Author Archives: Hedge Fund Lawyer

NFA Prohibits CPO Firm From Doing Business

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For Immediate Release

For more information contact:
Larry Dyekman (312) 781-1372, [email protected]
Karen Wuertz (312) 781-1335, [email protected]

NFA takes an emergency enforcement action against GlobeFX Club, Inc.

March 24, Chicago – National Futures Association (NFA) announced today that it has taken an emergency enforcement action against GlobeFX Club, Inc. (GlobeFX Club), a Commodity Pool Operator located in Homestead, Florida. Effective immediately, the Member Responsibility Action (MRA) is deemed necessary to protect pool participants, customers and other NFA Members because GlobeFX Club has provided contradictory information in regards to whether it is conducting business, has customer accounts and is operating a pool. NFA has been unable to determine the nature of GlobeFX Club’s business, the identities of its customers, the treatment of customer funds and the identity of two individuals who purportedly loaned money to the firm. The firm has also failed to produce books and records requested by NFA and answer questions concerning its operations.

The MRA suspends GlobeFX Club from NFA membership until further notice. GlobeFX Club is prohibited from soliciting or accepting any customer or pool participant funds or placing trades for any pool that its operates or customer accounts that it holds. Additionally, the MRA prohibits GlobeFX Club from disbursing or transferring any funds from any accounts without prior NFA approval.

The MRA will remain in effect until GlobeFX Club has demonstrated that it is in complete compliance with all NFA requirements. GlobeFX Club may request a prompt hearing before NFA’s Hearing Committee.

The complete text of the MRA can be found on NFA’s Website (www.nfa.futures.org).

NFA is the premier independent provider of innovative and efficient regulatory programs that safeguard the integrity of the futures markets.

Discussion about Forex Registration and the Series 34 Exam

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(www.hedgefundlawblog.com)

Creating Series 34 Exam Prep Materials

One central issue in the investment management industry is increases in regulation of previously unregulated or lightly regulated activities.  The major area which will see direct regulation within the next 12 months is the retail off-exchange foreign currency industry.  As we have discussed, forex managers and those parties which solicit retail forex investors are is expected to have to register with the NFA as forex CPOs, forex CTAs or forex introducing brokers.  As part of this process, individuals subject to registration are going to need to pass the Series 34 exam.  This article will discuss the exam and the new exam prep materials I have been creating to help managers pass the exam.

Overview of the Series 34 Exam

The Series 34 exam is a brand new test created by the NFA at the very end of last year. I have talked with the National Futures Association (which is the self regulatory organization in charge of the forex registration process) and they have told me that individuals can now take the Series 34 exam.  To take this exam individuals are going to need to submit a Form U-10, pay the $70 testing fee and sign up with either Pearson Vue or Prometric to actually take the exam.  The exam is 60 minutes long, has 40 questions and requires 70% correct answers for successful completion.

Series 34 Exam Preparation Materials

There are very few Series 34 materials out there for managers to study from.  I have talked with many different groups and they are planning on potentially releasing a Series 34 exam study guide, but these groups will be waiting until they are able to judge the demand for such a product.  Of course we cannot know the demand for the product until the CFTC proposes its forex registration rules, but it is a safe bet that many forex managers will need to take the exam.  Accordingly, I have started creating a free series 34 exam study guide for the general public.

The free series 34 exam study guide will provide an explanation of all of the major concepts that the NFA has stated will be covered in the exam.  I have provided in depth explanations on the concepts through my own research through many available online resources.  I believe that these materials will be strong, especially with regard to the regulatory requirements for forex managers – I have been reporting on these requirements now for over 6 months and have been able to cull together great resources.

In addition to the free guide, I will also have premium materials available for purchase.  These materials will include an outline, notecards, and practice questions.

  • The series 34 outline will be similar to an outline that you might see prepared for a law school exam – I have taken numerous exams (including many FINRA sponsored exams – Series 3, Series 7, Series 24, Series 63, Series 65) and have found that an outline is a great way to make sure all of the basic concepts are ingrained prior to taking the exam.
  • The series 34 notecards will be an exact replica of the notecards which I will use to study.  You can either print out the notecards and cut them out or you can copy the information onto individual notecards yourself.  I would recommend you write out the information onto individual notecards – in this way you enforce the learning process.  Probably my favorite way of studying is through notecards.  I can take them with me anywhere I am going and then study them when I am in line at a store, on a bus, during a TV commercial, etc.
  • The series 34 practice questions will be similar in style to the questions which you will expect to see on the exam.  I am going to write practice exam questions before I take the exam based on what material I think will be covered in the exam.  I am going to try to write toward areas of expected weakness so I anticipate the questions will be more difficult than those to be seen on the exam.  Additionally, I plan to go back and add more questions after I take the exam to best reflect the nature and difficulty of the questions on the exam.

Information on How to Study for the Series 34 Exam

The ultimate goal of the above exam prep materials is to provide forex managers with the tools they need in order to pass the test on the first try.  It is a waste of time and money to study and then not pass the test on the first time because of lack of preparation or study materials.  If the manager does not pass the exam on the first try, they will need to wait 30 days before they can take it again; if a manager does not pass the exam on the second try, they will need to wait 60 days before they can take it again.

As I have coached managers through the test taking process numerous times before I understand what is needed to pass on the first time – it is simply not enough to only read an exam prep guide.  You must read an exam prep guide and proactively study the concepts which will be tested.  Very smart people have failed the regulatory exams because of not properly studying.   You will need to over-study.

A common joke in the industry is that the perfect score is 70% because it means that you didn’t study too much to pass.  If someone else is paying for you to take the exam, and if you are still considered “on the clock” if you take time off of work to go take the exam, then this thinking may be fine (if you don’t mind taking tests) – however, for busy forex managers your time is too valuable to waste by not passing on the first try.  You should go into the test confident that you will pass and not hoping that you studied “just enough” to pass.

Series 3 Exam – A Pre-Requisite

While anyone can take the Series 34 exam, forex managers will likely need to have passed the Series 3 in addition to the Series 34 exam.  [HFLB Note: the CFTC has not promulgated rules on this issue so this is not a for sure requirement yet.]  I have taken the Series 3 exam and passed and provided more information here (general guidelines on how to study for a FINRA exam can be found here) – please review these articles in addition to the other resources linked on this page.

Timing of Materials Release

I should be able to release the materials later on this week.  I am currently planning to take the exam sometime this week.  I will update this article once the materials have been posted on our other websites.  In the meantime, please feel free to contact us with any questions you might have.

Other related hedge fund law articles:

Hedge Fund Law – State Law Issues

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Dealing with Ambiguous State Securities Laws

An issue which often arises during the planning phase of the hedge fund formation process is whether certain state securities or investment advisory laws or regulations apply to a certain fact situation.  Many times these issues arise in the context of investment advisor registration (especially with regard to “custody” and net worth requirements), but they can also apply to less common issues (such as spot forex registration and matters involving commodities and futures licensing).  The problem is not only that the laws and regulations may not apply to a specific situation (many state laws are based on a model code which was written over 50 years ago), but also that there are no judicial or administrative actions which can provide valuable insight into how the state or the enforcement division would view a similar situation.

Unfortunately it can be very hard to receive clarification on these laws and regulations  and sometimes reaching out to state regulators can be an exercise in futility.  In a recent call with the California Department of Corporations (which is in charge of, among other things, administering the state securities laws) I was practically scolded by the staff attorney for first reaching out to the state to determine if they had any informal thoughts on my question.  In situations where we cannot receive informal guidance from a state, the client may choose to request a no-action letter from the state with regard to their situation.

Requesting a No-Action Letter or Interpretive Opinion

NASAA, the North American Securities Administrators Association, has provided this description of no-action letters and interpretive opinions:

Many state securities regulators have the authority issue “no-action letters” in which staff confirms that a transaction carried out under a set of assumed facts will not result in a recommendation for enforcement action.  Some states also issue “interpretive opinions” in which staff provides guidance by indicating how a provision of law applies to a situation presented.

Generally states will allow groups to submit either request.  The request letter will include a restatement of the applicable facts and laws and an argument as to why the requested relief or opinion should be granted.  The attorney will draft this letter on behalf of the manager.  The manager will also need to pay a fee to the state, usually $100-$300 to receive an answer to the request letter.  There is no guarantee that the state will agree with manager and grant any relief.  It will usually take a minimum of 30 days to receive an answer from the state.

Unfortunately the process is both expensive and time consuming.

Fixing the Problem

There are many problems with the federalism system with regard to securities regulation.  One of the biggest issues is the lack of uniformity between the state laws and the disparity between states with regard to enforcement.  I posted an article yesterday about what NASAA is doing this area.  I commend NASAA for taking this step forward – it will be a big improvement over the current system and hopefully will lead to more uniform laws (and application of those laws) throughout the states.  However, this is not a panacea and we are unlikely to see truly fair and efficient enforcement of laws unless there is a wholesale scrapping of the current system and unfortunately even then we are still left with federalism which provides state securities commissions with powers that most do not understand how to deal with.

Ultimately this increases costs to the managers and ultimately investors.

NASAA Proposes Multi-State No-Action Request Process

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Currently each state has their own securities laws and their own interpretation of those laws.  While many of the laws and regulations are based on the same set of model rules, no two states seem to take the same interpretation with regard to the rules.  Enforcement is completely different as well.  This presents many problems for those involved in the securities and investment management industries because of the disparate treatment under similar circumstances in different states.

NASAA is taking a step forward to try to unify the laws of the states through a multi-state no-action request process.  Basically questions on the application or interpretation of state securities laws would be decided on a multi-state level instead of at just a single state(each state would have the ability to issue a distinct opinion or opt out of the discussion, see below for more details).  This is good because it (1) allows all states to address an issue which may be applicable (currently or in the future) to a resident of their state and (2) it will promote discussion between the states as to how to handle certain situations.  Hopefully this create a more uniform set of laws between the states which will decrease lawyer fees in the future and will increase certainty in the application of current laws and regulation.

With regard to the specific proposal we will likely respond to the NASAA with the following comments:

Section 5, number 7 – this section should be deleted unless it goes directly to an issue with the request at hand.  Disclosing this information otherwise would serve no purpose with regard to the request.

Suggestion – NASAA should also create a database on their website to track all of requests as well as the rulings on the requests.

We will be covering this in greater detail over the next few weeks.  Please contact us if you have questions or ideas with regard to the proposal.

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Notice of Request for Public Comment on NASAA’s Proposed Adoption of a Statement of Policy Regarding Multi-State Review of Requests for Interpretive Opinions and No-Action Letters

The NASAA Coordinated Interpretations Project Group requests comment from the public on the adoption of a new Statement of Policy Regarding Multi-State Review of Requests for Interpretative Opinions and No-Action Letters.

The comment period begins February 20, 2009 and will remain open for 30 days.  Accordingly, all comments should be submitted on or before March 22, 2009.  Comments should be directed by email or in writing to:

Rick A. Fleming
General Counsel
Office of the Securities Commissioner
618 S. Kansas Avenue
Topeka, Kansas  66603
[email protected]

Rex Staples
General Counsel
NASAA
750 First Street, NE, Suite 1140
Washington, DC  20002-4251
[email protected]

Background and Purpose of the Proposed Statement of Policy

Many state securities regulators have the authority issue “no-action letters” in which staff confirms that a transaction carried out under a set of assumed facts will not result in a recommendation for enforcement action.  Some states also issue “interpretive opinions” in which staff provides guidance by indicating how a provision of law applies to a situation presented.  These types of no-action letters and interpretive opinions are authorized by subsection 413(e) of the Uniform Securities Act of 1956, as amended, and subsection 605(d) of the Uniform Securities Act (2002).

Subsection 420(b)(7) of the 1956 USA and subsection 608(c)(9) of the 2002 USA authorize the states to cooperate with each other in the development of no-action letters and interpretive opinions in order to encourage uniform interpretation of laws and maximize the effectiveness of regulation.  Toward those ends, NASAA proposes this Statement of Policy.

Summary of the Proposed Statement of Policy

The proposed Statement of Policy describes the application and review process for multi-state consideration of requests for interpretive opinions and no-action letters.  The proposed Statement of Policy contains the following major elements:

  • Section II contains definitions, including the terms “interpretive opinion” and “no-action letter.”
  • Section III places restrictions on the types of matters that qualify for multi-state review.  For example, it prohibits requests concerning purely hypothetical situations and transactions that have already occurred.
  • Sections IV and V contain rules governing the content of the request letter, citation to state laws, payment of fees, etc.
  • Section VI describes the review process.  Conference calls and a list-serve will be used to facilitate communication between states, and responses to requests for interpretive opinions and no-action letters should be generated within 60 days.
  • Section VII contains optional disclaimers for the states to consider using.

The full policy statement, reprinted below, can also be found here.

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STATEMENT OF POLICY REGARDING
MULTI-STATE REVIEW OF REQUESTS FOR
INTERPRETIVE OPINIONS AND NO-ACTION LETTERS

(Adopted ____)

I. OVERVIEW

1. This Statement of Policy of the North American Securities Administrators Association (NASAA) describes the application and review process for multi-state consideration of requests for Interpretive Opinions and No-Action Letters.

2. The policy is intended to promote efficiency in the review of applications and produce responses to requests within 60 days.

3. This policy is intended to promote consistency in the interpretation of blue sky laws, particularly when the laws are based upon uniform or model provisions. However, the issuance of Interpretive Opinions and No-Action Letters is done solely at the discretion of each state, and each state is ultimately responsible for interpreting and enforcing its own law.

II. DEFINITIONS

1. “Interpretive Opinion” means a letter that states a conclusion regarding the applicability of a relevant provision of law to a situation presented. An Interpretive Opinion represents a judgment based solely on the fact situation as described by the applicant and an analysis of existing law and judicial, legislative, and administrative history.

2. “No-Action Letter” means a letter by which a person is advised that a transaction carried out under a set of assumed facts will not result in a recommendation by staff that an enforcement action be taken. An Interpretive Opinion often includes an assurance of “no action;” however, a No-Action Letter does not necessarily include any interpretation of law.

3. “Participating Jurisdictions” means those states that have agreed to accept applications for multi-state review of requests for Interpretive Opinions or No-Action Letters in accordance with this Statement of Policy. Authority for a multi-state review is provided in section 608(c)(9) of the Uniform Securities Act of 2002 and section 420(b)(7) of the Uniform Securities Act of 1956, as amended by NASAA. All Participating Jurisdictions are listed on Form MS-ONA.

4. “Selected Jurisdictions” means the states from whom an applicant seeks an Interpretive Opinion or No-Action Letter, as indicated by the applicant on Form MS-ONA.

III. CRITERIA FOR ELIGIBILITY

1. An application for multi-state review of a request for an Interpretive Opinion or No-Action Letter shall not involve a hypothetical situation, a past transaction, or an issue that is currently subject to or in preparation for litigation.

2. An application shall not involve a matter that the applicant knows or should know is currently under investigation or subject to regulatory action.

3. An application shall not relate to an interpretation of antifraud provisions.

IV. APPLICATION PROCESS

1. To apply for multi-state review of a request for an Interpretive Opinion or No-Action Letter, the applicant shall file the following documents with each Selected Jurisdiction and the Program Administrator:

a.  A copy of “Form MS-ONA – Application for Multi-State Review of Request for Interpretive Opinion or No-Action Letter.” The form is available on the NASAA web site at [insert current web address] and contact information for each state is available at [insert current web address].

b.  A request letter that complies with the requirements set forth below; and

c.  Any supporting materials.

2. The applicant shall submit an application fee directly to each Selected Jurisdiction in the amount indicated on Form MS-ONA.

V. CONTENT OF REQUEST LETTER

1. A request for an Interpretive Opinion or No-Action Letter shall succinctly present the issue to be considered and provide a thorough recitation of all material facts. The request shall contain the applicant’s reasoning and legal analysis, including references to applicable law and previous Interpretive Opinions or No-Action Letters that support the interpretation or relief requested. Additionally, the request should include a discussion of previous Interpretive Opinions or No-Action Letters that militate against granting the interpretation sought or relief requested and set forth the applicant’s reasoning and legal analysis distinguishing them from the facts and issues presented in the request.

2. The request should be limited to one legal issue and should be narrowly tailored to resolve the specific issue. The request should not attempt to discuss every possible situation.

3. The request must identify the persons or entities that are the subject of the request or will rely upon the response and identify the states in which such persons reside or maintain their principal places of business. The request may state that the person or entity seeks confidential treatment to the extent permitted by the open records or public records laws of the Selected Jurisdictions (e.g., state laws modeled after section 607 of the Uniform Securities Act of 2002). However, the applicant should take note that the laws of some states do not permit confidential treatment, and this Statement of Policy does not assure that any state will maintain the confidentiality of the person or entity or any other information contained in the application.

4. If a request for an Interpretive Opinion or No-Action Letter relates to a definition, exemption, or other provision that is derived from the Uniform Securities Act of 1956, the Uniform Securities Act of 2002, a NASAA model rule, or a NASAA Statement of Policy (SOP), the request letter shall include in the heading a citation to the relevant provision(s) of each applicable uniform act, model rule, or SOP.

5. The request shall set forth in tabular form, as an appendix, a specific citation to the relevant laws of each Selected Jurisdiction.

6. The request shall include a representation that any proposed transaction has not yet been consummated, that the matter is not currently subject to or in preparation for litigation, and that the applicant is not aware of any regulatory investigation involving the matter.

7. The request shall disclose whether any of the persons who are the subject of the request or will rely upon the response, or any of the persons’ predecessors, affiliates, directors, officers, general partners, beneficial owners of 10 percent or more of any class of its equity securities, any promoter presently connected with the persons in any capacity, any underwriter to be involved in a transaction described in the request, or any partner, director or officer of the underwriter:

a.  Within the last five years, has filed a registration statement which is the subject of a currently effective registration stop order entered by any state securities administrator or the United States Securities and Exchange Commission;

b.  within the last five years, has been convicted of any criminal offense in connection with the offer, purchase or sale of any security, or involving fraud or deceit;

c.  is currently subject to any state or federal administrative enforcement order or judgment, entered within the last five years, finding fraud or deceit in connection with the purchase or sale of any security; or

d.  is currently subject to any order, judgment or decree of any court of competent jurisdiction, entered within the last five years, temporarily, preliminary or permanently restraining or enjoining such party from engaging in or continuing to engage in any conduct or practice involving fraud or deceit in connection with the purchase or sale of any security.

8. If the applicant has communicated with any state securities administrator concerning the transaction or subject matter that is the subject of the request, the applicant shall disclose the nature of the communication and any response received from the state. If a separate request for an Interpretive Opinion or No-Action Letter has already been filed with one or more states in connection with the same transaction or subject matter, the applicant shall (1) provide a copy of any requests that have been filed and disclose the status of each state’s response; (2) provide a copy of any response that has been issued by a state; and (3) explain the reason that it did not initially seek multi-state review.

VI. REVIEW PROCESS

1. Within 5 business days after receipt of an application, the Program Administrator will determine whether the application is eligible for multi-state review and in proper form. If the application is ineligible or deficient, the Program Administrator will notify the applicant and the Selected Jurisdictions. If the application is eligible for multi-state review, the Program Administrator will notify the applicant and Selected Jurisdictions of the deadline to review the application and issue responses in accordance with paragraph VI.3. The Program Administrator will also send a copy of the application to any other state that provides contact information in accordance with Paragraph VI.6.

2. Within 45 days after receipt of a proper application by the Program Administrator, the Program Administrator shall arrange for a conference call to discuss the application and shall provide notice of the call to all states who submit contact information in accordance with paragraph VI.6. The Program Administrator may appoint a facilitator for the conference call, and the Program Administrator or facilitator may schedule additional conference calls as needed.

3. Within 60 days after receipt of a proper application by the Program Administrator, each Selected Jurisdiction shall use its best efforts to issue its response to the applicant. The response may include an Interpretive Opinion, No-Action Letter, or letter declining to give any such assurance. Failure of a Selected Jurisdiction to issue a response does not indicate assent to the granting of the interpretation or relief requested. A copy of the response should be sent to the Program Administrator and added to an electronic library containing the Interpretive Opinions and No-Action Letters issued under this Statement of Policy.

4. The Program Administrator may seek additional information from the applicant on behalf of any Selected Jurisdiction, and the applicant shall file copies of all supplemental material with each Selected Jurisdiction and the Program Administrator. If supplemental material is requested, the review period may be extended up to 30 additional days after receipt of the supplemental material at the discretion of the Program Administrator. The Program Administrator will notify the applicant and Selected Jurisdictions of the extension and send copies of the supplemental material to states that are not Selected Jurisdictions.

5. The timelines contained herein may be postponed at the discretion of the Program Administrator in extenuating circumstances. The Program Administrator will notify the applicant and the Selected Jurisdictions of the new deadlines and the reasons for any postponement.

6. Each Participating Jurisdiction and any other state that wants to receive notices from the Program Administrator must provide and update the Program Administrator with the name, title, address, phone number, fax number, and e-mail address of one or more contact persons. The Program Administrator will maintain a list-serve or other electronic system to facilitate communication between such persons.

VII. DISCLAIMERS

1. Each Participating Jurisdiction is encouraged to use the following disclaimers in any letter issued under this policy:

a.  The letter applies only to the party requesting it, and persons having similar fact situations should submit a separate request.

b.  The letter is conditioned upon the specific facts set forth in the request and the accuracy of any representations that are required to be made under this Statement of Policy.

c.  The conclusions are based upon current law, should not be regarded as precedent, and are not binding on any court, agency, or tribunal.

d.  The letter does not preclude investors, other regulatory agencies, or other persons from asserting their rights under the law.

Schwab Drops Hedge Fund Platform

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Self Directed IRA Investments in Funds Likely to Become Harder to Accomplish

In an earlier article about hedge fund IRA investments I discussed the general process which an investor will need to go through in order to invest their IRA assets in a hedge fund.  As a gross generalization the investor’s custodian will need to make the actual investment into the hedge fund.  In the past I have helped many clients navigate the hurdles which are sometimes involved in this process.  While the process is not exactly easy, it may become more difficult in the future based on anticipated regulatory changes.  These developments may make it harder for investors to invest in a hedge fund with their IRA assets.

In addition, Schwab has recently announced that they will no longer allow self-directed IRA investors to invest in alternative investments such as hedge funds.  This news comes as a big surprise to both advisors and investors.  Schwab was known for having a very good platform for self-directed IRAs.  In fact, out of all of the custodians that my clients have used for these transactions, Schwab was by far the best.  Their representatives were well versed in the mechanics of these investments where many other firms seemed to be learning on the job.  There was more than one time when a client’s investor had to switch IRA custodians in order to find a group which allowed a self-directed IRA investment into a hedge fund.

With Schwab exiting this space it may be more difficult for some investors to try to find good custodians who are able to process these transactions.  I have known at least a couple of well name groups who difficult to work with and lost business because of that.  The article I linked to above noted the backlash by RIAs and hopefully Schwab will reconsider based on the community support for their platform – I do believe that the reason for the backlash is because of good support which was provided to both the managers and customers.  So many times we face horrible customers service and it is always refreshing to find groups who do value the customer.

Hopefully we will be able to continue to rely on Schwab for these services in the future.

Other related hedge fund law articles include:

Hedge Fund Start Up Presentation

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How to Start a Hedge Fund in 2009

Below is a link to a powerpoint presentation in which I detail the background information a hedge fund manager must have prior to starting the hedge fund formation process.  The presentation is designed to familiarize a manager with the process of forming a fund while identifying potential issues which the manager should be aware of during the process.

The presentation is 18 slides long and is about 40 minutes.  I will also be posting a video here shortly.

Hedge Fund Presentation with Voice

Starting a hedge fund in 2009 (voice) (voice-over powerpoint)

For more viewing options, please see our Hedge Fund Lawyer youtube profile.

Hedge Fund Presentation without Voice
Starting a Hedge Fund

Thoughts on Hedge Fund Offering Documents

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FAQs on Offering Documents

I recently read an article by a hedge fund administration firm which discussed hedge fund offering documents and start up hedge fund expenses.  I thought this was an interesting topic and one which is popular with many of my start up clients.  Below I discuss some of the common questions regarding the offering documents and also provide reasons why a start up manager should use my law firm for starting a hedge fund.

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Offering documents are just boilerplate – why are they so expensive?

This is a common misperception.  Offering documents (if done correctly) are not merely boilerplate where the attorney pops in the fund name and the address – offering documents are a tailored to the specific needs of the client based on the client’s investment program and fund structure.

For instance, there are at least 12 different questions related to the management fee and performance fee/ performance allocation.  There are at least 22 different questions related to the fund’s contribution periods and withdrawal periods.  This level of customization does not come from a boilerplate form.  Furthermore, many of these questions or options may have specific implications for the manager’s business either from a legal standpoint or a business standpoint.  Many times the lawyer will need to have an in-depth discussion with the manager to help the manager determine which option is right for the fund.

Why are offering documents so long?

Offering documents are long – there is no getting around it.  The structure of the offering documents are determined by the federal and state securities laws and thus there is not really any wiggle room.  While it is often said that the hedge fund industry is “not regulated” or “lightly regulated” there are many hedge fund laws and regulations which managers must follow.   These laws dictate many aspects of the documents and are why offering documents are so long (and also why offering documents from different firms are structured so similarly).

In this prior post, discussing “Prospectus Creep” we discussed the length of offering documents:

4.  Is the Prospectus written for the Manager or the Investor?

Castle Hall discusses the interesting phenomenon of “Prospectus Creep” or basically the lengthening of hedge fund offering documents as hedge fund lawyers add more clauses to the documents which are designed to protect the managers.  Castle Hall notes that “today’s offering documents are typically drafted to give maximum freedom of action for the manager and often permit unrestricted investment activities. Investors are also faced with offering documents which list every possible risk factor in an attempt to absolve the manager from responsibility under virtually all loss scenarios.”

HFLB: We agree that offering documents can be long and that often they contain a long list of risk factors associated with the investment program.  The purpose of the offering documents is to explain the manager’s investment program and if the manager truly has a “kitchen sink” investment program, then all of the disclosures and risk factors are a necessary part of the offering documents.  However we also feel that hedge fund offering documents should accurately describe the manager’s proposed investment program and that if the manager has a very specific strategy, he should provide as much detail to the investors as possible.


Can I draft offering documents myself?  I have a friend who has some documents I think I can modify.

No.  You should never draft offering documents yourself.  I have seen countless examples of people who have tried to draft their own offering documents based on another fund.  Many times these people will ask me to “check the documents.”  Ninety-five percent of the time a brief skim of the documents will reveal major errors that cannot simply be fixed with a 2 hour review.   In most all occasions the documents will need to be completely scrapped.

Are all law firm offering documents the same?

No, but law firm documents are all very similar.

It is an interesting phenomenon in the hedge fund legal world that attorneys are always interested in (or obsessed with) reading the other law firms offering documents. As one of those lawyers that is very interested in the differences between the offering documents, I have studied the documents from most all of the major hedge fund law firms including the firms listed below which are considered to be the best in the industry.

  • Sidley Austin
  • Shartsis Friese
  • Seward & Kissel
  • Kleinberg, Kaplan, Wolff & Cohen
  • Katten Muchin Rosenman
  • Schulte Roth & Zabel
  • Akin Gump Strauss Hauer & Feld
  • K&L Gates

I have probably read through 500 different offering documents (many from the same large law firms) and have found most documents to be quite similar. For the most part with a name brand firm you are going to get a quality product that is probably pretty equal to another large or name brand law firm.  These documents will very likely protect you in all of the necessary ways.

However, that is not to say that all large law firm offering documents are perfect.  I have seen offering documents which cost over $70,000 with typos and errors.  Many times expensive offering documents are sloppy in certain respects – I expect this is because many large law firms use inexperienced associate attorneys to draft the offering documents.

Does price equal quality?

Not necessarily.  While you are less likely to receive white glove service from a document shop, BigLaw does not necessarily equate to fine quality – especially for small and start up managers.  In a large law firm you are going to probably initially talk with a partner about your program who will then relay the information to an associate who will be in charge of your project.  This means that your offering documents are likely drafted by an overworked associate who has relatively little experience.

I always recommend a start up manager ask the law firm who will be drafting the offering documents and how much experience the person has.  Many large law firms will say that an associate will draft the documents but the partner will review prior to finalization.  I find it hard to believe that a partner will review offering documents – many times this is not true.

Low cost offering documents – are you getting less quality?

In some cases yes, but in the case of my law firm documents the answer is a resounding NO.  While my firm will charge around $13,000 to $18,000 for offering documents (considered to be on the lower end), this does not mean that the quality of my work is less than any other firm.

As I have mentioned before on this site, I have worked with a substantial number of start up hedge funds and have drafted the offering documents or worked on around 150 funds.   Also, I have spent a great deal of time dissecting offering documents from a large number of firms.  My dedication to completely understanding the offering documents, along with my passion for the industry and helping managers with their business issues makes my services a compelling alternative to other firms which may cost more.

Additionally, I value the client relationship and always strive to return emails and phone calls promptly.

Conclusion

While the offering documents are the tangible item which you receive from your hedge fund lawyer, it is not the only part of the representation.  The offering documents are not valuable as objects, but really as a representation of the prior experience of the attorney who prepared those documents for your fund, based on your needs.

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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 Taxes May Increase under Obama

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Obama to Propos Taxing Hedge Fund Carried Interest

Groups such as the New York Times and Daily Finance are reporting that Obama’s proposed fiscal 2010 budget, which will be released tomorrow, will include provisions which will increase taxes for hedge fund managers (and private equity fund managers).   Such a provision would likely be written to provide that a carried interest (also called a performance allocation) paid to a management company would be characterized as ordinary income instead of capital gain (to the extent the underlying profits were long term capital gains which are subject to a lower tax rate).

Hedge fund managers are not likely to receive much sympathy from the general public, but this is a hot button issue which will likely incense many of Obama’s supporters.  Hedge fund taxation has been an issue batted around in the media and was especially popular a year and a half ago when the Blackston group was preparing to go public (see Bloomberg article).  The issue has been smoldering for a while (see Hedge Fund Tax Issues 2007), but groups are beginning to examine and analyze this issue (see the abstract of an academic report below) rather than react in a knee-jerk manner.

What we will ask of the President, lawmakers and regulators is that they examine the issue from an academic perspective and make informed decisions.  Hopefully reports like the one below will persuade lawmakers to ultimately keep the carried interest tax preference for hedge funds and private equity funds.

We will continue to report on this issue and will release any applicable information once the fiscal budget is released.  Please feel free to contact us if you have any questions if you have any hedge fund law questions.

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Measuring the Tax Subsidy in Private Equity and Hedge Fund Compensation

Karl Okamoto
Drexel University College of Law

Thomas J. Brennan
Northwestern University School of Law

February 26, 2008

Drexel College of Law Research Paper No. 2008-W-01

Abstract:

A debate is raging over the taxation of private equity and hedge fund managers. It is being played out in the headlines, in Congress and among legal scholars. This paper offers a new analysis of the subject. We provide an analytical model that allows us to compare the relative risk-reward benefit enjoyed by private equity and hedge fund managers and other managerial types such as corporate executives and entrepreneurs. We look to relative benefits in order to determine the extent to which the current state of the world favors the services of a private equity or hedge fund manager over these other workers. Our conclusion is that private equity and hedge fund managers do outperform other workers on a risk-adjusted, after-tax basis. In the case of hedge fund managers, this superiority persists even after the preferential tax treatment is eliminated, suggesting that taxes alone do not provide a complete explanation. We assume that over time compensation of private equity and hedge fund managers should approach equilibrium on a risk-adjusted basis with other comparable compensation opportunities. In the meantime, however, our model suggests that differences in tax account for a substantial portion of the disjuncture that exists at the moment. It also quantifies the significant excess returns to private fund managers that must be taken into account by arguments in support of their current tax treatment by analogy to entrepreneurs and corporate executives. This analysis is important for two reasons. It provides a perspective on the current issue that has so far been ignored by answering the question of how taxation may affect behavior in the market for allocating human capital. It also provides quantitative precision to the current debate which relies significantly on loosely drawn analogies between fund managers on the one hand and entrepreneurs and corporate executives on the other. This paper provides the mathematics that these comparisons imply.

Other hedge fund tax and law articles include:

New Hedge Fund Laws Proposed in Connecticut

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State to Increase Regulation of Hedge Funds

(www.hedgefundlawblog.com)  Connecticut, home of many of the biggest hedge funds in the world, may begin regulating hedge funds in a heavy handed manner.  Recently state lawmakers have introduced three bills (Raised Bill No. 953, Raised Bill No. 6477 and Raised Bill No. 6480) which would greatly increase oversight of hedge funds which have a presence in Connecticut.   This article provides an overview of the three raised bills and provides reprints the actual text of these bills.

Raised Bill No. 953

The largest of the three bills, No. 953 has the following central features:

  • Definitions certain terms (including the term “Hedge Fund”) which are used throughout the bill.
  • Provides that, starting in 2011, hedge funds may not have individual investors  who do not have $2.5 million in “investment assets” (different than net worth)
  • Provides that, starting in 2011, hedge funds may not have institutional investors who do not have $5 million in “investment assets”
  • Provides that funds must disclose certain conflicts of interest of the manager
  • Provides that funds must disclose the existence of side letters
  • Requires an annual audit (beginning in 2010)

The above provisions would apply to those funds which have an office in Connecticut where employees regularly conduct business on behalf of the fund.   It is currently unclear whether there will be any sort of grandfathering provisions for those funds which currently have investors who do  not meet the “investment assets” threshold.   Another interesting part of the bill is that it defines a hedge fund with reference to Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act.  The recently proposed Hedge Fund Transparency Act would actually eliminate these sections and add new Section 6(a)(6) and Section 6(a)(7).

Raised Bill No. 6477

The next bill is No. 6477 which would require hedge funds to be regulated by the Connecticut Banking Commission.  The bill requires hedge funds to purchase a $500 license issued by the Connecticut Banking Commissioner prior to conducting business in Connecticut.  The license would need to be purchased each year.  The bill also provides the Banking Commission with authority to adopt regulations.

This bill is interesting because it is fundamentally different from most hedge fund regulations which seek to regulate the management company through investment advisor registration.  This bill regulates the fund entity (as opposed to the management company) and does so through the power of the state to regulate banking.   Right now it looks like this bill will apply to all hedge funds, even those who do not utilize leverage.  It is not currently clear why or how the Banking Commission has jurisdiction non-banking private pools of capital, especially for those funds which do not utilize any sort of leverage.

It is also interesting to note that No. 6477 would apply regardless of the registration status of the fund’s management company.  This means that a fund could be subject to SEC oversight and may also be subject to direct oversight by the Connecticut Department of Banking (“DOB”), which means the DOB could presumably conduct audits of the fund.  Of course, this could potentially greatly increase operational costs for hedge funds with an office in Connecticut.

Raised Bill No. 6480

The final bill is No. 6480 which would require Connecticut based hedge funds with Connecticut pension fund investors to disclose detailed portfolio information to such pension funds upon request.  It goes without saying that this bill is likely to receive a considerable amount of scrutiny from the Connecticut hedge fund community.

Conclusion

The hedge fund industry continues to be a major focus of both state and federal lawmakers who are anxious to start regulating these vehicles.  Unfortunately we are witnessing a patchwork approach to regulation where there is little communication between the states and the federal lawmakers.  If other states follow Connecticut’s lead then we face the potential situation where funds in each state will need to follow state specific laws enacted by quick-to-legislate, out-of-touch lawmakers.   Efficiency in the securities markets is undercut by overlapping and unnecessary regulations – both managers and investors would be better served by a comprehensive effort to revise the securities laws at the federal and state levels.

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Raised Bill No. 953
January Session, 2009

Referred to Committee on Banks
Introduced by: (BA)

AN ACT CONCERNING HEDGE FUNDS.

Be it enacted by the Senate and House of Representatives in General Assembly convened:

Section 1. (NEW) (Effective October 1, 2009) (a) As used in this section:

(1) “Hedge fund” means any investment company, as defined in Section 3(a)(1) of the Investment Company Act of 1940, located in this state (A) that claims an exemption under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940; (B) whose offering of securities is exempt under the private offering safe harbor criteria in Rule 506 of Regulation D of the Securities Act; and (C) that meets any other criteria as may be established by the Banking Commissioner in regulations adopted under subsection (f) of this section. A hedge fund is located in this state if such fund has an office in Connecticut where employees regularly conduct business on behalf of the hedge fund;

(2) “Institutional investor” means an investor other than an individual investor including, but not limited to, a bank, savings and loan association, registered broker, dealer, investment company, licensed small business investment company, corporation or any other legal entity;

(3) “Investment assets” includes any security, real estate held for investment purposes, bank deposits, cash and cash equivalents, commodity interests held for investment purposes and such other forms of investment assets as may be established by the Banking Commissioner in regulations adopted under subsection (f) of this section;

(4) “Investor” means any holder of record of a class of equity security in a hedge fund;

(5) “Major litigation” means any legal proceeding in which the hedge fund is a party which if decided adversely against the hedge fund would require such fund to make material future expenditures or have a material adverse impact on the hedge fund’s financial position;

(6) “Manager” means an individual located in this state who has direct and personal responsibility for the operation and management of a hedge fund; and

(7) “Material” means, with respect to future expenditures or adverse impact on the hedge fund’s financial position, more than one per cent of the assets of the hedge fund.

(b) On or after January 1, 2011, no hedge fund shall consist of individual investors who, individually or jointly with a spouse, have less than two million five hundred thousand dollars in investment assets or institutional investors that have less than five million dollars in assets.

(c) The manager shall disclose to each investor or prospective investor in a hedge fund, not later than thirty days before any investment in the hedge fund, any financial or other interests the manager may have that conflict with or are likely to impair, the manager’s duties and responsibilities to the fund or its investors.

(d) The manager shall disclose, in writing, to each investor in a hedge fund (1) any material change in the investment strategy and philosophy of the fund and the departure of any individual employed by such fund who exercises significant control over the investment strategy or operation of the fund, (2) the existence of any side letters provided to investors in the fund, and (3) any major litigation involving the fund or governmental investigation of the fund.

(e) On January 1, 2010, and annually thereafter, the manager shall disclose, in writing, to each investor in a hedge fund (1) the fee schedule to be paid by the hedge fund including, but not limited to, management fees, brokerage fees and trading fees, and (2) a financial statement indicating the investor’s capital balance that has been audited by an independent auditing firm.

(f) The Banking Commissioner may adopt regulations, in accordance with chapter 54 of the general statutes, to implement the provisions of this section.\

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Raised Bill No. 6477
January Session, 2009

Referred to Committee on Banks
Introduced by: (BA)

AN ACT CONCERNING THE LICENSING OF HEDGE FUNDS AND PRIVATE CAPITAL FUNDS.

Be it enacted by the Senate and House of Representatives in General Assembly convened:

Section 1. (NEW) (Effective October 1, 2009) (a) No person shall establish or conduct business in this state as a hedge fund or private capital fund without a license issued by the Banking Commissioner. Applicants for such license shall apply to the Department of Banking on forms prescribed by the commissioner. Each application shall be accompanied by a fee of five hundred dollars. Such license shall be valid for one year and may be renewed upon payment of a fee of five hundred dollars and in accordance with the regulations adopted pursuant to subsection (b) of this section.

(b) The Banking Commissioner shall adopt regulations in accordance with the provisions of chapter 54 of the general statutes for purposes of this section.

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Raised Bill No. 6480
January Session, 2009

Referred to Committee on Banks
Introduced by: (BA)

AN ACT REQUIRING THE DISCLOSURE OF FINANCIAL INFORMATION TO PROSPECTIVE INVESTORS IN HEDGE FUNDS AND PRIVATE CAPITAL FUNDS.

Be it enacted by the Senate and House of Representatives in General Assembly convened:

Section 1. (NEW) (Effective October 1, 2009) Any hedge fund or private capital fund that is (1) domiciled in the state, and (2) receiving money from pension funds domiciled in the state shall disclose to each prospective pension investor in such funds, upon request, financial information including, but not limited to, detailed portfolio information relative to the assets and liabilities of such funds.