Registration and Compliance for “Exempt Reporting Advisers”

About the Authors:

Gary J. Ross is the founder and managing attorney of Jackson Ross PLLC, a corporate and securities law boutique that specializes in the representation of venture capital and private equity funds.

Kevin McNiff is an associate at Jackson Ross PLLC, where he focuses his practice in the areas of venture capital fund formation and emerging-growth fintech companies.

Over six years have passed since the creation of a class of investment advisers exempt from registered investment adviser requirements, or “exempt reporting advisers,” under the Dodd-Frank Act. In that time the U.S. Securities and Exchange Commission (SEC) has enhanced its examination and investigations of private investment funds and their investment advisers. For example, in the first half of 2016, a number of SEC cases focused on lack of adequate cybersecurity, investment advisers’ failure to disclose fees, misuse of investor funds, and the failure of fund administrators to appropriately respond to red flags. On May 12, 2016, Andrew Ceresney, the director of the SEC’s Division of Enforcement, stated that securities regulators should focus on private equity enforcement due to the “unique characteristics” of private equity funds, including restrictions on the ability of fund investors to withdraw their investments.

“Exempt reporting advisers” in particular are a topic of interest among the SEC’s Enforcement Division due to their growing popularity among the investment adviser community. In a 2011 release implementing the Dodd-Frank Act’s new rules for exempt reporting advisers, the SEC indicated that they would not be subject to routine SEC examinations, a position that corroborated a previous statement made by former SEC Chairman Mary Schapiro. However, on November 20, 2015, Marc Wyatt, the director of the SEC’s Office of Compliance, Inspections, and Examinations (OCIE), announced that OCIE would in fact begin examining exempt reporting advisers as part of its routine examination program.

Given the likely prospect of heightened scrutiny, current and aspiring exempt reporting advisers should be aware of applicable filing and compliance requirements and best practices to better serve their customers and avoid falling afoul of federal and state regulations.

What Is an Exempt Reporting Adviser?

Investment advisers must register with either federal or state securities authorities, depending on the amount of assets under management. “Small advisers” (with under $25 million in assets) may register only with state securities authorities. “Large advisers” (with over $110 million in assets) and certain “mid-sized advisers” (with $25 to $110 million in assets) must register with the SEC unless they fall under the “Private Fund Adviser Exemption” or “Venture Capital Adviser Exemption” to registration, each of which were created by amendments enacted under the Dodd-Frank Act to the Investment Advisers Act of 1940 (the Advisers Act).

The Private Fund Adviser Exemption is available to advisers based in the United States that solely manage private funds and have less than $150 million in assets under management. A “private fund” is an issuer of securities that would be an “investment company” but for the exceptions in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (the Investment Company Act)—that is, an investment fund limited to 99 accredited investors or exclusively qualified purchasers, respectively. The Venture Capital Adviser Exemption is available to investment advisers that solely advise venture capital funds. A “venture capital fund,” as defined in the Advisers Act, is a private fund that: (i) invests no more than 20 percent of its total capital in assets other than qualifying investments (meaning equity securities issued by a nonreporting or foreign-traded portfolio company that are directly acquired by the venture capital fund) and short-term holdings (i.e., cash and cash equivalents, U.S. Treasuries with remaining maturities of 60 days or less, and shares of registered money-market funds); (ii) is not leveraged; (iii) does not offer its investors liquidity rights except in extraordinary circumstances; (iv) is not registered under the Investment Company Act; (v) has not elected to be treated as a business development company; and (vi) represents that it follows a venture capital strategy.

Investment advisers that meet either the Private Fund Adviser Exemption or the Venture Capital Adviser Exemption are known as “exempt reporting advisers” (ERAs). ERAs are not subject to the same federal or state registration procedures as other investment advisers, but must still register with and report to securities regulators and satisfy certain compliance requirements.

Federal Registration Process

An ERA is required to file with the SEC and does so by completing and filing Form ADV—the same registration document submitted by registered investment advisers (RIAs). However, instead of the entire form, ERAs complete only certain items in Part 1A, along with corresponding schedules. These items disclose, among other things, basic identifying information about the ERA (e.g., its legal name, principal office, and place of business), details about the size of any private funds it advises, other business interests of the ERA and its affiliates, and disciplinary history of the ERA and its employees. In particular, an ERA must identify “control persons” that directly or indirectly control it.

Form ADV is electronically filed, and the information provided on it is available to the public on the Investment Adviser Registration Depository, operated by the Financial Industry Regulatory Authority. An ERA must complete and file Form ADV with the SEC (and pay associated filing fees) within 60 days of the date on which the investment adviser commences an advisory relationship with its first fund. Form ADV must be updated at least annually within 90 days of the ERA’s fiscal year, and more frequently following any material developments described therein. ERAs relying on the Private Fund Adviser Exemption must include any updates to their valuation of the private fund assets under management to determine whether the exemption is still applicable. If an ERA determines that it no longer manages under $150 million in assets, it is given a 90-day grace period to file an application for registration with the SEC.

State Registration Process

A number of states require ERAs that have a place of business and a minimum number—typically five or six—of investment advisory clients (i.e., private or venture capital funds) in-state to make additional filings, to pay fees, and to report to state securities authorities when filing or amending their Form ADV. Although specific state requirements vary, as a general rule, SEC Rule 222-1(a) defines the term “place of business” as an office or other location held out to the public as a location in which the investment adviser regularly provides investment advisory services or solicits, meets with, or otherwise communicates with clients. These “notice filings” may be accomplished by the ERA selecting the relevant states on Item 2.C of Part 1A of the Form ADV, which will automatically send the form to those states. It is important for the ERA to determine whether it is subject to notice filing requirements in individual states. If required to register with one or more state securities authorities, an ERA must complete the entire Form ADV for the SEC registration.

Advisers who are exempt from investment adviser registration with the SEC must still comply with applicable state law. Many states have adopted exemptions for venture capital advisers and private fund advisers that are similar to the federal exemptions. An ERA should check with the state in which it conducts investment advisory activities to determine whether there is a state exemption and what, if any, compliance requirements exist at that level. The North American Securities Administrators Association (NASAA) provides information about state investment adviser laws and rules on its website (www.nasaa.org). NASAA has also issued model state ERA registration rules, modified versions of which have been or are being implemented by a number of states.

Compliance Requirements and Best Practices

ERAs are not subject to some of the Advisers Act provisions regarding registration, recordkeeping, or performance that apply to RIAs. However, ERAs have fiduciary responsibilities to their clients and must abide by certain other compliance requirements applicable to all investment advisers, including anti-fraud rules and pay-to-play provisions. Furthermore, adopting certain best practices as described below can help an ERA stay on the right track and protect itself and its clients.

1. Anti-Fraud Requirements

An ERA should be forthcoming and honest with clients about its services to avoid falling afoul of its fiduciary obligations, which are set forth in Sections 206(1) and 206(2) of the Advisers Act. It is unlawful for any investment adviser, whether an ERA or RIA, to use any device, scheme, or artifice in order to defraud a client or a prospective client. Investment advisers must also refrain from engaging in any transaction, practice, or course of business that operates as a fraud or deceit upon a client or a prospective client. Examples of practices that run afoul of the anti-fraud rules include promising clients a guaranteed return from an equity investment or making false statements about the ERA’s investment history (once a client loses her money, she is not going to be sympathetic to claims that the ERA was merely “puffing”). Advisers Act Rule 206(4)-8 makes it a fraudulent, deceptive, or manipulative act or practice for any investment adviser, whether an ERA or a RIA, to make any untrue statement of material fact or omit a material fact such that a statement to an investor or potential investor becomes misleading, or otherwise engages in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor. ERAs must be wary of conduct that poses conflicts of interest, such as tradeoffs between clients or tradeoffs between a client and other business dealings of the adviser, its affiliates, or their principals, officers, directors, employees, or other agents. Although ERAs are not subject to specific restrictions on advertising, general fiduciary obligations (as well as sound business practices) require avoiding misleading statements, such as through selectively cherry-picking performance information when soliciting investors. To prevent misuse of information regarding investments, ERAs should institute policies and procedures against insider trading.

2. Pay-to-Play Requirements

ERAs are subject to Advisers Act Rule 206(4)-5, which prohibits certain investment advisers from engaging in pay-to-play practices (i.e., being compensated for investment advisory services to a government entity or official after making political contributions to the same). Rule 206(4)-5, which is modeled after the Municipal Securities Rulemaking Board’s pay-to-play rules applicable to broker-dealers, imposes three main conditions on ERAs. First, investment advisers and their associates are subject to a two-year “cooling-off” period after making a contribution to an official of a government entity before the adviser can receive compensation for providing advice to the government entity. Second, investment advisers are not allowed to use third-party solicitors who themselves are not subject to pay-to-play restrictions. Finally, investment advisers may not solicit or coordinate campaign contributions from others (a practice known as “bundling”) for officials of a government entity to which the adviser provides or is seeking to provide services.

3. Anti-Money Laundering Requirements

Unlike broker-dealers and mutual funds, investment advisers are not subject to the anti-money laundering (AML) program requirements imposed by the USA PATRIOT Act, the Money Laundering Control Act of 1986, or the Bank Secrecy Act of 1970. However, due to counterparty risk management, investment funds often wisely refuse to do business with investment advisers that do not have AML programs of their own. Furthermore, U.S. investment advisers, including ERAs, are subject to the rules promulgated by the Office of Foreign Asset Control (OFAC) of the U.S. Treasury Department, which prohibits investment advisers from doing business with individuals and entities on OFAC’s list of “Specially Designated Nationals and Blocked Persons.” Investment advisers must ensure that they do not accept those individuals or entities as clients and must notify OFAC of any suspect clients or transactions.

Although not required by law, an investment adviser should conduct routine employee AML training to identify and report suspicious activity and should also implement a customer identification and due diligence program. The latter likely will involve obtaining appropriate AML documentation from prospective and existing investors. For example, an investment adviser may require natural persons with whom the adviser has not established a prior relationship to provide notarized signatures on his or her subscription agreement or a notarized copy of a driver’s license or passport.

4. Recordkeeping, Examinations, and Proxy Voting

Section 204 of the Advisers Act requires investment advisers to make and keep records and to make and disseminate such reports as the SEC may require. Although the SEC has yet to establish recordkeeping rules specific to ERAs, it is possible future ERAs could be subject to recordkeeping requirements.

The SEC has the legal authority to examine an ERA’s books and records. Historically, it has limited its examinations to those “for cause,” in which the SEC believed or had reason to believe there was wrongdoing (likely through tips, complaints, or referrals). However, as of November 20, 2016, the SEC has begun examining ERAs as part of its routine examination program. Thus, even ERAs without red flags could be subject to the scrutiny of the SEC’s Office of Examination and Compliance.

Given the SEC’s interest in this area (as well as for practical business reasons), it is advisable for ERAs to maintain most, if not all, of the records RIAs are required to maintain under Advisers Act Rule 204(2). These records include general and auxiliary ledgers, records of communications, financial records, purchases and sales, bank and custodial statements, evidence of political contributions, disciplinary records, policies and procedures, supervisory or operational procedures, and any other records one might expect an SEC examination team to request during an on-site inspection. Investment advisers should retain records for at least five years, and such records should be easily accessible for at least the first two years. Records may be maintained on paper or on micrographic or electronic media in accordance with Rule 204-2(g).

The SEC does not require ERAs to establish a written proxy voting policy, which RIAs usually file in Part 2A of Form ADV. However, certain states do require investment advisers doing business within their borders, including ERAs, to comply with recordkeeping requirements, including rules relating to proxy voting policies. ERAs should check the relevant states’ securities regulations to ensure they are in compliance with all applicable requirements.

5. Protecting Investor Privacy

ERAs and RIAs are both subject to rules promulgated under the Gramm-Leach Bliley Act that govern maintenance of investors’ personal information. Unlike RIAs, which are subject to privacy rules issued by the SEC, ERAs, along with broker-dealers and state-registered investment advisers, are subject to privacy rules issued by the Federal Trade Commission (FTC). The FTC privacy rules require ERAs to “develop, implement and maintain a comprehensive information security program that is written in one or more readily accessible parts.” In particular, ERAs must identify reasonably foreseeable risks to the security, confidentiality, and integrity of customer information, design and implement information safeguards, test and monitor these safeguards, and make adjustments as needed. Additionally, one or more employees must be appointed to coordinate the program, which could prove burdensome for ERAs that are individuals or smaller entities short on human resources.

ERAs are required to send initial privacy notices to investors along with standard fund documents describing their privacy policies and procedures. In addition, ERAs must send investors annual privacy disclosures, except when the ERA: (i) only shares investors’ nonpublic personal information with unaffiliated third parties that do not require an opt-out right be provided to investors under the Fixing America’s Surface Transportation Act (the FAST Act); and (ii) has not changed its privacy policies and procedures since its last privacy disclosure. Under the FAST Act, opt-out rights need not be provided to investors when information is shared with insurance rate advisory organizations, ratings agencies, consumer agencies, attorneys, accountants, auditors, and others determining industry standards; unaffiliated third parties providing services for or on behalf of the ERA; or for the purpose of fraud prevention or to comply with federal, state, or local laws.

6. Adoption of a Compliance Manual and Code of Ethics

Under Advisers Act Rule 206(4)-7, RIAs must adopt, review annually, and designate a chief compliance officer (CCO) to administer written policies and procedures to prevent violations of federal securities laws. Further, RIAs must adopt and enforce codes of ethics applicable to their “supervised persons,” which, as defined under the Advisers Act, include partners, officers, directors, employees, or other individuals who provide investment advice on behalf of the investment adviser and are subject to its supervision and control. Codes of ethics are meant to prevent misconduct by reinforcing fiduciary principles that govern the conduct of investment advisory firms and their personnel.

In contrast, ERAs are not required to adopt or implement compliance policies or procedures. However, doing so is considered a “best practice,” as internal compliance is the first line of defense against a violation of the securities laws to which ERAs are subject. If an ERA does decide to take this recommended route and adopt policies and procedures, these should be followed regardless of whether they are required by law. When the SEC conducts an examination, it will ask for—and will want to see evidence the ERA is complying with—all of an ERA’s policies and procedures.

Compliance policies often include an employee manual and code of ethics. These documents impose obligations on an ERA’s employees, contractors, and supervised persons to ensure that the ERA is in compliance with insider trading, pay-to-play, and privacy and confidentiality requirements, among others. For example, a compliance manual may require that an ERA’s supervised persons provide regular updates on the contractor’s equity or debt interests in any portfolio companies they recommend for investment by a fund the ERA advises. The documents may include other restrictions, such as limits on gifts an employee may accept, a conflicts-of-interest policy, and a catch-all provision for employee conduct.

It is important to note that the constraints imposed by an ERA compliance manual on supervised persons can be a major impediment to attracting talented investment professionals. For example, a small, recently formed ERA that is reliant on due diligence by supervised persons to advise investment funds may find it difficult to attract big-name investment or industry experts if the ERA’s compliance manual requires those supervised persons to attend quarterly, multiday training sessions on insider trading. An ERA should consult with counsel and take care to balance precautionary measures while maintaining a competitive edge against other investment advisers.

Codes of ethics typically designate a CCO, set forth the CCO’s responsibilities, and instruct employees to report to the CCO any potential violation of the investment adviser’s compliance manual or code of ethics, or other suspected wrongdoing. If an ERA appoints a CCO, the CCO’s name and contact information must be included in Form ADV along with the ERA’s basic identifying information. To the extent possible, a CCO should be a different individual than the manager, president, or chief executive officer of the ERA to avoid the appearance of conflicts of interest at the higher levels of the ERA’s organizational structure. Appearance of conflicts should not, however, hinder the relationship between a CCO and general counsel and outside general counsel, which is critical for a CCO to provide proper guidance and take corrective action. An ERA may even appoint its general counsel as CCO for economies of scale, although in such cases its general counsel/CCO must take care to remember which “hat” is being worn at a given moment to prevent any waivers of attorney-client privilege. Although an ERA that is a small entity, bereft of a general counsel, could theoretically engage outside counsel to serve as CCO, it would likely be very difficult for outside general counsel to enter into such a committed relationship while maintaining a separate law practice.

7. Other Investment Adviser Regular Updates

There are a number of other compliance obligations that all investment advisers, including ERAs, should bookmark in their calendars for review and possible action. This is not an exclusive list of an ERA’s recurring responsibilities, but they are important to note.

  • ERAs engaged in ongoing securities offerings should remember to ensure that information provided in their Form D and annual Form ADV filings is up to date, which may entail mandatory annual renewal of any state blue sky notice filings. These amendments should also be made when there have been any material changes to information previously provided.
  • ERAs may need to modify disclosures made in marketing materials and offering documents (e.g., partnership or operating agreements, private placement memoranda, and subscription agreements) to ensure that they remain consistent with and representative of the adviser’s business. For example, carried interest, fees, and expense allocations should conform to offering documents and communications with investors. Modifications to fund documents often are made through the use of side letters.
  • ERAs should conduct ongoing monitoring of equity participation by “benefit plan investors,” as defined under the Employee Retirement Income Security Act of 1974 (ERISA), to ensure that their investment funds are not deemed to include “plan assets” (thereby becoming subject to ERISA rules). ERAs should also send “venture capital operating company” or “real estate operating company” certifications to investors if so agreed upon in the fund documents, and may consider seeking an annual representation from all investors that there has been no change in their eligibility to participate in profits and losses from new issues.
  • ERAs, like investment funds and their general partners, should also obtain updated certifications and annually review their “bad actor” obligations under Rule 506(d) of Regulation D. Due diligence, including background checks and questionnaires, should be conducted on any service providers. ERAs should also monitor regulatory developments at the federal level and in the states in which they do business.

Conclusion

As evident by the rules and restrictions described in this article, “exempt reporting adviser” is somewhat of a misnomer. Although RIAs may have more onerous registration and reporting requirements, there are many regulatory pitfalls for ERAs at both the federal and state level. Adopting compliance policies and procedures to the extent practicable can help an ERA prevent securities laws violations, protect investors’ investments and privacy, instill investor confidence, and even help the ERA’s business run smoothly. Although it may seem like an administrative hassle initially, adopting a strong, yet flexible set of compliance policies and procedures will ultimately benefit new and up-and-coming ERAs.

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