Monthly Archives: October 2008

Hedge Fund Formation for January 1, 2009 Launch – Start Today!

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The end of the year tends to be a busy time for hedge fund attorneys as many managers are deciding to prepare hedge funds for launch on January 1.  As we’ve noted in previous articles it can take 6-8 weeks to get a hedge fund launched depending on the investment program.  Accordingly, this is a reminder to all potential hedge fund managers that it is time to start discussing your hedge fund launch with an attorney if you want to have the fund ready for January 1.

Some of the issues that will need to be discussed and planned include:

For more information please see our start up hedge fund timeline and please feel free to contact us if you have any questions or would like to schedule a consultation with a hedge fund attorney.

DOL Sues Investment Adviser for Receiving Undisclosed Fees from Hedge Fund

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The case below provides a great example of why registered investment advisors and hedge funds need to have competent legal counsel advising them on all aspects and arrangements of their business.  Basically a registered investment advisor (RIA) had a selling arrangement with a hedge fund where the RIA would receive a portion of the performance fees earned by the fund on those assets which the RIA directed to the fund.  The RIA directed ERISA assets and did not disclose the arrangement with the hedge fund.  The DOL is seeking remedial action on many fronts and is asking that the RIA be banned from acting as a fiduciary to ERISA assets in the future.  The SEC has also frozen the hedge fund’s asset.

I am actually shocked by this story.  Not because of what the RIA or the fund did, but because it actually happened.  I would assume that an RIA with over $500 million in assets (including ERISA assets) would have an attorney review all of the transactions which it contemplated.  I am also in disbelief that the hedge fund manager did not run the proposed transaction through its own attorney.  If an attorney had seen this transaction in proposed form, it would not have gone through.  In addition to the potential ERISA issues, there are potential broker-dealer issues for the RIA as it is essentially acting as a broker in this transaction and if the firm is not registered as a broker, there may be more issues the RIA will have to face with the SEC.

This case highlights the importance of having competent legal counsel and discussing all issues and proposed transactions with counsel on a regular basis.  The consequences are real and severe – the fund’s assets are frozen and now both of these firms have sullied names.  The press release can be found here.

Release Date: October 24, 2008
Release Number: 08-1536-SAN
Contact Name: Gloria Della/Richard Manning
Phone Number: 202.693.8664/202.693.4676

U.S. Labor Department sues California investment advisor and executives to recover losses and hidden fees charged to employee benefit plans

San Francisco – The U.S. Department of Labor has sued Zenith Capital LLC of Santa Rosa, California, and its executives for allegedly investing the assets of 13 retirement plan clients in the hedge fund Global Money Management LP while receiving undisclosed incentive fees from the hedge fund’s sponsor and manager.
The lawsuit alleges that Zenith Capital and executives Rick Lane Tasker, Michael Gregory Smith and Martel Jed Cooper violated their fiduciary obligations under the Employee Retirement Income Security Act (ERISA). The defendants allegedly made investment decisions for their ERISA plan clients. From April 1999 to September 2003, the defendants caused the plans to invest in Global Money Management and received undisclosed incentive fees from LF Global Investments LLC, the general partner and manager of Global Money Management.

In 2004, Zenith Capital LLC was a registered investment advisor with 1,214 clients and approximately $538 million in assets under management. In addition to paying Zenith incentive fees not disclosed to the 13 ERISA plan clients, LF Global held an ownership interest in Zenith. The U.S. Securities and Exchange Commission has frozen the remaining assets of Global Money Management and secured the appointment of a receiver.

The Labor Department’s suit seeks a court order requiring the defendants to restore all losses owed to the plans, requiring them to undo any transactions prohibited by law and permanently barring them from serving in a fiduciary or service provider capacity to any employee benefit plan governed by ERISA. The suit was filed in the U.S. District Court for the Northern District of California.

“We will vigorously pursue investment advisors who try to line their own pockets by illegally steering pension investments. Fiduciaries must invest solely in the interests of the workers to whom these funds ultimately belong,” said Bradford P. Campbell, assistant secretary for the Labor Department’s Employee Benefits Security Administration (EBSA).

The suit resulted from an investigation conducted by the San Francisco Regional Office of EBSA as part of EBSA’s Consultant Adviser Project. Employers and workers may contact EBSA’s San Francisco office at 415.625.2481 or toll-free at 866.444.3272 for help with problems relating to private sector pension and health plans. In fiscal year 2007, EBSA achieved monetary results of $1.5 billion related to pension, 401(k), health and other benefits for millions of American workers and their families.

Zenith Capital LLC, Civil Action Number C-08-4854 (EMC)

U.S. Department of Labor news releases are accessible on the Department’s Newsroom page. The information in this news release will be made available in alternate format (large print, Braille, audio tape or disc) from the COAST office upon request. Please specify which news release when placing your request at 202.693.7828 or TTY 202.693.7755. The Labor Department is committed to providing America’s employers and employees with easy access to understandable information on how to comply with its laws and regulations. For more information, please visit the Department’s Compliance Assistance page.

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Please contact us if you have any questions or need to contact a hedge fund attorney.

Style Drift and Hedge Funds

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Style drift is a very important issue for hedge fund managers.  Style drift is basically a change in the hedge fund’s investment strategy from what was defined in the hedge fund’s offering documents.  Normally style drift will start small and get larger.  Some managers will not need to worry about style drift if they’ve crafted a sufficiently broad investment program which allows them to invest in any instruments and without regard to any sort of position limits.

It will be difficult for most investors to detect style drift unless the manager reports its positions as well as its monthly or quarterly profit and losses. However, if a hedge fund manager get sued, one of the first things that the plaintiff’s attorney will do is see if the manager stuck to the investment program as it was laid out in the fund’s offering documents (which includes, if applicable, powerpoints and other marketing materials).  If the hedge fund manager strays from the investment program then the aggrieved investor will have a very good case against the manager.

Some commentators and lawyers believe that we are likely to see investor lawsuits arise as a result of losses from style drift.  These commentators believe that managers may look outside of the stated investment objectives in order to chase returns in this volatile investment environment.  We urge all investment managers to stay within the stated investment objectives and to discuss a potential change with their attorney.

Style drift is an especially important issue for institutional investors, including fund of funds, who have invested in certain hedge funds based on their own asset allocation parameters.  Sometimes institutional investors and fund of funds will request investment level disclosure to monitor this risk – this will normally be laid out in a side letter if the manager does not provide this level of transparency through the offering documents.  Typically the hedge fund prime broker or the administrator can provide position level reporting to the investor.

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NFA Increases Required Capital for Forex Dealers

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Yesterday the NFA announced that Forex Dealer Members, those brokers who engage in Forex transactions with retail customers, will need to have a minimum net capital of $10 million by October 31, 2008.  This doubles the current minimum net capital of $5 million.

The NFA has been very aggressively moving to regulate the retail forex market.  Congress has helped through passing the Farm Bill, but separately from the Farm Bill, the NFA, in conjunction with the CFTC, has been moving towards regulating not only the managers of Forex hedge funds, but also the Forex dealers.

Earlier this year the NFA changed the minimum net capital for Forex Dealers from $1 million to the current $5 million; there are two more hikes scheduled to be implemented in the first half of next year.  While this will undoubtedly serve to protect investors, it also cast a huge burden on current and future Forex Dealer Members.  The NFA notice is posted below and can be found here.

Notice I-08-27
October 24, 2008

Net Capital Requirements for Forex Dealer Members

On October 22, 2008, the Commodity Futures Trading Commission approved increases to NFA’s capital requirements for Forex Dealer Members (FDMs). As stated in a July 23, 2008 Notice to Members, the minimum requirement will be $10 million as of October 31, 2008, $15 million as of January 17, 2009, and $20 million as of May 16, 2009.

Questions concerning these requirements should be directed to Sharon Pendleton, Director, Compliance ([email protected] or 312-781-1401) or Valerie Kretschmer, Manager, Compliance ([email protected] or 312-781-1290).

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More on Congress Talking to Hedge Funds

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Yesterday we wrote about the House Financial Services Committee requesting a hearing with certain hedge fund managers (see Barney Frank to Hedge Funds: See You on November 12).  Other news organizations also picked up on this story.  Below is a story from the website ohmygov.com, the original article can be found here.

BREAKING NEWS: Congress talking tough to hedge fund managers refusing to lower mortgage rates

The New York Times reported yesterday that two hedge funds are fighting proposals to ease the terms of home mortgages put forth by the government in H.R. 3221, a bill passed over the summer that gives flexibilities to some mortgage holders to renegotiate their rates. The hedge fund managers are arguing that such a move would hurt their investments.

Today, the House Financial Services Committee issued a press statement to these institutions expressing their “outrage” over the remarks of these hedge fund managers and their intentions to combat the private sector backlash to government programs aimed at preventing additional home foreclosures.

“For hedge funds, which have been the beneficiary of a lack of regulations and a very permissive attitude, now to put obstacles in the way of this important national policy is intolerable.  Because this is so important, and because this irresponsible, antisocial behavior by these hedge funds has such important implications, we have set a hearing of the Financial Services Committee for November 12, and we are inviting these companies as well as the Managed Funds Association to attend. If we are not able to get voluntary attendance, then we will pursue steps to compel them,” said members of the House Financial Services Committee.

The two funds, Greenwich Financial and Braddock Financial, intend to hold the companies issuing mortgages that they support through their financial instruments to their term rates. That means they’ll use their influence over mortgage companies to prevent the companies from lowering rates for struggling homeowners.

In his statement to the Times, William Frey, the president Greenwich Financial Services said that he was acting to protect the firm’s investments. “Any investor in mortgage-backed securities has the right to insist that their contract be enforced,” he said.

This position is unacceptable to House Financial Services Committee members, who feel the hedge funds are providing road blocks to healing a deeply troubled economy.

“What Congress passed overwhelmingly and President Bush signed last July provides for a reasonable modification of mortgages that clearly never should have been granted in the first place to avoid foreclosure and thus lessen the economic damage that a cascade of foreclosures has been doing to our economy…We believe the law clearly allows for modification where such changes would involve a lesser loss than foreclosure, and the benefits to the whole economy of such an approach are obvious.”

According to the House Financial Services website, H.R. 3221, The American Housing and Foreclosure Act:

  • Provides mortgage refinancing assistance to keep families from losing their homes, protect neighboring home values, and help stabilize the housing market.
  • Expands the FHA program so many borrowers in danger of losing their home can refinance into lower-cost government -insured mortgages they can afford to repay.  This legislation will help troubled borrowers avoid foreclosure while minimizing taxpayer exposure.
  • Only primary residences are eligible: NO speculators, investment properties, second or third homes will be refinanced.
  • Protects taxpayers by requiring lenders and homeowners to take responsibility.  This is not a bailout; in order to participate, lenders and mortgage investors must take significant losses by reducing the loan principal.  In exchange for an FHA guarantee on the mortgage, borrowers must share any profit from the resale of a refinanced home with the government.
  • Contains important protections for taxpayers’ dollars, including higher refinancing fees that establish a new FHA reserve to cover possible losses from defaults on these government-backed mortgages.
  • Provides $230 million for financial counseling to help families stay in their homes.

If other companies join the attitudes of these two hedge funds in fighting government bailout bills, a second wave of panic might overtake the financial markets, which have already factored government interventions into their calculations. Any deviations at this point, and in this tumultuous market, would send stocks spiraling downward even further.

Barney Frank to Hedge Funds: See You on November 12th

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As we’ve previously noted, Congress is chomping at the bit to regulate hedge funds.  An article in the New York Times yesterday regarding hedge fund managers opposing mortgage modifications “outraged” the House Financial Services Committee.  Because of this “irresponsible” and “antisocial” behavior, Congress has summoned the funds mentioned in the NYT article to a hearing on November 12th.  The tone of the Congressional announcement is definately antagonistic, something that the hedge fund industry does not need at this time.  The press release, reprinted below, can also be found here.

For Immediate Release: October 24, 2008

Chairmen Frank, Kanjorski, Maloney, Waters, Gutierrez and Watt Demand Hedge Funds Drop Opposition to Foreclosure Prevention

November 12th Financial Services Committee Hearing Announced

Washington, DC – House Financial Services Committee Chairman Barney Frank (D-MA), along with Capital Markets, Insurance and Government Sponsored Enterprises Subcommittee Chairman Paul E. Kanjorski (D-PA), Financial Institutions and Consumer Credit Subcommittee Chairwoman Carolyn Maloney (D-NY), Housing and Community Opportunity Subcommittee Chairwoman Maxine Waters (D-CA), Domestic and International Monetary Policy Trade and Technology Chairman Luis Gutierrez (D-IL), and Oversight and Investigations Subcommittee Chairman Melvin Watt (D-NC), expressed their “outrage” at the report in the New York Times today that at least two hedge funds have warned companies servicing mortgages they should not take advantage of a bill passed by Congress and signed by the President aimed at reducing the rate of foreclosure:

“What Congress passed overwhelmingly and President Bush signed last July provides for a reasonable modification of mortgages that clearly never should have been granted in the first place to avoid foreclosure and thus lessen the economic damage that a cascade of foreclosures has been doing to our economy.  In drafting this legislation, we consulted with a wide range of consumers, industry, and government regulatory groups, and we believe we adopted a reasonable proposal. Indeed, we have been criticized by some in the consumer community for not doing more to pressure institutions to avoid foreclosure while minimizing their losses.  In light of this, we were outraged to read that two hedge funds, Greenwich Financial Services and Braddock Financial Corporation, are instructing the servicers of their mortgages to defy this national program and to insist on further socially and economically damaging foreclosures. We believe the law clearly allows for modification where such changes would involve a lesser loss than foreclosure, and the benefits to the whole economy of such an approach are obvious.”

“For hedge funds, which have been the beneficiary of a lack of regulations and a very permissive attitude, now to put obstacles in the way of this important national policy is intolerable.  We have written to these two hedge funds and to the Managed Funds Association as well, strongly urging them to reverse this policy which will have such negative impacts on the economy.  Because this is so important, and because this irresponsible, antisocial behavior by these hedge funds has such important implications, we have set a hearing of the Financial Services Committee for November 12, and we are inviting these companies as well as the Managed Funds Association to attend.  If we are not able to get voluntary attendance, then we will pursue steps to compel them.

“Many in the financial community have objected to the argument many of us have made that homeowners should be allowed to invoke the protection of the bankruptcy laws on single family residences, as they are on second and third homes.  The argument in the financial community has been not only that this would be damaging, but that it would not be necessary to achieve the economically desirable result of reduced foreclosures.  But the decision of these two companies actively to oppose our efforts to achieve voluntary compliance quickly undercut that argument, and people in the financial community should not be surprised if this sort of blatant refusal to show any cooperation whatsoever with our efforts leads to an increased demand for much tougher legislation.”

Other related HFLB articles include:

Overview of the Investment Company Act of 1940

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The Investment Company Act of 1940 (the “Investment Company Act”) is what gives structure to the hedge fund industry.  The Investment Company Act provides very strict regulations for entities which are “investment companies” such as mutual funds. While hedge funds do fall within the definition of “investment company” they will seek an exemption from the registration provisions because such restrictions are onerous. This article provides an overview of certain aspects of the Investment Company Act including the reason hedge funds seek exemption from the registration provisions and the definition of “investment company”.  In depth discussion of the exemptions for hedge funds under the Investment Company Act can be found elsewhere on this website.

Reason to seek exemption – Onerous Regulation

While the advantage for a mutual fund is that they can publicly advertise investments in their shares, there are many regulations which the mutual fund must follow.  These include:

  • Mutual funds must register their securities under the Securities Act and Investment Company Act, this is a long and very costly process.
  • Mutual funds must have a Board of Directors and 75% of the Board must be independent.  The Board must approve and vote on various items related to the mutual fund, include 12b-1 fees.
  • Mutual funds have certain investment restrictions.  Form example, mutual funds use of leverage is limited; there are percentage restrictions on investment into other mutual funds and hedge funds
  • Mutual funds have daily net asset value (NAV) calculations and daily redemptions.  Because of the possibility of daily redemption the mutual fund must keep a certain amount of cash available at all times.
  • Mutual funds can only be advised by a registered investment advisor.

Definition of Investment Company

Section 3(a)(1) of the Investment company act as follows:

When used in this title, “investment company” means any issuer which (A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities; (B) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or (C) is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

Exemption from registration under Section 3(c)(1)

Please see Section 3(c)(1) Hedge Funds

Exemption from registration under Section 3(c)(7)

Please see Section 3(c)(7) Hedge Funds

In addition to the above sections, below is the SEC’s description of the Investment Company Act of 1940 and its important provisions.  This description can also be found here.

Investment Company Act of 1940

This Act regulates the organization of companies, including mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public. The regulation is designed to minimize conflicts of interest that arise in these complex operations. The Act requires these companies to disclose their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis. The focus of this Act is on disclosure to the investing public of information about the fund and its investment objectives, as well as on investment company structure and operations. It is important to remember that the Act does not permit the SEC to directly supervise the investment decisions or activities of these companies or judge the merits of their investments. The full text of this Act is available at: http://uscode.house.gov/download/pls/15C2D.txt (Subchapter I). (Please check the Classification Tables maintained by the US House of Representatives Office of the Law Revision Counsel for updates to any of the laws.)

Pooled Investment Vehicles – Non-Traditional Hedge Fund Strategies

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The term “hedge fund” is really a misnomer as most hedge funds are not hedged.  A better term would be pooled investment vehicle.  Traditional types of pooled investment vehicle structures include hedge funds, private equity funds, venture capital funds, real estate funds, and “hybrid” funds (funds which combine components of the above).

This article is going to discuss other types of non-traditional hedge funds, that is hedge funds which do not fall within the typical types of hedge fund securities trading strategies (long/short equity, multi-strategy, global macro, fixed income, equity market neutral, managed futures, etc). As more people become familiar with hedge funds and become interested in investing in them, managers will begin to create funds to fit specific demographics.  The following are interesting projects which can be accomplished through the hedge fund (or pooled investment vehicle) structure:

Green Hedge Funds – in a vein similar to the Vice Fund*, hedge funds can concentrate their investments in any specific hot area. Green companies is currently a hot area and many people are already calling a bubble in “green” companies, at least in the private equity space.  According to this article by Richard Wilson, mandates at institutional level to invest in “green” hedge funds are expected to significantly increase in the coming years.

Horse Racing Hedge Funds – there are two ways that a fund like this would work.  First, the hedge fund can actually pool investor money and then the manager would place bets on various horses through various betting establishments.  With a fund like this the sponsor would need to make sure to disclose the exact nature of the program so that any legal or gambling issues could be vetted before the hedge fund launch.  Second, the hedge fund could buy racing horses and then race them for profit.  There are already these types of pooled vehicles out there and they are usually have a private equity structure with capital calls.

Gambling or Online Gambling Hedge Funds – with the rise in popularity of Texas Hold-em on television and the proliferation of online gambling there has been discussion of hedge funds devoted to making money from this phenomenon.  Basically this would be done through pooling money and then allocating to traders (live or online) who would then play with money.  With a fund like this there are many issues, not the least of which is the illegality of gambling in much of the US and online.  It is likely that a gambling attorney would need to be brought in to opine on the issue of the legality of such a fund.

Sports Betting Hedge Fund – like the gambling hedge fund, sports betting presents a very attractive opportunity for potential hedge fund managers.  A couple of years back Mark Cuban discussed the idea of a sports betting hedge fund on his blog (blog post).  While his fund never got off the ground, I have heard of other potential hedge fund sponsors trying to get a fund like this launched.  I have not yet heard of a successful fund like this, but I think it is just a matter of time.

Lottery Hedge Fund – about a year and a half ago I had the idea of starting a lottery hedge fund which would pool money to buy a large amount (or all possible number combinations) of number combinations at one of the very large lottery drawings.  While it is feasible to create a fund to do this, there are many technical issues which would need to be resolved if a fund like this was to launch.

Charitable Hedge Funds – while not necessarily having a different strategy from traditional hedge funds, these charitable hedge funds would take a portion of their profits and devote them to charitable causes.  Presumably the sponsor of a charitable hedge fund would create such a fund for his network of friends and family, all of whom would have similar views on the nature of the charitable donation.

Shariah Compliant Hedge Funds – such funds have become more over the past couple of years and are expected to continue such growth in the future.

Other Issues – in general, establishing a non-traditional hedge fund or pooled investment vehicle will involve the same basic steps as forming a hedge fund (see Start Up Hedge Fund Timeline).  The key issue is what type of assets the fund will buy and sell.  The nature of the assets will necessarily drive the structure.  These are they types of issues you would discuss with your attorney, include whether the manager will need to be registered as an investment advisor. Other articles of interest may include:

* The Vice Fund is a mutal fund which invests in domestic and foreign companies engaged in the aerospace and defense industries, owners and operators, gaming facilities as well as manufacturers of gaming equipment, manufactures of tobacco products and producers of alcoholic beverages.  The website can be found here.

The Beginning of Hedge Fund Regulation…

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As much as it is despised by all in the industry, it is likely that hedge fund regulation will be coming to the U.S.  Today the House Oversight Committee interviewed three very important regulations as part of an examination into the role of federal regulators in the current financial crisis.  Congress will interview Former Federal Reserve Chairman Alan Greenspan, Former Treasury Secretary John Snow and SEC Chairman Christopher Cox.  Hopefully these three will be able to stem the rising tide of hedge fund regulation rhetoric and help congress to realize that hedge funds are not the problem.

From the House website:

Committee Holds Hearing on the the Role of Federal Regulators in the Financial Crisis
Table of Contents

The Committee is holding a hearing titled, “The Financial Crisis and the Role of Federal Regulators” at 10:00 a.m. on Thursday, October 23, 2008, in 2154 Rayburn House Office Building. The hearing will examine the roles and responsibilities of federal regulators in the current financial crisis.

From the SEC website:

Chairman Christopher Cox to Testify

Chairman Cox will testify before the House Committee on Oversight and Government Reform on Thursday, October 23, 2008, at 10:00 a.m. at the Rayburn House Office Building, Room 2154, concerning “The Role of Federal Regulators”.

Distressed Debt Fund of Hedge Funds to be Launched Soon

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As many hedge funds scramble to keep investor’s from redeeming and/or proposing to restructure the terms of the fund, other funds are getting ready for the next wave of hot investments: distressed assets.

As evidence that money will be moving into these areas is a story by Reuters about a new launch of a distressed debt fund of funds.  According to the article, the fund of funds will invest in other distressed asset hedge funds and will have a two year lock up person.  GAM chief executive David M. Solo told Reuters that “We are completing a thorough review of a range of the best managers in the U.S. and Europe so as to create a diversified vehicle to benefit from this unique opportunity.”

While this is the first article I have seen announcing a fund of funds focusing on this asset strategy, there are likely to be more of these fund of funds launching in the future.  The New York Times also ran a story this morning about “vulture investors” sitting on the sidelines for now.  While the NYT article discusses players biding their time, it also notes that the “volume of loan portfolios sold in the first three weeks of October has already beaten the previous monthly record.”  This indicates that the area is heating up and is likely to be a popular strategy near the end of this year and the beginning of next.  Additionally, other types of credit based funds, like asset based lending funds, are likely to be popular in the next year as the credit markets continue to be locked.

Investing in distressed assets has always been one of the central hedge fund strategies.  These investments might include investing in distressed debt and other types of distressed assets.  One of the bigger issues for investors in distressed asset hedge funds is going to be lock-up period.  Because the asset class is not as liquid, the lock-up for investors is going to be longer, as it will generally be in the hedge fund industry going forward.

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