Author Archives: Hedge Fund Lawyer

SEC and Registered Hedge Fund Investment Advisors: Report by the GAO

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This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds.  The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here.

There are many important items in the except below.  While many hedge fund investment advisors are no longer registered with the SEC because the hedge fund registration rule was vacated by a circuit court judge, many hedge fund managers are registered.  As I have done with certain previous articles (see SEC Emphasizes IA Compliance for Hedge Funds), I believe that the following excerpt should be required reading for all investment advisor chief compliance officers (CCOs). The article discusses, the areas which the SEC examiners are likely to emphasize during an examination.  Such areas include: soft dollars, prime brokerage, calculation of the performance fee, valuation of hedge fund assets, and custody of hedge fund assets.

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GAO Report Provides Insight into Potential Future Hedge Fund Regulation

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As we have discussed previously, hedge funds, and the investment management industry, are likely to face increasing regulations in the future.  As we look toward Congressional testimony by hedge funds (see Congress to talk with Hedge Funds on November 12) and by other government officials, we have decided to look back at previous GAO reports to see what issues the GAO identified as important.

The U.S. Government Accountability Office has released two reports this year on hedge funds.  The first report (released in February of 2008) described the current hedge fund regulatory regime and some of the risks the current system posed.  The second report (released in September of 2008) focused on some of the issues which pension plans must consider when investing in hedge funds.  I’ve provided a brief overview of the objectives of the two studies below.

Additionally, this week we are going to examine the February report as it includes many of the issues which have surfaced because of the recent market events, especially with regard to counterparty risk.  A list of the topics we will discuss this week include (links activated as soon as articles are published):

The GAO Hedge Fund Reports

Hedge Funds: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention Is Needed

GAO-08-200 Released February 25, 2008  (for full report, please see PDF)

According to the preamble, “This report (1) describes how federal financial regulators oversee hedge fund-related activities under their existing authorities; (2) examines what measures investors, creditors, and counterparties have taken to impose market discipline on hedge funds; and (3) explores the potential for systemic risk from hedge fund-related activities and describes actions regulators have taken to address this risk.”

Defined Benefit Pension Plans: Guidance Needed to Better Inform Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity

GAO-08-692 Released September 10, 2008 (for full report, please see PDF please also see an earlier article we released on this report entitled Hedge Fund and Pension Report Issued by GAO)

GAO was asked to examine (1) the extent to which plans invest in hedge funds and private equity; (2) the potential benefits and challenges of hedge fund investments; (3) the potential benefits and challenges of private equity investments; and (4) what mechanisms regulate and monitor pension plan investments in hedge funds and private equity.

Other Related HFLB articles include:

State Registered Investment Advisors and Hedge Funds

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Hedge fund managers which are registered with their state of residence as investment advisors need to be very aware of their state investment advisory rules.  While many state securities divisions do not pay attention to hedge funds, there are many states which are aware of hedge funds and understand how the state investment advisory rules apply to hedge funds.  States which I have found particularly knowledgeable about hedge funds include: Colorado, Utah, California and Washington.  There are other states which are basically on heightened alert for registration applications from hedge fund managers. Continue reading →

Forex Disclosure Documents Overview Part II

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(www.hedgefundlawblog.com)

Article by Bart Mallon (www.forexregistration.com)

Thursday’s installment of the Forex Disclosure Documents Overview focused on much of the routine disclosure items which a manager must provide in the disclosure document.  Today we focus mainly on the performance reporting side of the disclosure documents.

Performance Reporting

Overview

Basically the performance reporting aspect of the disclosure documents requires the manager to provide very detailed summaries of the performance of the offered program (either managed account or fund), the manager’s other trading programs, and potentially the performance of key employees.  Any other performance which is material will also need to be reported.  These performance disclosures will usually take up a few pages of the disclosure document and will face the greatest scrutiny by the NFA reviewers. Continue reading →

Overview of Hedge Fund Investment Strategies

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The term “hedge fund” is an imprecise description of any type of pooled investment vehicle which utilizes an investment strategy (generally involving securities) to make money.  There are many different types of strategies which a hedge fund manger might use to make its returns, including the following:

In addition to these more “traditional” types of hedge fund strategies, there are different types of investment strategies which are forming all of the time including asset based lending hedge funds, life settlement hedge funds, among other types.  Sometimes lumped into the hedge fund category are Private Equity Funds and Venture Capital Funds which are pooled investment vehicles like hedge funds, but typically have different focuses and structures from hedge funds.

In the coming weeks we will detailing the main characteristics of the above strategies and what hedge fund managers running these strategies need to think about when crafting an investment program for their hedge fund.  Below I’ve also reprinted a summary of the different hedge fund strategies as stated in a hedge fund report issued by the Government Accountability Office earlier this year.  The report can be found here.

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Appendix III: Various Hedge Fund Investment Strategies Defined:

Hedge funds seek absolute rather than relative return–that is, look to make a positive return whether the overall (stock or bond) market is up or down–in a variety of market environments and use various investment styles and strategies, and invest in a wide variety of financial instruments, some of which follow:

Convertible arbitrage: Typically attempt to extract value by purchasing convertible securities while hedging the equity, credit, and interest rate exposures with short positions of the equity of the issuing firm and other appropriate fixed-income related derivatives.

Dedicated shorts: Specialize in short-selling securities that are perceived to be overpriced–typically equities.

Emerging market: Specialize in trading the securities of developing economies.

Equity market neutral: Typically trade long-short portfolios of equities with little directional exposure to the stock market.

Event driven: Specialize in trading corporate events, such as merger transactions or corporate restructuring.

Fixed income arbitrage: Typically trade long-short portfolios of bonds.

Macro: Take bets on directional movements in stocks, bonds, foreign exchange rates, and commodity prices.

Long/short equity: Typically exposed to a long-short portfolio of equities with a long bias.

Managed futures: Specialize in futures trading–typically employing trend following strategies.

Other HFLB articles:

NFA Suspends Commodity Hedge Fund Firm

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The NFA suspended the membership of SNC Investments, a firm which ran commodity hedge funds and commodity managed accounts.  The original post can be found here.

For Immediate Release

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

NFA takes emergency enforcement action against SNC Investments, Inc. and its principal, Peter Son

October 31, Chicago – National Futures Association (NFA) announced that it has taken an emergency enforcement action that suspends SNC Investments, Inc. (SNC) and its principal, Peter Son, from NFA membership and associate membership, respectively. SNC is a Futures Commission Merchant, Commodity Pool Operator, Commodity Trading Advisor and former Forex Dealer Member. SNC is located in New York City with a branch office in Pleasanton, California.

The Member Responsibility Action (MRA), effective immediately, is deemed necessary to protect customers because SNC and Son have suddenly ceased operations, Son is reported missing, and there are allegations that millions of dollars in customer funds are also missing. Under the circumstances, NFA is unable to determine if SNC and Son are in compliance with NFA Requirements or if they have misappropriated customer funds.

Additionally, the MRA prohibits SNC and Son from soliciting or accepting any funds from customers, pool participants or investors. SNC and Son are also prohibited from placing trades on behalf of customers and from disbursing or transferring any funds of customers, pool participants or investors from any accounts without prior NFA approval. The MRA will remain in effect until such time SNC and Son have demonstrated to NFA that they are in complete compliance with NFA Requirements. SNC and Son may request a hearing before NFA’s Hearing Committee.

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

Hedge Fund Performance Fee Issues for State Registered Investment Advisors

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One of the problems with the securities laws in the United States is that there are two levels of rules to be cognizant of at any single time – the federal rules and the state level rules.

For hedge fund managers that are registered as investment advisors with the SEC, there is a simple rule regarding performance fees – performance based fees can only be charged to those investors in the hedge fund who are “qualified clients” (the $1.5 million net worth requirement).  For hedge fund managers that are registered as investment advisors with the state, however, the manager may need to be aware of the performance fee rules of states other than their own state because each state has different securities laws.  (HFLB note: we will be discussing the issue of different state securities laws in an upcoming article on the Uniform Securities Act.)

Issues

There are three issues for a state-registered investment advisor to be aware of with regard to a hedge fund:

1.  Are performance fees allowed at the state level?  If so, what are the state’s investor qualification requirements?

2.  Does an investment advisor need to “look through” the hedge fund to the individual investors to determine if a performance fee can be charged?

3.  In the situation where a hedge fund investor resides in a state other than the state where the manager is registered, and with regard to the performance fee and “look through” rules, does the manager need to adopt the laws of the investor’s state or the laws of the state in which it is registered?

Discussion

First, generally all states will allow performance fees, but each state has different investor qualification requirements.  Some states track the federal rules and require that performance fees be charged only to qualified clients, some states require that the performance fees be charged only to accredited investors, and some states do not allow state-registered investment advisors to charge performance fees (whether a state can legally have such a requirement is another issue).

With regard to the second issue, most all of the states which allow performance fees will “look through” the hedge fund to the individual investor for the purpose of determining who can take the performance fees; this means that each investor in the hedge fund will need to meet the qualification requirements.  However, some states interpret their securities laws to mean that the performance fee can be taken at the fund level and that there is no “look through.”  In these cases, if the hedge fund itself meets the qualification standards (say $1.5 million dollar net worth), then presumably the performance fee can be taken on all of the hedge funds assets, even if no single investor in the hedge fund is a qualified client.  The central reason that anomalies like this exist is poor drafting on the part of the state legislatures.

Finally, we come to the third issue which is essentially a conflict of laws question.  There are a couple of situations where this would apply.

Situation 1: Manager is registered as an investment advisor in State X which allows performance fees to be charged only to “accredited investors” ($1 million net worth) and “look through” rules apply.  Investor from State Y wishes to invest in the hedge fund, but State Y has laws which prohibit performance fees except to those people who are qualified clients.

Situation 2: Same facts as above, but State X provides that there is no “look through” at the fund level and only the fund needs to be an “accredited investor” in order to charge a performance fee at the fund level (which would ultimately be paid by the investor through a diminished capital account).

While we believe that in both situations above the manager should be able to charge performance fees based on its own state laws and without regard to the laws of other states, there have been some state securities commissions that have stated informally to me over the phone that they believe the manager should charge performance fees to investors from their state pursuant to their state rules.  We have never heard of a state instituting a proceeding against a hedge fund manager in this situation, but it is one potential issue and it has not been clearly resolved.

To try to bring a little bit of resolution to this issue, we did a conflicts of law analysis and found that it would probably be ok for a hedge fund manager to charge performance fees to its investors pursuant to the manager’s state law and without regard to the state law of the investors.  However, I do not think a law firm would provide any sort of legal opinion on this issue because it is definitely still within the grey area of the law (HFLB note: this discussion should not be taken as any sort of legal advice, pursuant to our standard website disclaimer).

Generally I would recommend that state registered hedge fund managers only charge performance fees to qualified clients even if the manager’s state had lower requirements.  If the manager wanted to charge performance fees to non-qualified clients, then the manager should consider charging performance fees pursuant to the state laws of each investor in the fund.  The issue with this of course is that it would present additional work for the administrator and create additional costs for the fund.  Additionally, the subscription documents would need to be redrafted to address the state law issues.

In any event, if this situation applies to a state-registered investment advisor who manages a hedge fund, the hedge fund manager should discuss this issue with their legal counsel.

Other HFLB articles include:

Conversion of a 3(c)(1) hedge fund to a 3(c)(7) hedge fund

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Below is a question we received through the comment portion of this blog:

A fund we participate in converted in mid-2007 from a 3(c)(1) fund to a 3(c)(7) fund. Upon receipt of the K-1 for the year, there was a large realized short-term capital gain realized with a large corresponding unrealized capital loss. When I asked about what triggered the short-term gain, I was told that it related to the conversion to 3(c)(7) status. Is there anything within the conversion process which would inherently trigger recognition of a capital gain, especially short-term? Thanks for any insight you may be able to share with me on this.

First, let’s examine what it means to “convert” from a 3(c)(1) hedge fund to a 3(c)(7) hedge fund.  There is no form that a hedge fund submits to the government or any agency which declares whether they are a 3(c)(1) hedge fund or a 3(c)(7) hedge fund.  There is no sort of internal declaration like with certain IRS rules.

The 3(c)(1) structure limits the number of investors to 99, the 3(c)(7) structure does not limit the number of investors, but limits the type of investors.  So, to “convert,” a hedge fund would just make sure that all of its investors were qualified purchasers and then have more than 99 of them.  Therefore, when a hedge fund “converts” from a 3(c)(1) hedge fund to a 3(c)(7) hedge fund, the fund is basically informing investors that the number and “type” of investor in the hedge fund (a limited partnership or limited liability company) will be changing.  (Please also note that a 3(c)(7) hedge fund with 99 or less investors would also be exempt from registration under the Investment Company Act as a 3(c)(1) hedge fund. )

When the conversion takes place, the fund would redeem those investors who are not qualified purchasers (the offering documents will typically provide managers with this unilateral authority).  In order to have the cash on hand to mandatorily redeem the investors, the fund may have to liquidate some underlying positions.  Based on the holding period of the underlying positions, the gain or loss may be long-term or short-term gain or loss, each of which has different tax consequences to investors in the hedge fund.

At the end of the year, the hedge fund accountant will prepare K-1s for all investors in the partnership which will include each investors allocation of gains and losses (realized and unrealized) during the year.  The manner in which these gains and losses are allocated is generally dictated by the hedge fund’s offering documents, which generally allow the manager wide latitude in how to make allocations.

With regard to the specific situation above, I cannot answer this question because it depends on the facts.  One thing an investor in this situation may want to do is review the audited financial statements from the hedge fund and then determine if an allocation was made which was incorrect – an accountant should be able to do this.  If there is still a question on the allocation, the investor should discuss the issue with the hedge fund manager in conjunction with the manager’s auditor or accountant.  From there the investor should be able to get further clarity on the issue.

Please note that the above is not legal advice and please read our disclaimer.  Please also feel free to contact us if you have further questions.  Other related HFLB articles include:

Investment Advisor and Investment Advisor Representative IARD System Fee Waiver

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The SEC and NASAA have waived two separate charges for Investment Advisors for the 2009 calendar year.  The first charge being waived is a systems charge for the Investment Advisor to access the IARD system.  This fee used to be $30.  The second charge is the fee to access the IARD system for each investment advisor representative.  This fee used to be $30 as well, which went to the NASAA.  For small investment advisors this amounts to a small savings, however, larger firms with many investment advisor representatives will be pleased they will not have to pay this system fee.

However, fees which go to the individual states are not being waived and these fees are often in the range of $100-$500 for each investment advisory firm, and $30-$125 for each investment advisor representative depending on the state of registration.  For more information please see the press release below or contact your hedge fund attorney or compliance professional.  The full press release can be found here.

SEC, NASAA Announce IARD System Fee Waiver

FOR IMMEDIATE RELEASE
2008-259

Washington, D.C., Oct. 30, 2008 — The Securities and Exchange Commission and the North American Securities Administrators Association (NASAA) today announced they will waive the initial set-up and annual system fees paid by investment adviser firms to maintain the Investment Adviser Registration Depository (IARD) system. Separately, NASAA announced that for next year it will also waive those system fees paid by investment adviser representatives (IARs).

Andrew J. Donohue, Director of the SEC’s Division of Investment Management, said, “We are pleased to be able to continue the fee waiver of initial and annual fees paid by investment advisers through July 31, 2009. We are also pleased that enhancements will continue to be made to this important and useful online adviser registration and public disclosure system, which enables the investing public easily to access information about investment advisers.”

Fred J. Joseph, NASAA President and Colorado Securities Commissioner, said, “The IARD system promotes effective and efficient investor protection through readily accessible disclosure while offering a consistent and streamlined registration process for investment advisers and their representatives. Given the current economic climate, we are pleased that the IARD system’s ongoing success has allowed us to maintain the system fee waivers put in place in 2005 for investment adviser firms and also to fully waive for the first time the system fees paid by investment adviser representatives.”

For next year, NASAA will waive payment of initial and renewal IARD system fees by state-regulated investment adviser firms and investment adviser representatives’ initial and renewal fees. NASAA’s Board of Directors approved the system fee waiver and will continue to monitor the system’s revenues to determine whether future fee adjustments are warranted.

The IARD system is an Internet-based national database sponsored by NASAA and the SEC and operated by FINRA in its role as a vendor. IARD provides a single nationwide database for the collection and dissemination of information about individuals and firms in the investment advisory field and offers investment advisers and representatives a single source for filing state and federal registration and notice filings. The system contains the employment and disciplinary histories of more than 25,000 investment adviser firms and nearly 250,000 individual investment adviser representatives. IARD system fees are used for user and system support and for enhancements to the system.

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Related HFLB articles include:

Forex Disclosure Documents Overview Part I

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(www.hedgefundlawblog.com)

Article by Bart Mallon (www.forexregistration.com)

This is part one of a two part discussion.  This article will provide an overview of the likely requirements for Forex Disclosure Documents.  The items in this Forex Disclosure Document Overview are based on the items discussed in “Disclosure Documents – A Guide for CPOs and CPAs” provided by the NFA and based on CFTC rules and regulations.

Please note that these are only likely requirements as proposed and final rules have not yet been released.  For those managers which will be managing forex hedge funds, the disclosure document requirements are in addition to the requirements imposed by other securities laws (please see hedge fund offering documents or a more detailed explanation of the forex hedge fund offering document requirements).  Additionally, if the Forex CPO or CTA also trades other instruments besides spot forex then the document will need to address those items as well – your hedge fund forex attorney will be able to help you draft these items.

Who must prepare a Forex Disclosure Document?

The NFA has discussed a new category of CPO and CTA whose business involves retail off-exchange foreign exchange (forex) contracts.  These new categories of registered persons, as provided by the NFA, are called “Forex CPOs” and “Forex CTAs.”  Like the CPO and CTA disclosure documents, it is likely that both Forex CPOs and Forex CTAs will need to deliver a disclosure document to prospective investors.  The Forex CPO or Forex CTA will need to make delivery at the same time or before the delivery of the Forex Pool’s offering documents or the Forex Program’s advisory agreement.  The Forex CPO or CTA will need to receive signed acknowledgement by the investor that they have received the disclosure document.

We do not yet know if there are any exceptions to Forex Disclosure Document delivery requirements.  One question that the CFTC will need to answer is whether Forex CPOs and CTAs will be able to fall within the 4.7 exemption like traditional CPOs and CTAs.

The Basics of the Forex Disclosure Document

Cover Page.  The Forex Disclosure Document will probably need to have a CFTC mandated disclaimer which basically states that the CFTC has not reviewed the disclosure document for the merits of the trading program.

Front Cover Disclaimer. Inside the front cover the Forex disclosure document there will need to be a few paragraphs that serve as a general disclaimer of risk disclosure statement. This disclaimer will be based on a uniform template for all Forex disclosure documents.

Table of Contents. A basic table of contents will be required.

Basic Background Information. The beginning part of the document will need to include such basic information as name of the Forex CPO or CTA, addresses, phone numbers, etc.  The business background of each principal (each a “Forex Associated Person” or “Forex AP”) as well as the officers and directors of the firm will need to be provided.  The information each of the people will need to provide includes: date of NFA membership, date of CFTC registration, and dates of employment for last five years.

Forex Dealer Member. For Forex CTAs, if the program requires an investor to maintain an account with a Forex Dealer Member (“FDM”) then the name of the FDM must be disclosed.  For Forex CPOs, the document should disclose who will be the fund’s FDM.

Forex Introducing Brokers. For Forex CTAs, if the program requires an investor to have an account introduced by a Forex Introducing Broker (“Forex IB”), then the name of the Forex IB must be disclosed.

Principal Forex Risk Factors. For both Forex CPOs and Forex CTAs the document must include a discussion of the main risks involved in the Forex program.  Such risks are expected to include: country or sovereign risk, credit risk, exchange rate risk, interest rate risk, liquidity risk, market risk, operational risk, settlement risk and Herstaat risk.  In addition, for Forex CPOs, there are other risks involved in the structure of the investment vehicle which will need to be disclosed.

Forex Trading Program. All aspects of the proposed trading program must be disclosed and discussed.  A Forex trading program will usually include information on the investment object and the investment strategies as well as a discussion of the risk management procedures the Forex manager will utilize.  This area of the program may also discuss the Forex manager’s investment philosophy.
Forex Fees.  All aspects of the fee structure of the Forex hedge fund or Forex separately managed account must be discussed.  This will include both management fees and performance fees (if applicable) as well as the methods for calculating the fees.  The rules require specificity here so this will be one area where precise information is required.

Conflicts of Interest. This will be very important information and the Forex manager will want to discuss this section thoroughly with its attorney or compliance professional.  All actual or potential conflicts of interest must be disclosed.  All fee and business arrangements must be disclosed.  For example, if the forex manager will have any sort of pip sharing arrangement with the Forex Dealer Member, this will need to be disclosed.

Litigation. If any of the persons or entities involved in the trading program have been subject to “material administrative, civil or criminal” actions within the past five years, all information regarding the action must be disclosed.  Disclosure is required for the Forex CTA, Forex CPO, Forex IB, Forex Dealer Member or FCM, and any principles of the Forex CPO or CTA.  Oftentimes the FCM (with regard to CPO and CTA disclosure documents) must disclose a lengthy list of actions.

Trading Forex for Own Account. The disclosure document must disclose whether the Forex manager and/or any employees will be trading for their own accounts.  If the Forex manager and/or any employees will be trading for their own accounts then the document must disclose whether the manager or employees will allow investors to review the trading records of the manager or employees.

Forex Disclosure Documents Overview Part II will be released tomorrow and will cover the following items: Performance Disclosures, Other General Items, Material Information and Supplemental Information.

Please see other related HFLB articles: