COMPLIANCE ALERTS

The deadline for achieving compliance with the Massachusetts information security regulations is less than one week away, March 1, 2010. In addition, the effective date of the SEC’s amended Custody Rule under the Investment Advisers Act of 1940 (“Advisers Act”) is March 12, 2010. In light of these important deadlines, ACA offers the following reminders for updating your regulatory compliance program.

Massachusetts Information Security Regulations

The Massachusetts Standards for the Protection of Personal Information (201 CMR 17.00) (the “Standards”) apply to all firms that own or license personal information about a Massachusetts resident regardless of the location of the firm. As such, financial services firms such as investment advisers, broker-dealers, mutual funds, and banks with access to personal information (as defined in the Standards) about a Massachusetts resident generally must follow the Standards.

The Standards, similar to current SEC and FTC guidance, require the development of a written comprehensive information security program. However, the Standards also require a firm to take the following actions, among others:

Designate one or more individuals responsible for maintaining the information security program;
Assess information security risks on an ongoing basis;
Terminate access to information by former employees;
Oversee service providers;
Place reasonable restrictions on physical records;
Implement secure user authentication and access controls for electronic systems;
Encrypt, where feasible, all electronically transmitted records;
Maintain up-to-date virus definitions, firewall protections, and operating system security patches;
Provide initial and ongoing training to employees; and
Document the responses to information security breaches and records of corrective actions taken as a result of the breach.

Although the Standards only apply to the personal information of natural persons who are residents of Massachusetts, ACA anticipates that many states will adopt similar regulations. Accordingly, ACA recommends that firms implement their information security programs on a global basis.

Advisers Act Custody Rule

On December 30, 2009 the SEC published the final adopting release for amendments to Rule 206(4)-2 under the Advisers Act (the “Custody Rule”). The Custody Rule becomes effective on March 12, 2010. Registered investment advisers subject to the rule should be aware of the deadlines noted below. Additionally, since we have not provided an exhaustive list of all of the requirements of the Custody Rule, we encourage advisers to review their operations to ensure full compliance with the Custody Rule.

Policies and Procedures - By March 12, 2010, advisers should implement enhanced policies and procedures designed to safeguard client assets from “conversion or inappropriate use by advisory personnel,” according the Custody Rule Adopting Release.

The SEC’s suggestions for policies and procedures to be adopted by advisers, as applicable, include the following:

Background and credit checks on employees who will have access to client assets;
Requiring authorization of more than one employee before the movement of assets within, and withdrawals and transfers from, a client’s custodial account, as well as before changes to account ownership information;
Limiting the number of employees who are permitted to interact with qualified custodians with respect to client assets and rotating the approved employee roster periodically;
Segregating duties of advisory personnel from those personnel employed by a related qualified custodian to make it difficult for any one person to misuse client assets without being detected;
Testing a sample of fee calculations to determine their accuracy and overall reasonableness of the amount of fees deducted; and
Segregating duties among the personnel responsible for billing, reviewing, and reconciling invoices.

Confirm Qualified Custodian’s Delivery of Account Statements - Also by March 12, 2010, an adviser that has custody of client assets must make “due inquiry” to attain a reasonable belief that a qualified custodian sends account statements directly to clients at least quarterly. The most common means of establishing this reasonable belief is through the receipt and maintenance of duplicate account statements from the custodian.
Books and Records - The Custody Rule also amends the Advisers Act books and records rule as of March 12, 2010. Specifically, an adviser with custody is now required to maintain, if applicable, (i) the internal control report that such adviser is required to obtain or receive from its related person (Rule 204-2(a)(17)(iii)), and (ii) the memorandum describing the basis upon which the adviser determined that the presumption that any related person is not operationally independent, has been overcome (Rule 204-2(b)(5)). These records must be maintained for five years from the end of the fiscal year in which the internal control report or memorandum is finalized.
Notification Requirements when an Adviser Opens Client Accounts at Qualified Custodians - After March 12, 2010, an adviser with custody that opens a custodial account on a client’s behalf must send a notification to the client of the custodial account information. This notification must be resent following any changes to the custodial account information. In addition, these notices, as well as any account statements prepared by the adviser reflecting information about such accounts, should include a legend urging the client to compare the account statements the client receives from the custodian with those the client receives from the adviser.
Surprise Examination, Internal Control Report, and Pooled Investment Vehicle Audited Financial Statements - The Custody Rule also contains various compliance dates related to obtaining a surprise examination (the first examination generally must take place by December 31, 2010), obtaining or receiving the internal control report (within six months of becoming subject to the requirement), and obtaining audited financial statements for pooled investment vehicles with fiscal years beginning on or after January 1, 2010 (the auditor must be PCAOB registered and inspected). More information with respect to these compliance dates will be provided in future ACA Compliance Alerts.

Please do not hesitate to contact your ACA compliance consultant, Damon Zappacosta in ACA’s Morristown, NJ office at (973) 631-1085, or Dee Stafford in ACA’s Boca Raton, FL office at (561) 988-3310 if you have any questions related to the deadlines and compliance dates discussed in this alert.

Financial Responsibility Rule Changes

In Regulatory Notice 09-71 (“RN 09-71”), FINRA has consolidated a number of NASD and NYSE rules governing financial responsibility. The new rules adopted by FINRA will become effective on February 8, 2010.

The following areas are covered by RN 09-71, which relates primarily to Securities Exchange Act (“Exchange Act”) Rule 15c3-1, the Net Capital Rule:

Authority to Increase Capital Requirements;
Suspension of Business Operations;
Withdrawal of Equity Capital;
Sale-and-leasebacks, Factoring, Financing, Loans, and Similar Arrangements;
Subordinated Loans and Notes Collateralized by Securities and Capital Borrowings;
Regulatory Notification;
Restrictions on Business Expansion;
Reduction in Business;
Members Experiencing Financial and/or Operational Difficulties;
Audits; and
Notifications, Questionnaires, and Reports.

Below is a summary of the rule consolidation:

Authority to Increase Capital Requirements
Existing Rule: NYSE Rule 325(d)
New Rule: FINRA Rule 4110(a) **Will now apply to former non-NYSE clearing and carrying members

This rule will allow FINRA to increase the net capital or net worth requirements for clearing and carrying members only.^[1] The authority to make this decision is vested with FINRA’s Executive Vice President who oversees financial responsibility. A notice would be sent to the member under FINRA Rule 9557. The intention of the rule is for FINRA to use this authority only in emergencies.

Suspension of Business Operations
Existing Rule: NASD Rule 3130(e)
New Rule: FINRA Rule 4110(b)(1)

Consistent with current law, the rule will explicitly require a broker-dealer that is not in net capital compliance with Exchange Act Rule 15c3-1 to suspend its business operations until it can return to capital compliance. Firms must comply with this requirement even if FINRA does not send a notice under Rule 9557.

Withdrawal of Equity Capital
Existing Rule: NYSE Rule 312(h)
New Rule: FINRA Rule 4110(c) **Will now apply to former non-NYSE clearing and carrying members

New FINRA Rule 4110(c) is similar to some of the provisions of Exchange Act Rule 15c3-1 regarding withdrawal of capital. The rule prohibits a member from withdrawing equity capital for a period of one year unless otherwise permitted by FINRA. FINRA has indicated that permission would be given on a limited basis. This rule would apply to clearing and carrying members only.

Sale-and-leasebacks, Factoring, Financing, Loans, and Similar Arrangements
Existing Rule: NYSE Rule 328
New Rule: FINRA Rule 4110(d) **Will now apply to former non-NYSE members

FINRA will now require carrying and clearing members to obtain prior approval for entering into arrangements that allow unsecured receivables to be considered an allowable asset for net capital purposes. Such arrangements include sale-and-leasebacks, factoring, financing, and other similar arrangements. In addition, loan agreements that reduce the net capital deduction for fixed assets must be approved by FINRA if the proceeds exceed 10% of the member’s tentative net capital. There would be a di minimis exception allowing a broker-dealer to enter into such arrangements if the arrangements do not increase tentative net capital more than 10%.

The rule also contains provisions that address situations where these arrangements would in the aggregate exceed 20 percent of tentative net capital. In addition, collateral for a loan from a bank under Exchange Act Rule 15c3-1(c)(11)(ii) must be determined by FINRA to be deemed acceptable as having a “ready market.” This determination applies to all members and FINRA estimates that its approvals would take approximately one week.

Subordinated Loans, Notes Collateralized by Securities and Capital Borrowings
Existing Rule: NYSE Rule 420
New Rule: FINRA Rule 4110(e) **Will now apply to former non-NYSE members that are partnerships

For those firms that are organized as partnerships, the prior approval of FINRA will be required for subordinated loans and other loans that are meant to be contributed as capital. This includes not only subordinated loans to be approved under Appendix D of the Net Capital Rule, but also secured and unsecured borrowings.

Regulatory Notification
Existing Rule: NYSE Rule 325(b)
New Rule: FINRA Rule 4120(a) **Will now apply to former non-NYSE clearing and carrying members

The rule will require broker-dealers to notify FINRA within 24 hours regarding specified financial triggers as follows:
- If the broker-dealer’s net capital falls below 150 percent of its minimum net capital dollar requirement;
- If the ratio of aggregate indebtedness to net capital is applicable, when the broker-dealers net capital is less than 10 percent of aggregate indebtedness;
- If the alternative net capital requirement percentage is applicable, when the broker-dealer’s net capital is less than five percent of the aggregate debit items in the Formula for Determination of Reserve Requirements for Brokers and Dealers under Exchange Act Rule 15c3-3;
- If the risk-based capital requirements of Commodity Exchange Act Rule 1.17 is applicable, when the broker-dealer’s net capital is less than 120% of the risk-based capital requirements.

Restrictions on Business Expansion
Existing Rule: NASD Rule 3130 and NYSE Rule 326(a)
New Rule: FINRA Rule 4120(b)

For clearing and carrying members only, Rule 4120(b) will restrict firms from expanding when certain conditions exist over a specified time. Such conditions would include when the broker-dealer’s net capital is less than 125 percent of its minimum dollar net capital requirement, aggregate indebtedness is more than 1,200 percent of its net capital, or net capital is less than four percent of the aggregate debit items in the Formula for Determination of Reserve Requirements for Brokers and Dealers under Exchange Act Rule 15c3-3. A notice may also be sent by FINRA pursuant to Rule 9557 advising the firm that it cannot expand its business.

In addition, pursuant to the rule, FINRA is authorized to restrict a member’s ability to expand its business for any financial or operational reason. FINRA would send the member a notice that describes the restriction and the rationale pursuant to Rule 9557.

Reduction in Business
Existing Rule: NASD Rule 3130(d) and NYSE Rule 326(b)
New Rule: FINRA Rule 4120(c)

Rule 4120(c) will address those situations when FINRA would require a member to reduce the size or scope of its business. The rule will apply only to clearing and carrying members that continue to exceed the standards noted in Rule 4120(a)(1) over a specified time.

Similar to new Rule 4120(b), FINRA is authorized to require firms to reduce the size or scope of a member’s business for any financial or operational reason. FINRA would send the member a notice that describes the required reductions and the rationale pursuant to Rule 9557.

Section 15C Members Experiencing Financial and/or Operational Difficulties
Existing Rule: NASD Rule 3131
New Rule: FINRA Rule 4130

This rule only applies to the few broker-dealers that are subject to the Treasury Department’s liquid capital requirements.

Audits
Existing Rule: NASD Rule 3130 and IM-3130, and NYSE Rule 418
New Rule: FINRA Rule 4140

The rule grants FINRA the authority to request an audit or an agreed-upon procedures review when certain circumstances occur at a broker-dealer. These circumstances include when the firm is experiencing any of the following conditions:
- A reduction in excess net capital of 25% in the preceding two months or 30% or more in the three-month period immediately preceding such computation;
- A substantial change in the manner in which it performs its business which, in the view of FINRA, increases the potential risk of loss to customers and members;
- The books and records are not maintained in accordance with the provisions of Exchange Act Rules 17a-3 and 17a-4;
- The firm is not in compliance, or is unable to demonstrate compliance, with applicable net capital requirements;
- The firm is not in compliance, or is unable to demonstrate compliance, with Exchange Act Rule 15c3-3 (Customer Protection — Reserves and Custody of Securities);
- The firm is unable to clear and settle transactions promptly;
- The overall business operations are in such a condition, given the nature of its business, that a determination of financial or operational difficulty should be made; or
- A broker-dealer registered as a futures commission merchant has net capital of less than 7% of the funds required to be segregated pursuant to the Commodity Exchange Act.

Notifications, Questionnaires and Reports
Existing Rule: NASD Rule 3150 and IM-3130, NYSE Rules 325(b)(2), 416 and 421(2)
New Rule: FINRA Rule 4521 **Will now apply to former non-NYSE clearing and carrying members

Carrying and clearing members will be subject to FINRA’s requests for financial and operational information regarding their correspondents when it deems such information necessary. In addition, within 48 hours, the carrying or clearing member will have to file a notice when its net capital declines 20% or more from its last reported FOCUS Report.

Members carrying margin accounts for customers will also have to submit on a settlement date basis:
- The total of all debit balances in securities margin accounts; and
- The total of all free credit balances in cash or margin accounts.

Hearing Procedures for Expedited Procedures
Existing Rule: FINRA Rules 9557 and 9559
New Rule: N/A

FINRA has revised two rules that provide for the service of notice to firms that are experiencing financial or operational difficulties. The rule changes make a number of conforming revisions to FINRA Rules 9557 and 9559 in light of several of the new financial responsibility rules described above. The revisions provide further clarifications and discuss notices that FINRA may send to its members based on the new financial responsibility rules.

ACA suggests that all broker-dealers review their written supervisory procedures to determine what enhancements are need to address changes based on the rule consolidation.

For more information please contact Dee Stafford at (561) 988-3310 or via email at dstafford@acacompliancegroup.com.

^[1] References to clearing and carrying members also includes those firms that clear customer trades or hold customer funds in a bank account established for compliance with Exchange Act Rule 15c3-1(k)(2)(i).

SEC Adopts Amendments to the Custody Rule

On December 30, 2009 the SEC published the final adopting release for amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940 (the “Custody Rule”). Originally proposed in May 2009 in response to the Madoff and other financial frauds, the amendments are designed to provide additional safeguards for client assets when a registered adviser has custody of client funds or securities. Below is a non-exhaustive summation of the Custody Rule:

Custody Definition. The amended Custody Rule revises the definition of custody to specifically state that advisers have custody if a related person of the adviser holds, directly or indirectly, client funds or securities, or has the authority to obtain possession of them, in connection with advisory services provided by the adviser.

Annual Surprise Examination. The amended Custody Rule requires advisers with custody of client assets to undergo a surprise examination of those client assets by an independent public accountant. However, advisers are exempt from this requirement in the following circumstances:

Advisers who are deemed to have custody solely because of their ability to deduct fees from client accounts;
Advisers to pooled investment vehicles that are subject to an annual financial statement audit by an independent public accountant registered with the PCAOB, and that distribute the audited financial statements to investors in accordance with existing guidelines; and
Advisers who have custody of client assets solely because a related person has custody of advisory clients’ assets or securities. This exception is limited to advisers who are “operationally independent” of the related person custodian.

No exemptions are provided for advisers who have custody through trustee or executor relationships. And notably, advisers that maintain custody of privately offered securities on behalf of their clients will also be required to obtain an annual surprise examination. Privately offered securities will have to be verified along with other funds and securities during the surprise examination.

Internal Control Reports. In addition to the surprise examination, an adviser (or an operationally dependent related person) who is the qualified custodian for advisory client funds or securities will now be required to obtain an internal control report. The internal control report must include an opinion from an independent public accountant regarding the adviser’s (or the related person’s) controls to maintain custody of and safeguard client assets. The internal control report, such as a Type II SAS 70 report, and surprise examination must be performed by an accountant registered with the PCAOB. We note that the requirement to conduct or obtain an internal control report also applies to pooled vehicles where assets are maintained with a qualified custodian that is the adviser or a related person of the adviser to the pool.

Liquidation Audit. The Custody Rule requires advisers to pooled investment vehicles that distribute audited financial statements to investors to satisfy the Custody Rule requirements to obtain a final audit of the pool’s financial statements upon liquidation. These financial statements must also be prepared in accordance with GAAP and provided to investors promptly after completion.

Account Statements. Advisory clients must now receive account statements directly from the qualified custodian. This change amends the exemption, which permitted advisers to deliver statements as long as the adviser underwent an annual surprise examination. An exemption remains, however, for advisers to pooled investment vehicles if they are audited annually by an independent public accountant and audited financial statements are distributed to all investors in the pool. Interestingly, the SEC indicated in the Custody Rule’s adopting release that annual financial statements alone may be insufficient for pooled vehicle investors and suggested that they are exploring alternatives, so more may be to come!

"Due Inquiry" of Statement Delivery. As originally proposed, the SEC adopted an amendment that advisers must make “due inquiry” to attain a reasonable belief that qualified custodians are sending account statements directly to clients. A common industry practice of receiving duplicate statements from the qualified custodian(s) was noted by the SEC as one method of due inquiry, although advisers are not limited to this technique.

SEC Reporting. Accountants conducting surprise examinations must continue to file a Form ADV-E and an accountant’s certificate, which are now required within 120 days of the examination. The amended Custody Rule also requires the accountant to file a statement regarding its resignation or dismissal within four business days of such event. Advisers are also responsible for reporting accountant dismissals on Form ADV. Form ADV-E, previously a paper filing, will now be filed electronically through the IARD once system upgrades are completed in late 2010.

Form ADV Amendments. The SEC adopted several amendments to Form ADV, which largely follow the amendments to the Custody Rule. Of note, advisers must now name each related person that is a broker-dealer, report the amount of assets and number of clients of whose accounts the adviser or related person maintains custody. Schedule D is amended to identify and provide information about accountants performing audits or preparing internal control reports and to identify related persons that serve as qualified custodians. Responses to the revised Form ADV will be required in the first annual amendment after January 1, 2011. The IARD system for the upcoming March 2010 Form ADV annual updates will not reflect these rule amendments.

The final rule release, which can be found at www.sec.gov/rules/final/2009/ia-2968.pdf, also contains guidance for amended policies and procedures as required under rule 206(4)-7. The SEC has also published a companion release to provide guidance for accountants with respect to conducting the surprise examination and internal control reports required under the amended Custody Rule.

The revised Custody Rule is effective 60 days after publication in the Federal Register (approximately March 1, 2010). Advisers required to obtain a surprise examination must enter into a written agreement with an independent public accountant to ensure the first examination takes place by December 31, 2010. Advisers required to obtain internal control reports must do so within six months of the effective date (approximately September 1, 2010)

Chairman Schapiro Announces New Head of OCIE

This afternoon SEC Chairman Mary Schapiro named a successor to Lori Richards as the Director of the SEC’s Office of Compliance Inspections and Examinations. The winner is…Carlo V. di Florio, who was a partner in the Financial Services Regulatory Practice of PricewaterhouseCoopers (“PwC”).

According to an SEC release, Mr. di Florio played a leading role in strengthening PwC’s corporate governance, risk management and regulatory compliance practice and defining new industry standards, including the Committee of Sponsoring Organizations (COSO) Enterprise Risk Management standard and the Open Compliance and Ethics Guidelines (OCEG).

Mr. di Florio’s experiences include leading independent reviews and advising clients on regulatory expectations and industry leading practices across capital markets, investment management, banking and other financial services sectors and regulatory regimes.

Mr. di Florio received his Master of Laws (LL.M) with distinction from Georgetown University Law Center, his JD from Penn State University, and his BA in Political Economy from Tulane University

SEC Case Highlights Importance of Trade Tickets/Order Memoranda

Last month the SEC brought a case against a New York-based investment adviser for, among other things, allegedly allocating profitable trades to hedge fund accounts – which paid a performance fee and which were partially owned by the adviser’s employees, friends, and family – at the expense of separately managed client accounts. In addition, the adviser failed to maintain “accurate order tickets that reflected allocation determinations contemporaneous with the order, failed to make and keep accurate memoranda showing modifications or cancellations of certain orders, discarded certain order tickets, and altered order memoranda after execution of orders.”

Between August 2000 and December 2003, a portfolio manager (now deceased) routinely placed trades on behalf of client accounts and “cherry-picked” the allocations after the trades were executed. Such allocations resulted in approximately $19 million in ill-gotten gains for the adviser as a result of increased performance fees, according to the SEC’s order.

The adviser was charged with violating Exchange Act Rule 10b-5, which prohibits fraudulent conduct in connection with the purchase or sale of securities, Sections 206(1) and 206(2) of the Advisers Act, which prohibit investment advisers from defrauding clients, and Rule 204-2(a)(3) under the Advisers Act, which requires registered investment advisers to maintain order memoranda with respect to the purchase and sale of any security on behalf of a client.

Although it appears that there was intent to defraud in this case, it is important to note the SEC’s focus on the maintenance of correct order tickets, which is typically viewed by the industry as a technical requirement that, if not met, would not result in any significant repercussions from the SEC. While we are not anticipating the SEC’s commencement of an “Order Ticket Sweep” in the future, we did want to note this case since it highlights why the “order memo rule” exists in the first place as well as the importance of completing order tickets correctly.

A complete copy of the order is available at: www.sec.gov/litigation/admin/2009/ia-2962.pdf

As always, please do not hesitate to contact your ACA compliance consultant, Damon Zappacosta in ACA’s Morristown, NJ office at (973) 631-1085, or Dee Stafford in ACA’s Boca Raton, FL office at (561) 988-3310 if you have any questions related to these issues

SEC Charges Billionaire Hedge Fund Manager Raj Rajaratnam with Insider Trading

“It would be wise for investment advisers and corporate executives to closely look at today’s case, their own internal operations, and the increasing focus and scrutiny on hedge fund trading activity by the SEC and others, and consider what lessons can be learned and applied to their own operations.”

– Robert Khuzami
Director, Division of Enforcement
U.S. Securities and Exchange Commission, October 16, 2009

Insider Trading Reviews

Insider trading has been and will continue to be a high priority for federal law enforcement agencies as well a focus area for the SEC during regulatory examinations. With the sources, types, and medium of non-public information continuously expanding, firms, now more than ever, are struggling with whether their investment personnel are getting too close to “the line” in their pursuit of data and information.

ACA stands well-positioned to provide quality and objective insider trading reviews to a diverse client base. Through analyzing controls and procedures, interviewing investment personnel, reviewing emails and instant messages and performing focused compliance tests, ACA will assist firms in assessing the ways in which non-public information can enter the firm, whether employees’ actions could put the firm at substantial risk, and whether appropriate controls are in place. In doing so, ACA’s experienced consultants, many of whom are former SEC examiners, typically will:

Evaluate analysts’, traders’, and portfolio managers’ sources of data and information, including personal and professional relationships;
Analyze firm and employee trading activity for suspicious transactions;
Investigate circumstances surrounding particularly profitable and/or unusual trades; and look for potential transactions resulting from MNPI;
Review employees’ communications, including e-mails, instant messages, faxes, calendars and phone records;
Review financial records and expense reports for suspicious payments; and
Examine investments being made across an issuer’s capital structure and evaluate the effectiveness of information walls and other applicable controls.

We welcome the opportunity to speak with you. Please call us for a no-obligation consultation at (973) 631-1085 or visit our website at www.acacompliancegroup.com.

ACA Compliance Group, a regulatory compliance consulting firm headquartered in Washington D.C., is comprised of former SEC, FINRA, NYSE and state regulators as well as in-house counsel and senior compliance managers from a number of prominent financial institutions.

SEC Continues to Revamp and Retool

Over the past few days the SEC has announced key changes that will likely affect your next examination.

Replacement Named for New York Head of Investment Adviser and Investment Company Examinations

On November 3, 2009, the SEC announced the much anticipated replacement of Tom Biolsi as the head of New York’s investment adviser and investment company examination program.

And the winner is…Norman (“Norm”) Barnard Champ, a Harvard-trained lawyer who for the past 10 years has served as General Counsel of Chilton Investment Company, a multi-national investment adviser and hedge fund manager based in Stamford, CT that is registered as an investment adviser with the SEC and the securities authorities in the U.K. and Hong Kong. Mr. Champ’s other current industry activities include being a member of the Board of Directors of the Managed Funds Association (a position he will be resigning prior to joining the SEC) and being a lecturer on Private Funds Investment Management Law at Harvard Law School.

Mr. Champ is expected to bring to the SEC’s examination program a deep knowledge of the legal and compliance issues facing investment companies and investment advisers, and particularly hedge fund managers.

SEC Bolsters New Division of Risk, Strategy, and Financial Innovation

On November 5, 2009, the SEC announced the addition of three senior officials to the Division of Risk, Strategy, and Financial Innovation (“RSF”), which is headed by Henry Hu, and was established in September 2009 to increase the SEC’s ability to identify developing risks and trends in the financial markets.

The new officials include:

Richard Bookstaber, a Ph.D. in Economics from MIT who has served in the capacities of director of firm-wide risk management at Salomon Brothers, director of risk management at Moore Capital Management, and market risk manager at Morgan Stanley. He has been appointed as a Senior Policy Advisor to the Director of the RSF.
Adam Glass, a Stanford-trained lawyer who has completed tenures at law firms Linklaters LLP and Sidley Austin Brown & Wood. He has been appointed as Counsel to the Director of the RSF.
Bruce Kraus, a Yale-trained lawyer who comes to the SEC from law firm Willkie Farr & Gallagher LLP. He has also been appointed as Counsel to the Director of the RSF.

The SEC’s continued commitment to develop the expertise of the RSF is expected to enable the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) to more proactively and effectively analyze emerging risks in the investment management industry through the conduct of more “sweep” examinations that focus on the identified emerging risks.

Red Flags Rule Delayed Again

On October 30, 2009, the Federal Trade Commission (“FTC”) announced a seven month deferral of enforcement of its “Red Flags Rule,” which requires financial institutions and creditors with covered accounts to develop and implement written identity theft prevention programs. The rule, which had been scheduled to become effective on November 1, 2009, is now set to go into effect on June 1, 2010. As a result of the passage of a bill by the House of Representatives that would exempt from the Red Flags Rule any health care, accounting, or legal practice with twenty or fewer employees (and certain other businesses), some members of Congress requested that the FTC further delay enforcement in order to allow Congress to finalize such legislation.

Additional information is available from the FTC on its website: http://www.ftc.gov/os/2009/10/091030redflagsrule.pdf.

ACA is continuing its analysis related to the application of the Red Flags Rule to its clients and will provide more information as it becomes available.

SEC Sues Dual Registrant for Failure to Comply with Regulation S-P

On September 29, 2009, the SEC found that a dually registered broker-dealer and investment adviser (“Dual Registrant”), failed to, among other things, require its registered representatives to maintain antivirus software on personal computers used to access customer account information through the Internet. As a result, an intruder obtained unauthorized access to 368 customer accounts and effected a limited number illicit trades in eight of the accounts. Fortunately, the accounts’ clearing broker detected the activity and blocked additional trading from occurring. The Dual Registrant voluntarily reported the breach to the 368 account owners and to the SEC.

Background of Regulation S-P (“Reg S-P”)

Rule 30(a) of Reg S-P requires that every entity registered with the SEC adopt policies and procedures that address administrative, technical, and physical safeguards for the protection of non-public customer information. These policies and procedures must be reasonably designed to:

Ensure the security and confidentiality of customer records and information,
Protect against any anticipated threats or hazards to the security or integrity of customer records and information, and
Protect against unauthorized access to or use of customer records or information that could result in substantial harm or inconvenience to any customer.

The SEC’s Findings

The SEC cited the Dual Registrant for failing to, among other things:

Implement adequate procedures requiring registered representatives to maintain appropriate security measures on their personal computers where customer account information was stored.
Maintain procedures requiring that registered representatives’ personal computers be monitored and/or audited to ensure that security measures were correctly implemented and maintained, and
Maintain procedures requiring proper follow-up on potential security issues reported by registered representatives prior to the incident.

The SEC noted that, while certain of the Dual Registrant’s procedures may have addressed administrative, technical, and physical safeguards to protect customer records, they did not require the implementation of these basic safeguards. The SEC further noted that appropriate written procedures to protect customer information did not exist. Ultimately, the SEC found that the Dual Registrant “failed to adhere to the standards of reasonable design” mandated by Rule 30(a) and therefore “willfully violated” Reg S-P. In addition to a cease and desist and censure, the Dual Registrant was ordered to pay a $100,000 fine.

For a complete copy of the proceeding, click here.

Reminders for Investment Advisers

In light of this recent incident, we would like to remind advisers that the protection of customers’ private information remains a regulatory focus for not only the SEC but also state regulatory authorities. In addition to complying with the procedural requirements of Reg S-P noted above, we recommend that advisers consider implementing the practices noted below, as appropriate:

Administrative and Procedural Safeguards

Require those with access to customer information to certify that they have read and agree to comply with the firm’s privacy policies and procedures, and
Regularly supervise employees’ activities, especially those involving access to and use of customers’ information.
Implement a clean desk policy whereby all documents are under lock-and-key at the end of the day or otherwise kept protected from unauthorized access, and
Implement a document destruction policy that specifically addresses the disposal of documents with private customer information.

Physical Safeguards

Install keyed access to the offices/work areas containing private customer information, and
Install lock filing cabinets to store private customer records and information.

Technical and Electronic Safeguards

Install regular updates to security software (which may include antivirus and firewall protection) to detect, prevent and respond to attacks, intrusions or other systems failures,
Require complex passwords that must be changed periodically, and
Encrypt laptops containing customers’ private information.

Note that the list above is not exhaustive. Please do not hesitate to contact your ACA compliance consultant, Damon Zappacosta in ACA’s Morristown, NJ office at (973) 631-1085, or Dee Stafford in ACA’s Boca Raton, FL office at (561) 988-3310 if you have any questions related to this SEC proceeding.

Registration of Broker-Dealers Affiliated with Hedge Funds and Private Equity Firms

Current market conditions are not only presenting new challenges, but also new opportunities. ACA notes that we have seen an increased interest from hedge funds and private equity firms in creating affiliated broker-dealers to participate in the following activities:

Payment and receipt of private placement fees;
Origination, syndication and capital advisory services;
Distribution of research; and
Merger and acquisition consulting.

Before engaging in the above activities, firms generally need to register a broker-dealer with the SEC by filing an application with FINRA. The filing of a complete and accurate membership application is crucial. Failure to submit key information in the format designated by FINRA may result in termination of the application and loss of filing fees.

ACA provides a turnkey solution for firms seeking to register a broker-dealer. ACA’s consultants, all of whom are former SEC and FINRA examiners, are specialists in expediting the application process.

As part of the registration process, ACA performs the following services:

Preparation of the FINRA filing;
Reservation of the applicant’s name with FINRA Membership;
Preparation of the filing with the Domiciled State;
Preparation of FINRA Form NMA;
Preparation of the business plan as required by FINRA;
Assistance with preparation of the initial disaster recovery plan;
Preparation of the initial written supervisory procedures;
Preparation of the initial continuing education needs analysis/training plan;
Assistance with development of initial anti-money laundering procedures;
Preparation of Forms U4 of principals, as required;
Preparation and submission of the initial fidelity bond application;
Registration with the Lost & Stolen Securities program; and
Organization of a conference call with the principals of the new broker-dealer in preparation for pre-membership interview with FINRA.

In addition, ACA can provide outsourced services through its C3 Solution that is designed to alleviate the ongoing compliance burden that it takes to maintain a broker-dealer. ACA can also train principals and employees to perform their day-to-day compliance obligations and requirements.

ACA is pleased to offer hedge funds and private equity firms with fixed-fee pricing. All costs are known prior to proceeding with the registration of the broker-dealer. We appreciate the opportunity to assist you in your new broker-dealer application process. Let ACA help you navigate the regulations and uncertainties of starting a new business by taking advantage of our experience.

For more information please contact Dee Stafford at (561)-988-3310 or via email at dstafford@acacompliancegroup.com.

Late Summer Regulatory Changes for Investment Advisers

Massachusetts Amends Privacy Regulation…Again

The Massachusetts Office of Consumer Affairs and Business Regulation (“OCABR”) has implemented additional amendments to the Commonwealth’s privacy regulation in response to complaints from businesses that the new rules would be costly and difficult to implement. Among other changes, the effective date was changed from January 1, 2010 to March 1, 2010.

To access the OCABR’s FAQs regarding the Massachusetts’ privacy regulation, click here.

Changes to Forms U4 and U5 Approved by the SEC

FINRA’s proposed changes to Forms U4 and U5 have been accepted by the SEC. Form U4 is used by investment advisers to register investment adviser representatives (“IARs”) and Form U5 is used to terminate the employment of IARs.

A number of new disciplinary questions have been added to Form U4 and firms will be required to amend Form U4 and respond to the new disciplinary questions no later than November 14, 2009. A summary of the new questions are below:

Willful violations – Additional questions have been added in order to allow regulators to more readily identify IARs who may be subject to statutory disqualification for willful violations of federal securities laws. Firms will need to review past regulatory actions brought against IARs and determine whether they were found to have “willfully violated” any rule.

Allegations of sales practice violations – Additional questions have been added to require the disclosure of allegations of sales practice violations made against an IAR who is the subject of the complaint. Previously, no disclosure was required provided that the IAR was not named as a defendant or respondent. Now, however, if an IAR is the subject of an arbitration or litigation filed on or after May 18, 2009, the event must be disclosed.

Monetary thresholds – The monetary reporting threshold for reporting settlements of customer complaints, arbitrations, or litigation filed on or after May 18, 2009 has been raised from $10,000 to $15,000.

Date and Reason for Termination – Firms will be able to amend Form U5 and update the date of termination along with the reason for termination. Previously, firms could not amend the Form U5 once it was filed.

An FAQ describing all of the changes to the forms is available here. Please do not hesitate to contact Rhea Shelton, of ACA’s Richmond office, at (804) 323-7800 if you have any questions related to updating Forms U4 and U5.

SEC Adopts Affiliate Marketing Regulation

On August 4, 2009 the SEC adopted Regulation S-AM, which limits the use of information received from affiliates for marketing purposes. The regulation applies to registered advisers, broker-dealers, registered transfer agents, and investment companies.

To summarize, the “affiliate marketing rule” prohibits firms from using “eligibility information” received from an affiliate to market to or solicit a consumer unless the consumer has received notice and an opt-out opportunity. The notice may be combined with other required notices, such as the Regulation S-P privacy notice.

“Eligibility information” refers to consumer information that is used to establish a consumer’s eligibility for (i) credit or insurance to be used primarily for personal, family or household purposes, (ii) employment purposes, or (iii) other purposes authorized in the Fair Credit Reporting Act.

Firms with multiple affiliates are encouraged to analyze their information gathering and distribution practices in order to determine if Regulation S-AM applies. Compliance will be mandatory as of January 1, 2010.

The Regulation S-AM adopting release is available at www.sec.gov/rules/final/2009/34-60423fr.pdf.

SEC Proposes Investment Adviser Regulation Aimed at Pay to Play Schemes

SEC Proposes “Pay to Play” Prohibitions

On August 3, the SEC released proposed new Advisers Act Rule 206(4)-5 – Political Contributions of Certain Investment Advisers. The proposed rule would restrict “pay to play” practices by preventing investment advisers from making political contributions or payments to government officials in order to influence the selection of investment advisers to manage state and local government assets. The proposed rule would also prohibit other types of pay to play arrangements that are intended to conceal the true purpose of a gift or a payment.

Specific Provisions of the Rule

If adopted, proposed Rule 206(4)-5 would generally prohibit advisers from the following:

Providing advisory services to a government entity for two-years after the adviser makes a political contribution to a public official or government entity that has the ability to influence the hiring of investment managers.A government entity is defined rather broadly in the proposing release and includes any state (or political subdivision of a state), any pool of assets sponsored by a state or political subdivision, and any employees of a state or political subdivision acting in their official capacity.
Paying parties that are not affiliated with the adviser to solicit government entities for advisory business. In other words, investment advisers would no longer be able to rely on the cash solicitation rule to pay third-party solicitors to obtain government clients.ACA believes that this provision of the proposed rule is likely to cause the most controversy. In fact, since the proposed rule was released, approximately 20 comments have been posted to the SEC’s website and nearly all of the comments oppose this prohibition.
Soliciting or coordinating contributions for a government official or entity to which the adviser is seeking to provide investment advisory services. Advisers also may not solicit payments for the political party of a government entity where the adviser is providing or seeking to provide investment management services.

In addition, the rule proposal includes a provision that would prohibit an adviser or any of its covered associates from doing anything indirectly that would result in a violation of the rule if done directly. Finally, the SEC explicitly stated in the rule proposal that investment advisers to certain pooled investment vehicles in which a government entity invests would be treated as if the adviser were providing investment advisory services directly to the government entity. So, with respect to Rule 206(4)-5, fund investors are treated the same as clients.

Application of the Rule

Rule 206(4)-5 would apply to every investment adviser registered or required to be registered with the SEC, as well as advisers that are not registered in reliance on the Section 203(b)(3) exemption. According to the SEC, the agency is “including this category of exempt advisers within the scope of the rule in order to make the rule applicable to the many advisers to private investment companies that are not registered under the Advisers Act.” Unregistered hedge fund advisers – if adopted, this rule will apply to you.

The SEC is requesting comments by October 6, 2009. To see a complete copy of the rule proposal release, click here.

Private Fund Investment Advisers Registration Act of 2009

Private Fund Adviser Registration Proposed

The proposed Private Fund Investment Advisers Registration Act of 2009 (the “Registration Act”), issued on July 15th by the Treasury Department, is the next step in the Obama Administration’s efforts to increase transparency in the capital markets. If the legislation is voted into law, the Registration Act will require most unregistered investment advisers managing more than $30 million in assets, including private equity, venture capital, and hedge funds managers, to register as advisers with the SEC. The legislation would accomplish this goal by: (a) Removing from the Advisers Act the exemption from registration for advisers with fewer than 15 clients that do not hold out to the public; and (b) Requiring the registration of a new category of advisers to “private funds.”

The Registration Act defines a “private fund” as a pooled investment vehicle that would be an investment company but for the exceptions contained in sections 3(c)(1) or 3(c)(7) of the Investment Company Act and is either domiciled in the U.S. or is more than ten percent owned by U.S. persons. Thus, advisers that are currently not registered, but manage funds that rely on the section 3(c)(1) or 3(c)(7) exemptions, would have to register if the Registration Act is signed into law in its current form. CFTC registered Commodity Trading Advisors that manage a private fund would generally lose their exemption from registration under the Advisers Act pursuant to this legislation as well.

Many foreign advisers would also be forced to register pursuant to the Registration Act proposed amendments. Any investment adviser that satisfies the definition of a “foreign private adviser” would not have to register with the SEC. The Registration Act defines a “foreign private adviser” as any adviser that:

Has no place of business in the United States;
During the preceding 12 months has had fewer than 15 U.S. clients and less than $25 million in assets under management attributable to clients in the U.S.; and
Neither holds itself out generally to the public in the U.S. as an investment adviser, nor acts as an investment adviser to a registered investment company or a company that has elected to be a business development company.

It isn’t clear how the SEC would define “place of business” for purposes of the foreign private adviser exemption, but we note that “place of business” is currently defined under the Advisers Act as any office at which the investment adviser regularly provides investment advisory services, solicits, meets with, or otherwise communicates with clients. If a similar definition is used, foreign advisers that manage only foreign funds would potentially have to register, even if they maintain only a small office in the U.S.

The Registration Act would also authorize the SEC to require registered advisers to maintain certain records and provide information regarding any private funds they manage. Such information would include, at a minimum, assets under management, use of leverage, counterparty credit risk exposure, trading and investment positions, and trading practices. The SEC would be instructed to adopt rules that would require advisers to provide investors and counterparties with certain reports and other documentation. Finally, the section of the Advisers Act permitting investment advisers to generally withhold the identity of their clients from the SEC would also be removed under this legislation.

In a nod to the 2006 Goldstein v. SEC case that invalidated the SEC’s prior attempt to register most hedge fund managers, the Registration Act authorizes the SEC to “ascribe different meanings to terms (including the term ‘client’)…as the Commission determines necessary….”

Considering that the White House and the SEC both support the legislation, and that three similar bills have already been introduced in Congress, we expect that the Registration Act, or some variation thereof, will be sent to the President’s desk before the end of the year.

Is it Time to Implement FTC Red Flags Procedures?

As you may know, the Federal Trade Commission (the “FTC”) has adopted “Red Flags” rules that require certain companies to take steps to detect, prevent, and mitigate the effects of identity theft (refer to http://www.ftc.gov/redflagsrule). Two of these rules, as described in Section 681 of Title 16 of the Code of Federal Regulations, may be applicable to investment advisers. Enforcement of the Red Flags rules commences on August 1, 2009.

It is important to note that the FTC appears to have crafted these rules with the entire business community in mind. Strictly interpreted, certain provisions may be applicable to investment advisers even though such an interpretation seemingly extends the reach of the rules beyond what may be their intended purpose. Nonetheless, the FTC has repeatedly signaled its intention to interpret the scope of the Red Flags rules broadly.

Please review the descriptions of the rules below to determine how Rules 1 and 2 of the Red Flags rule may apply to your firm.

Rule 1

Rule 1 requires users of consumer reports (also known as “credit reports”) to develop and implement policies and procedures that are reasonably designed to:

· Enable the report’s user, when notified of a material address discrepancy by a consumer reporting agency, to develop a reasonable basis for determining whether the report relates to the individual in question; and

· When applicable, provide the address that has been confirmed as accurate to the reporting agency that reported the discrepancy. Any such notice must be provided in the same reporting period that the relationship is established with the consumer.

Notably, Rule 1’s applicability is not limited to reports about clients or investors. Rule 1 can apply if an investment adviser uses consumer reports for other purposes, such as to evaluate a prospective employee.

Rule 2

Rule 2 requires each “financial institution” and “creditor” to periodically evaluate whether it offers or maintains any “covered accounts.” The term “financial institution” is defined to include entities such as banks, savings and loan associations, and credit unions, while the term “creditor” is defined to include, among other things, any person who extends or arranges credit. The FTC has indicated that the term “creditor” should be interpreted broadly to include any business that provides services and then collects payment for such services at a later time. Therefore, investment advisers that bill in arrears are expected to be deemed “creditors” under Rule 2. Other activities that might be considered an extension or arrangement of credit include the accrual of incentive fees, directly arranging for private funds to use margin, or futures, forward, or swap contracts, and indirectly assisting clients with the use of margin, or futures, forward, or swap contracts.

If an investment adviser is deemed to be a creditor then it must periodically evaluate whether it offers or maintains any “covered accounts.” The term “covered account” has been broadly defined by the FTC; it includes, among other things, any “account that the financial institution or creditor offers or maintains for which there is a reasonably foreseeable risk to customers or to the safety and soundness of the financial institution or creditor from identity theft, including financial, operational, compliance, reputation, or litigation risks.” Pursuant to Rule 2, financial institutions and creditors that offer or maintain any covered accounts must:

Develop and implement a written identity theft prevention program (a “Program”) that is reasonably designed to detect, prevent, and mitigate identity theft in connection with new and existing covered accounts.
Take certain steps to ensure an effective implementation of the Program, including the involvement of senior management in the Program’s implementation, and the provision of training to employees.
Ensure that service providers performing activities in connection with one or more covered accounts have their own reasonable policies and procedures designed to detect, prevent, and mitigate the risk of identity theft, and exercise appropriate oversight of those service providers.

What are the Next Steps for My Firm?

The good news is that while the Red Flags rules may be applicable to you given your firm’s human resources practices and/or advisory activities, chances are your firm’s compliance procedures (more specifically, your firm’s Privacy policy and procedures) address identity theft issues on some level. The bad news is that the Red Flags rules will likely require your firm to strengthen its identity theft program through the implementation of enhanced procedures that specifically address the Red Flags rules, the training element of the rules and the requirement that third-party service providers maintain similar procedures.

ACA will continue to monitor for any clarification from the FTC on the applicability of the Red Flags rules to the investment management industry. In the meantime, please do not hesitate to contact your ACA compliance consultant, Damon Zappacosta in ACA’s Morristown, NJ office at (973) 631-1085, or Dee Stafford in ACA’s Boca Raton, FL office at (561) 988-3310 if you have any questions related to this issue.

Guidance from Massachusetts on its Privacy Regulations

Massachusetts Issues a Privacy Checklist

The Massachusetts data privacy regulation, 201 CMR 17.00 or the Standards for The Protection of Personal Information of Residents of the Commonwealth, applies to anyone that owns, stores, or maintains personal information about a resident of Massachusetts, including banks, investment advisers, broker-dealers, and mutual funds. Firms subject to the regulation are required to develop a broad information security program.

In an effort to assist small businesses that may not have the resources to develop a comprehensive plan on their own, the Massachusetts Office of Consumer Affairs & Business Regulations (“OCABR”) has put together a very helpful Compliance Checklist. The Checklist, which reads more like a test you’ll be graded on later, covers all aspects of the regulation, including employee training, computer security, and physical safeguards.

The OCABR notes that the Checklist “is not a substitute for compliance with 201 CMR 17.00.” However, if you can pass this test, you are probably in pretty good shape.

The Compliance Checklist (listed as the “201 CMR 17.00 Compliance Checklist”) and other helpful resources from the OCABR are available here.

Obama’s Regulatory Overhaul and Changes to OCIE’s Examination Program

President Obama Issues Plans for Regulatory Reform

On Wednesday the Obama Administration issued a report (the “Plan”) outlining its recommendations for overhauling the U.S. financial regulatory system. (For a copy of the report, click here.)

The Plan's key objectives:

Promote robust supervision and regulation of financial firms,
Establish comprehensive supervision and regulation of financial markets,
Protect consumers and investors from financial abuse,
Improve tools for managing financial crises, and
Raise international regulatory standards and improve international cooperation.

To achieve these objectives, the Plan proposes, among other things, to create a new Consumer Financial Protection Agency and to give the Federal Reserve additional authority over large financial institutions. Below is a brief summary of how the Plan, if adopted, will likely impact investment advisers, investment companies, and broker-dealers.

Investment Advisers

For investment advisers, the most significant aspect of the Plan is the requirement for venture capital, private equity, and hedge fund managers to register as investment advisers with the SEC. Under the Plan, advisers that manage private funds with assets in excess of a “modest threshold” would be required to register and to “report information on the funds they manage that is sufficient to assess whether any fund poses a threat to financial stability.”

In addition, registered investment advisers would be subject to reporting requirements sufficient to allow the SEC to assess the evolution of funds and “whether any such funds have become so large, leveraged, or interconnected that they require regulation for financial stability purposes.” Specifically, the reporting requirements would include fund asset size, leverage, and off-balance sheet exposure and would be shared by the SEC with the Federal Reserve. If deemed “systemically important,” funds would be subject to additional supervision and regulation by the Federal Reserve.

Investment Companies

The Plan recommends that the SEC continue its rulemaking efforts “to reduce the credit and liquidity risk profile” of money market funds to make them “less susceptible to runs.” In addition, the SEC should be allowed to require that certain disclosures “be provided to investors at or before the point of sale, if [the SEC] finds that such disclosures would improve investor understanding of the particular financial products, and their costs and risks.”

Broker-Dealers

No surprise, the Plan calls for harmonization of investment adviser and broker-dealer regulation. “Standards of care for all broker-dealers when providing investment advice about securities to retail investors should be raised to the fiduciary standard to align the legal framework with investment advisers.” Further, the Plan calls for the SEC to be allowed to prohibit compensation to intermediaries for placing clients into products that are favorable to the intermediary, “but are not in the investors’ best interest.”

These are of course just proposals and it is too early to tell which regulations may be enacted by the end of this year, if at all. However, given the pressure to harmonize investment adviser and broker-dealer standards and to require hedge fund managers to register, we expect Congress to enact legislation very similar to the reforms proposed in the near future.

OCIE Director Discusses Examination Oversight

At a SIFMA conference in St. Louis on Wednesday, Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), outlined her office’s plans to strengthen examination oversight of broker-dealers and investment advisers. Among other things, OCIE is:

Enhancing examiners’ training and expertise in complex financial products and fraud detection,
Conducting focused examinations of firms with high fraud risk profiles, and
Improving the handling of tips and complaints inside the SEC.

In addition, Ms. Richards echoed the sentiments of SEC Chairman Schapiro regarding the necessity of hiring additional examination staff. “Indeed, while I have the utmost confidence in the SEC’s exam corps,” she stated, “overarching all of the changes we’re making to our examinations is the fact that there should simply be more cops on the Wall Street beat than there are today.”

Ms. Richards’ speech is a must read for every broker-dealer and investment adviser compliance professional. For a complete copy, click here.

Significant Proposals Calling for Regulatory Reform Continues

IAA Advises Members to Write Their Congressmen

The Investment Adviser Association is urging its members to forward the IAA’s testimony before the Senate Banking Committee hearing to their representatives in Congress. On March 26, Executive Director David Tittsworth testified at the Senate Committee on Banking, Housing, and Urban Affair’s hearing, “Enhancing Investor Protection and the Regulation of Securities Markets” and spoke about, among other things, regulatory reform, registration of hedge funds, the creation of an IA Self Regulatory Organization, and “harmonization” of IA and BD laws. (For a complete copy of the testimony, click here.)

To make your voice heard regarding the upcoming legislative proposals, contact your representatives in Congress. Go to www.house.gov and type in your zip code. The website will provide your representative’s email and street addresses. The same information for Senators can be found at www.senate.gov.

Investment Adviser Regulatory Reform – Round One: Custody

In response to recent major investment scams, the SEC last Friday unanimously approved a proposal that would substantially increase the controls that apply to investment advisers that maintain custody of client assets. During deliberations, Chairman Schapiro stated that the SEC’s proposal “protects investors by promoting independent custody – that is taking the assets out of the control of the adviser or an affiliate of the adviser and putting them in the control of a truly independent third party.”

Under the proposal, if an adviser or its affiliate maintains actual custody of client assets (i.e., assets are not held by an independent custodian), the adviser will have to undergo an annual “custody control examination” by a PCAOB-registered and inspected public accountant. The accountant would be required to prepare a report describing the custody controls in place and the tests conducted of the operating effectiveness of such controls.

A second proposal would require an adviser with actual or implied custody to engage an independent public account to conduct an annual “surprise exam” to verify client assets. According to Chairman Schapiro, “this surprise examination would provide ‘another set of eyes’ on client assets, and thereby provide additional protection against their theft or misuse.” This proposal would affect any investment adviser that is deemed to have custody, even if only through the adviser’s authority to withdraw management fees. Roughly 9,600 of the 11,300 registered investment advisers fall into this category.

Chairman Schapiro indicated that the proposal will be open to public comment, and before ending her remarks, alluded to further intentions of the SEC. “I want to emphasize that the new rules that we are considering today are part of a larger package of reforms — all of which are intended to better protect investors from fraud.”

SEC Publishes Asset Confirmation Letter

A few months ago, the SEC disclosed its plan to begin requesting confirmations of cash and securities directly from clients and investors as part of the agency’s examination process. Last week, the SEC posted information on its website about the confirmation process, as well as a copy of the accompanying letter that may be sent to clients and fund investors.

“In the past,” states the website, “examiners have made requests for independent confirmations of assets in forms that have differed from the model below. However, as of May 13, 2009, all requests will be in this form.” The “form” is an explanatory letter with an attached Routine Account Information Confirmation, which requests that the recipient confirm its account balance, last deposit, and last withdrawal.

The letter explains that requests may be made during the course any examination (i.e., not solely during an enforcement investigation) and that receipt of a confirmation request “should in no way be construed, in and of itself, as an indication of any problem or irregularity by the firm being inspected.”

Click here for a copy of the letter and confirmation form.

Plans to Regulate “Dark Market” Unveiled

Last week, the Obama administration revealed its plan to regulate derivatives. The plan has four objectives:

Require most derivatives to trade through a regulated clearinghouse;
Obligate derivatives dealers to disclosure extensive information about their trades to regulators;
Authorize regulators to require traders to provide information upon request; and
Prevent the marketing of derivatives to investors that may not comprehend their risks.

The plan, if adopted, would regulators access to the inner workings of the derivatives market for the first time give. There are a number of challenges to achieving the necessary legislative consensus to move forward, including making a determination as to which regulator will oversee this market – the SEC or the CFTC. In addition, some industry experts have expressed concerns that the proposal could result in a reduction in trading in the derivatives market, which provides important risk-management tools for many market participants.

ACA is following this issue closely and, as always, we’ll keep you posted of any new developments.

FINRA Issues an FAQ on Revised Forms U4 and U5

On May 13, 2009, the SEC approved FINRA’s proposed amendments to Forms U4 and U5. The amendments make significant changes to the reporting of disclosure items. Among a number of additional disclosures, investment advisory and broker-dealer registered representatives will be subject to the following:

The revised forms now require the reporting of allegations of sales practice complaints made against registered persons in a civil lawsuit or arbitration, even if the registered person is not named in the claim or litigation;
The monetary threshold for reporting complaints is has been increased from $10,000 to $15,000; and
Form U5 now contains a revised definition of the “date of termination” field and permits the firm to change the date and reason of termination, provided that the firm states a reason for the change.

The revised forms were implemented in the CRD system on Monday, May 18. An FAQ describing all of the changes to the forms is available here.

The SEC Push for Continued Reform

SEC Chairman Discusses Hedge Fund Regulation

In a recent interview on Bloomberg Television’s “Political Capital with Al Hunt,” SEC Chairman Mary Schapiro discussed the SEC’s authority to regulate hedge funds, and where such authority is lacking. According to Bloomberg’s coverage of the interview (click here for the complete article), Schapiro’s view is that registration alone “falls short of what’s needed to police the $1.33 trillion industry.”

So what is needed? According to Schapiro, the SEC “should be given authority to regulate what hedge funds can buy and how much money they can borrow to maximize bets.” Further, according to Bloomberg, Schapiro stated that “it’s certainly possible” that the SEC would consider rulemaking that would require public disclosure of short sale positions. The SEC’s imposition of restrictive buying and borrowing regulations and the requirement to publicly disclose short sale positions are certain to send chills down the back of any hedge fund manager.

Although Schapiro’s remarks do not reflect definitive intentions of the SEC, they are disquieting in the least and suggest that plenty of changes are on the horizon.

Commissioner Calls for Investment Adviser SRO

SEC Commissioner Elisse Walter spoke yesterday at the Mutual Fund Directors Forum Policy Conference in Washington, D.C. about the harmonization of broker-dealer and investment adviser regulation. “Although I am continually amazed at how well our securities statutes have done their job over the decades, when you look closely at the full fabric of our regulatory system, it is apparent, although not shocking, that there are gaps and overlaps,” Walter stated. “Addressing these gaps and overlaps is high on the Commission’s agenda.”

Walter then set forth her view of how the SEC could manage the incongruent treatment of investment advisers and brokers under its current authority. The SEC could, through rulemaking, more clearly differentiate between investment advisers and broker-dealers or, alternatively, the SEC could harmonize the existing rules. Favoring the latter approach, Walter stated her belief that “the Commission should try to harmonize, among other things, the registration process, disclosure obligations, supervisory responsibilities, and recordkeeping requirements of broker-dealers and investment advisers.” In order to fully harmonize investment adviser and broker-dealer regulations, however, Congress will need to get involved. In Walter’s view, Congress should “throw both statutes on the floor, select what is best in each, and cover any holes through which the floor boards show.”

In addition to the harmonization of investment adviser and broker-dealer regulation, Walter expressed her support for an adviser SRO. “I also believe that all financial professionals should be required to be members of one or more self-regulatory organizations.” Such organization, she stated, should be authorized to set standards and enforce rules, subject to SEC oversight.

Lastly, Walter stated all financial professionals, whether they work for a broker-dealer or an investment adviser, should be subject to a fiduciary duty standard. She explained that while it is easy to define what a fiduciary is, the difficulty lies in determining what a fiduciary standard requires. Further, in Walter’s view, a fiduciary standard is not a replacement for business practice rules. The SEC, she stated, “can use business practice rules to prohibit certain conflicted behavior or to require mitigation or management of the conflict. This is important when you consider that investors often do not read disclosure, and too often fail to fully understand its significance when they do.” Ultimately, however, the SEC should not stray from the basic notion that brokers and advisers must always act in the best interests of investors.

The calls for an adviser SRO are expected to meet significant industry resistance. Again, we will be closely monitoring upcoming developments related to this matter and will keep you posted.

SEC Brings First Insider Trading Case Involving CDS

The SEC has charged two men with insider trading in credit default swaps. According to the SEC’s complaint, a salesman at Deutsche Bank Securities Inc. learned about a change to a proposed bond offering for which Deutsche Bank was the underwriter. The offering was expected to increase the price of credit default swaps on the bonds. Rorech allegedly tipped a portfolio manager at hedge fund adviser Millennium Partners L.P., who then purchased credit default swaps on the bond for a Millennium hedge fund. The CDS position ultimately netted a profit of approximately $1.2 million.

ACA notes that this is the first insider trading case specifically involving credit default swaps, which had been largely criticized as being unregulated financial instruments. The case also continues to underscore the SEC’s efforts to bring cases against hedge fund advisers. In fact, the SEC has already brought more enforcement actions against hedge funds in the first four months of 2009 than it did in all of 2008.

Red Flags Rule has been delayed, Yet Again

The Federal Trade Commission has announced a further three-month deferral of enforcement of its “Red Flags Rule,” which requires financial institutions and creditors with covered accounts to develop and implement written identity theft prevention programs. The rule, originally set to go into effect on Friday, May 1, 2009, is now scheduled to go into effect August 1, 2009. The purpose of the delay is to give firms more time to develop and implement written identity theft prevention programs.

For ACA’s May 1st Compliance Alert summarizing the Red Flags Rule requirements (See This Spring’s Regulatory Activity…the Relative Calm before the Storm?) click here. For the FTC Release, see http://www.ftc.gov/opa/2009/04/redflagsrule.shtm.

ACA is continuing its analysis related to the application of the Red Flags Rule to its clients and will provide more information as it becomes available.

This Spring’s Regulatory Activity…the Relative Calm before the Storm?

As we wait for substantial regulatory proposals from the SEC under the new direction of Chairman Schapiro, we wanted to share some recent noteworthy information that may also impact your firm.

Are you Ready for Red Flag Friday?

The Federal Trade Commission’s (“FTC”) Red Flags Rule, promulgated under the Fair and Accurate Credit Transactions Act of 2003 (FACT Act), takes effect today, Friday, May 1st. Certain broker-dealers and investment companies that meet the definition of a “financial institution” or “creditor” and offer or maintain “covered accounts” must develop, implement, and administer a written Identity Theft Prevention Program (“Program”) designed to safeguard against identity theft. Firms should carefully analyze their customers and accounts to determine the extent to which they must comply with the Red Flags Rule.

We’ll help get you started…

Financial Institution – Firms that offer accounts where the customer can make payments or transfers to third parties may fall within the definition of financial institution, which is defined as a depository institution or any other person that, directly or indirectly, holds a transaction account belonging to a consumer. The term “transaction account” means an account that permits the account holder to make withdrawals for payment or transfer to third parties of securities or funds via telephone transfers, check, debit card, or other similar items. If your firm permits check-writing or debit/credit card privileges on accounts, your firm likely meets the definition of a financial institution.

Creditor – The Red Flags Rule also applies to firms that are considered creditors. The definition of creditor includes anyone who regularly participates in the decision to extend, renew, or continue credit, including setting the terms of credit. A firm that is not covered by the definition of financial institution could still be a creditor. If your broker-dealer acts as either an introducing or clearing firm and offers margin accounts, your firm would likely be deemed to be a creditor for purposes of the Red Flags Rule.

Covered Accounts – If your firm meets the definition of a financial institution or creditor, you must conduct a risk assessment to determine if you have covered accounts. The definition of “covered accounts” generally applies only to retail accounts, although it also includes any type of account (including institutional accounts) if the firm determines that those accounts pose a reasonably foreseeable risk to its customers or to its own safety or soundness from identity theft.

When developing a Program, you may appropriately rely on existing anti-money laundering (“AML”) procedures and various written supervisory procedures as a framework. Consider the following general requirements:

Identify red flags when accounts are opened. Does your firm have detailed account opening procedures and a customer identification program?
Identify suspicious activities by existing accounts. Do your firm’s AML procedures adequately address the detection and reporting of suspicious activities?
Report red flags and/or suspicious activities to the AML Compliance Officer. Does your firm’s AML Program detail the appropriate actions to be taken once red flags are detected?
Lastly, because identity theft is an ever-changing threat, the Firm will need to at least annually re-evaluate the Program to reflect new risks. For instance, did your firm recently grant online account access and/or online trading capabilities?

Firms that do not meet the definition of a financial institution or creditor do not need to develop a Program. Further, we believe that the Red Flags Rule generally will not apply to investment advisers or hedge funds, as advisory and partnership capital accounts do not fall within the definition of covered accounts (i.e., these accounts generally do not engage in third-party transactions). Finally, ACA notes that the Red Flags Rule should not be confused with the SEC’s proposed amendments to Regulation S-P, which have yet to be finalized.

Recently Released Fair Valuation Guidance

On April 9, 2009, the Financial Accounting Standards Board issued new guidance regarding the fair valuation of financial assets and liabilities when the volume and level of activity for the asset or liability have significantly decreased. FASB Staff Position FAS 157-4 makes significant changes to the methodology and standards set forth in FAS 157-3 and proposed FAS 157-e regarding fair valuation under such conditions. In summary, FAS 157-4:

Re-emphasizes that fair value for purposes of FAS 157 is the price at which market participants would engage in an orderly transaction (not a forced liquidation or distressed sale) under current market conditions. An entity’s intent to hold a position for a given period of time is not pertinent to a fair value determination.
States that current transactions or quoted prices may not be determinative of fair value if there has been a significant decrease in the volume and level of activity for the asset or liability (or similar instruments) below normal market activity.
Provides guidance on how to determine whether there has been a significant decrease in market activity.
Provides guidance on how much credibility to give to current transactions and quoted price in a market that has experienced a significant decrease in activity, focusing on the degree to which such prices are based on orderly transactions.

Compliance with FAS 157-4 will be required for reporting periods ending after June 15, 2009. The text of FAS 157-4 is available at http://www.fasb.org/pdf/fsp_fas157-4.pdf.

It’s CCOutreach Season Again!

The SEC recently announced plans for 11 regional CCOutreach seminars for investment advisers and investment companies, to be held in cities around the country from May through July. During the same period, the SEC will also hold five regional CCOutreach seminars for broker-dealers in cooperation with FINRA.

CCOutreach seminars are a great way to learn about current regulatory developments and examination trends, to get to know your local regulators, and to possibly get answers to your burning compliance questions (anonymously, if preferred). The SEC staff speaking at these seminars generally tends to be candid with participants regarding their perspectives on current issues. This year, the broker-dealer CCOutreach seminars will include industry representatives on panels with regulators, which should provide for more lively discussions.

As a result of the current regulatory environment and anticipated initiatives highlighted in speeches by Chairman Schapiro, CCOutreach seminars are expected to fill up fast; be sure to register soon if you are interested in attending. Most of the investment adviser/investment company seminars are also available live via webcast, but registration is still required. You can register for the investment adviser/investment company CCOutreach at http://www.sec.gov/info/cco/ccorsgeninfo2009.htm and the broker-dealer CCOutreach at http://www.finra.org/Industry/Education/ConferencesEvents/P037195.

Pay-to-Play

Recently the New York state comptroller banned the use of placement agents to direct the management of New York’s pension assets to investment advisers. Additionally, on April 30, the New York Attorney General brought criminal charges against an investment adviser that allegedly made illegal payments to a placement agent in order to secure an investment from the New York state Common Retirement Fund.

While the pay-to-play issue is not new, ACA anticipates that New York state’s allegations are likely to lead to additional SEC scrutiny in this area. Indeed, the SEC filed civil charges simultaneously with the Attorney General’s office. Accordingly, ACA advises firms to consider prioritizing reviews of their placement agent/solicitor relationships and to revisit their solicitation policies and procedures.

Please do not hesitate to contact your ACA compliance consultant, Damon Zappacosta in ACA’s Morristown, NJ office at (973) 631-1085 or Dee Stafford in ACA’s Boca Raton, FL office at (561) 988-3310 if you have any questions related to these issues.

SEC Warns Mutual Funds of Requiring Oversight in AML Programs

Recently, the SEC has become more vigilant by implementing target or “sweep” exams of regulatory concerns. During the same period, the SEC has made several speeches to the industry that continue to stress the greater need for attention to compliance programs and oversight responsibilities. Notwithstanding from these responsibilities, is the increased need for AML oversight.

According to SEC officials, funds are relying too much on third party service providers in regards to their AML responsibilities. At the Practising Law Institute's "SEC Speaks in 2009" Program in Washington, DC last month, Karen Buck Burgess of the SEC’s Office of Compliance Inspections and Examinations (OCIE) stated that “Sometimes funds just thought they could rely on the service provider for AML and would not have its own AML program or would not have appointed its own AML officer.” She added that funds have taken too casual of an approach in reviewing independent reports of their service providers. “You can’t just delegate it to a service provider,” she says.^[1]

In the adopting release for Customer Identification Programs (CIP) for Mutual Funds, regulators stated that “it is permissible for a mutual fund to contractually delegate the implementation and operation of its CIP to another affiliated or unaffiliated service provider, such as a transfer agent. However, the mutual fund remains responsible for assuring compliance with the rule, and therefore must actively monitor the operation of its CIP and assess its effectiveness.”

ACA reminds its mutual funds and mutual fund distributor clients to review their adopted AML and CIP programs to assess changes to its operational, technology, vendors and/or marketing/service practices that could affect their current AML and CIP Policies and Procedures. The following represents examples of common “gaps” ACA has noted in its AML Program Reviews for mutual funds, transfer agents and distributors:

The adopted CIP of the Fund is inconsistent or more restrictive than the Transfer Agent’s procedures for processing shareholder applications (e.g. documentary vs. non-documentary processes).
The Fund’s and Distributor’s AML Programs fail to assess the risks associated with non-direct business (e.g. omnibus and third party administrators with non-“financial institutions”).
The Fund, Distributor and Transfer Agent AML Programs fail to discuss the responsible parties for receiving and reviewing FinCEN 314(a) requests and for making the Sharing of Information filing with FinCEN under 314(b).
The Fund receives limited or no information from the Transfer Agent and/or its Distributor regarding ongoing services provided under the Fund’s AML and CIP Program (e.g. OFAC and FinCEN checks, Cash/Cash Equivalents received, failure to verify, identified accounts with suspicious activities, foreign accounts).
Disclosure in the Fund’s prospectus/SAI is not consistent with the current practice to close accounts if they cannot be verified.
Contracts with delegated service providers for AML are not in accordance with regulatory requirements.

ACA Compliance Group has established a diligent process to review the AML Programs of Fund Complexes, Transfer Agents and Distributors. These reviews are staffed with a consultancy team comprised of former SEC and FINRA examiners and those with experience working at a mutual fund transfer agent operations.

For additional information regarding ACA’s AML services, including independent reviews and training, please contact Dee Stafford at nprokos@acacompliancegroup.com or at (561) 988-3310, or Nick Prokos at nprokos@acacompliancegroup.com or at (617) 589-0904.

^[1] Source: by Peter Ortiz “SEC Urges Vigilance on Money Laundering Practices” Ignites, February 20, 2009.

Extended MA Data Security Deadline and Recent Observations regarding SEC Examinations

Over the past several weeks we have seen additional regulatory and examination activity related to Massachusetts data security regulations and SEC examinations.

Revisions to and Extension of MA Data Security Deadline

On February 12, 2009, The Massachusetts Office of Consumer Affairs and Business Regulation (the “OCABR”) extended the effective full compliance date of new data security regulations to January 1, 2010 from the previous effective full compliance date of May 1, 2009.

The OCABR’s recent changes amended prior regulations, including that written certifications from third-party service providers no longer be required, but rather “reasonable steps” be taken to ensure that the third-parties have appropriate security measures in place. Additionally, the scope of data that must be encrypted has been limited to records and files containing personal information and traveling across public networks and wireless transmissions of data containing personal information.

The Massachusetts data security regulations apply to every person who owns, licenses, stores or maintains personal information about a resident of Massachusetts. For a complete listing of all of the requirements of Massachusetts’s new data security guidelines please see 201 CMR 17.00.

Update on SEC Examinations

Recent revelations of large scale fraud and the ongoing economic crisis are causing industry observers to predict significant changes in the federal securities laws and a reorganization of the regulatory system. These predictions were bolstered by comments from Obama Administration officials calling for action to be taken as early as April.

But what does this mean for your firm now?

Recently, ACA has noted a few examination trends that may impact how you prepare for an upcoming examination. First, we have noted an increase in “surprise” examinations, where firms receive notice 24 to 48 hours in advance (or no prior notice). Despite potentially less lead time, OCIE director Lori Richards signaled at the recent "SEC Speaks" conference in Washington, D.C., that examiners will be taking “no excuses” during exams and will be expecting prompt delivery of all required records. Second, ACA has observed SEC examination teams spending a significant amount of time reconciling internal records to custodial records and ensuring the overall safety of client assets. The SEC has even begun to contact client custodians to verify the existence of client assets. Third, ACA has noted a greater emphasis on email reviews, with requests covering up to two years and sometimes without keyword qualifiers (i.e., emails related to a specific client, investment or event). Finally, ACA has observed SEC examination teams recently requesting all versions of specified documents (e.g., compliance manual, Part II of Form ADV, marketing materials, etc.) utilized and implemented during the entire examination review period versus only requesting the most recent version of the documents.

Please do not hesitate to contact your ACA compliance consultant if you have any questions related to these issues.

Ramifications of Supervisory Failures and Falsification of Records Related to Variable Annuity (“VA”) Transactions

Although tempting in this difficult economic environment, it is important to remember that we cannot cut corners in our compliance reviews, circumvent established supervisory controls or mask resource and time constraints by backdating evidence of supervisory reviews. These are practices that will likely come back to haunt the offender with what may seem a personal lifetime of damaging consequences. We recognize that you may be asked to do more with less; do less with fewer controls; or simply postpone certain compliance and supervisory obligations, with the intention of catching up at a later date, only to realize that the “to be done later” list has become lengthy and requires substantial prioritization. Compliance and supervisory responsibilities that have traditionally been viewed as routine functions are now forced to be treated as special clean-up projects. These scenarios may be indicative of problems within or between departments, broader-reaching systemic issues, or weaknesses in the firm’s enterprise risk management program.

In December 2008, FINRA fined Mutual Service Corporation (“MSC”), an insurance affiliated broker-dealer, over $1.5 million for failing to supervise its VA business, conduct timely reviews of VA 1035 Exchange transactions, and falsifying books and records to give the appearance that VA transactions were reviewed in a timely manner during a 2004 time period.[1] MSC has over 1,200 independent contractors located in over 800 branch offices nationwide and dealer agreements with most significant VA and variable life sponsors. VAs comprised a substantial portion of MSC’s overall business in 2004. Among the penalties for individuals, six home office professionals were sanctioned, three of whom were permanently barred from the securities industry for falsifying the firm’s books and records.

According to the hearing panel there was a “complete meltdown of MSC’s supervisory system for the review of variable annuity transactions.” Although MSC had a process for reviewing VA transactions and identifying red flags and despite repeated internal staff complaints about understaffing, MSC’s Chief Compliance Officer and MSC’s Chief Administrative Officer directed personnel to suspend red flag blotter reviews after determining that a backlog could not be readily resolved and other projects, including the acquisition of another broker dealer, were higher priorities. To address the increasing backlog, staff was reassigned from other departments to perform reviews of nearly 600 backlogged 1035 Exchange transactions. The complaint focused on a staff member who was not a registered principal and was largely unsupervised. MSC supervisory and compliance personnel backdated information to make it appear that red flag reviews were completed within a few days following the trade date.

ACA reminds its variable product and mutual fund distributor clients that robust compliance, ethics and risk management programs are vital in setting the “tone at the top”. Following is a short list of control objectives to consider when assessing the adequacy of your firm’s overall compliance program:

Conduct “end-to-end process reviews” periodically to ensure there are no gaps in supervisory or compliance flows (e.g. ensuring branch office visits by the OSJ include supervisory structure assessments).
Ensure a formal process is in place to supervise implementation and performance of key compliance-risk and ethics related activities (e.g., individuals responsible for performing supervisory functions can articulate the process in place and demonstrate a clear understanding of how infractions are detected and there is documentation is maintained demonstrating the implementation and corrective action taken to remediate identified weaknesses. The company should also measure whether implementation of key activities is being performed as expected).
Assess whether the company has adequate resources and individuals with requisite skills to implement all required compliance, risk, and ethics functions to the level expected by the company (e.g., evaluate existing resource needs on a periodic basis, such as when product volumes increase beyond a certain percentage threshold or when new laws and regulations require implementation of new processes or when company reorganization is imminent, etc.).
Assess whether sufficient connectivity exists between compliance, risk and ethics functions across the enterprise to effectively maintain and execute robust compliance, risk and ethics functions (e.g. established committees are in place to facilitate communication between compliance, risk management, legal, internal audit and business operations to execute key compliance functions).
Ensure the company has a process to formally connect all individuals implementing and managing compliance functions (e.g., the company’s organizational structure lends itself to effective communication, clear lines of accountability and reporting).
Employees, agents and customers have an effective means for communicating compliance, ethics and risk-related concerns (e.g., a confidential hotline in the legal or ethics office).

ACA Compliance Group is staffed with former SEC and FINRA examiners who have a track record of working with top tier variable product sponsors and broker-dealer firms to assess supervisory and compliance processes and controls, conduct end-to-end process reviews of high-risk processes, and redesign compliance functions for greater transparency.

For additional information regarding ACA’s Variable Insurance Product services, including operational, regulatory compliance and supervisory requirements and performing process and controls-focused reviews, please contact Nick Prokos at nprokos@acacompliancegroup.com or (617) 589-0904.

New FINRA Rules Became Effective on February 17, 2009

The second batch of new consolidated FINRA Rules, approved by the SEC last November, became effective on February 17, 2009. These rules relate to warrants, options and security futures and include, among other things, provisions requiring enhanced disclosure documents, additional diligence surrounding the account opening process, and specific requirements for confirmations, suitability, recordkeeping, and reporting. According to Regulatory Notice 08-78, these rules were largely adopted with only minor changes to the existing rules.

Specifically, FINRA adopted: (1) NASD Rules 2840 through 2853 (“Warrant Rules”) as FINRA Rules 2350 through 2359; (2) NASD Rule 2860 (“Option Rule”) as FINRA Rule 2360; and (3) NASD Rule 2865 (“Security Futures Rule”) as FINRA Rule 2370. Corresponding provisions of Incorporated NYSE Rule 414 (Index and Currency Warrants), Rule 424 (Report of Options) and the Rule 700 Series (Option Rules) were deleted as the substance of these rules is addressed in the new FINRA rules.

Most notably, the adopted Option Rule: (1) changes all references to “Registered Options and Security Futures Principal” to “Registered Options Principal;” (2) permits a Limited Principal-General Securities Sales Supervisor (Series 9/10) to approve the opening of an options account; (3) allows a Limited Principal-General Securities Sales Supervisor in addition to a Registered Options Principal (Series 4) to accept discretionary options accounts; and (4) codifies as Supplementary Material provisions of NASD Notice to Members 07-03 covering control relationships.^[1] The Warrant Rules and the Securities Futures Rule were adopted in substantially the same form, with only minor organizational changes.

Please do not hesitate to contact your ACA compliance consultant if you have any questions related to these issues.

^[1] For additional discussion, See SEC Release No. 34-58932; File No. SR-FINRA-2008-032.

SEC Marketing and Examination Guidance and Extension of Massachusetts Identity Theft Prevention Regulations

Late last week the SEC released a pair of documents with guidance that provides advisers with more flexibility related to the content of marketing materials and provides a further glimpse into the types of documents that its examination teams will review during the routine examination process. Additionally, Massachusetts extended the deadline for compliance with standards for how advisers must protect and store clients’ personal information.

Including Positions in Marketing Materials that Contribute to the Performance of a Strategy

On November 7, 2008, the SEC’s Division of Investment Management (“IM”) issued a no-action letter to the TCW Group (“TCW Letter”, refer to TCWLetter) that permits the presentation in marketing materials of positions that significantly contributed to the positive and negative performance of an investment strategy over a measurement period. The conditions under which IM granted the no-action relief as well as other key points addressed in the TCW Letter include the following:

At least 5 positive and 5 negative holdings - the marketing material must show no fewer than 10 holdings, including an equal number of the most positive and most negative holdings that contributed to the performance results of the investment strategy over the measurement period;
Weighting the returns - the contribution analysis must take into account the weighting of every holding in the investment strategy over the measurement period in order to determine the most positive and most negative holdings (i.e., a holding that returned 100% but that constituted only 1% of the strategy would have less impact on the strategy’s performance than a holding that returned 10% but constituted 20% of the strategy);
Consistency of presentations – the presentation of information and the number of holdings must be consistent across measurement periods;
Selection of representative account – the adviser may select a representative account from which the holdings may be analyzed to calculate the most positive and most negative contributors to the investment strategy’s performance. The selection of the representative account must be completed in compliance with federal securities laws;
Disclosures - the presentation must disclose: (i) how to obtain the methodology of the return contribution analysis; (ii) how to obtain a list showing every holding’s contribution to the overall performance during the measurement period; (iii) that the holdings identified do not represent all of the securities purchased, sold, or recommended for advisory clients; and (iv) that past performance does not guarantee future results;
Preventing a misleading presentation – the presentation must include all information necessary to not make it misleading, including presenting the best- and worst-performing holdings on the same page with equal prominence, and with appropriate disclosure as discussed above, in close proximity to the performance information;
Required books and records to substantiate the presentation and return methodology – books and records must be kept related to: (1) the criteria used to select the specific securities listed in each presentation (i.e., the performance contribution calculation); (2) a list showing the contribution of each holding in the strategy to the overall performance of the strategy during the measurement period; and (3) all supporting data necessary to demonstrate the calculation of the presentation’s contribution analysis and to demonstrate the appropriateness of the holdings included in each presentation.
Who may receive a presentation of the performance contribution analysis? - the TCW Letter permits advisers to provide the performance contribution presentation to prospective clients and consultants who do not specifically request the information, and to current clients who are not invested currently in the investment strategy included in the presentation.

Release of the New Model Examination Document Request List

On November 13, 2008, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) released its long-awaited model core initial document request list (the “List”, refer to SECModelCoreDocumentRequestList). If you are a long-time recipient of ACA’s Compliance Alerts, the List should come as no surprise. Below is an outline of the sections of the List:

General information about the adviser
Information regarding the adviser’s compliance program, risk management and internal controls

Compliance procedures and types of tests performed
Risk identification practices
Internal audit review schedules
Remote office/sub-adviser oversight
Client complaints
Non-compliance with code of ethics
Valuation
Information processing, reporting and protection

Information to facilitate OCIE’s testing of adviser’s trading activities

Trade blotter review
Information regarding advisory clients
Portfolio management issues
Brokerage issues
Conflicts of interests and/or insider trading

Information to facilitate OCIE’s testing for compliance in various areas

Performance advertising and/or marketing
Financial records
Custody
Anti-Money Laundering

While our review of the List revealed few controversial or ground-breaking requests, ACA notes the following:

Applicability to traditional money managers - the List is for an adviser that provides only traditional money management services to non-fund clients. If an adviser's business has other features, the information initially requested will include both the core set of information described above and additional information that will allow the OCIE examination staff to evaluate compliance activities for these additional activities and relationships (e.g., sponsoring a family of registered investment companies, sponsoring one or more privately offered funds, participating in PIPES offerings, participating in a separately managed account (wrap-fee) program, being also registered as a broker-dealer and being a manager of managers);
Expect additional document request lists - the List will likely be supplemented by numerous other document requests during a review, including documents that may or may not be required by the Advisers Act books and records rule; and
List may vary based on SEC office - ACA expects that the SEC’s regional offices will tailor the List to more adequately address its registrant population; therefore, do not expect the initial document request list that your firm receives to be identical to the List.

Extension of Compliance with Massachusetts Privacy Regulations

On November 14, 2008, the Massachusetts Office of Consumer Affairs and Business Regulation extended the deadline to May 1, 2009 for firms to:

implement written identity theft prevention programs;
ensure that third-party services providers are capable of protecting personal information and contractually binding them to do so (note that the deadline for requiring written certification from third-party providers has been extended to January 1, 2010); and
ensure the encryption of laptops and other portable devices.

ACA notes that the original compliance deadline was January 1, 2009. Refer to MassachusettsPrivacyExtension for the full text of the release.

Please do not hesitate to contact your ACA compliance consultant or ACA’s Washington DC office at (202) 955-5800 if you have any questions related to these issues.

State Privacy Rules and Part II of Form ADV

Now that the election-mania is finally over, we wanted to fill the void with some important regulatory updates.

Less than 60 days to Effective Date for Massachusetts Privacy Laws

We remind you that as of January 1, 2009, all persons that own, license, store or maintain “personal information” about a resident of Massachusetts will be required to develop, implement, maintain and monitor a comprehensive, written information security program applicable to any records containing such personal information. In addition, all persons who electronically store or transmit such information must include provisions for the establishment and maintenance of a security system covering its computers, including any wireless systems. It is important to note that the state of Massachusetts has provided specific minimum requirements for both the written information security program as well as the electronic security system covering its electronic records. For a complete listing of these requirements please refer to 201 CMR 17.00.

Finally, compliance professionals should be aware that other state regulatory authorities have amended and enhanced their privacy laws (e.g., Nevada) and that ACA expects more states to follow with similar amendments.

Part II of Form ADV Revisions

SEC Chairman Christopher Cox recently indicated in an October 27 letter to the Investment Adviser Association (IAA) that “The tentative schedule for consideration of final amendments to Form ADV, Part 2, is early December 2008”. The letter responded to the IAA’s request for the SEC to finalize the proposed amendments to the Part II of Form ADV that were released on March 3, 2008 (IA-2711). Chairman Cox noted in his letter that the SEC received approximately 80 comment letters on the proposed amendments. Given the December 2008 timeframe noted by Chairman Cox, ACA would expect mandatory compliance with the final amendments to be required not less than 6 months following the final rule release, or in mid-year 2009.

Revisions to Form D Filings

For those advisers that manage private funds, we remind you that we are currently in a phase-in period (that started September 15, 2008) during which electronic filings of Form D are voluntary, until March 16, 2009 when electronic filings of Form D become mandatory. A summary of the most notable changes to the Form D is as follows:

Filing of the Form D is required in the standard eXtensible Markup Language (XML) format that is currently being implemented for other electronic filings;
Requiring more specific information on the registration exemption claimed by the issuer in the Form D notice as well information on any exclusion claimed from the definition of “investment company” under the Investment Company Act of 1940;
Replacing the current requirement to disclose information on a wide variety of expenses and applications of proceeds with a requirement to report expenses only as to amounts paid for sales commissions and, separately stated, finders’ fees, and report use of proceeds only as to the amount of proceeds used to make payments to executive officers, directors and promoters; and
Permitting a limited amount of free writing in “clarification” fields to the extent necessary to clarify certain information provided.

Please do not hesitate to contact your ACA compliance consultant if you have any questions related to these issues.

Regulatory Focus On Securities Lending

The unprecedented market turmoil and credit crisis continues to have a significant impact on the financial services industry, including both traditional investment advisers and hedge funds managers. In particular, the securities lending industry is in a state of flux as several mutual fund groups and hedge funds have ended their lending program or stopped the issuance of new loans (See Securities-Lending Sector Feels Credit-Crisis Squeeze, Wall Street Journal, October 30, 2008).

Securities Lending Risks and Considerations

The risks associated with a firm's securities lending program appear to be on the rise due to issues such as: (1) cash collateral programs taking large losses on subprime investments, (2) the increased potential for counterparty default, and (3) recent regulations imposed on short selling which has reduced the supply of securities available for lending. Accordingly, we believe that it will become increasingly important for compliance professionals to consider the following with regard to a firm's securities lending program:

Re-evaluating counterparty risk on a more frequent basis. Many firms review the creditworthiness of their counterparties on an annual or semi-annual basis. In today's market, that may not be frequent enough. Counterparty exposure should be measured at various levels: out on loan, collateral reinvestment, the portfolio's direct investments particularly in derivative or complex instruments and non-DVP transactions. An adviser should review its firm's exposure to a particular counterparty on an aggregate basis in addition to any such reviews that may be conducted by a firm on a portfolio by portfolio (or client by client) basis.
Periodic reviews of portfolio holdings in cash collateral vehicles. A firm's senior executives and investment personnel should be asking themselves tougher questions regarding its securities lending program's invested collateral. How are current market conditions impacting the risk/return profile of invested collateral? Are there any credit issues related to recent downgrades? What valuation issues, if any, are arising with respect to the invested collateral? Recent industry news indicates increased concern with "breaking the buck," and restrictions being implemented on investor redemptions. Staying current with potential issues in the portfolio and self-evaluation of the holdings in the cash collateral vehicle may provide lead time in remedying a potential situation.
Increased monitoring of sell fails. As the rate of default by borrowers increases, advisers need to be wary of potential sell fails. They must stay diligent in ensuring that the lending agent or prime broker/custodian monitors the borrower to return the securities. Advisers, particularly those providing investment advice to registered mutual funds, should be monitoring the amount of time that its securities are out on loan. In general, the probability of a sell fail is correlated to the length of time that a security has been out on loan (securities out on loan for longer periods of time are more likely to be susceptible to sell fails). A compliance officer should review and evaluate a firm's sell fails for potential trends, such as whether a single borrower has continuously failed to deliver. This may lead to discussions with the lending agent in excluding said broker from borrowing in the future.
Evaluation of loan limits. Advisers, and particularly mutual funds, should evaluate their current lending limitation on a security. Decreasing the percentage of how much can be loaned to any one borrower, or on a security by security basis, could alleviate the counterparty and sell fail risks while allowing the firm to continue to effect an active lending program.
Improving disclosure to investors. Fund Boards and advisers may consider disclosing risks associated with participating in securities lending programs such as the potential for delays in the recovery of loaned securities and the impact on the portfolio should the borrower default. Another disclosure may address restrictions on the redemptions of assets, and the possibility of providing redemptions in-kind, both of which may have an impact on the adviser's ability to manage the account in accordance with the fund's investment objectives.

Short Selling Filing Requirements, Prohibitions and Frequently Asked Questions

On September 19, 2008, the SEC issued two emergency orders that directly affect institutional investment managers that engage in short selling activities.

Prohibition on Short Selling Financial Stocks

The SEC issued an emergency order pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 that prohibits the short selling of roughly 800 financial stocks set forth in Appendix A of the emergency order at http://www.sec.gov/rules/other/2008/34-58592.pdf.

Mandatory Filing of Short Selling Activity on Form SH

The SEC issued an emergency order pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 that requires all institutional investment managers that are currently required to file Form 13F as of June 30, 2008 to file new Form SH with the SEC on the first business day of every calendar week immediately following a week in which the manager effected short sales. Form SH must be filed electronically on the EDGAR system and the filing will become publicly available once submitted. ACA notes that the Form SH is similar in format to the Form 13F and includes the following 8 data fields:

Name of issuer
CUSIP
Short Position (Start of Day)
Number of Securities Sold Short (Day)
Value of Securities Sold Short (Day)
Short Position (End of Day)
Largest Intra-Day Short Position
Time of Day of Largest Intra-Day Short Position

The preceding data must report a manager’s short selling activities each day, and similar to Form 13F, in order to prevent duplicative reporting, managers must indicate whether they are reporting for other managers on the Form SH (i.e., by virtue of filing a “notice”, “entries” or “combination” report).

ACA further notes that managers will not be required to report short positions if:

The short position constitutes less than .25% of the class of the issuer’s issued and outstanding securities; and
The fair market value of the short position is less than $1,000,000.

No filing will be required when no short sales of a section 13(f) security have been effected since the previous filing of a Form SH, and the filing requirement only applies to short sales effected on or after September 22, 2008. The first Form SH must be filed on September 29, 2008 (based on the manager’s short selling activities during the week of September 22, 2008) and will be the only required Form SH filing unless the SEC extends the emergency order beyond the current October 2, 2008 termination date.

If you would like assistance with the completion and submission of Form SH, please contact your ACA consultant or 13F/13G filings contact for additional information and refer to http://www.sec.gov/rules/other/2008/34-58591.pdf for a copy of the emergency order. Additionally, a copy of the Form SH is available at http://www.sec.gov/about/forms/formsh.pdf and the instructions to the Form SH are available at http://www.sec.gov/about/forms/formsh_instructions.pdf.

Frequently Asked Questions on Short Selling and Form SH

Below are a few of the more frequently asked questions, and our responses to those questions, that we have been fielding from clients this morning. Additionally, the SEC is said to be working on a Form SH FAQ that will likely be released in the upcoming days.

Does the prohibition on shorting financial stocks require us to unwind pre-existing short positions in the financial stocks listed in Appendix A of the SEC’s Order?

No. A manager is not required to unwind pre-existing short positions on the financial stocks listed in Appendix A of the SEC’s Order.
What if a manger holds a short position now and through a reporting period (e.g., 9/22 thru 9/28) but has no activity in this investment (i.e., does not add to it or cover any), then is there a reporting obligation on Form SH?

No. As noted in the instructions to Form SH, the Short Position (Start of Day) for Monday, September 22, 2008 shall be zero. Only short positions put-on, or added-to on or after September 22, 2008 require reporting on Form SH for the September 22, 2008 through September 28, 2008 reporting period.
If we buy to cover a short position that was entered into prior to September 22, 2008 does that require reporting?

No. The reporting of short positions begins on Monday, September 22, 2008. No pre-existing short-positions entered into prior to September 22, 2008 are required to be reported on Form SH.
Should a manager report swap positions on Form SH if the swaps provide them with a synthetic short against a company?

No. Swap positions are not 13F securities.
Can a manager buy ETFs (e.g., SKF) that are short the financial sector? If so, are these also reportable?

Yes. A manager can go short the financial sector via ETF to the extent that option is available (See http://biz.yahoo.com/bw/080919/20080919005500.html?.v=1 for announcement from ProShares on the suspension of subscriptions to SEF and SKF until further notice).

It should be noted that certain ETFs are reportable on Form 13F. Thus, for example, a manager’s acquisition of an ETF such as SEF or SKF would not be reportable on Form SH; however, they would still be reportable on the manager’s next Form 13F filing to the extent such investment was still held at the end of the 13(f) reporting period.
Since the SEC does not require registered investment advisers to time stamp its order tickets, what happens if a manager is unable to report the time of day for its “largest intra-day short position” (Column 8 on Form SH)?

The emergency order does not provide for any exception related to the completion of Column 8; therefore, investment advisers should be prepared to track this information for reporting in Column 8.
If my firm manage less than $100 million in 13(f) securities, but we happen to have billions of dollars in short positions, are we required to file Form SH?

No. The instructions to Form SH state that “…every Manager that exercises investment discretion with respect to accounts holding section 13(f) securities…who has filed or was required to file a Form 13F for the calendar quarter ended June 30, 2008, must file a report on Form SH with the Commission to report certain information about short sales and short positions” [Emphasis Added]
If we are not required to file Form 13F in 2008 because we did not go over the 13(f) threshold during any quarter in 2007, yet we now manage more than $100 million in 13(f) securities, are we required to file Form SH?

No. As noted in the instructions to Form SH, you are only required to report short positions and transactions if you have filed or were required to file a Form 13F for the calendar quarter ended June 30th 2008.
Can we buy puts on the underlying stocks noted in the Order and, if so, would those positions and transactions be reportable?

The order does not prohibit the purchase of puts on the underlying stocks noted in Appendix A of the order prohibiting the short selling of financial stocks. Neither the purchase of the puts nor the writing of options are required to be reported on Form SH.
Is the SEC likely to continue requiring the filing of Form SH beyond October 2, 2008?

The wording of the order, the Form SH and the instructions to the Form SH certainly makes continued filings an option; however, ACA is uncertain as to the SEC’s desire to collect such information in periods of relative calm in the financial markets.

We will continue to closely monitor these and other developments that may occur as a result of this extraordinary time in the financial markets. Please do not hesitate to contact your ACA compliance consultant if you have any questions related to these issues.

SEC's New and Proposed Short Selling Initiatives

SEC’s New Short Selling Rules

As many of you are aware, the SEC’s new emergency short selling rules went into effect today in response to regulatory concerns about possible market manipulation “based on unfounded rumors regarding the stability of financial institutions and other issuers.” It is believed that the extreme volatility in the market is being exacerbated, at least in part, by “naked” short sellers and that without this action securities may continue to experience “sudden and excessive” price fluctuations that could threaten fair and orderly markets. Among other things, the new rules include a “naked” short selling antifraud rule and enhanced delivery requirements on sales of all equity securities. Please visit http://www.sec.gov/rules/other/2008/34-58572.pdf to read a copy of the SEC’s new rules on short selling.

Proposed Rule for Disclosure of Adviser and Hedge Fund Managers Short Positions

In addition to the adoption of the new short selling rules, today Chairman Cox intends to ask the SEC Commission to consider the adoption of another emergency rule that will require hedge funds and other large institutional investors to “begin public reporting of their daily short positions.” The specific requirements of this new short position disclosure rule are unclear at this time. For example, it is not known whether managers would be required to file these reports directly with the SEC staff, over the SEC’s EDGAR database or via some other reporting mechanism. For a copy of the SEC’s press release on this topic, please visit http://www.sec.gov/news/press/2008/2008-209.htm.

We will certainly monitor these developments closely and provide you with an updated note once more is known. Please do not hesitate to contact your ACA compliance consultant if you have any questions related to these issues.

OCIE and Other Regulators Sent Into Action to Review Rumors

As a result of recent cases and allegations relating to the misuse of rumors, on July 13, 2008 the SEC announced the commencement of a “Rumor Sweep” to be conducted by its Office of Compliance Inspections and Examinations (“OCIE”) and other regulators (http://www.sec.gov/news/press/2008/2008-140.htm), and aimed at preventing the intentional spread of false information intended to manipulate securities prices. ACA has observed the following requests for documents submitted to advisers by OCIE related to rumors:

Policies and procedures related to rumors;
Training of advisory staff on the handling of rumors;
Policies and procedures related to electronic communications;
Tests implemented by advisers to ensure that its procedures are effective as they relate to rumors; and
The occurrence of violations of the adviser’s code of ethics as they relate to rumors.

Notwithstanding the results of the “Rumor Sweep,” ACA expects OCIE to incorporate a review of rumors into its routine examinations of investment advisers. However, given the widely-publicized nature of the events leading-up to the Rumor Sweep, the SEC’s articulation of the impact of those events on the financial system and the fact that the Rumor Sweep involves multiple regulators, ACA expects that coordinated formal guidance may be proposed in this area by the SEC, FINRA and the NYSE. It is also possible that the SEC’s Enforcement Division could bring additional enforcement actions against investment advisers and broker/dealers based on the findings that are collected in the Rumor Sweep.

SEC Subpoenas Related to Trading in Specific Investments

The SEC has reportedly issued over 50 subpoenas to investment management firms as a result of allegations and suspicions surrounding trading in the stock and derivatives of two financial services firms. The SEC has requested the following documents related to trading in the securities of the two companies:

Position and trading records related to the adviser’s position in stock and derivatives of the issuers;
The identification of advisory personnel that are responsible for directing the transactions in the issuers;
Relationships that the adviser maintains with the issuers, including prime brokerage, swap counterparty, etc. and a summary of the size and scope of the relationships;
Changes in the relationships that the adviser maintained with the issuers, including withdrawals, cancellations, novations, etc.; and
All documents and communications, including emails, instant messages, etc., related to a timeline of events regarding the issuers.

In the event that your firm receives the subpoena, ACA advises you to consider forwarding the list to Legal and Compliance personnel and to contact outside counsel.

SEC Protects against Naked Short Selling Certain Financial Services Firms

On July 15, 2008, the SEC issued an emergency order (available on the SEC website at http://www.sec.gov/rules/other/2008/34-58166.pdf and http://www.sec.gov/rules/other/2008/34-58166.pdf) intended to enhance investor protections against “naked“ short selling in the securities of Fannie Mae, Freddie Mac, and primary dealers at commercial and investment banks.

The SEC concluded that requiring all persons to borrow or arrange to borrow the securities of 19 firms prior to effecting a short sale of those securities is in the “public interest and for the protection of investors to maintain fair and orderly securities markets, and to prevent substantial disruption in the securities markets” and that the emergency requirement will “eliminate any possibility that naked short selling may contribute to the disruption of markets in these securities”.

The order takes effect at 12:01 a.m. on Monday, July 21 and terminates at 11:59 p.m. on Tuesday, July 29, 2008; although the Commission has the ability to extend the emergency order for a period of no more than 30 calendar days in total duration. ACA recommends that a firm intent on shorting a security on the SEC’s list consider obtaining guidance from outside counsel and the firm’s counterparties on to go about complying with the SEC’s emergency order.

SEC Interpretive Letter Regarding the Application of the Cash Solicitation Rule to Managers of Private Funds

On July 15, 2008, the Office of Chief Counsel of the SEC’s Division of Investment Management issued an interpretive letter to Mayer Brown LLP which clarifies that Rule 206(4)-3 under the Investment Advisers Act of 1940, otherwise known as the “cash solicitation rule,” generally does not apply to an adviser that compensates individuals/entities for soliciting investors in privately managed investment pools managed by the adviser. Through the interpretive letter, the SEC has waived substantially all of the requirements of the solicitation rule, including maintaining a written agreement with the solicitor, maintaining a separate written solicitor disclosure document, requiring solicited investors to acknowledge their receipt of various documents, etc.

Notwithstanding, while the SEC’s interpretive letter does not comment on the nature or detail of disclosure, if any, that may be necessary to describe the referral arrangement, ACA recommends that advisers to privately managed investment pools include certain disclosures regarding such arrangements in Schedule F of Part II of Form ADV in response to Item 13B. Specifically, an adviser may consider including disclosure regarding the existence of all referral arrangements, the summary terms of the compensation paid to the referring party, whether the investor is paying greater fees as a result of the referral arrangement and any other material conflict of interest presented by the referral arrangement.

Supplemental Initial Document Request List

As noted in ACA’s most recent Compliance Alert dated July 6, 2008, OCIE appears to be nearing its goal of implementing a significantly revised standard document request list (“Standard List”) for nationwide use during routine examinations of registered investment advisers. Further review of a sample of Standard Lists indicates that the Standard List also includes Supplemental Initial Request Items (“Supplemental List”) which appear to be included as a supplement to the Standard List based on the types of clients managed by the adviser. For example, the Supplemental List contains targeted document requests specific to advisers that manage registered investment companies, privately offered funds or who serve as a manager-of-managers. Examples of the Standard List and Supplemental List can be viewed at (http://www.acacompliancegroup.com/documents/SECDocumentRequestList-061608.pdf and http://www.acacompliancegroup.com/documents/SupplementalInitialDocumentRequests7-08.pdf).

Has the New Nationwide SEC Document Request List Arrived?

As widely reported, the SEC’s Office of Compliance Inspections and Examinations (OCIE), appears to be nearing its goal of implementing a significantly revised standard document request list for nationwide use during routine examinations of registered investment advisers. The latest document request list, which can be viewed at http://www.acacompliancegroup.com/documents/SECDocumentRequestList-061608.pdf, may be the most representative version of a nationwide list that we have seen and seems to materially differ from the preceding version in the following manner:

The existence of an expanded cover letter – The cover letter describes: 1. OCIE’s expectation as to the format and timing in which document requests should be provided to the examination team; 2. the on-site portion of OCIE’s examination, including the provision of office space for the examination team, as well as OCIE’s desire to interview various advisory personnel; and 3. the rationale for certain document requests and the general information that the examination team learns from various types of documents.
The modification of the section entitled “Information Regarding the Adviser’s Compliance Program, Risk Management and Internal Controls” – A similar section from the previous document request list asked for an adviser to provide documentation to substantiate the effectiveness of its compliance policies and procedures in eleven different areas, such as portfolio management, trade allocation, and advertising. These requests have been replaced by more general requests for information about an adviser’s compliance policies and procedures, periodic testing and reviews, and risk mapping processes.
Omission of requests for records that may not be required – The new document request list includes fewer requests for documents that are arguably not required records under the Advisers Act books and records rule. For example, the new document request list does not ask for lists of cross trades or trading errors, nor for specific information about an adviser’s anti-money laundering program.
Omission of “secondary requests” – The new document request list does not include a “secondary requests” section that was included on previous document request lists. Secondary requests were typically viewed as documents that should be “readily available upon SEC request”, even though the documents were not initially being requested. However, a “supplemental initial request for items” section exists in the new document request list and includes document requests that should be relevant to the specific type of adviser being examined (e.g., hedge fund managers, CDO managers, etc.).

ACA is expecting that the latest document request list will be rolled-out on a nationwide basis with substantially similar content to the version on the ACA website (which came from the New York Regional Office). While the shortened list should be a welcome change for investment advisers, ACA cautions that the initial document request list is often supplemented with extensive additional document requests during the course of a typical OCIE examination. Additionally, OCIE continues to signal its belief that all records developed by an investment adviser, whether required or not under the Advisers Act books and records rule, are subject to review during an examination.

Please do not hesitate to contact your ACA compliance consultant if you have any questions pertaining to how the new document request list may impact the current practices at your firm.

SEC “Springing” Into Action on Several Fronts

A. Continued Focus on Gifts

On March 5, 2008, the SEC announced an Administrative Proceeding against Fidelity Management and Research Company and FMR Co., Inc. (together, “Fidelity”) regarding the improper acceptance by traders and executives of more than $1.6 million in travel, entertainment, and other gifts paid for by outside brokers seeking to receive “order flow” from the mutual funds managed by Fidelity.

Although many investment management firms have made significant enhancements to their gift and entertainment policies, procedures and compliance testing program over the last several years, we do note the following regarding the case:

This case gives clear rationale for the SEC’s concern regarding the negative influences that the receipt of gifts and entertainment can create for investment advisers; therefore, despite the fact that an investment adviser is not formally required under the Investment Advisers Act of 1940 (“Advisers Act”) to monitor employees’ receipt of gifts and entertainment, the case makes the argument for an adviser to implement a “Gifts and Entertainment” policy and procedures that require, among other things, the reporting of employees’ receipt of gifts and entertainment. The SEC noted this issue as a “failure to supervise” claim under the Investment Company Act of 1940 and the Advisers Act.
Investment advisers must consider reviewing employees’ receipt of gifts and entertainment as part of its overall analysis to determine whether it is adequately seeking to obtain best execution on its clients’ transactions.
Investment advisers must review the relationships that employees have with sell-side brokers, including romantic and familial relationships and effectively address such conflicts by disclosing their existence or mitigating them in whole or in part.
Electronic correspondence, specifically Bloomberg emails, was once again utilized by the SEC to support its finding in this case. Investment advisers should consider developing an “Electronic Communications” policy and procedures and periodically test the effectiveness of the procedures. In addition, and most importantly, compliance officers should implement a thoughtful email and instant messaging search program with regard to higher risk compliance areas.

Please refer to http://www.sec.gov/litigation/admin/2008/ia-2713.pdf for a copy of the Administrative Proceeding.

B. Update to Part II of Form ADV

On March 3, 2008 the SEC posted IA Release No. 2711, which is the highly-anticipated proposed revision to Part II of Form ADV. ACA believes that the most noteworthy proposed changes to Part II of Form ADV are the following:

The current Part II of Form ADV will become Part 2A, which is the “Firm Brochure,” and Part 2B, which is the “Brochure Supplement.”
Part 2A will be a written description of an adviser’s services, fees, business practices, and conflicts of interest, addressing 19 separate items in a “Plain English” format. The information in proposed Part 2A is similar to the information that is currently made available in Part II of Form ADV and Schedule F.
Part 2B consists of supplements that disclose pertinent information about all of a firm’s employees that provide investment advice. Each such employee would have a supplement consisting of the following six items: (1) a cover page that includes background on the individual and the adviser, (2) educational background and business experience, (3) disciplinary history, (4) other business activities engaged in by the individual, (5) additional compensation received by the individual, and (6) how the individual is supervised.
Both Parts 2A and 2B will be filed electronically with the SEC through the IARD system in PDF or an alternate approved format.
Part 2A will be required to be delivered (not offered) to clients on an annual basis no later than 120 days after the end of the adviser’s fiscal year. However, changes in the disciplinary history of the adviser would require an interim delivery of Part 2A.
Part 2B supplements will be required to be delivered as follows: (1) the supplements of individuals providing investment advice must be furnished initially; and (2) thereafter, the supplements only need to be furnished pursuant to changes in the individual’s disciplinary history.
An annual update of Part 2A must be filed on the IARD system.

Please refer to http://www.sec.gov/rules/proposed/2008/ia-2711.pdf for a copy of the proposed amendments to Part II of Form ADV. The comment period for the amended Part II and relevant rules extends through May 16, 2008.

C. Regulation S-P Amendments on the Way

On March 4, 2008 the SEC proposed amendments to Regulation S-P in IA Release No. 2712 in light of the increase in information security breaches. Of particular note is the following:

Overall strengthening of the information security program, including: (1) designating an employee to administer the program, (2) documenting the risks that are to be addressed in the program, (3) designing and implementing written safeguards to guard against the risks, (4) regularly testing the safeguards, (5) training employees about the program, (6) ensuring that service providers have reasonable protections in place, and (7) revising the program as necessary.
Development of procedures for responding to incidents of unauthorized access to or use of personal information, including: (1) assessing the extent of the incident, (2) taking steps to prevent additional unauthorized access or use of personal information, (3) conducting an investigation to determine the likelihood that the information will be misused, and (4) notifying affected clients if the adviser determines that misuse of the information has occurred or is likely to occur (proposed guidance exists on the form of the notification).
An expansion of the scope of information covered by the safeguards and disposal rules.
A proposed exception from Regulation S-P’s notice and opt-out requirements to allow investors to more easily follow a representative who moves from one brokerage or advisory firm to another.

Please refer to http://www.sec.gov/rules/proposed/2008/34-57427.pdf for a copy of the proposed amendments to Regulation S-P. The comment period for the proposed amendments to Regulation S-P extends to the middle of May 2008.

D. SEC’s 2008 CCOutreach Regional Seminars

Finally, we encourage all of you to consider registering for one of the local CCOutreach Seminars that the SEC will be hosting in throughout the spring of 2008. These events afford you the opportunity to hear directly from your regulator about their main priorities and concerns. In addition, these events have also proven to be a great way to network and meet other compliance professionals in your area. A full listing of the SEC’s regional events can be found by clicking on: http://www.sec.gov/info/cco/ccorscal2008.htm.

Please do not hesitate to contact your ACA compliance consultant if you have any questions pertaining to how these issues may impact the current practices at your firm.

New Comprehensive SEC Document Request List

The Staff (“Staff”) of the SEC’s New York Regional Office (“NYRO”) has recently begun utilizing a new document request list that appears to have expanded the number of documents that the Staff desires to review at the onset of its examinations. While the new document request list includes many familiar document requests, ACA has observed the following issues related to the new document request list:

Each broad category of documents requested, such as Portfolio Management/Trading documents and Disclosure documents, includes a request to provide exception reports and other documents that demonstrate how the adviser’s policies and procedures work “in practice”. The list indicates that a failure by an adviser to provide such documents could be interpreted by the SEC as a sign of “weak or ineffective risk management and control processes”.
Each broad category of documents requested includes a request to identify the individuals responsible for developing and maintaining the policies and procedures and the individuals responsible for ensuring compliance with the policies and procedures.
The new document request list continues to request documents in a format that appears to accommodate the Staff’s review, but may be difficult for your firm to assemble. In the event that your firm does not maintain the documents in the format requested by the Staff, you are encouraged to review the document request with the Staff prior to dedicating a large amount of resources to develop a document in the requested format. We expect a reasonable amount of latitude in this area given the fact that the Investment Advisers Act of 1940 does not include a requirement to maintain documents in a specified format.
The document request list is comprehensive and the initial requests in each broad category of documents are very detailed. The breadth and depth of the initial document requests may signal a departure from the risk-based approach that the Staff had reportedly adopted.

The expanded document requests, coupled with our observed increase in the number of interviews conducted by the Staff during examinations, will likely increase the burden an SEC examination places on your firm. To receive the new document request list visit ACA’s website at www.acacompliancegroup.com/news/ or click on www.acacompliancegroup.com/news/documents/SEC_NYRO_Request_List-Aug2007.pdf

New York Regional Office Examination Staff Interviews on the Rise

The SEC’s New York Regional Office (“NYRO” or “Staff”) has recently been conducting a larger number of interviews with registered investment adviser staff during routine SEC inspections. The interviews, which tend to last between 30 and 60 minutes, are being requested with portfolio managers, traders, analysts, executive officers (e.g., CFO, CCO) and information technology professionals.

If your firm is located in the SEC’s New York Region (i.e., New Jersey and New York), we believe it would be prudent to review the following questions and areas of focus:

Potential conflicts of interest.
- Relationships with non-employees that work in the same office space as the registered adviser (e.g., unaffiliated research analysts) are being scrutinized from a privacy standpoint to evaluate whether such individuals have access to the investment adviser’s non-public trading information.
- Relationships with “value-added” investors are also being analyzed. “Value-added” investors can include sell side brokers, investment banking research analysts, other brokerage employees, other hedge funds, employees of unaffiliated investment advisers to hedge funds, senior executives of public companies, and paid consultants.
- Trading on behalf of clients that provide client or investor referrals are being reviewed for any form of preferential treatment, such as reduced fees.
- Any business relationships with persons that also have personal relationships with investment adviser employees are being reviewed. For example, the Staff will ask a firm’s traders whether they execute client transactions or otherwise maintain any business relationship with anyone to whom they are related (e.g., parent, sibling, in-law, etc.). Investment advisers can expect to be asked about internal anti-nepotism policies, if any, as well.
Sharing office space. NYRO is inquiring about any lease- or office-sharing arrangements with other investment advisers. The focus appears to be on internal procedures to restrict the flow of material non-public information, thus offices of multiple investment advisers in close proximity may also receive scrutiny. In addition, if the costs associated with such office space are passed through to any of an adviser’s clients (e.g., private investment fund), then you should be prepared to address how such costs are allocated between the fund and any outside third-parties with whom you are sharing space.
Restriction of material non-public information. With respect to restricted trading lists, relevant personnel (e.g., traders, portfolio managers) are being asked about internal procedures detailing how a security is added to, or removed from, the list.
Sourcing ideas. NYRO is asking investment personnel about how investment ideas are generated (e.g., conferences sponsored by broker-dealers, other investment advisers, idea dinners) and potentially cross-referencing responses with the relevant personnel’s personal trading activities.
Investment guidelines in marketing materials. If your firm advertises broad and general investment guidelines in its marketing materials (e.g., no more than 5% of a client’s capital in any one issuer or no more than 15% of a client’s capital in a particular sector), then the SEC may ask about how your firm is monitoring its compliance relative to such guidelines regardless of any disclosure in the investment management agreement or other client governing documents.
PIPE transactions. Confidentiality agreements executed prior to information exchange about upcoming PIPE deals are being evaluated. The SEC’s examination staff wants information on both PIPES that your firm invested in and also those that were offered to the firm but that the adviser ultimately decided to pass upon.

These more detailed questions may be supplemented with additional document requests that would enable NYRO staff to conduct further analysis of the issues.

Please do not hesitate to contact your ACA compliance consultant or ACA’s Washington, DC office at (202) 955-5800 if you have any questions about how this relates to your firm’s practices.

SEC Staff Cautions Firms to Beware of Imposters

Late last week, the SEC staff posted an alert to its website warning firms to be cautious of individuals impersonating SEC staff. According to the alert, individuals have contacted firms by telephone, identified themselves as members of the SEC staff, and demanded immediate access to confidential records. In some cases, they claimed to be conducting an “emergency” examination. In others, they claimed to be gathering information on behalf of some well-known SEC official.

If you or anyone at your firm is contacted by someone claiming to be from the SEC, you should immediately take steps to confirm the individual’s identity before divulging any confidential information. Specifically, ask for the individual’s name, office, and telephone number. SEC phone numbers for each office are posted on the SEC’s website at: http://www.sec.gov/contact/addresses.htm. According to the alert, firms should “call the main number of the particular office that the caller identified, and ask to speak to the SEC staff person.” You can always call an ACA consultant as well in order to confirm the identity of an SEC examiner.
If you are contacted by anyone claiming to work for the SEC and you are unable to verify the individual’s identity, you should immediately report the incident to the SEC’s Examination Hotline at (202) 551-EXAM, or to the SEC’s Inspector General at (202) 551-6060.
To read the full alert, go to: http://www.sec.gov/about/offices/ocie/imposteralert.htm

Soft Dollar Reminder

On July 18, 2006 the SEC issued its revised interpretation of the scope of “brokerage and research services” under Section 28(e) of the Securities Exchange Act of 1934 (the “Release”).

Refer to http://www.sec.gov/rules/interp/2006/34-54165.pdf for a copy of the Release.

The Release permits market participants to rely on the SEC’s prior interpretations of Section 28(e) until January 24, 2007. As that date is fast approaching, advisers are reminded to review their soft dollar products and services in light of the revised interpretation and take appropriate action prior to January 24, 2007.

SEC Announces Proposals Impacting Hedge Funds

On December 13th at the SEC’s Open Meeting, the Commission voted to propose several new rules aimed at protecting hedge fund investors. The proposals will be available shortly on the SEC’s web site at www.sec.gov.

Anti-Fraud Rule Proposal

This proposal would make it fraudulent for an investment adviser to mislead or defraud investors or prospective investors in pooled investment vehicles. The rule would apply to any adviser managing a pooled investment vehicle that relies on the Section 3(c)(1) or 3(c)(7) exclusions of the Investment Company Act.

The new anti-fraud rule proposal is among those that Chairman Cox predicted would replace recently vacated rule 203(b)(3)-2. Rule 203(b)(3)-2, also known as the Hedge Fund Rule, required certain previously exempt hedge fund advisers to register with the SEC. Although the rule was vacated, most hedge fund managers have chosen to remain registered.

Proposed Changes to Accredited Investor Definition

A second proposal changes the accredited investor standard, making it more difficult for individuals to invest in private investment vehicles. Under the proposal, natural persons would not only have to meet the normal net worth/income requirement for an accredited investor, but would also have to own at least $2.5 million in investments. Since this rule applies only to natural persons, institutional investors would not be affected.

Associate Regional Director in the SEC’s Northeast Regional Office Discusses Exam Program Changes

Thomas Biolsi, Associate Regional Director of the SEC’s Northeast Regional Office (“NERO”), spoke this week at the NYC Compliance Officer Winter Roundtable co-sponsored by Sidley Austin LLP and Adviser Compliance Associates, LLC. Mr. Biolsi discussed the following changes to NERO’s examination protocol:

Firms will receive two weeks notice of an examination and will be expected to produce all initially requested documents no later than the end of the first week of the exam. Firms that fail to meet the deadline will be required to explain the reason(s) for the delay to SEC senior management.
Examiners will conduct bi-weekly internal training sessions to ensure the consistency of their approach and that a minimum level of review is occurring on all examinations. Biolsi stressed that NERO examiners will be conducting more interviews of advisory personnel while on-site and that senior examiners in NERO’s investment adviser and investment company (mutual fund) branches are now involved in a cross training program.
Examiners will be particularly alert to abuses arising from conflicts of interest, inside information, and questionable brokerage activity. Activities that may receive increased scrutiny from NERO’s examiners include: (1) executing trades through brokers who also invest in a firm’s hedge fund, (2) directing brokerage to firms that provide client and/or investor referrals, and (3) obtaining investment ideas from investors and employees who have access to inside information about other companies.
The Staff is very interested in the results and documentation of advisers’ annual reviews. Biolsi indicated that examiners want to see the results of the annual review and how the firm or the CCO arrived at the results. More specifically, he stressed that examiners will want to get a sense of (1) what was tested, (2) who was interviewed and (3) what was the outcome. They expect senior executives in various business units to be involved in the conflict assessment and annual review process. Additionally, Biolsi appears to believe very strongly that CCO’s and compliance professionals need to have a clear action plan on how to resolve problems or issues that are identified during the annual review process.

SEC Increases Scrutiny

Recent reports from the U.S. Securities and Exchange Commission (“SEC”) indicate that insider trading cases are on the rise and that hedge funds may be under increased scrutiny. Hedge funds have historically been known to receive inside information regarding equity markets, but are becoming increasingly entrenched in the loan markets, which are rife with confidential information. Hedge funds’ access to deal information is growing, and regulators seem to be watching.

How Compliance Officers Can Look for Improper Sharing of Inside Information

Compliance officers may utilize the following review points to detect improper sharing of inside information:

Attend meetings during which inside information may be shared;
Educate personnel on penalties associated with insider trading and firm policies;
Review email correspondence, minutes from portfolio management meetings, confidentiality agreements, proxies for notice of buy-outs, travel records for evidence of proxy vote takeover and other significant company events, and profitable short-term trading activities around company news;
Require prior approval of confidentiality agreements by the Chief Compliance Officer; and
Investigate vehicles receiving buy-out targeted stocks.

AIMA Issues Guidance on Side Letter Disclosures

On September 27th, the Alternative Investment Management Association (“AIMA”), a United Kingdom trade association, issued guidance regarding side letter disclosure standards to assist firms in complying with UK Financial Services Authority (“FSA”) requirements. While the AIMA Guidance Note is not binding, the FSA is expected to take the guidance into account when exercising its regulatory functions.

Why is this Important to a US Hedge Fund Manager?

The guidance is directed toward FSA-regulated advisers and their affiliates. However, US fund managers with affiliates or branch offices in the UK may need to add disclosure regarding side letters. Additionally, the AIMA Guidance Note may also influence the position of the U.S. Securities Exchange Commission (“SEC”) on the issue of side letter disclosure, as evidenced by the SEC’s recent focus in this area.

What Should be Disclosed?

Per the AIMA Guidance Note, investment advisers should disclose the existence of side letters that contain “material terms” and the nature of any such terms. A “material term,” as defined in the AIMA Guidance Note, includes any term that is reasonably expected to put other shareholders at a material disadvantage. Examples include: (1) grants of preferential redemption rights (including shorter notice periods), (2) providing redemption gate waivers, (3) giving certain shareholders portfolio transparency rights, (4) “key man” provisions and (5) percentage of investor holdings where grants are to investors owning over 10% of the fund.

Advisers do not need to disclose the following: (1) the existence of fee rebates, (2) “most favored nation” clauses, (3) the number of side letters entered into by the hedge fund, (4) the dates in which a side letter agreement was entered, or (5) the identities of the parties to any side letters.

ACA encourages all hedge fund managers to review their side letter arrangements in light of the issues raised in the AIMA Guidance Note, which is promoting full compliance by October 31, 2006. For additional information refer to: www.aima.org/uploads/IndustryGuidanceNoteSideLettersPublic.pdf.