Author Archives: Hedge Fund Lawyer

LP and LLC Fund Taxation

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Hedge funds are popular vehicles for hedge fund investors because of the manner in which they are taxed.  Hedge funds are usually structured as limited partnerships or limited liability companies.  Such entities by default are taxed as partnerships under Subchapter K of the Internal Revenue Code.

The partners in a partnership, and not the partnership itself, are taxed on the partnership’s income.  In this manner the partnership is markedly different than a corporation which is subject to double taxation (tax at both the corporate and shareholder level).  Because of the manner of taxation, partnerships are referred to as “flow through” vehicles because the income is taxed at the investor level instead of (or in addition to) the entity level.

Yearly LP and LLC Fund Tax Returns

Each year a hedge fund will need to file a tax return with the federal government.  In addition the hedge fund will probably need to file a tax return with the state where the manager resides.  These issues should be discussed with a hedge fund auditor or accountant, who will typically prepare the partnership’s tax returns.  The IRS specifically states with regard to Form 1065:

Every partnership that engages in a trade or business or has gross income must file an information return on Form 1065 showing its income, deductions, and other required information. The partnership return must show the names and addresses of each partner and each partner’s distributive share of taxable income. The return must be signed by a general partner. If a limited liability company is treated as a partnership, it must file Form 1065 and one of its members must sign the return.

A partnership is not considered to engage in a trade or business, and is not required to file a Form 1065, for any tax year in which it neither receives income nor pays or incurs any expenses treated as deductions or credits for federal income tax purposes.

The hedge fund will also need to send each investor a Schedule K-1 so that the investor can prepare its tax returns for the year.  The accountant will help the hedge fund manager to prepare these items.

Schedule K-1 can be found here: Schedule K

Other Tax Items

Some other partnership taxation topics which we will be discussing in the future include:

–    Gains and losses from securities transactions
–    Constructive sales
–    1256 contracts
–    Original Issue Discount
–    Itemized deductions
–    Allocations of the fund’s income, deductions and/or loss
–    AMT
–    UBTI
–    Passive Activity Losses
–    Distributions
–    Section 754 Adjustments
–    “Stuffing” provisions

Overview of Investment Advisers Act of 1940

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One of the most important set of the federal securities laws which relate to hedge fund managers is the Investment Advisers Act of 1940 (Investment Advisers Act).  The Investment Advisers Act provides the manner in which investment advisers will register with the SEC, provides the laws that must be followed as an investment advisor, and makes it illegal for both registered and unregistered investment advisors to act fraudulently toward any investors.

If a hedge fund manager is registered as an investment advisor with the SEC then the manager should make sure he understands all parts of the Investment Advisers Act. Below I’ve highlighted and discussed those provisions which are most important to a hedge fund manager.  The entire act can be found here: Investment Advisers Act of 1940.

Definition of Investment Adviser

The term investment adviser is very broad.  Section 202(a)(11) provides:

“Investment adviser” means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities;

but does not include

(A) a bank, or any bank holding company as defined in the Bank Holding Company Act of 1956, which is not an investment company, except that the term “investment adviser” includes any bank or bank holding company to the extent that such bank or bank holding company serves or acts as an investment adviser to a registered investment company, but if, in the case of a bank, such services or actions are performed through a separately identifiable department or division, the department or division, and not the bank itself, shall be deemed to be the investment adviser;

(B) any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession;

(C) any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore;

(D) the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation;

(E) any person whose advice, analyses, or reports relate to no securities other than securities which are direct obligations of or obligations guaranteed as to principal or interest by the United States, or securities issued or guaranteed by corporations in which the United States has a direct or indirect interest which shall have been designated by the Secretary of the Treasury, pursuant to section 3(a)(12) of the Securities Exchange Act of 1934, as exempted securities for the purposes of that Act; or

(F) such other persons not within the intent of this paragraph, as the Commission may designate by rules and regulations or order.

Pre-requiste for Registration

Only those managers which manage at least $25 million in assets are eligible to register with the SEC.  If a manager has less than $25 million of assets under management, then the manager will be subject only to the registration with the managers state of residence (if required).  Specifically Section 203A(a)(1)(A) provides:

No investment adviser that is regulated or required to be regulated as an investment adviser in the State in which it maintains its principal office and place of business shall register under section 203, unless the investment adviser – has assets under management of not less than $ 25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; …

Investment Adviser Registration Requirement

In general, all investment advisors must register with the SEC pursuant to Section 203(a).

Except as provided in subsection (b) and section 203A, it shall be unlawful for any investment adviser, unless registered under this section, to make use of the mails or any means or instrumentality of interstate commerce in connection with his or its business as an investment adviser.

Exemption from registration

While the definition of investment adviser is sufficiently broad to include most all hedge fund managers, there is a widely used exemption from the registration provisions.  Section 203(b)(3) provides:

The provisions of subsection (a) [the registration provisions noted above] shall not apply to … any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under title I of this Act, or a company which has elected to be a business development company pursuant to section 54 of title I of this Act and has not withdrawn its election. For purposes of determining the number of clients of an investment adviser under this paragraph, no shareholder, partner, or beneficial owner of a business development company, as defined in this title, shall be deemed to be a client of such investment adviser unless such person is a client of such investment adviser separate and apart from his status as a shareholder, partner, or beneficial owner;

There are two important items to note here.  First, the investment adviser cannot have more than 15 clients over a 12 month rolling period.  A hedge fund counts as a single client for these purposes.  Second, the investment adviser

Prohibited Transactions

The act has very strong anti-fraud provisions.  Most SEC actions against investment advisers will be based on this section of the act.  Section 206, in full, provides:

It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly –

(1) to employ any device, scheme, or artifice to defraud any client or prospective client;

(2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;

(3) acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction. The prohibitions of this paragraph (3) shall not apply to any transaction with a customer of a broker or dealer if such broker or dealer is not acting as an investment adviser in relation to such transaction;

(4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative. The Commission shall, for the purposes of this paragraph (4) by rules and regulations define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.

Other Important Sections

There are other important sections to the act which include the following:

Section 204 – Record Keeping Requirements

Section 205 – Investment Advisory Contracts

Section 222 – State Regulation of Investment Advisers

Hedge Fund Auditor – Hedge Fund Audit Information and Questions

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A hedge fund auditor is a service provider to the hedge fund; the main job of the auditor is to audit the accounting practices of the hedge fund.

During the audit period, the auditor will work with the hedge fund manager to review the hedge fund’s valuation methodology as well as the implementation of that methodology.  The auditor will also review the fund’s account statements, including the profits and losses.  Usually the auditor will work with the hedge fund administrator as the administrator is the one who has prepared the fund’s financial statements.

Hedge Fund Audit Costs

As with all of the service providers which I have discussed, there is not a one size fits all solution to hedge fund audits.  There are three general groups of audit firms and costs

Small audit firm – the small audit firm may be a one to five or more person shop.  Like the small administrator, the small audit firm is going to be able to give the hedge fund manager the most one-on-one time and really provide good insight and advice to the manager on his business, in addition to the audit work.  The costs for the small audit firm will range anywhere from about $6,000 to $10,000 per year, depending on the nature of the investment program.

Medium sized, boutique hedge fund audit firm – there are a few audit firms that specialize in hedge fund auditing.  These firms are well recognized in the industry and are well regarded by most institutional investors.  These firms are going to be larger than the small audit firm and may not be able to provide as much face time to the manager.  The costs for medium sized firms are going to be in the $12,000 to $18,000 range, depending on the nature of the investment program.

Big four accounting firms – big four accounting firms have large hedge fund audit practices.  These firms are very expensive and thus these firms are usually retained by funds with at least $250 million in assets.  The costs for a big four accounting firm will probably be at least $25,000 per year.

Funds with less than $250 million should not use a big four accounting firm.  One client with $100 million in assets under management used a big four accounting firm and they were put at the end of the line.  The accounting firm actually completed the audit late and the client could never get a hold of anyone in the office – our client’s account was a very low priority to this firm.  The client made the switch to a boutique hedge fund audit firm and has been happy with the results.

Note on costs.  The costs above will generally not include the costs for tax preparation work, which will run extra.  Additionally, if the hedge fund invests in certain instruments that are hard to value, the costs may run higher.  If you have an unusual asset class, like life settlements, then you will need to discuss your program with your auditor during the offering document drafting process.  If there is a master-feeder structure in place, there will be added costs because of the additional entities involved.

Hedge Fund Audit Questions

1.  Do domestic hedge funds need to be audited on a yearly basis?

Generally there is no requirement for a domestic hedge fund to have a yearly audit.  However, if the manager is registered as an investment advisor with the SEC, then the manager will need to have an annual audit.  If the manager is registered as an investment advisor with a state securities commission, the manager will probably need to have an annual audit.

While for some managers an audit may not be required, it is always recommended as investors give great weight to the fact that a fund has an audit.  If the fund does not have a yearly audit, it will raise a red flag to potential investors.

2.  Do offshore hedge funds need to be audited on a yearly basis?

This will depend on the jurisdiction of the offshore hedge fund.  If the hedge fund is based in the Cayman Islands, the hedge fund will need to have a yearly audit and the audit will need to be completed by a Cayman based audit firm.  Most hedge fund auditors will have a Cayman based partner which will be able to complete the audit for the fund.  This may add a little extra to the cost of the audit.

In the BVI there is no present requirement for a hedge fund audit.

Previous SEC Testimony to Congress Regarding Hedge Funds

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As noted in an earlier post, I have started a new section which will deal with the potential for new hedge fund regulations.  In order to get an idea of where we might be headed, I have looked backed to see what the SEC has said to Congress about hedge funds previously.  Below is a transcript of Susan Ferris Wyderko’s testimony before a Senate Subcommittee.  Some of the more interesting parts of this speech include:

  • background of hedge fund industry
  • hedge fund regulation
  • hedge fund fiduciary obligation
  • cases against fraudulent hedge fund managers
  • discussion of prime brokerage

Please note that the discussion on investment advisor registration for hedge fund managers is no longer accurate thanks to Phillip Goldstein of Bulldog Investors who successful challenged the SEC’s registration rule. The link for this testimony can be found here.

Testimony Concerning Hedge Funds

by Susan Ferris Wyderko
Director, Office of Investor Education and Assistance
U.S. Securities & Exchange Commission
Before the Subcommittee on Securities and Investment of the
U.S. Senate Committee on Banking, Housing, and Urban Affairs
May 16, 2006

Chairman Hagel, Ranking Member Dodd, and Members of the Subcommittee:

I. Introduction

Thank you for inviting me to testify today about hedge funds, the role they play in our securities markets, and the Commission’s role in their oversight. The Commission has a substantial interest in the activities of hedge funds and their advisers, which only recently have become major participants in our securities markets.

The Commission recognized the growing importance of hedge funds almost four years ago when it directed the staff of the Division of Investment Management to undertake a fact-finding mission aimed at reviewing the operation and practices of hedge funds and their advisers. That review led to the publication by the Commission of a staff report entitled “Implications of the Growth of Hedge Funds,” in which the staff described in detail the organization of the hedge fund industry, its growth, and regulation.1

While identifying a number of concerns and making several policy recommendations, the report also described the many benefits hedge funds provide investors and our national securities markets. They contribute substantially to market efficiency, price discovery and liquidity. By actively participating, for example, in markets for derivative instruments, hedge funds can help counterparties reduce or manage their own risks, thus reducing risk assumed by other market participants. Moreover, many hedge funds provide an important risk management tool for institutional investors wishing to allocate a portion of their portfolio to an investment with low correlation to overall market activity.2

II. Background

Hedge funds are pools of investment capital that are managed by professional investment advisers and that are not offered generally to the public. They are operated so that they are not subject to the same regulatory requirements of mutual funds, which are governed by the Investment Company Act of 1940 which contains many safeguards for retail investors. Hedge funds are not characterized by a single dominant investment strategy, although many seek to obtain returns that are not correlated to market returns and instead seek to obtain an “absolute return” in a variety of market environments. Some adopt a “multi-strategy” approach that permits the adviser to determine, at any given time, what investment strategy to follow to pursue returns for the investors. Hedge funds also do not have a single risk profile. Some utilize leveraging techniques that expose investors to substantial risks, while others adopt investment strategies more similar to mutual funds.

Hedge funds do, however, share some organizational characteristics that distinguish them from most mutual funds. Most are organized by advisers that retain a substantial equity participation in the fund, and who receive compensation based, in large part, upon gains achieved by the fund (a “performance fee”). A typical fee arrangement will pay the adviser two percent of the total amount of assets under management and 20% of both realized and unrealized gains. Hedge fund managers view these fee structures as better aligning their interests with the interests of their investors and providing substantial incentives for good performance.

Hedge fund managers usually have a great deal of flexibility in managing the fund, which permits them to take advantage of market opportunities that may not be available to other types of institutional investors. They can change investment strategies, trade rapidly, and utilize leveraging techniques not permitted to mutual funds. And, in contrast to mutual funds, which must disclose publicly their portfolio holdings quarterly, many hedge funds do not even disclose portfolio holdings to all of their investors. Hedge fund advisers do, however, often offer disclosure to their investors about the extent and flexibility of their investment strategies.

1. Growth and Significance of Hedge Funds

The ability of some hedge fund managers to generate significant returns has attracted a great deal of investor interest. It is estimated that hedge funds today have more than $1.2 trillion dollars of assets, a remarkable growth of almost 3,000% in the last 16 years.3 In 2005, an estimated 2,073 new hedge funds opened for business.4 One report recently projected that assets of hedge funds may grow to $6 trillion by 2015.5

Much of the growth of hedge funds is attributable to increased investment by institutions, such as private and public pension plans, endowments and foundations.6 Many of these investors sought out hedge funds during the recent bear markets in order to address losses from traditional investments.

The ability of hedge fund managers to sustain above-market returns is a matter of some debate, as is the likelihood that hedge funds as an asset class will continue to grow.7 Nonetheless, hedge funds play and will likely continue to play an important role in the securities markets, the significance of which exceeds the amount of their assets. Although hedge funds represent just 5% of all U.S. assets under management, they account for about 30% of all U.S. equity trading volume.8 They are highly active in the convertible bond and credit derivatives markets. Moreover, hedge funds are becoming more active in the markets for corporate control,9 private lending, and crude petroleum. Their activities affect all Americans directly or indirectly.

2. Application of the Federal Securities Laws

Press articles typically refer to hedge funds as “lightly regulated” investment pools. In a sense, they are correct. As noted above, hedge funds are organized and operated so that they are not subject to the Investment Company Act of 1940. In addition, hedge funds issue securities in “private offerings” that are not registered with the Commission under the Securities Act of 1933, and hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934. However, hedge funds are subject to the same prohibitions against fraud as are other market participants, and their managers have the same fiduciary obligations as other investment advisers.

III. The Commission’s Oversight of Hedge Fund Activities

The Commission’s oversight responsibilities with respect to hedge fund activities generally fall into three principal areas: fiduciary obligations; market abuse; and risks to broker-dealers. Each is described below.

1. Fiduciary Obligations

Hedge fund managers are “investment advisers” under the Investment Advisers Act of 1940. As a result, a hedge fund manager owes the fund and its investors a fiduciary duty that requires the manager to place the interests of the hedge fund and its investors first, or at least fully disclose any material conflict of interest the manager may have with the fund and its investors. Hedge fund advisers have this fiduciary obligation as a matter of law regardless of whether they are registered with the Commission.

The Advisers Act provides the Commission with authority to enforce these obligations, which the Commission has exercised vigorously in order to protect investors. Over the past several years the Commission has brought a number of enforcement cases against hedge fund advisers who have violated their fiduciary obligations to their hedge funds and investors. These cases involve advisers who have engaged in misappropriation of fund assets; portfolio pumping; misrepresenting portfolio performance; falsification of experience, credentials and past returns; misleading disclosure regarding claimed trading strategies; and improper valuation of assets. In some cases we have worked with criminal authorities.

Recent examples of significant cases brought by the Commission include:

* SEC v. Samuel Israel III; Daniel E. Marino; Bayou Management, LLC et al. The Commission alleged that the advisers of a Connecticut-based group of hedge funds defrauded investors in the funds and misappropriated millions of dollars in investor assets for their personal use. Over $450 million was raised from investors. The advisers issued fictitious account statements to investors and used a sham accounting firm to forge audited financial statements in order to hide substantial losses. These losses resulted from, among other things, the theft of funds by the advisers who withdrew “incentive fees” to which they were not entitled. On September 29, 2005, the Commission filed an action in U.S. District Court seeking injunctions, disgorgement of ill-gotten gains, prejudgment interest, and civil money penalties.10 Also on that date, Israel and Marino pleaded guilty in a companion criminal case. They have not yet been sentenced. On April 19, 2006, the defendants in the civil case consented to an order permanently enjoining them from future violations of the antifraud statutes of the federal securities laws.11

* SEC v. Sharon E. Vaughn and Directors Financial Group, Ltd. The Commission alleged that an Illinois hedge fund adviser registered with the Commission defrauded fund investors by improperly investing fund assets in a fraudulent “prime bank” trading scheme contrary to the fund’s disclosed trading strategy. According to the Commission’s complaint, the adviser and its principal had an undisclosed profit sharing agreement with one of the trading program promoters. The adviser and principal consented to injunctions and agreed to disgorgement of over $800,000.12 As a result of the SEC’s action and a subsequent criminal action brought by the U.S. Attorney’s office involving individuals associated with the trading program, hedge fund investors were returned most of their principal investment and profits prior to investment in the trading program.

a. New Registration Requirement

Until recently, registration with the Commission was optional for many hedge fund advisers. In February of this year, new rules became effective that require that most hedge fund advisers register with the Commission under the Advisers Act.13 The new rules do not regulate hedge fund strategies, risks or investments. The new rules have given the Commission basic census data about hedge fund advisers. In addition, registration has required hedge fund advisers to implement compliance programs to prevent, detect and correct compliance violations and to designate a chief compliance officer to administer each adviser’s compliance program. Registration also has provided the Commission authority to conduct compliance examinations of registered hedge fund advisers. Based upon registration data we now know that 24% of the 10,000 investment advisers currently registered with the Commission advise at least one hedge fund. Of the 2,456 hedge fund advisers registered with us as of the end of April, 1,179 (45%) registered in response to the new rule.14 The vast majority of the hedge fund advisers (88%) registered with the Commission are domiciled in the United States.

b. Examinations

As mentioned above, registered hedge fund advisers may be subject to on-site compliance examinations by SEC examiners in the Office of Compliance Inspections and Examinations (OCIE). The SEC maintains a risk-based examination program, and determines which firms to examine based on their risk characteristics. Hedge fund advisers have been included in the same pool as other registered advisers, and thus, like other advisers, the staff determines which firms to examine based on the compliance risks the firm presents to investors. Examination staff are working with the Division of Investment Management and Office of Risk Assessment to develop improved metrics to assess the compliance risks of registered advisers in order to continue to focus our exam resources. In addition, OCIE has developed a specialized training program to better familiarize examiners with the operation of hedge funds and thus improve the effectiveness of our examination of hedge fund advisers.

During a routine compliance examination, the staff reviews the effectiveness of the compliance controls that every registered investment adviser must have in place to prevent or detect violations of the federal securities laws. In those areas where controls appear to be weak, our examiners will obtain additional information to determine if the weak control environment has resulted in a violation of the securities laws. The staff also reviews disclosure documents, including any private placement memoranda provided to hedge fund investors, to determine whether the disclosure appears to accurately reflect the hedge fund adviser’s management of the fund. In addition, the staff identifies areas of potential conflicts of interest with respect to the hedge fund adviser and the fund that it advises to determine whether appropriate disclosure has been made.

It is the staff’s experience that many of the compliance issues raised by an adviser’s management of a hedge fund are similar to those raised by other advisers’ asset management activities. For example, these compliance issues include: the use of soft dollar arrangements, the allocation of investment opportunities among clients, the valuation of securities, the calculation of performance, and the safeguards over customers’ assets and non-public information. In this regard, let me identify a few areas in which we plan to focus our examinations of hedge fund advisers:

Side-by-Side Management. Some hedge fund managers also advise other types of advisory accounts, including mutual funds.15 Because the adviser’s fee from the hedge fund is based in large measure on the fund’s performance-and because the adviser typically invests heavily in the hedge fund itself, this “side-by-side” management presents significant conflicts of interest that could lead the adviser to favor the hedge fund over other clients. The staff will focus on whether the hedge fund manager appears to have sufficient controls in place to prevent such bias and whether, in fact, the adviser has favored its hedge funds over other clients.

Side Letter Agreements. Side letters are agreements that hedge fund advisers enter into with certain investors that give the investors more favorable rights and privileges than other investors receive. Some side letters address matters that raise few concerns, such as the ability to make additional investments, receive treatment as favorable as other investors, or limit management fees and incentives. Others, however, are more troubling because they may involve material conflicts of interest that can harm the interests of other investors. Chief among these types of side letter agreements are those that give certain investors liquidity preferences or provide them with more access to portfolio information. Our examination staff will review side letter agreements and evaluate whether appropriate disclosure of the side letters and relevant conflicts has been made to other investors.

Valuation of Fund Assets. A hedge fund manager typically values the assets of the hedge fund using the market value of those securities. When the fund holds publicly traded securities, that process is fairly simple. Many hedge funds, however, own thinly traded securities and derivative instruments whose valuation can be very complicated and, in some cases, highly subjective. Unlike a mutual fund, hedge fund valuation practices are not overseen by an independent board of directors. A number of the Commission’s enforcement cases against hedge fund advisers involve the adviser’s valuation of fund assets in order to hide losses or to artificially boost performance. Thus, a review of valuation policies and practices is a key element of hedge fund adviser examinations.

Custody of Fund Assets. A hedge fund manager typically has access to and directs the use of fund assets. Such access presents a significant risk to fund investors — as demonstrated in a number of the Commission’s enforcement actions involving theft or misuse of fund assets by a hedge fund manager. Therefore, Commission examiners focus attention on the controls used to protect fund assets.

2. Market Abuse

Hedge fund advisers’ active trading plays an important role in our capital markets. The federal securities laws and Commission regulations establish rules designed to prevent market abuses. When market activity by hedge fund advisers-like any other participant in the securities markets-crosses the line and violates the law, the Commission has taken appropriate remedial action. In the past year, the Commission has brought enforcement actions against hedge fund advisers for a variety of market abuses, including insider trading, improper activities in connection with short sales, market manipulation, scalping, and fraudulent market timing and late trading of mutual funds.

Recent significant cases have included:

* In the Matter of Millennium Partners, L.P., Millennium Management, L.L.C., Millennium International Management, L.L.C., Israel Englander, Terence Feeney, Fred Stone, and Kovan Pillai. The Commission brought an action against hedge fund managers alleging that the managers generated tens of millions of dollars in profits for their hedge funds through deceptive and fraudulent market timing of mutual funds at the expense of the mutual funds and their shareholders. The adviser and its principals agreed to disgorgement and civil monetary penalties, and have undertaken to implement particular compliance, legal, and ethics oversight measures.16

* SEC v. Hilary Shane. The Commission alleged a particular type of insider trading involving a PIPE transaction, where the hedge fund adviser agreed to buy shares of a public company in a private offering – a transaction that the Commission alleged was likely to have a significant dilutive effect on the value of the company’s shares – and then misused information she had been given (and which she had agreed to keep confidential) about the private offering by short-selling the company’s shares. The adviser agreed to disgorge the trading profits, paid a civil penalty, and has consented to be barred from the broker-dealer industry and suspended from the investment advisory industry.17

* SEC v. Scott R. Sacane, et al. The Commission alleged that hedge fund advisers manipulated the market by creating the appearance of greater demand for two stocks than actually existed. The individual defendants in this case have both pled guilty to related criminal charges and have been barred by the Commission from associating with an investment adviser. In addition, one of the defendants has agreed to pay disgorgement and a civil penalty in the Commission’s civil action, which remains pending against the other defendants.18

Not only has the Commission brought enforcement actions against the hedge funds and hedge fund advisers that engage in these transactions, it has brought actions against fund service providers who facilitated these unlawful securities trading activities. Recently, for example, we settled an enforcement action against a large broker-dealer that helped hedge funds foil the efforts of mutual funds to detect the hedge funds’ market timing, and made it possible for certain favored hedge fund clients to “late trade” mutual fund shares.19

3. Risks to Broker-Dealers

Hedge funds can (although we understand many do not) make significant use of leverage. Most hedge funds use one or more “prime brokers,” which provide clearing and related services to the fund and its adviser. One core service prime brokers offer their hedge fund customers is secured financing, notably margin lending, where the hedge fund borrows from the prime broker in order to buy securities, which then serve as collateral for the loan.20

The Commission continues to focus attention on broker-dealers’ exposure to hedge fund risks and the broader implications this aspect of the financial system may have. The Commission staff meets regularly with other members of the President’s Working Group on Financial Markets, and works with the industry members that comprise the Counterparty Risk Management Policy Group. In addition, the Commission’s consolidated supervision program for certain investment banks now allows the staff to examine not only the broker-dealer entities within a group, but also the unregulated affiliates and holding company where certain financing transactions with hedge funds are generally booked. Commission staff meets at least monthly with senior risk managers at these broker-dealer holding companies to review material risk exposures, including those resulting from hedge fund financing and those related to sectors in which hedge funds are highly active.

IV. Looking Forward

As a result of our recently-implemented hedge fund adviser registration rulemaking, the Commission now has more data about hedge funds and their advisers. The staff is in the process of evaluating those data and considering methods to refine its ability to target our examination resources by more precisely identifying those advisers, including hedge fund advisers, that pose greater compliance risks.

In addition, the Commission staff is working with the United Kingdom’s Financial Services Authority, to coordinate policy and oversight of the 165 hedge fund advisers registered with the Commission that are located in the United Kingdom. The staff also expects to coordinate examinations with the Commodity Futures Trading Commission (CFTC). To that end, we recently provided information to the CFTC indicating the identities of hedge fund advisers registered with the Commission who report on their registration forms that they are also actively engaged in commodities business (approximately 350 firms).

V. Conclusion

In conclusion, I would like to thank the Subcommittee for holding this hearing on a subject of growing importance to us and to all American investors. Hedge funds play an important role in our financial markets. With respect to hedge funds, their advisers and all market participants, the Commission will continue to enforce vigorously the federal securities laws.

Endnotes

1 Implications of the Growth of Hedge Funds, Staff Report to the United States Securities and Exchange Commission (Sept. 2003), available at http://www.sec.gov/news/studies/hedgefunds0903.pdf.

2 A recent study reported that 78% of institutional investors surveyed said that hedge funds reduced the volatility of their portfolio. State Street Corporation, Hedge Fund Research Study (Mar. 2006) at 4.

3 See Hedge Fund Research, HFR Q1 2006 Industry Report.

4 See Hedge Fund Research, HFR Q1 2006 Industry Report. During 2005, 848 funds were liquidated. Id.

5 Van Hedge Fund Advisers, International, LLC, Hedge Fund Demand and Capacity 2005-2015 (Aug. 2005).

6 See Hennessee Group, 2004 Hennessee Hedge Fund Survey of Foundations and Endowments (reporting that the investors surveyed had an average commitment of 17% of assets, and a projected commitment of 19% by 2005).

7 See Nicholas Chan, Mila Getmansky, Shane M. Haas, and Andrew W. Lo, “Systemic Risk and Hedge Funds,” (Aug. 1, 2005) (unpublished manuscript, to appear in M. Carey and R. Stulz, eds., The Risks of Financial Institutions and the Financial Sector, Chicago, IL: University of Chicago Press).

8 See Pam Abramowitz, “Trade Secrets,” Institutional Investor’s Alpha, January/February 2006.

9 Mara Der Hovanesian, “Attack of the Hungry Hedge Funds,” Business Week (Feb. 2006); Henry Sender, “Hedge Funds: The New Corporate Activists–Investment Vehicles Amass Clout In Public Firms, Then Demand Management Boost Share Price,” The Wall Street Journal (May 13, 2005).

10 Litigation Release No. 19406 (Sept. 29, 2005).

11 Litigation Release No. 19692 (May 9, 2006).

12 Litigation Release No. 19589 (Mar. 3, 2006).

13 The Commission’s recent rulemaking required certain hedge fund advisers to register as investment advisers with the Commission under the Investment Advisers Act of 1940, under which registration previously had been optional for many hedge fund advisers. Commissioners Glassman and Atkins dissented from the rulemaking. Registration Rule at 72089. With respect to the management of hedge funds whose advisers are registered with the Commission, the Commission in adopting the adviser registration requirement observed that, “The [Advisers] Act does not require an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments.” Registration Rule at section II.A. [Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. 2333 (Dec. 2, 2004), 69 FR at 72060, petition for review filed (D.C. Cir. No. 04-1434 (argued Dec. 9, 2005). (“Registration Rule”).]

14 Registration forms indicate that these advisers report just over 13,000 hedge funds with aggregate assets of about $2 trillion. Because reported assets include assets of “feeder” funds as well as “master” funds in which they invest, total reported assets likely are higher than if assets of “feeder” funds were excluded.

15 Almost 15% (379) of the hedge fund advisers registered with the Commission report that they also advise at least one mutual fund.

16 Investment Advisers Act Release No. 2453 (Dec. 1, 2005).

17 Litigation Release No. 19227 (May 18, 2005). Because she entered into the short sales prior to the effective date of the registration statement for the PIPE and then covered her short sales with those she obtained in the PIPE offering, the Commission also alleged that Ms. Shane violated section 5 of the Securities Act.

18 Litigation Release No. 19424 (Oct. 12, 2005). See also In the Matter of Scott R. Sacane, Investment Advisers Act Release No. 2483 (Feb. 8, 2006); In the Matter of J. Douglas Schmidt, Investment Advisers Act Release No. 2491 (Feb. 28, 2006); SEC v. Scott R. Sacane, et al., Litigation Release No. 19515 (Dec. 22, 2005); SEC v. Scott R. Sacane, et al., Litigation Release No. 19605 (Mar. 9, 2006).

19 In the Matter of Bear, Stearns & Co., Inc., and Bear, Stearns Securities Corp., Securities Act Release No. 8668 (Mar. 16, 2006) (defendants agreed to censure, payment of disgorgement and civil monetary penalties, and have undertaken to implement particular compliance oversight measures).

20 Prime brokers may also structure these financing transactions as repurchase agreements, where they buy the securities from the hedge fund subject to the fund’s obligation to repurchase the securities from the broker in the future at a specified price. Prime brokers may also produce similar economics through the use of over-the-counter derivative contracts with hedge funds.

Hedge Fund Prime Brokerage

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Hedge fund prime brokerage is provided by a prime broker.  While the central service the prime broker provides to a hedge fund is trading services, the prime broker provides many other services to hedge funds as well.

Trading and execution

Generally a hedge fund prime broker will act as a hedge fund’s central broker and will execute most of the hedge fund’s trades.  Many prime brokers have online interfaces and/ or programs which allow a manager to automate many trades.  Additionally, the prime broker will be able to execute trades in large blocks and will also be able to execute trades in illiquid securities for the fund.

Custodial and settlement services

One of the main advantages of having a prime broker is that the broker will act as a custodian of the fund’s assets.  If the hedge fund executes trades through other brokers, the prime broker’s back office will work with the back office of the executing broker-dealer to make sure that the assets are settled and transferred over to the fund’s account at the prime broker.

There are a couple of advantages of having the assets custodialized at one institution: (i) reporting of the fund’s positions is easier when there is one custodian and (ii) the prime broker can use all of the fund’s assets for margin purposes (instead of simply part of the fund’s assets if there are multiple brokers or custodians).

Other Services

In addition to custodial and execution services, the prime broker can provide a whole host of other services including:

Leverage and margin – prime brokers can provide the fund with leverage and margin, depending on the fund’s investment program and circumstances.

Short sales – prime brokers generally have a “short box” of securities which can be borrowed to be sold short.

IPOs – prime brokers will often have access to initial public offerings.  Some hedge funds will choose a prime broker based on the broker’s ability to allocate IPOs to the fund.

Capital introduction – a prime broker may, in certain circumstances, introduce potential investors to the hedge fund.

Reporting – the prime broker can produce period reports which can be sent to the hedge fund administrator or to hedge fund investors.

Soft dollars – the prime broker may be able to provide certain research and other items to the hedge fund manager.  Under revised soft dollar guidance, soft dollars cannot be used for non-research items such as computer equipment or rent for the hedge fund’s management company.

Office space and IT support – some prime brokers (and other broker-dealers) will provide office space and IT support for hedge funds.  Such arrangements are often called by the perjorative term “hedge fund hotels.”

Stress test analysis and other portfolio monitoring

Joint Back Office (JBO) arrangements – these arrangements allow a hedge fund to receive more margin by becoming a broker-dealer.  These arrangements used to be more popular but the margin rules changed to a risk-based model which, for many hedge funds, abrogated the need for many JBO arrangements.

Deciding on a prime broker

The prime broker is definitely a major piece of the hedge fund puzzle.  You should discuss prime brokers with your hedge fund attorney; your attorney will be able to give you some recommendations based on your trading program and other factors.  Please contact us if you have any questions.

New Hedge Fund Regulations – SEC to Conduct Roundtable Today

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As I’ve mentioned previously we can expect tighter regulations in the coming months for the financial services industry in general and the hedge fund industry specifically.  To track these changes I’ve instituted a new section entitled new hedge fund regulations which I will keep updated with information.

Below the SEC is taking the first steps to decide how to move forward in this new world financial order through a series of panel discussions.  The SEC is also soliciting comments from the financial services industry on a variety of questions.  These steps are obviously necessary and should be productive if the SEC really listens to the practitioners from the industry.  The release can be found here.

SEC Roundtable on More Transparent Disclosure to Address Lessons of Current Credit Crisis
FOR IMMEDIATE RELEASE
2008-241

Washington, D.C., Oct. 7, 2008 — The Securities and Exchange Commission today announced the agenda for Wednesday’s roundtable on providing more transparency to investors that will include discussion of lessons from the current credit crisis. Among other issues, panelists will address better ways to explain complex financial instruments to investors and the marketplace, and will propose ways to provide investors with more transparent, useful, and timely access to high-quality information. The roundtable is part of the SEC’s 21st Century Disclosure Initiative (www.sec.gov/disclosureinitiative) that is fundamentally rethinking disclosure.

Panel One: The Market’s Use of Disclosure Information and the SEC’s Disclosure System

This panel will explore whether the current system of collecting and filing data for SEC disclosure obligations has kept pace with the market. It will examine how investors can get all the information they need to make increasingly complex investment decisions. It will also consider the data, technology, and processes that companies and other filers use in satisfying their SEC disclosure obligations. The panel will compare the needs and uses of investors and companies to the capabilities of the SEC’s disclosure system in an effort to better understand any gaps and inefficiencies that can lead to inaccuracies, delays, and unnecessary complexity.

  • John Bajkowski, Vice President and Senior Financial Analyst, American Association of Individual Investors
  • Robert Sorrentino, Director of Accounting Policy and External Reporting, Xerox Corp.
  • David Copenhafer, former Director of EDGAR Services, Bowne & Co., Inc.
  • Glenn Doggett, Policy Analyst, CFA Institute Centre for Financial Market Integrity
  • Paul Haaga, Jr., Vice Chairman, Capital Research and Management Co.
  • Kara Jenny, Chief Financial Officer, Bluefly, Inc.
  • Timothy Thornton, Principal, Web Services, The Vanguard Group, Inc.

Panel Two: Modernizing the SEC’s Disclosure System

This panel will consider how the SEC could better organize and operate its disclosure system so that investors could have better access to high-quality information and companies could enjoy efficiencies. In particular, the panel will discuss ways to structure disclosure data so investors can more effectively search for company data and compare investment options. The panel will describe a possible “company file system,” in which core company information would be collected in a central structured data file, and will also discuss other approaches that harness technology to better serve investors and the markets.

  • Alan Beller, Partner, Cleary Gottlieb Steen & Hamilton LLP
  • Steven Bochner, Partner, Wilson Sonsini Goodrich & Rosati
  • Esther Dyson, Chairman, EDventure Holdings
  • Joseph Grundfest, Professor of Law, Stanford Law School
  • Eric Roiter, Lecturer on Law, Harvard University Law School and Boston University School of Law
  • Liv Watson, Member, Board of Directors, IRIS
  • Hillary Sale, Chair in Corporate Finance and Law, University of Iowa College of Law
  • Douglas Chia, Senior Counsel and Assistant Corporate Secretary, Johnson & Johnson

Moderators:

  • John White, Director of SEC’s Division of Corporate Finance
  • Andrew Donohue, Director of SEC’s Division of Investment Management
  • Jim Kaput, Counsel to 21st Century Disclosure Initiative
  • Matthew Reed, Assistant Director of 21st Century Disclosure Initiative

The SEC’s roundtable will be held on Wednesday, October 8 in the auditorium of the SEC’s Washington D.C. headquarters at 100 F Street, NE from 9 a.m. until approximately 1 p.m. The roundtable will be open to the public on a first-come, first-served basis. It will be webcast live on the SEC’s Web site, and an archived version of the webcast will later be available for free download.

The Commission welcomes feedback regarding any of the topics to be addressed at the roundtable, and has issued a formal request for public comment. The Commission is particularly interested in comments responding to these questions:

General Issues

  1. Should the Commission make changes to its current forms-based disclosure system? Please explain why or why not.
  2. What are the key issues to be considered in the review of the Commission’s disclosure system? Are particular aspects of the system and process especially useful and well executed, and are particular aspects especially in need of improvement?
  3. What are the purposes of issuer disclosure from the perspective of investors, filers, and regulators?

Specific Issues

The Market’s Use of Disclosure Information

  1. How do operating and investment companies collect, summarize, analyze, file, and disseminate the information that is submitted to the Commission?
  2. How do operating and investment companies submit disclosure and reporting information to the Commission? How have these methods changed during the last 15 years, particularly after filing via EDGAR was fully implemented? How could the Commission’s system be changed to reduce burdens and create efficiencies, consistent with investor protection?
  3. How do investors retrieve and use the disclosure information that companies submit to the Commission? How could this information be better presented, and more easily retrieved and used through technological improvements?
  4. What disclosure information that companies submit to the Commission is used by investors to make investment decisions? Is any information that companies submit to the Commission not used? What information that is not required to be filed or furnished with the Commission do investors and others use to make investment decisions or give investment advice?

The Commission’s Current Disclosure Syste

  1. Does the Commission’s current disclosure system present difficulties? What difficulties can be attributed to technological problems? Which can be attributed to regulatory or statutory problems?

Modernizing the Commission’s Disclosure System

  1. How should the Commission’s disclosure system be modernized? One possibility is a company file system. What alternative systems should be considered? What different or additional benefits might these alternatives provide?
  2. How should a modern disclosure system, such as a company file system, be organized, and how could it improve the way disclosure information is submitted and used?
  3. What features should any modernized disclosure system provide in order to serve the needs of filers, investors, regulators, and other users of information? Why? Data tagging using XBRL, or eXtensible Business Reporting Language, is one way, but we understand there are other ways to structure data. What alternative ways could be used by companies to submit structured data to the Commission?
  4. What are the costs and benefits to investors and other market participants of structuring non-financial disclosures, including, for example, data tagging?
  5. What time frame would be appropriate for implementing a company file system?
  6. What benefits and costs to preparers and users of information would accompany the implementation of modernized disclosure system, such as a company file system, that requires all, or virtually all, data to be filed in a structured format? Would such a system be more useful to some investors, such as small or less sophisticated investors? Would some investors be harmed by such a system? Would larger companies benefit more than smaller companies? Would costs fall disproportionately on one group of companies?
  7. Are any changes to the Commission’s disclosure regulations required for a transition to a company file system? How could these changes be identified?

The information that is submitted for comment will become part of the public record of the roundtable. All submissions received will be posted without change. The SEC does not edit personal identifying information from submissions. Only information desired to be shared publicly should be submitted.

Hedge Fund Administrator – What is a Hedge Fund Administrator?

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A hedge fund administrator is a service provider to the hedge fund; the main job of the administrator is to provide certain accounting and back office services to a hedge fund as detailed below.

Hedge fund administrator services

Generally, administrators will provide a variety of services to the hedge fund manager.  The central service is monthly or quarterly accounting of investor contributions and withdrawals and computing the profits and losses for the accounting period.  The administrator may also provide other back end services such as transfer agent services (handling the subscription documents and making sure checks are cashed or wires are appropriately handled).

A relatively new service which some administrators provide is a “second signer” service which is designed to give investors greater confidence that a hedge fund manager will not run off with their money.  Under a “second signer” agreement, the hedge fund manager will need to get a sign off from the administrator before the manager can make a transfer or a withdrawal from the fund’s account.

In addition to the above, the hedge fund administrator may perform the following duties:

  • calculating the management fee and performance fee
  • working with the auditor
  • keeping certain financial records
  • may act as the registered agent and registrar (offshore hedge funds)
  • Anti Money Laundering review (generally only for offshore hedge funds)

Three types of hedge fund administrators

Small administration firms – these types of administrators are very lean organizations which are controlled and run by one or two people.  Typically the one or two people will have significant experience in the hedge fund industry, many times with other administration firms, hedge fund audit firms and hedge fund consultants.  The typical client will be a start-up hedge fund.  While these administrators can handle funds with assets of up to and sometimes beyond $500 million, most of their clients will generally start with less than $50 or $100 million.

These administrators are going to be the most cost-effective solution for a start up hedge fund.  Additionally, these administrators often provide some of the best customer service – usually the manager will be able to talk to the principal at any time.  For these administrators, the manager will be looking at a start-up fee of anywhere from $500 – $1,500 and then a monthly administration fee of $750 – $1,500.

Medium-sized firms – these firms are usually established businesses with strong structure, have been around for a while, and have a fairly large and established client base.  It is expected that a medium-sized firm would have one to two principals with 10-20 years of experience in the hedge fund industry.  These firms will have clients that range in size from $50 to $500 million and may have clients which have $2 to $5 billion in assets.

Medium-sized firms will charge a start-up fee of $1,500 or more and will usually base their administration fee as a percentage (basis points) of AUM, subject to a minimum monthly fee which is usually around $2,000.

Large firms – these firms are well-established within the hedge fund industry and are thriving businesses themselves.  These firms may be subsidiaries of large international banks or (former) investment banks.  The principals of these firms are well-connected to the major players in the industry and most of the clients of these firms are the large hedge funds.  If a hedge fund uses a large firm for administration, the fund should expect to pay a minimum of around $5,000 a month.  Because of the relatively high costs of the large administrators, it may not make sense for a fund with less than $250 million to use such an administrator.

Offshore hedge fund administration

Offshore hedge fund administration generally refers to the administration of an offshore hedge fund.  Typically the process and function will be the same, but there are more issues that come into play with an offshore hedge fund.  Because offshore hedge fund fees can be structured in a variety of ways, the administrator may want to discuss the structure with the hedge fund attorney if there are any uncertainties with the structure.

Questions on hedge fund administrators

1.  How do I find a hedge fund administrator?

There are many ways you can find a hedge fund administrator and other hedge fund service providers.  Your hedge fund attorney can help recommend a administrator based on the needs of your fund.  Please note that not all administrators offer services to all types of hedge funds.  Please contact us if you would like us to recommend a hedge fund administrator (or if you have any other hedge fund administration questions).  Additionally, you can reference this survey of hedge fund administrators.

2.  Who pays for the costs of the administrator?

As I noted in an article on hedge fund expenses, the costs of the administrator are usually paid by the fund and not by the management company.  Some managers may choose to pay the administration costs so that these costs will not be a drag on performance.  You should discuss this issue with your attorney.  Additionally, please note that the costs above are general guidelines – if your strategy requires more in-depth valuation practices  (i.e. the fund trades hard to value instruments), the administration costs may be higher.

3.  Does a start-up hedge fund need an administrator?

Yes.  While there is no law that requires a domestic hedge fund to have an administrator, there is no real good reason why a hedge fund should not have an administrator.  Outside verification of a hedge fund’s numbers, especially given the current state of the capital markets, is becoming a requirement for hedge fund investors.  Additionally, there are law firms which will not work with start-up hedge funds that do not have an administrator.  Another consideration is the audit – if there are no independent third party numbers to review, the audit becomes more difficult and potentially more costly.

Hedge Funds in the BVI – new requirement to submit annual information

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The British Virigin Islands (BVI) is a popular jurisdiction for many offshore hedge funds to be located.  The BVI is known to have good financial oversight and relatively reasonable offshore hedge fund formation fees.  Over the past year the BVI Financial Services Commission (FSC) has become more involved in hedge fund oversight as political pressure increases.  It is expected that the BVI’s Mutual Funds Law will undergo changes within the next 6 months to a year because of this political pressure.

In addition, on September 9 the FSC surprisingly announced that BVI hedge funds (known as “mutual funds” in the BVI) will need to submit a yearly Annual Return to the FSC which provides information about the fund to the FSC.  This is a new requirement for all BVI based hedge funds.  Before this year the FSC had a voluntary mutual funds survey which requested information similar to the information requested in the Annual Return.  Certain closed end funds (generally private equity funds established in the BVI) will not need to submit the Annual Return.

BVI Annual Return Requirement

The items a fund will need to submit are:

–    Basic information on the fund and its service providers, including the registered agent
–    Financial information including:

Beginning NAV
Total subscriptions
Total redemptions
Net income/ net loss
Dividends/ distributions
Ending NAV
Year end gross assets

–    General description of the fund’s asset allocation (but not individual positions)

The Annual Return will need to be submitted to the FSC by June 30 of 2009.  Funds which do not submit the Annual Return by that date may face an enforcement action.

A sample Annual Return can be found here: sample-annual-return

What this means for offshore hedge funds

With regard to this new requirement, current BVI funds are going to need to complete the Annual Return.  While the Annual Return will not be a huge resource drain, it will take some time to complete.  Generally most of the questions can be answered fairly quickly by the hedge fund manager or by an assistant.  Some of the information may require input from the hedge fund administrator and potentially the hedge fund attorney as well.

In the future, this seems to be the first step towards greater scrutiny and disclosure requirements from offshore hedge fund jurisdictions.  However, it is unclear whether this will affect the number of start up funds which will be based in the BVI as the intrusion is relatively mild.  However, it may mean that other offshore jurisdictions such as Nevis, Guernsey and Dubai become more popular in the future.

Please see guidance from here from Maples and Calder, an offshore law firm: BVI Annual Return Requirement

Hedge Fund Liquidation Procedure

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It has been a tough year for many managers and there are many funds that will be shutting their doors before the end of the year.  Funds may decide to close their door for many reasons which might range from poor performance to large amounts of investor withdrawals.  While many of the managers and traders at these funds will go on to work for other firms, many of these managers and traders will start new hedge funds and potentially with some of the same investors.

In either case, there are a few things that a hedge fund manager will need to do in order to ensure the orderly liquidation and winding down of the hedge fund.

Liquidation pursuant to the offering documents

The hedge fund limited partnership agreement or LLC agreement (part of the hedge fund offering documents) will set out the manner in which the dissolution and liquidation of the fund will proceed.  Generally there will be some sort of liquidation and then final accounting.  The timing of these will be determined by the offering documents.

Talk with the hedge fund service providers

A manager should first contact his hedge fund attorney to inform him of the plans to close down the fund.  The lawyer will be able to help guide the manager through the process and will be able to help with any issues which may arise.  The auditor, broker and administrator should also be contacted so that these service providers can begin their own processes for winding the fund down.  During the wind down process, the manager should expect to talk with each of the service providers a few times.

Inform your investors

A manager will need to inform the investors that the fund will be winding down.  The manager will probably want to do this through some sort of letter.  After the manager has discussed the wind down with the attorney, the attorney can help the manager draft the letter.  The letter should inform the investors that the fund will be closing and also let the investors know what steps are being taken before the final liquidation is complete.  The manager may also ask the investor how the final proceeds should be sent to the investor – either through wire or through a check.  Additionally, if the manager is going to be starting a new hedge fund, he may want to mention this in the letter.  (However, the manager will need to be careful that the mention of the new fund does not rise to the level of a public offering – the attorney can discuss this with the manager.)

During this time, it is critical for the manager to keep the lines of communication with the investor open.  During a wind down when emotions are high, investors may be looking for any reason to complain or create a reason for a suit against the general partner.  It is most important to be honest during these times.

Make the final wind down and distributions

The final wind down is the process of liquidating all of the fund’s positions to cash and then transferring the fund’s assets to the fund’s bank account.  From the bank account, the manager will then be able to distribute the assets to the investors pursuant to the final accounting by the administrator and/or auditor.

Provide the final audit

The auditor will provide final audited financial statements to the manager who will then provide these statements to all of the investors in the fund.  Usually the final audit will be completed prior to the actual distribution of the assets to the investors in the fund.

Close down the entities

After the final audit and distribution to the investors, the manager will want to close down, or cancel, the fund entity.  To do this the attorney will:

  1. Submit articles of cancellation to the Delaware Secretary of State to close down the entity.  The filing fees for this are typically $200-$300 dollars payable to Delaware.
  2. Pay any outstanding Delaware franchise taxes.  Generally these are going to be less than $200, but it will depend on the fund.  The attorney will be able to contact Delaware to determine the amount of the taxes owed.
  3. Provide the manager with an explanation of how to contact the IRS about the canceled entity.
  4. Contact the registered agent in Delaware to cancel registered agent services with them.

The above is a rough outline of the steps involved in closing a Delaware entity and will usually be completed by a paralegal in a few hours.  There are more steps involved with the process of closing down an offshore entity which will depend on the jurisdiction of the fund.  Generally the wind down process for each offshore entity will range in cost from $800 – $3,000 or more depending on the circumstances of the wind down.
Additionally, the hedge fund manager should also decide whether the hedge fund management company will also need to be wound down.  In many cases, the entity will be kept alive in order to serve a future purpose for the manager; in some cases the management company will serve as the general partner to a new hedge fund.

Potential roll over issues

For mangers who are simultaneously closing one hedge fund and starting another, a common practice is to simply roll the assets from the old fund to the new fund.  In such instances the manager will definitely need to have close contact with all of the service providers to ensure a smooth transition.  Additionally, there may be some issues which the manager will need to discuss with counsel if there are tax-exempt entities in the old fund.

If you have any questions on the process, please feel free to contact us at any time.

Hedge Fund IRA Investments

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Individual retirement account (IRA) investments into hedge funds are increasing rapidly.  Below are some common questions hedge fund managers have about potential investments by IRAs.

Can an IRA invest in a hedge fund?

Generally yes, however the IRA and the hedge fund must make sure to follow certain regulations which a manager should discuss with a hedge fund attorney.    A manager should not accept IRA investments into the hedge fund without first discussing this with his lawyer.

How does an IRA actually make the investment into the hedge fund?

Each IRA investment into the hedge fund needs to be made by the custodian of the IRA.  That is, the beneficial owner of the IRA cannot simply take the money out of his IRA account and then place the money in the hedge fund – this would be deemed to be a withdrawal from the IRA and would be subject to very negative tax consequences.

In order to avoid these negative tax consequences the custodian needs to directly transfer the IRA assets to the hedge fund.  Typically this is done through a self directed IRA account at a brokerage firm.  Many brokerage firms do not have these self directed programs in place.  If the brokerage firm does not have such a program in place the beneficial owner of the IRA would need to transfer the IRA to another custodian which does.  Our law firm has worked with many custodians who have these programs and we can make recommendations.

Each custodian has different requirements for an investment into a hedge fund from an IRA.  Typically the hedge fund manager is going to need to fill out a few pages of paperwork with the custodian and provide custodian with the fund’s offering documents.  After the custodian’s compliance department has reviewed the paperwork, the custodian will be able to make the investment into the fund on behalf of the IRA.  During this process the hedge fund manager is going to be spending time talking with the custodian and the compliance department.  Additionally the law firm may need to be involved with the process as well; however, this is usually to a much lesser extent.

Are there any other issues with IRA investments into hedge funds?

Yes.  There are many issues which a hedge fund manager should be aware of which include the following:

1.  The manager should be sure that the hedge fund and the management company do not engage in any prohibited transactions with respect to the fund and the IRA.  [More on this in a later article.]

2.  The manager should make sure that if it uses any sort of leverage that such activities are clearly discussed in the fund’s offering documents.  In certain circumstances where there is leverage, an IRA could be subject to tax on its unrelated business taxable income or UBTI.

3.  The manager should make sure that the fund does not stray from its investment program.  IRA are not allowed to make certain investments like investments in life insurance policies (life settlements).
As noted in an earlier article on hedge funds and ERISA, while IRAs are not specifically ERISA assets, they do count towards the 25% threshold and thus the manager needs to be aware of the amount of IRA and other ERISA assets in the hedge fund.

HFLB Note

Because of the gravity of the tax consequences to potential IRA investors, please contact your hedge fund attorney or accountant if you have specific questions about IRA investments into your fund.  Additionally, savvy hedge fund investors will usually want to make sure that their own tax advisors have reviewed the hedge fund offering documents before investing in the fund.

Please contact us if you have any questions on the above.  Also, please read our disclaimer with regard to discussions about tax items.