Monthly Archives: May 2010

Hedge Fund Law Blog Notes For Week

Private Fund Investment Advisers Registration Act of 2010

Full Text of PFIARA of 2010 (requiring Hedge Fund Registration)

The following is the full text of the Private Fund Investment Advisers Registration Act of 2010 which was part of the recently passed Senate financial regulation bill. The central part of this act eliminates the Section 203(b)(3) exemption for registration for hedge fund managers (see Section 403). The act also requires hedge fund managers to provide the SEC with certain information about their trading program and investment positions (see Section 404).

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TITLE IV—REGULATION OF ADVISERS TO HEDGE FUNDS AND OTHERS

SEC. 401. SHORT TITLE.

This title may be cited as the ‘‘Private Fund Investment Advisers Registration Act of 2010’’.

SEC. 402. DEFINITIONS.

(a) INVESTMENT ADVISERS ACT OF 1940 DEFINITIONS.—Section 202(a) of the Investment Advisers Act of1940 (15 U.S.C. 80b–2(a)) is amended by adding at the end the following:

‘‘(29) The term ‘private fund’ means an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a–3), but for section 3(c)(1) or 3(c)(7) of that Act.

‘‘(30) The term ‘foreign private adviser’ means any investment adviser who—

‘‘(A) has no place of business in the United States;

‘‘(B) has, in total, fewer than 15 clients who are domiciled in or residents of the United States; on DSKH9S0YB1PROD with BILLS

‘‘(C) has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the investment adviser of less than $25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; and

‘‘(D) neither—

‘‘(i) holds itself out generally to the public in the United States as an investment adviser; nor

‘‘(ii) acts as—

‘‘(I) an investment adviser to any investment company registered under the Investment Company Act of 1940; or

‘‘(II) a company that has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940 (15 U.S.C. 80a–53), and has not withdrawn its election.’’.

(b) OTHER DEFINITIONS.—As used in this title, the terms ‘‘investment adviser’’ and ‘‘private fund’’ have the same meanings as in section 202 of the Investment Advisers Act of 1940, as amended by this title.

SEC. 403. ELIMINATION OF PRIVATE ADVISER EXEMPTION; LIMITED EXEMPTION FOR FOREIGN PRIVATE ADVISERS; LIMITED INTRASTATE EXEMPTION.

Section 203(b) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3(b)) is amended—

(1) in paragraph (1), by inserting ‘‘, other than an investment adviser who acts as an investment adviser to any private fund,’’ before ‘‘all of whose’’;

(2) by striking paragraph (3) and inserting the following:

‘‘(3) any investment adviser that is a foreign private adviser;’’; and

(3) in paragraph (5), by striking ‘‘or’’ at the end; (4) in paragraph (6), by striking the period at the end and inserting ‘‘; or’’; and (5) by adding at the end the following: ‘‘(7) any investment adviser, other than any entity that has elected to be regulated or is regulated as a business development company pursuant to section 54 of the Investment Company Act of 1940 (15 U.S.C. 80a–54), who solely advises— ‘‘(A) small business investment companies that are licensees under the Small Business Investment Act of 1958; ‘‘(B) entities that have received from the Small Business Administration notice to proceed to qualify for a license as a small business investment company under the Small Business Investment Act of 1958, which notice or license has not been revoked; or ‘‘(C) applicants that are affiliated with 1 or more licensed small business investment companies described in subparagraph (A) and that have applied for another license under the Small Business Investment Act of 1958, which application remains pending.’’.

SEC. 404. COLLECTION OF SYSTEMIC RISK DATA; REPORTS; EXAMINATIONS; DISCLOSURES.

Section 204 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–4) is amended—

(1) by redesignating subsections (b) and (c) as subsections (c) and (d), respectively; and

(2) by inserting after subsection (a) the following:

‘‘(b) RECORDS AND REPORTS OF PRIVATE FUNDS.—

‘‘(1) IN GENERAL.—The Commission may require any investment adviser registered under this title—

‘‘(A) to maintain such records of, and file with the Commission such reports regarding, private funds advised by the investment adviser, as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk by the Financial Stability Oversight Council (in this subsection referred to as the ‘Council’); and

‘‘(B) to provide or make available to the Council those reports or records or the information contained therein.

‘‘(2) TREATMENT OF RECORDS.—The records and reports of any private fund to which an investment adviser registered under this title provides investment advice shall be deemed to be the records and reports of the investment adviser.

‘‘(3) REQUIRED INFORMATION.—The records and reports required to be maintained by a private fund and subject to inspection by the Commission under this subsection shall include, for each private fund advised by the investment adviser, a description of—

‘‘(A) the amount of assets under management and use of leverage;

‘‘(B) counterparty credit risk exposure;

‘‘(C) trading and investment positions;

‘‘(D) valuation policies and practices of the fund;

‘‘(E) types of assets held;

‘‘(F) side arrangements or side letters, whereby certain investors in a fund obtain more favorable rights or entitlements than other investors;

‘‘(G) trading practices; and

‘‘(H) such other information as the Commission, in consultation with the Council, determines is necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk, which may include the establishment of different reporting requirements for different classes of fund advisers, based on the type or size of private fund being advised.

‘‘(4) MAINTENANCE OF RECORDS.—An investment adviser registered under this title shall maintain such records of private funds advised by the investment adviser for such period or periods as the Commission, by rule, may prescribe as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk.

‘‘(5) FILING OF RECORDS.—The Commission shall issue rules requiring each investment adviser to a private fund to file reports containing such information as the Commission deems necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

‘‘(6) EXAMINATION OF RECORDS.—

‘‘(A) PERIODIC AND SPECIAL EXAMINATIONS.—The Commission—

‘‘(i) shall conduct periodic inspections of all records of private funds maintained by an investment adviser registered under this title in accordance with a schedule established by the Commission; and

‘‘(ii) may conduct at any time and from time to time such additional, special, and other examinations as the Commission may prescribe as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk.

‘‘(B) AVAILABILITY OF RECORDS.—An investment adviser registered under this title shall make available to the Commission any copies or extracts from such records as may be prepared without undue effort, expense, or delay, as the Commission or its representatives may reasonably request.

‘‘(7) INFORMATION SHARING.—

‘‘(A) IN GENERAL.—The Commission shall make available to the Council copies of all reports, documents, records, and information filed with or provided to the Commission by an investment adviser under this subsection as the Council may consider necessary for the purpose of assessing the systemic risk posed by a private fund.

‘‘(B) CONFIDENTIALITY.—The Council shall maintain the confidentiality of information received under this paragraph in all such reports, documents, records, and information, in a manner consistent with the level of confidentiality established by the Commission pursuant to paragraph (8). The Council shall be exempt from section 552 of title 5, United States Code, with respect to any information in any report, document, record, or information made available, to the Council under this subsection.’’.

‘‘(8) COMMISSION CONFIDENTIALITY OF REPORTS.—Notwithstanding any other provision of law, the Commission may not be compelled to disclose any report or information contained therein required to be filed with the Commission under this subsection, except that nothing in this subsection authorizes the Commission—

‘‘(A) to withhold information from Congress, upon an agreement of confidentiality; or

‘‘(B) prevent the Commission from complying with—

‘‘(i) a request for information from any other Federal department or agency or any self-regulatory organization requesting the report or information for purposes within the scope of its jurisdiction; or

‘‘(ii) an order of a court of the United States in an action brought by the United States or the Commission.

‘‘(9) OTHER RECIPIENTS CONFIDENTIALITY.— Any department, agency, or self-regulatory organization that receives reports or information from the Commission under this subsection shall maintain the confidentiality of such reports, documents, records, and information in a manner consistent with the level of confidentiality established for the Commission under paragraph (8).

‘‘(10) PUBLIC INFORMATION EXCEPTION.—‘‘(A) IN GENERAL.—The Commission, the Council, and any other department, agency, or self-regulatory organization that receives information, reports, documents, records, or information from the Commission under this subsection, shall be exempt from the provisions of section 552 of title 5, United States Code, with respect to any such report, document, record, or information. Any proprietary information of an investment adviser ascertained by the Commission from any report required to be filed with the Commission pursuant to this subsection shall be subject to the same limitations on public disclosure as any facts ascertained during an examination, as provided by section 210(b) of this title.

‘‘(B) PROPRIETARY INFORMATION.—For purposes of this paragraph, proprietary information includes—

‘‘(i) sensitive, non-public information regarding the investment or trading strategies of the investment adviser;

‘‘(ii) analytical or research methodologies;

‘‘(iii) trading data;

‘‘(iv) computer hardware or software containing intellectual property; and

‘‘(v) any additional information that the Commission determines to be proprietary.

‘‘(11) ANNUAL REPORT TO CONGRESS.—The Commission shall report annually to Congress on how the Commission has used the data collected pursuant to this subsection to monitor the markets for the protection of investors and the integrity of the markets.’’.

SEC. 405. DISCLOSURE PROVISION ELIMINATED.

Section 210(c) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–10(c)) is amended by inserting before the period at the end the following: ‘‘or for purposes of assessment of potential systemic risk’’.

SEC. 406. CLARIFICATION OF RULEMAKING AUTHORITY.

Section 211 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–11) is amended—

(1) in subsection (a), by inserting before the period at the end of the first sentence the following:

‘‘, including rules and regulations defining technical, trade, and other terms used in this title, except that the Commission may not define the term ‘client’ for purposes of paragraphs (1) and (2) of section 206 to include an investor in a private fund managed by an investment adviser, if such private fund has entered into an advisory contract with such adviser’’; and

(2) by adding at the end the following:

‘‘(e) DISCLOSURE RULES ON PRIVATE FUNDS.—The Commission and the Commodity Futures Trading Commission shall, after consultation with the Council but not later than 12 months after the date of enactment of the Private Fund Investment Advisers Registration Act of 2010, jointly promulgate rules to establish the form and content of the reports required to be filed with the Commission under subsection 204(b) and with the Commodity Futures Trading Commission by investment advisers that are registered both under this title and the Commodity Exchange Act (7 U.S.C. 1a et seq.).’’.

SEC. 407. EXEMPTION OF VENTURE CAPITAL FUND ADVISERS.

Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3) is amended by adding at the end the following:

‘‘(l) EXEMPTION OF VENTURE CAPITAL FUND ADVISERS.—No investment adviser shall be subject to the registration requirements of this title with respect to the provision of investment advice relating to a venture capital fund. Not later than 6 months after the date of enactment of this subsection, the Commission shall issue final rules to define the term ‘venture capital fund’ for purposes of this subsection.’’.

SEC. 408. EXEMPTION OF AND RECORD KEEPING BY PRIVATE EQUITY FUND ADVISERS.

Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3) is amended by adding at the end the following:

‘‘(m) EXEMPTION OF AND REPORTING BY PRIVATE EQUITY FUND ADVISERS.—

‘‘(1) IN GENERAL.—Except as provided in this subsection, no investment adviser shall be subject to the registration or reporting requirements of this title with respect to the provision of investment advice relating to a private equity fund or funds.

‘‘(2) MAINTENANCE OF RECORDS AND ACCESS BY COMMISSION.—Not later than 6 months after the date of enactment of this subsection, the Commission shall issue final rules—

‘‘(A) to require investment advisers described in paragraph (1) to maintain such records and provide to the Commission such annual or other reports as the Commission taking into account fund size, governance, investment strategy, risk, and other factors, as the Commission determines necessary and appropriate in the public interest and for the protection of investors; and

‘‘(B) to define the term ‘private equity fund’ for purposes of this subsection.’’.

SEC. 409. FAMILY OFFICES.

(a) IN GENERAL.—Section 202(a)(11) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–2(a)(11)) is amended by striking ‘‘or (G)’’ and inserting the following:

‘‘; (G) any family office, as defined by rule, regulation, or order of the Commission, in accordance with the purposes of this title; or (H)’’.

(b) RULEMAKING.—The rules, regulations, or orders issued by the Commission pursuant to section 202(a)(11)(G) of the Investment Advisers Act of 1940, as added by this section, regarding the definition of the term ‘‘family office’’ shall provide for an exemption that—

(1) is consistent with the previous exemptive policy of the Commission, as reflected in exemptive orders for family offices in effect on the date of enactment of this Act; and

(2) recognizes the range of organizational, management, and employment structures and arrangements employed by family offices.

SEC. 410. STATE AND FEDERAL RESPONSIBILITIES; ASSET THRESHOLD FOR FEDERAL REGISTRATION OF INVESTMENT ADVISERS.

Section 203A(a)(1) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3a(a)(1)) is amended —

(1) in subparagraph (A)—

(A) by striking ‘‘$25,000,000’’ and inserting ‘‘$100,000,000’’; and

(B) by striking ‘‘or’’ at the end;

(2) in subparagraph (B), by striking the period at the end and inserting ‘‘; or’’; and

(3) by adding at the end the following:

‘‘(C) is an adviser to a company that has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940, and has not withdrawn its election.’’.

SEC. 411. CUSTODY OF CLIENT ASSETS.

The Investment Advisers Act of 1940 (15 U.S.C. 80b–1 et seq.) is amended by adding at the end the following new section:

‘‘SEC. 223. CUSTODY OF CLIENT ACCOUNTS.

‘‘An investment adviser registered under this title shall take such steps to safeguard client assets over which such adviser has custody, including, without limitation, verification of such assets by an independent public accountant, as the Commission may, by rule, prescribe.’’.

SEC. 412. ADJUSTING THE ACCREDITED INVESTOR STANDARD FOR INFLATION.

The Commission shall, by rule—

(1) increase the financial threshold for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, by calculating an amount that is greater than the amount in effect on the date of enactment of this Act of $200,000 income for a natural person (or $300,000 for a couple) and $1,000,000 in assets, as the Commission determines is appropriate and in the public interest, in light of price inflation since those figures were determined; and

(2) adjust that threshold not less frequently than once every 5 years, to reflect the percentage increase in the cost of living.

SEC. 413. GAO STUDY AND REPORT ON ACCREDITED INVESTORS.

The Comptroller General of the United States shall conduct a study on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds, and shall submit a report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of such study not later than 1 year after the date of enactment of this Act.

SEC. 414. GAO STUDY ON SELF-REGULATORY ORGANIZATION FOR PRIVATE FUNDS.

The Comptroller General of the United States shall—

(1) conduct a study of the feasibility of forming a self-regulatory organization to oversee private funds; and

(2) submit a report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of such study, not later than 1 year after the date of enactment of this Act.

SEC. 415. COMMISSION STUDY AND REPORT ON SHORT SELLING.

(a) STUDY.—The Division of Risk, Strategy, and Financial Innovation of the Commission shall conduct a study, taking into account current scholarship, on the state of short selling on national securities exchanges and in the over-the-counter markets, with particular attention to the impact of recent rule changes and the incidence of—

(1) the failure to deliver shares sold short; or

(2) delivery of shares on the fourth day following the short sale transaction.

(b) REPORT.—The Division of Risk, Strategy, and Financial Innovation shall submit a report, together with any recommendations for market improvements, including consideration of real time reporting of short sale positions, to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of the study conducted under subsection (a), not later than 2 years after the date of enactment of this Act.

SEC. 416. TRANSITION PERIOD.

Except as otherwise provided in this title, this title and the amendments made by this title shall become effecttive 1 year after the date of enactment of this Act, except 5 that any investment adviser may, at the discretion of the investment adviser, register with the Commission under the Investment Advisers Act of 1940 during that 1-year period, subject to the rules of the Commission.

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UCITS Hedge Funds

1 Reply

Overview of UCITS Hedge Funds

Bryan Goh of the blog Ten Seconds Into The Future has let us repost his article on UCITS hedge funds. We have posted a number of articles from Bryan, see end of post, and believe that he has some great industry insight (see especially here and here).

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What are UCITS?

UCITS are funds that comply with the European Directive for retail open-ended investment funds, are incorporated and authorised by the regulator in an EEA member state and can be distributed throughout the European Economic Area.

UCITS is a framework to standardise rules for the authorisation, supervision, structure and activities of collective investment undertakings in the EEA and so to enable them to be marketed throughout the EEA.

To be UCITS a fund must be open-ended, liquid, well-diversified, invest only in certain ‘eligible’ assets (namely quoted securities, money market instruments, deposits, certain derivatives and units in other UCITS) and can only employ limited leverage.

Why would a hedge fund manager offer a UCITS version of their fund?

Managers who are able to offer their strategies in UCITS format will be able to access a large universe of investors attracted by the UCITS brand in Europe, globally, and particularly in the Asia.

The transparency, liquidity and regulatory oversight required in a UCITS addresses investor concerns in a post-Madoff, post-credit 2008 crunch environment.

A UCITS lies outside the scope of the European draft Alternative Investment Fund Managers Directive which is likely to impact unregulated offshore hedge funds in yet undefined ways. This is potentially beneficial as the AIFM Directive is likely to impose constraints on European investors investing in third-country funds, which would include those domiciled in offshore jurisdictions such as Cayman Islands and Bermuda.

What is the process of launching a UCITS?

It’s complicated but it can be largely outsourced. Below is a list of the main features of UCITS. It all sounds complicated and laborious but a competent partner will be able to take most of the initial and ongoing burden away so that the fund manager can concentrate on managing money in as uninterrupted and unmodified a fashion as possible.

Fund Structures:

There are several fund structures available to UCITS. These include Unit Trusts, which are familiar vehicles and preferred by certain Asian investors such as Japanese, Variable Capital Companies, which are the OEICs and SICAVs and will look similar to a hedge fund structure with additional segregation of assets ex prime broker and Contractual Funds which are niche structures which are more complex to administer and market.

Management Companies:

The structure and indeed the existence of a management company is based on the tax planning of the investment manager. A Management Company brings with it minimum capital requirements, oversight and accounting and consolidation requirements. Roughly speaking, a UCITS Management Company needs to have 125,000 EUR of capital as a minimum plus 2 basis points per EUR of AUM over 250 million. This capital cannot be held on the group Holdco balance sheet and must be invested in liquid investments.

Sponsors:

There are some onerous capital requirements on Sponsors.

In Ireland the capital requirement is 635,000 EUR.
In Luxembourg the capital requirement is 7.5 million EUR.
These are largely unwritten rules.
A sponsor can be rented.

Legal Documentation:

There are rules for the prospectus
There is a simplified prospectus
Constitutional documentation, memoranda and articles.
Legal contracts:

– IMA
– Administration Agreement
– Custody Agreement
– Distribution Agreement

Business Plan and Substance Application
Risk Management Process

The Business Plan and Substance Application:

Constitutional documents
Capital requirements
Probity and competence of directors
Suitability of qualifying shareholders and organizational structure
Conduct of business
Board meetings – Frequency and content – minimum of 4 in the domicile.
Managerial functions
Frequency and content of reporting
Exception reporting
Escalation measures

The managerial functions require at least 2 Conducting Officers or Dirigeants. These can be:

Employees (usually not)
Directors of the UCITS can assume these functions
UCITS can appoint consultants.
In Ireland a board can be collectively appointed. In Luxembourg individuals have to be named.

The managerial functions include:

Appointment of Chairman
Frequency of board meetings
Distinguishing between decisions for the board versus the conducting officers
Compliance monitoring.

– Investment breaches
– Pricing errors
– Complaints
– AML issues

Risk Management

– Investment risk
– Use of Derivatives
– Pricing issues
– Reconciliation
– Failed trades

Performance Monitoring

– Performance metrics
– Benchmarks – especially if VaR relative to benchmark is used as a formal exposure metric
– Explanation of unusual performance
– Outlook
– A bi annual detailed commentary for inclusion in the financial statements

Finance Control

– Management company and fund financial statements
– Annual audit process
– Monthly management accounts of Management Company and Fund

Monitoring Capital

– Monthly review of capital adequacy.

Supervision of service providers

– UCITS requires regular ongoing due diligence on the Administrator, Custodian, and other service providers.

Eligible Markets and Securities:

List of Eligible Assets

Transferable Securities (TS)
Money Market Instruments (MMI)
TS and MMI with a derivative element (example Convertible Bonds)
Financial Derivative Instruments (FDI)
Open ended Collective Investment Schemes (CIS)
Deposits with credit institutions
Ancillary liquid assets
Financial indices
Repos, reverse repos, stock lending

List of non eligible assets

Direct or indirect investments in

Commodities
Real estate
Private equity
Hedge funds
Non financial indices
Short selling of MMI
Anything that circumvents the investment limits of the UCITS directive

Note that exposure to the above can be gained through financial indices on the underlyings.

Transferable Securities:

Generally:

Max loss limited to cost
Liquid
Regular, accurate reliable pricing
Negotiable

Closed end funds:

Corporate governance has to be robust
Asset manager subject to national regulation

Money Market Instruments
Generally:

Normally dealt in on the money markets
Liquid
Can be accurately valued

If not dealt in on a regulated market:

Meet certain issue/issuer criteria
Information available for a credit assessment
Freely transferable

Derivatives:

Underlyings consist of:

– TS, MMI, CIS, FDI, deposits, financial indices,
– Interest rates
– FX rates
– Currencies

Do not expose UCITS to risks it could not otherwise assume
Does not cause deviation from investment objectives
Does not result in the delivery of underlying which is not an Eligible Asset

Shorting comes in under derivatives on TS and financial indices. It will allow shorting equities and bonds via CDS.
OTC derivatives are allowed. There are requirements on the counterparty.

The counterparty must provide valuations
The counterparty must provide unwind

Collective Investment Schemes:

UCITS funds can invest in Collective Investment Schemes provided

The underlying CIS does not itself invest more than 10% of NAV in another CIS (UCITS or otherwise)
The CIS is diversified
The CIS is liquid
There is a 30% limit on exposure to non UCITS CIS even if they comply with the above
Non UCITS CIS must be subject to some form of supervision equivalent to UCITS, with sufficient investor protection

Financial Indices:

Automatically eligible if the constituents are themselves eligible
All other indices require separate regulator approval

– Requires sufficient diversification
– Be an adequate benchmark for the reference market
– Appropriately published
– Must have independent management from the management of the UCITS

A number of bespoke indices have emerged that appear to game this rule. The indices resemble bespoke, alpha optimized portfolios instead of an index representative of some class of assets.

Hedge fund investable indices are eligible provided:

No backfill used in their construction
No payments are made to the index provider from the index constituents
Index construction is objective and systematic
UCITS must perform adequate due diligence on the quality of the index

Repos, Reverse Repos and Stock Lending

UCITS can enter into repos and reverse repos and stock lending. Conditions apply.
Collateral must be posted.

Diversification:

Unsatisfied with the almost universal concept of diversification, UCITS has adopted the term Risk Spreading.

Unlisted Securities:

Limit of 10% of NAV in unlisted securities.
Additional 10% of NAV in recently unlisted securities destined to list in less than 12 months
Limit does not apply to certain 144A securities provided they list within a year
Bonds with a liquid market traded between regulated broker dealers and are subject only to general limits

5/10/40 Rule:

10% NAV issuer limit across capital structure.
For positions exceeding 5% NAV issuer limit, the aggregate shall not exceed 40% of NAV.

For bonds issued by EU credit institutions subject to special public supervision

25% NAV issuer limit across capital structure.
For positions exceeding 5% NAV issuer limit, the aggregate shall not exceed 80% of NAV.

For Index Trackers, there are looser limits.

Max 20% NAV issuer limit. 35% in exceptional circumstances. (e.g. 0005 HK in the HSI Index)
Index must be:

– Sufficiently diversified
– Represent an adequate benchmark
– Published appropriately
– Independently managed of the UCITS

Control Limits:

Max 10% of non voting shares of any issuer
Max 10% of debt securities of any issuer
Max 10% of money market instruments of any issuer

Government Securities:

35% NAV issuer limit (from 10%) for TS and MMI issued by:
EU member state and their local authorities

– Non Member State
– Public international body of which at least one member state is a member

Exempt from 5/40 rule

Up to 100% of NAV may be invested in TS, MMIs issued by a member state or their local authority, non member state or public international body if:

Held over 6 or more different issues
Limit 30% per single issue
Intention to use these limits and target issuers is disclosed in constitution and offering docs
Limited to OECD / Investment Grade (quite independent of each other these days)
Gilt Funds for example can be UCITS compliant and invest in 1 single issuer. (not quite investment grade these days)

Investments in Other Collective Investment Schemes:

Max 20% of NAV in a single CIS
Max 30% of NAV aggregate in non UCITS CIS (to remain ourselves UCITS)
Underlying CIS limited to no more than 10% in other CIS in aggregate (prevents FOFOF layering)
Max 25% of units of a single CIS (control issue)

General:

20% NAV limit in issuer exposure across their capital structure, net. Includes TS, MMIs, cash, OTC counterparty, exposure via derivatives
Max 5% in warrants
No uncovered short sales
Limits do not apply to the exercise of subscription rights

Borrowing Limits:

The Fund can borrow up to 10% of NAV for temporary purposes.
Credit balances may not be offset against borrowing in calculating the percent borrowed.
Leveraged is achieved through derivatives.

Risk Management:

Risk Management Process:

A fund using Derivatives must submit to the Regulator a detailed Risk Management Process (RMP)
The RMP will set out the list of derivatives that will be used, the controls, processes, systems and personnel involved in the management and monitoring of risk relating to these derivatives.
Material changes to the RMP need regulator re-approval.

Level of Sophistication:

The Fund may self classify itself as Sophisticated or Non-Sophisticated.
The Regulator may disagree
Sophisticated funds are required to implement VaR
Non Sophisticated funds can use commitment or (delta) notional exposure
Self classifying as Non Sophisticated exempts a fund from the use of VaR but can impose restrictive notional leverage limits
Self classifying as Sophisticated allows more latitude in definition of leverage within a VaR framework

Global Exposure:

Total gross exposure including derivatives is limited to 200% NAV
Synthetic shorting is allowed
Physical shorting is not allowed

Commitment Approach:

Notional value
Global exposure is NIL for funds using derivatives purely for hedging or risk reduction purposes
Options can be treated on delta adjusted basis
Purchased and sold derivatives can be netted only if there is explicit netting arrangements with the Custodian or counterparties

VaR:

VaR model based on:

99% confidence interval
Max 1 month holding period
Min 1 year historical observations
Stress tests and back tests must be applied
Adequate internal controls, staffing and experience are required
Description of VaR model and 3rd party verification
VaR may be specified as a multiple of a benchmark. That multiple is limited to 200%.

Position Exposure:

Limits are defined on total exposure aggregating direct, indirect and derivative exposure.
Except for certain Index based derivatives.

Counterparty Exposure:

Counterparty risk is limited to 5% of NAV for OTCs and 10% for EU or equivalent credit institutions.
All derivative exposures to the same OTC counterparties must be aggregated and an “add on” for future credit exposure based on Market Value (Ireland) and Notional (Luxembourg).
Counterparty risk can be reduced by the fund receiving collateral from the counterparty.
Positive and negative positions can be netted but only if there are formal netting agreements with the counterparty.

Liquidity:

A UCITS must re-purchase or redeem its units at the request of the unit holder.
Minimum frequency is twice a month. (Note that there is no specification on when in the month.)
Maximum notice until payout of cash is 14 days.
A UCITS can have a 10% gate per redemption date, thus a maximum 20% gate per month.

Feasible Strategies:

The following strategies are feasible under UCITS:

Long short equity
Long short credit – liquid markets only
Convertible arbitrage
Global Macro
Fixed income arbitrage – definitions of leverage need to be addressed
Commodity index funds – there is no question of physical of derivatives on underlying commodities. Only commodity indices are eligible.
CTA and Managed Futures
Event Driven
Funds of UCITS Funds
Structured and guaranteed products
ETFs

The following are not recommended for UCITS and fall foul of UCITS liquidity and valuation requirements: Less liquid credit strategies, distressed debt, mezzanine, private equity strategies, small and micro cap strategies.

A Final Word:

For the hedge fund manager, UCITS provides a delivery channel to a different investor base diversifying business risk. It also addresses investor concerns about the operational and fraud risks that plagued parts of the offshore unregulated industry in 2008. In addition, it provides a potential means of dodging the AIFM directive. There will be managers who see UCITS as a convenient dodge and an easier path to raising capital, and there will be those who see it for what it is; the evolution of European mutual fund legislation to ensure better investor protection while providing investors more choice. It is important that managers comply with the spirit of the law as well as the letter. The risk to UCITS as a brand is that it is abused by some managers which abuse the market uncovers in the usual discontinuous fashion and the fallout tars all UCITS with the same brush.

UCITS is designed for liquid strategies. Shoe-horning illiquid strategies into UCITS is a very bad idea. Not many people are aware that UCITS has a gating facility. This is an emergency feature for when normally liquid markets seize up. To run an illiquid portfolio in a UCITS in the hope that the gate provision is never needed is irresponsible on the part of the manager and the service providers who help to bring that UCITS to market.

UCITS is designed for low to moderate leverage strategies. The Sophisticated Fund classification which measures leverage in terms of VaR allows liquid strategies where delta notional exposure is not an appropriate measure of leverage admission as a UCITS. It is not there so that a highly levered and risky strategy can be slipped into a UCITS.

UCITS is designed for portfolios of eligible assets which are eligible by virtue of their liquidity, price discovery and transparency. It is designed so that the UCITS can feasibly supply the represented liquidity, provide an accurate and representative valuation of assets and not carry surprisingly large liabilities on the balance sheet which unexpectedly erode the value of the Net Asset Value.

Use with care.

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Other HFLB articles reposted from Bryan:

Disclosure Document Guidance for CTAs and CPOs

2 Replies

NFA Provides Overview of Manager Background (Bio) Disclosure Requirements

CFTC registered CTAs and CPOs need to have their disclosure documents reviewed by the NFA prior to using those documents to solicit clients or investors. As any manager who has gone through this NFA review process understands, the NFA will take their time to scrutinize the documents. One issue which comes up again and again is the background information that must be disclosed for any principals or managers disclosed in the disclosure document. Managers should take note of the following points:

Each bio must include a complete and detailed business background for the last 5 years (any gaps must be explained);
Business background further back than 5 years does not need to be disclosed; and
If a manager chooses to mention anything that happened in the manager’s business background further back than 5 years, the manager must disclose all subsequent employment.

The third point is really the most important for this discussion. Let’s say a manager makes a general reference that he has been in the investment management business for 16 years – that means that the manager will need to provide a description of each job, including dates of employment (month and year) over the last 16 years. Because in practice this would lead to ridiculously long bios (for some managers), it is generally recommended to leave the bio to the last 5 years so that the bio is manageable.

The NFA recently released a member notice, reprinted below, discussing this issue and the various questions that arise. The following NFA Notice can be found here.

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Notice I-10-12

May 11, 2010

NFA provides guidance for disclosure of business background information by commodity pool operators and commodity trading advisors

In 1997, the Commodity Futures Trading Commission (CFTC) delegated the review of disclosure documents submitted by commodity pool operators (CPO) and commodity trading advisors (CTA) to NFA. The Division of Clearing and Intermediary Oversight (DCIO) performs periodic oversight of NFA’s implementation of its delegated authority. As part of these reviews, DCIO staff has communicated to NFA its expectations as to the type and breadth of information that must be disclosed regarding the background of CTAs, CPOs, and relevant individuals. NFA is providing the following guidance to clarify the requirements of the applicable regulations regarding the disclosure of business background.

CFTC Regulations 4.24 and 4.34 require that disclosure documents include, for the previous five years from the date of the document, the business backgrounds of the CTA, the CPO, the major CTAs, the CPOs of major investee pools, the pool’s trading manager, and each principal of the foregoing who participates in making trading or operational decisions, or supervises persons so engaged. For each of the persons listed above, the document must include employers, business associations, or ventures (including the starting and ending month and year) for the same five year period, as well as a discussion of the duties performed by the person for each. When disclosing business background information, the discussion must be complete for the entire five year period. Any gaps in time must be explained.

Examples of disclosures within the most recent five year period:

Ms. Smith attended ABC University and graduated in June 2005 with a degree in Economics. In August 2008, she joined XYZ LP as an associated person.

The business background must disclose what Ms. Smith was doing during the period between June 2005 and August 2008. Additionally, if XYZ LP is not the entity for which the disclosure document has been prepared, a description of its main business must be included.

Mr. Jones has been a listed principal of XYZ Company, a commodity trading advisor, since January 2005. In 2007 Mr. Jones began publishing a monthly newsletter entitled “The Trading Corner,” which outlines Jones’ trading research in the energy markets.

The business background must disclose Mr. Jones’ duties at XYZ Company. The month in which Mr. Jones began publishing his newsletter and the name and main business of the employer, if any, for whom the newsletter is being published must also be disclosed.

Mrs. Green was registered as an associated person of LMN LLC, a commodity pool operator from March 2008 until May 2008. In June 2008, she formed PQR Limited Partnership (PQR), a commodity pool operator which became registered on November 1, 2008. Mrs. Green became a registered AP and listed principal of PQR on November 1, 2008.

The business background must be complete for the last five years. Specifically, it must disclose what Mrs. Green was doing prior to March 2008. Mrs. Green’s and PQR’s activities between June 2008 (when she formed PQR) and November 2008 (when she and the firm became registered) must also be disclosed.

As noted above, CFTC Regulations mandate disclosure of business background information for only the last five years from the date of the disclosure document. DCIO has advised NFA, however, that if a CTA or CPO elects to provide business background information beyond the previous five year period it must provide this information in the same level of detail as that required for the last five years. DCIO has further directed that a general reference regarding the length of an entity’s or individual’s experience or involvement in an industry serves to extend the time period for which disclosures must be made.

The following is an example of a disclosure recently submitted to NFA and an explanation as to why it would not comply with the above stated policy:

Example of disclosure beyond the most recent five year period:

Mr. Brown has been in the futures industry since October 1982 or Mr. Brown has over twenty eight years of management experience.

Mr. Brown’s business background must be disclosed from October 1982 to the present. The disclosure must be complete for the entire period including the name and main business of each employer, the nature of the duties performed for each employer, and the starting and ending dates (month and year) of employment, including an explanation of any gaps in employment.

CPOs and CTAs are encouraged to review their existing disclosure documents in light of DCIO’s guidance and make any necessary changes prior to submitting subsequent filings of the document. If you have any questions concerning this notice or disclosure documents generally, please contact Mary McHenry, Senior Manager, Compliance ([email protected] or 312-781-1420) or Kaitlan Chi, Manager, Compliance ([email protected] or 312-781-1219).

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Other related hedge fund law blog posts include:

Cole-Frieman & Mallon LLP is a hedge fund law firm which provides CTAs and CPOs with comprehensive formation and regulatory support. Bart Mallon, Esq. can be reached directly at 415-868-5345.

CPO Quarterly Filing Reminder

Hedge Fund Events May 2010