Monthly Archives: October 2008

Schedule 13D

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Below is information from the SEC’s website on Schedule 13D which can be found here.  Generally, hedge fund managers who must file Schedule 13D will have their hedge fund attorney submit this filing for them on their behalf.  Additionally, there may be other legal issues which arise and so it is advisable for the manager to discuss all aspects of an investment subject to the filing requirements of Section 13(d) of the Securities Exchange Act.

Schedule 13D

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.

For more information, please contact us.  Additional information can be found:

Hedge Fund Capital – How to Raise Assets for a Hedge Fund

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The biggest issue for start up hedge funds (and also established hedge fund managers) is how to grow assets under management.  Growing a hedge fund’s capital base is very important because increased AUM mean both increased management fees and performance fees (assuming the fund has positive performance returns).   This article focuses on traditional avenues of raising capital for a hedge fund.

Raising Hedge Fund Capital – Friends and Family

Most hedge funds raise capital to start up through their friends and families.  Often this can be a significant sum, other times it can be relatively small.  I have seen some hedge funds start with as little as $500,000 and sometimes less.  Often, after a hedge fund has a few months of performance (assuming again positive performance) these friends and family members will invest more money.  Other friends and family members, who did not originally invest, may also decided to invest.  Family members of investors may also be persuaded to invest in the hedge fund.

Generally investments from friends and family are completed fairly quickly and through less formal conversations than from other types of investors.  However, the hedge fund manager must always make sure that the friends and family have the fund’s offering documents and have made the appropriate representations in the subscription documents.

After an initial investment from friends and family, it is important for a start up manager to focus on the trading as it is most important to have a good 6-12 month track record that you will be able to market to other potential investors.

Raising Hedge Fund Capital – High Net Worth Individual Investors

High net worth investors (generally qualified purchasers as well as some qualified clients and accredited investors) often invest in hedge funds.  High net worth investors will usually have legal and investing teams which will vet the managers and the strategy.  Usually there will at least be a minimum amount of due diligence requests on the manager and the fund.  Managers can be introduced to high net worth investors through their own networks or through other channels such as hedge fund conferences, hedge fund databases or through other means.

Raising Hedge Fund Capital – Institutional Investors

Institutional investors will occasionally invest in hedge funds with a track record shorter than one year.  Generally in these cases the hedge fund sticks out to them for various reasons.  Such reasons might be that the hedge fund performance was just spectacular, or the institutional investor likes the way the particular investment strategy fits within the institution’s allocation design, or the hedge fund manager may have a strong pedigree which appeals to the institutional investor.

Whatever the reason, getting an investment from an institutional investors is usually a longer and more in depth process than receiving money from friends and family or from a high net worth investor.  The hedge fund manager will need to first establish a meeting with the institutional investor.  Generally the meeting will be at the office of the institution and the manager will have a certain amount of time to give his pitch, usually through a pitchbook presentation.  Some managers of the institution will look carefully at these presentations; others will not even open the cover.  However, the hedge fund manager should be ready to answer any number of different questions from the institution regarding the program.  Such questions will likely cover the following topics: risk management procedures, expected performance in down markets, performance analytics, etc.  The hedge fund manager should act composed and answer each question directly and completely – this is the time for the manager to show his knowledge of the investment strategy and sell the strategy to others.

Either before or after the meeting with the institution, the hedge fund manager will likely be asked to complete some basic due diligence.  I’ve outlined a sample request in this article: Institutional Hedge Fund Due Diligence.  After the institution has interviewed and vetted a manager it may take some time before the institution actually invests in the fund.  This happens for a variety of reasons and the hedge fund manager is urged to stay patient during the process.

Non-tradtional forms of raising hedge fund capital

I will be discussing other ways to raise capital in subsequent articles.  Such non-traditional ways include: utilizing the services of a third party marketer, capital introduction services, hedge fund conferences, and hedge fund databases.

Legal Implications of Raising Capital for a Hedge Fund

As most hedge fund managers know, under the Regulation D offering rules managers cannot raise capital through any type of general advertising or solicitation.  This means that they cannot: buy advertising in any financial publications, advertise generally on the internet (but please see article on Hedge Fund Websites), cold call potential investors and or engage in other similar activities.  Additionally, hedge fund managers, and others raising money for hedge funds, must be aware of and abide by all broker-dealer regulations.  This is a very important issue, so please discuss it with your hedge fund attorney (please see Guide to Broker-Dealer Registration).

Please contact us if you have a story on raising capital for you hedge fund – we would like to hear your story and potentially profile your fund on our blog.  Other articles which are related to items in this article include:

Hedge Fund Manager – Information on Hedge Fund Managers

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I have seen many hedge fund managers and, like the investment strategies they pursue, each one is different.  This article will attempt to discuss hedge fund managers in general, if you have any specific questions, please feel free to contact us.

Who are hedge fund managers?

In general hedge fund managers are people who have a strong conviction about their certain investment program and who are willing to put their money where their mouth is so to speak.  At any given time there are any number of different ways to make money and because of this we have a chance to see all types of hedge fund managers, even those who go against conventional wisdom.

What types of backgrounds do hedge fund managers have?

I have seen all types of hedge fund managers.  Many were traders at other investment advisory firms or were brokers at a broker or investment bank.  Many managers were previously employed outside of the financial industry and traded for themselves on the side – managers like this have often found a program that works and want to allow their friends, family and other investors participate in the investment program and potential gains.  Some hedge fund managers were involved in real estate and choose to run a real estate hedge fund or some sort of hybrid hedge fund.  Some managers have relatively less experience in managing money and will act as a kind of sponsor of the hedge fund – participating in the business aspects of the hedge fund like raising assets.

Most all hedge fund managers will have at least a college degree.  Many hedge fund managers, and analysts, will also have a Masters in Business Administration (MBA).  Some hedge fund managers will be former professionals such as doctors or lawyers.  It is also common to see a manager with a third party designation like a Chartered Financial Analyst (CFA) which is bestowed by the CFA Institute.

Are there any exam or qualification requirements to be a hedge fund manager?

There are no specific requirements to be a hedge fund manager, but depending on the domicile of the manager he may need to be registered as an investment advisor with the state securities commission or the SEC.  If a manager was required to be registered as an investment advisor, he would likely need to have the Series 65 exam license or the Series 7 and Series 66.  Depending on the nature of the hedge fund and the extent of the hedge fund’s activities, the manager may need to have the Series 7 and the fund, or a related company, would need to be registered as a broker-dealer.

Is there anything hedge fund managers cannot do?

Generally a hedge fund manager can mold his investment program as he sees fit.  However there are two specific items to note.  First, the manager should be careful when trading that he stays within the description of the trading program.  Especially in these very volatile times, investors are very aware of style drift and managers should be very cognizant of this.

Second, the hedge fund manager cannot violate any laws while trading.  The federal securities laws apply to hedge fund managers who are not registered as investment advisers in certain instances.  In addition to out and out fraud, the manager should not engage in any activities which he is not sure is legal.  If there are any questions, the hedge fund manager should consult a hedge fund attorney.

What are the common qualities of hedge fund managers?

The number one commonality between hedge fund managers is a desire to see their program and ideas come to fruition.  Another trait which is common to hedge fund managers is a very strong work ethic.

What about pedigree?

You will often hear advisors and consultants talk about pedigree, especially hedge fund marketers.  To these groups the term “pedigree” essentially means the strength of the manager’s bio.  A manager who went to Harvard undergrad, Harvard MBA and then worked for Goldman Sachs will have a strong pedigree.  It is generally going to be easier for a manager with a strong pedigree to get his foot in the door with regard to institutions and high net worth investors.

However, having a strong pedigree does not guarantee a hedge fund manager will be able to sell his hedge fund to investors.  Indeed, I have seen firsthand instances where a manager with a strong pedigree did very poorly in front of institutional investors.  Likewise, I have seen where a manager with a less strong pedigree shot the lights out during an institutional investor presentation.  All this is to say that while pedigree is important in the eyes of some, it will not necessarily help a hedge fund manager to raise assets and of course, once a manager has assets, the manager must perform.

Start up hedge fund managers

If you are a start up hedge fund manager, you will first need to discuss the hedge fund formation process with a hedge fund attorney.  Some other articles which provide background on many of the subjects covered in this article include:

Hedge Fund Side Pocket Investments

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Overview of Side Pockets

In general hedge fund side pocket investments are illiquid investments which the hedge fund manager places into a side pocket account.  Mechanically the side pocket account is simply an entry on the hedge fund’s books which is tracked separate from the liquid, non side pocket investments.  The structure is flexible so that an asset can be deemed a side pocket asset at any time – either at the time of purchase or at a later date.  Typically a follow-on investment to an investment in a side pocket account will also be placed in the side pocket.  Hedge fund managers will usually place an outside limit on the amount of assets which can be placed in the side pocket investments, usually calculated as a percentage of the fund’s assets and based on the purchase price of the side pocket investment. There are potentially additional issues for side pocket accounts in a master-feeder structure which should be discussed by the hedge fund attorney.

The actual mechanics of the side pocket account will be discussed in the hedge fund offering documents.  It is advisable that the manager discuss the side pocket provision with the administrator and the auditor as well to make sure that all of the service providers are comfortable with the mechanics of the account.

The following asset types are usually good candidates for side pocket accounts:

  • Real Estate
  • PIPEs
  • Thinly traded securities
  • Private Equity investments
  • Any follow-on investment related to the above

Reasons for the side pocket account

The main reason to have a side pocket investment is so that the manager does not get under or overpaid from a valuation before an investment is sold.  For instance, if the manager held a piece of property in a non-side pocket account it would be difficult to find a valuation for the property at the end of a performance fee period.  Because managers are paid a performance fee (or allocated gains) on unrealized as well as realized investments, there is the potential for the manager to overstate the hedge funds unrealized gains by overvaluing the piece of property.

Another characteristic of the side pocket account is that a withdrawing investor cannot receive any part of his investment which is in the side pocket account.  This allows the manager the flexibility to sell an illiquid asset on the manager’s terms and not merely to satisfy an investor’s redemption request.  Once the side pocket investment is liquidated, appropriate distributions are made to the investor which has made a previous redemption.

Please feel free to contact us with any questions.  Other articles which relate to this subject include:

Hedge Fund PIPE Transactions

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What are PIPE transactions?

The SEC has defined a PIPE transaction as follows:

“PIPE” stands for “private investment in public equity.” In a PIPE offering, investors commit to purchase a certain number of restricted shares from a company at a specified price. The company agrees, in turn, to file a resale registration statement so that the investors can resell the shares to the public. To the extent that they increase the supply of a company’s stock in the market, PIPE offerings can potentially dilute the value of existing shares.  (Source)

Hedge Fund Investments – PIPE transactions

PIPE transactions can be a part of a hedge fund investment strategy and in some cases a whole investment strategy. Generally hedge fund managers who focus on PIPE investments are hoping for a large exit strategy such as a reverse merger or a public offering.  Such managers have experience in the PIPE space and have concluded many PIPE transactions.

For such hedge fund managers, there are many considerations with regard to these investments including:

Structure – hedge fund managers who invest in PIPEs can be very creative when it comes to the structure of their hedge fund.  The fund can be structured as a private equity fund, a normal hedge fund or a combination.  A manager should discuss the options with his attorney.

Side Pocket Investments – based on the structure of the fund, the manager may want to institute side pocket investments.  Side pocket investments allow a manager to segregate certain illiquid or hard to value assets until a disposition of the asset.  A side pocket investment would be more likely in a normal hedge fund or a combination fund.  Many PIPE hedge funds have side pocket investments.

Lock-up – because of the recent market volatility and the rush for redemptions, many managers are re-examining their lock-up periods.  For hedge funds with investments in illiquid securities, this is especially important from a cash management perspective.  The manager should spend some time discussing the lock-up with the attorney; the lock-up should generally be a little longer than the expected time horizon of the investments.  For example, if the fund will make PIPE investments which is expected to have an 18 month duration then the lock-up should not be only a year.

Investment program – the manager will need to define the areas and limits of the investment program in the offering documents.  While broad and vague investment programs have generally been acceptable, it is likely that investors are going to want to know more specifics of the program going forward.  The manager will want to describe what types of companies it will invest in, what types of securities it will recieve (common stock, warrants, and convertible instruments), what the manager looks for in a potential company/ management team, what is the expected duration of the investment, among other items.  Of course the manager should include a component dealing with its risk management procedures as well.

Fee range – generally PIPE investments will follow the standard fee range for hedge funds.  The manager may choose to institute a higher management fee.  Additionally, thought should be given to the fund’s expenses in making investments.

Risks and Other Considerations for PIPE hedge funds

Liquidity – the PIPE securities which the hedge fund owns are not liquid.  Accordingly the hedge fund manager will need to closely manage the hedge fund’s cash.  While manager used to be able to rely on some sort of credit facility to take care of the fund’s cash management needs, this is not as likely to be the case in the tight credit markets today.

Valuation – like many hedge fund strategies the central concern for hedge funds with a PIPE program is going to be valuation.  The fund will hold some of the more illiquid assets – restricted securities which cannot be sold for a certain amount of time.  As with other programs with liquidity issues, the basic methods of valuation include: (1) book value; (2) outside valuation agent; or (3) by formula. There are advantages and disadvantages to each one of these methods and if you need to have a valuation methodology your lawyer will be able to help you to decide on one of theses methods.  A manager should also discuss the valuation with the administrator and the auditor as well.

Contractual risk – there is a risk that the underlying company would not honor the contractual provisions of the PIPE transaction.  In such a case it is likely that a hedge fund would seek to enforce its contractual rights through the court system which is both time consuming and expensive.

Regulatory risks – there are various regulatory risks associated with PIPE investments.  Central is an investigation into the PIPE transaction by the SEC.  As discussed in greater depth below, the SEC is very interested in PIPE transactions. There is also the risk that, as a reseller of securities, the fund may deemed to be an underwriter which would subject it to further regulation – the hedge fund manager and attorney should discuss this issue.

Due Diligence – the fund managers must conduct research and due diligence on the underlying company.  This type of research is typically more involved than many hedge fund investing strategies.  If the manager will be conducting in-person reviews of the company and the company’s management team, the manager should discuss this with the hedge fund attorney so that the offering documents explicitly state that such expenses be paid by the fund instead of the management company.

SEC on PIPE transactions

The SEC has taken many enforcement actions over the years on PIPE transactions.  Hedge fund managers should be especially aware of this because the SEC is on the lookout and the fines are stiff.  Below are a few of the many actions the SEC has taken to stop abusive PIPE transactions:

SEC v. Deephaven Capital Management, LLC (release)

In this case a hedge fund manager traded on insider information.  The manager received information that a PIPE transaction would be announced and sold short the publicly traded securities of the company.  When the PIPE transaction was announced, the stock went lower and the fund made large gains.  The manager had to disgorge the profits and was subject to a fine.

SEC v. Joseph J. Spiegel (release)

This case represents a classic PIPE case – the hedge fund manager agreed to participate in a PIPE transaction and then sold the company’s stock short, against representations that he would not.  When the restricted stock became unrestricted, he used this stock to cover his previous short.  The manager had to pay a fine and was also barred from association with any investment advisor for five years.

SEC v. Jeanne M. Rowzee, James R. Halstead, and Robert T. Harvey (release)

In this case fraudsters promoted investments in PIPE transactions but never invested the money and instead spent lavishly on themselves.  In classic Ponzi Scheme fashion, the fraudsters solicited new investors to pay off the original investors.

As always, please feel free to contact us if you have any questions.  Additional resources which relate to this post include:

Hedge Fund Analyst Fined for Insider PIPE Trading

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According to a SEC litigation release, a hedge fund analyst was fined $317,000 for engaging in insider trading with regard to a PIPE investment.  PIPE transactions are subject to close scrutiny from the SEC.  In this instance the fund which the analyst worked for established a short position in a company which was completing a PIPE transaction.  Evidently the reason the fund established the short was because of inside information about the deal from the analyst.  The SEC release can be found here.

U.S. SECURITIES AND EXCHANGE COMMISSION
Litigation Release No. 20784 / October 20, 2008
SEC v. Brian D. Ladin et al., Civil Action No. 1:08-CV-01784 (RBW) (D.D.C.)

SEC Charges Former Hedge Fund Analyst with Improper Trading

The Securities and Exchange Commission today charged Brian D. Ladin, a former analyst for Bonanza Master Fund Ltd. (“Bonanza”), a Dallas-based hedge fund, with improper trading in the U.S. District Court for the District of Columbia. Ladin, without admitting or denying the allegations in the Commission’s complaint, agreed to settle charges that he engaged in unlawful insider trading in connection with a 2004 “PIPE” (an acronym for private investment in public equity) offering conducted by Radyne Comstream Inc. As detailed below, Ladin agreed to entry of a final judgment imposing an injunction and ordering him to pay $330,427, consisting of $13,427 in disgorgement and prejudgment interest and a $317,000 civil penalty.

The Commission’s complaint alleges, among other things, that Ladin accepted a duty to keep the offering information confidential. The Complaint further alleges that Ladin, on the basis of the material, non-public PIPE information, presented an investment in Radyne to Bonanza, resulting in Bonanza establishing a 100,000 share short position in Radyne stock. The Commission’s complaint further alleges that Ladin, in signing the offering’s stock purchase agreement on behalf of Bonanza, represented that Bonanza did not hold a short position in Radyne common stock when he knew, or was reckless or negligent in not knowing, that Bonanza held a short position in Radyne’s common stock.

Ladin consented to the entry of a final judgment (i) permanently enjoining him from future violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Section 17(a) of the Securities Act of 1933; (ii) ordering him to pay $10,895 in disgorgement, along with $2,532 in prejudgment interest thereon; and (iii) ordering him to pay a $317,000 civil penalty. Bonanza and its investment adviser, Bonanza Capital, Ltd., consented to the entry of a final judgment ordering them, as relief defendants, to pay a total of $371,429 in ill-gotten gains derived from Ladin’s unlawful conduct (and prejudgment interest thereon).

For more information on this subject, please see:

  • Hedge Funds and PIPE Transactions

If you have any questions, please contact us.

Hedge Fund Service Providers Expanding During Market Turmoil

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If you read a lot of the stories which have been coming out in the last couple of weeks, you would think that the hedge fund industry was about to go the way of the dinosaur.  (See NYT Deal Book Article)  Personally, I think the exact opposite – that the hedge fund industry, after a bit of a cooling off period, will see assets come back to the table in greater force than before.  I also believe that hedge funds will become more institutionalized products with more robust due diligence procedures as a standard practice and that hedge funds will (eventually) emerge as retail products.  Whether any of the above happens quickly or slowly remains to be seen, but there were four separate press releases we published last week that shows hedge fund service providers are especially bullish on the industry.

The four press releases deal with (1) expanding hedge fund due diligence; (2) increased investment from single family offices; (3) prime brokers continuing expansion based on industry changes and (4) a hedge fund administrator moving into the prime brokerage arena.  I’ve highlighted the takeaways from the press releases below.

1.  Hedge Fund Due Diligence Firm Expands. (Link to release)  The press release below provides details on a hedge fund due diligence firm which is expanding its operations.  In the coming months and years hedge fund due diligence is poised to become a central part of the hedge fund investing process. Specifically, the press release quotes the new hire as saying… “in the current markets, hedge fund investors face multiple challenges that, more than ever, involve operational risk. Investors must understand many new issues, including counterparty risks, the impact of FAS 157 and how to deal with funds which impose gates, suspend redemptions or restructure. Castle Hall helps investors enhance their due diligence program and better respond to these new challenges.”  I completely agree.  For more information on due diligence, please see the following HFLB articles:

2.  Single family offices to increase hedge fund investing in the next year. (Link to release) Rothstein Kass, a well known hedge fund audit and administration firm, released a study which indicates that Single Family Offices will continue to invest in hedge funds.  This press release states two interesting items from the report:

Good Performance and Additional Investment – family offices are generally happy with the performance of hedge funds and will commit more money to funds within the next twelve months.

Transparency – the release states that more than 70% of single family offices said that a lack of transparency in their hedge fund investments is concerning.  Additionally, a director of Rothstein Kass is quoted as saying  “while high-net-worth individuals generally recognize advantages of hedge fund investing, they are frequently confounded by the growing roster of products and services available.”  This really comes as no surprise and signals that hedge fund due diligence will become a major focus from here on out.  Transparency is achieved not only through the hedge fund manager, but also through hedge fund service providers who have developed technology solutions to offer to hedge fund managers.  On a going forward basis hedge funds are going to need to be more transparent.  For more information, please also see:

3.  Prime Broker continues to expand during industry changes. (Link to release) The prime brokerage industry is going through a lot of changes currently as the biggest prime brokerage firms, Goldman and Merrill have changed into bank holding companies.  Additionally, with the collapse of Lehman, the conventional wisdom is for larger hedge funds to prime with multiple brokers.  As this trend continues to develop I expect that more firms will jump into the prime brokerage business and that prime brokers will begin to offer more back office and administration services to hedge funds.  New and surviving hedge funds should benefit as prices decrease and quality of services increase.

4.  Hedge fund administration and back office firm, announced that it is expanding into hedge fund prime brokerage. (Link to release) This press release highlights two specific interesting trends in the hedge fund industry.  The first is the move from segregated service providers to shows which provide a whole suite of services including back office, admin and prime brokerage.  The second trend is the move from one main prime broker to housing assets at many prime brokerage firms.  We saw with the collapse at Lehman and the corresponding freeze of some hedge fund assets, that small and large funds alike want to diversify across brokers and custodians.  I believe Conifer is the first in a wave of admin/ back office firms which will put a shingle out as a mini-prime or introducing prime broker.

Conclusion

While none of these individually provide conclusive evidence that the industry will remain strong in the coming months, it does show that people in the industry are investing in the infrastructure which will allow the industry to expand in the coming years. Please feel free to contact us if you have questions or comments on any of the above.

Hedge Fund Graduated Performance Fees

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No two hedge funds or hedge fund managers are the same – the same is also true for hedge fund performance fees which can take any structure that the hedge fund manager fancies.  I have seen many different styles of performance fees and many different hedge fund hurdle rates.

Some managers will institute “graduated” performance fees.  The graduated performance fee is characterized by fees which change based on the returns to the partnership.  The fee is typically calculated on gross returns.  Many times you will see a hurdle rate with a graduated performance fee. An example of a graduated performance fee follows:

  • Returns up to 20% will be charged a 20% performance fee
  • Returns of 20% to 40% will be charged a 25% performance fee
  • Returns of 40% to 50% will be charged a 35% performance fee
  • Returns greater than 50% will be charged a 40% performance fee

There are two different ways the fee can be applied.  The fee can be on the overall returns or it can be on the returns from the plateau only.  Using the numbers from above, here is how it would work:

If straight 20% performance fee applies:

Total
Return    % to Manager        % to Investors
20%        4%                        16%
40%        8%                        32%
50%        10%                      40%
60%        12%                      48%

If fee applies to overall returns:

Total
Return    % to Manager        % to Investors
20%        4%                        16%
40%        10%                      30%
50%        17.5%                   32.5%
60%        24%                      36%

If fee applies to return on each plateau only:

Total
Return    % to Manager        % to Investors
20%        4%                        16%
40%        9%                        31%
50%        12.5%                   38.5%
60%        16.5%                   43.5%

The purpose of the graduated performance fee is to provide greater marginal compensation to the hedge fund manager when the fund’s performance is particularly good.  One downfall of the graduated performance fee is the potential for the manager to take excessive risks once a certain return level has been reached in order to get to a higher performance plateau.  Generally, it seems that in my experience, both investors and managers can benefit from the graduated performance fee structure.  As I noted above, though, each hedge fund fee structure is different and a graduated performance fee may not be appropriate in all situations.

Other related articles:

Please contact us if you would like to discuss performance fees or other issues.

Hedge Fund Manager Fined and Banned for a Year for “Portfolio Pumping”

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This is another example of a hedge fund manager acting with incredible audacity.

Last week the SEC issued a release detailing an action taken against a hedge fund manager for his “portfolio pumping” practices.  Bascially the manager was caught buying a large amount of shares through another fund he ran in order to boost the price of the thinly traded security.  The manager then charged higher management fees based on the inflated price of the securities.  The manager was fined $100,000 and ordered to disgorge the higher management fee of $80,000.

The end of the release states that the adviser will be allowed to reapply for association with an investment advisor for a year, but I believe the damage has been done.  If this manager does start another fund, proper hedge fund due diligence will show this SEC action which by itself should send investors running for the door.  In this case the hedge fund manager ruined his career for a few thousand dollars.

The release can be found in full here.

SEC Charges San Francisco Hedge Fund Adviser for “Portfolio Pumping”
FOR IMMEDIATE RELEASE
2008-251

Washington, D.C., Oct. 16, 2008 — The Securities and Exchange Commission today charged San Francisco investment adviser MedCap Management & Research LLC (MMR) and its principal Charles Frederick Toney, Jr. with reporting misleading results to hedge fund investors by engaging in a practice known as “portfolio pumping.”

The SEC alleges that Toney made extensive quarter-end purchases of a thinly-traded penny stock in which his fund was heavily invested, more than quadrupling the stock price and allowing him to report artificially inflated quarterly results to fund investors. Without admitting or denying the SEC’s allegations, MMR and Toney have agreed to settle the charges by paying financial penalties and agreeing to an order barring Toney from acting as an investment adviser for at least one year.

“Fund investors relied on MMR and Toney to abide by their fiduciary duties and put the fund’s interests ahead of their own,” said Marc J. Fagel, Regional Director of the SEC’s San Francisco Regional Office. “Instead, Toney engaged in trading activity which hid his poor performance.”

According to the SEC’s order, MedCap Partners L.P. (MedCap), a hedge fund run by MMR and Toney, was suffering from dramatic losses and facing increasing redemptions from fund investors by September 2006. Over the last four days of the month, Toney — through a separate fund that MMR managed — placed numerous buy orders for a thinly-traded over-the-counter stock in which MedCap already was heavily invested. Toney’s buying pressure caused the stock price to more than quadruple, from $0.85 to $3.72.

The SEC alleges that because the stock represented over one-third of MedCap’s holdings, the brief boost in its price inflated MedCap’s reported value by $29 million, masking what would otherwise have been a 40 percent quarterly loss for MedCap. Immediately after the quarter ended, Toney reported to MedCap’s investors that the fund’s investments had begun to “bounce” and that the fund’s performance was improving. Toney failed to disclose that this “bounce” was almost entirely the result of his four-day purchasing spree. Following MMR’s brief buying activity, both the stock price and MedCap’s asset value declined to their previous levels.

According to the SEC’s order, at the same time, MMR charged fees to the fund based on the inflated quarter-end asset value.

The Commission found that MMR and Toney breached their fiduciary duties to MedCap and to MMR’s other fund in which the penny stock was acquired. Toney and MMR, without admitting or denying the Commission’s findings, have agreed to cease and desist from violating the antifraud provisions of the Investment Advisers Act of 1940. MMR also will disgorge the higher management fees it received due to the inflated fund asset value, plus interest — an amount totaling $70,633.69 — and receive a Commission censure. Toney also has agreed to a bar from association with any investment adviser with the right to reapply after one year, and to pay a $100,000 penalty.

Other releated articles:

Please contact us if you have questions or if you would like to discuss.

NFA to Begin Regulating FOREX

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The last unregulated space within the hedge fund industry was the retail foreign exchange (“Forex”) market.  As of November 30 of this year, many hedge fund managers which invest in the spot forex markets will need to be registered with the NFA.  More analysis on this to follow.

The press release and the new NFA rules follow below.

Notice I-08-26

October 16, 2008

Effective Date of NFA Compliance Rules 2-41 and 2-42: Disclosure by Forex Pool Operators and Trading Advisors

NFA has received notice that the Commodity Futures Trading Commission has approved NFA Compliance Rules 2-41 and 2-42. The new rules will become effective on November 30, 2008. Accordingly, after November 30th Members that manage forex accounts on behalf of customers or offer pools trading forex must provide prospective clients and pool participants with a disclosure document that has been filed with NFA prior to use. The new rules only apply if the forex pool or the person for whom the forex account is being managed is not an eligible contract participant as defined in Section 1a(12) of the Commodity Exchange Act. A forex pool, however, may not claim to be an eligible contract participant by virtue of Section 1a(12)(A)(v)(II) or (III) of the Commodity Exchange Act.

The disclosure document must provide disclosures similar to those currently required under CFTC Part 4 regulations. Finally, a Member operating a pool subject to the new rules must provide periodic (monthly or quarterly) account statements and an annual report to the pool participants.

Copies of the new rules are attached for your convenience. Additionally, NFA’s February 29, 2008, submission letter to the CFTC contains a more detailed explanation of the changes. You can access an electronic copy of the submission letter at http://www.nfa.futures.org/news/newsRuleSubLetter.asp?ArticleID=2101.

Questions concerning these changes should be directed to Mary McHenry, Senior Manager, Compliance ([email protected] or 312-781-1420) or Susan Koprowski, Manager, Compliance ([email protected] or 312-781-1288).

COMPLIANCE RULES

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Part 2 – RULES GOVERNING THE BUSINESS CONDUCT OF MEMBERS REGISTERED WITH THE COMMISSION

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RULE 2-41. FOREX POOL OPERATORS AND TRADING ADVISORS

(a) Pool Operators. Except for Members who meet the criteria in Bylaw 306(b) and Associates acting on their behalf, any Member or Associate operating or soliciting funds, securities, or property for a pooled investment vehicle that is not an eligible contract participant as defined in Section 1a(12) of the Act must comply with this section (a) if it enters into or intends to enter into any transaction described in NFA Bylaw 1507(b)(1) except as described in NFA Bylaw 1507(b)(3). For purposes of this section, a pooled investment vehicle may not claim to be an eligible contract participant by virtue of Section 1(a)(12)(A)(v)(II) or (III) of the Act.

(1) For each such pooled investment vehicle, the Member or Associate must prepare a Disclosure Document and must file it with NFA at least 21 days before soliciting the first potential pool participant that is not an eligible contract participant.

(2) The Member or Associate must deliver the Disclosure Document to a prospective pool participant who is not an eligible contract participant no later than the time it delivers the subscription agreement for the pool. Any information delivered before the Disclosure Document must be consistent with the information in the Disclosure Document.

(3) The Disclosure Document must comply with the requirements in CFTC Regulations 4.24, 4.25, and 4.26 as if operating a pool trading on-exchange futures contracts. The term “commodity interest” in those regulations should be read to include forex transactions, and the Risk Disclosure Statement required by CFTC Regulation 4.24(b)(1) must be replaced by the following if the pool does not trade on-exchange contracts and must be added as a separate statement if the pool trades both on-exchange contracts and forex.

RISK DISCLOSURE STATEMENT

YOU SHOULD CAREFULLY CONSIDER WHETHER YOUR FINANCIAL CONDITION PERMITS YOU TO PARTICIPATE IN A POOLED INVESTMENT VEHICLE. IN SO DOING, YOU SHOULD BE AWARE THAT THIS POOL ENTERS INTO TRANSACTIONS THAT ARE NOT TRADED ON AN EXCHANGE, AND THE FUNDS THE POOL INVESTS IN THOSE TRANSACTIONS MAY NOT RECEIVE THE SAME PROTECTIONS AS FUNDS USED TO MARGIN OR GUARANTEE EXCHANGE-TRADED FUTURES AND OPTIONS CONTRACTS. IF THE COUNTERPARTY BECOMES INSOLVENT AND THE POOL HAS A CLAIM FOR AMOUNTS DEPOSITED OR PROFITS EARNED ON TRANSACTIONS WITH THE COUNTERPARTY, THE POOL’S CLAIM MAY NOT RECEIVE A PRIORITY. WITHOUT A PRIORITY, THE POOL IS A GENERAL CREDITOR AND ITS CLAIM WILL BE PAID, ALONG WITH THE CLAIMS OF OTHER GENERAL CREDITORS, FROM ANY MONIES STILL AVAILABLE AFTER PRIORITY CLAIMS ARE PAID. EVEN POOL FUNDS THAT THE COUNTERPARTY KEEPS SEPARATE FROM ITS OWN OPERATING FUNDS MAY NOT BE SAFE FROM THE CLAIMS OF OTHER GENERAL AND PRIORITY CREDITORS.

FOREX TRADING CAN QUICKLY LEAD TO LARGE LOSSES AS WELL AS GAINS. SUCH TRADING LOSSES CAN SHARPLY REDUCE THE NET ASSET VALUE OF THE POOL AND CONSEQUENTLY THE VALUE OF YOUR INTEREST IN THE POOL. IN ADDITION, RESTRICTIONS ON REDEMPTIONS MAY AFFECT YOUR ABILITY TO WITHDRAW YOUR PARTICIPATION IN THE POOL.

INVESTMENTS IN THE POOL MAY BE SUBJECT TO SUBSTANTIAL CHARGES FOR MANAGEMENT, ADVISORY, AND BROKERAGE FEES, AND THE POOL MAY NEED TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETING OR EXHAUSTING ITS ASSETS. THIS DISCLOSURE DOCUMENT CONTAINS A COMPLETE DESCRIPTION OF EACH EXPENSE (SEE PAGE [insert page number]) AND A STATEMENT OF THE PERCENTAGE RETURN NECESSARY TO BREAK EVEN, THAT IS, TO RECOVER THE AMOUNT OF YOUR INITIAL INVESTMENT (SEE PAGE [insert page number]).

THIS BRIEF STATEMENT CANNOT DISCLOSE ALL THE RISKS AND OTHER FACTORS NECESSARY TO EVALUATE YOUR PARTICIPATION IN THIS POOL. THEREFORE, BEFORE YOU DECIDE TO PARTICIPATE YOU SHOULD CAREFULLY REVIEW THIS DISCLOSURE DOCUMENT, INCLUDING A DESCRIPTION OF THE PRINCIPAL RISK FACTORS OF THIS INVESTMENT (SEE PAGE [insert page number]).

NATIONAL FUTURES ASSOCIATION HAS NEITHER PASSED UPON THE MERITS OF PARTICIPATING IN THIS POOL NOR THE ADEQUACY OR ACCURACY OF THIS DISCLOSURE DOCUMENT.

(b) Trading Advisors. Except for Members who meet the criteria in Bylaw 306(b) and Associates acting on their behalf, any Member or Associate managing, directing or guiding, or soliciting to manage, direct, or guide, accounts or trading on behalf of a client that is not an eligible contract participant as defined in Section 1a(12) of the Act by means of a systematic program must comply with this section (b) if it intends to manage, direct, or guide the client’s account or trade in transactions described in NFA Bylaw 1507(b).

(1) The Member or Associate must prepare a Disclosure Document and must file it with NFA at least 21 days before soliciting the first potential client that is not an eligible contract participant.

(2) The Member or Associate must deliver the Disclosure Document to a prospective client who is not an eligible contract participant no later than the time it delivers the agreement to manage, direct, or guide the client’s account or trading. Any information delivered before the Disclosure Document must be consistent with the information in the Disclosure Document.

(3) The Disclosure Document must comply with the requirements in CFTC Regulations 4.34, 4.35, and 4.36 as if managing, directing, or guiding accounts or trading in on-exchange futures contracts. The term “commodity interest” in those regulations should be read to include forex transactions, and the Risk Disclosure Statement required by CFTC Regulation 4.34(b)(1) must be replaced by the following if the managed, directed, or guided account or trading will not include transactions in on-exchange contracts and must be added as a separate statement if it will include transactions in both on-exchange contracts and forex.

RISK DISCLOSURE STATEMENT

THE RISK OF LOSS IN FOREX TRADING CAN BE SUBSTANTIAL. YOU SHOULD THEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. IN CONSIDERING WHETHER TO TRADE OR TO AUTHORIZE SOMEONE ELSE TO TRADE FOR YOU, YOU SHOULD ALSO BE AWARE OF THE FOLLOWING:

FOREX TRANSACTIONS ARE NOT TRADED ON AN EXCHANGE, AND THOSE FUNDS DEPOSITED WITH THE COUNTERPARTY FOR FOREX TRANSACTIONS MAY NOT RECEIVE THE SAME PROTECTIONS AS FUNDS USED TO MARGIN OR GUARANTEE EXCHANGE-TRADED FUTURES AND OPTIONS CONTRACTS. IF THE COUNTERPARTY BECOMES INSOLVENT AND YOU HAVE A CLAIM FOR AMOUNTS DEPOSITED OR PROFITS EARNED ON TRANSACTIONS WITH THE COUNTERPARTY, YOUR CLAIM MAY NOT RECEIVE A PRIORITY. WITHOUT A PRIORITY, YOU ARE A GENERAL CREDITOR AND YOUR CLAIM WILL BE PAID, ALONG WITH THE CLAIMS OF OTHER GENERAL CREDITORS, FROM ANY MONIES STILL AVAILABLE AFTER PRIORITY CLAIMS ARE PAID. EVEN CUSTOMER FUNDS THAT THE COUNTERPARTY KEEPS SEPARATE FROM ITS OWN OPERATING FUNDS MAY NOT BE SAFE FROM THE CLAIMS OF OTHER GENERAL AND PRIORITY CREDITORS.

THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN FOREX TRADING CAN WORK AGAINST YOU AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO LARGE LOSSES AS WELL AS GAINS.

MANAGED ACCOUNTS MAY BE SUBJECT TO SUBSTANTIAL CHARGES FOR MANAGEMENT AND ADVISORY FEES AND THE ACCOUNT MAY NEED TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETING OR EXHAUSTING ITS ASSETS. THIS DISCLOSURE DOCUMENT CONTAINS A COMPLETE DESCRIPTION OF EACH FEE TO BE CHARGED TO YOUR ACCOUNT BY THE ACCOUNT MANAGER. (SEE PAGE [insert page number]).

THIS BRIEF STATEMENT CANNOT DISCLOSE ALL THE RISKS AND SIGNIFICANT ASPECTS OF THE FOREX MARKETS. THEREFORE, YOU SHOULD CAREFULLY REVIEW THIS DISCLOSURE DOCUMENT BEFORE YOU TRADE, INCLUDING THE DESCRIPTION OF THE PRINCIPAL RISK FACTORS OF THIS INVESTMENT (SEE PAGE [insert page number]).

NATIONAL FUTURES ASSOCIATION HAS NEITHER PASSED UPON THE MERITS OF PARTICIPATING IN THIS TRADING PROGRAM NOR THE ADEQUACY OR ACCURACY OF THIS DISCLOSURE DOCUMENT.

RULE 2-42. FOREX POOL REPORTING

(a) Except for Members who meet the criteria in Bylaw 306(b), any Member operating a pool that trades forex must comply with the requirements in CFTC Regulation 4.22 in the same manner as would be applicable to the operation of a pool trading on-exchange futures contracts. The term “commodity interest” in that regulation should be read to include forex transactions.

(b) A Member may file with NFA a request for an extension of time in which to file the annual report in the same form as provided for in CFTC Regulation 4.22(f).