Monthly Archives: August 2008

SEC to replace ancient EDGAR database


On Tuesday the SEC announced that a new company filing database which will be faster and easier to use than the current EDGAR system. The new system is called IDEA, short for Interactive Data Electronic Applications. With IDEA, investors will be able to instantly collate information from thousands of companies and forms, and create reports and analysis on the fly, in any way they choose.

Press Release:

SEC Announces Successor to EDGAR Database
“IDEA” Will Make Company and Fund Information Interactive

Washington, D.C., Aug. 19, 2008 — Securities and Exchange Commission Chairman Christopher Cox today unveiled the successor to the agency’s 1980s-era EDGAR database, which will give investors far faster and easier access to key financial information about public companies and mutual funds.

The new system is called IDEA, short for Interactive Data Electronic Applications. Based on a completely new architecture being built from the ground up, it will at first supplement and then eventually replace the EDGAR system. The decision to replace EDGAR marks the SEC’s transition from collecting forms and documents to making the information itself freely available to investors to give them better and more up-to-date financial disclosure in a form they can readily use.

Currently, most SEC filings are available only in government-prescribed forms through EDGAR. Investors looking for information must sift through one form at a time, and then re-keyboard the information — a painstaking task. With IDEA, investors will be able to instantly collate information from thousands of companies and forms, and create reports and analysis on the fly, in any way they choose.

IDEA will ensure that both the SEC and the investors who rely upon the financial reporting the agency demands are ready for the new world of financial disclosure that will soon arrive when financial information is presented in interactive data format. The SEC has formally proposed requiring U.S. companies to provide financial information using interactive data beginning as early as next year, and separately has proposed requiring mutual funds to submit their public filings using interactive data.

“IDEA will ensure that the SEC continues to stay ahead of the needs of investors,” said Chairman Cox. “This new SEC resource powered by interactive data will give investors far faster, more accurate, and more meaningful information about the companies and mutual funds they own. IDEA’s launch represents a fundamental change in the way the SEC collects and publishes company and fund information – and in the way that investors will be able to use it.”

Interactive data relies on computer “tags,” similar in function to bar codes, which identify individual items in a company’s financial disclosures. With every number on an income statement or balance sheet individually labeled, information about thousands of companies contained on thousands of forms could be easily searched on the Internet, downloaded into spreadsheets, reorganized in databases, and put to any number of other comparative and analytical uses by investors, analysts, journalists, and financial intermediaries.

The ease with which interactive data will make financial information available also is expected to generate many new Web-based services and products for investors.

As he unveiled the new IDEA platform at a Washington news conference today, Chairman Cox announced that the IDEA logo will begin to appear immediately on the SEC’s Web site as the agency transitions to making IDEA the new primary source for all SEC filings. Companies’ interactive data filings are expected to be available through IDEA beginning late this year.

Investors and others who currently use EDGAR will be able to continue doing so for the indefinite future. During the transition to IDEA, investors will be able to take advantage of new interactive, IDEA-like features that will be grafted onto EDGAR in the short run. This will make it possible for investors to tap IDEA’s advanced search capabilities, and to use the information from EDGAR within spreadsheets and analytical software – something that was never possible with EDGAR. The EDGAR database also will continue to be available as an archive of company filings for past years.

“When Congress created the SEC, and even when EDGAR was launched, the markets worked on paper and by mail. Today, the marketplace works online and by e-mail,” explained disclosure and transparency expert Dr. William D. Lutz, who is leading the SEC’s 21st Century Disclosure Initiative. “Companies and investors alike compile, analyze, and produce information and reports electronically. With the move to an electronic data-based filing system, the SEC will not only keep pace with the markets, but will provide investors with a dynamic system they can use to get the information they need, rather than having to wade through an avalanche of paper forms, legalese, and doublespeak.”

David Blaszkowsky, Director of the SEC’s Office of Interactive Disclosure, added, “After 75 years of document-based static financial reporting, whether in paper documents or in electronic equivalents, it is exciting to see the SEC poised to cross the ‘data threshold’ and help investors receive financial information that is dynamic, usable and ready to go as they make their investment decisions. And when the investor wins, so does the public company, fund, or other filer who simultaneously benefits from greater transparency and trust in our markets. By tapping the power of interactive data to tear down barriers to quick and meaningful investment information, markets can become fairer and more efficient while investors can possess far better quality data than was ever possible before.”

What is a hedge fund?

In short, hedge funds are pooled investment vehicles. That is, a hedge fund is a company which pools money from its investors (owners) and makes investments pursuant to the fund’s stated investment objective. There are many different types of hedge funds, which can invest in everything from stocks and bonds to more esoteric investments like derivatives, commodities and real estate. In addition to investments in a wide variety of financial or other instruments, hedge funds can “short” certain financial instruments and can also borrow to “leverage” their investments.

Unlike mutual funds, hedge funds are not registered with the U.S. Securities and Exchange Commission. While this means that hedge funds are not subject to the same level of government scrutiny as mutual funds, it does not mean that the SEC and the states cannot bring enforcement actions against hedge fund managers who break the law or make misrepresentations to investors.

While hedge funds are not subject to the more rigorous standards of mutual funds, they will need to comply with the U.S. securities laws regarding “private placements.” Hedge funds are generally sold to investors in “private placements” which means that hedge fund managers cannot advertise and that, generally, investors will need to be “accredited investors” that is they must have either (i) a one million dollar net worth or (ii). The investment managers will also need to adhere to certain filings within each state in which an investor resides. This will generally mean that they must file a “Form D” notice with each state within 15 days of the date in which each investor invests in the fund. The “Form D” must also be filed with the SEC within this time period.

NFA workshop in New York announced

National Futures Association
Promotional Material Workshop/Small Firms Workshop
Monday, October 20, 2008
The Westin Hotel
New York City

NFA announces two half-day workshops for NFA Members and futures compliance professionals on Monday, October 20, 2008 in New York. The workshops will be held in the Broadway Ballroom at The Westin New York, located at 270 W. 43rd Street. The morning workshop will cover all aspects of promotional material rules and regulations, while the afternoon workshop will address small firm regulatory issues and compliance practices. Participants may choose to attend either of the workshops or both.

For more information, click here.

Ron Insana’s failed hedge fund

Today in the New York Times Business section, there is an article about a hedge fund run by form CNBC news anchor Ron Insana (click here for article). The article details Mr. Insana’s quest to become a fund of funds manager and the pitfalls that befell the former market commentator.

The Times does a great job at identifying many of the issues which a start up hedge fund manager will need to be aware of, especially the costs.

In truth, there are thousands of Mr. Insanas desperately trying to raise money from nondescript little offices across the country. Some of them raised $10 million, some raised $100 million or more. And, as money has gotten tighter, and the bloom has come off the hedge fund rose, some have raised none at all.

Although the big boys get most of the ink, Mr. Insana’s is a far more common story — and far more representative of what is happening in the land of hedge funds today.

While the landscape for a start up hedge fund manager is a difficult one, it is also one in which a manager can succeed if the manager takes the time to plan accordingly. To quote Yogi Berra, “If you don’t know where you are going, you will wind up somewhere else.”

DOL tells ERISA plan to monitor hedge fund valuation practices

I came across this ERISA hedge fund article last night and found it to be very interesting.  This article highlights an issue that is plaguing the hedge fund industry – how to value illiquid and other hard to value assets.  This issue has come to the forefront over the last year as the bank and large hedge funds have posted huge losses due to improper valuation of assets.  More to come on this issue.  The orginal article can be found here:

ERISA vs. the Hedge Fund Industry

According to Pensions and Investment, the Boston office of the US Department of Labor (the “DOL”) recently issued a letter to an (unidentified) US Pension Plan subject to ERISA (the Employee Retirement Income Security Act) stating that the plan was in violation of ERISA regulations.  The DOL is responsible for monitoring – and sanctioning – ERISA plans and, in their letter, threatened legal action if the plan in question did not remedy the noted violations.

The problem?

When valuing hedge funds and other alternative assets for purposes of the Plan’s annual filing, the pension investor had apparently relied upon valuations provided by the underlying funds’ general partners and, in some cases, on audited financial statements for those funds.

This is, of course, standard practice for many hedge fund investors.  It appears, however, that this approach could create a major roadblock for ERISA plans.

According to the DOL, “it is incumbent on the Plan Administrator to establish a process to evaluate the fair market value of any hard to value assets held by the Plan.  Such a process would include a complete understanding of the underlying investments and the fund’s investment strategy.  In addition, the Plan Administrator must have a thorough knowledge of the general partner’s valuation methodology to ensure that it comports with the fund’s written valuation provisions and reflects fair market value.  A process which merely uses the general partner’s established value for all funds without additional analysis may not insure that the alternative investments are valued at fair market value.”

In other words, the entity which has to value all assets – and especially hard to value assets – is the pension investor subject to ERISA.  There is no way of dodging this poison chalice – the ERISA investor cannot simply rely on the hedge fund’s own valuation.

This is an enormously challenging obligation, particularly in the context of the severe fiduciary standards set by ERISA.  Indeed, the DOL position raises a broad question – is it even possible for ERISA plans (or indeed any hedge fund investor) to meet this duty of care?

We have three observations.

Firstly, very few hedge funds provide position level transparency.  However, it is stating the obvious to say that, without position level transparency, it is impossible for an ERISA investor (or any other investor for that matter) to have a “complete” understanding of the underlying investments and the fund’s investment strategy.  Moreover, even if managers do provide position information, how can investors ensure that it is timely and accurate?  The best solution to the transparency issue is a managed account – as such, would one outcome of the DOL’s position, if enforced, be for ERISA plans to only invest through managed account structures?

Secondly, the DOL states that ERISA plans must have a “thorough knowledge of the general partner’s valuation methodology”.  However, in practice, most hedge fund offering documents have deliberately vague and unspecific clauses as to valuation and calculation of the net asset value, especially in relation to hard to value instruments. To add salt to the wound, every prospectus we have ever read includes a final caveat along the lines of “notwithstanding the above policies, the general partner (or the Board of directors in “consultation” with the investment manager for an offshore fund) may elect any “alternative method” of fair valuation. “ There is hence very limited specificity as to valuation procedures in virtually all hedge fund offering materials, and certainly insufficient information to provide a “thorough knowledge” of the valuation methodology which will be applied.

If the prospectus gives an inadequate description of the valuation process, investors need to turn to supplementary information from the hedge fund manager.  At this point, however, things get worse – many hedge fund managers have not developed any internal, written valuation policy at all.  For those funds which do have a valuation document, there is no standardization, and many valuation policies remain uncomfortably vague and unspecific (although, in fairness, we congratulate the minority of managers who have some stepped up and do furnish investors with comprehensive valuation information.)

The worst case is when a manager does have a valuation document, but will not provide it to the investor.  Ironically, the worst culprits in this situation are some of the industry’s largest and most well known hedge fund managers.  The issue is liability: hedge fund lawyers now appear to advise managers that the more information provided to investors, the more the potential liability.  (As an aside, we recently spoke with the CFO of a large hedge fund: he noted that the sight of the Bear Stearns hedge fund managers being led away in ‘cuffs had resulted in urgent calls from the firm’s lawyers, advising the manager to reduce the amount of information it provided to investors.)

The third area of concern is the ongoing assumption by many investors, including many ERISA plans, that third party administrators assume responsibility for valuing hedge fund portfolios.  As such, the administrator, it is perceived, can provide the necessary independence in the valuation process.

Not so fast.  As we have noted before, much of today’s administration industry is now emphatic that they perform only the services of a “calculation agent” not a “valuation agent”.  This is a relatively mute point when dealing with exchange traded securities, but it is an enormous issue when looking at a hedge fund which trades hard to value instruments (it goes without saying that we need help to value exotic CDOs, not IBM stock).

As a “calculation agent”, many administrators have amended their legal contracts to retain the right to “consult with” the manager and, indeed, accept prices from the hedge fund manager without further verification.  Again, we hate to make an “emperor has no clothes” comment, but this is obviously nonsense: taking prices from the manager is like a police officer issuing speeding tickets on the basis of asking drivers how fast they were going.

These issues, in our mind, share a common theme.  In recent years, with an ever-accelerating pace, we have watched the legal pendulum which defines how investors and hedge fund managers transact drift ever further in favor of the manager at the expense of the investor.  It is trite, but uncomfortably accurate, to say that, in today’s hedge fund industry, no-one wants to be responsible for anything.  Everyone is instead seeking to be indemnified to the point of invulnerability.

And this is the disconnect between the hedge fund industry and DOL.  ERISA establishes onerous standards of fiduciary responsibility, deliberately designed to make those responsible for ERISA plans accountable, responsible and liable for their actions.  Today’s hedge funds, however, are increasingly structured to ensure the lowest possible degree of accountability and liability on the part of pretty much everyone involved.

Against this background, we will watch with great interest ongoing developments as the DOL monitors ERISA plans with material hedge fund portfolios.  The question, of course, is whether investing in opaque, uncommunicative hedge funds (even when they are some of the largest in the world) is too close to pushing a square peg in a round hole for investors who do operate within a strict fiduciary framework.

New hedge fund podcast

I have started my hedge fund podcasts once again. Each week I’ll review the most interesting or important stories that involve the hedge fund industry and analyze how the such stories affect hedge fund managers and investors.  This week I discuss two hedge fund news stories, two SEC actions, and the CFTC’s formation of a retail forex task force.  I also discuss how to register as a CPO or CTA.

I am trying to make these podcasts as informative and interesting as possible, so please feel free to send me your comments and suggestions. I hope you like the podcast.

What expenses does a hedge fund pay for?

Question: What costs does a hedge fund pay for and what costs does the hedge fund management company pay for?

Answer: This is another very common question. Most hedge fund offering documents provide a boilerplate approach for splitting costs between the hedge fund and the management company. The general rule of thumb is that any cost which is directly associated with the fund’s investment activities (e.g. brokerage costs) will be paid for by the hedge fund. Any cost which is directly associated with the management company’s operations or overhead (e.g. salaries) will be paid for by the management company.

There are some costs which, arguably, could go either way – one such item is a Bloomberg terminal. A Bloomberg terminal could arguably be an expense of the management company (a Bloomberg is an informational tool similar to magazines and other information that a manager must use to shape its decision-making process) or of the hedge fund (information from the Bloomberg is directly attributable to investment decisions which are made). I do not have a bias as to which entity should pay these fees; however, a hedge fund manager with a smaller asset base that pays for the Bloomberg out of the fund must beware of the effect of Bloomberg’s costs on the fund’s performance.

Hedge Fund Expenses

  • hedge fund management fee
  • hedge fund performance allocation
  • offering and other start-up related expenses (often the management company will pay these expenses)
  • the administrator’s fees and expenses
  • accounting and tax preparation expenses
  • auditing
  • all investment expenses (such as brokerage commissions, expenses related to short sales, clearing and settlement charges, bank service fees, spreads, interest expenses, borrowing charges, short dividends, custodial expenses and other investment expenses)
  • costs and expenses of entering into and utilizing credit facilities and structured notes, swaps, or derivative instruments
  • quotation and news services (Bloomberg, NASDAQ) (or can be a management company expense)
  • ongoing sales and administrative expenses (e.g. printing)
  • legal and fees and expenses related to the fund (include Blue Sky filing fees)
  • optional: professional fees (including, without limitation, expenses of consultants and experts) relating to investments
  • optional: the management company’s legal expenses in relation to the Partnership
  • optional: advisory board fees and expenses
  • optional: reasonable out-of-pocket expenses of the management company (such as travel expenses related to due diligence investigations of existing and prospective investments)
  • other expenses associated with the operation of the hedge fund, including any extraordinary expenses (such as litigation and indemnification)

Hedge Fund Management Company Expenses

  • offering and other start-up related expenses (often the fund will pay these expenses)
  • salaries, benefits and other related compensation of the management company’s employees
  • rent
  • maintenance of its books and records
  • fixed expenses
  • telephones
  • computers
  • general purpose office equipment

While the above list of expenses is fairly standard, please remember that these expenses can be switched around to a certain extent. If you are a hedge fund manager, you should discuss with your attorney how the expenses are split between the hedge fund and the management company.

Should a start-up hedge fund have an audit?

Question: Should a start-up hedge fund have an audit?

Answer: This is a question which we will get very often for funds that aim to launch on July 1 or later.  While there is generally no legal requirement for a hedge fund to have their performance results audited, a vast majority of hedge funds have their returns audited because it will aid in the marketing efforts by lending credibility to performance results.

With regard to this question, and as with most business-issue oriented hedge fund questions, the answer is going to depend on the manager’s program and what the manager plans to accomplish during the first 6, 12 and 18 months of operations.

Generally, first year hedge fund manager’s are going to need to focus on costs. Not only from a cash flow perspective, but also from a return perspective. Any costs (which the fund bears) affect performance. Accordingly, many start-up hedge fund managers may forgo an audit of the fund’s track record during the first year. The manager then may have the fund audited after the end of the fund’s second year. A manager might consider doing this in a couple of situations. The first situation is when the fund starts trading during mid-year or later. In this instance it will probably not make a lot of sense to have an audit for fund operations of less than one year. An exception to this generality is if you have a decent amount of AUM and you are looking to begin courting institutional investors. If this is the case, then it will generally be a good idea to have an audit.

The second situation when a start-up hedge fund manager might not choose to have an audit after the first year is if the manager has a longer term hedge fund incubation program. This might be the case if the hedge fund manager has a longer term trading strategy (buy and hold) or when the manager does not plan to seek institutional money during the second year. Many managers will go with this slow and steady approach to asset raising in order to understand the back end operations of their fund. As noted in numerous places, one of the main reasons why hedge funds fail is inadequate back office operations.

If a start-up hedge fund manager plans to start with a larger asset base, say $10 million or more, and plans to aggressively court the institutional market during the first half of the coming year, then it might be wise to think about an audit. While the decision to forgo a first year audit is strictly a business decision, it is recommended that you discuss this decision with both your legal team and your potential auditor.  Additionally, if you will be using the services of a third party marketer, you will want to discuss this decision with the third party marketer.

Distressed debt hedge fund closes doors

I previously wrote an article about distressed debt hedge funds and the popularity of such funds as they try to get in for a deal. However, the considerable amount of media attention which has been focused on this sector of the market has spooked investors enough to get them moving on redemption day. FINaltenatives is reporting that a fairly large hedge fund managed by Turnberry Capital Management is completely closing its doors. It is at least somewhat surprising that a group this large (the fund reportedly ran up to $800 million at one point) would close its doors immediately instead of trying to wind the fund down over the course of a couple redemption dates.

A few reasons why they might want to wind down the fund over a period of time may include: (1) the fund offering documents did not include a hedge fund gate provision, (2) the manager no longer thought the fund’s strategy was viable with such a severely reduced asset base or (3) the manager thought that he could get the best prices on the assets if he sold them in a large bundle instead of piece meal over time. The article also stated the manager is planning to start a corporate bond fund, which is another reason the manager decided to wind the fund down immediately.

What is most interesting about this event is the disconnect between the strategies managers wish to pursue and the strategies that the investing masses are willing to (remain) invest(ed) in.

The article is at

How to register as a CPO or a CTA

Many hedge fund managers choose to utilize futures and/or commodities in their trading purposes. Generally such managers will need to register as commodity pool operators (“CPO”) and as commodity trading advisors (“CTA”). The hedge fund itself will be deemed to be a commodity pool. For purposes of the Commodities Exchange Act (“CEA”), a future and commodity are functionally equal as it relates to hedge fund manager registration. Registration as a CPO or a CTA is an often overlooked part of the hedge fund formation process. Your attorney should discuss the requirements for registration and whether any exemptions from registration are available.

In addition to hedge fund managers, retail foreign exchange (“Forex”) managers may very soon be required to register because of the recently passed “Farm Bill.” The retail Forex markets have been very loosely regulated and the CFTC and NFA have been clamoring for authority to regulate this are of the markets. Accordingly, this article will give you the basics on how to register as a CPO and/or a CTA.

A very general outline of the CPO registration process is as follows:

Prerequisite – the Series 3 exam

Each CPO or CTA firm will need to have at least one Associated Person (AP). Generally an AP will be anyone in the firm who has contact with clients in something more than a purely administrative or clerical role. All managers and non-clerical employees will be APs. All APs must have passed the Series 3 exam. Information on the Series 3 exam:

  • Series 3 (National Commodity Futures Examination)
  • Cost: $95
  • Number of Questions: 120 True/False and Multiple Choice
  • Subject Matter: (part 1) Market knowledge and (part 2) U.S. regulations
  • Time: 2 hours 30 minutes
  • Passing Score: 70% for each part

Like the Series 65 exam, I highly recommend you spend plenty of time studying for the exam. If you would like some suggestions on various study guides, please let me know.

Filing the application forms with the NFA

During this process your compliance professional will: gain access to the NFA’s registration system on your behalf, input certain basic information on the Form 7-R (for your CPO/CTA firm) and Form 8-R (for the initial AP) – generally you will provide this information to your compliance professional prior to completing these forms, and submit the 7-R and 8-R on your firms behalf.

After the Form 7-R and 8-R have been submitted you will need to pay for registration ($200 registration fee for the CPO or CTA; $85 for each associated person or principal; $750 for NFA membership (this is an annual fee)). After payment has been submitted, the NFA will review your application. Typically registration should be complete within about 3-5 weeks. The next step will be to have your disclosure document approved by the NFA – your compliance professional can help you with this process.

You will be able to check on your registration through the NFA’s BASIC system.


According to the CFTC website, the definition of CPO and CTA are as follows:

Commodity Pool Operator (CPO): A person engaged in a business similar to an investment trust or a syndicate and who solicits or accepts funds, securities, or property for the purpose of trading commodity futures contracts or commodity options. The commodity pool operator either itself makes trading decisions on behalf of the pool or engages a commodity trading advisor to do so.

Commodity Trading Advisor (CTA): A person who, for pay, regularly engages in the business of advising others as to the value of commodity futures or options or the advisability of trading in commodity futures or options, or issues analyses or reports concerning commodity futures or options.

Associated Person (AP): An individual who solicits or accepts (other than in a clerical capacity) orders, discretionary accounts, or participation in a commodity pool, or supervises any individual so engaged, on behalf of a futures commission merchant, an introducing broker, a commodity trading advisor, a commodity pool operator, or an agricultural trade option merchant.