Expert Networking Certification Requirement Imposed on MA Advisers
Alex Kreonidis | Bloomberg Law
The Massachusetts Securities Division (Division) adopted a certification requirement for MA investment advisers using expert networking services. The requirement appears to be the first of its kind adopted by state regulators, and comes at a time when hedge fund managers, expert networking consultants, and others have been the focus of a nationwide insider trading probe resulting in numerous convictions and guilty pleas. In Massachusetts, the Division has brought enforcement proceedings against hedge fund manager James Silverman and the entities he controls, alleging that they traded on material, non-public information obtained from consultants that expert networking firm Guidepoint Global LLC made available to Silverman. The Silverman proceeding and federal cases stemming from other expert networking arrangements appear to be the impetus for the Division’s new certification requirement. The Division also adopted a provision that prohibits MA advisers from receiving performance-based fees unless done in accordance with Rule 205-3 under the Investment Advisers Act of 1940 (Advisers Act).
Effective August 19, 2011, a MA adviser will be required to obtain a written certification signed by an expert networking consultant if the adviser pays him/her or the networking firm for “Investment Consulting Services.” Investment Consulting Services is defined to mean “a consultation for the purposes of assisting the investment adviser’s decision as to whether to buy, sell, or abstain from buying or selling, positions in client accounts.”
The written certification must describe the consultant’s confidentiality restrictions as relevant to the consultation with the adviser. It also must state affirmatively that the consultant will not provide to the adviser any nonpublic information that the consultant is required to keep confidential. The certification must be accurate as of the date of the initial consultation, and any subsequent consultation(s).
Failing to obtain a certification would be deemed “dishonest or unethical conduct or practices in the securities business,” and subject the adviser to enforcement proceedings.
In its adopting release, the Division noted that several commenters requested that investment advisers registered with the Securities and Exchange Commission (SEC) be explicitly excluded from the certification requirement. While the Division acknowledged the preemption provisions of the National Securities Market Improvement Act of 1996, the Division said that the certification requirement should not be treated differently than other Division regulations that are subject to preemption. Accordingly, it appears that the certification requirement applies only to MA advisers that are registered with the Division or applying for registration.
The SEC has not imposed any specific requirements on SEC-registered advisers using expert networking consultants. However, Carlo V. di Florio, Director of the SEC’s Office of Compliance Inspections and Examinations, provided some guidance in a March 2011 speech at the IA Watch Annual IA Compliance Best Practices Seminar. Di Florio noted that the recent insider trading cases involving expert networking consultants should not be interpreted as undermining the mosaic theory of analysis, provided the information assembled through different public and private sources “is not material nonpublic information obtained in breach of or by virtue of a duty or relationship of trust and confidence.”
While advisers should not think they must avoid expert networks, di Florio continued, they should nevertheless “address any increase to their compliance risks that expert networks may pose, and build appropriate controls around information obtained from expert networks, at both the front end and the back end.” Notable suggestions for front-end controls included pre-approving every conversation with an expert and at least occasionally having compliance personnel listen in on the conversations. Some back-end controls mentioned included obtaining certifications from adviser employees who use expert networks and reviewing relevant trading activity after consultations occur.
Effective December 1, 2011, MA advisers are prohibited from receiving performance-based fees unless done in accordance with Advisers Act Rule 205-3. The rule permits an adviser to charge performance-based fees to “qualified clients,” which currently include individuals or entities that (1) have at least $750,000 in assets under management with the adviser; (2) have a net worth of more than $1.5 million; or (3) are “qualified purchasers,” as defined in Section 2(a)(51)(A) of the Investment Company Act of 1940. Qualified clients also include certain individuals who are affiliated with the adviser.
However, the assets under management threshold and the net worth threshold for qualified client status increases effective September 19, 2011. Specifically, the assets under management threshold increases from $750,000 to $1 million, and the net worth threshold from $1 million to $2 million. See Bloomberg Law Reports®—Securities Law, Dollar Amount Tests for Determining Qualified Client Status Increase under SEC Order (July 14, 2011).
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.
©2011 Bloomberg Finance L.P. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of Bloomberg Finance L.P.