Category Archives: Business Issues

Massachusetts Proceeds Against Fund Manager Using Expert Networks

Revocation of Investment Adviser License & Disgorgement of Profits

Managers are becoming more aware of the various securities laws and compliance issues involved with the use of expert networks.  While the SEC has recently been active in this area (both in the RR insider trading complaint and the recent expert network action), the states are also becoming more aware of the potential issues involved with expert networks.  Recently the Massachusetts Securities Division instituted an administrative complaint against a Massachusetts state registered fund manager who utilized expert networks to gain inside information.  This post will provide an overview of that compliant.

Overview

James Silverman was registered as an investment adviser representative for a Massachusetts registered IA firm which was managing the RRC Bio Fund, LP (“Fund”).  The IA firm was subject to a routine announced examination by the Massachusetts Securities Division (“Division”).  During that routine examination, the examiners found a number of violations of the various state securities laws including the fact that Silverman was trading on inside information obtained from an expert network firm.

The examiners found that Silverman started using the expert network firm after the Fund suffered a long period of losses.  After utilizing the expert network firm, the Fund posted consecutive years of gains in excess of 50%.  During the course of the relationship with the expert network firm, the Fund paid $80,000 a year to the firm so that Silverman could have access to certain consultants in the biotechnology industry.  Many of these consultants were either insiders or otherwise bound to confidentiality agreements with respect to their activities in the industry.  The expert network firm did not monitor their consultants in any way but, pursuant to the firm’s policies, the consultants’ had a duty to identify and avoid any disclosure that would violate a confidentiality agreement.  The agreement that Silverman signed with the expert network fir

m provided that Silverman agreed not to elicit or otherwise obtain any “material nonpublic or otherwise confidential information” from the expert consultants.

In addition to the insider trading, Silverman and the IA firm engaged in either blatantly illegal or egregiously sloppy business practices, especially once the examination began.  For example, the complaint states that Silverman did the following:

  • deleted notes containing study results prior to producing the notes to the Division in response to its subpoena
  • deleted certain documents and correspondence
  • failed to maintain required records
  • made false filings with the Division
  • violated minimum financial requirements
  • violated document retention requirements
  • improperly assessed performance fees
  • left client data vulnerable

The Order

The consequences for breaking the securities laws, whether at the state or federal level, are severe.  The Enforcement Section of the Massachusetts Securities Division sought the following items in its action against Silverman:

  • accounting and disgorgement of all ill-gotten gains as a result of insider trading
  • disgorgement of direct and indirect remuneration from the insider trading
  • revocation of the IA registration for the firm and Silverman
  • enjoining Silverman from performing any investment advisory services for compensation on behalf of any person or entity within the Commonwealth of Massachusetts
  • imposition of a fine

Protecting Your Firm – Developing Compliance Programs

This case and the earlier SEC actions do not mean that fund managers can no longer use expert network firms.  However, managers need to be careful and the best practice is for managers to develop compliance policies for all interaction with expert network firms.  These policies and procedures need to be tailored to the business practices of each manager and need to be followed consistently.

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Cole-Frieman & Mallon LLP is a boutique hedge fund law firm.  We provide hedge fund compliance and registration services to SEC and state registered hedge fund managers.  Bart Mallon can be reached directly at 415-868-5345.

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Cole-Frieman & Mallon LLP Quarterly Newsletter – 1st Quarter 2011

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Below is our quarterly newsletter.  If you would like to be added to our distribution list, please contact us.

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February 18, 2010
www.colefrieman.com

Clients and Friends,

There have been an extraordinary amount of regulatory developments over the past three plus months of concern to investment managers.  These include:

  • SEC Registration Issues
  • New Form ADV Part 2
  • New Form PF
  • CFTC Proposals
  • Yearly Update Issues
  • Other Regulatory Updates

Below we detail these developments and also provide some of our thoughts on the current regulatory environment. Please feel free to contact us with any thoughts or questions on these matters.

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SEC Registration Issues

New Fund Manager Registration Requirement – under the Dodd-Frank Act, the previous exemption from registration for fund managers was eliminated.  This generally means that hedge fund and private equity fund managers will be required to register as investment advisers with the SEC.  Recently the SEC has proposed rules with respect to the new registration requirement.  Broadly this means:

  • investment managers with less than $100MM AUM will need to register with the state securities commission unless an exemption from registration applies;
  • investment managers with more than $100MM AUM will need to register with the SEC unless another exemption applies; and
  • investment managers only to hedge funds or private funds (i.e. no separately managed accounts) with less than $150MM AUM will not need to register with the SEC, but may need to register with the state securities commission.

The SEC has proposed transition rules for managers who are moving to or from SEC registration.

The comment period on the proposed regulations closed recently and we expect to see final regulations promulgated within the next couple of months.  Even if exempt from adviser registration, fund managers may fall into a new reporting category called “exempt

reporting advisers.”

Exempt Reporting Advisers – under proposed Rule 204-4, there is a new category of advisers called “exempt reporting advisers” (“ERAs”) which are generally advisers (i) only to venture capital funds or (ii) to private funds (hedge funds and private equity funds) with less than $150MM of AUM combined.  These ERAs will still be required to report certain information on Form ADV including information about the firm, its clients, and its owners.  ERAs would be required to make annual and periodic updates and be subject to a filing fee.

New Form ADV Part 2

In 2010 the SEC created a new and completely different Form ADV Part 2.  The old form included “check the box” representations and longer explanations in Schedule F.  The old form has now been replaced by a long form plain English discussion of the adviser’s business.  While the basic type of information provided to customers/investors remains essentially the same, the new format adds a significant amount of length to the brochure.  In addition to the firm part of the brochure, managers will also need to complete a supplement for each of the firm’s IA representatives who meet certain activity requirements.   The changes to new Form ADV Part 2 are fairly significant and we recommend that firms allocate plenty of time to update the form.

Managers should also note that the SEC has estimated it will cost managers between $3,000 and $5,000 to complete the new form.  Based on a couple of revisions we have already completed, we feel this is an accurate estimate for many private fund managers.

Form PF

As part of the Dodd-Frank Act, investment advisers will be required to file reports containing information on their businesses for the assessment of systemic risk.  Accordingly, the SEC, in conjunction with the CFTC, recently proposed a new Form PF which SEC registered investment advisers will be required to file on either a quarterly or annual basis, depending on AUM.  The form as currently proposed requires managers to provide detailed information on their investment strategies and positions.  There is likely to be significant pushback from the investment management community and reporting requirements may change when the final form and regulations are promulgated.

CFTC Proposals

Just recently the CFTC proposed to rescind the current 4.13(a)(3) and 4.13(a)(4) exemptions from CPO registration.  Rescission of these widely used exemptions means that more investment managers would be required to register with the CFTC.  The CFTC also proposed rescinding the 4.5 exemption (applicable to mutual fund managers).

Additionally, CPOs and CTAs would be required to file Form PF (if also registered with the SEC) as well as new Form CPO-PQR and Form CTA-PR.

Yearly Updating

Annual ADV Update for IA Firms – most registered IA firms (state and SEC) will be required to submit an annual update of Form ADV by March 31.  Most of these firms will also be required to submit the new Form ADV Part 2 which, as discussed above, is more time consuming to prepare.  We recommend that registered IA firms begin the updating process with their law firm or compliance consultant by the end of this month.

CFTC & NFA Annual Compliance – the beginning of the year means CFTC registered firms will need to focus on quarterly and annual compliance matters.  Major items include: quarterly CPO reporting, quarterly email review (if applicable under the firm’s compliance program), yearly review of compliance manual and procedures, NFA self-examination checklist, privacy policy review and delivery to clients, ethics training, annual reports and audit (CPOs), and bunched orders allocation procedure review (CTA).  Note: some CPOs may be able to apply for exemptive relief from the annual audit requirement.

Other Items

SEC Releases Two Studies – the Dodd-Frank Act required the SEC to produce two studies which were released in late January.

In the SEC study on Uniform Fiduciary Duty for Broker Dealers, the SEC staff recommended that the SEC should apply a uniform fiduciary duty with respect to both IA and BD firms which provide personalized investment advice with respect to securities to retail customers.  The staff also recommended harmonizing a number of regulations which should be applied consistently to similarly situated BDs and IAs.

In the SEC study on Enhancing IA Examinations, the SEC staff dealt with the issue of the SEC’s limited budget and how the Commission should deal with IA examinations in light of insufficient resources.  The staff recommended that Congress direct the SEC to take one of three courses of action: (i) impose user fees on SEC registered investment advisers, (ii) authorize FINRA or another SRO to examine SEC registered investment advisers, and/or (iii) authorize FINRA to examine dual registrants (firms registered as both an IA and BD).  We are likely to hear much more on this issue in the coming months.

State IA Exemption for Hedge Fund Managers – NASAA, the organization generally representing the state securities divisions, recommends that states should amend their investment adviser regulations to exempt from registration only those managers who provide investment advice solely to Section 3(c)(7) hedge funds.  If adopted by any state, this would increase the number of firms required to register with the state as investment advisers.  Because the states are already having difficulties with their budgets and maintainingappropriate staffing levels for the current amount of registered firms, it is unlikely that many (if any) states will adopt the recommended model rule.

Other – the CFTC recently provided additional guidance to managers on disclosures for performance fees.

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For assistance with any compliance, registration, or planning issues with respect to any of the above topics, please contact Bart Mallon of Cole-Frieman & Mallon LLP at 415-868-5345.

Cole-Frieman & Mallon LLP is a law firm with a national client base and is focused on the investment management industry.  Our clients include hedge fund managers, investment advisers, commodity advisors, and other investment managers.  We also provide general business and start up legal advice and have an emerging practice in real estate and cleantech.

Please note our new address:

Cole-Frieman & Mallon LLP
150 Spear Street, Suite 825
San Francisco CA 94105

SEC Study on Enhancing IA Examinations

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Recommendations for Enhancing IA Exams

Under Section 914 of the Dodd-Frank Act, the SEC was required to conduct a study with respect to the need for enhanced examination and enforcement resources for investment advisers.  SEC staff recently released the study which is designed to provide Congress with recommendations with respect to the findings of the study.  In general, the study found that the SEC is not currently properly equipped to appropriately handle IA examinations because of capacity issues.  The study presents a number of statistics which show that IA registrations have greatly increased while the funding for the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) has been subject to cutbacks in staff.

To strengthen the IA examination process, the SEC staff recommended that Congress take one of three different courses of action:

  1. Impose user fees on SEC-registered investment advisers
  2. Authorize one or more SROs to examine SEC-registered investment advisers
  3. Authorize FINRA to examine dual registrants (firms registered as both IAs and BDs)

SEC Recommendations

The Study provides three different options that Congress should consider with respect to the issue of instituting the most appropriate infrastructure for IA examinations.  These options and some of the positive and negative implications are discussed below.

1.  User Fees

Congress could authorize the SEC to implement user fees for registration.  These fees would go directly to the OCIE and pay for the IA examination program.

Discussion items:

  • would provide scalable resources (i.e. resources would increase or decrease in proportion to the number of registered investment advisor firms) – these resources would not be subject to the Congressional appropriations process
  • may be less expensive than instituting a new SRO regime and would utilize the existing OCIE staff expertise and knowledge
  • avoid all of the issues which would exist with establishing an SRO structure (inefficiencies, authority, membership, governance, and funding issues)
  • supported by some parts of the IA industry

2.  Delegation to SRO or SROs

Congress could authorize the SEC to delegate examination responsibilities to FINRA or another self regulatory organization(s).

Below are some of the points both for and against delegation to an SRO or multiple SROs:

  • scalable resources (i.e. funded by membership fees)
  • additional rulemaking – IA firms would be subject to laws (Investment Advisers Act of 1940), regulations (SEC Rules) and member (SRO) rules
  • SEC would need to oversee the SRO and subject the SRO to periodic audit/examination
  • an SRO would provide for more examination of IAs – for example, FINRA and NFA have examined more BDs and CPOs/CTAs than the SEC has examined IAs
  • many logistical issues involved with instituting any SRO and/or allowing FINRA to take over these responsibilities
  • multiple SROs (for different types of IAs) would likely create even more logistical issues
  • unclear how the SRO structure would work with state registered IAs
  • potential conflict of interest if the SRO (FINRA) was the same for the buy side and the sell side

3.  Authorize FINRA to examine dual IA-BD registrants

Congress could expand FINRA’s jurisdiction to oversee those firms which are registered as both an IA and as a BD.

  • only marginally helpful – only 5% of IAs are also registerd as BDs and many of these firms are the largest broker-dealer firms
  • gets rid of inefficiency by having two examinations – one from FINRA on the BD side and one from the OCIE on the IA side
  • risk of different interpretation of provisions of the Investment Advisers Act

Conclusion

This study simply states the obvious – the SEC does not have the resources it needs to adequately do its job.  It seems like the major conclusion has already been reached – IA firms are going to need to pay for their oversight because Congress will not pay for it.  The only question is whether managers will be making payments to the SEC (first option) or to FINRA or other SRO(s) (second two options).  Whatever Congress ultimately decides, it is likely that managers will be facing more fees in the future.

The full text can be found here: Study on Enhancing Investment Adviser Examinations

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Bart Mallon is an attorney focused on the investment management industry and provides investment adviser registration and compliance services through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.

GSEC to Stop Clearing for Small Hedge Funds

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According to a recent Bloomberg article, and a couple of my recent clients, Goldman Sachs Execution and Clearing (GSEC) will no longer act as the custodian and clearing agent for most small hedge funds with less than $5 million in AUM.  As a quick background, smaller funds which do not have the minimum asset size or strategy to establish a direct relationship a major prime broker will generally establish an account with a mini-prime broker.  The mini-prime broker will act as the relationship manager and will interface with the fund manager while the fund assets will be custodialized at the major prime broker.

This move will only affect the very small fund launches and will limit the mini-primes that small funds can use as some mini-primes only execute through GSEC.  Current funds utilizing GSEC are not likely to be affected, but those funds which are just now establishing their accounts with GSEC should discuss this issue with their contact at the mini-prime.

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Bart Mallon, Esq. runs the hedge fund law blog and provides registration and compliance services to hedge fund managers through Cole-Frieman & Mallon LLP, a hedge fund law firm.  He can be reached directly at 415-868-5345.

Important Hedge Fund Articles

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As of the date we published this list of important hedge fund articles, the Hedge Fund Law Blog has over 600 posts.  In order to highlight some of the more important items on this website we have created the following list of articles which we think will be useful for most of our readers.  Articles without links will be forthcoming and we look forward to hearing your feedback on what information you would like to see in the future.  The categories include:

  1. Basics & Structure
  2. Offering Documents
  3. Service Providers
  4. Investment Adviser Regulation
  5. Futures & Commodities Regulation
  6. Marketing & Advertising
  7. Operational Issues

We would also like to remind managers who are thinking of starting a fund to view our Start Up Presentation.

BASICS & STRUCTURE

OFFERING DOCUMENTS

INVESTMENT ADVISER

FUTURES & COMMODITIES

MARKETING & ADVERTISING

OPERATIONAL ISSUES

ERISA

LAWS & REGULATIONS

OTHER ISSUES

FOREX

COLE-FRIEMAN & MALLON LLP QUARTERLY NEWSLETTERS

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Cole-Frieman & Mallon LLP, a hedge fund law firm, sponsors the Hedge Fund Law Blog.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Bart Mallon Quoted in Wall Street Journal on Hedge Fund Registration

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(www.hedgefundlawblog.com)

In an article published today in the Wall Street Journal, Bart Mallon of Cole-Frieman & Mallon LLP was quoted discussing the current and future role of the state securities divisions with respect to hedge funds.  After the implementation of the new SEC registration thresholds under Dodd-Frank, previously SEC registered hedge fund managers will be required to de-register from the SEC and register with the states.  Outside of the logistical hurdles involved with this process, the central issue for managers and investors is whether the states have the resources or expertise to deal with an increased workload.  This is an especially important question as more and more states like California face budget shortfalls and institute furlough days.

For more information on this specific topic, please see our survey on state securities divisions which includes information on number of examiners, number of furlough days, and the frequency of audits of investment advisers.

The Wall Street Journal article can be found here.

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Cole-Frieman & Mallon LLP provides legal support and hedge fund start up services to all types of investment managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Wall Street Reform Bill Issues – Performance of State Securities Regulators

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As we move closer to the signing of the Dodd-Frank Wall Street Reform and Consumer Protection Act, more groups are highlighting the fact that state securities divisions are going to be affected by the act.  After pressure from NASAA, the association of state securities regulators, Congress has provided that state regulators will be required to provide oversight of investment advisers with up to $100 million of AUM – a significant increase from the current level of $30 million of AUM.  Of course this will increase the number of advisers that the states oversee and will make the job of the securities divisions much more difficult.  We have consistently stated that we do not think the states, collectively, are going to be capable to provide proper oversight with the increase in responsibility – mostly because of budget issues.  We have been surveying the states to see which divisions have budget issues and will be reporting on that shortly.  Until then we will examine one securities division which has faced scrutiny from members of the investment community and the state legislature.

Overview of Utah Division of Securities Audit

Over the years there has been a number of complaints about the manner in which the Utah Division of Securities conducts business – a simple Google search will reveal a number of interesting stories.  After repeated complaints the state legislature decided to audit the division and released a report in July of 2008 entitled A Performance Audit of the Division of Securities.

The results are nothing less than shocking.

Faith in government agencies is based on the belief that they will act fairly and effectively.  The report shows capricious behavior and essentially a belief that members of the investment management community are ‘guilty’ until proven ‘innocent’.  Special attention should be paid to the fact that the state securities divisions do have power to make life miserable for a business owner, even if that business owner has not acted wrongly.  Redress is difficult and “the Division Always Wins” (see below).  It is in with this understanding that we question whether the states will be in the best position to oversee the investment management industry.

Below are a number of direct quotes from the audit – many should make any ready angry and sick.  [Please note that we are not saying that all securities divisions have these problems.  Additionally, we have not conducted any follow up with Utah so we do not express any opinion on the current state of the division.]

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Reason for audit:

The credibility of the Division of Securities has been challenged by those investigated by the division. Their concerns are with procedural errors, an alleged overzealous pursuit of securities violations, and the perception that those investigated do not receive fair treatment.

While the division protects securities investors, it is alleged the division has abused its power and damaged reputations. The division has significant authority but its credibility depends on using that authority judiciously.

Page i

Ad Hoc Manner of Conducting Investigations:

There does not appear to be a consistent relationship between the number of complaints, number of cases opened, and the number of actions filed. This is because cases can be opened without a resulting action, there can be multiple actions on one case, or the action may not be filed until the following year. In addition, our evaluation leads us to believe the information is not reliable.

Page 3

Reason for Division Audit

Legislators requested this audit based on concerns about how the division managed three cases. We reviewed the division’s administrative process followed in these cases and a number of others brought to our attention. We did not address the legal issues of any of the cases. Our work has been complicated by the desire of many interviewees to keep their names confidential. They fear reprisal for criticizing the division’s actions.

Page 9

Lack of Policies & Procedures Equals Inconsistent Decisions

The division has not been operating under set, written policies and procedures. As a result, division decisions for actions against the regulated industry and the treatment of its employees rest solely with department and division management. Frequent management changes have brought changes in management philosophy and an increased likelihood for inconsistent decisions.

Page 9

Years of No Policies & Procedures

During the course of this audit, we were told that the division did have policies and procedures a number of years ago. However, there have been no written policies and procedures in place, or operational procedures followed, for at least the last four years under the direction of three division directors.  Shortly before this audit’s completion, division staff found a discarded copy of a 1993 policies and procedures manual. It is disconcerting that the division has faced procedural control difficulties for a number of years, yet no one in either departmental or divisional leadership noted the lack of policies and procedures.

Page 9 and 10

HUGE ISSUE FOR STATE REGISTERED MANAGERS

Complaints surfaced that those charged with securities violations could not get a fair hearing.

Page 10

Division Bias Ignored

In several cases, it was questionable if the former director had maintained an independent and unbiased perspective. For example, the former director did not recuse himself from serving as the presiding officer after helping to draft the pleadings for the case. It was apparent he was no longer impartial. Even the perception that the presiding officer is biased is concerning as it can give the appearance of unfair treatment.

Page 10

Intimidation…and…the Division always wins…

Those accused of securities violations told us they felt intimidated into settling, given that the division’s former director would likely serve as the presiding officer. One business owner perceived the system as “a stacked deck” because the investigator, jury, and judge are all in the same office. He informed us that during an investigation, a division employee boasted that the division always wins.

Page 11

State Lawyer Effectively Pushed Out

poor communication between the former director and an attorney resulted in the exclusion of the attorney from a decision on how a case would be handled, even though the attorney had been involved in the case for a number of months. The attorney was frustrated and raised concerns when the former director drafted and sent out documents over the attorney’s name, thus implying the AG gave his approval, even though the attorney was not aware a decision had been made and had not reviewed the final document. He learned about the legal action when defendants contacted him because they assumed he represented the division. The former director contends that the attorney was familiar with the document.

Pages 12-13

Questionable Actions

During the audit, many individuals associated with various cases contacted us with complaints about the division. Our review of case files resulted in a number of questionable actions including: inappropriate publicity, emphasis on punishment rather than compliance, the use of intimidation tactics, violating terms of settlement agreements, failure to notify those being investigated, and inconsistent case management.

Page 15

Fear of Retaliation!!??

To evaluate these complaints, we reviewed case files, listened to tapes of hearings, and interviewed staff and attorneys involved with the cases. Many of those who talked with us requested confidentiality because they feared retaliatory action by the division if they were identified.

Page 15

Inconsistent Procedures…

questionable actions often can be attributed to the divisions lack of clearly defined procedures. A discarded policy manual states that “the manual will be reviewed and updated on a yearly basis to reflect current or additional practices.” Not complying with this requirement has resulted in division policies and procedures that are inconsistently applied.

Page 15

Emphasis on Punishment Rather than Compliance

The division appears to emphasize punishment of offenders rather than compliance with securities laws. A number of those involved in the division’s actions believe the division has overzealously pursued securities violations. They criticize that charges are brought one after another, cases are drawn out over long periods of time, and decisions on who to investigate can be arbitrary.

Page 17

Threats and Coercion

The division’s use of intimidation to obtain information has been cited by both those being investigated and others involved with the division. In one case, the accused stated that an investigator attempted to coerce cooperation by intimidating and threatening that the person would be arrested. In another case, investigators seized personal information by copying all information from the business owner’s computer without distinguishing business and personal information. The owner said that he complied with the investigator’s demands only because they threatened to immediately close him down if he refused.

Page 18-19

Does not Honor Settlement Agreements

The division has, at times, violated the terms of its settlement agreements. In one case, the division agreed to not publicize the action or commence further administrative actions and then violated both terms of the agreement. The person accused told us he felt compelled to plead guilty to a lesser criminal charge rather than place his business in jeopardy defending a greater charge. The division agreed to not seek additional charges but nevertheless pursued an administrative action. The respondent then signed the settlement agreement after the division agreed to not publicize it. However, the day the settlement was signed, the division publicized the information on its web page and also published the information in its newsletter the following month.

Page 19-20

Surprised Charges Filed…Harming Innocent Business

According to the business owner, he learned about the investigation only after it was completed and charges were filed. Before he had an opportunity to respond, the media called to ask about the division revoking his license and issuing fraud charges. The media release was damaging to the business and the resulting retraction and apology was damaging to the division.

Page 21

Fines Arbitrary!!??

The division has been criticized for not identifying how fines are set. Board minutes disclosed the former director explained that fines are set to “make it hurt,” which is troublesome to those in the securities industry. The former director explained to us that fines are set based on an evaluation of the seriousness, nature, circumstances, and persistence of the conduct which is consistent with the Financial Industry Regulatory Authority (FINRA) guidelines. However, because the division does not have written guidelines or procedures identifying the process used to set fines, they appear to be set arbitrarily, based solely at the discretion of the division.

Page 22

Staff Demoralized, Scared of Reprisal

Personnel conflicts within the Division of Securities (division) have resulted in management turnover and a demoralized staff. Both the department executive director and the division’s former director have been open about their beliefs that specific employees have seemed reluctant to accept change and may be subverting management authority. A number of division staff feel their jobs are threatened or other forms of management reprisal may occur should they offend management in some way. The escalating conflicts have resulted in reprimands, restructuring, and ultimately, the resignation of the director, and the threat of legal action by several employees.

Page 25

Division Blatantly Breaks Laws at Director’s Direction

After being hired in October 2005, a number of the former director’s actions have been questionable. He was reprimanded and received a one-day suspension without pay for instructing staff to hold fine payment checks without processing them within the three-day time period required by statute (Utah Code 51-4-1). Delaying the deposit would allow the division to retain funds in the division rather than transfer them to the state general fund. By statute, if a balance in the division’s education fund exceeds $100,000 at the close of a fiscal year, the excess must be transferred to the General Fund (Utah Code 61-1-18.7(6)).

Staff related other instances in which they feel the former director gave them inappropriate directions. For example, staff provided information showing the director:

  • directed staff to sign pleadings that the former director had either drafted or modified, possibly to prevent his name, as the presiding officer, from appearing on documents. Administrative rules state “the signature shall be deemed to be a certification that the signer has read the pleading and that, to the best of his knowledge and belief, there is good ground to support it.”
  • directed staff to provide protected information to an influential person which violates Utah securities law prohibiting employees from disclosing non-public information filed with or obtained by the division (Utah Code 61-1-18.3).
  • used coercive settlement tactics by instructing staff to keep unwarranted allegations in the pleadings to serve as a bargaining chip for the negotiations. The respondent agreed to the settlement after the allegations were removed.
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We hope that this provides another look at the issue of having the states responsible for investment advisers with a wide ranging practice which may involve investors from many states.

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Cole-Frieman & Mallon LLP provides comprehensive formation and hedge fund start up support.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Positive 2010 Outlook for Investors and Hedge Funds

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In March, Deutsche Bank’s Hedge Fund Capital Group presented a closer look at the current status of the hedge fund industry in its “2010 Alternative Investment Survey” report (see press release).  The report focuses on responses from 606 investors.  42% of the respondents were Fund of Funds, 21% were asset management companies, 12% were family offices/high net worth individuals, and the remaining group consisted of corporations, foundations and endowments, insurance companies, investment consultants, private banks, and private and public pensions.

This article summarizes the 2010 outlook from investors and the increasing relevance of the seeding business.  In particular, it presents the strategies being favored/disfavored, regional markets being favored/disfavored, predicted allocation amounts, and other information related to due diligence and reasons for investing in hedge funds.

For the most part, investors are optimistic about 2010 and money is flowing back into the industry.  Strategies for this year reflect concerns about the lack of transparency and protection in uncertain markets in 2008 and 2009.  Investors are making choices that ride on renewed confidence in the industry and that favor reduced volatility.

Investors

Investors Generally Optimistic for the Future

Investor sentiment about how the hedge fund industry will fare in 2010 has greatly improved.  In 2009, 41% predicted net asset outflows of over $150 billion and 30% predicted outflows of over $200 billion.  In contrast, 73% of investors surveyed this year predict net asset inflows of over $100 billion and fewer than 2% are predicting outflows.  Consistent with those percentages, investors are also predicting a positive 2010 performance on the leading indices (S&P500, MSCI World, and MSCI EM).

Favored and Disfavored Strategies

Surveyed investors predict that some of the best strategies for 2010 are global macro, equity long/short, distressed, and event driven.  In fact, equity long/short makes up the largest portion of hedge fund assets.  51% of investors plan to add assets to this strategy (an increase from 31% in 2009), 38% plan to maintain their assets in the strategy, and 5% plan to reduce assets.  Event driven also performed very well in 2009 with 42% of surveyed investors now planning to add assets to this strategy and 41% planning to maintain their assets.  Investor interest in merger arbitrage has also jumped greatly from 6% intending to increase exposure to 26% in 2010.  While 29% of investors planned to reduce exposure in 2009, only 4% now seek to reduce exposure.

The strategies that are anticipated to perform the worst in 2010 include cash, volatility arbitrage, CTA, convertible arbitrage, market neutral, and asset backed securities.  Market neutral was one of the worst strategies for 2009 when other strategies were bouncing back.  The percentage of investors seeking to add assets to this strategy has decreased from 26% in 2008 to only 17% this year.  In terms of cash allocation, only 3% of investors plan to increase exposure (a drop from 13% last year), 43% plan to maintain their assets, and a whopping 32% plan to reduce their assets.

Regional Allocations

Overall, investors predict that the Asia region (excluding Japan) will perform the best in 2010 and the Western European region will perform the worst.  This year, 45% of investors plan to invest in Asian (excluding Japan) funds–a significant jump from only 18% in 2009.  Interest in investing in Chinese and Japanese funds is high compared with other countries.  The percentage of investors that do not plan to allocate to each country is 22% and 23% respectively. In contrast, 52% of investors do not plan to allocate in Russia, 44% do not plan to allocate in Eastern and Central Europe (excluding Russia), and 37% of investors do not plan to allocate in India.

Surveyed investors expressed a similar interest in the Emerging Markets, with 38% wanting to increase exposure, 38% wanting to maintain exposure, and only 6% wanting to reduce exposure.  These findings are in response to the strong 2009 returns after a rough 2008 that saw many Emerging Market funds close.  In contrast, investors anticipate the Western European region will not fare well–with 56% seeking to maintain their current assets, 23% seeking to increase exposure, and 12% seeking to reduce exposure.

Hedge Funds

Investors are increasingly investing in hedge funds.  In fact, 76% of consultants surveyed indicated that their clients were increasing allocations to this investment vehicle.   When asked what the main benefit of investing in hedge funds was, 68% of the investors surveyed indicated that hedge funds provide “better risk adjusted returns.”  This benefit is particularly valuable in a volatile and uncertain market.   “Diversification,” which was previously the number one answer, remains a close second.

Amount Currently Invested in Hedge Funds

Currently, over 50% of surveyed investors still manage less than $1 billion in hedge funds.  The Hedge Fund Capital Group expressed concern about this figure, explaining that more than $1 billion AUM is often necessary to build the institutional infrastructure for greater investments and to perform vigorous due diligence.  On the other side of the range, the number of investors with under $100 million invested in hedge funds is decreasing.  The Hedge Fund Capital Group explains that these funds have likely simply shut down due to the economy and inability to attract institutional investors, pension funds, endowments, and other larger investors.

A majority of surveyed investors have track records of investing in hedge funds for longer than five years (only 17% have less than 5 years), with nearly all of those with 15 or more years of experience based in North America, compared with their European and Asian investor bases.

Hedge Fund Managers

Since 2008 and in part due to the market, investors have been reducing the number of managers they use.  They have also started disfavoring portfolios that are too diverse due to the fact that due diligence requirements are now more costly and timely.  In addition to reducing the number of managers investors place their money with, investors are also preferring to place their money in larger hedge funds with AUMs of over $1 billion.  Those investors focused on managers with smaller AUMs are generally based in Asia or Europe.

Allocations

In 2009, most investors made 5-10 initial allocations.  Those investors who made over 10 initial allocations in 2009 were concentrated in Europe–a total of 54%.  But in terms of follow-on allocations, U.S. based investors led the pack, with 50% making over 30 follow-on allocations.

Redemptions

Despite generally positive performance last year, investors are continuing to make redemptions–the Hedge Fund Capital Group explains this as a result of those managers who have not performed during the market bounce or those that froze assets and their investors are only now able to begin redeeming.  The investors that have made the most partial redemptions–30 or more in the last year, were primarily fund of funds and private banks.  This finding is consistent with the perception that these investors are performance chasers.

Available Cash to Allocate

Compared with 2009, surveyed investors are generally holding less cash.  50% of investors are either fully invested or only holding 0-5% cash.  But the good news is that 29% have 10% or more cash available for investment.

Following up on the previous findings, surveyed investors are confident for 2010.  Those that predict they will be fully invested in the next six months increased from 18% to 21%.  Those that predict they will hold 0-5% cash increased from 32% to 39%, demonstrating a goal of investing more.

Hedge Fund Managers

Challenges and Assessing a Manager

In terms of the biggest challenges investors faced in 2009 and 2010, “selecting and monitoring manager” posed the biggest challenge, with “lack of transparency” also ranking highly.  This year, “investments frozen with a manager” was a new category and also ranked very high.  When assessing a hedge fund manager, investors used to cite the 3Ps: performance, philosophy, and pedigree.   While those qualities continue to be important, investors have increasingly focused on risk management and transparency.     This reflects greater caution and less reliance merely on manager pedigree.  Performance ranks first, risk management ranks second, and philosophy ranks third in terms of importance.

Length of Due Diligence Process

The due diligence process has gotten more costly and timely.  For most investors–over 50%, need 3-6 months to conduct due diligence of a manager.  This statistic is consistent over the last three years.  The percentage of investors who can complete this in less than 3 months has increased slightly and so has the percentage of those who need 7-12 months.

Seeding Business

The institutionalization of hedge fund investing is making it increasingly difficult for new launches to attract investors. While a minimum of $50 million AUM was once sufficient, the critical minimum is now $100 million.  Emerging managers are therefore increasingly turning to the seeding business “to overcome the hurdle of reaching the critical size to gain visibility and profitability.”  17% of the investors surveyed seed managers.  The majority of seeders are U.S. based–59%, with 30% in Europe, 9% in Asia, and 2% in Australia.  Funds of funds are the primary investors that seed, with asset management companies and high net worth individuals following.

45% of fund of funds seed managers, followed 26% of asset management companies and 17% of family office/high net worth individuals.

There are three seeding business models: (1) revenue split, (2) equity split, and (3) platform.  Under the revenue split model, seeders provide capital in exchange for participation in management and incentive fees.  Nearly half of seeders surveyed use this model.  Seeders provide capital in exchange for equity ownership and generally take active partnership role under the equity split model.  19% of seeders surveyed adopt that model.  Finally, under the platform model, established hedge funds and financial institutions provide capital and “turnkey” solutions in exchange for profit share.  Only 9% of seeders surveyed adopt the platform model.  Before a manager turns to the seeding business, it should consider the support offered by the seeder, including the form of operations, risk management, marketing, strategic assistance and business development, and compliance and legal support.  In addition to providing funding, well-respected seeders can also provide reputational capital.

For the most part, the average seeding ticket ranges from $25 million to $75 million, with fewer under $10 million and even fewer greater than $100 million.

Consultants

6% of the surveyed investors consider themselves to be investment consultants.  The findings show that there has been an increasing presence of such consultants in the hedge fund industry.  These firms serve as the “bridge between investment managers and pension funds.”  The largest percentage of the consultants’ client base is the family office/high net worth individuals, followed by government funds, and fund of funds.

Hedge fund investors are also more frequently turning to consultants to perform extensive due diligence.  These investors do not have the resources to perform increasingly rigorous due diligence and rely on consultants.

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Cole-Frieman & Mallon LLP provides comprehensive hedge fund start up and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Audit Issues from Due Diligence Provider

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The following article is written by Chris Addy, president and CEO of Castle Hall Alternatives which is a hedge fund due diligence firm.

For funds raising assets from institutional investors, the due diligence process will be quite familiar and Chris describes some of the frustrations from the investor/due diligence standpoint.  I would imagine that these issues will continue to arise as more service providers strive to find ways to limit their potential future liability.  Please feel free to comment below.

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A recap on some audit issues

Looking back over our posts over the past year or so, we’ve commented on a number of issues which impact investors’ due diligence procedures when thinking about the audit process, the financial statements, and the auditor themselves.

We thought it would be useful to recap on a group of issues which continue to be troubling:

1) And why can’t the auditor identify themselves?

Back in November, we commented on the challenge of getting the Big 4 audit firms to admit that they are, actually, the auditor of the fund in question.  In the six months since then, practices appear to have standardized: typically, the Big 4 will now provide a form response, but only after the investor has signed an extensive disclaimer letter.  The slight snag?  The disclaimer is usually so wide ranging that it appears to materially impact the investors’ ability to sue the auditor in the event of audit failure (which, of course, is the idea).  We advise our clients not to sign it.

As a counterpoint, it is worth noting – and forcefully reminding the Big 4 – that every other auditor on the planet makes the confirmation process smooth and effective.  Castle Hall is particularly appreciative of the responsiveness and professionalism of Rothstein Kass each time we make an audit confirmation request.  In fact, that reminds me…do I actually need a Big 4 auditor?

2) And it’s pretty much the same for SAS 70s..

Unfortunately, the SAS 70 process is pretty much the same – it is becoming increasingly difficult for the end investor to obtain a copy of the SAS 70 document for many administrators.  This is, of course, despite the fact that the SAS 70 is now a key marketing point in the admin industry.

It’s particularly annoying when the SAS 70 is stated only to available (i) to the auditors of (ii) the administrator’s clients, the funds.  The first point makes the SAS 70 process seem more than a little self serving, as the auditors give each other work for the sake of it.  The second raises the broader issue (and one of our favorite topics) of who exactly is the administrator’s client – the fund or the investor?

A particular black mark goes to those administrators who will not provide investors with a copy of the SAS 70 under any circumstances, and insist on providing a summary of the SAS 70…prepared by themselves.  And exactly how is the investor supposed to place any reliance on that?

An honorable mention in the hall of shame must go, however, to those administrators who try to charge the costs of their SAS 70 review through to their fund clients as an out of pocket expense.  In other words, the admin expects the funds’ shareholders’ to pay for their own SAS 70.

And no, we still can’t see it.

3) Who distributes the financial statements?

While the confirmation issue above is tediously annoying, thinking practically, the risk that a hedge fund simply fabricates a relationship with PwC or KPMG is pretty remote.  What is more likely is that a reputable audit firm has been appointed and completes their work…but a manager then elects to change some or all of the financial statements and gives investors a set of fake accounts.  As we have said before, a copy of Adobe photoshop only costs $500.

The double irony is that, even with the audit confirmation we discussed above, the auditor does not send the investor the accounts directly.  There is, therefore, no way of getting a direct confirmation from the auditor that the accounts in your possession are, in fact, genuine.

One suggestion we have heard would be, in the offshore world at least, for investors to access financial statements direct from the Cayman Monetary Authority (perhaps via a secure website with appropriate authorizations).  This would draw on the requirement that the fund auditors must give the Cayman authority a copy of the (genuine) accounts themselves.  An excellent idea….Cayman?

As a more immediate solution, we are always anxious to confirm that the fund administrator receives the audited financials direct from the auditor and thereafter sends them to investors.  This is a great control – it ensures that the financial statements are authentic, and it also unequivocally confirms the identity of the auditor at the same time.

The snag?  While this is crucially important, administrators seem pretty casual about the whole process.  Admins are generally happy to do this, but only if a fund asks for this “service”, and many admins are certainly far from proactive on this topic.  There are some admins, mind you, that don’t want to get involved (we came across one admin that had decided, on a related point, that they would not send offering memos to investors.)

In our mind, this is a vital control and should be mandatory for every administrator.  Getting the financials from the admin is just as important as ensuring that the investor monthly NAV statements come from the admin and not from the manager.

4) And who is the audit report addressed to?

Another particular bugbear is the obsession of one of the Big 4 audit firms in Cayman to change the addressee of the audit report from “to the board of directors and shareholders” to just “to the board of directors”.  The objective, of course, is transparent and predictable – the auditor is looking to enhance the concept of privity and assert that the firm only has a relationship with the Board and no relationship – none, never, nada – with the investor.

The irony here – the directors who are now the sole recipient of the audit are usually our rent a director friends who sit on a few hundred other hedge fund boards.  And does anyone really think – including the partner at the Big 4 firm signing the opinion – that these guys really have time to read every set of audited financial statements from cover to cover?

One solution here – could the Cayman regulator mandate that the audit opinion must be addressed to the shareholders in order to be meet Cayman requirements?  Again, this would be a small change that would send a very helpful, investor friendly signal from this jurisdiction.

5) In fact, do you even have to leave the office?

A final observation reflects what seems to be an emerging trend over the past audit cycle – certain auditors (and certain offices of certain auditors in particular) seem to be adopting a desk fieldwork process.  We have recently completed due diligence on a number of funds – albeit usually long short equity – when both the administrator and the manager stated that the audit team had never came on site to do any audit work.  All work was done remotely from the auditor’s own offices.

Now, aside from the fact that fieldwork is called fieldwork for a reason (er…you’re in the field) we see this as a worrying trend.  It stands to question that the quality of the audit is not the same if you never look the individual responsible for preparing the accounts in the eye.

As a counterpoint to our observations, we do continue to recognize that the audit process is ever more challenging and that many skilled professionals work incredibly hard, especially during busy season. As just one example, we were recently speaking with the audit partner of a Big 4 firm discussing FIN 48 – a tortuous challenge for the profession.

At the same time, the audit process is critical for investors and we’re certainly entitled to ask tough questions – we are “sophisticated”, after all.

It’s also worth noting that the auditors’ ever increasing fees are, of course, borne by the end allocator.  We’re happy to pay….provided we get good value.  Net net, the hedge fund audit profession would certainly be well served to make things a little easier for the person cutting the pay cheque.

www.castlehallalternatives.com
Hedge Fund Operational Due Diligence
“Risk Without Reward” is a trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP is one of the top hedge fund law firms and provides comprehensive formation and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

For more articles by Chris Addy, please see the Castle Hall Alternatives post where we have listed our reprinted articles.

State Budget Shortfalls and Investment Adviser Registration

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Financial Reform Bill May Devastate Overburdened State Securities Divisions

As many states are facing huge budget shortfalls, government services have been cutback and certain states have furloughed workers in certain divisions. In a number of states (including California) these budget cuts have affected the state securities divisions and accordingly the many state securities divisions are running dangerously lean. For example, I just recently talked with an examiner in the Oregon Division of Finance and Corporate Securities regarding a state blue sky filing for a hedge fund manager. The examiner told me that because of budget cuts and furlough days, the division will not even have a chance to review the blue sky filing we submit for five months! (Of course, they will cash the check immediately.)

This is obviously a huge issue and is only one instance of a state which does not currently have the resources to adequately perform oversight of the investment and securities activity which occur within its borders. In fact, many states currently don’t have the staff or expertise to adequately oversee the investment advisers and brokers registered with their securities division. While this is troubling, the problem is only going to get worse if the Financial Reform Bill proceeds as currently drafted.

While many have lauded the Senate bill, which will require hedge fund registration for managers with $100MM in AUM or more, an important issue has been overlooked. All investment advisers (in addition to hedge fund managers) with AUM of less than $100MM will be subject to state and not SEC registration. The $100MM threshold is an increase from the current threshold of $25MM. This means that a financial planner overseeing $90MM in assets (which was previously subject to SEC registration and periodic examination) will now be subject to regulation, generally, by the state in which that manager resides.

This means that if the financial reform bill goes through as currently drafted in the senate, the states are suddenly going to be responsible for overseeing a larger pool of managers. Even though the state will have increased responsibility, it is unlikely that state budgets will provide the securities divisions with more funding to properly oversee the new managers the divisions will be responsible for regulating. We find this troubling for investor protection reasons and for manager business continuity – that is, managers would be better off registered at the SEC level and subject to examination by SEC staff better trained (presumably) than state regulators.

We concede that the SEC has its own problems with funding and this provision allows them to focus on larger, more systemically important managers. However, we believe that states are going to be greatly burdened by the increase in jurisdictional oversight. Accordingly, we believe either Congress or the SEC provide a grandfathering provision which would allow current managers who exceed the $25MM threshold (but not the new $100MM threshold) to register or remain registered with the SEC.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP is one of the top hedge fund law firms and provides comprehensive formation and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.