By David Mainzer

June 2011

Managers of hedge funds and private equity funds currently are not required to register with the SEC as investment advisers if they come within the "private adviser exemption" from registration. The private adviser exemption is generally available to investment managers with fewer than 15 clients (each fund is typically treated as one client) that do not hold themselves out to the public. This is set to change pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, which eliminated the private adviser exemption effective July 21, 2011. As a result, a significant number of investment managers of hedge funds and private equity funds (i.e. those with fewer than 15 clients and $150 million or more in assets under management) will be required to register as investment advisers with the Securities and Exchange Commission (the "SEC").

With the July deadline approaching, on June 22, 2011, the SEC sensibly adopted a "transitional exemption" to allow the affected hedge fund and private equity fund managers sufficient time to register as investment advisers and put in place the necessary compliance infrastructure. As a result, hedge fund and private equity fund managers that have $150 million or more in assets under management, and currently come within the private adviser exemption, will have until March 30, 2012 to register as investment advisers with the SEC.


©2011 Cohen/Mainzer LLP.  All Rights Reserved.  Attorney Advertisement.  This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and Cohen/Mainzer makes no representation or warranty that it is.  Receipt or use of this article does not create any attorney-client relationship between the user and Cohen/Mainzer.

By David Mainzer

February 2011

This month, the Commodity Futures Trading Commission (the “CFTC”) announced that it is considering requiring a significant number of currently exempt hedge fund managers that trade in futures and commodity option products regulated by the CFTC to become “dual registrants.”   Dual registrants are required to register both as an investment adviser, with the Securities and Exchange Commission (the “SEC”), and as a commodity pool operator (a “CPO”), with the National Futures Association (the “NFA”).  The CFTC would accomplish this by eliminating two exemptions from the CPO registration requirements that are commonly used by hedge funds.

The following is a summary of certain parts of the proposed changes.  Note that these changes have not been enacted and the CFTC has not published a proposed timetable for their implementation.

CPO Exemptions

Currently, hedge fund managers may be exempt from registration as a CPO under one of two widely used exemptions: (a) the “limited trading exemption” under CFTC Rule 4.13(a)(3), which exempts managers of hedge funds that, among other things, limit the margin premiums required to establish the futures and commodity option positions to 5% of the fund’s net asset value; or (b) the “sophisticated investor exemption” under CFTC Rule 4.13(a)(4), which exempts managers of hedge funds that, among other things, require that each natural person investor in the hedge fund is a “qualified eligible person.”

As a result of the elimination of these two exemptions, many hedge fund managers that trade futures or commodity options, but are not currently required to be registered as CPOs, will be required either to register with the NFA as a CPO or else cease trading in these kinds of investments.

CTA Exemption

In addition to registration as a CPO, the manager of a hedge fund that trades in futures and commodity options is also subject to registration as commodity trading advisor (“CTA”) unless it comes within one of the exemptions from CTA registration.  Hedge fund managers that are exempt from CPO registration under the limited trading exemption and/or the sophisticated investor exemption are currently exempt from registering as CTAs under CFTC Rule 4.14(a)(8).  As a result, we expect that many hedge fund managers that are required to register as CPOs, because of the elimination of these two exemptions, will also be required to register as CTAs.

NFA Registration

Registration with the NFA (as a CPO and/or a CTA) is generally more time consuming and expensive than SEC registration as an investment adviser.  Hedge fund managers that register with the NFA are required to file Form 7-R for the manager and Form 8-R for each principal and associated person, and certain of the manager’s principals and other associated persons are required to pass the FINRA Series 3 examination.  The registration process can take 3 to 4 months.

Once registered as a CPO, the hedge fund manager becomes subject to the disclosure and reporting obligations in Part 4 of the CFTC Rules.  These include requirements that specific provisions must be included in the fund’s private placement memorandum, or otherwise disclosed to each investor, and acknowledged in writing by the investor.  The disclosure document must be filed with the CFTC and must be updated not less that once every nine months.  In addition, the CPO must provide specified annual reporting to investors and is subject to NFA/CFTC recordkeeping and regulatory examination requirements.

The CFTC is also currently proposing additional reporting requirements for CPOs that are dual registrants.  This is expected to include information about the hedge fund, including assets under management, use of leverage, counterparty exposure and trading and investment positions.  These requirements would be satisfied by filing Form PF with the SEC, with Part 1 due on an annual basis from CPOs with less than $1 billion under management, and Part 1 and 2 due on a quarterly basis from CPOs with more than $1 billion under management.

Conclusion

The CFTC has proposed to eliminate the limited trading exemption and the sophisticated investor exemption to CPO the registration requirements.  As a result, many hedge funds that trade futures or commodity options would be required to either register with the NFA as a CPO or else cease trading in these kinds of investments.  The CFTC has stated that the additional registration requirements are designed to limit regulatory arbitrage and increase transparency.  We expect that the elimination of these exemptions will, if enacted, aggravate the current increase in regulatory and compliance costs already impacting hedge funds.


©2011 Cohen/Mainzer LLP.  All Rights Reserved.  Attorney Advertisement.  This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and Cohen/Mainzer makes no representation or warranty that it is.  Receipt or use of this article does not create any attorney-client relationship between the user and Cohen/Mainzer.

By David Mainzer and Theodore J. Cohen

January 2011

Investment management companies very often grant equity interests to their key employees as a way to reward performance and retain talent.  For California employees, there is an additional benefit for firms that grant equity – they may be able to enter into enforceable non-competition agreements with these employees.  This article provides a brief summary of some of the more relevant legal considerations under California law.

Non-Competition Agreements

Effective non-competition and non-solicitation obligations create a disincentive for key employees to leave the firm, and to prevent those who do leave from taking clients and other employees with them.  Generally, a non-competition agreement requires that the employee not engage in a similar business to that of his or her former employer for a period of time after the employee resigns or is terminated.  A non-solicitation agreement typically prevents former employees from encouraging the firm’s clients, employees and others to cease doing business with the firm or to start doing business with the employee’s new firm.  California law generally views a non-solicitation agreement as a form of non-competition agreement, and so the balance of this article refers to both kinds of agreements as “non-competition agreements.”

Note that there are legal restrictions on a former employee’s ability to use confidential information, trade secrets or other property of his or her former employer to compete with his or her former employer.  This article focuses solely on the enforceability of non-competition agreements and assumes that the former employee is not using any such property of the former employer.

Business and Professions Code Section 16600

California law imposes very stringent conditions that must be satisfied in order for non-competition agreements to be enforceable, because California’s public policy, in this regard, strongly favors competition and the rights of employees to be free to work where they choose.   This policy is enshrined in Section 16600 of the California Business & Professions Code (the “BPC”), which says that “[e]xcept as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.”  In short, unless you come within one of these specific exceptions, your non-competition agreement will not be enforceable under California law.  The exceptions relevant to the investment management industry are contained in Sections 16601, 16602 and 16602.5 of the BPC.  All of these exceptions require that the former employee have an equity interest in the employer firm.

Business and Professions Code Section 16601

Section 16600 of the Business and Professions Code, among other things, allows a non-competition agreement to be enforceable if it is entered into by a person that is a member, partner or stockholder, of a partnership, limited liability company or corporation employer, that sells all of their membership interest, partnership interest or stock, as the case may be, back to their employer.  In order to come within BPC Section 16601, the firm must issue an equity interest (membership interest, partnership interest or stock, as applicable) to the employee and then repurchase that equity interest at some time.  Typically, the equity interest will be repurchased upon the termination of the employee’s employment.

The non-competition agreement must come within certain limits set forth in BPC Section 16601: (a) the non-competition agreement must be between the former employee and the purchaser of the equity interest (generally the employer firm); (b) the former employee may only be prohibited from carrying on a business that is “similar” to the business of the firm; (c) the non-competition agreement must be limited to a specified geographic area where the firm conducted its business; (d) the non-competition agreement must be for a reasonable amount of time; and (e) the non-competition agreement may only be enforceable for so long as the buyer (or someone to whom the buyer has sold the business) continues to carry on a similar business in the same geographic area.

There is some uncertainty as to whether the purchase of the equity interest must be for “fair value” or whether it can be for a purchase price that does not reflect the value of the underlying business.  Also, the amount of equity being bought must be substantial.  A number of cases related to corporations have held that the price must in some way reflect the value of the underlying goodwill of the business, or, along the same lines, that the purchase cannot be a sham transaction set up to get around the prohibition on non-competition agreements.  Overall, a non-competition agreement based on the repurchase of a substantial equity interest at fair value is more likely to be enforceable than the repurchase of a token equity interest at a nominal price.

The question as to what constitutes a “similar business” is a factual one that often involves some uncertainty.  In this case, a non-competition agreement that casts a wider net (for example, covering the entire investment management industry) creates less certainty about enforceability.  An agreement that more narrowly defines the prohibited business is more likely to be enforceable as written.  In this context, non-solicitation provisions are generally more easily enforceable that general non-competition agreements, because they are more clearly tied to the firm’s business.  Note that, in certain circumstances, a court may reduce the scope of an overly broad non-competition agreement instead of striking it down completely.

Whether the duration of the non-compete is reasonable is also a factual question.  Generally, the longer the period, the less likely it will be enforceable.  Periods of five years have been upheld, but periods of one to three years are more common in our experience.  In this case also, in certain circumstances, a court may reduce the duration of an overly broad non-competition agreement instead of striking it down completely.

Finally, it is not always clear whether the geographic area of the restriction is within the geographic area where the firm conducted its business.  Territory including the United States has been upheld, but territory limited to several counties in California has been held to be too wide an area, in each case based on an evaluation of the scope and nature of the business and its operations.  In this case also, in certain circumstances, a court may reduce the duration of an overly broad non-competition agreement instead of striking it down completely.

Business and Professions Code Section 16602

Section 16602 of the Business and Professions Code allows a partner to enter into a non-competition agreement upon, or in anticipation of, dissolution of the partnership or the dissociation of the partner from the partnership.

Under Section 16602 of the BPC, the non-competition agreement is limited as follows: (a) the former employee may only be prohibited from carrying on a business that is “similar” to the business of the partnership; (b) the non-competition agreement must be limited to a specified geographic area where the partnership conducted its business; (c) the non-competition agreement must be for a reasonable amount of time; and (d) the non-competition agreement may only be enforceable for so long as one or more of the other partners (or someone to whom such other former partner has sold such a business) continues to carry on a similar business in the same geographic area.  These considerations are discussed above.

Business and Professions Code Section 16602.5

Section 16602.5 of the Business and Professions Code allows a member of a limited liability company to enter into a non-competition agreement upon, or in anticipation of, dissolution of the limited liability company or the termination of his or her interest in the limited liability company.

Under Section 16602 of the BPC, the non-competition agreement is limited as follows: (a) the former employee may only be prohibited from carrying on a business that is “similar” to the business of the limited liability company; (b) the non-competition agreement must be limited to a specified geographic area where the limited liability company conducted its business; (c) the non-competition agreement must be for a reasonable amount of time; and (d) the non-competition agreement may only be enforceable for so long as one or more of the other members of the limited liability company (or someone to whom such other former member has sold such a business) continues to carry on a similar business in the same geographic area.  These considerations are discussed above.

Conclusion

The law regarding non-competition agreements in California is complicated, because of how the relevant statutory provisions are drafted and as the result of more than 100 years of litigation over these provisions.  While this article provides some guidance about how non-competition agreements may be enforceable in California, it is more accurate to say that these guidelines describe how to increase the probability that a non-competition agreement will be enforceable than it is to say that following these guidelines will ensure that a non-competition agreement is enforceable.  California is widely reputed to be an “employee friendly” state as far as the law is concerned, and the law regarding non-competition agreements is consistent with that reputation.


©2011 Cohen/Mainzer LLP.  All Rights Reserved.  Attorney Advertisement.  This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and Cohen/Mainzer makes no representation or warranty that it is.  Receipt or use of this article does not create any attorney-client relationship between the user and Cohen/Mainzer.

By David Mainzer

October 2010

One effect of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”),  which came into effect on July 21, 2010, is expected to be an increase the number of investment advisers that are required to register with the State of California.  There are two primary reasons for this.  First, the Dodd-Frank Act increased the minimum amount of assets under management allowing investment advisers to register with the Securities and Exchange Commission (the “SEC”) from $25 million to $100 million.  As a result, SEC registered investment advisers with a presence (a place of business or more than 5 clients) in California that manage more than $25 million but less than $100 million will be required to transfer their registrations from the SEC to the California Department of Corporations (the “California DOC”).  Second, the Dodd-Frank Act eliminates the exemption from the SEC’s registration requirements for investment advisers with fewer than 15 clients.  As the analogous exemption in California requires that an investment adviser qualify for the SEC exemption, the California DOC is considering whether to require smaller hedge fund managers and other investment advisers in the $25 million to $100 million range to register with the California DOC.

Transition Period

The changes to the SEC investment adviser registration requirements contained in the Dodd-Frank Act are scheduled to take effect on July 21, 2011.  The SEC is working on rules to implement the transition of investment advisers with between $25 million and $100 million in assets under management from SEC to state regulation.  These rules are expected to be proposed by the SEC in November, 2010.  The California DOC has set a July 16, 2011 deadline for the transition. The California investment adviser registration requirements are being reassessed by the California DOC in light of the Dodd-Frank Act.  The following is a summary of certain of the current differences between the registration issues faced by SEC and California registered investment advisers.

Form ADV

Registering with the California DOC requires an investment adviser to file Form ADV with the Investment Adviser Registration Depository (“IARD”).  Currently, while SEC registered investment advisers are required to file only Part I of Form ADV on IARD, California registered investment advisers are required to file both Part I and Part II on IARD.  In last month’s Client Update, I discussed the changes to Part II of Form ADV, including a new SEC requirement that Part II be filed on IARD.  As a result, the federal and California requirements will be substantially the same with respect to Form ADV IARD filing requirements once the new SEC ADV Part II rules come into effect (January 1, 2011).

Investment Adviser Representatives

Under the California Corporate Securities Law of 1968 (the “California Securities Law”), each partner, officer, director (or any person with similar status or responsibilities) or other employee or associate (other than clerical or ministerial personnel) that provides investment advice (including managing client assets) or marketing services, or supervises persons that provide investment advice or marketing services, is an Investment Adviser Representative (an “IAR”).  This is presumed to include all of the investment adviser’s executive management and any person that owns 25% or more of the investment adviser.  The California Securities Law definition is different than the definition under the Investment Advisers Act of 1940, which generally defines IARs as those supervised persons who regularly communicate with more than a certain number of natural person clients.  As a result of the difference in the IAR definitions, California registered investment advisers will generally have more IARs than similarly situated SEC registered investment advisers.

IARs of California registered investment advisers, as well as IARs of SEC registered investment advisers that have a place of business in California, in each case other than those solely involved in marketing, are required to pass certain examinations (or qualify for an exemption) and must register with the California DOC.  In general, IARs must pass either (a) the FINRA Series 65 Examination, or (b) both of the FINRA Series 7 and Series 66 Examinations, in order to register with the California DOC.  The investment adviser is required to file Form U-4 on the FINRA Central Registration Depository (“CRD”) when an IAR is hired and file Form U-5 on CRD when the IAR is terminated (amendments are also required, where applicable, on Form U-4).

The additional cost and investment of time required to satisfy the FINRA examination requirements may be material to investment advisers required to register with the California DOC in 2011. They should plan accordingly.

Minimum Net Worth Requirements

California registered investment advisers (other than those also registered as broker-dealers) are required to maintain a minimum net worth of $35,000, if they have custody of client funds or securities, or $10,000 if they have discretionary authority over client accounts but do not have custody.  In addition, if a California registered investment adviser accepts prepayment of more than $500 of advisory fees six or more month in advance, the investment adviser is required to maintain a positive net worth (which is only relevant to investment advisers without custody or discretionary management authority).  California registered investment advisers are required to file a balance sheet and a minimum financial requirements worksheet with their application to the California DOC, and are thereafter required to file verified annual financial statements.  If a California DOC registered adviser’s net worth drops below 120% of the applicable minimum net worth requirements, certain interim reports must be filed on a monthly or more frequent basis.  If the California investment adviser has custody of client funds or securities, the annual financial statements must be audited by an independent accounting firm.

Custody of Client Funds and Securities

California DOC registered investment advisers that have custody of client funds or securities must retain an independent accounting firm to verify the funds and securities in the clients’ accounts.  The accountants must verify the funds and securities at least once during each calendar year, at a time chosen by the accountants without prior notice to the investment adviser.  The accountants are required to file a certificate with the California DOC promptly after each examination.  In addition, as noted above, California investment advisers are required to maintain a minimum net worth of $35,000 and file audited financial statements with the California DOC each year.

Sample Client Agreements; Other Documents

California registered investment advisers are required to file samples of their investment advisory agreements with their application to the California DOC.  The samples must include (a) a description of the services to be provided, (b) the term of the contract, (c) the advisory fees, (d) how any prepaid fees will be refunded, (e) whether the agreement provides the investment adviser with discretionary investment management authority (and, if not, an acknowledgment by the investment adviser that it must obtain client permission before effecting transactions on the client’s behalf) and (f) that the agreement may not be assigned by the investment adviser without the client’s consent.

Financial planners that receive commissions or other compensation from the sale of securities, insurance, real estate or other businesses, have a conflict of interest with their clients.  Any financial planner with such a conflict of interest, or another conflict, must provide written notice to his/her clients stating that the conflict exists and that the client is free to disregard the investment adviser’s recommendation and, for example, select another broker-dealer to execute trades on the client’s behalf.  This disclosure must be included in the investment management agreement or Part II of Form ADV (or both).

In addition to the foregoing, California registered investment advisers are also required to file a Customer Authorization of Disclosure of Financial Records, a Notification Regarding Compliance with Cash Solicitation Rule, a Conflict of Interest Disclosure a Performance Fees Disclosure, a Statement of Citizenship, Alienage, and Immigration Status, and certain other form documents with the California DOC at the time they file Form ADV on IARD.

Securities Filing

The California DOC expects that an investment adviser applying for registration in California will provide the California DOC with a copy of the securities filing(s) that the investment adviser made in connection with the issuance of its equity securities to its owners.  For example, this would include membership interests of an investment adviser that is a limited liability company or stock of an investment adviser that is a corporation.  Investment advisers, as with any other issuers of securities, must ensure that they have complied with the California Securities Law (and the regulations thereunder), the Securities Act of 1933 (and the regulations thereunder), and the securities laws and regulations of any other states, as applicable.

Conclusion

Investment advisers, whether or not registered with the California DOC or the SEC, are generally subject, among other things, to fiduciary duties to act in their clients’ best interests, requirements related to advertising and other communications to clients and other laws and regulations designed to protect clients and the public.  In addition, both SEC and California registered investment advisers are required to develop and maintain effective compliance policies and procedures designed to ensure that they comply with a wide range of legal requirements.  Finally, California registered investment advisers and their IARs may be required to register in other states as well – this article considers only the California requirements.  This article describes some of the more significant procedural requirements for California registered investment advisers, but does not address these or other potentially applicable regulatory issues.



©2010 Cohen/Mainzer LLP.  All Rights Reserved.  Attorney Advertisement.  This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and Cohen/Mainzer makes no representation or warranty that it is.  Receipt or use of this article does not create any attorney-client relationship between the user and Cohen/Mainzer.

Spolin Silverman Cohen & Bosserman LLP have become Official Sponsors of the California Hedge Fund Association.

The inaugural event will take place on November 10th, 2010 at:
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