to obtain possession of them. If an Adviser has “custody” of client funds and securities then they must be maintained by a “qualified custodian” with clear indication that the funds in the account belong to the client or the adviser as agent for its client. A “qualified custodian” is defined to include most banks and registered broker dealers. An adviser must have a reasonable belief that the qualified custodian will send a quarterly account statement to each client or investor for whom the custodian has custody of funds or securities. Quarterly account statements are not necessary if a fund is audited at least annually and distributes audited financial statements prepared in accordance with generally accepted accounting principles to all investors within 120 days after the end of each year.

Proxy Voting

Since investment advisers holding securities for their clients typically are given the authority to vote proxies for funds they manage, they have a fiduciary duty to vote these proxies in the best interests of their clients. Rules issued under the Advisers Act require a registered adviser with proxy voting authority to adopt and implement written proxy voting policies and procedures to ensure the adviser votes client and fund securities in the best interests of clients and fund investors. These policies must be disclosed to clients and investors. The adviser also must provide a means by which the client can request information on how their securities were voted. The records relating to an adviser’s proxy policies should be retained as a matter of policy

Code of Ethics Requirements

Effective Aug. 31, the SEC adopted a rule that requires each registered investment adviser to adopt a code of ethics. The rule requires an adviser’s code of ethics to set forth standards of conduct and require compliance with federal Securities laws. In addition, the code of ethics must address personal trading, require adviser personnel to report their personal securities holdings and transactions and obtain preapproval of certain investments. Copies of codes of ethics and related records must be kept on file by the adviser and the registered adviser must describe its code of ethics to clients on Form ADV Part II.

Compliance Program Requirement

Also effective as of February of this year, each registered investment adviser is required to adopt and implement compliance programs. The SEC has specified that at a minimum it expects these policies to address portfolio management processes, trading practices, proprietary trading of the adviser, the accuracy of disclosures made to investors, safeguarding of client assets, recordkeeping and maintenance, valuation processes, safeguards for privacy protection of client records and information and business continuity plans. Each registered adviser must review its policies and procedures annually to determine the adequacy and effectiveness of their implementation. The rule also requires each adviser to designate a chief compliance officer to administer its compliance policies and procedures.

As the preceding discussion shows, the rules governing a registered investment adviser and its relationship with its clients are complex, and sometimes unclear. While the foregoing discussion has provided an introduction to these rules, compliance with the Adviser’s Act will require consultation with legal counsel.

The comment period for the SEC’s proposed rule ended on Sept. 15. Release of a final rule may be implemented by the end of the year, although election year politics and other events may delay or even prevent implementation of a final rule. If the proposed rule becomes final, the SEC is contemplating a period of six months during which previously non-registered investment advisers would be required to register and revise compliance systems to meet requirements of the Adviser’s Act.

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Contact Bob Keane with questions or comments at: [email protected]