Category Archives: Business Issues

SEC Action Against Manager for Related Party Transactions

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While this happened in the middle of last year, we thought it might be helpful to managers to review this particular case especially as registered investment advisers are currently in the process of updating Form ADV.

Overview of Case

On June 21, 2012, the SEC filed in action in the US District Court for the Northern District of California against Mark Feathers (“Feathers”) and Small Business Capital Corp. (“SB Capital”), Investors Prime Fund (“IPF”), and SBC Portfolio Fund (“SPF”). The SEC alleges that Feathers and SB Capital made material misrepresentations and omissions regarding both IPF’s and SPF’s investment activities. Feathers and SB Capital also allegedly violated broker-dealer registration provisions and created fraudulent management fees.

The SEC alleges Feathers and SB Capital used a Ponzi-like scheme to pay returns to investors. SB Capital allegedly misrepresented the portfolios of the funds at issue, the funds’ lending standards, the nature of the funds’ loans, and the existence of conflicts of interest between SB Capital and the funds. These misrepresentations appeared in advertisements in California publications, newsletters, and offering documents. In addition, SB Capital allegedly made transfers between IPF and SPF to increase management fees. Finally, the SEC claims that SB Capital never registered as a broker-dealer.

The SEC asserted causes of action under Section 17(a) of the Securities Act (prohibiting fraudulent interstate transactions), Section 10(b) of the Exchange Act and related rules (prohibiting the use of manipulative and deceptive devices in the buying and selling of securities); Section 15(a) of the Exchange Act (prohibiting unregistered broker-dealers from inducing the trading of securities); and Section 20(a) of the Exchange Act (creating liability for the person in control of an entity which violates Section 15(a) of the Exchange Act).

The SEC’s complaint is available here.

Takeaways for Managers

The alleged conduct included the following:

  • Never registering with the SEC as a broker-dealer.
  • Representing that the funds’ returns would be 7.5% per year;
  • When returns did not meet that threshold, using money from new investors to make up the difference;
  • Failure to disclose the use of investor money to pay SB Capital’s day-to-day expenses, conduct that was in direct conflict with materials provided to investors;
  • Stating that the funds would not make loans to SB Capital, when in fact they did;
  • Mischaracterizing the funds’ loan portfolios as secured, when in fact they were not;
  • Misrepresenting the audit procedures in place;
  • Causing IPF to purchase loans at a premium from SPF to generate management fees; and
  • Assuring investors SB Capital owed them a fiduciary duty, even though Feathers and SB Capital would cause the funds to engage in related party transactions to generate management fees.

The bottom line:

  • Broker-dealers should register with the SEC to avoid liability under Section 15(a) of the Exchange Act;
  • Be honest about the nature of the funds you manage, including the portfolios of the funds, the kinds of transactions the funds engage in, and how returns operate;
  • Be upfront with investors about potential conflicts and related party transactions; and
  • Take care that the materials you provide investors are accurate.

Conclusion

On the most basic level, Small Business Capital Corp. represents a warning to managers to not engage in fraudulent or exploitive conduct like taking advantage of conflicts of interest and related party transactions. More generally, it is a good reminder that providing truthful information to investors is paramount. The SEC approaches the anti-fraud provisions of the securities laws broadly. We recommend that managers have their attorney, in-house counsel or compliance consultant review all materials meant for distribution prior to distributing them, and that managers retain these materials and backup information in their files.

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Cole-Frieman & Mallon LLP provides a full suite of legal and advisory services to hedge fund managers and the investment management industry.  Bart Mallon can be reached directly at 415-868-5345.

BEA Reporting for Fund Managers: the SEC is not the only regulator gathering investment-related data.

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Background on the U.S. Department of Commerce, Bureau of Economic Analysis (“BEA”).

The BEA collects data on U.S. direct investment abroad, among other mandates. Its tools include Form BEA-11 (“BEA-11”) for U.S. persons that have ownership interests in foreign affiliates. Historically, these filings received almost no attention. Enforcement of the filing requirements was rare, but is expected to increase following the BEA’s announcement in May of 2012 that it would be more vigilant.  [Note: Enforcement penalties include civil and criminal fines and even imprisonment for failure to file.]

BEA-11 is due annually by May 31 for those who meet a two-pronged test. The filing is confidential and requires data points on employees, assets, expenses, share/interest structure and other financial information (much of it, such as imports and exports will be inapplicable to most fund managers).

Do I have to file?

The filing requirement is most likely to apply to larger U.S. fund managers (the term “Manager” includes U.S. managers, their principals, and any affiliated U.S. entities) that have full master-feeder structures, offshore blocker entities or other special purpose vehicles. The following events trigger a filing:

  • Meeting the below test, regardless of whether a Manager has been contacted by the BEA; or
  • If a Manager receives a letter from the BEA, it must either file if it meets the test, or submit a Claim of Not Filing (“Claim”). NB: A Claim is only required if the Manager is contacted by the BEA. Because the Claim contains much of the same information as required on BEA-11, we would not recommend filing it preemptively.

The First Prong – Reporting Thresholds:

Reporting is not required with respect to offshore affiliates where:

  • none of the following (each, an “Exemption Item”) exceeded $60 million for the offshore affiliate’s most recent fiscal year: (a) total assets, (b) sales or gross operating revenues excluding sales taxes and (c) net income (or loss) after provision for foreign income taxes; OR
  • the U.S. person’s interest in the offshore affiliate was acquired or established in the most recent fiscal year, and none of the Exemption Items exceeded $25 million for the affiliate’s most recent fiscal year.

The $60 million and $25 million thresholds are referred to as “Reporting Thresholds.”

The Second Prong – Ownership Level:

Filing is required of U.S. persons that own or control, directly or indirectly, 10 percent or more of an offshore affiliate’s voting securities (or equivalent). Consider the following examples (see note below):

  • Offshore Limited Partnerships (“LPs”): generally, LP interests in a master fund are structured as non-voting. Accordingly, its feeders would not be U.S. reporters. In contrast, the fund’s general partner would be considered to own 100 percent of its voting securities, and would be a U.S. reporter.
  • Offshore Companies: voting rights will vary depending on the share class in question. A company that has one class of shares, all with voting rights, may provide enough dilution such that a Manager owns less than 10% of total shares. On the other hand, it is common to issue one class of voting shares to the Manager, and another class of non-voting shares to outside investors (similar to the structure of a LP). In such a case, the Manager would be a U.S. reporter.

[Note: While these examples will be helpful in identifying potential reporters within your structure, we recommend reviewing your offshore entities’ constituent documents to determine the nature of any voting interests and related provisions.]

Putting It All Together:

Remember that both prongs must be met to trigger the filing. We suggest starting your analysis by determining the amount of your AUM attributable to offshore affiliates (“Offshore AUM”); if it is less than the $60 million Exemption Item for total assets, it is likely that the offshore affiliates would be under the Exemption Items for income and revenue (i.e., performance gains or other income, if any) as well. If your Offshore AUM exceeds $60 million, proceed to the rest of the analysis to determine whether a filing is required.

Disclosure and Reporting Requirements Continue to Evolve.

Post-crisis, we have seen an increase in disclosure and reporting requirements, particularly for larger fund managers. BEA reporting highlights the fact that regulators other than the SEC collect data and can penalize those who do not file. We encourage you to stay in touch with your outside counsel, compliance consultants and other service providers who can keep you apprised of regulatory developments.

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Cole-Frieman & Mallon LLP is a boutique hedge fund law firm focused on providing hiqh quality counsel for the investment management industry.  Bart Mallon can be reached directly at 415-868-5345.

Cole-Frieman & Mallon LLP 2012 End of Year Checklist

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Below is our end of year checklist we send out to our mailing list.  If you would like to be added to the mailing list, please contact us here.

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December 14, 2012

Clients and Friends:

December is the busiest month of the year for most hedge fund managers. In addition to all of the administrative details involved in closing out the year, the regulatory landscape has shifted dramatically over the past year. As a result, year-end processes and 2013 planning are particularly important, especially for General Counsels, Chief Compliance Officers and key operations and financial personnel. We have updated our own year-end checklist to help managers stay on top of these priorities.

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Adviser Registration:

Form ADV Annual Amendment. Registered investment advisers, or managers filing as exempt reporting advisers (an “ERA”), with the SEC or a state securities authority must file an annual amendment to Form ADV within 90 days of the end of their fiscal year. Registered investment advisers must provide a copy of the updated Form ADV Part 2A brochure and Part 2B brochure supplement (or a summary of changes with an offer to provide the complete brochure) to each “client”. Note that for private fund managers, a “client” for purposes of this rule is the fund.

Switching to/from SEC Regulation.

SEC Registration. Managers who no longer qualify for SEC registration as of the time of filing the annual amendment must withdraw from SEC registration within 180 days after the end of their fiscal year by filing Form ADV-W. Mangers should consult their state securities authority to determine if they are required to register in the state. Managers who are required to register with the SEC as of their annual amendment must register with the SEC within 90 days of filing the annual amendment.

Exempt Reporting Advisers. Managers who no longer meet the definition of an ERA will need to submit a final report as an ERA and apply for registration with the SEC or the state securities authority, if necessary, generally within 90 days after the filing of the annual amendment.

California Private Fund Adviser Exemption. The California private fund adviser exemption (“Private Fund Adviser Exemption”) is available to advisers who provide advice solely to “qualifying private funds,” which include venture capital funds, Section 3(c)(1) funds and Section 3(c)(7) funds. Advisers who qualify for the Private Fund Adviser Exemption and manage less than $100 million can file as an ERA in California and avoid registration and compliance requirements.

CFTC Matters:

Expanded CFTC Regulation. As of October 12, 2012 an investment manager that trades certain swaps will be subject to regulation by the CFTC, even if the manager does not trade futures or commodity interests. Managers should review the recently expanded list of CFTC regulated products to determine whether they will be subject to CFTC regulation. Managers subject to CFTC regulation will need to evaluate whether they are eligible for an exemption or need to register with the CFTC by December 31, 2012.

Annual Re-Certification of CFTC Exemptions. CPOs and CTAs currently relying on exemptions from registration with the CFTC will be required to re-certify their eligibility by December 31, 2012. CPOs currently relying on CFTC Regulation 4.13(a)(3) will need to evaluate whether the commodity pool is still eligible for the exemption when taking into account the new CFTC regulated products. Managers who had previously relied on the 4.13(a)(4) exemption from CPO registration will need to determine whether they are eligible to rely on another exemption or will need to register with the CFTC by December 31, 2012.

CPO and CTA Annual Updates. Registered CPOs and CTAs must prepare and file Annual Questionnaires and Annual Registration Updates with the NFA, as well as submit payment for annual maintenance fees and NFA membership dues. Registered CPOs must also prepare and file an annual report for each commodity pool. Unless eligible to claim relief under Regulation 4.7, registered CPOs and CTAs must update their disclosure documents periodically, as they may not use any document dated more than 9 months prior to the date of its intended use. Disclosure documents that are materially inaccurate or incomplete must be promptly corrected and the correction must be promptly distributed to pool participants.

General Regulatory Matters:

New Issue Status. On an annual basis, a manager needs to confirm or reconfirm the eligibility of investors that participate in initial public offerings or new issues. Most managers reconfirm this via negative consent, i.e., investors are informed of their status as on file with the manager and asked to inform the manager of any changes. No response operates as consent to the current status.

ERISA Status. Given the significant problems that can occur from not properly tracking ERISA investors, we recommend that managers also confirm or reconfirm on an annual basis the ERISA status of its investors. This is particularly important for managers that track the underlying percentage or ERISA funds for each investor. This reconfirmation can also be obtained through a negative consent.

Annual Privacy Policy Notice. On an annual basis, a registered investment adviser must also provide its investors with a copy of its privacy policy, even if there are no changes to the policy.

Annual Compliance Review. On an annual basis, the Chief Compliance Officer (“CCO”) of a registered investment adviser must conduct an annual review of the manager’s compliance policies and procedures. This annual compliance review should be in writing and presented to senior management. We recommend that you discuss the annual review with your outside counsel, who can provide guidance about the review as well as a template for the assessment and documentation. Managers should be careful that sensitive conversations regarding the annual review are protected by attorney-client privilege. CCOs may also want to consider additions to the compliance program. Managers who are not registered may still wish to review their procedures and/or implement a compliance program as a best practice.

Trade Errors. Managers should make sure that all trade errors are addressed by the end of the year pursuant to the manager’s polices regarding trade errors. Documentation of trade errors should be finalized, and if the manager is required to reimburse the funds, it should do so by year-end.

Soft Dollars. Managers that participate in soft dollar programs should make sure that they have addressed any commission balances from the previous year.

Custody Rule Annual Audit. SEC registered advisers must comply with certain custody procedures, including (i) maintaining client funds and securities with a qualified custodian; (ii) having a reasonable basis to believe that the qualified custodian sends an account statement to each advisory client at least quarterly; and (iii) undergoing an annual surprise examination conducted by an independent public accountant.

Advisers to pooled investment vehicles may avoid both the quarterly statements and surprise examination requirements by having audited financial statements prepared in accordance with GAAP by an independent public accountant registered with the Public Company Accounting Oversight Board. Statements must be sent to the fund or, in certain cases, investors in the fund, within 120 days after the fund’s fiscal year end. Managers should review their custody procedures to ensure compliance with the rules. Requirements for state-registrants may differ, and we encourage you to contact us if you have any questions or concerns about your custody arrangements.

Schedule 13G/D and Section 16 Filings. Managers who exercise investment discretion over accounts (including funds and separately managed accounts) that are beneficial owners of 5% or more of a registered voting equity security must report these positions on Schedule 13G. Schedule 13G filings are updated annually within 45 days of the end of the year. For managers who are also filing Schedule 13D and/or Section 16 filings, this is an opportune time to review your filings to confirm compliance and anticipate needs for Q1.

Form 13F. A manager must also file a Form 13F if it exercises investment discretion with respect to $100 million or more in certain securities within 45 days after the end of the year in which the manager reaches the $100 million filing threshold. The SEC lists the securities subject to 13F reporting on its website.

Form 13H. Managers who meet the SEC’s large trader thresholds (in general, managers whose transactions in exchange-listed securities equal or exceed two million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month) are required to file an initial Form 13H with the SEC within 10 days of crossing the threshold. Large traders will need to file amended annually within 45 days of the end of the year. In addition, changes to the information on 13H will require interim amendments following the calendar quarter in which the change occurred.

Blue Sky Filings. On an annual basis, a manager should review its blue sky filings for each state to make sure it has met any renewal requirements. States are increasingly imposing late fees or rejecting late filings altogether. Accordingly, it is critical to stay on top of filing deadlines for both new investors and any renewals.

SEC Form D. Form D filings for most funds need to be amended on an annual basis, on or before the anniversary of the initial SEC Form D filing. Copies of Form D can be obtained by potential investors via the SEC’s website.

IARD Annual Fees. Preliminary annual renewal fees for state registered and SEC registered investment advisers were due by December 13, 2012. Managers filing after the deadline will likely be subject to additional late filing fees and these must be paid through the IARD by February 1, 2013.

Pay-to-Play Rules. In 2010, the SEC adopted Rule 206(4)-5, which disqualified investment advisers, their key personnel and placement agents acting on their behalf, from seeking to be engaged by a governmental client if they have made political contributions. State and local governments are following suit, including California, which requires such persons to register with the state as lobbyists and mandates lobbyist registration in California’s cities and counties. We recommend reviewing your reporting requirements to make sure you are in compliance with the rules.

Form PF. Managers to private funds that are either registered with the SEC or required to be registered with the SEC began filing Form PF earlier this year. Managers to private funds with less than $5 billion in regulatory AUM will need to make Form PF filings with the SEC beginning on December 15, 2012, on either a quarterly or annual basis, depending on the types of private funds managed and regulatory AUM.

Foreign Tax Compliance Act (“FATCA”). FATCA will require certain financial institutions to identify and disclose direct and indirect U.S. investors and withhold U.S. income tax on nonresident aliens and foreign corporations, or be subject to a 30% FATCA tax. Foreign financial institutions, which include hedge funds, funds of funds, commodity pools and other offshore investment vehicles, will be required to enter into an agreement with the IRS (an “FFI Agreement”) by January 1, 2014 to avoid being subject to the FATCA tax. Domestic funds will also be required to determine the FATCA status of their investors and will need to institute specific withholding and reporting procedures for recalcitrant investors. Managers should discuss FATCA compliance methods with their administrators and other third party service providers to ensure proper document collection and due diligence procedures. Managers may want to update their documents to include FATCA disclosure and representations.

Jumpstart Our Business Startups Act (“JOBS Act”). The JOBS Act, enacted earlier this year, directed the SEC to remove the prohibitions on general solicitation or general advertising for certain private securities offerings. The proposed rule amendments, which are still awaiting final approval by the SEC, would allow issuers to use general solicitation and general advertising to offer securities, provided that the issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors. Managers should remember that while general solicitations may be allowable in the future, these rules are not yet final. In addition, all registered investment advisers will still be subject to applicable advertising regulations under the Investment Advisers Act. CFTC registered managers are still subject to certain CFTC regulations that prohibit marketing to the public, and managers that intend to rely on the 4.13(a)(3) “de minimus” exemption (discussed above) are also prohibited from marketing to the public.

Other Fund Matters:

Wash Sales. Managers should carefully manage wash sales for year end. Failure to do so could result in embarrassing book/tax differences for investors. Certain dealers can provide managers with swap strategies to manage wash sales, including Basket Total Return Swaps and Split Strike Forward Conversion. These strategies should be considered carefully to make sure they are consistent with the investment objectives of the fund.

Redemption Management. Managers with significant redemptions at the end of the year should carefully manage the unwinding positions so as to minimize transaction costs in the current year (that could impact performance), and prevent transaction costs from impacting remaining investors in the next year. When closing funds or managed accounts, managers shall pay careful attention to the liquidation procedures in the managed account agreement and the fund constituent documents.

NAV Triggers and Waivers. Managers should promptly seek waivers of any termination events that may be triggered by redemptions, performance or a combination of redemptions and performance in a fund’s ISDA or other counterparty agreement at the end of the year (NAV declines are typically included in these provisions).

Fund Expenses. Managers should wrap up all fund expenses for 2012 if they have not already done so. In particular, managers should contact their outside legal counsel to obtain accurate and up to date information about legal expenses for inclusion in the NAV for year-end performance.

Management Company Issues:

Management Company Expenses. Managers who distribute profits on an annual basis should attempt to address management company expenses in the year they are incurred. If ownership or profit percentages are adjusted at the end of the year, a failure to manage expenses could significantly impact the economics of the partnership or the management company.

Employee Reviews. An effective annual review process is important to reduce employment related litigation and protect the management company in the event of such litigation. Moreover, it is an opportunity to provide context for bonuses, compensation adjustments, employee goals and other employee-facing matters at the firm. It is not too late to put an annual review process in place.

Compensation Planning. In the hedge fund industry, and the financial services industry in general, the end of the year is the appropriate time to make adjustments to the compensation program. Since much of a manager’s revenue is tied to annual income from incentive fees, any changes to the management company structure, affiliated partnerships, or any shadow equity program should be effective on the first of the year. Make sure that partnership agreements and operating agreements are appropriately updated to reflect such changes.

Insurance. If a manager carries D&O Insurance or other liability insurance, the policy should be reviewed on an annual basis to make sure that the manager has provided notice to the carrier of all claims and all potential claims. Also, newly launched funds should be added to the policy as appropriate.

Please feel free to reach out to us if you have any questions regarding your end-of-the-year compliance. We wish you all the best as 2012 comes to a close.

Sincerely,

Karl Cole-Frieman & Bart Mallon

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Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP has an international practice that services both start-up investment managers as well as multi-billion dollar firms. The firm provides a full suite of legal services to the investment management community, including: hedge fund, private equity fund, and venture capital fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters. The firm also publishes the prominent Hedge Fund Law Blog (www.hedgefundlawblog.com) which focuses on legal issues that impact the hedge fund community. For more information please visit us at: www.colefrieman.com.

Hedge Fund Seed Deals Overview

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Seed Capital Arrangements for Hedge Fund Managers

We receive numerous inquiries from new managers seeking capital sources in today’s challenging financial climate. Recent regulatory changes have increased legal and compliance costs associated with launching a hedge fund and many smaller investors are wary to invest with first time managers, despite their potential to generate alpha. One way emerging managers can secure the much needed capital is via a “seed deal” whereby a seed capital provider (the “Seeder”) makes a significant capital investment (the “Investment’) in the manager’s fund (the “Fund”) in exchange for a share of the management fees and/or incentive fees. In addition to providing the manager with start-up operating and investment capital, the manager gets additional credibility with prospective investors. This article will summarize some of the basic terms involved in seed deals, as well as a number of issues a manager should consider. Please note that each seed deal is unique and a manager should work with experienced counsel to negotiate the appropriate terms.

Seed Deal Basics

Investment.

The amount of Investment can range greatly, the initial funding can be as much as $150 million

or as little as $1 million depending on a variety of factors.

Lock-Up Period.

Depending on the size of the Investment and other negotiated terms, the Seeder will generally commit keep the Investment in the Fund for a period 2 to 4 years, subject to certain early withdrawal rights, including but not limited to:

    • Violation of proscribed investment guidelines;
    • Decline of Investment by a certain percentage;
    • Misconduct by the manager or its principals;
    • Key man provisions or change of control; and
    • Reaching a certain AUM threshold.

Share of Revenues.

In exchange for the Investment, the Seeder receives a percentage of the manager’s revenues (including management fees and/or incentive fees) lasting in perpetuity or for a specified term. This arrangement is usually accomplished in one of two ways:

1. Equity Interest: The Seeder receives a direct equity interest in the management entity and typically receives revenues “net” of expenses. In this type of deal, the Seeder will generally require limitations or consent for expenses.

2. Fee Sharing Agreement: The Seeder enters into a profit/fee sharing agreement with the manager whereby the Seeder will be entitled to a portion of the management and/or incentive fees received by the manager. Fee sharing agreements have been more common as they offer greater freedom for the manager to operate its business. In this type of arrangement, the fees will generally be calculated on a gross basis. The actual sharing percentage varies depending on the amount of the Investment; however, amounts from 15 to 30% are common.

Seeder Rights and Obligations

Depending on the size of the Investment, the Seeder may obtain certain special rights, including but not limited to:

  • Access to Fund records and accounts, including “side letters” with other investors;
  • Portfolio transparency;
  • Most Favored Nation treatment;
  • Capacity rights
  • Right of first refusal on launch of subsequent funds, service providers or corporate events;
  • Management and oversight rights, including budget approval, fund terms, investment guidelines and restrictions;
  • Special liquidity terms;
  • Notification of significant matters and periodic meetings with principals of the manager.

The Seeder may agree to serve on an advisory committee for the manager, assist in the marketing of the Fund, and/or provide office space or other specified services to the manager.

Fund Manager Obligations

Depending on the size of the Investment, the manager may agree to additional obligations, including but not limited to:

Principal Investment

Principals of the manager agree to make and maintain a certain investment in the Fund, and may be required to re-invest a portion of received inventive allocation.

Revenue Share of All Fees

The fee sharing agreement will include all fees the manager receives from its investment management related activities (including other funds or managed accounts managed by the manager).

Non-Compete/Non-Solicitation

Principals of the manager will be prohibited from forming other management companies or funds for a period of time and may agree to a specific time commitment. In addition, the principals will agree to not solicit other employees of the manger or the Seeder for a period of time after they leave.

Representations, Warranties and Covenants

The manager will be required to make certain representations, warranties and covenants relating to regulatory and compliance issues.

Indemnification

The Seeder will usually be fully indemnified by the manager against losses arising out of the seed agreement or the investment in the Fund or any Fund document.

Additional Considerations

When contemplating entering into a seed deal arrangement, the manager should also consider the following:

Buyout Rights

The manager may request the right to buyout (in whole or in part) the Seeder’s interest in the Fund, after a specified number of years or upon receiving a certain amount of fees. The buyout price can be determined ahead of time and is generally determined by a formula based on Investor receiving a certain amount of fees or a certain rate of return on the Investment.

Put Rights

Similar to the above, the Seeder may also request the right to sell its interest back to the manager.

Tag Along Rights

In the event of a sale of the manager, the Seeder may request a provision that would require the purchaser to also buy out the Seeder’s interest in the manger on a pro rata basis.

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Cole-Frieman & Mallon LLP is an investment management law firm focused on established and emerging hedge fund managers. If you have questions about hedge fund seed deals, please contact us.

 

FATCA Implications for Hedge Funds

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Foreign Account Tax Compliance Act Overview

The Foreign Account Tax Compliance Act (“FATCA”) was enacted by Congress as part of the HIRE Act of 2010. FATCA will become effective on January 1, 2013 and some parts of the act will be applicable to investment managers. The primary objective behind FATCA is to combat tax evasion by making it difficult for U.S. persons to hide income and assets overseas. To accomplish this objective, the new regulations will require financial institutions to identify and disclose direct and indirect U.S. investors and withhold U.S. income tax on nonresident aliens and foreign corporations. Foreign financial institutions, and certain onshore entities, will be required to comply with the new disclosure and tax withholding requirements or be subject to a 30% FATCA tax. While proposed regulations and applicable forms have yet to be finalized, investment managers should be prepared for the new FATCA regime and compliance rules.

Application to Investment Funds

Non-U.S. Funds

Foreign financial institutions (each, an “FFI”), which include hedge funds, funds of funds, commodity pools and other offshore investment vehicles, will be required to enter into an agreement with the IRS (“FFI Agreement”) to avoid being subject to the FATCA tax. Each FFI will be required to:

  • obtain, verify and report information on its direct and indirect U.S. investors pursuant to specific due diligence procedures;
  • perform annual reporting;
  • deduct and withhold 30% from any payment made by the fund to U.S. investors refusing disclosure and non U.S. investors without proper FATCA documentation; and
  • comply with requests for additional information.

U.S. Funds

Domestic funds will need to determine the FATCA status of each of their investors and will be subject to new due diligence and reporting obligations for current and new investors. In addition, U.S. funds will be required to deduct and withhold a 30% FATCA tax from investors who do not provide the required documentation.

FATCA Timeline

The current timeline for FATCA compliance is as follows (however dates may change as regulations are finalized):

  • FFI Agreement – FFIs will be able to enter into an FFI Agreement through an IRS online system starting on January 1, 2013 (but no later than June 30, 2013).
  • Reporting Obligations – due diligence and reporting requirements under FATCA will be implemented in a staggered manner, based on an investor’s account balance, beginning on January 1, 2013. IRS plans to release new tax forms in the next few months.
  • Withholding Obligations – the 30% FATCA tax will be implemented in a staggered manner, beginning on January 1, 2014 and will eventually include interest, dividends and other FDAP (fixed, determinable, annual, periodic) income from U.S. sources, gross proceeds from sale of U.S. securities and foreign pass-through payments.

Next Steps

As we mentioned previously, final regulations have not been promulgated. However, when they are, managers will need to do the following:

  1. Review and update fund offering documents and other investor agreements to disclose additional reporting obligations imposed by FATCA and risk of withholding for “recalcitrant investors” (those investors who choose not to disclose their name to the IRS).
  2. Asses fund structure and identify entities that may be affected by new FATCA regime.
  3. Work with third-party service providers to ensure proper registration and compliance once FATCA rules are finalized, including: (a) investor due diligence and documentation; (b) FFI Agreement; and (c) FATCA withholding.

If you have questions about the new FATCA requirements and how they impact your fund, please contact us directly.

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Cole-Frieman & Mallon LLP, an investment management law firm which provides legal services to the hedge fund industry. Bart Mallon can be reached directly at 415-868-5345.

Hedge Fund Schedule K-1 Update

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New IRS Procedure Allows Partnerships to Electronically Deliver Schedule K-1s to Investors

Effective February 12, 2012, a new IRS Revenue Procedure allows partnerships to exclusively deliver electronic Schedule K-1 Statements (“K-1s”) instead of paper statements. In order to send electronic K-1s, a partnership (such as a hedge fund) must follow certain steps and obtain each partner’s consent. Many fund managers either have or will want to go through the process of switching to electronic K-1s. This post will provide more information on how to complete the process and managers should also feel free to contact us if there are additional questions.

Switching from Paper to Electronic K-1s

Provided that the electronic K-1 is an exact copy of the official Schedule K-1 and the partnership follows the procedures in the revenue procedure above, a partnership does not need to gain the approval of the IRS before switching to electronic K-1s. However, a partnership should be careful to comply with the requirements of the revenue procedure because a failure to do so could be deemed a failure to furnish a Schedule K-1 to partners possibly triggering penalties under Revenue Code Section 6722.

In general, a partnership must (1) provide certain disclosures, (2) obtain each partner’s consent in a manner that demonstrates that such partner has access to the technology required to access the electronic K-1, and (3) follow certain policies and procedures detailed in the revenue procedure.

1. Required Disclosures

When obtaining a partner’s consent the partnership must disclose the following:

i) That a partner will continue to receive paper K-1s unless the partner consents to receive electronic K-1s;

ii) If consent is effective until withdrawn or for a shorter duration;

iii) The procedure for obtaining a paper copy after consent;

iv) The procedure to withdraw consent, and when withdrawal of consent becomes effective;

v) Under what conditions the partnership will cease providing electronic K-1s to a partner;

vi) How a partner can update his contact information; and

vii) The hardware and software required to access electronic K-1s.

2. Obtaining Effective Consent

In addition to the disclosures above, a partnership must obtain consent from each partner

in a manner that demonstrates that the consenting partner has access to the technology that will be used to deliver the electronic K-1s. The simplest way to do this is to create a consent form that uses the same technology through which electronic K-1s will be delivered. For example, if a partnership intends to send electronic K-1s via secure email it should it send its consent form via secure email and require that each partner signs and sends back the consent form via secure email. Section 4 of the revenue procedure contains additional examples of how a partnership may obtain effective consent.

3. Required Policies and Procedures

In order for electronic delivery of K-1s to be permitted a partnership must institute policies and procedures so that

i) Electronic K-1s are identical copies of official K-1s;

ii) If electronic K-1s will be delivered by publication on the partnership’s website each partner must be given timely notice of the posting;

iii) If any email notice is returned as undeliverable, the partnership must, within 30 days of the return, email the notice to a correct email address or mail a paper copy of the notice;

iv) If electronic K-1s will be delivered by publication on the partnership’s website, a K-1 must be available on the website for the later of 12 months after the taxable year to which K-1 refers or 6 months after K-1 is posted; and

v) A partnership must deliver paper K-1s to any partner that withdraws consent to receive electronic K-1s.

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Bart Mallon is a partner with Cole-Frieman Mallon & Hunt LLP, an investment management law firm. Bart can be reached directly at 415-868-5345.

Year-End Planning for Hedge Fund Managers

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www.colefrieman.com

Clients, Friends, Associates:

Although we are late in publishing this year-end planning memo, we believe it may still be helpful for managers on this last day of 2011 and into the new year.  In addition to all of the administrative details involved in closing out the year, the regulatory landscape has shifted dramatically over the past year. As a result, year-end processes and 2012 planning are particularly important, especially for General Counsels, Chief Compliance Officers (CCOs) and key operational and financial personnel. We have updated our own year-end checklist to help managers stay on top of these priorities.

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Regulatory Compliance:

New Issue Status. On an annual basis, a manager needs to confirm or reconfirm the eligibility of investors that participate in initial public offerings or new issues. Most managers reconfirm this via negative consent, i.e., investors are informed of their status as on file with the manager and asked to inform the manager of any changes. No response operates as consent to the current status.

In addition, this is a good time to review your offering documents to confirm that they include FINRA’s anti-spinning rule (Rule 5131), as well as the SEC’s current thresholds for accredited investor and qualified client status, which became effective this year.

ERISA Status. Given the significant problems that can occur from not properly tracking ERISA investors, we recommend that managers also confirm or reconfirm on an annual basis the ERISA status of its investors. This is particularly important for managers that track the underlying percentage or ERISA funds for each investor. This reconfirmation can also be obtained through a negative consent.  [For more information, please see our post on ERISA issues for hedge funds.]

Annual Privacy Policy Notice. On an annual basis, a registered investment adviser must also provide its investors with a copy of its privacy policy, even if there are no changes to the policy.

Annual Compliance Review. On an annual basis, the CCO of a registered investment adviser must conduct an annual review of a manager’s compliance policies and procedures. This annual compliance review should be in writing and presented to senior management. We recommend that you discuss the annual review with your outside counsel, who can provide guidance about the review as well as a template for the review. Managers should be careful that sensitive conversations regarding the annual review are protected by attorney-client privilege. CCOs may also want to consider additions to the compliance program, including implementation of policies relating to use of social media, a hot topic for both managers and regulators in 2011.

Managers who are not registered may still wish to review their procedures and/or implement a compliance program as a best practice.

Trade Errors. Managers should make sure that all trade errors are addressed by the end of the year, pursuant to the manager’s polices regarding trade errors. Documentation of trade errors should be finalized, and if the manager is required to reimburse the funds, it should do so by year-end.

Soft Dollars. Managers that participate in soft dollar programs should make sure that they have addressed any commission balances by the end of the year.

Custody Rule Annual Audit. SEC-registered advisers must (i) maintain client funds and securities with a qualified custodian in a separate account for each client under that client’s name, or in an account that contains only client funds and securities with the adviser listed as agent or trustee for the clients; (ii) have a reasonable basis, formed after “due inquiry,” for believing that the qualified custodian holding client funds or securities sends an account statement to each advisory client at least quarterly; (iii) notify clients upon opening any new custodial account on behalf of the client (or changes to any such account) and include a legend in such notice urging the clients to compare custodial account statements with any statements received from the adviser (if the adviser elects to send any such statements directly); and (iv) undergo an annual surprise examination conducted by an independent public accountant.

Advisers to pooled investment vehicles may avoid both the quarterly statements and surprise examination requirements by having audited financial statements prepared in accordance with GAAP by an independent public accountant registered with the Public Company Accounting Oversight Board. Statements must be sent to the fund or, in certain cases, investors the fund within 120 days after the fund’s fiscal year end. Managers should review their custody procedures to ensure compliance with the rule. Requirements for state-registrants may differ, and we encourage you to contact us if you have any questions or concerns about your custody arrangements.

Please see our post on the SEC Custody Rule for more information.

Schedule 13G/D and Section 16 Filings. A manager whose managed funds are beneficial owners of 5% or more of a registered voting equity security must report these positions on Schedule 13G. Schedule 13G filings are updated annually within 45 days of the end of the year. For managers who are also filing Schedule 13D and/or Section 16 filings, this is an opportune time to review your filings to confirm compliance and anticipate needs for Q1.

Form 13F. A manager must also file a Form 13F if it exercises investment discretion with respect to $100 million or more in certain securities within 45 days after the end of the year in which the manager reaches the $100 million filing threshold. The SEC lists the securities subject to 13F reporting on its website.

Form 13H. Managers who meet the SEC’s new large trader thresholds (in general, managers whose transactions in exchange-listed securities equal or exceed two million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month) were required to file an initial Form 13H with the SEC on December 1, 2011. Large traders will need to file amended 13Hs on an annual basis. In addition, changes to the information on 13H will require interim amendments following the calendar quarter in which the change occurred.

Blue Sky Filings. On an annual basis, a manager should review its blue sky filings for each state to make sure it has met any renewal requirements. States are increasingly imposing late fees or rejecting late filings altogether. Accordingly, it is critical to stay on top of filing deadlines, for both new investors and any renewals.

SEC Form D. Form D filings for most funds need to be amended on an annual basis, on or before the anniversary of the initial SEC Form D filing. Copies of Form D can be obtained by potential investors via the SEC’s website.

IARD Annual Fees. Preliminary annual renewal fees for state registered and SEC registered investment advisors were due by December 12, 2011. In the event a manager has not submitted these fees, the manager should submit these fees immediately through the IARD system. The manager will likely be subject to additional late filing fees and these must be paid through the IARD by February 3, 2012.

Pay-to-Play Rules. In 2010, the SEC’s adopted Rule 206(4)-5, which disqualified investment advisers, their key personnel and placement agents acting on their behalf from seeking to be engaged by a governmental client if they have made political contributions. State and local governments are following suit, including California, which requires such persons to register with the state as lobbyists, and mandates lobbyist registration in California’s cities and counties as well. This is an important issue for any manager seeking investments by government pension plans.

Registered Commodity Pool Operators and Commodity Trading Advisers. Registered CPOs and CTAs must prepare and file Annual Questionnaires and Annual Registration Updates with the NFA. Registered CPOs must also prepare and file an annual report for each commodity pool. Unless its funds qualify for an exemption, registered CPOs and CTAs must update their disclosure documents periodically, as they may not use any document dated more than 9 months prior to the date of its intended use. Disclosure documents that are materially inaccurate or incomplete must be promptly corrected and the correction must be promptly distributed to pool participants.

Fund Accounting and Financial Matters:

Wash Sales. Managers should carefully manage wash sales for year end. Failure to do so could result in embarrassing book/tax differences for investors. Certain dealers can provide managers with swap strategies to manage wash sales, including Basket Total Return Swaps and Split Strike Forward Conversions. These strategies should be considered carefully to make sure they are consistent with the investment objectives of the fund.

Financial Accounting Standards Board Interpretation No. 48 (“FIN48”). Under FIN48, which became effective in 2009, managers must implement procedures to assess material tax positions, and potentially accrue liabilities. Managers should begin preparing to implement FIN48 as soon as possible, and should discuss with their auditors whether FIN48 will apply to them. Funds with exposure to certain countries, including Spain and Australia, should make sure they are aware of the implications of FIN48.

Redemption Management. Managers with significant redemptions at the end of the year should carefully manage the unwinding of positions so as to minimize transaction costs in the current year (that could impact performance), and prevent transaction costs from impacting remaining investors in the next year. When closing funds or managed accounts, managers shall pay careful attention to the liquidation procedures in the managed account agreement and the fund constituent documents. Offshore funds may involve unusual or lengthy dissolution procedures. Please contact us to help you evaluate and manage any fund dissolutions you are considering.

NAV Triggers and Waivers. If redemptions, performance or a combination of these are expected cause a termination event (NAV declines are typical inclusions in these provisions) in a fund’s ISDA or other counterparty agreement, managers should seek waivers of those events before the end of the year. We recommend starting this process early as credit officers at many banks may become unavailable during the holiday season.

Fund Expenses. Managers should make sure that all fund expenses for a particular year are paid for in that year, and do not roll over into the next year. In particular, managers should contact their outside legal counsel to obtain accurate and up to date information about legal expenses. Outside counsel and other vendors should be given a deadline so that checks do not need to be processed on New Year’s Eve.

Management Company Issues:

Management Company Expenses. Similarly, managers who distribute profits on an annual basis should attempt to pay management company expenses in the year they are incurred. If ownership or profit percentages are adjusted at the end of the year, a failure to manage expenses could significantly impact the economics of the partnership or the management company.

Employee Reviews. An effective annual review process is important to reduce employment related litigation and protect the management company in the event of such litigation. Moreover, it is an opportunity to provide context for bonuses, compensation adjustments, employee goals and other employee-facing matters at the firm. It is not too late to put an annual review process in place for 2011.

Compensation Planning. In the hedge fund industry, and the financial services industry in general, the end of the year is the appropriate time to make adjustments to the compensation program. Since much of a manager’s revenue is tied to annual income from incentive fees, any changes to the management company structure, affiliated partnerships, or any shadow equity program should begin on the first of the year.

Insurance. If a manager carries D&O Insurance or other liability insurance, the policy should be reviewed on an annual basis to make sure that the manager has provided notice to the carrier of all claims and all potential claims.

Future Regulatory Change:

Form ADV. Current registrants must file an annual amendment to Form ADV within 90 days of the end of its fiscal year. For SEC registrants, an updated Part 1A will be due on March 30, 2012, regardless of your FYE, to indicate your AUM for purposes of eligibility to remain registered with the SEC.

Annual amendments for SEC registrants will include Parts 1A and 2A (the firm brochure). For most state registrants, this will include all parts of the ADV as well as U4s for its investment adviser representatives. For managers who have not yet filed using the revised ADV Part 2 (for example, those who filed at the end of 2010, but were not approved until after January 1, 2011), you should anticipate additional time translating your old Part II and Schedule F information into the narrative format of Part 2A and B.

Additionally, on an annual basis, registered investment advisers must provide a copy of the updated Form ADV 2A brochure and Part 2B brochure supplement to clients (or a summary of changes, with an offer to provide the complete brochure).

For managers who are required to register with the SEC, the deadline to be registered is March 30, 2012. We recommend filing the ADV by at least February 14, 2012 to ensure meeting this deadline.

Managers who will no longer meet the AUM threshold to maintain registration with the SEC will have until June 28, 2012 to transition to state registration.

Form PF. Managers to private funds who are either registered with the SEC, or required to be registered with the SEC, will begin filing Form PF in 2012. Most private fund advisers will be required to begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, to end on or after December 15, 2012. Those with $5 billion or more in private fund assets must begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, to end on or after June 15, 2012.

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For assistance with any compliance, registration, or planning issues with respect to any of the above topics, please contact Karl Cole-Frieman at 415-352-2300, Bart Mallon at 415-868-5345 or Aisha Hunt at 415-762-2854.

Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for financial services matters.

Cole-Frieman & Mallon LLP
150 Spear Street, Suite 825
San Francisco, CA 94105
t. 415-352-2300
f. 646-619-4800
www.colefrieman.com

This Cole-Frieman & Mallon LLP Announcement is published as a source of information only for clients and friends of the firm, and should not be construed as legal advice or opinion on any specific facts or circumstances. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Circular 230 Disclosure: Pursuant to regulations governing practice before the Internal Revenue Service, any tax advice contained herein is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Cole-Frieman & Mallon LLP is a California limited liability partnership.

Is there SIPC Insurance for Futures Accounts?

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SIPC Does Not Cover Futures Accounts at MF Global

The MF Global bankruptcy is creating a number of problems for managers with accounts at the firm. One question we have received from some managers is whether their client accounts are insured either through the Securities Investor Protection Corporation (“SIPC”) or through some sort of similar company.  Unfortunately there is no SIPC coverage for futures accounts and it is currently unclear how and when clients will find out whether they wil be made whole.  It is curious that there is no insurance for futures accounts given the Refco collapse in 2005, but with this bankruptcy, we are probably more likely to see calls for the creation some sort of SIPC-like insurance.

SIPC & What Losses are Insured

The following is a description of the SIPC from FINRA:

SIPC is a non-profit organization created in 1970 under the Securities Investor Protection Act (SIPA) that provides limited coverage to investors on their brokerage accounts if their brokerage firm becomes insolvent. All brokerage firms that do business with the investing public are required to be members of SIPC. SIPC protection is limited. It covers the replacement of missing stocks and other securities up to $500,000, including $250,000 in cash claims. However, it does so only when a firm shuts down due to financial circumstances in which customer assets are missing—because of theft, conversion, or unauthorized trading—or are otherwise at risk because of the firm’s failure.

SIPC does not cover the following:

  • Ordinary market loss;
  • Investments in commodity futures, fixed annuities, currency, hedge funds or investment contracts (such as limited partnerships) that are not registered with the SEC; and
  • Accounts of partners, directors, officers or anyone with a significant beneficial ownership in the failed firm.

SIPC Moves Quickly & Makes Statement

The following was posted on the SIPC website on Monday:

WASHINGTON, D.C. – October 31, 2011 – The Securities Investor Protection Corporation (SIPC), which maintains a special reserve fund authorized by Congress to help investors at failed brokerage firms, announced today that it is initiating the liquidation of MF Global Inc., under the Securities Investor Protection Act (SIPA).

SIPC today filed an application with the United States District Court for the Southern District of New York for a declaration that the customers of MF Global Inc. are in need of the protections available under the SIPA.

The United States District Court for the Southern District of New York granted the application and appointed James W. Giddens as trustee for the liquidation, and further appointed the law firm of Hughes Hubbard & Reed as counsel to Mr. Giddens.

Orlan Johnson, board chairman of the Securities Investor Protection Corporation (SIPC), said: “When the customers of a failed SIPC member brokerage firm have left their securities in the custody of that firm, SIPC acts as quickly as possible to protect those customers. In this case, SIPC initiated the liquidation proceeding within hours of being notified by the SEC that a SIPC case was necessary to protect the investing public.”

While the SIPC is not insuring the accounts, they are involved with helping investors.  The following press release discusses the SIPC’s involvement in helping investors to transfer accounts:

U.S. Bankruptcy Judge Martin Glenn approved a request to allow the transfer of certain segregated customer commodity positions from MF Global Inc. to one or more futures commission merchants (FCMs). The request was made by the trustee appointed by the Securities Investor Protection Corporation and oversee- ing the liquidation of MF Global Inc.

This action will allow for the transfer of approximately 50,000 client accounts, the substantial majority of which were cleared through the Chicago Mercantile Ex- change (CME). These transfers will unfreeze commodity positions with a notional value of $100 billion and represent a substantial position of all existing commod- ity accounts at MF Global Inc.

The notice above can be found on MF Global’s regulatory notices webpage.

Next Moves & Conclusion

Commodity pool operators who advise funds with accounts at MF Global should have already alerted investors in such funds.  For more information on this please see our post on the NFA Guidance re: MF Global.

Other persons who are interested in receiving more information about the liquidation and account transfer process should find the following websites helpful:

We will continue to provide updates on MF Global which we think will be helpful to our readers.  If you have specific questions, please feel free to send us questions and we will do our best to provide appropriate information through the blog.  As we mentioned above, we think that there is likely to some sort of regulatory fall-out from this and we believe that law makers will call for insurance for customer accounts.

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Cole-Frieman & Mallon provides legal advice to FCMs, IBs, CTAs and CPOs.  Bart Mallon can be reached directly at 415-868-5345.

NFA Provides Guidance re: MF Global

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CPOs Must Provide Information to Fund Investors

Below is guidance just provided by the NFA regarding MF Global.  Commodity Pool Operators must provide investors with a disclosure regarding the fund’s assets held at MF Global.  Additionally, if the CPO is soliciting new investors for the fund, the CPO will need to amend their disclosure document and have the disclosure document reviewed by the NFA prior to first use.

Please contact us if you need help with respect to any of the items discussed in the NFA memo below.

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November 1, 2011

Proposed Guidance for CPOs with Pool Funds Held at MF Global, Inc.

NFA recognizes the need for our CPO Members to keep their pool participants informed as to what has occurred with MF Global, Inc. (MF Global) and how it may affect future operations. In this regard, NFA, in consultation with the CFTC, is providing guidance on disclosures that CPO Members with pool funds held at MF Global must make to their participants. At a minimum, CPO Members must provide their pool participants with a disclosure statement that includes the disclosures summarized below. Members are also encouraged to provide any additional disclosures that are necessary given their specific business operations.

If you are a Member operating a pool that has pool funds held at MF Global, you must make the following disclosures:

  • On October 31, 2011, MF Global reported to the SEC and CFTC possible deficiencies in customer segregated accounts held at the firm. As a result, the SEC and CFTC determined that a SIPC-led bankruptcy proceeding would be the safest and most prudent course of action to protect customer accounts and assets, and SIPC initiated the liquidation of MF Global under the Securities Investor Protection Act.
  • As of (insert date) approximately $XXX of (Name of Pool)’s assets were on deposit in an account(s) at MF Global. These assets represent XX% of the (Name of Pool)’s net asset value of $XXX.
  • The General Partner does/does not believe that these actions will have a material impact upon the operations of (Name of Pool) and its ability to:
    • Satisfy redemptions requests;
    • Adequately value redemption requests and the manner in which they will be handled;
    • Accept new subscriptions in (Name of Pool) and properly value the net asset value for new subscribers; and
    • Provide for accurate valuation in the (Name of Pool)’s account statements provided to participants.
  • Participants are cautioned that there can be no assurances:
    • That (Name of Pool) will have immediate access to any or all of its assets in accounts held at MF Global; and
    • As to the amount or value of those assets in the context of the bankruptcy.
  • Participants should also be aware that future actions involving MF Global may impact (Name of Pool)’s ability to value the portion of its assets held at MF Global and/or delay the payment of a participant’s pro-rata share of such assets upon redemption.

The above disclosures must be provided to current pool participants through a separate written communication. In addition, Members who have a current disclosure document and plan to solicit new participants must ensure that they have updated their disclosure document to include these disclosures. In this regard, please remember that all amended disclosure documents must be submitted to NFA for review prior to use.

Further, with respect to the valuation of pool assets and redemptions, each Member is urged to consult with its CPA to ensure these items are reported in accordance with generally accepted accounting principles or international financial reporting standards, as applicable.

If you have any questions, please do not hesitate to contact the following individuals:

Mary McHenry at (312)781-1420 or at [email protected]

Tracey Hunt at (312)781-1284 or [email protected]

Todd Maines at (312)781-1560 or at [email protected]

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Cole-Frieman & Mallon LLP is an investment management law firm which provides CPO registration and compliance services.  Bart Mallon can be reached directly at 415-868-5345.

Alternative Mutual Funds Overview

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Hedge Fund Strategies Employed by Mutual Funds

Since the financial crisis of 2008, a growing number of retail investors have sought access to more sophisticated investment strategies to protect against downside risk.  Most retail investors are not eligible to invest directly in hedge funds so they have turned to mutual funds that employ alternative investment strategies to achieve greater diversification.  This increasing demand for alternative mutual funds is also fueled by hedge fund investors seeking greater transparency and liquidity, as well as more conservative investment strategies that are typically utilized by mutual funds.  Additionally, the Dodd-Frank Act restricts certain individuals and institutions from investing in hedge funds, which will likely force these investors to seek out “hedge-like” investment vehicles in which to invest the money formerly invested in hedge funds.  To accommodate these new investors and the converging demands of retail and hedge fund investors, investment managers have developed mutual funds designed to mimic hedge fund investment strategies to the extent permitted under federal securities laws.

What is an Alternative Mutual Fund?

An alternative mutual fund is a professionally managed, pooled investment vehicle, designed to provide individual investors with access to investment strategies that offer non-correlated returns and diversification benefits. Generally, the goal of alternative mutual funds is to minimize portfolio volatility and preserve return objectives. Strategies utilized by alternative mutual funds include traditional hedge fund investment strategies such as long-short, market neutral, arbitrage and merger/arbitrage strategies.

Starting an Alternative Mutual Fund – Legal Considerations

Some of the operational and legal steps for launching a mutual fund are similar to starting a hedge fund, but there are some important differences. The high-level legal steps to launch an alternative mutual fund include:

  1. Register the fund manager as an investment adviser with the SEC.
  2. Form a corporation or a business trust (or leveraging an existing business trust) – a mutual fund will typically be established as a Delaware statutory trust or Massachusetts business trust.
  3. Prepare and file Form N-1A with the SEC to simultaneously register the fund as an investment company under the Investment Company Act of 1940 (’40 Act) and register fund shares under the Securities Act of 1933. This filing includes the fund’s prospectus, which discloses the fund’s investment objective, investment strategies and principal investment risks, as well as other material information regarding the fund manager and the fund.
  4. Seed the fund (or fund family) with at least $100,000 as required by the ’40 Act.
  5. Choose a board of directors (or trustees). While board sizes vary, the ’40 Act requires that at least 40% of the directors on a board be independent. Typically, independent directors hold a majority (75%) of board seats in nearly 90% of fund complexes.
  6. Negotiate agreements with fund service providers, including a custodian, prime broker (for fund derivative transactions), transfer agent, fund accountant, independent auditor, administrator, financial printer, and distributor. [Note: some hedge fund service providers also provide services to mutual funds, but in general the service providers are likely to be different.]
  7. Draft fund compliance policies and procedures reasonably designed to detect, prevent, and resolve violations of federal securities laws.
  8. Make requisite blue sky filings (or notice filings) in states where fund shares will be sold.

Other Considerations

The ‘40 Act also imposes leverage and other investment restrictions on mutual funds. While some of these restrictions can be addressed by investing in ETFs and other investments, it is imperative that investment managers consult a ’40 Act attorney prior to launching an alternative mutual fund to fully understand the implications of regulatory restrictions on portfolio management.

Conclusion

Investor preference and regulatory developments are driving the convergence of mutual funds and hedge funds and resulting in a rapidly growing demand for mutual funds that employ hedge fund strategies. This demand is being met by the emergence of alternative mutual funds. The process of launching an alternative mutual fund varies depending on the complexity of the fund, however, these steps along with others can typically be completed in six months with the assistance of a seasoned ’40 Act attorney and other fund service providers.  For more information on registering a mutual fund and the regulations governing mutual funds, please see the SEC’s Investment Company Registration and Regulation Package or contact us.

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Cole-Frieman & Mallon LLP is a boutique investment management law firm with an alternative mutual funds law practice. Aisha Hunt, a Partner and the head of the ’40 Act practice at Cole-Frieman & Mallon LLP, can be reached directly at 415-762-2854.