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CFTC Form 40 – Statement of Reporting Trader

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Managers Must File CFTC Form 40 for Reportable Futures Positions

Managers who maintain large positions in certain futures instruments will need to be aware of the speculative position limits with respect to the instruments.  In the event a position reaches a certain level, the CFTC will request more information about the position from the manager.  For managers which are registered with the NFA as either a commodity pool operator (CPO) or commodity trading adviser (CTA), the CFTC may send a request for the manager to complete and file a Form 40 – Statement of Reporting Trader.  This request is also referred to as a “Special Call” and CFTC regulations require every trader that holds or controls a reportable futures and option position to file Form 40 when they receive the CFTC request. CFTC Form 40 allows the CFTC to compile information to assess whether a trader’s activities could potentially impact the market and whether traders are complying with speculative position limits.

This post provides a brief description of Form 40, the reasons a CPO/CTA may receive a Special Call, as well as how to appropriately respond to the request.

Definitional Aspects of Form 40

Form 40 needs to be completed by the trader of the reportable position.  A trader is “a person who, for his own account or for an account which he controls, makes transactions in commodity futures or options, or has such transactions made.” For most commodity pools, the trader would be the manager of the fund—the CPO.

In the event there is a reportable postion, the CFTC will issue a Special Call based on information provided by futures commission merchants, clearing members and foreign brokers (collectively, “reporting firms”). If, at the daily market close, a reporting firm has a customer with a position at or above the reportable position level in any single futures or option expiration month (a “special account”), the reporting firm must send a report to the CFTC with that customer’s entire position in all futures and options expiration months in that commodity. A “special account” is any commodity futures or option account in which there is a reportable position.

A reportable position that may trigger the Special Call is defined as:

“any open contract position that at the close of the market on any business day equals or exceeds the quantity specified in CFTC Regulation 15.03 in either:

  • Any one future of any commodity on any one reporting market, excluding future contracts against which notices of delivery have been stopped by a trader or issued by the clearing organization of a reporting market; or
  • Long or short put or call options that exercise into the same future of any commodity, or long or short put or call options for options on physicals that have identical expirations and exercise into the same physical, on any one reporting market.”

Reporting Levels for Form 40

Reporting levels vary and can range from 25 contracts for smaller markets to 125,000 contracts for the largest market – for a full description of the reporting requirements, please see the full text of CFTC Regulation 15.03. Reporting thresholds cover the following categories:

  • Agricultural;
  • Broad-based security indexes;
  • Financial;
  • Hedge Street products;
  • Natural resources;
  • Security futures products;
  • TRAKRS; and
  • All other commodities.

Once a reporting threshold is crossed, the fund’s FCM will submit a form to the CFTC which may then prompt a Special Call to the CPO/CTA.

Receiving the Special Call and How to Respond 

When a CPO receives the Special Call, it must complete the Form 40 by the date specified in the letter. Form 40 is comprised of three parts.

Part A requests the following information:

  • Name and address of the CPO;
  • Principal business and occupation of the CPO;
  • Type of entity;
  • Whether the CPO is registered under the Commodity Exchange Act;
  • Whether the CPO controls the futures or option trading for any other person;
  • Whether any other person controls the CPO;
  • Names and locations of all firms at which futures or option trading accounts are carried;
  • Whether any other persons guarantee the futures or option trading accounts of the CPO or have a financial interest of 10% or more in the CPO or the futures or option accounts of the CPO;
  • Whether the CPO guarantee or has a financial interest of 10% or more in futures or option accounts not in the CPO’s name or has a financial interest of 10% or more in another futures or option trader; and
  • Whether the CPO represents a foreign government.

Part B must be completed if the CPO is an individual, joint tenant, or partnership.

Part C must be completed if the CPO is corporation, association, trust, or “other” type of trader. These sections request information that allows the CFTC to aggregate related accounts controlled or held by the CPO. They also request information about whether the CPO is engaged in activities hedged by the use of futures or option markets.

Schedule A requests information about the types of futures/options in which the CPO hedges or covers risk exposure, the CPO’s merchandising or marketing activities, all futures/option markets used, and all cash commodities hedged or risk exposure covered.

Conclusion

If you receive a Special Call from the CFTC, it is important that you respond by the date listed on the letter. The information provided should be for the person or entity that makes transactions in commodity futures or options. For funds, the CPO should complete Form 40 as the trader. A link to the form can be found here (http://www.cftc.gov/ucm/groups/public/@forms/documents/file/cftcform40.pdf).

For more information, please see the CFTC’s discussion on market surveillance and large trader reporting.

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Cole-Frieman & Mallon LLP provide legal advice to CPOs, CTAs and traders in the managed futures space.  Bart Mallon can be reached directly at 415-868-5345.

CFTC Regulation 15.03 – Reporting Levels

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CFTC Form 40 Reporting Levels 

Managers who trade in the futures and commodities markets should be aware of the amount of contracts they are trading.  For certain products, once a manager reaches a reporting level, the CFTC may request that the manager complete and submit a Form 40 to the CFTC.  CFTC Regulation 15.03, reprinted in full below, provides the number of contracts for each commodity which is deemed to be a reporting level for CFTC Form 40.

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TITLE 17–COMMODITY AND SECURITIES EXCHANGES

CHAPTER I–COMMODITY FUTURES TRADING COMMISSION

PART 15 REPORTS GENERAL PROVISIONS–Table of Contents

Sec. 15.03 Reporting levels.

(a) Definitions. For purposes of this section:

Broad-based security index is a group or index of securities that does not constitute a narrow-based security index.

HedgeStreet products are contracts offered by HedgeStreet, Inc., a designated contract market, that pay up to $10.00 if in the money upon expiration.

Major foreign currency is the currency, and the cross-rates between the currencies, of Japan, the United Kingdom, Canada, Australia, Switzerland, Sweden and the European Monetary Union.

Narrow-based security index has the same meaning as in section 1a(25) of the Commodity Exchange Act.

Security futures product has the same meaning as in section 1a(32) of the Commodity Exchange Act.

(b) The quantities for the purpose of reports filed under parts 17 and 18 of this chapter are as follows:

Commodity (Number of contracts)

Agricultural:

Cocoa (100)

Coffee (50)

Corn (250)

Cotton (100)

Feeder Cattle (50)

Frozen Concentrated Orange Juice (50)

Lean Hogs (100)

Live Cattle (100)

Milk, Class III (50)

Oats (60)

Rough Rice (50)

Soybeans (150)

Soybean Meal (200)

Soybean Oil (200)

Sugar No. 11 (500)

Sugar No. 14 (100)

Wheat (150)

Broad-Based Security Indexes:

Municipal Bond Index (300)

S&P 500 Stock Price Index (1,000)

Other Broad-Based Securities Indexes (200)

Financial:

30-Day Fed Funds (600)

3-Month (13-Week) U.S. Treasury Bills (150)

2-Year U.S. Treasury Notes (1,000)

3-Year U.S. Treasury Notes (750)

5-Year U.S. Treasury Notes (2,000)

10-Year U.S. Treasury Notes (2,000)

30-Year U.S. Treasury Bonds (1,500)

1-Month LIBOR Rates (600)

3-Month Eurodollar Time Deposit Rates (3,000)

3-Month Euroyen (100)

2-Year German Federal Government Debt (500)

5-Year German Federal Government Debt (800)

10-Year German Federal Government Debt (1,000)

Goldman Sachs Commodity Index (100)

Major Foreign Currencies (400)

Other Foreign Currencies (100)

U.S. Dollar Index (50)

Natural Resources:

Copper (100)

Crude Oil, Sweet (350)

Crude Oil, Sweet–No. 2 Heating Oil Crack Spread (250)

Crude Oil, Sweet–Unleaded Gasoline Crack Spread (150)

Gold (200)

Natural Gas (200)

No. 2 Heating Oil (250)

Platinum (50)

Silver Bullion (150)

Unleaded Gasoline (150)

Unleaded Gasoline–No. 2 Heating Oil Spread Swap (150)

Security Futures Products:

Individual Equity Security (1,000)

Narrow-Based Security Index (200)

Hedge Street Products. (125,000) \1\

TRAKRS (50,000) \1\

All Other Commodities (25)

 

\1\ For purposes of part 17, positions in HedgeStreet Products and TRAKRS should be reported by rounding down to the nearest 1,000 contracts and dividing by 1,000.

[69 FR 76397, Dec. 21, 2004, as amended at 71 FR 37817, July 3, 2006]

* The above CFTC Regulation 15.03 can be found on the government website here.

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Cole-Frieman & Mallon LLP provides legal advice and compliance consulting for the managed futures industry.  Bart Mallon can be reached directly at 415-868-5345.

 

GAO Report on SRO for Private Fund Advisers

SRO for Private Fund Adviser could be established, but not without challenges

Over the last few weeks we have heard much talk about the potential formation of a self-regulatory organization (“SRO”) for registered investment advisers (i.e. hedge fund managers). In July the U.S. Government Accountability Office (“GAO”) released a report on the feasibility of forming an SRO to provide oversight to private fund advisers. The report was required by the Dodd-Frank Act and it discusses the feasibility of establishing the SRO as well as the potential advantages and disadvantages of forming such an organization.  This report comes on the heels of an SEC study of IA examinations which analyzed whether an IA SRO would be feasible.  [We concluded:  This study simply states the obvious – the SEC does not have the resources it needs to adequately do its job.  It seems like the major conclusion has already been reached – IA firms are going to need to pay for their oversight because Congress will not pay for it.]  In the GAO report, the issue is examined further and the conclusion states that an SRO could be established and there would be potential advantages and disadvantages for doing so.

Feasibility of Establishing the SRO

The report discussed the feasibility of establishing the SRO. In general there are a number of items which would need to be put into place before an SRO could be formed and operating. The main item is that Congress would need to specifically authorize, through legislation, the creation of the SRO which would then be subject to SEC oversight.  After authorization, a determination would be made as to whether the SRO would be created ab initio or if an existing SRO would take over the responsibilities of overseeing private fund advisers. It is likely that, given the costs of establishing an entirely new entity, an existing SRO (such as FINRA or the NFA) would simply be given the new oversight responsibilities. Once an SRO was determined, bylaws and operational issues will need to be addressed including fee and governance structures, board of directors, compliance rules and enforcement rules.

In any event, establishing an SRO for private fund advisers is likely to be resource intensive and subject to various levels of the political process – Congress, the SEC, (potentially) the CFTC, NASAA, and the SRO would all have agendas with respect to the SRO. Additionally, even within the private fund advisers group there is likely to be political positioning – large managers are going to have different concerns

than small managers and are most likely going to want to have a larger say with respect to operations (especially if they are paying a disproportionate amount of the fees to support the IA oversight functions of the SRO).

Potential Advantages of a Private Fund Adviser SRO

The report listed the following as potential advantages of the SRO:

Advantages of a private fund adviser SRO include its potential to (1) free a portion of SEC’s staff and resources for other purposes by giving the SRO primary examination and other oversight responsibilities for advisers that manage private funds, (2) impose higher standards of conduct and ethical behavior on its members than are required by law or regulations, and (3) provide greater industry expertise and knowledge than SEC, given the industry’s participation in the SRO.

Potential Disadvantages of a Private Fund Adviser SRO

The report listed the following as potential disadvantages of the SRO:

Some of the disadvantages of a private fund adviser SRO include its potential to (1) increase the overall cost of regulation by adding another layer of oversight; (2) create conflicts of interest, in part because of the possibility for self-regulation to favor the interests of the industry over the interests of investors and the public; and (3) limit transparency and accountability, as the SRO would be accountable primarily to its members rather than to Congress or the public

State Registration Issues

One of the questions which this particular report did not address is whether managers registered with a state securities division (instead of the SEC) would be subject to oversight by the SRO.  The discussion of the advantages and disadvantages did not include state jurisdictional issues, but these issues are important.  The state securities divisions are subject to the same budgetary limitations as the SEC and many times the states do not (contrary to reports by NASAA) have the expertise necessary to properly examine fund managers and other investment advisers.  If state managers are not required to be part of the SRO then you are likely to see a wide disparity in examination and oversight between state registered managers and SEC registered managers (who would also be subject to SRO oversight).  Expect to see this discussed in greater depth going forward.

Conclusion

The issue of whether or not there should be an IA SRO is not going to go away any time soon – especially with the SEC under intense budget pressure and the looming deadline for hedge fund IA registration (March 30, 2012). It is clear that in the race to be the SRO for investment advisers, FINRA is the leader and really probably the only viable option. While having FINRA oversee both BDs and IAs may not make the most sense, it is probably better than the alternatives which right now include (1) the NFA (which oversees managed futures firms) or (2) starting an SRO from scratch.  Expect to hear more on this issue soon from both Congress and the SEC.

For the full GAO report, please see GAO Private Fund Adviser SRO Report.

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Cole-Frieman & Mallon LLP is a law firm which provides adviser registration, compliance and legal support to SEC registered hedge fund managers. Bart Mallon can be reached directly at 415-868-5345; Karl Cole-Frieman can be reached at 415-352-2300.

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Hedge Fund SEC Custody Rule Overview

Compliance Requirements of the SEC Custody Rule

Hedge fund managers are preparing to register as investment advisers with the SEC pursuant to the new Dodd-Frank registration requirements.  One of the issues which managers will be dealing with during that process is the hedge fund custody rule (Rule 206(4)-2 under the Investment Advisers Act).  In general this means that the SEC registered fund manager will need make sure that the fund (1) maintains its assets with a qualified custodian and (2) has an annual audit by a PCAOB Registered and Inspected audit firm.

Hedge Fund Managers Generally Have Custody

The requirements of the SEC Custody Rule are triggered when an investment adviser has “custody.”  A fund manager is deemed to have “custody” of the fund's assets when it, or a related person, directly or indirectly has authority to obtain possession of” the fund's assets.  The Rule specifically indicates that custody includes any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives the investment adviser or a related person “legal ownership of or access to client funds or securities.”

Because hedge funds are generally structured so that the manager or a related entity serves as the general partner, hedge fund managers will generally be deemed to have custody under the Rule.  Managers who also provide advice through separate accounts would not be considered to have custody of those separate accounts unless they have authority to automatically deduct fees from the account (or have custody for some other reason).  If a manager is deemed to have custody, the manager will generally need to follow certain safe-keeping requirements.

Qualified Custodian Requirement

The first safe-keeping requirement of the Rule is that a fund's cash and securities must be maintained at a qualified custodian in “a separate account for each [fund] under that [fund’s] name” or in an account under the name of the fund manager as agent for the fund. Under the Rule, “qualified custodians” include banks, registered broker-dealers, registered futures commission merchants, and foreign financial institutions that customarily hold financial assets for their customers.  Hedge fund managers generally satisfy the qualified custodian requirement by holding funds’ cash and securities at a prime broker or other broker-dealer.

Audit Requirement

Managers of hedge funds are exempt from the Rule’s other safe-keeping requirements (or are deemed to comply with those requirements) if the fund has its financial statements audited annually and upon liquidation.  The audited financial statements must be prepared in accordance with generally accepted accounting principles (GAAP) and the audit must be conducted by an “independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board [(PCAOB)] in accordance with its rules.” Care should be taken to ensure that any audit firm engaged by a fund is subject to regular inspection by the PCAOB.

The annually audited financial statements must be delivered to all limited partners within 120 days of the end of” a fund’s fiscal year.

Alternative to the Annual Audit Requirement

If a hedge fund manager does not qualify for the exemptions from other safe-keeping requirements by conducting an annual fund audit as discussed above, the other provisions to the Rule require that the manager to: (1) instruct the fund's qualified custodian(s) to send quarterly account statements directly to each limited partner, and (2) engage an independent public accountant to conduct an actual “surprise” examination of the funds’ cash and securities and file Form ADV-E with the SEC.

Because most funds will have an annual audit, the surprise examination alternative is rare.

Responses to Form ADV Questions Regarding Custody

In addition to satisfying the safe-keeping requirements of the Rule, hedge fund managers must make certain disclosures regarding custody on their Form ADV.  Form ADV Part 1, Item 9.A requires managers to disclose the amount of funds and securities for which they have custody and Item 9.B requires the same disclosure for related persons of the manager.  Additionally, Item 9.C requires managers to indicate whether they have engaged an accountant to conduct an annual audit of funds’ financial statements (and whether the managers use other means of satisfying the Rule’s safety requirements).  The name and contact information of the accountant so engaged must be provided in Form ADV Schedule D, Section 9.C.  Information provided on Form ADV Part 1, Item 9 (except the amount of funds and securities and number of clients for which the manager has custody) is considered material and must be updated promptly whenever there is a change.

Item 15 of Form ADV Part 2 (the Brochure) requires additional disclosures for those managers who have instructed qualified custodians to send account statements directly to the investors.

Other Items

For most fund managers who will be going through the SEC registration process, complying with the custody rule will be a straight forward exercise.  State-registered investment advisers are subject to the various custody rules of the states in which they are registered.

For more information, please also see SEC Responses to Custody Rule Questions.

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Cole-Frieman & Mallon LLP provides investment adviser registration and compliance support to hedge fund managers.  Bart Mallon can be reached directly at 415-868-5345.  Karl Cole-Frieman can be reached at 415-352-2300.

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Rule 206(4)-2 – Hedge Fund Custody Rule

From time to time on this site we discuss the custody rule for SEC registered hedge fund managers.  Below we have reprinted the entire regulation.

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Rule 206(4)-2 –Custody of Funds or Securities of Clients by Investment Advisers

a. Safekeeping required. If you are an investment adviser registered or required to be registered under section 203 of the Act, it is a fraudulent, deceptive, or manipulative act, practice or course of business within the meaning of section 206(4) of the Act for you to have custody of client funds or securities unless:

1. Qualified custodian. A qualified custodian maintains those funds and securities:

i. In a separate account for each client under that client's name; or

ii. In accounts that contain only your clients' funds and securities, under your name as agent or trustee for the clients.

2. Notice to clients. If you open an account with a qualified custodian on your client's behalf, either under the client's name or under your name as agent, you notify the client in writing of the qualified custodian's name, address, and the manner in which the funds or securities are maintained, promptly when the account is opened and following any changes to this information. If you send account statements to a client to which you are required to provide this notice, include in the notification provided to that client and in any subsequent account statement you send that client a statement urging the client to compare the account statements from the custodian with those from the adviser.

3. Account statements to clients. You have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each of your clients for which it maintains funds or securities, identifying the amount of funds and of each security in the account at the end of the period and setting forth all transactions in the account during that period.

4. Independent verification. The client funds and securities of which you have custody are verified by actual examination at least once during each calendar year, except as provided below, by an independent public accountant, pursuant to a written agreement between you and the accountant, at a time that is chosen by the accountant without prior notice or announcement to you and that is irregular from year to year. The written agreement must provide for the first examination to occur within six months of becoming subject to this paragraph, except that, if you maintain client funds or securities pursuant to this section as a qualified custodian, the agreement must provide for the first examination to occur no later than six months after obtaining the internal control report. The written agreement must require the accountant to:

i. File a certificate on Form ADV-E (17 CFR 279.8) with the Commission within 120 days of the time chosen by the accountant in paragraph (a)(4) of this section, stating that it has examined the funds and securities and describing the nature and extent of the examination;

ii. Upon finding any material discrepancies during the course of the examination, notify the Commission within one business day of the finding, by means of a facsimile transmission or electronic mail, followed by first class mail, directed to the attention of the Director of the Office of Compliance Inspections and Examinations; and

iii. Upon resignation or dismissal from, or other termination of, the engagement, or upon removing itself or being removed from consideration for being reappointed, file within four business days Form ADV-E accompanied by a statement that includes:

A. The date of such resignation, dismissal, removal, or other termination, and the name, address, and contact information of the accountant; and

B. An explanation of any problems relating to examination scope or procedure that contributed to such resignation, dismissal, removal, or other termination.

5. Special rule for limited partnerships and limited liability companies. If you or a related person is a general partner of a limited partnership (or managing member of a limited liability company, or hold a comparable position for another type of pooled investment vehicle), the account statements required under paragraph (a)(3) of this section must be sent to each limited partner (or member or other beneficial owner).

6. Investment advisers acting as qualified custodians. If you maintain, or if you have custody because a related person maintains, client funds or securities pursuant to this section as a qualified custodian in connection with advisory services you provide to clients:

i. The independent public accountant you retain to perform the independent verification required by paragraph (a)(4) of this section must be registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules; and

ii. You must obtain, or receive from your related person, within six months of becoming subject to this paragraph and thereafter no less frequently than once each calendar year a written internal control report prepared by an independent public accountant:

A. The internal control report must include an opinion of an independent public accountant as to whether controls have been placed in operation as of a specific date, and are suitably designed and are operating effectively to meet control objectives relating to custodial services, including the safeguarding of funds and securities held by either you or a related person on behalf of your advisory clients, during the year;

B. The independent public accountant must verify that the funds and securities are reconciled to a custodian other than you or your related person; and

C. The independent public accountant must be registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules.

7. Independent representatives. A client may designate an independent representative to receive, on his behalf, notices and account statements as required under paragraphs (a)(2) and (a)(3) of this section.

b. Exceptions.

1. Shares of mutual funds. With respect to shares of an open-end company as defined in section 5(a)(1) of the Investment Company Act of 1940 (“mutual fund”), you may use the mutual fund's transfer agent in lieu of a qualified custodian for purposes of complying with paragraph (a) of this section;

2. Certain privately offered securities.

i. You are not required to comply with paragraph (a)(1) of this section with respect to securities that are:

A. Acquired from the issuer in a transaction or chain of transactions not involving any public offering;

B. Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and

C. Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

ii. Notwithstanding paragraph (b)(2)(i) of this section, the provisions of this paragraph (b)(2) are available with respect to securities held for the account of a limited partnership (or a limited liability company, or other type of pooled investment vehicle) only if the limited partnership is audited, and the audited financial statements are distributed, as described in paragraph (b)(4) of this section.

3. Fee deduction. Notwithstanding paragraph (a)(4) of this section, you are not required to obtain an independent verification of client funds and securities maintained by a qualified custodian if:

i. you have custody of the funds and securities solely as a consequence of your authority to make withdrawals from client accounts to pay your advisory fee; and

ii. if the qualified custodian is a related person, you can rely on paragraph (b)(6) of this section.

4. Limited partnerships subject to annual audit. You are not required to comply with paragraphs (a)(2) and (a)(3) of this section and you shall be deemed to have complied with paragraph (a)(4) of this section with respect to the account of a limited partnership (or limite

d liability company, or another type of pooled investment vehicle) that is subject to audit (as defined in rule 1-02(d) of Regulation S-X (17 CFR 210.1-02(d))):

i. At least annually and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year;

ii. By an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules; and

iii. Upon liquidation and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) promptly after the completion of such audit.

5. Registered investment companies. You are not required to comply with this section with respect to the account of an investment company registered under the Investment Company Act of 1940.

6. Certain Related Persons. Notwithstanding paragraph (a)(4) of this section, you are not required to obtain an independent verification of client funds and securities if:

i. you have custody under this rule solely because a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services you provide to clients; and

ii. your related person is operationally independent of you.

c. Delivery to Related Person. Sending an account statement under paragraph (a)(5) of this section or distributing audited financial statements under paragraph (b)(4) of this section shall not satisfy the requirements of this section if such account statements or financial statements are sent solely to limited partners (or members or other beneficial owners) that themselves are limited partnerships (or limited liability companies, or another type of pooled investment vehicle) and are your related persons.

d. Definitions. For the purposes of this section:

1. Control means the power, directly or indirectly, to direct the management or policies of a person, whether through ownership of securities, by contract, or otherwise. Control includes:

i. Each of your firm's officers, partners, or directors exercising executive responsibility (or persons having similar status or functions) is presumed to control your firm;

ii. A person is presumed to control a corporation if the person:

A. Directly or indirectly has the right to vote 25 percent or more of a class of the corporation's voting securities; or

B. Has the power to sell or direct the sale of 25 percent or more of a class of the corporation's voting securities;

iii. A person is presumed to control a partnership if the person has the right to receive upon dissolution, or has contributed, 25 percent or more of the capital of the partnership;

iv. A person is presumed to control a limited liability company if the person:

A. Directly or indirectly has the right to vote 25 percent or more of a class of the interests of the limited liability company;

B. Has the right to receive upon dissolution, or has contributed, 25 percent or more of the capital of the limited liability company; or

C. Is an elected manager of the limited liability company; or

v. A person is presumed to control a trust if the person is a trustee or managing agent of the trust.

2. “Custody”means holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. You have custody if a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services you provide to clients. Custody includes:

i. Possession of client funds or securities (but not of checks drawn by clients and made payable to third parties) unless you receive them inadvertently and you return them to the sender promptly but in any case within three business days of receiving them;

ii. Any arrangement (including a general power of attorney) under which you are authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and

iii. Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities.

3. Independent public accountant means a public accountant that meets the standards of independence described in rule 2-01(b) and (c) of Regulation S-X (17 CFR 210.2-01(b) and (c)).

4. Independent representative means a person that:

i. Acts as agent for an advisory client, including in the case of a pooled investment vehicle, for limited partners of a limited partnership (or members of a limited liability company, or other beneficial owners of another type of pooled investment vehicle) and by law or contract is obliged to act in the best interest of the advisory client or the limited partners (or members, or other beneficial owners);

ii. Does not control, is not controlled by, and is not under common control with you; and,

iii. Does not have, and has not had within the past two years, a material business relationship with you.

5. Operationally independent: for purposes of paragraph (b)(6) of this section, a related person is presumed not to be operationally independent unless each of the following conditions is met and no other circumstances can reasonably be expected to compromise the operational independence of the related person:

i. Client assets in the custody of the related person are not subject to claims of the adviser's creditors;

ii. advisory personnel do not have custody or possession of, or direct or indirect access to client assets of which the related person has custody, or the power to control the disposition of such client assets to third parties for the benefit of the adviser or its related persons, or otherwise have the opportunity to misappropriate such client assets;

iii. advisory personnel and personnel of the related person who have access to advisory client assets are not under common supervision; and

iv. advisory personnel do not hold any position with the related person or share premises with the related person.

6. Qualified custodian means:

i. A bank as defined in section 202(a)(2) of the Advisers Act or a savings association as defined in section 3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act (12 U.S.C. 1811);

ii. A broker-dealer registered under section 15(b)(1) of the Securities Exchange Act of 1934, holding the client assets in customer accounts;

iii. A futures commission merchant registered under section 4f(a) of the Commodity Exchange Act (7 U.S.C. 6f(a)), holding the client assets in customer accounts, but only with respect to clients' funds and security futures, or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon; and

iv. A foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients' assets in customer accounts segregated from its proprietary assets.

7. Related person means any person, directly or indirectly, controlling or controlled by you, and any person that is under common control with you.

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Cole-Frieman & Mallon LLP provides comprehensive legal support to hedge fund managers.  Bart Mallon can be reached directly at 415-868-5345.

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Hedge Fund Carried Interest on Chopping Block Again?

President Obama Proposes Taxing Carried Interest as Ordinary Income

Every couple of years there are various proposals floated around congress to tax the hedge fund performance fee (or “carried interest”) as ordinary income (see a previous post on this topic from 2009 here).  This week President Obama announced a proposal to tax the “carried interest” of an investment partnership as ordinary income.  The tax will help to pay for the $447 billion American Jobs Act.  According to the White House’s section-by-section analysis of the proposed legislation, the current capital gains treatment of income from the performance of services “creates an unfair and inefficient tax preference.”

The Proposal

Because the carried interest from an investment partnership is derived from the performance of services, the proposal would tax a service partner’s carried interest as ordinary income and make it subject to self-employment tax.  The proposed language indicates that “in the case of an investment services partnership interest . . . an amount equal to the net capital gain with respect to such interest for any partnership taxable year shall be treated as ordinary income.” An investment services partnership interest is defined as “any interest in an investment partnership acquired or held by any person in connection with the conduct of a trade or business” that includes providing investment advice, managing or acquiring assets, arranging financing with respect to acquiring assets, or any activity in support of providing investment advice.

The proposal excludes any partnership interest that is attributed to invested capital (which is called “qualified capital interest” in the proposal) of a partner providing investment management services from being recharacterized as ordinary income as long as the partnership reasonably allocates its income and loss between the invested capital and any interest derived from the performance of services for the partnership.

The proposed language with respect to the carried interest can be found here under Title IV, Subtitle B – Tax Carried Interest in Investment Partnerships as Ordinary Income.

Time to Worry?

The sky is not falling yet. This proposal affects more groups than simply hedge fund managers – private equity, real estate and VC fund managers would be affected by the proposal as well.  Accordingly, there are a number of interested parties ready to challenge the bill and there is already a strong lobbying presence in Washington. In the past we've seen this issue die relatively quickly and, given we are entering another election year, it is likely that we will see it die again in committee soon.

If enacted, the proposal would be effective for taxable years beginning after December 31, 2012.

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Cole-Frieman & Mallon LLP provides legal advice to hedge funds and private equity funds.   Bart Mallon can be reached directly at 415-868-5345.

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Hedge Fund Regulatory Changes Panel Event

100 Women in Hedge Funds September 2011 Event

There are a number of events throughout the country this month for hedge fund managers.  In addition to the end of summer, the industry is preparing for a number of significant changes which will begin affecting managers this year and next year.  As we've discussed previously, we think that some of the major issues for managers going forward will be:

While we will be exploring these topics in greater depth over the coming months, the 100 Women in Hedge Funds San Francisco event will be a great opportunity to hear industry leaders discuss how these issues are likely to affect managers.   For more information, please see the notice below.

If you are interested in registering for the event, you can sign up here.

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Strategically Anticipating & Managing the Impact of Regulatory Reform

September 20, 2011 at 6 PM

San Francisco CA

With the expansion of the SEC’s jurisdiction and mission through regulatory reform, a hedge fund adviser’s efficiency in anticipating and managing the impact of the onslaught of new regulation is critical to its investment and business success. Please join senior hedge fund legal and compliance practitioners for an interactive discussion that will highlight how advisers can better tailor their regulatory risk mitigation practice to specific areas of recent SEC focus.

The discussion will include:

  • An assessment of the SEC’s new focus on investment advisers in examinations and enforcement, including best practice for managing compliance with disclosed investment strategies and risks, redemption and liquidity terms, trading practices, and enforcement actions against CCOs.
  • The cumulative effect of new disclosure requirements: Form ADV, Form PF, FATCA
  • How firms should manage issues created by the regulation of political contributions, including the SEC’s pay-to-play rule and California’s lobbying rules for placement agents

Participants

Helane Morrison, Moderator, Hall Capital Partners LLC

Mark Perlow, K & L Gates LLP

Danell Doty, Passport Capital LLC

Event Details

Date: September 20, 2011

Time: 5 PM Registration.

We will begin promptly at 6 PM; please arrive early. Since it is disruptive to everyone when latecomers enter the session, those arriving after an education session has begun will only be admitted at the discretion of 100WHF and the host. Please note the start time on this invite and plan to arrive early.

Networking and cocktails prior to session.

Host: K & L Gates LLP

Location: K&L Gates LLP

Four Embarcadero Center, Suite 1200, San Francisco, CA 94111 – Directions

RSVP: http://www.100womeninhedgefunds.org/pages/event_registration.php

This event is NOT FOR ATTRIBUTION.

Admission is free, but there is a $25 charge if you register and do not attend, even if you cancel in advance. No-show proceeds will be donated to the Clinton Global Initiative's US Childhood Obesity Prevention Program, the 2011 beneficiary of 100WHF's US philanthropic initiatives.

If you have no-show fees in arrears, the system cannot register you for an event. You can view and pay for any outstanding no-show fees online from your member profile at: http://www.100womeninhedgefunds.org/pages/my_profile.php

Space is limited. No walk-ins will be permitted.

Biographies

Helane Morrison, General Counsel & CCO, Hall Capital Partners LLC

Helane L. Morrison is a Managing Director, General Counsel, and Chief Compliance Officer of Hall Capital Partners LLC. She is also a member of the firm's Executive Committee.

Prior to joining the firm in 2007, Ms. Morrison headed the San Francisco Office of the U.S. Securities and Exchange Commission (“SEC”) from 1999 to 2007. In her capacity as Regional Director and earlier as District Administrator, Ms. Morrison was responsible for securities enforcement, litigation, and regulatory matters in Northern California and five Northwest States. From 1996 to 1999, Ms. Morrison was head of enforcement for the San Francisco SEC office. She represented the SEC in legal, business, and financial communities, as well as with other government agencies and news media.

Previously, Ms. Morrison practiced law at the San Francisco law firm Howard, Rice , Nemerovski, Canady, Falk & Rabkin from 1986 to 1996 where she was elevated to partner in 1991. Her practice focused on business litigation and defense of private securities actions and SEC matters. She also conducted internal corporate investigations. Before entering private practice, Ms. Morrison served as a law clerk for Supreme Court Justice Harry A. Blackmun (1985-1986) and Hon. Richard A. Posner of tile U.S. Court of Appeals for the Seventh Circuit (1984-1985).

Ms. Morrison has served as a Director of the Bar Association of San Francisco (“BASF”) and a member of the BASF Judiciary Committee. Ms. Morrison served as a Lawyer Representative (Northern District of California) to the Ninth Circuit Judicial Conference, and was Co-Chair. She was a member of the Northern District of California, Civil Justice Reform Act Advisory group. She served on the Board of Directors of the University of California, Berkeley, School of Law Alumni Association and was Secretary of the Board. She was a member of the Federal Courts Committee of the California Bar Association and served on the Contra Costa County Human Relations Commission.

Ms. Morrison received a B.S. in Journalism from Northwestern University and earned a J.D. from the University of California at Berkeley, School of Law, where she was Editor-In-Chief of the California Law Review.

Mark Perlow, Partner, K & L Gates LLP

Mr. Perlow is a partner in the San Francisco office of K&L Gates LLP. His practice focuses on investment management and securities law, and he regularly represents hedge fund managers, mutual funds, investment advisers, fund boards of directors, and broker-dealers on a broad range of regulatory and transactional matters. Before K&L Gates, Mr. Perlow served as senior counsel in the Office of the General Counsel of the Securities and Exchange Commission, focusing on investment management, fund and corporate governance, and enforcement, and he also served in the SEC’s Division of Enforcement. Mr. Perlow is a frequent speaker and author on topics relating to investment management and the law, and he teaches a class at the UC Berkeley School of Law on the structure and regulation of capital markets and financial institutions.

Danell Doty, Senior Compliance Officer, Passport Capital LLC

Ms. Doty is a Senior Compliance Officer at Passport Capital, LLC, a global investment firm managing approximately $4.7 billion in assets. Her responsibilities include a broad range of activities including maintaining the firm’s compliance program. Before joining Passport, Ms. Doty served as Director of Fund Administration at Genworth Financial Wealth Management and Treasurer to its mutual fund companies. Ms. Doty was hired at Barclays Global Investors in 1999, where, as Head of Mutual Fund Administration, she was involved in the creation of the iShares products. She then served as Fund Chief Compliance Officer from 2004 to 2006. Prior to BGI, Ms. Doty served in several capacities for London Pacific Group, including Vice President of Operations. She was also instrumental in creating the Govett Funds and the Berkeley Funds.

About 100 Women in Hedge Funds (www.100womeninhedgefunds.org)

100 Women in Hedge Funds is a global, practitioner-driven non-profit organization serving over 10,000 alternative investment management investors and professionals through educational, professional leverage and philanthropic initiatives. Formed in 2001, 100 Women in Hedge Funds has hosted more than 250 events globally, connected more than 250 senior women through Peer Advisory Groups and raised globally over $21.5 million gross for philanthropic causes in the areas of women's and family health, education and mentoring. For more information about 100 Women in Hedge Funds, please visit www.100womeninhedgefunds.org.

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Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog.  About Cole-Frieman & Mallon LLP:

Informed by significant in-house and private practice experience at some of the most prestigious Wall Street firms, hedge funds, and law firms Cole-Frieman & Mallon LLP has the business acumen and market knowledge to provide legal solutions for a wide range of financial services matters. With offices in San Francisco and New York, Cole-Frieman & Mallon LLP has a nationwide practice that services both start-up managers as well as multi-billion dollar firms. Cole-Frieman & Mallon LLP provides a variety of services including: hedge fund formation, advisor registration and counterparty documentation, CFTC and NFA matters, seed deals, internal investigations, operational compliance, regulatory risk management, hedge fund due diligence, marketing and investor relations, employment and compensation matters, and routine business matters. For more information please visit us at: http://www.colefrieman.com/.

Karl Cole-Frieman can be reached at 415-352-2300.

Bart Mallon can be reached directly at 415-868-5345.

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Series 65 Exam Opinions Requested

Seeking Opinions on How to Pass to the Series 65 Exam

I am hoping readers of this blog would be able to provide some feedback on their experiences with the Series 65 exam. As a

little background, many of our firm's clients are managers who will be state registered investment advisers and therefor these groups will need to make sure certain individuals take the Series 65 exam in order to become registered in the state of principal residence.

The North American Securities Administrators Association (NASAA) is the group in charge of creating the Series 65 and the exam is administered by FINRA at any number of locations across the U.S. and in different countries. At the beginning of 2010 NASAA changed the grading of the Series 65 exam so that it was more difficult to pass. From that time forward we have anecdotally noticed that there were in fact less people who were passing the exam on the first try.  Accordingly, we are trying to gather information on the exam to help out those people who will be taking it in the future.

If you have taken the e

xam over the last year we are asking if you can provide us with a little information on your experiences and some thoughts on how you would prepare for the exam, given what you know now. For example, we think the following information would be helpful:

  • Date you took the exam (month, year)
  • Final score
  • Series 65 Exam prep / study guide(s) you used
  • Amount of time spent studying (approximate number of hours)
  • Number of practice exams you took? Scores on those exams?
  • Areas you did well on/ could have done better on
  • Overall impressions – was it similar to the practice exams?
  • How would you study for the exam differently?

If you have other comments or information that might be helpful, please feel free to post that as well.  Responses can be posted in the comment section below or you can contact us directly.

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Cole-Frieman & Mallon LLP is a boutique law firm focused on the hedge fund industry.  We help fund managers with investment adviser registration and hedge fund formation matters.  Bart Mallon can be reached directly at 415-868-5345.

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Bart Mallon Speaking at Financial Services Conference

Moss Adams Event on September 26, 2011

On September 26, 2011 Bart Mallon, co-managing partner of Cole-Frieman & Mallon LLP, is scheduled to speak on a panel with respect to recent regulatory issues affecting asset managers. The panel is entitled “Dodd-Frank and the Impact on the Asset Management Business” and also features David E. Tang, a partner at Sidley Austin LLP, and will be moderated by Bryan Cartwright of Moss Adams.

While we do not yet know the exact topics for the panel, there has been a number big picture issues which will affect fund managers over the next several months. Some of these issues include:

After the event we will

provide a review of the major items discussed during the panel.  An overview of the conference is reprinted below and more information can be found here.

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09/26/2011
9:00 a.m. – 5:00 p.m. PT
Hilton Hotel
San Francisco, CA

What’s happening in the investment community now, and where are asset management companies headed?

Join Moss Adams LLP, Arizona State University emeritus professor Dr. Stephen Happel, and US Bancorp former chief economist John Mitchell for an economic update. We’ll also discuss a range of issues and developments affecting broker-dealers, RIAs, hedge funds, and asset managers. Topics will include:

  • Impact of the Dodd-Frank Act
  • Retention and succession
  • Producing superior AUM growth
  • Transaction and advisory activity
  • Accounting and auditing roundup

Alongside our annual Community Banking Conference, this event will provide you an opportunity to network with banking professionals during lunch and at our joint reception.

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Cole-Frieman & Mallon LLP is a hedge fund law firm which provides comprehensive formation and SEC/CFTC regulatory support to start-up and established hedge fund managers.  Please contact us if you have any questions.

Bart Mallon

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Hedge Fund Subscription & Withdrawal Process

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The hedge fund subscription process (i.e. placing investor money into the fund’s brokerage account for investment) is a basic process that may be slightly different for each fund based on a number of factors.  Managers should make sure they understand the subscription process because investors may ask questions about the process and how the subscription amounts ultimately get into the fund’s trading account.  This post will discuss the framework for how subscription amounts move from the investor to the fund’s bank and brokerage accounts.

Bank Accounts

We previously discussed items related to establishing bank accounts for a hedge fund structure.  In general bank accounts will be established for the fund as well as the management company.  Establishing a bank account for a fund will be required when a fund’s broker requires all subscriptions and withdrawals to come from/go to a “same name” bank account.  Some managers may choose not to establish a bank account for the fund and simply have the prime broker deal with subscriptions, redemptions and fund expenses if their prime broker does not have “same name” requirements.  For the purposes of this article we generally discuss the subscription process with respect to structures where there are bank accounts for each individual fund.

Fund Administrator

The subscription process will be different if the fund utilizes a full service administrator instead of a non-full service administrator.

Full Service Fund Administration

If a fund’s administrator deals with the subscription process as well as the general accounting and NAV calculations (usually referred to as “full service” administration), then the fund manager generally will not deal with the subscription process at all.  Many times the “full service” administrator will actually establish (or work with the manager to establish) the bank and brokerage accounts and will dictate to the manager the subscription process.  Usually in these circumstances the administrator will also act as a “second signer” to add a layer of protection to the assets.  [Note: the “second signer” process essentially involves the fund administrator reviewing and approving all movements of money from the fund’s bank accounts.  While this service has been around for a number of years, it has become more common post-Madoff.]

Non- Full Service Fund Administration

For fund’s which do not have full service fund administration, the manager will be generally responsible for accepting subscription amounts and then making sure the amounts are properly moved to the brokerage account.  Generally the attorney will work with the manager to help the manager establish the proper structure and processes but managers should also discuss the process with the administrator to make sure all parties understand how the movement of subscription proceeds affect the calculation of the NAV.

Subscription Process in General

Generally the investor will wire the subscription amount to the fund’s bank account.  In the case of individual investors, subscriptions may sometimes be made by check.  Once the subscription amount has been credited to the fund’s bank account, it may either be wired to the fund’s brokerage account or it may sit there until the first

day of the trading period.*  Either the manager or the administrator (as described above) will work with the bank and broker to make sure the subscriptions are correctly transferred.

* Note: there are a number of different issues which may arise at this point including situations where the subscription is placed in the brokerage account before or after the first day of the trading period, and whether the investor will receive interest on the subscription amounts prior to the amounts being transferred to the brokerage account.  These issues should be discussed between the fund manager, administrator and lawyer prior to the fund launch.

Single Fund Structure – Domestic or Offshore Hedge Fund

In a single fund structure, whether the fund is located in the U.S. or offshore, moving subscription amounts is straight-forward.  Investors will place assets in the fund’s bank account and then the subscription amounts will be wired to the fund’s brokerage account. Generally a withdrawal is processed by a wire from the fund’s brokerage account to the fund’s bank account and then by a wire from the bank account to the withdrawing investor.  Depending on the broker, subscriptions and redemptions may be able to be effected directly between the investor and broker for credit/debit directly to the fund’s brokerage account.

Single Fund Subscription Process: Single Fund Structure Org Chart – Investor Subscription Process

Offshore Master-Feeder Hedge Funds

Offshore master-feeder funds will have process similar to the single entity fund structure process.  The general master-feeder hedge fund will have domestic taxable investors invest into a domestic feeder fund and offshore and non-taxable U.S. investors invest into an offshore feeder.  Both feeder funds will then invest directly into the master fund which ultimately makes investments directly.  A typical investment process might be: investors wire funds to the appropriate feeder fund bank account, the feeder fund then wires the subscription to the master fund bank account and from there the subscription amount would be wired to the brokerage account.  As above, withdrawals would be processed in the reverse order.

Master-Feeder Subscription Process: Master Feeder Org Chart – Investor Subscription Process

Mini-Master Hedge Funds

Mini-master hedge funds are becoming more popular because of cost considerations.  Additionally these structures can be easier to deal with from an operational perspective.  In the basic mini-master structure there will be two fund entities – an offshore fund and a domestic fund.  Then, like the traditional master-feeder structure, offshore investors and non-taxable U.S. investors will place their assets in the offshore feeder and U.S. taxable investors will place their assets in the domestic feeder.  Domestic investors will subscribe to the domestic fund which will act as the “master” fund.  From there the offshore fund will invest its assets in the domestic “master” fund, becoming in-essence an investor in the domestic fund. [Note: separate post on mini-master hedge funds to be coming soon.]

Mini-Master Fund Subscription Process: Mini-Master Org Chart – Investor Subscription Process

Other Items

The above discussion is general – each fund structure is unique and there may be certain reasons why a specific fund may have a process which is different from the discussion above.  Indeed, in many cases the administrator and broker may be able to handle subscription amounts which bypass the bank accounts or the feeder funds in master-feeder structures.  In any event, the fund manager’s operational team should work closely with the administrator to develop processes to ensure that the subscription process is seamless.  We have specifically not discussed offshore segregated portfolio companies or series LLC structures because these structures are unique and subscription processes may vary widely.

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Cole-Frieman & Mallon LLP is a hedge fund law firm which provides comprehensive formation and SEC/CFTC regulatory support to start-up and established hedge fund managers.  Please contact us if you have any questions.

Bart Mallon, Esq. can be reached directly at 415-868-5345.  Karl Cole-Frieman can be reached at 415-352-2300.