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Investment Adviser Pay to Play Rules

SEC Proposal Would Ban Third Party Solicitors from Seeking Public Monies

Back in July there was much discussion about new “pay to play” rules proposed by the SEC. The proposed “pay to play” rules would limit the ability of investment managers (including hedge fund managers) to make political contributions and would also limit the ability of third party marketers to raise capital for managers from state and federal pension plans.

There have been many interesting comments on these proposed rules so far, and, as some have noted, it seems to me that these rules may hinder the first-amendment rights of these money managers. The comment period ends October 6, 2009 and the SEC may choose to vote on the rule thereafter, but I would not expect for any rule to be finalized before the end of this year. However, hedge fund managers may want to review their investment advisory compliance manual to make sure they have discussed this issue. Hedge fund managers who are not yet registered with the SEC as investment advisers will likely deal with this issue when they register.

I have included below (i) a definition of pay to play below, (ii) the SEC press release announcing the proposal, and (iii) a discussion of pay to play from 1999, the last time the SEC had a proposal to regulate these activities.

Mallon P.C. will be commenting on the proposal so please let us know your opinions below.

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Pay to Play Definition (see old SEC release, reprinted below)

When I refer to pay-to-play, I am talking about the practice of requiring, either expressly or implicitly, municipal securities participants to make political contributions to municipal officials in order to be considered for an award of underwriting, advisory, or related business from the municipality. In most cases these practices do not amount to outright bribery – which is already prohibited under state and federal law, since there is no express quid pro quo – but it is simply an understanding that if you don’t give, you don’t get business.

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SEC Proposes Measures to Curtail “Pay to Play” Practices

FOR IMMEDIATE RELEASE
2009-168

Washington, D.C., July 22, 2009 — The Securities and Exchange Commission today voted unanimously to propose measures intended to curtail “pay to play” practices by investment advisers that seek to manage money for state and local governments. The measures are designed to prevent an adviser from making political contributions or hidden payments to influence their selection by government officials.

The proposals relate to money managed by state and local governments under important public programs. Such programs include public pension plans that pay retirement benefits to government employees, retirement plans in which teachers and other government employees can invest money for their retirement, and 529 plans that allow families to invest money for college.

To help manage this money, state and local governments often hire outside investment advisers who may directly manage this money and provide advice about which investments they should make. In return for their advice, the investment advisers typically charge fees that come out of the assets of the pension funds for which the advice is provided. If the advisers manage mutual funds or other investments that are options in a plan, the advisers receive fees from the money in those investments.

Investment advisers are often selected by one or more trustees who are appointed by elected officials. While such a selection process is common, fairness can be undermined if advisers seeking to do business with state and local governments make political contributions to elected officials or candidates, hoping to influence the selection process.

The selection process also can be undermined if elected officials or their associates ask advisers for political contributions or otherwise make it understood that only advisers who make contributions will be considered for selection. Hence the term “pay to play.” Advisers and government officials who engage in pay to play practices may try to hide the true purpose of contributions or payments.

“Pay to play practices can result in public plans and their beneficiaries receiving sub-par advisory services at inflated prices,” said SEC Chairman Mary Schapiro. “Our proposal would significantly curtail the corrupting and distortive influence of pay to play practices.”

Andrew J. Donohue, Director of the SEC’s Division of Investment Management, added, “Pay to play serves the interests of advisers to public pension plans rather than the interests of the millions of pension plan beneficiaries who rely on their advice. The rule we are proposing today would help ensure that advisory contracts are awarded on professional competence, not political influence.”

The rule being proposed for public comment by the SEC includes prohibitions intended to capture not only direct political contributions by advisers, but other ways advisers may engage in pay to play arrangements.

Restricting Political Contributions

Under the proposed rule, an investment adviser who makes a political contribution to an elected official in a position to influence the selection of the adviser would be barred for two years from providing advisory services for compensation, either directly or through a fund.

The rule would apply to the investment adviser as well as certain executives and employees of the adviser. Additionally, the rule would apply to political incumbents as well as candidates for a position that can influence the selection of an adviser.

There is a de minimis provision that permits an executive or employee to make contributions of up to $250 per election per candidate if the contributor is entitled to vote for the candidate.

Banning Solicitation of Contributions

The proposed rule also would prohibit an adviser and certain of its executives and employees from coordinating, or asking another person or political action committee (PAC) to:
1. Make a contribution to an elected official (or candidate for the official’s position) who can influence the selection of the adviser.
2. Make a payment to a political party of the state or locality where the adviser is seeking to provide advisory services to the government.

Banning Third-Party Solicitors

The proposed rule also would prohibit an adviser and certain of its executives and employees from paying a third party, such as a solicitor or placement agent, to solicit a government client on behalf of the investment adviser.

Restricting Indirect Contributions and Solicitations

Finally, the proposed rule would prohibit an adviser and certain of its executives and employees from engaging in pay to play conduct indirectly, such as by directing or funding contributions through third parties such as spouses, lawyers or companies affiliated with the adviser, if that conduct would violate the rule if the adviser did it directly. This provision would prevent advisers from circumventing the rule by directing or funding contributions through third parties.

* * *

Public comments on today’s proposed rule must be received by the Commission within 60 days after their publication in the Federal Register.

The full text of the proposed rule will be posted to the SEC Web site as soon as possible.
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http://www.sec.gov/news/press/2009/2009-168.htm

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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Pay-To-Play and
Public Pension Plans
Remarks of
Robert E. Plaze
Associate Director, Division of Investment Management,
U. S. Securities and Exchange Commission

At the Annual Joint Legislative Meeting of
The National Association of State Retirement Administrators,
National Conference on Public Employee Retirement Systems and
The National Council on Teacher Retirement, Washington, D.C.

January 26, 1999

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission.

Thank you for inviting me to address this meeting of the group of state pension administrators. My father was a state retiree and lived on his pension for a number of years. I know how the importance the security of a pension plan is to millions of persons like my Dad, and how important your jobs are.

I am a member of the staff of the Commission. But my remarks this afternoon are my own, and I am not speaking for the Commission or my colleagues on the staff.

When Arthur Levitt became Chairman almost six years ago, among his goals was the reform of the municipal securities markets. Since then, a series of initiatives have improved investor disclosure in the municipal securities markets. A second area of reform – and one most relevant to why you have invited me here today – has been the curbing of pay-to-play practices.

Chairman Levitt, and several SEC officials have been involved in the municipal securities markets. They knew that pay-to-play practices had been pervasive and corrupting to the market for municipal securities. And if you ask them, they will tell you stories about checks left on the table at a dinner. They may even know the minimum required contributions in a particular jurisdiction to be eligible for public contracts.

Pay-to-play creates the impression that contracts for professional services are awarded on the basis of political influence rather than professional competence. It harms the citizens of the municipality and the investing public asked to purchase the securities. It brings discredit on the businesses and professionals who participate in the practice.

In 1993, the first in a series of steps to end pay-to-play practices began when a group of investment banks voluntarily agreed to swear off making contributions for the purpose of obtaining municipal business. In 1994, the SEC approved MSRB rule G-37 – which is known as the pay-to-play rule.1

G-37 prohibits municipal securities dealers from engaging in the municipal securities business with an issuer two years after contributions are made to an official of an issuer by the dealer or its employees engaged in municipal finance business. The prohibition applies equally to officials who are incumbents and those who are candidates. There is a de minimis exception, which permits contribution of up to $250 to candidates for whom they can vote.

The rule was met with howls of protest from some state and municipal officials. Some argued that it violated their First Amendment rights to make and solicit political contributions. These claims were soon tested in the federal courts, and in an important decision, a federal court of appeals held that G-37 was a constitutionally permissible restraint on free speech – because it serves a compelling governmental interest of rooting out corruption in the market for municipal securities.2

As we meet this afternoon, the American Bar Association is considering proposals to bar the practice of lawyers obtaining business through political contributions. Deans of 47 law schools across the country have joined Chairman Levitt in calling for an end to what the San Francisco Chronicle called “a sleazy practice that costs taxpayers.” 3 We hope that my profession will adopt a strong and effective ban.

Bringing an end to pay-to-play practices thus has been a step-by-step process.

Recently, Chairman Levitt has asked my Division to look into the question of whether the Commission needed to address pay-to-play in the public pension area. We are now in the fact-gathering stage of this project, which could very well lead to a rule proposal.

What have we found? So far, we see strong indicators that pay-to-play can be a powerful force in the selection of money managers of public pension plans. There are public reports of pay-to-pay problems with the management of public money in 12 states – and many of these are the largest states.

* In one small state a former state treasurer raised over $73,000 in campaign contributions, virtually all from contractors for the state retirement system 4

* The controller of a large state has raised $1.8 million from pension fund contractors, many of which are out-of-state 5

* In another state, a former state treasurer raised contributions from contractors, one of whom received a five-fold increase in the custody fees it charged. The treasurer’s candidate lost and the contract was terminated by the new treasurer.6

* The Executive Director of the MSRB has been quoted in the Wall Street Journal as saying that “the conflicts of interest in the [public pension business] are as bad as anything we’ve seen in the muni-bond market.7

* An elected state official has told me that she thought that G-37 has resulted in the movement of some pay-to-play activity over to the public pension area. Phone calls from some advisers have confirmed this.

Claims that pay-to-play really isn’t a problem are refuted by the findings of states and plans that have taken on the issue. Vermont and Connecticut have enacted legislation.8 Both were concerned that awards of advisory contracts were being made on the basis of political favoritism rather than expertise. They concluded that even where no actual corruption occurred, the appearance of impropriety was intolerable.

CalPERS has acted in California, and the records of its rulemaking proceeding and subsequent litigation are particularly instructive about how pay-to-play works and its insidiousness.

It is heartening to see some of the plans and jurisdictions putting an end to the culture of pay-to-play. As you know, it takes two to tango, and it takes two to participate in these practices – the payer and the payee. Our concern is with the activities of the payers – investment advisers, whom we regulate under the Investment Advisers Act of 1940.9

The Advisers Act imposes a federal fiduciary duty on advisers with respect to their clients and prospective clients.10

* When the process of the selection of an investment adviser is corrupted, the duties of an adviser to his client are compromised.

* When the selection process is corrupted and advisers are selected based not on their merit but on the amount or their political contributions, the ultimate clients of advisers – the pension pools they manage – are harmed and the benefits of retirees threatened.

A similar harm occurs when advisers are not chosen because they have not made the requisite amount of contributions.

We at the Commission believe that G-37 is working pretty well. And I have to believe, based on the evidence we have collected so far, that the burden will fall on those who argue that the Commission should not apply the core principles of G-37 to investment advisers and the public pension plan area.

We have spoken with your representatives from NASRA, and we have discussed the matter with some of your colleagues. They have described the difficult position in which a professional manager is placed when it becomes apparent that the decision-making process is being skewed by considerations of political contributions. You have a unique perspective from which to help us understand the issues.

I look forward to further discussions with you and look forward to hearing your views.

Thank you.

1 Self-Regulatory Organizations; Municipal Securities Rulemaking Board, Securities Exchange Act Release No. 34-33868 (Apr. 7, 1994).

2Blount v. SEC , 61 F.3d 938 (1995), cert. denied , 517 U.S. 1119 (1996).

3A Sleazy Practice That Costs Taxpayers , San Francisco Chron., Aug. 1, 1997, at A26.

4See Office of Vermont State Treasurer James H. Douglas, If You Play, You Pay: New Campaign Finance Legislation Prohibits Contracts for Wall Street Firms Contributing to State Treasurer Races, a Provision Pushed by Douglas (06/16/97) http://www.state.vt.us/treasurer/press/pr970616.htm.

5 Clifford J. Leavy, Firms Handling N.Y. Pension Fund Are Donors to Comptroller , N.Y. Times, Oct. 3, 1998, at A16)

6See Steve Hemmerick, See You in Court,’ Bank Tells Its Client: State Street Sues over Custody Contract, Pens. & Inv., Feb. 23, 1998, at 2.

7 Charles Gasparino and Jonathan Axelrod, Political Money May Sway Business of Public Pensions , Wall St. J., Mar. 24, 1997, at C1.

8 Conn. Gen. Stat. § 9-333 o (1997); Vt. Stat. Ann. tit. 32, § 109 (1997).

9 15 U.S.C. 80b.

10SEC v. Capital Gains Research Bureau, Inc. , 375 U.S. 180 (1963).

http://www.sec.gov/news/speeches/spch2501.htm

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

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

Securitizing Life Settlement Investments

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New Investment Opportunities for Hedge Funds

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

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

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

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Other articles related to hedge funds and life settlements include:

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

Hedge Fund Investors Asking for More Meaningful Communication

Clients are demanding that investment managers communicate more than just data

The following white paper was released by BK Communications Group, a company which provides outsourced marketing and client communications solutions for the asset management industry. According to a recent survey of institutional hedge fund investors, clients largely prefer that managers take the call for transparency one level further and communicate to them in a meaningful way that explains what they’re doing with the funds. Popular forms of communication adopted by investment firms include pitch-books, websites, and personal contact. According to a report by McKinsey & Co., providing full transparency and enhancing communication efforts can be useful in client retention and future asset gathering.

The executive summary and highlights of the paper is re-printed in full below as well as a link to the paper.

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BKCG White Paper
June 2009
The New Transparency: Words

Clients are demanding that investment managers communicate more than just data

Executive Summary

Transparency has typically been equated with access to data (trade, exposure, valuation, etc.), but the financial crisis and fund scandals have led clients, investors, as well as regulators to demand more. Major surveys and anecdotal evidence indicate communication is now in demand. Clients want managers to put the numbers in context, to explain what they’re doing, to communicate on a clear and meaningful basis. This expanded transparency can help retain clients and strategically position a firm for future asset gathering, both by building a brand associated with full transparency and by ensuring that all touchpoints – from pitchbooks to websites to personal contact – are fully in place and high quality. Investment firms must carefully examine how they currently communicate, decide on any adjustments that must be made, and determine whether they have the internal capabilities and resources to execute on those adjustments.

Highlights

Communication is the new transparency. Data alone is no longer sufficient. Clients want managers to put the numbers in context, to explain what they’re doing, to communicate on a clear and meaningful basis
SEI/Greenwich Associates’ global survey of institutional investors finds investors will “intensify their scrutiny of investment processes” and increasingly emphasize client reporting and communications.
Preqin’s survey of 50 institutional hedge fund investors finds that events of the past 12 months have led 43% of respondents to expect “increased transparency and understandable strategy.”
Providing full transparency can be a way of helping to retain clients and strategically position a firm for future asset gathering. McKinsey & Co’s major report (“The Asset Management Industry in 2010”) concludes that “winning asset managers will be those who forge a superior reputation and capabilities for service and sophisticated advice.”
Communications transparency can be approached strategically, to ensure an investment firm’s brand is associated with openness and clarity, and to establish a reputation for thought leadership, as this is associated with mastery of core competence.
Communications transparency can also be approached tactically by making sure that all touchpoints – from pitchbooks to websites to personal contacts – are fully in place and high quality.
Many investment firms are shedding internal resources that are not profit centers, including communications personnel, or are hesitant to bring on those resources – leaving them without the necessary skills, or bandwidth, for an appropriate level of communications.

For the full report, please see BKCG Transparency White Paper

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

Hedge Fund Operational Issues and Failures

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Hedge Fund Due Diligence Firm Releases White Paper

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

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

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

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

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

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

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

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

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

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

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

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

About Castle Hall Alternatives

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

Contacts

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

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Other related hedge fund law and start up articles include:

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

Series 79 Exam Available November 2, 2009

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FINRA Announces Date of First Series 79 Exam

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

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

Series 79 Overview

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

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

FINRA’s Stated Exam Purpose

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

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

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

Start a Hedge Fund in the Cayman Islands

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How to Set Up a Cayman Islands Hedge Fund

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

Why the Cayman Islands?

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

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

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

Does Every Hedge Fund Have to be Registered with CIMA?

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

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

What are the CIMA Hedge Fund Registration Requirements?

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

2. Preparation of the fund’s Offering Document.

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

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

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

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

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

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

What Are the Costs for CIMA Registered Funds?

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

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

Article Written by Michelle Richie

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

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

Hedge Funds and Bloomberg

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Many hedge fund managers were introduced to the Bloomberg terminal when they began their trading careers. The terminal, with its iconic user interface which has changed only by small increments over time, can be found in most large asset management companies as well as in smaller groups like family offices, fund of hedge funds, hedge funds and even single manager investment advisory firms. The breadth and depth of the Bloomberg services may be matched by other similar financial information and news services (like Thompson/Reuters), but managers and traders seem to be drawn to the Bloomber services nonetheless. Below is an overview of information we compiled on the Bloomberg services – please feel free to share any thoughts in the comments below.

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Bloomberg Terminal Information Overview

What is Bloomberg?

The Bloomberg terminal is a computer system that enables financial professionals to access the Bloomberg Professional service through which users can monitor and analyze real-time financial market data movements and place trades. The system also provides news, price quotes, and messaging across its proprietary and secure network. Most large financial firms have subscriptions to the Bloomberg Professional service, and many exchanges charge their own additional fees for access to real-time price feeds across the terminal.

What services does Bloomberg offer?

Bloomberg offers financial professionals access to a top-of-the-line financial, regulatory, and market database. The system is of particular benefit to investors, as it allows them to simultaneously:

access, process, and store information on the companies they wish to monitor;
teleconference with colleagues around the world; and
monitor the relationship between domestic and foreign currencies.

The activities for which Bloomberg users most commonly subscribe to the service include, but are not limited to:

Earnings Estimates
Analyst Recommendations
Related Securities
Various graphs of a company’s stock price
Stock screening search: Search for equities based on user-defined criteria
Corporate Actions: Calendar of events that might impact markets
Corporate actions of a specific company
Broad information on U.S. Treasury and Money Markets
U.S. Economic surveys and releases
Mergers & Acquisitions Home Page
Current news and deals

Bloomberg Mobile, which is a free mobile application for iPhone and Blackberry users, doesn’t offer quite the same level of functionality as the full Bloomberg terminal, but it is a beautifully designed app that provides up-to-the-minute news, stock quotes, company descriptions, and price chart and market trend analysis. The My Stocks feature is a more detailed replacement for Apple’s Stocks app. Additionally, Bloomberg Mobile takes full advantage of the iPhone’s position sensor by providing larger charts when you rotate the phone to a horizontal position.

The Bloomberg Platform & Equipment

The Bloomberg terminal implements a client-server architecture with the server running on a multiprocessor UNIX platform. Although the look and feel of the Bloomberg keyboard is very similar to the standard computer keyboard, there are several enhancements that help a user navigate through the system. Originally a self-contained operating system running on custom hardware, the Bloomberg Terminal now functions as an application within the Windows environment. There are essentially three levels to the system:

(1) The Core Terminal:

This is the original system, consisting typically of 4 windows, each containing a separate instance of the terminal command line. By entering tickers and functions, data can be displayed and programs run to analyze it. This seemingly large number of windows allows users to call up several entirely different sets of data, and compare it quickly; for those users who have more than one computer display, each terminal window can be assigned independently, creating, in effect, four terminals.

(2) The Launchpad:

Launchpad is a customizable display consisting of a number of smaller windows, called ‘components’, each of which is dedicated to permanently displaying one set of data. A typical user would be a stockbroker who wishes to keep a list of 30 stocks visible at all times: Launchpad creates a small component which will show these prices constantly, saving the broker from having to check each stock independently in the terminal. Other functions, such as email inboxes, calculation tools and news tickers can be similarly displayed. The Instant Bloomberg messaging/chat tool is another Launchpad component that allows brokers to communicate instantly with other Bloomberg users.

(3) Application Programming Interface:

The final level of the Bloomberg system is the ability to export data from the terminal to 3rd party applications, such as Microsoft Excel. A user might wish to use Bloomberg data from the terminal to create his or her own calculations; by exporting the live data into another program, they can build these formulae. Bloomberg supports this through a range of add-ins which are packaged with the terminal software.

How much does Bloomberg cost?

While Bloomberg offers a great variety of services, it is relatively expensive. Monthly rates can be as high as $1,500 – $1,800 per month. However, as Bloomberg saw a decline in revenue over 2007 and 2008, it is to be expected that the rates will come down by the end of 2009. Although Bloomberg has become an institutional cornerstone in the finance world, leading competitors for electronic financial data provision include Thomson/Reuters, Morgan Stanley, FactSet Research Systems, Jackson Terminal, Advantage Data Inc., Fidessa and Dow Jones.

Conclusion

Bloomberg Terminal currently caters to more than 300,000 users worldwide, and is highly regarded by financial professionals as a powerful data-warehouse for institutional investors. Since the relatively high ongoing cost makes it unfeasible for individual investors with relatively small amounts of capital to purchase, the product targets a unique subsector of investors with the purchasing power to enjoy the benefits of comprehensive access to the financial marketplace.

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

Hedge Fund Hotels

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Office Space, IT, Trading For Start up Hedge Funds

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

Issues with Hedge Fund Hotels

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

Hedge Fund Hotel Controversy

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

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

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

Page 2-3 of the complaint

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

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

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

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

Page 9 of the complaint

Conclusion

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

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

Prime Brokers, Margin Lock-ups & Hedge Funds

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Today we have another guest post from Karl Cole-Frieman who specializes in providing legal advice to hedge funds and other alternative asset managers. Mr. Cole-Frieman specializes in Loan Trading and Distressed Debt Transactions, ISDAs, Soft Dollars and Commission Management arrangements, and Wage and Hour Law Matters among other legal matters which hedge fund managers face on a day to day basis.

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The Margin Lock-up Returns to Prime Brokerage
By Karl Cole-Frieman, www.colefrieman.com

In 2009, the problems affecting major banks have also impacted their prime brokerage units, and accordingly there is less appetite to extend credit to hedge funds. As the banking industry recovers, however, credit terms are beginning to loosen up again. As a result, we are beginning to see the return of the margin lock-up for larger prime brokerage clients, who may in fact be in a stronger bargaining position for such agreements than they were a year ago.

What is a Margin Lock-up or Term Commitment?

In the most basic terms, a “margin lock-up” or a “term commitment” is a credit facility extended by a prime broker to a hedge fund or other institutional client. The terms are used interchangeably in the industry. Margin lock-ups prevent the prime broker from changing margin rates, collateral requirements, and often from declining to clear the hedge fund’s trades during the term of the lock-up. For large managers, they are often 90 days, but can range from 30 days to 120 days, and perhaps even longer for the largest hedge fund managers. Practically speaking, the way the arrangement works is that if a prime broker wants to make a change covered by the margin lock-up, they will provide the manager with the requisite notice before doing so.

Margin Lock-ups and Prime Brokerage Agreements

A margin lock-up is negotiated separately from a prime brokerage agreement, but ideally the two agreements are negotiated at the same time. Our experience has been that it is significantly more difficult to negotiate a margin lock-up after the prime brokerage relationship has been established, and that a fund’s greatest negotiating leverage is before signing the prime brokerage agreement.

Negotiating a Margin Lock-up

There are two significant points to negotiate in a margin lock-up: (1) the scope of the commitment (and exclusions), and (2) the termination events. For the scope of the commitment, it is essential that the commitment includes clearing trades. Remember that a prime brokerage arrangement is a demand facility, and the prime broker can normally decide to stop clearing a hedge fund’s trades at any time and for any reason. This is potentially highly disruptive, and could result in significant losses for a fund. If clearing trades are covered by the margin lock-up, the prime broker will have to provide the requisite notice, which will allow time to make alternative arrangements with other counterparties.

Termination Events and Margin Lock-ups

Termination events can be very contentious in a margin lock-up negotiation. The termination events in a margin lock-up give the prime broker the right to terminate the margin lock-up if a certain event occurs. The prime brokers will want to negotiate off of their templates, which will initially have so many termination events it would make the margin lock-up worthless. Managers should be wary of a completely subjective termination event, and such provisions should be negotiated out of the agreement. For example, some prime brokers will try to insist on including a provision that it will be a termination event if the prime broker determines that it would cause the prime broker reputational risk to continue to do business with the fund. More typical termination events include NAV triggers and key person provisions.

Bilateral Termination Events are a Secondary Consideration

Some hedge fund lawyers advocate that the termination events in a margin lock-up should not be completely unilateral, meaning, for example, that the credit rating of the prime broker should be a termination event. We view this as a secondary consideration, and not a point to get bogged down on in the negotiation. If a manager is concerned about the credit rating of the prime broker, they can simply move their balances. They don’t need to terminate the lock-up – leave it in place in case the fund restores balances with that prime broker.

To find out more about margin lock-ups and other topics relating to prime brokerage or custody, please contact Karl Cole-Frieman of Cole-Frieman & Mallon LLP (www.colefrieman.com) at 415-352-2300 or [email protected].

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If you are thinking of starting a hedge fund, please contact Mr. Bart Mallon, Esq. at 415-296-8510. Other related hedge fund law and start up articles include: