Tag Archives: SEC

Hedge Fund Manager Charged with Insider Trading

SEC Brings Case Against Raj Rajaratnam

Below is another case of a hedge fund manager who was alledgedly engaged in insider trading. The SEC seems particularly excited about this cased because of the high profile nature of the manager who was involved. The major charge is against Raj Rajaratnam who reportedly has a net worth in excess of $1 billion and who is a member of the Forbes 400 richest persons in the world.

There will undoubtedly be continued press in this case which is not good news for the hedge fund industry. The industry has been subject to criticism and increased calls for regulation for the last year and high profile cases like this one only serve to rile up members of congress. The SEC seems to be particularly proud about this “catch” as the agency has itself been under increasing scrutiny as the details of the fumbled Madoff case have been made public.

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SEC Charges Billionaire Hedge Fund Manager Raj Rajaratnam with Insider Trading

FOR IMMEDIATE RELEASE
2009-221

High-Ranking Corporate Executives Also Charged in Scheme That Generated More Than $25 Million in Illicit Gains

Washington, D.C., Oct. 16, 2009 — The Securities and Exchange Commission today charged billionaire Raj Rajaratnam and his New York-based hedge fund advisory firm Galleon Management LP with engaging in a massive insider trading scheme that generated more than $25 million in illicit gains. The SEC also charged six others involved in the scheme, including senior executives at major companies IBM, Intel and McKinsey & Company.

The SEC’s complaint, filed in federal court in Manhattan, alleges that Rajaratnam tapped into his network of friends and close business associates to obtain insider tips and confidential information about corporate earnings or takeover activity at several companies, including Google, Hilton and Sun Microsystems. He then used the non-public information to illegally trade on behalf of Galleon.

“This complaint describes a web of fraud that has been unraveled,” said SEC Chairman Mary L. Schapiro.

“What we have uncovered in the trading activities of Raj Rajaratnam is that the secret of his success is not genius trading strategies. He is not the astute study of company fundamentals or marketplace trends that he is widely thought to be. Raj Rajaratnam is not a master of the universe, but rather a master of the rolodex,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. “He cultivated a network of high-ranking corporate executives and insiders, and then tapped into this ring to obtain confidential details about quarterly earnings and takeover activity.”

In addition to Rajaratnam and Galleon, the SEC’s complaint charges:

  • Danielle Chiesi of New York, N.Y. — a portfolio manager at New Castle Funds.
  • Rajiv Goel of Los Altos, Calif. — a managing director at Intel Capital, an Intel subsidiary.
  • Anil Kumar of Saratoga, Calif. — a director at McKinsey & Company.
  • Mark Kurland of Mount Kisco, N.Y. — a Senior Managing Director and General Partner at New Castle.
  • Robert Moffat of Ridgefield, Conn. — a senior vice president at IBM.
  • New Castle Funds LLC — a New York-based hedge fund

According to the SEC’s complaint, Rajaratnam and Galleon traded on inside information about the following events or transactions:

  • An unnamed source, identified in the SEC’s complaint as Tipper A, obtained inside information about earnings announcements at Polycom and Google, as well as a takeover announcement of Hilton. Tipper A then allegedly provided this information to Rajaratnam, who used it to trade on behalf of Galleon.
  • Goel provided inside information to Rajaratnam about certain Intel quarterly earnings and a pending joint venture concerning Clearwire Corp., in which Intel had invested. Rajaratnam then used this information to trade on behalf of Galleon. As payback for Goel’s tips, Rajaratnam, or someone acting on his behalf, executed trades in Goel’s personal brokerage account based on inside information concerning Hilton and PeopleSupport, which resulted in nearly $250,000 in illicit profits for Goel.
  • Kumar obtained inside information about pending transactions involving AMD and two Abu Dhabi-based sovereign entities, which he shared with Rajaratnam. Rajaratnam then traded on the basis of this information on behalf of Galleon.
  • Chiesi obtained inside information from an executive at Akamai Technologies and traded on the information on behalf of a New Castle fund, netting a profit of approximately $2.4 million. Chiesi also passed on the inside information to Rajaratnam, who then traded on behalf of Galleon.

The SEC also alleges that Moffat provided inside information to Chiesi about Sun Microsystems. Moffat obtained the information when IBM was contemplating acquiring Sun. Chiesi then allegedly traded on the basis of this information on behalf of New Castle, making approximately $1 million in profits.

The SEC’s complaint charges each of the defendants with violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and, except for Kumar and Moffat, violations of Section 17(a) of the Securities Act of 1933 and. The complaint seeks a final judgment permanently enjoining the defendants from future violations of the above provisions of the federal securities laws, ordering them to disgorge their ill-gotten gains plus prejudgment interest, and ordering them to pay financial penalties. The complaint also seeks to permanently prohibit Goel, Kumar and Moffat from acting as an officer or director of any registered public company.

The SEC acknowledges the assistance and cooperation of the U.S. Attorney’s Office for the Southern District of New York and the Federal Bureau of Investigation.

The SEC’s investigation is continuing.

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For more information, contact:
David Rosenfeld
Associate Director, SEC’s New York Regional Office
(212) 336-0153

Sanjay Wadhwa
Assistant Director, SEC’s New York Regional Office
(212) 336-0181

http://www.sec.gov/news/press/2009/2009-221.htm

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Other related hedge fund law articles:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs Hedge Fund Law Blog.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund or if you are a current hedge fund manager with questions about the securities laws, please contact us or call Mr. Mallon directly at 415-868-5345.

OTC Derivatives Markets Act of 2009 Passes House Committee Vote

CFTC Chairman Gensler Applauds “Historic Progress”

In a first step towards increased regulation of the over-the-counter derivatives markets, the House Financial Services Committee approved the Over-the-Counter Derivatives Markets Act of 2009.  The act is one of several initiatives to increase regulatory oversight of the financial markets and if passed by Congress would be signed into law by President Obama. Among other things the act would require Swap dealers and major swap participants to register with either the CFTC or the SEC.

Below I have reprinted press releases from both the House Financial Services Committee and the CFTC.

UPDATE: The Securities Industry Financial and Markets Association (SIFMA) just issued a press release reposted below as well.

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Financial Services Committee Approves Legislation to Regulate Derivatives

Committee completes work on a key element of President Obama’s plan to bring accountability and responsibility to Wall Street

Washington, DC – {The House Financial Services Committee today approved legislation that would, for the first time ever, require the comprehensive regulation of the over-the-counter (OTC) derivatives marketplace. Today’s bill, which was approved by a vote of 43-26, represents a key part of a broader effort by Congress and President Obama to modernize America’s financial regulatory system in response to last year’s financial crisis.

Under the bill, all standardized swap transactions between dealers and large market participants, referred to as “major swap participants,” would have to be cleared and must be traded on an exchange or electronic platform. A major swap participant is defined as anyone that maintains a substantial net position in swaps, exclusive of hedging for commercial risk, or whose positions creates such significant exposure to others that it requires monitoring. OTC derivatives include swaps, which are contracts that call for an exchange of cash between two counterparties based on an underlying rate, index, credit event or the performance of an asset.

The legislation then sets out parallel regulatory frameworks for the regulation of swap markets, dealers, and major swap participants.  Rulemaking authority is held jointly by the Commodity Futures Trading Commission (CFTC), which has jurisdiction over swaps, and the Securities and Exchange Commission (SEC), which has jurisdiction over security-based swaps.   The Treasury Department is given the authority to issue final rules if the CFTC and SEC cannot decide on a joint approach within 180 days. Subsequent interpretations of rules must be agreed to jointly by the Commissions.

Description of the Over-the-Counter Derivatives Markets Act of 2009

Clearing

The legislation provides a mechanism to determine which swap transactions are sufficiently standardized that they must be submitted to a clearinghouse. For transactions that are clearable, clearing is a requirement when both counterparties are either dealers or major swap participants.  Clearing organizations must seek approval from the appropriate regulator—either the CFTC or the SEC—before a swap or class of swaps can be accepted for clearing.

Transactions in standardized swaps that involve end-users are not required to be cleared. Such customized transactions must, however, be reported to a trade repository.

Mandatory Trading on Exchange or Swap Execution Facility

A standardized and cleared swap transaction where both counterparties are either dealers or major swap participants must either be executed on a board of trade, a national securities exchange or a “swap execution facility”—as defined in the legislation.  If none of these venues makes a clearable swap available for trading, the trading requirement would not apply.  Counterparties would, however, have to comply with transaction reporting requirements established by the appropriate regulator.  The legislation also directs the regulators to eliminate unnecessary obstacles to trading on a board of trade or a national securities exchange.

Registration and Regulation of Swap Dealers and Major Swap Participants

Swap dealers and major swap participants must register with the appropriate Commission and dual registration is required in applicable cases.  Capital requirements for swap dealers’ and major swap participants’ positions in cleared swaps must be set at greater than zero.  Capital for non-cleared transaction must be set higher than for cleared transactions.  The prudential regulators will set capital for banks, while the Commissions will set capital for non-banks at a level that is “as strict or stricter” than that set by the prudential regulators.

The regulators are directed to set margin levels for counterparties in transactions that are not cleared.   The regulators are not required to set margin in transaction where one of the counterparties is not a dealer or major swap participant.  In cases where an end user is a counterparty to a transaction, any margin requirements must permit the use of non-cash collateral.

Reporting and Public Disclosure of Swap Transactions

Reporting and recordkeeping is required for all over-the-counter derivative transactions.  Clearing organizations must provide transaction information to the relevant Commission and a designated trade repository.   Swap transactions that are not cleared and for which no trade repository exists, must be reported directly to the relevant Commission.   The legislation also provides for public disclosure of aggregate data on swap trading volumes and positions—in a manner that does not disclose the business transactions or market position of any person.  Large positions in swaps must also be reported directly to regulators.

Swap Execution Facilities

Swap execution facilities, or facility for the trading of swaps that are not Boards of Trade or National Securities Exchanges, must register with the relevant regulator as a swap execution facility (SEF).  SEFs must also adhere to core regulatory principles relating to enforcement, anti-manipulation, monitoring, information collection and conflicts of interest, among others. The CFTC and SEC are required to prescribe joint rules governing the regulation of swap execution facilities.  A Commission may exempt a SEF from registration if it is subject to comparable, comprehensive supervision and regulation by another regulator.

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Statement of Chairman Gary Gensler on House Financial Services Committee Passage of OTC Derivatives Regulatory Reform Legislation

October 15, 2009

Washington, DC – U.S. Commodity Futures Trading Commission Chairman Gary Gensler today commented on the OTC Derivatives Markets Act of 2009, passed this morning by the House of Representatives Committee on Financial Services.

Chairman Gensler said:

“Today’s vote by the House Financial Services Committee represents historic progress toward comprehensive regulatory reform of the over-the-counter derivatives marketplace. The Committee’s bill is a significant step toward lowering risk and promoting transparency. Substantive challenges remain. I look forward to building on this Committee’s hard work with Chairman Frank, Chairman Peterson and others in the House and Senate to complete legislation that covers the entire marketplace without exception and to ensure that regulators have appropriate authorities to protect the public.”

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Release Date: October 15, 2009

Contact: Andrew DeSouza, (202) 962-7390, adesouza@sifma.org

SIFMA’s Bentsen Statement on Committee Passage of Derivatives Regulation

October 15, 2009, Washington, DC—The Securities Industry and Financial Markets Association today released a statement from Ken Bentsen, Executive Vice President, Public Policy and Advocacy in response to the House Financial Services Committee’s passage of the Over-the-Counter Derivatives Markets Act of 2009.

“Bringing greater regulatory transparency and oversight to derivatives markets and products is a key component of reforming our financial system. That oversight must also recognize the important role these risk management tools play for countless companies across the country and for our broader economy. Mandating particular transaction modes, as this bill does, could raise transaction costs while not necessarily reducing risk in a commensurate amount—results that we believe are contrary to our shared reform goals. As the legislative process continues we look forward to working with the Congress toward a bill that strikes a balance between the need for transparency and risk management efficiency.”

The Securities Industry and Financial Markets Association brings together the shared interests of more than 550 securities firms, banks and asset managers. SIFMA’s mission is to promote policies and practices that work to expand and perfect markets, foster the development of new products and services and create efficiencies for member firms, while preserving and enhancing the public’s trust and confidence in the markets and the industry. SIFMA works to represent its members’ interests locally and globally. It has offices in New York, Washington D.C., and London and its associated firm, the Asia Securities Industry and Financial Markets Association, is based in Hong Kong.

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Other related hedge fund law articles:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-868-5345.

Hedge Fund Investors to Sue SEC

SEC’s Madoff Failure Cited in Lawsuit

Just a quick note that the New York Times has written an article about two Madoff investors who are suing the SEC for not doing its job.  It will likely be a tough case for the investors/plaintiffs to prevail upon because of the doctrine of sovereign immunity (i.e. government agencies cannot be sued for actions made pursuant to their legislative mandate).  However, the inspector general’s Madoff report, which in no uncertain terms castigates the SEC, is likely to be the basis of many of the investors’ complaints.

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Other related hedge fund law and Madoff stories:

Hedge Funds and Insider Trading

Hedge Fund Manager/Trader Settles Charges with SEC

Insider trading cases pop up every now and again and most cases do not warrant highlighting – post-Boesky everyone in the securities industry is well aware that trading on inside information is illegal.  However, it warrants emphasis that the SEC will crack down on hedge fund managers or traders involved with insider trading and the penalties are harsh.  The individuals (including a hedge fund manager) involved in the action described in the SEC litigation release reprinted below were subject to fines and disgorgement, of course, but were also barred from the securities industry.  The severity of such a penalty underscores the importance of understanding and abiding by the insider trading rules.

As noted below, trading on insider information is illegal under both civil (Section 17(a) of the 1933 act, Section 10(b) of the 1934 act, and Rule 10b-5 thereunder) and criminal laws (generally securities fraud, but depending on the facts charges may also include wire fraud and commercial bribery).

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U.S. Securities and Exchange Commission
Litigation Release No. 21244
October 8, 2009

SEC v. Mitchel S. Guttenberg, Erik R. Franklin, David M. Tavdy, Mark E. Lenowitz, Robert D. Babcock, Andrew A. Srebnik, Ken Okada, David A. Glass, Marc R. Jurman, Randi E. Collotta, Christopher K. Collotta, Q Capital Investment Partners, LP, DSJ International Resources Ltd. (d/b/a Chelsey Capital), and Jasper Capital LLC, C.A. No. 07 CV 1774 (S.D.N.Y) (PKC)

Three Defendants in Wall Street Insider Trading Ring Settle SEC Charges

The Securities and Exchange Commission announced today that on September 29, 2009, the Honorable P. Kevin Castel, United States District Judge for the Southern District of New York, entered final judgments against defendants Erik R. Franklin, Q Capital Investment Partners, LP (“Q Capital”), and David M. Tavdy, in SEC v. Guttenberg, et al., C.A. No. 07 CV 1774 (S.D.N.Y.), an insider trading case the Commission filed on March 1, 2007. The Commission’s complaint alleged illegal insider trading in connection with two related schemes in which Wall Street professionals serially traded on material, nonpublic information tipped by insiders at UBS Securities LLC (“UBS”) and Morgan Stanley & Co., Inc. (“Morgan Stanley”), in exchange for cash kickbacks.

The Commission’s complaint alleged that from 2001 through 2006, Mitchel S. Guttenberg, an executive director in the equity research department of UBS, illegally tipped material, nonpublic information concerning upcoming UBS analyst upgrades and downgrades to two Wall Street traders, Franklin and Tavdy, in exchange for sharing in the illicit profits from their trading on that information. The complaint also alleged that Franklin was a downstream tippee in another scheme in which, in 2005 and 2006, Randi Collotta, an attorney who worked in the global compliance department of Morgan Stanley, illegally tipped material, nonpublic information concerning upcoming corporate acquisitions involving Morgan Stanley’s investment banking clients.

The complaint alleged that Franklin illegally traded on the inside information for two hedge funds he managed, Lyford Cay Capital, LP and Q Capital, and in his personal accounts. Tavdy illegally traded on the inside information (i) for Andover Brokerage, LLC and Assent LLC, registered broker-dealers where Tavdy was a proprietary trader, (ii) in his own personal account, (iii) in the accounts of a relative and friend, and (iv) in the accounts of Jasper Capital LLC, a day-trading firm with which Tavdy was associated. Franklin and Tavdy also had downstream tippees who traded on the inside information. Without admitting or denying the allegations in the complaint, Franklin, Q Capital, and Tavdy settled the Commission’s insider trading charges.

Franklin and Q Capital consented to the entry of a final judgment which (i) permanently enjoins them from violating Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”), Rule 10b-5 thereunder, and Section 17(a) of the Securities Act of 1933 (“Securities Act”); and (ii) orders, on a joint and several liability basis, disgorgement of $5,400,000, with all but $290,000 waived based on a demonstrated inability to pay. In a related administrative proceeding, Franklin consented to the entry of a Commission order barring him from future association with any broker, dealer, or investment adviser. In a parallel criminal case, Franklin previously pled guilty to charges of securities fraud and conspiracy to commit securities fraud and is awaiting sentencing. U.S. v. Erik Franklin, No. 1:07-CR-164 (S.D.N.Y.).

Tavdy consented to the entry of a final judgment which (i) permanently enjoins him from violating Section 10(b) of the Exchange Act, Rule 10b-5 thereunder, and Section 17(a) of the Securities Act; and (ii) orders him to pay disgorgement of $10,300,000. In a related administrative proceeding, Tavdy consented to the entry of a Commission order barring him from future association with any broker or dealer. In a parallel criminal case, Tavdy previously pled guilty to charges of securities fraud and conspiracy to commit securities fraud, and was sentenced to 63 months in prison. U.S. v. Mitchel Guttenberg and David Tavdy, No. 1:07-CR-141 (S.D.N.Y.).

The Commission also announced that Samuel W. Childs, Jr., a former general securities principal at Assent LLC, consented to a Commission order barring him from future association with any broker or dealer, based on his criminal conviction for conspiracy to commit securities fraud, wire fraud and commercial bribery. U.S. v. Samuel W. Childs, Jr. and Laurence McKeever, No. 1:07-CR-142 (S.D.N.Y.). In that case, the criminal indictment alleged that Childs accepted bribes from traders at Assent LLC in exchange for not reporting their illegal trading to Assent management.

The Commission acknowledges the assistance and cooperation of the U.S. Attorney’s Office for the Southern District of New York and the Federal Bureau of Investigation.

For further information, see Litigation Release Nos. 20022 (March 1, 2007), 20367 (November 20, 2007), 20725 (September 18, 2008), and 21086 (June 16, 2009).

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Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs Hedge Fund Law Blog.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund or if you are a current hedge fund manager with questions about the securities laws, please contact us or call Mr. Mallon directly at 415-868-5345.  Other related hedge fund law articles include:

Section 13(d) Filings and Section 13(g) Filings

Section 13(d) of the Securities Act of 1934 requires any person who beneficially owns 5% or more of a class of equity securities of a publicly traded company to file a report with the SEC within 10 days of reaching the 5% ownership threshold.  SEC Rule 13d-1 provides more detailed guidance on the reporting requirements.

Generally those persons who are subject to this rule will need to file a Schedule 13D (discussed in greater detail below) with the SEC.  Because Schedule 13D is fairly detailed (the SEC estimates that it will take 14.5 hours to complete the form), the SEC has provided an alternate form and alternate reporting procedures for those persons who acquire 5% but who are generally not purchasing the securities with the purpose nor with the effect of changing or influencing the control of the issuer.

Schedule 13D

The following discussion is from the SEC website and can be found here.

Schedule 13D is commonly referred to as a “beneficial ownership report.” The term “beneficial owner” is defined under SEC rules. It includes any person who directly or indirectly shares voting power or investment power (the power to sell the security).

When a person or group of persons acquires beneficial ownership of more than 5% of a voting class of a company’s equity securities registered under Section 12 of the Securities Exchange Act of 1934, they are required to file a Schedule 13D with the SEC. (Depending upon the facts and circumstances, the person or group of persons may be eligible to file the more abbreviated Schedule 13G in lieu of Schedule 13D.)

Schedule 13D reports the acquisition and other information within ten days after the purchase. The schedule is filed with the SEC and is provided to the company that issued the securities and each exchange where the security is traded. Any material changes in the facts contained in the schedule require a prompt amendment. The schedule is often filed in connection with a tender offer.

You can find the Schedules 13D for most publicly traded companies in the SEC’s EDGAR database. You can learn how to use EDGAR to find information about companies. You can find an HTML version of the Schedule and download a PDF version for easier printing.

Schedule 13G Filing Categories

As discussed above, there is an alternative to the Schedule D filing requirement if the hedge fund manager falls within certain categories desicribed below.  If the manager does fall within these categories, the manager can file the less onerous Schedule 13G.

Rule 13d-1(b) – provides that Schedule G can be filed, in lieu of filing Schedule D, within 45 days of the end of the calendar year in which the 5% threshold was exceeded if: (i) generally the person has not acquired the securities with any purpose, or with the effect of, changing or influencing the control of the issuer and (ii) the person is one of a number of enumerated persons (i.e. broker-dealers, registered investment advisors, investment companies, etc).

Rule 13d-1(c) – provides that Schedule G can be filed, in lieu of filing Schedule D, within 10 days of the date which the 5% threshold was exceeded if: (i) generally the person has not acquired the securities with any purpose, or with the effect of, changing or influencing the control of the issuer; (ii) the person is not a certain enumerated person; and (iii) the person does not directly or indirectly own 20% or more of the class of equity securities.

Rule 13d-1(d) – requires Schedule G be filed within 45 days after the end of the calendar year in which the 5% threshold was exceeded if the person meets certain requirements.

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Please contact us if you have any questions or if you are interested in starting a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about the Schedule D or Schedule G filing process, please call Mr. Mallon directly at 415-296-8510.

Investment Adviser Pay to Play Rules

SEC Proposal Would Ban Third Party Solicitors from Seeking Public Monies

Back in July there was much discussion about new “pay to play” rules proposed by the SEC.  The proposed “pay to play” rules would limit the ability of investment managers (including hedge fund managers) to make political contributions and would also limit the ability of third party marketers to raise capital for managers from state and federal pension plans.

There have been many interesting comments on these proposed rules so far, and, as some have noted, it seems to me that these rules may hinder the first-amendment rights of these money managers.  The comment period ends October 6, 2009 and the SEC may choose to vote on the rule thereafter, but I would not expect for any rule to be finalized before the end of this year.  However, hedge fund managers may want to review their investment advisory compliance manual to make sure they have discussed this issue.  Hedge fund managers who are not yet registered with the SEC as investment advisers will likely deal with this issue when they register.

I have included below (i) a definition of pay to play below, (ii) the SEC press release announcing the proposal, and (iii) a discussion of pay to play from 1999, the last time the SEC had a proposal to regulate these activities.

Mallon P.C. will be commenting on the proposal so please let us know your opinions below.

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Pay to Play Definition (see old SEC release, reprinted below)

When I refer to pay-to-play, I am talking about the practice of requiring, either expressly or implicitly, municipal securities participants to make political contributions to municipal officials in order to be considered for an award of underwriting, advisory, or related business from the municipality. In most cases these practices do not amount to outright bribery – which is already prohibited under state and federal law, since there is no express quid pro quo – but it is simply an understanding that if you don’t give, you don’t get business.

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SEC Proposes Measures to Curtail “Pay to Play” Practices

FOR IMMEDIATE RELEASE
2009-168

Washington, D.C., July 22, 2009 — The Securities and Exchange Commission today voted unanimously to propose measures intended to curtail “pay to play” practices by investment advisers that seek to manage money for state and local governments. The measures are designed to prevent an adviser from making political contributions or hidden payments to influence their selection by government officials.

The proposals relate to money managed by state and local governments under important public programs. Such programs include public pension plans that pay retirement benefits to government employees, retirement plans in which teachers and other government employees can invest money for their retirement, and 529 plans that allow families to invest money for college.

To help manage this money, state and local governments often hire outside investment advisers who may directly manage this money and provide advice about which investments they should make. In return for their advice, the investment advisers typically charge fees that come out of the assets of the pension funds for which the advice is provided. If the advisers manage mutual funds or other investments that are options in a plan, the advisers receive fees from the money in those investments.

Investment advisers are often selected by one or more trustees who are appointed by elected officials. While such a selection process is common, fairness can be undermined if advisers seeking to do business with state and local governments make political contributions to elected officials or candidates, hoping to influence the selection process.

The selection process also can be undermined if elected officials or their associates ask advisers for political contributions or otherwise make it understood that only advisers who make contributions will be considered for selection. Hence the term “pay to play.” Advisers and government officials who engage in pay to play practices may try to hide the true purpose of contributions or payments.

“Pay to play practices can result in public plans and their beneficiaries receiving sub-par advisory services at inflated prices,” said SEC Chairman Mary Schapiro. “Our proposal would significantly curtail the corrupting and distortive influence of pay to play practices.”

Andrew J. Donohue, Director of the SEC’s Division of Investment Management, added, “Pay to play serves the interests of advisers to public pension plans rather than the interests of the millions of pension plan beneficiaries who rely on their advice. The rule we are proposing today would help ensure that advisory contracts are awarded on professional competence, not political influence.”

The rule being proposed for public comment by the SEC includes prohibitions intended to capture not only direct political contributions by advisers, but other ways advisers may engage in pay to play arrangements.

Restricting Political Contributions

Under the proposed rule, an investment adviser who makes a political contribution to an elected official in a position to influence the selection of the adviser would be barred for two years from providing advisory services for compensation, either directly or through a fund.

The rule would apply to the investment adviser as well as certain executives and employees of the adviser. Additionally, the rule would apply to political incumbents as well as candidates for a position that can influence the selection of an adviser.

There is a de minimis provision that permits an executive or employee to make contributions of up to $250 per election per candidate if the contributor is entitled to vote for the candidate.

Banning Solicitation of Contributions

The proposed rule also would prohibit an adviser and certain of its executives and employees from coordinating, or asking another person or political action committee (PAC) to:
1. Make a contribution to an elected official (or candidate for the official’s position) who can influence the selection of the adviser.
2. Make a payment to a political party of the state or locality where the adviser is seeking to provide advisory services to the government.

Banning Third-Party Solicitors

The proposed rule also would prohibit an adviser and certain of its executives and employees from paying a third party, such as a solicitor or placement agent, to solicit a government client on behalf of the investment adviser.

Restricting Indirect Contributions and Solicitations

Finally, the proposed rule would prohibit an adviser and certain of its executives and employees from engaging in pay to play conduct indirectly, such as by directing or funding contributions through third parties such as spouses, lawyers or companies affiliated with the adviser, if that conduct would violate the rule if the adviser did it directly. This provision would prevent advisers from circumventing the rule by directing or funding contributions through third parties.

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Public comments on today’s proposed rule must be received by the Commission within 60 days after their publication in the Federal Register.

The full text of the proposed rule will be posted to the SEC Web site as soon as possible.
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http://www.sec.gov/news/press/2009/2009-168.htm

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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Pay-To-Play and
Public Pension Plans
Remarks of
Robert E. Plaze
Associate Director, Division of Investment Management,
U. S. Securities and Exchange Commission

At the Annual Joint Legislative Meeting of
The National Association of State Retirement Administrators,
National Conference on Public Employee Retirement Systems and
The National Council on Teacher Retirement, Washington, D.C.

January 26, 1999

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission.

Thank you for inviting me to address this meeting of the group of state pension administrators. My father was a state retiree and lived on his pension for a number of years. I know how the importance the security of a pension plan is to millions of persons like my Dad, and how important your jobs are.

I am a member of the staff of the Commission. But my remarks this afternoon are my own, and I am not speaking for the Commission or my colleagues on the staff.

When Arthur Levitt became Chairman almost six years ago, among his goals was the reform of the municipal securities markets. Since then, a series of initiatives have improved investor disclosure in the municipal securities markets. A second area of reform – and one most relevant to why you have invited me here today – has been the curbing of pay-to-play practices.

When I refer to pay-to-play, I am talking about the practice of requiring, either expressly or implicitly, municipal securities participants to make political contributions to municipal officials in order to be considered for an award of underwriting, advisory, or related business from the municipality. In most cases these practices do not amount to outright bribery – which is already prohibited under state and federal law, since there is no express quid pro quo – but it is simply an understanding that if you don’t give, you don’t get business.

Chairman Levitt, and several SEC officials have been involved in the municipal securities markets. They knew that pay-to-play practices had been pervasive and corrupting to the market for municipal securities. And if you ask them, they will tell you stories about checks left on the table at a dinner. They may even know the minimum required contributions in a particular jurisdiction to be eligible for public contracts.

Pay-to-play creates the impression that contracts for professional services are awarded on the basis of political influence rather than professional competence. It harms the citizens of the municipality and the investing public asked to purchase the securities. It brings discredit on the businesses and professionals who participate in the practice.

In 1993, the first in a series of steps to end pay-to-play practices began when a group of investment banks voluntarily agreed to swear off making contributions for the purpose of obtaining municipal business. In 1994, the SEC approved MSRB rule G-37 – which is known as the pay-to-play rule.1

G-37 prohibits municipal securities dealers from engaging in the municipal securities business with an issuer two years after contributions are made to an official of an issuer by the dealer or its employees engaged in municipal finance business. The prohibition applies equally to officials who are incumbents and those who are candidates. There is a de minimis exception, which permits contribution of up to $250 to candidates for whom they can vote.

The rule was met with howls of protest from some state and municipal officials. Some argued that it violated their First Amendment rights to make and solicit political contributions. These claims were soon tested in the federal courts, and in an important decision, a federal court of appeals held that G-37 was a constitutionally permissible restraint on free speech – because it serves a compelling governmental interest of rooting out corruption in the market for municipal securities.2

As we meet this afternoon, the American Bar Association is considering proposals to bar the practice of lawyers obtaining business through political contributions. Deans of 47 law schools across the country have joined Chairman Levitt in calling for an end to what the San Francisco Chronicle called “a sleazy practice that costs taxpayers.” 3 We hope that my profession will adopt a strong and effective ban.

Bringing an end to pay-to-play practices thus has been a step-by-step process.

Recently, Chairman Levitt has asked my Division to look into the question of whether the Commission needed to address pay-to-play in the public pension area. We are now in the fact-gathering stage of this project, which could very well lead to a rule proposal.

What have we found? So far, we see strong indicators that pay-to-play can be a powerful force in the selection of money managers of public pension plans. There are public reports of pay-to-pay problems with the management of public money in 12 states – and many of these are the largest states.

* In one small state a former state treasurer raised over $73,000 in campaign contributions, virtually all from contractors for the state retirement system 4

* The controller of a large state has raised $1.8 million from pension fund contractors, many of which are out-of-state 5

* In another state, a former state treasurer raised contributions from contractors, one of whom received a five-fold increase in the custody fees it charged. The treasurer’s candidate lost and the contract was terminated by the new treasurer.6

* The Executive Director of the MSRB has been quoted in the Wall Street Journal as saying that “the conflicts of interest in the [public pension business] are as bad as anything we’ve seen in the muni-bond market.7

* An elected state official has told me that she thought that G-37 has resulted in the movement of some pay-to-play activity over to the public pension area. Phone calls from some advisers have confirmed this.

Claims that pay-to-play really isn’t a problem are refuted by the findings of states and plans that have taken on the issue. Vermont and Connecticut have enacted legislation.8 Both were concerned that awards of advisory contracts were being made on the basis of political favoritism rather than expertise. They concluded that even where no actual corruption occurred, the appearance of impropriety was intolerable.

CalPERS has acted in California, and the records of its rulemaking proceeding and subsequent litigation are particularly instructive about how pay-to-play works and its insidiousness.

It is heartening to see some of the plans and jurisdictions putting an end to the culture of pay-to-play. As you know, it takes two to tango, and it takes two to participate in these practices – the payer and the payee. Our concern is with the activities of the payers – investment advisers, whom we regulate under the Investment Advisers Act of 1940.9

The Advisers Act imposes a federal fiduciary duty on advisers with respect to their clients and prospective clients.10

* When the process of the selection of an investment adviser is corrupted, the duties of an adviser to his client are compromised.

* When the selection process is corrupted and advisers are selected based not on their merit but on the amount or their political contributions, the ultimate clients of advisers – the pension pools they manage – are harmed and the benefits of retirees threatened.

A similar harm occurs when advisers are not chosen because they have not made the requisite amount of contributions.

We at the Commission believe that G-37 is working pretty well. And I have to believe, based on the evidence we have collected so far, that the burden will fall on those who argue that the Commission should not apply the core principles of G-37 to investment advisers and the public pension plan area.

We have spoken with your representatives from NASRA, and we have discussed the matter with some of your colleagues. They have described the difficult position in which a professional manager is placed when it becomes apparent that the decision-making process is being skewed by considerations of political contributions. You have a unique perspective from which to help us understand the issues.

I look forward to further discussions with you and look forward to hearing your views.

Thank you.

1 Self-Regulatory Organizations; Municipal Securities Rulemaking Board, Securities Exchange Act Release No. 34-33868 (Apr. 7, 1994).

2Blount v. SEC , 61 F.3d 938 (1995), cert. denied , 517 U.S. 1119 (1996).

3A Sleazy Practice That Costs Taxpayers , San Francisco Chron., Aug. 1, 1997, at A26.

4See Office of Vermont State Treasurer James H. Douglas, If You Play, You Pay: New Campaign Finance Legislation Prohibits Contracts for Wall Street Firms Contributing to State Treasurer Races, a Provision Pushed by Douglas (06/16/97) http://www.state.vt.us/treasurer/press/pr970616.htm.

5 Clifford J. Leavy, Firms Handling N.Y. Pension Fund Are Donors to Comptroller , N.Y. Times, Oct. 3, 1998, at A16)

6See Steve Hemmerick, See You in Court,’ Bank Tells Its Client: State Street Sues over Custody Contract, Pens. & Inv., Feb. 23, 1998, at 2.

7 Charles Gasparino and Jonathan Axelrod, Political Money May Sway Business of Public Pensions , Wall St. J., Mar. 24, 1997, at C1.

8 Conn. Gen. Stat. § 9-333 o (1997); Vt. Stat. Ann. tit. 32, § 109 (1997).

9 15 U.S.C. 80b.

10SEC v. Capital Gains Research Bureau, Inc. , 375 U.S. 180 (1963).

http://www.sec.gov/news/speeches/spch2501.htm

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Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.

SEC Budget to Double Under Schumer Proposal

Embarrassed Agency Would Get Much Needed Funding

“The SEC’s failure to catch Bernie Madoff shows a level of incompetence unseen since FEMA’s handling of Hurricane Katrina” — Charles Schumer

To say that the SEC is or should be embarrassed about the Madoff scandal is an understatement (please see our most recent discussion on the SEC and Madoff).  However, we have to recognize that the SEC has always been (and potentially always will be) hampered by a limited government budget.  Budget size affects the ability of the SEC to be an effective enforcer in a number of key ways – not the least of which is the SEC’s (in)ability to train and retain staff who are able to understand the nuance and intricacies of the investment management industry.  The budget issue may soon become a non-issue if a proposal by Democratic Senator Charles Schumer makes its way through congress.  The Schumer proposal would provide the SEC with badly needed additional funding by allowing the agency to collect fees from the institutions it oversees.  According to Schumer’s press release, reprinted in full below, “In 2007, though the SEC brought in $1.54 billion in fees, it secured just $881.6 million in funding. Had the agency simply been able to hold onto all the fees it collected, it would have represented a 75 percent increase over the budget it was allotted through the appropriations process.”

We fully stand behind the Schumer proposal and believe that the SEC needs significantly more funding (than it currently receives) in order to do its job effectively.  Additional funding is also needed because of the likely increase of the scope of the SEC’s oversight responsibilities.  As we have reported before President Obama is calling for increased financial regulation and members of the Senate and Congress have been quick to propose a handful of bills which would completely burden the SEC if it was not appropriated more funds.  We also would like to point out that the CFTC has similar budget concerns and should also be appropratiated more funds.

We urge Congress to move forward with the Schumer proposal and to pass a similar bill for the benefit of the CFTC.

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FOR IMMEDIATE RELEASE:
September 3, 2009

IN WAKE OF EXPLOSIVE REPORT ON FAILURE TO CATCH MADOFF… SCHUMER PROPOSES ALLOWING SEC TO KEEP ALL FEES IT COLLECTS IN ORDER TO AFFORD BETTER-TRAINED PERSONNEL—LEGISLATION COULD RESULT IN NEAR-DOUBLING OF AGENCY BUDGET

Yesterday’s Inspector General Report Faulted SEC
Staff’s Lack of Expertise and Experience For Failure To Discover Madoff Ponzi Scheme

Schumer’s Proposal Would Give SEC Access To Millions In Badly-Needed Funds To Recruit And Retain Higher-Caliber Examiners

Schumer Bill Would Treat Investor Protection Agency Like Fed and FDIC, Which are Already Allowed To Keep Fees They Collect

On the heels of an explosive independent report that blamed the failure to catch Bernie Madoff’s fraud scheme on widespread incompetence at the Securities and Exchange Commission, U.S. Senator Charles E. Schumer (D-NY) announced Thursday that he is drafting legislation to allow the agency to keep all of the fees it collects so it can afford to recruit and retain better-trained personnel.

Schumer’s proposal, to be introduced when Congress returns to session next week, would, on average, bolster the SEC’s budget by hundreds of millions on an annual basis, enabling the agency to attract professionals with the expertise required to uncover complex financial fraud. In recent years, the size of the financial markets has grown rapidly while the SEC’s budget has remained essentially flat. The new funding scheme Schumer is proposing would treat the SEC in the same way as Federal Reserve and the Federal Deposit Insurance Corporation, both of which are funded through fees it collects from institutions it oversees.

SEC Chairman Mary Schapiro has already signaled her support for Schumer’s proposal.

“The SEC’s failure to catch Bernie Madoff shows a level of incompetence unseen since FEMA’s handling of Hurricane Katrina. It is clear the SEC needs a bigger, more reliable funding stream so it can retain and recruit the top talent that has fled the agency of late,” Schumer said. “Under the current system, the agency’s rank-and-file personnel are struggling to keep up with the more sophisticated actors in the market. We cannot keep starving the SEC’s budget or the agency will remain a shadow of its former self.”

Schumer’s proposal comes after the SEC released a damning report by the Inspector General yesterday. According to a summary of the report, the SEC had enough evidence against Madoff to merit an investigation into the dealings of his investment firm, but the agency simply didn’t see what was happening right in front of them. The report repeatedly cites the lack of experience and expertise of the SEC personnel assigned to investigate Madoff, finding that they “failed to appreciate the significance of the analysis” in the complaints about Madoff and “failed to follow up on inconsistencies.”

Schumer said the agency’s ability to retain experienced personnel is an ongoing problem since Wall Street firms are increasingly able to lure the agency’s experts with higher salaries. Schumer said the SEC’s chronic under-funding must be addressed in a comprehensive way. Currently, the SEC raises millions more dollars every year in registration and transaction fees (not including enforcement penalties or settlements) than it is allocated through the appropriations process, but its budget is limited to the amount approved by Congress.  In 2007, though the SEC brought in $1.54 billion in fees, it secured just $881.6 million in funding. Had the agency simply been able to hold onto all the fees it collected, it would have represented a 75 percent increase over the budget it was allotted through the appropriations process.

The SEC is one of only two financial regulators in the U.S. that must go through the annual Congressional appropriations process.  U.S. banking regulators such as the Federal Reserve and the FDIC, on the other hand, can use what they collect in fees, deposit insurance and interest income to fund their operations.

Under Schumer’s proposal, the SEC will fund its own operations by using the transaction and registration fees it collects in place of a Congressionally-mandated budget.  Self-funding will give the SEC access to millions more than is allocated through the Congressional appropriations process. Shapiro has suggested that hiring hundreds of new employees over the next few years for the Division of Enforcement and the Office of Compliance, Inspection, and Examination will give the SEC the human and technological resources it needs to keep up with a vast and expanding market.

The SEC’s staff of approximately 3,650 oversees 35,000 entities.  Securities trading volume has increased 261% between 2003 and 2008, but the SEC staff grew only 15% over that period of time.  The number of registered investment advisors has grown by 47%, and the assets they manage have increased by 105%.  Meanwhile, the SEC examination staff charged with overseeing this portion of the financial system has grown by only 13% in that same time.  The number of tips and complaints received by the SEC has increased by 146%, but the enforcement staff has expanded by only 23%.  The SEC does not have the technology to track such a large market with so many players, and currently the SEC has limited capabilities to analyze data and identify market and trading risk.
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Other hedge fund law articles related to increased hedge fund regulation:

Outstanding Congressional Bills increasing financial regulation:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.

Over-the-Counter Derivatives Markets Act of 2009

Obama Administration to Regulate Derivatives Markets

Today the Treasury announced that the Obama Administration proposed a bill named the “Over-the-Counter Derivatives Markets Act of 2009”.  The bill proposes to amend a number of the securities laws (including the Commodity Exchange Act, the Securities Act of 1933 and the Securities Exchange Act of 1934), to regulate the OTC derivatives markets.  A summary of the release is reprinted below.  For the full legislation, please see Over-the-Counter Derivatives Markets Act of 2009.

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August 11, 2009
TG-261

Administration’s Regulatory Reform Agenda Reaches New Milestone: Final Piece of Legislative Language Delivered to Capitol Hill

For the legislative language, visit link.

Acting on its commitment to restoring stability in our financial system, the Administration delivered legislative language to Capitol Hill today focusing on the regulatory reform of over-the-counter (OTC) derivatives. One of the most significant changes in the world of finance in recent decades has been the explosive growth and rapid innovation in the markets for credit default swaps (CDS) and other OTC derivatives.  These markets have largely gone unregulated since their inception.  Enormous risks built up in these markets – substantially out of the view or control of regulators – and these risks contributed to the collapse of major financial firms in the past year and severe stress throughout the financial system.

Under the Administration’s legislation, the OTC derivative markets will be comprehensively regulated for the first time.  The legislation will provide for regulation and transparency for all OTC derivative transactions; strong prudential and business conduct regulation of all OTC derivative dealers and other major participants in the OTC derivative markets; and improved regulatory and enforcement tools to prevent manipulation, fraud, and other abuses in these markets.

Today’s delivery marks an important new milestone, as the Administration has now delivered a comprehensive package of financial regulatory reform legislation to Capitol Hill.  Less than two months since the release of its white paper, “Financial Regulatory Reform: A New Foundation,” on June 17, the Administration has successfully translated all of its proposals into detailed legislative text – a remarkable effort in both speed and scope.  The Administration looks forward to working with Congress to pass a comprehensive regulatory reform bill by the end of the year.

As part of the Administration’s proposed legislation, credit default swap markets and all other OTC derivative markets will be subject to comprehensive regulation in order to:

  • Guard against activities in those markets posing excessive risk to the financial system
  • Promote the transparency and efficiency of those markets
  • Prevent market manipulation, fraud, insider trading, and other market abuses
  • Block OTC derivatives from being marketed inappropriately to unsophisticated parties

These goals will be reached through comprehensive regulation that includes:

  • Regulation of OTC derivative markets
  • Regulation of all OTC Derivative dealers and other major market participants
  • Preventing market manipulation, fraud, insider trading, and other market abuses
  • Protecting unsophisticated investors

Regulation of OTC Derivative Markets

Require Central Clearing and Trading of Standardized OTC Derivatives:

  • To reduce risks to financial stability that arise from the web of bilateral connections among major financial institutions, the legislation will require standardized OTC derivatives to be centrally cleared by a derivatives clearing organization regulated by the CFTC or a securities clearing agency regulated by the SEC.
  • To improve transparency and price discovery, standardized OTC derivatives will be required to be traded on a CFTC- or SEC-regulated exchange or a CFTC- or SEC-regulated alternative swap execution facility.

Move More OTC Derivatives into Central Clearing and Exchange Trading:

  • Through higher capital requirements and higher margin requirements for non-standardized derivatives, the legislation will encourage substantially greater use of standardized derivatives and thereby will facilitate substantial migration of OTC derivatives onto central clearinghouses and exchanges.
  • The legislation proposes a broad definition of a standardized OTC derivative that will be capable of evolving with the markets.

o An OTC derivative that is accepted for clearing by any regulated central clearinghouse will be presumed to be standardized.
o The CFTC and SEC will be given clear authority to prevent attempts by market participants to use spurious customization to avoid central clearing and exchange trading.

Require Transparency for All OTC Derivative Markets:

  • Accordingly, all relevant federal financial regulatory agencies will have access on a confidential basis to the OTC derivative transactions and related open positions of individual market participants.
  • In addition, the public will have access to aggregated data on open positions and trading volumes.

Regulation of All OTC Derivative Dealers and Other Major Market Participants

Extend the Scope of Regulation to Cover all OTC Derivative Dealers and other Major Participants in the OTC Derivative Markets:

  • Our legislation will require, for the first time, the federal supervision and regulation of any firm that deals in OTC derivatives and any other firm that takes large positions in OTC derivatives.

Bring Robust and Comprehensive Prudential Regulation to all OTC Derivative Dealers and other Major Participants in the OTC Derivative Markets:

  • Under the legislation, OTC derivative dealers and major market participants that are banks will be regulated by the federal banking agencies.  OTC derivative dealers and major market participants that are not banks will be regulated by the CFTC or SEC.
  • The federal banking agencies, CFTC, and SEC will be required to provide robust and comprehensive prudential supervision and regulation – including strict capital and margin requirements – for all OTC derivative dealers and major market participants.
  • The CFTC and SEC will be required to issue and enforce strong business conduct, reporting, and recordkeeping (including audit trail) rules for all OTC derivative dealers and major market participants.

Preventing Market Manipulation, Fraud, and other Market Abuses

Provide the CFTC and SEC with the Tools and Information Necessary to Prevent Manipulation, Fraud, and Abuse:

  • The legislation gives the CFTC and SEC clear, unimpeded authority to deter market manipulation, fraud, insider trading, and other abuses in the OTC derivative markets.
  • The CFTC and SEC will be given the authority to set position limits and large trader reporting requirements for OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets.
  • The full regulatory transparency that the legislation will bring to the OTC derivative markets will assist regulators in detecting and deterring manipulation, fraud, insider trading, and other abuses.

Protecting Unsophisticated Investors

Better Protect Unsophisticated Investors from Abuse in the OTC Derivative Markets:

  • The legislation will tighten the definition of eligible investors that are able to engage in OTC derivative transactions to better protect individuals and small municipalities.

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Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.

Investment Adviser Registration Filing Tips

How to get an IA application approved quickly

Occasionally we find the opportunity to comment on other blog posts from other legal professions within and outside of the investment management industry.  A legal blogger who I regularly follow is David Feldman from the Reverse Mergers & SPAC Blog.  David is the expert in the reverse mergers field and has authored the authoritative text Reverse Mergers: Taking a Company Public Without an IPO (Bloomberg Press).  In his post yesterday, Speeding a Self-Filing, he discusses some tips that are designed to help self-filers get through the registration process as quickly as possible.  The points are well-received and I would like to take the opportunity to discuss a couple of the points as they relate to the investment adviser registration process with the various state securities commissions.  [Note: unlike other types of regulatory filings with the SEC, a SEC investment advisor registration is fairly quick and relatively straightforward.  Managers should be aware, however, that the SEC is likely to do a quick examination within the first couple of months after a hedge fund manager registers with the SEC.  Usually this is to make sure the advisor is broadly aware of the compliance issues involved with being registered with the SEC.]

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Tip 1

Respond quickly to comments: Management is busy, so are the lawyers and accountants. Nevertheless, one part of the process in your control is how fast you get back to the SEC when they have comments. If you care about getting the self-filing done quickly, drop everything and get the response done as soon as possible.

HFLB thoughts: it is the rare case when a state investment advisor registration gets approved without some sort of comment or inquiry from the securities commission.  Depending on the state, the inquiry can be more or less detailed and probing.  In most cases, however, once an inquiry is provided to the applicant, registration is likely to be right around the corner.  Accordingly, once an inquiry is provided to the manager, the manager and the lawyer should work to get a response drafted immediately.

Tip 2

Don’t argue on comments you will probably give in on later: Often a company or accountant will say, well, we think they will very likely not give us any room on our response, but let’s try and see what happens. If you care about the speed of the process, it is usually not worth challenging comments if your advisers believe there is virtually no chance of success.

HFLB thoughts: we would also like to add that if the regulators are asking for something that does not materially affect the investment program or the manner in which the management company will operate, the manager might be better off acquiescing instead of fighting.  I have had groups fight with regulators on principles only to later abandon the fight for practicality.  There is definitely an element of picking your battles wisely.

Tip 3

Always be respectful: The SEC is an important and powerful government agency. Almost everyone I have worked with there are highly intelligent and well-meaning folks. But their focus sometimes jibes with that of companies they are seeking to regulate for the protection of investors. Make sure you are always respectful and responsive to the SEC. Not only do they deserve it, but belligerence is just as likely to lead to more ire from them than positive results.

HFLB thoughts: this is an extremely important point.  Regulators are charged with a tough and important job and it does not help anyone to be anything less than absolutely respectful.

Many of the above comments apply equally as well for those groups who are registering with other regulatory bodies such as the CFTC (as a CPO or a CTA) and who need to go through the NFA disclosure document review process.

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Please contact us if you have any questions about investment advisor registration or if you would like information on starting a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice, Cole-Frieman & Mallon LLP, is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.

Mallon P.C. Comments on Proposed Investment Adviser Custody Rule

In May we reported that the SEC was requesting comments on the new Proposed Investment Adviser Custody Rules.  The SEC’s comment period ended this past week with a flurry of activity before the submission deadline.  As we reported previously, there has been a general industry backlash against the rule because it does not provide any substantive protection for investors and creates significant additional costs for investment advisory firms – including the requirement of a surprise audit for those adviser which directly debit advisory fees from the client’s brokerage account.

Mallon P.C. participated in this discussion by submitting the following Comment on Proposed Investment Adviser Custody Rule.  Specifically we found that there would be no good reason to institute the rule as written and believe that it would harm small investment advisory firms disproportionately.  Additionally, we urged the SEC to consider alternatives to the proposed rule which would have more effective investor protections with less impact on the business aspects of the investment advisers who would be subject to the rule.

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Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.