Author Archives: Hedge Fund Lawyer

Inspector General’s Madoff Report

SEC’s Madoff Investigation = Stunning Failure

As has been widely reported, the Inspector General has released a 450 page report on the SEC’s stunning failure to uncover the Bernard Madoff Ponzi scheme. Below I have republished some of the more interesting items from the summary portion of the report (emphasis mine). While we have heard many of the details before, the description of the “egregious” incompetence is still almost unbelievable.

To access the whole report, please see OIG Madoff Report. Chairman Shapiro’s comments, reprinted below, can be found here.

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Selected sections of the Inspector General’s summary

The OIG investigation did find, however, that the SEC received more than ample information in the form of detailed and substantive complaints over the years to warrant a thorough and comprehensive examination and/or investigation of Bernard Madoff and BMIS for operating a Ponzi scheme, and that despite three examinations and two investigations being conducted, a thorough and competent investigation or examination was never performed. The OIG found that between June 1992 and December 2008 when Madoff confessed, the SEC received six [arguably 8] substantive complaints that raised significant red flags concerning Madoff’s hedge fund operations and should have led to questions about whether Madoff was actually engaged in trading. Finally, the SEC was also aware of two articles regarding Madoff’s investment operations that appeared in reputable publications in 2001 and questioned Madoff’s unusually consistent returns.

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One effort was made to verify Madoff’s trading with an independent third-party, but even after they received a very suspicious response, there was no follow-up. The Assistant Director sent a document request to a financial institution that Madoff claimed he used to clear his trades, requesting records for trading done by or on behalf of particular Madoff feeder funds during a specific time period. Shortly thereafter, the financial institution responded, stating there was no transaction activity in Madoff’s account for that period. Yet, the response did not raise a red flag for the Assistant Director, who merely assumed that Madoff must have “executed trades through the foreign broker-dealer.” The examiners did not recall ever being shown the response from the financial institution, and no further follow-up actions were taken.

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At a crucial point in their investigation, the Enforcement staff was informed by a senior-level official from the NASD that they were not sufficiently prepared to take Madoff’s testimony, but they ignored his advice. On May 17, 2006, two days before they were scheduled to take Madoff’s testimony, the Enforcement staff attorney contacted the Vice President and Deputy Director of the NASD Amex Regulation Division to discuss Madoff’s options trading. The NASD official told the OIG that he answered “extremely basic questions” from the Enforcement staff about options trading. He also testified that, by the end of the call, he felt the Enforcement staff did not understand enough about the subject matter to take Madoff’s testimony. The NASD official also recalled telling the Enforcement staff that they “needed to do a little bit more homework before they were ready to talk to [Madoff],” but that they were intent on taking Madoff’s testimony as scheduled. He testified that when he and a colleague who was also on the call hung up, “we were both, sort of, shaking our heads, saying that, you know, it really seemed like some of these [options trading] strategies were over their heads.” Notwithstanding the advice, the Enforcement staff did not postpone Madoff’s testimony.

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During his testimony, Madoff also told the Enforcement investigators that the trades for all of his advisory accounts were cleared through his account at DTC. He testified further that his advisory account positions were segregated at DTC and gave the Enforcement staff his DTC account number. During an interview with the OIG, Madoff stated that he had thought he was caught after his testimony about the DTC account, noting that when they asked for the DTC account number, “I thought it was the end game, over. Monday morning they’ll call DTC and this will be over . . . and it never happened.” Madoff further said that when Enforcement did not follow up with DTC, he “was astonished.”

This was perhaps the most egregious failure in the Enforcement investigation of Madoff; that they never verified Madoff’s purported trading with any independent third parties. As a senior-level SEC examiner noted, “clearly if someone … has a Ponzi and, they’re stealing money, they’re not going to hesitate to lie or create records” and, consequently, the “only way to verify” whether the alleged Ponzi operator is actually trading would be to obtain “some independent third-party verification” like “DTC.”

A simple inquiry to one of several third parties could have immediately revealed the fact that Madoff was not trading in the volume he was claiming.

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The OIG summary concludes that:

As the foregoing demonstrates, despite numerous credible and detailed complaints, the SEC never properly examined or investigated Madoff’s trading and never took the necessary, but basic, steps to determine if Madoff was operating a Ponzi scheme. Had these efforts been made with appropriate follow-up at any time beginning in June of 1992 until December 2008, the SEC could have uncovered the Ponzi scheme well before Madoff confessed.

The OIG’s matter of fact concluding statement that “the SEC could have uncovered” the fraud rings hollow, especially for the people who lost life savings needlessly.

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Chairman Shapiro’s Statement

Statement by SEC Chairman:
Statement on the Inspector General’s Report Regarding the Bernard Madoff Fraud
by
Chairman Mary L. Schapiro
U.S. Securities and Exchange Commission
Washington, D.C.
September 4, 2009

Today we are releasing the Inspector General’s 450-page report regarding the Bernard Madoff fraud and the many missed opportunities to discover it.

As I stated earlier this week, it is a failure that we continue to regret, and one that has led us to reform in many ways how we regulate markets and protect investors.

In the coming weeks we will continue to closely review the full report and learn every lesson we can to help build upon the many reforms we have already put into place since January.

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A list of the SEC’s many reforms undertaken is available at
http://www.sec.gov/spotlight/secpostmadoffreforms.htm.

The Inspector General’s report is available at
http://www.sec.gov/news/studies/2009/oig-509.pdf.

SEC Chairman Schapiro’s September 2 statement is available at
http://www.sec.gov/news/speech/2009/spch090209mls-2.htm.

http://www.sec.gov/news/speech/2009/spch090409mls.htm

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Other Hedge Fund Law Blog related to the Madoff scandal:

Securitizing Life Settlement Investments

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New Investment Opportunities for Hedge Funds

A recent New York Times article discusses how some investment banks are planning to securitize life settlement policies. The article explains that there is likely to be a strong demand for such securities. Much like the securitization of mortgages, life settlement securities would have different tranches which would have different risk profiles.

We have talked earlier about the definition of life settlements and about life settlement hedge funds. Over the past couple of months I have talked with a number of people involved in this aspect of the alternative investment industry and it seems to continue to be quite a lively little niche. I believe that if these investments are securitized, this new asset class will be attractive for some hedge fund managers – either as a central investment program or as a compliment to their current hedge fund investment program.

It will be interesting to see how this plays out and how the SEC and various states will react.

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Other articles related to hedge funds and life settlements include:

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

Commodity Pool Operators Scrambling After Surprise CFTC Decision

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CFTC Withdraws Two No-Action Letters

In a surprise move the CFTC has withdrawn two no-action letters which is had just recently issued. Under the new Chairman Gary Gensler, the CFTC has made an about face on this issue with regard to two commodity pool operators who were relying on the no-action letters issued in 2006. Under the no-action letters, the CFTC provided no-action relief to the CPOs from certain speculative position limits. According to the release reprinted below, the reason for the change is because Chairman Gensler “believe[s] that position limits should be consistently applied and vigorously enforced.” While we generally believe that rules should be applied uniformly, we also believe that the governmental agencies (the CFTC and the SEC) should not make it a practice of revoking previously issued no-action letters. We also believe that the CFTC and the SEC should not be in the business of express politicking, which may have been the case here – it sets a horrible precedent for new/changing administrations. Additionally, we believe that the same “tough line” on position limits could have been effected in a less onerous manner.

The release states that the CFTC will work with the affected CPOs, but the damage has been done – how are businesses supposed to operate when these governmental agencies are constantly moving the target?

The no-action letters can be found here:

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Release: 5695-09
For Release: August 19, 2009

CFTC Withdraws Two No-Action Letters Granting Relief from Federal Speculative Position Limits on Soybeans, Corn and Wheat Contracts

Washington, DC – The U.S. Commodity Futures Trading Commission today announced that it is withdrawing two no-action letters that provided relief from federal agricultural speculative positions limits set forth in CFTC regulations (17 C.F.R §150.2).

“I believe that position limits should be consistently applied and vigorously enforced,” CFTC Chairman Gary Gensler said. “Position limits promote market integrity by guarding against concentrated positions.”

In CFTC Letter 06-09 (May 5, 2006), the agency’s Division of Market Oversight (DMO) granted no-action relief to DB Commodity Services LLC, a commodity pool operator (CPO) and commodity trading advisor (CTA), permitting the DB Commodity Index Tracking Master Fund to take positions in corn and wheat futures that exceed federal speculative position limits set forth in CFTC Regulation 150.2. Subsequently, in CFTC Letter 06-19 (September 6, 2006), DMO granted similar no-action relief to a CPO/CTA employing a proprietary commodity investment strategy that includes positions in Chicago Board of Trade corn, soybeans and wheat futures contracts. Among other things, DMO’s no-action position in both cases stated that any change in circumstances or conditions could result in a different conclusion. DMO has previously stated that the trading strategies employed by these entities would not qualify for a bona fide hedge exemption under the Commission’s regulations.

DMO will work with each of these entities as they transition to positions within current federal speculative limits. The withdrawal of these no-action positions is very specific and limited and does not affect any other no-action or regulatory positions taken by the CFTC or its staff with regard to these entities or other market participants.

Last Updated: August 19, 2009

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

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

Hedge Fund Operational Issues and Failures

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Hedge Fund Due Diligence Firm Releases White Paper

We’ve published a number of thoughtful pieces on this blog from Chris Addy, president and CEO of Castle Hall Alternatives (see, for example, article on Hedge Fund Auditors). Today we are publishing a press release which announces a new white paper from Castle Hall detailing the various reasons which hedge funds fail. The press release also describes a new web database called HedgeEvent which was created by Castle Hall and details a number of hedge fund operational failures over the last few years.

I found the white paper to be interesting. I would imagine that some fund of funds and other types of hedge fund investors would find the information useful. A couple of interesting facts from the whitepaper:

The most common causes of operational failure in hedge funds are (i) theft and misappropriation and (ii) existence of assets (i.e. Ponzi schemes).
Long/short equity and managed futures are the strategies which are most likely to be subject to operational failure.

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Castle Hall Alternatives Publishes White Paper on Hedge Fund Operational Failures: Launches “HedgeEvent” Database

MONTREAL–(BUSINESS WIRE)–Castle Hall Alternatives, the hedge fund industry’s leading provider of operational due diligence, today published its latest White Paper, ‘From Manhattan to Madoff: the Causes and Lessons of Hedge Fund Operational Failure.’ The Paper’s analysis and findings are based on HedgeEvent, a comprehensive, web-based database of more than 300 operational events, now available to Castle Hall’s due diligence clients. HedgeEvent supplements HedgeDiligence, the firm’s existing client web portal.

The White Paper may be downloaded from www.castlehallalternatives.com/publications.php

Chris Addy, Castle Hall’s CEO, said “the colossal fraud perpetrated by Bernie Madoff, together with a number of other recent cases, has made investors acutely concerned by the risk of operational ‘blow ups’. However, there has been little systematic study of operational failure, meaning that investors have limited guidance as to the extent of this problem.”

“The creation of HedgeEvent, which has taken more than two years to compile, has enabled us to summarize key metrics related to hedge fund operational failure” said Addy. “From Manhattan to Madoff analyzes operational events by number, estimated loss, causal factor and by the strategy of the funds involved.”

HedgeEvent contains 327 cases of hedge fund operational failure through June 30, 2009. Madoff, with an estimated financial impact of $64 billion, is by far the largest; the remaining cases have an aggregate estimated financial impact of approximately $15 billion. Of the 327 operational events, 121 have an estimated impact of $10 million or more, and 31 of at least $100 million.

“While operational failures are material – Madoff spectacularly so – it does not seem that fraud is pervasive in the hedge fund industry” said Addy. “Investors should, however, be very focused on the lessons which can be learned from those hedge funds which did generate large losses. Many of these were well established firms which attracted capital from reputable investors.”

Across all Events, the most common causes of operational failure are theft and misappropriation followed by existence of assets (the manager claimed to own fake securities or operated a Ponzi scheme where reported assets did not exist). The most common strategies subject to operational failure are long / short equity followed by managed futures. It is notable that investors have traditionally viewed these strategies, holding largely exchange-traded securities, as straightforward with low operational risk.

“HedgeEvent is an invaluable tool for both Castle Hall and our clients” said Addy. “A lot can be learned from historical events: better knowledge can help investors avoid the losses, both monetary and reputational, of hedge fund operational failure.”

About Castle Hall Alternatives

Castle Hall Alternatives helps leading institutional investors, fund of funds, family offices and endowments identify and manage hedge fund operational risk. Castle Hall’s team draws on more than 30 years of direct due diligence experience and is the industry’s largest, dedicated provider of operational due diligence. More information is available at www.castlehallalternatives.com

Contacts

Castle Hall Alternatives
Chris Addy, President and CEO, +1 450 465 8880
[email protected]

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Other related hedge fund law and start up articles include:

For more information, please call Bart Mallon, Esq. at 415-296-8510

Deal Book: New Hedge Fund with Questionable Name

Series 79 Exam Available November 2, 2009

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FINRA Announces Date of First Series 79 Exam

The new investment banking exam, the Series 79, will be available for those first new test takers on November 2, 2009 at any of the FINRA testing centers (Pearson and Prometric). In addition to the test date announcement, FINRA also published a Series 79 Content Outline which seems to be very comprehensive. We have provided an overview of the exam below and will continue to bring you updated information on this exam.

Also, please note that right now we do not know of any groups who have completed a Series 79 exam study guide, but we have had informal conversations with representatives from both STC and Kaplan – these representatives have stated that they are currently working on developing such a study guide which should be available soon. We will let you know when these study materials become available.

Series 79 Overview

According to FINRA, the following are the key stats for the Series 79 exam:

Questions: 175 multiple choice questions (plus 10 pre-test, non-graded questions)
Time: 5 hours testing time
Eligibility: FINRA member firm must sponsor the candidate
Application: Submission of Form U-4 through Web CRD
Purpose: This examination qualifies an individual to advise on or facilitate debt or equity offerings through a private placement or public offering or to advise or facilitate mergers or acquisitions, tender offers, financial restructurings, asset sales, divestitures or other corporate reorganizations or business combination transactions.

FINRA’s Stated Exam Purpose

The Series 79 Examination is designed to assess the competency of entry-level investment bankers. As a qualification examination, it is intended to safeguard the investing public by seeking to measure the degree to which each candidate possesses the knowledge, skills and abilities needed to perform the major functions of an entry-level investment banker. Candidates should note that the duties and functions of the investment banker must be performed in accordance with just and equitable principles of trade, federal and state laws, and industry regulations. Furthermore, it is the responsibility of the candidate to be aware of changes in current legislation, regulation and policy. A registrant who violates industry regulations is subject to disciplinary action, including censures, fines, suspension, and permanent loss of registration.

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

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about the Series 79 or investment banking activities, please call Mr. Mallon directly at 415-296-8510.

Start a Hedge Fund in the Cayman Islands

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How to Set Up a Cayman Islands Hedge Fund

There are two main jurisdictions to establish an offshore hedge fund (either as a single hedge fund or as part of a master-feeder structure). The two jurisdictions are the BVI and the Cayman Islands. This article will discuss some of the features of Cayman Island based hedge fund structures.

Why the Cayman Islands?

Cayman has been the leading jurisdiction for fund formation with an estimated 80% of the world’s hedge funds domiciled there. As of December 2008, Cayman had over 10,000 hedge funds registered with the local regulatory authority: The Cayman Islands Monetary Authority (“CIMA”).

First and foremost: establishing a fund in the Cayman Islands is easy and efficient, offering managers many competitive advantages over other jurisdictions including:

Non-public funds can be registered in as little as 3-5 days with CIMA and the vehicle of choice for the fund can be registered within 1 day prior to filing, if necessary;
Flexible statutory regimes, with an absence of exchange control provisions, that are well-established and relatively low-cost;
There are no restrictions on: (i) investment policy (ii) issue of equity interests (iii) prime brokers or (iv) custodians;
The regulatory and legislative environment is continuously evolving to strengthen the jurisdiction’s appeal for hedge funds in response to ever changing market conditions;
Cayman is a tax neutral jurisdiction – there are no capital gains, income, profits, withholding or inheritance taxes attaching to investment funds established there, nor to investors in such investment funds;
Cayman is a British Overseas Territory and as such maintains all of the security and stability associated with the British flag. The UK remains responsible for the islands’ external affairs, defence and their legal system; and
The quality and expertise of the Cayman Islands local services, infrastructure and legal system is well above par.

Does Every Hedge Fund Have to be Registered with CIMA?

While most funds (90%) will be required by Cayman Islands law to register with CIMA, there are some funds that will not: those funds where the equity interests are not held by more than 15 investors who collectively have the power to appoint or remove the “operator” of the fund i.e. the director, trustee, or general partner, depending on the fund’s choice of vehicle. For example, a private fund or closely held funds such as partners’ funds or those in incubation “testing the waters” before launching into the registered world. These funds need not make filings or pay fees to CIMA.

All other funds must register with CIMA, pay annual fees and undergo annual auditing.

What are the CIMA Hedge Fund Registration Requirements?

1. Incorporation/Formation of the fund vehicle. The fund must be in the form of one of three vehicles: i) a Cayman Islands Exempted Company (most common); ii) a Unit Trust; or iii) an Exempted Limited Partnership. (The latter is popular with US investors as the Cayman Islands Exempted Limited Partnership Law follows the equivalent legislation in Delaware.) There must be a minimum of two (2) directors appointed to the fund – corporate or individuals. The directors need not be local.

2. Preparation of the fund’s Offering Document.

3. Preparation of the fund’s constitutional documents (i.e. Memorandum and Articles of Association) to reflect the terms of the Offering Document. This is usually done by way of amending and restating the constitutional documents after the vehicle for the fund has been properly formed (see 1 above).

4. Preparation of the service agreements i.e. administration agreement/investment management agreement/advisory agreement etc.

5. Preparation of the form of subscription agreement to be executed by the investors of the fund.

6. Resolutions must be passed approving: the Offering Document, service agreements and the issue of equity interests by the fund.

7. All of the following documents must then be submitted to CIMA:

i)    A certified copy of the fund’s certificate of incorporation (or otherwise, depending on the vehicle used);
ii)    Fund’s Offering Document;
iii)    Application Form (“Form MF1”);
iv)    Auditor’s letter of consent; (A local auditor must be appointed. Such auditor must also sign off on the fund’s audited financial statements which are to be submitted annually to CIMA.)
v)    Administrator’s letter of consent (no requirement for local administrator);
vi)    Registration fee (approximately US$3,000 (subject to change))

What Are the Costs for CIMA Registered Funds?

The total approximate costs of setting up a Cayman Islands Hedge Fund will include: the incorporation/formation costs of the vehicle required plus the ongoing annual fee (for exempted companies); the annual administrator’s fee; the annual auditor’s fee; the initial registration fee of the fund with CIMA and an annual fee to maintain the fund’s registration, and any legal fees associated therewith.

Quotes for incorporation etc. and estimates for services may be obtained from service providers and legal counsel directly, as these will likely vary. Legal counsel may provide recommendations for service providers upon request.

Article Written by Michelle Richie

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

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

Over-the-Counter Derivatives Markets Act of 2009

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Obama Administration to Regulate Derivatives Markets

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

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August 11, 2009
TG-261

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

For the legislative language, visit link.

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

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

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

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

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

These goals will be reached through comprehensive regulation that includes:

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

Regulation of OTC Derivative Markets

Require Central Clearing and Trading of Standardized OTC Derivatives:

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

Move More OTC Derivatives into Central Clearing and Exchange Trading:

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

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

Require Transparency for All OTC Derivative Markets:

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

Regulation of All OTC Derivative Dealers and Other Major Market Participants

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

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

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

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

Preventing Market Manipulation, Fraud, and other Market Abuses

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

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

Protecting Unsophisticated Investors

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

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

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

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

Investment Adviser Registration Filing Tips

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How to get an IA application approved quickly

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

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Tip 1

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

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

Tip 2

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

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

Tip 3

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

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

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

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

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

Hedge Fund Hotels

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Office Space, IT, Trading For Start up Hedge Funds

The term hedge fund hotel generally describes the offering of office space, IT and consulting services (including, potentially, capital introduction) for start up hedge fund managers. Most of these relationships are established as turn-key solutions for managers which provide them the back-office infrastructure to run a hedge fund without the headaches of managing the development and maintenance of such infrastructure. Many times the rent is discounted and the managers are encouraged to utilize the services of the group that is providing the hedge fund hotel. Groups which typically provide these hedge fund hotel relationships include prime brokers, banks, and other hedge fund service providers or consultants. These relationships are not without controversy and

Issues with Hedge Fund Hotels

One of the major issues with hedge fund hotels is that they will pay below market rate for office space and IT which implicates issues is similar to soft dollar issues. Managers who use soft dollars need to be very cognizant of the conflicts of interest which may arise in soft-dollar contexts, especially if the manager has any ERISA fiduciary duties. Likewise, managers who have hotel relationships need to be cognizant of issues related to conflicts of interests with regard to brokerage and execution. Because managers will normally choose (and periodically review) their brokers based on a variety of criteria (such as pricing/speads/commissions, execution of orders, financial strength of the broker, available research, etc.), the fact that they receive (in certain cases) reduced rent should not influence the manner in which they decide upon brokerage. In theory it is easy to say, but in practice it is hard to do. As such, there have been a few recent controversy’s which have acknowledge the potential conflict of interest issues with these relationships.

Hedge Fund Hotel Controversy

In 2007 the Massachusetts Securities Division filed an action against UBS for its activities related to it running a hedge fund hotel. Below are a couple of excerpts from the UBS Hedge Fund Hotel Administrative Complaint:

Other than hedge fund adviser, prime brokers are the primary third party service providers to hedge funds. Prime brokers provide a suite of services essential to the successful implementation of hedge funds’ individual objectives. Prime Brokers generate substantial revenue from those hedge fund clients in exchange for these services. UBS competes for prime brokerage revenue in part by providing a range of benefits to the advisers of those hedge fund clients to induce the advisers to bring and keep the hedge fund business with UBS. Among the methods UBS used to influence or reward hedge fund advisers and their principals are: Provision of office space to hedge fund advisers at rates that are substantially below market rate; Free access to information technology personnel and other office personnel; Introductions to potential new clients (that would increase management fees for the adviser); Low interest personal loans; and Tickets to sporting events and other forms of entertainment.

Unbeknownst to the pension funds, university endowments, charitable foundations, institutional investors and individuals who invest in hedge funds, the rewards for the hedge fund advisers come implicit and sometimes explicit quid pro quos. UBS requires the hedge fund advisers to cause the hedge funds they manage to meet certain benchmarks of profitability for UBS or ensure they do not use other prime brokers.

Page 2-3 of the complaint

Later on in the complaint, the Enforcement Section of the Massachusetts Securities Division provides the following definition of prime brokerage and the fees generated by prime brokers.

“Prime Brokerage is a service provided by certain broker-dealers to facilitate the clearance of securities trades and other services to substantial retail and institutional customers, including hedge funds. The services offered by Prime Brokers may include: trading, securities lending, margin lending, customized reporting; research; valuation; technology; operations services; and other services needed by hedge funds or other large clients.

Prime Brokers generate revenue on hedge fund business from commissions, spreads, administrative fees, ticket charges, stock loans and credit interest earned from providing position financing and arranging securities loans (“Prime Fees”).

In the Prime Brokerage relationship, the client who pays the Prime Fees is the hedge fund. The Hedge Fund Adviser is an agent of the hedge fund, acts on behalf of the hedge fund and has fiduciary duties to the hedge fund.

Page 9 of the complaint

Conclusion

Hedge fund hotels actually can provide valuable services to start up hedge funds during a very important part of the hedge fund life cycle. However, there are a number of disclosure issues which must be addressed and which should be discussed in detail in the hedge fund offering documents. The managers should discuss their brokerage/hotel relationship with their hedge fund attorney who will help them to identify and properly disclose the various compliance and conflicts issues which may be present. Additionally, when a hedge fund and manager reaches a certain place in the fund growth/lifecycle, they may want to explore paying market rates for their space and/or moving to another location. These issues should be contemplated by management in consultation with the hedge fund attorney.

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

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