Statutes, Rules, and Related Cases

Investment Company Act of 1940 Exemptions:

3c1 (100 investor limit and non-public offering) (corp may only count as 1)
o
3c1(a) if investor-company holds 10% or more of funds securities, then
look through to individual investors
o
SEC Staff: If offshore fund may exclude foreign investors for purposes of
3c1 limit
o
note: b/c of Reg. D, all but 35 need to be Accredited Investors
o
3c5--Do not count K.E.s for 3c1 limit

3c7 (QPs & non-public offering) (QP = individual w/ 5 M invstmts, company 25M
invstmts)

Investments: assets held for inv. purposes. INCLUDE cash,

retirement accounts, etc. EXCLUDE: personal residence, RE used in bus.
(unless RE bus.). IGNORE: debt OK.

Measure QP at time of investment

3c5K.E.s do not need to be QPs for 3c7 fund

SEC staff: offshore fund relying on 3c7 for U.S. investors not subject
to QP reqs w/r/t foreign investors
o
H.G. Butts: Pension Plan can be single QP if manager makes all decisions (if
individual contributors decide then look through to them)
o
Standish Ayer: If 401(k) allows choices about particular Pfunds to invest,
each investor needs to be QP (BUT if give menu of broad options butnot
particular funds, one QP)
o
Shoreline: Parallel funds wont be integrated if are for different tax
treatments (thus appeal to different groups). Gen. Rule--whether funds would be
viewed by reas. investor as mat. different.
o
Frontier: Funds should be integrated b/c: similar objectives, similar
securities; SAME INVESTORS

3c5 (knowledgeable employees)(look to whether was K.E. at time of investment)

o
1. Director, Executive, trustee, GPs, advisory board members, unit/function
head
o
2. Employee who in connection with job functions participates in investment
activities

ABA Letter: SEC says look to whether participated in investment

decision

(IR, no; Analyst, yes; Research Analysts: probably yes;

Trader, No; accounting, No; GC, NO unless exec w/ say)

48 unlawful to create feeder structure to circumvent law (if do, look through &
count indiv. investors)
o
Cornish & Carey: SEC says if <40% of an entitys investment
in 1 PF, usually SEC finds not formed to circumvent law. But 40% not
necessary/sufficient b/c not statutory req. Here, plan couldnt represent <40%
in certain 3c1 fund & SEC said could still be OKdepends on facts and
circumstances. Company claims here purpose to reward employees.

33 Act

4(2) Exempts transactions not involving a public offer from registration

o
Reg D is a safe harbor under 4(2), but not the only way to be exempted
o
(summary of safe harbor: unlimited AIs, <=35 non-accredited, & non-public
offering)Rule 506(b) must comply with Rules 501 and 502

506(b)(2)(i) 35 Investors Max (Accredited Investors dont count see

501(e))

Rule 501(a)
o
individual AI=net worth (indiv/joint)>$1M, OR
income >$200k (or $300k joint) last 2 years and reasonable
expectation this year, OR director, officer, or GP of adviser
or fund
o
entity AI=banks and savings & loan, OR B/D, OR
corps/trusts/plans/p-ships >$5M assets
o
NOTE: QPs will always meet AI reqs so AI becomes
issue only for 3c1

506(b)(3)(ii) non accredited investors must have sufficient

experience and knowledge in financial and business matters to evaluate
the risk
o
Rule 502 (c) No general solicitation or general advertising,

No advertisement, article, notice or communication in newspaper,

magazine or similar media broadcast over television or Radio AND

No seminars whose attendees were invited in similar matter (Good

faith publication of Form D not an advertisement, items written by
journalist from OFFSHORE press releases or press conferences are not an
advertisement)

SEC Guidance: Must Have Preexisting Relationship

5
o
rule: if reqd to be registered, unlawful to sell securities before reg. in
effect in interstate commerce
o
cant short a PIPE or use a PIPE to close out a short position

17a Unlawful in offer or sale of any security, by use of instruments of interstate

communication or transportation in interstate commerce
o
1. Employ device, scheme, or artifice to defraud, OR
o
2. Obtain money or property by untrue statements of material facts or
material omission, OR
o
3. To engage in any transaction, practice, or course of business that operates
as fraud or deceit
o
NEGILIGENCE STANDARD (SEC v. Fife) (also no reliance needed for
fraud)

Fraud cases:
o
Fife: starts fund and just steals the money, transfers it to own account (17a
requires only negligence) 10b5 requires scienter, court says they have scienter.
Also section 206 violated.


They lied and defrauded investors
o
Northshore/Ardent bought an advisor so they could manage Ardent fund,
ripped off Ardent fund by investing in their own companies

Failed to disclose material fact of change of control of advisor;

deceived by not investing how they said they would

Secondary Resales (under 33): Private funds relying on Rule 506 must exercise
reasonable care to assure their investors are not investing w/ view to distribute to
public.

unrestricted resales to public jeopardizes exemption of the entire

private offering.

Reg. S (Under 5): If totally offshore, then considered a private placement (dont
need to worry about Registering under 33 Act or complying with Reg. D if totally
offshore as outlined in Reg. S)
o
Offer is Offshore, No directed selling efforts in the US, foreign investor
o
Can satisfy Reg S and still have your decision maker (adviser) onshore
Exchange Act of 34

9(a)(4) - market manipulation by use of interstate commerce, related to sale of

security, made statements that were false or misleading respecting material fact to induce
the purchase of a security
o
Knew or had reasonable ground to believe were false

10 Unlawful to use interstate commerce, the mails, or any security exchange to

o
b in connection with purchase or sale of any security, use manipulative or
deceptive practice

Rule 10b(5) unlawful by use of interstate commerce, mails, or natl security

exchange
o
Employ a device, scheme or artifice to defraud
o
Make any untrue statements of material facts or material omission
o
Engage in any practice, act, or course of business that would operate as fraud
or deceit
o
SCIENTER Knowing/Intent or High Degree of Recklessness (Sec v. Fife)
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INSIDER TRADING: 1. Material non-public information, 2. Some trade of
security, 3. Some duty violated

Mark Cuban was told info and person who told him said not to
trade on it, govt says should be a breach of duty, Cuban says no duty,
Cuban won in dist. Now at 5th Cir.

OHagen have duty to your firm that is representing acquirer not to

buy target stock (misappropriation)

Heard on the Street WSJ writer trading ahead of his columns,

misappropriation of info from Journal

Berliner--when you open your mouth to speak re: a security, maybe

at that moment you have duty to not misstate/omit (see Berliner
otherwise, who did Berliner have duty to?)


Rule 12g-1: < 499 investors per fund maximum or you have to register under 34
Act

13(d),(g) if fund owns more than 5% of a class of equity securities that are
registered under 12, then have to file beneficial ownership statement requires
disclosure about the identity and background of the reporting person and about the
acquisition of the security (might be able to file short schedule)

13(f) quarterly reporting for managers that control aggregate fiar value 100
million or more in equity securities

15(b) Broker dealers are those that engage in business of buying and selling
securities for own account as regular part of business (B/Ds must register) traders buy
and sell securities for investment generally and dont have to register

16 (a) must file initial report with Commission containing amount of ownership,
and amend as it changes (b) short swing profit provisions relate to beneficial owners of
10% of a class of securities of company registered under 1934

28(e) Safe Harbor: can pay > lowest rate for brokerage service (e.g. executing,
lending stock):
o
advisor wont be deemed to have breached their fiduciary duties of best
execution for paying higher commission to a B/D if they in good faith believe
that the commission was reasonable in relation to the value of the Brokerage
services and Research
o
SEC Interpretation:

Research Service: must be 1) reasoning or knowledge 2) re: a

qualifying subject matter

Brokerage Service: services somehow relating to execution of trades

temporal standard: begins at time of order and ends at

clearance & settlement
o
e.g. communications services incidental to settlement
process qualifies
o
hardware does not qualify

if outside of safe harbor, have to disclose what you use soft dollars
for in detail, but if in safe harbor then just have to tell client that you use
soft dollars for Brokerage Services and Research
Advisers Act of 1940 (Advisor is ANYONE that gives out advice about investments for money)

Registration Process: If need register (or voluntarily register) as investment adviser,

must fill out form ADV
o
Part I--filed w/ SEC electronically.--Basically putting some bare bones
information out there to SEC
o
Rule 204-3. Part II-of form ADV-not filed w/ SEC. Must be given to clients
at least 48 hours before investment. Or must give written document that has
same required information.

Champ: best practice (most efficient): basically just regurgitate the

OM


38a-1 Mutual Funds, Board has to choose CCO for the fund, (advisor also has
CCO) Fund CCO produces annual report to board

Registration Exceptions
o
203(b)(3): 1) Less than 15 Clients, and 2) Not Holding out to public as
Investment Advis and 3) not adviser to registered investment company, OR

Goldstein Funds are clients, not investors

Latham and WatkinsFund is client as long as 1) no individualized

advice to investors (including no recommendation whether take cash or
in kind distributions), and 2) adviser makes portfolio decisions based on
objectives of fund as whole, not indiv. investors.

Willkie Farr when have 2-tiered fund structure (top tier funds
invest substantially all capital in bottom tier funds), dont have to count
bottom funds as clients IF manager makes all decisions & only uses
bottom funds to advise/invest for top funds
o
Asset test (<=$25 million (total assets managed by advisor), dont have to
register regardless)

NOTE: IF RULES BELOW SAY REGISTERED THEN THEY APPLY TO

ALL ADVISERS THAT ARE REGISTERED OR REQUIRED TO BE REGISTERED
UNDER THE IA ACT.

Rule 204A-1 REGISTERED Advisors have to create written code of conduct

o
Fiduciary duties, comply with securities, report violations to CCO, access
people must report their securities (holdings-annual and transactions-quarterly),
give copy of code to access persons, access people need advisers pre-approval
for personal investments in ANY IPO

Rule 204-2 REGISTERED Advisors must keep books and records rule
o
Journals, ledgers, sales memoranda, check books, records of accounts,
written agreements w/ clients, powers of attorney etc.
o
memo on each transaction stating date, terms/conditions, B/D, adviser,
person who decided (usu. PM)
o
SEC: audit trail for all performance cited/marketed by advisor
o
Bowen letter: SEC: need to retain trade confirmation for each individual
trade

Rule 204-3. Part II-of form ADV-not filed w/ SEC. Must be given to clients at
least 48 hours before investment. Or must give written document that has same required
information.

205 NO REGISTERED Investment Advisor can charge incentive allocation,

UNLESS:
o
Rule 205-3(d) Can Only Collect Carry from Qualified Client (at time of
entering K)

750k under management OR

More than 1.5 million net worth OR

QP OR

Knowledgeable employee

206 shall be unlawful for ANY advisor to use mails, instate commerce to

o
(1) employ any device, scheme, or artifice to defraud client or prospective
client
o
(2) engage in any transaction, practice, or course of business which operates
as fraud or deceit upon client or prospective client
o
(3) to engage in principal sales or purchases w/out disclosing to client in
writing and getting consent

Consent needs to come from investors, depends on your OM how

many investors; cant approve yourself as GP b/c of the conflict of
interest; DISCLOSURE is huge here
o
(4) SEC will make rules (all that follow) to prohibit fraud
o
NO SCIENTER: Pretty much the same as 17(a), commentators say
NEGLIGENCE, in SEC v. Capital Gains, Supreme Court said no intent required
b/c based on fiduciary duties

Rule 206(4)-1 REGISTERED Advisor, Advertising Rule (applies

to advertisingany communication to more than one person that offers
advisory service w/r/t securities. See Clover.)

NO: 1. Testimonials; 2. Cant tout winners unless disclose

ALL fund positions or make them available; 3. Graphs, charts,
formulas, diagrams unless disclose limitations and difficulties;
4. Say things are free unless they are. 5. No untrue statement of
material fact, not misleading (both cases below about this).

Clover Hypothetical Funds; Maybe OK, not per se

illegal. (Rare b/c they had newsletter record of ALL of their
performance), 11 Factors
o
Champ: 3 factors: 1) different strategy?, 2)
relevance?, 3) cherry picking?

Horizon - Past Funds Performance OK if you were sole

decision maker before and are going to be sole decision maker
again.

Rule 206(4)-2 REGISTERED Advisor (OLD RULE)

Have a qualified custodian that you reasonably believe

sends statements to client (for managed accounts)

Exception for LLPs dont have to send the detailed

statement to clients or have surprise audit IF have annual audits

Exception uncertificated and only available from issuer

have to be held at custodian

NEW CUSTODY RULE --REGISTERED

1. If private fund and have qualified custodian (i.e. registered

B/D), then no surprise audit if have audited financial statements
filed w/in 120 days after year end (audited statements by PCAOBcertified auditor)

2. If managed account at QC, then surprise audit for advisor

3. If custodian is related then SAS 70 internal structures

review by PCAOB auditor AND advisor gets the surprise audit

Rule 206(4)-3 REGISTERED Advisors: Cash Payments to Solicitors

(Finders Fees)

Solicitor cant have criminal record; if finder onshore must be

reg. B/D to receive

Fee paid according to written agmt (terms: fee, re: disclosure

to clients, etc.)

Separate written disclosure about solicitation fee given to

client, must have written consent from client before entering
advisory contract with client

Rule 206(4)-6 Proxy Voting: REGISTERED advisor has to write

down proxy voting policies and disclose to clients. Also disclose how
investor can find out how voted.

Rule 206(4)-7 REGISTERED advisors must create written policies

and procedures reasonably designed to prevent violations of rules under
the IA act

Annual review adequacy of the procedure

o
SEC: review cant be privileged

CCO SEC: needs to have enough power (formally and in

reality) to enforce

Rule 206(4)-8 Constitute Fraud, deception, manipulation for ANY

advisor to

1. Make untrue statements of material fact or material

omission

2. Otherwise engage in any act practice or course of business

that is fraudulent or deceptive to any investor or prospective
investor in a pooled investment vehicle

Response to Goldstein, this is about investors;

NO SCIENTER (should be same as 206)

Other Rules (no section known) under IA Act:
o
RULE: (REGISTERED ADVISOR) If an investor ever complains about
something advisor required to be doing, a registered investment adviser has
to 1) document/file complaint, and 2) respond to the investor. UNLESS the
complaint is solely about performance.. 3) complaint must be distributed at
adviser
o
Errors by Traders

Will probably have to go in Advisors error account

SEC says B/D can fix error if in same day (if later cant help)
(Contrast: in UK cant fix it)

Whether B/D will fix can be element of best execution

What you do with mistakes will be disclosed in the OM

Commodities Futures Trading Commission (CFTC) Registration

Exception for 3c7 fund who engage in limited commodities trading

o
Fact that all investors are QPs is critical to get this exception

ERISA

Become a ERISA fiduciary if

o
More than 25% of funds securities are owned by benefit plans

If have one US pension investor, then all foreign pensions count

against limit
o
Real Estate/ Venture Capital Exception

Exempt from ERISA ff Fund has more than 50% of money invested
in operating companies and have management roles at those companies
o
Regulation: no cross trades, extensive conflicts regulation, 3rd party
valuations, stiff enforcement

FCC Requirements (rules against media investors investing in other media companies)
Anti-Money Laundering (onshore banks have extensive regulation, OFFSHORE: make
sure your administrator runs investor list through Office of Foreign Asset Control List
[cant take money from terrorists])
Blue Sky and World Sky Laws Fund subject to states and other countries regulations
NASD Rules

B/Ds have to comply w/ NASD

Main indicator of whether B/D is whether a commission is paid

Obligations when selling HF: 1) balanced disclosure in promotional efforts,

2) reasonable basis suitability evaluation (look at security in general), 3) customerspecific suitability determination, 4) internal controls, 5) internal training regarding risks,
features, of HFs

Hot Issues: fund advisors cant get Hot Issues if their fund is in that investment area
(B/Ds cant get hto issues either)

B/D need to make sure that these less sophisticated investors understand hedge
funds

Need to evaluate new products (and create and follow written guidelines for doing
so)

Altegris NASD RULE VIOLATION statements didnt adequately disclose risk;

didnt talk about leverage, volatility, used testimonials about unsupported future earnings

CitiGroup NASD RULE VIOLATION cherry picking b/c picking portfolios of

advisors that are winners, not showing all the advisors; also mixing real and hypothetical
earnings
Cases and No Action Letters

Advertising Issues Recap

o
see above for general solicitation (violates Reg D, 3c1, 3c7)

Lamp Technologies Electronic Disclosure - to avoid violating

general solicitation issues, cant just put up general website


Lamp used questionnaire to see if QP, then gave password,
charged $500 per month

Lamp II lowered standard to Qualified Eligible Participant

(2 mil. of investments) of the Commodities Exchange Act, and no
subscription fee

Setting up account and/or cooling off period creates

preexisting relationship
o
see above for 206(4)-1 (rule for advertising by registered investment
advisers)

Clover Hypothetical Funds; Maybe OK, not per se illegal. (Rare

b/c they had newsletter record of ALL of their performance), 11 Factors

Champ: 3 factors: 1) different strategy?, 2) relevance?, 3)

cherry picking?

Horizon - Past Funds Performance OK if you were sole

decision maker before and are going to be sole decision maker again.
o
see above for 17a, 10b (material misstatement in connection w/ purchase/
sale of security)

Millennium Trade Secrets employees stole trade secrets (quant code) and were
hired by competitor

Citadel employees broke non-compete, non-solicitation, and non-disclosure

agreements

Counting of Investors
o
Latham TO avoid counting each investor as client: can give option
of receiving partnership distributions in kind or in cash BUT cannot give any
individual advice (including whether to take cash or in kind), AND advisor makes
decisions for Funds interests not investors
o
Willkie Farr when have two tiered fund structure, dont have to count
bottom funds as clients IF manager makes all decisions and only uses bottom
funds for benefit of the top funds

206 Cases
o
McKenzie Walker multiple funds, channeling Hot IPOs into the incentive
allocation fund, under 206(2) they did not disclose these material facts, so are
guilty of fraud, no intent needed
o
Joan Conan PM bought debt warrants for herself, could have drastically
helped fund, this is 206(2) material Info; also breached 10b5 by failure to disclose

Also violated here companys compliance and reporting program

o
Vaughn misled investors, told them she was going invest in beta bond
strategy but really invested in bogus scheme and lost control of money (she is
guilty for not disclosing this loss of control too) 17a, 10b5, 206

Material Non-Public Information

o
Berliner made up MNPI rumor about a mergers price being reduced,
simultaneously shorted that stock, then covered the stock for thousands of dollars
of profits

17(a) and 10b violations DUTY whenever you speak to market

have duty to tell truth

o
Galleon Case - elaborate insider trading scam involving multiple hedge
funds and executives at large companies

Chain of tipping at end as long as they know it was MNPI and

was obtained in breach of duty, then are guilty under 10b5 and related
rulings (but must be trade by someone)
o
Deephaven PIPE was shorting the public shares of a company whose
PIPEs he was selling as a b/d was trading on MNPI about the PIPE. 10b5 and
17a violations. . (note: not 206 b/c did not involve selling to his investors)
o
Langley PIPE case was trading on MNPI about the PIPE (17a, 10b5),
but ALSO shorting the private shares before they were registered which is
violation of 5 1933 Act
o
Bayou - company falsified reports, made up fake auditing company, and
misappropriated money from the funds
o
Bear Sterns found innocent by jury, even though they said in private
correspondence to friends and family that the mortgage industry was toast, but
were telling investors at same time they wer comfortable with their positions (also
traded their own money out while telling investors that they were increasing their
personal positions)
Advisor Conflicts of Interest (may be FD issues)
o
OM often says potential conflicts of interest in that that

valuation practices (e.g. use fair value) give rise to an inherent COI
(b/c fees are based on value of portfolio)

i.e. marking something up increases fees

adviser manages multiple funds and may be COI in determining

which opportunity to allocate to which fund

limited access to IPO

agency cross transactions

principal transactions

agency transactions (i.e. w/ B/D, etc.)

Employees of the adviser may hold stock that is in the portfolio (at
least when they join)

transactions with other funds owned by adviser

performance allocation fee may give rise to COI (incentive to take

greater risks)

soft dollars--could give adviser more incentive more trades in order

get more credits for adviser

any conflicts of interest arising from relationships w/ related parties

B/D (if related):

o
churning
o
best execution

researcherquality of research services (best execution)

auditorrep letter or if not independent

o
Gardener Russo Agency Cross funds do not become the alter ego of
advisor unless advisor owns 25% or more of fund, so would not be principal trade
if owned less than 25%, but still issues

Need to set up in advance who to set the prices for the securities
traded (closing price, valuation for illiquid securities, etc)

DO THESE FOR FREE, dont charge the fund commissions, get into
conflict of interest issues
o
Kidder Peabody charged higher fees when doing principal trades than
they were being charged for other trades, need to disclose these fees

Was also leveraging up his friends and family account with

impermissible T-bill trading
o
Jamison in exchange for getting referrals, advisor would leave accounts
at high commission b/d without disclosing to client that they could get cheaper
commissions elsewhere

need to DISCLOSE, has conflict b/c getting referral benefit

o
Renberg BEST EXECUTION had two funds, tax exempt account paid
less commission than taxable account during agency cross Xactions ENSURE
FUNDS get same fees on agency cross
Misuse of Soft Dollars
o
Dawson-Sandburg paid for personal trips w/ soft $ b/c charged to same
AMEX as official travel & AMEX paid by B/D (when outside safe harbor must
disclose in detail what do w/ soft $)
o
Sage used church endowment clients account to create excessive fees
(churned the account, charged .30commissions) and then created shell company
that was paid the soft dollars by the B/D and kept the soft dollars for themselves
7