Category Archives: Business Issues

UCITS Hedge Funds

Overview of UCITS Hedge Funds

Bryan Goh of the blog Ten Seconds Into The Future has let us repost his article on UCITS hedge funds. We have posted a number of articles from Bryan, see end of post, and believe that he has some great industry insight (see especially here and here).

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What are UCITS?

UCITS are funds that comply with the European Directive for retail open-ended investment funds, are incorporated and authorised by the regulator in an EEA member state and can be distributed throughout the European Economic Area.

UCITS is a framework to standardise rules for the authorisation, supervision, structure and activities of collective investment undertakings in the EEA and so to enable them to be marketed throughout the EEA.

To be UCITS a fund must be open-ended, liquid, well-diversified, invest only in certain ‘eligible’ assets (namely quoted securities, money market instruments, deposits, certain derivatives and units in other UCITS) and can only employ limited leverage.

Why would a hedge fund manager offer a UCITS version of their fund?

Managers who are able to offer their strategies in UCITS format will be able to access a large universe of investors attracted by the UCITS brand in Europe, globally, and particularly in the Asia.

The transparency, liquidity and regulatory oversight required in a UCITS addresses investor concerns in a post-Madoff, post-credit 2008 crunch environment.

A UCITS lies outside the scope of the European draft Alternative Investment Fund Managers Directive which is likely to impact unregulated offshore hedge funds in yet undefined ways. This is potentially beneficial as the AIFM Directive is likely to impose constraints on European investors investing in third-country funds, which would include those domiciled in offshore jurisdictions such as Cayman Islands and Bermuda.

What is the process of launching a UCITS?

It’s complicated but it can be largely outsourced. Below is a list of the main features of UCITS. It all sounds complicated and laborious but a competent partner will be able to take most of the initial and ongoing burden away so that the fund manager can concentrate on managing money in as uninterrupted and unmodified a fashion as possible.

Fund Structures:

There are several fund structures available to UCITS. These include Unit Trusts, which are familiar vehicles and preferred by certain Asian investors such as Japanese, Variable Capital Companies, which are the OEICs and SICAVs and will look similar to a hedge fund structure with additional segregation of assets ex prime broker and Contractual Funds which are niche structures which are more complex to administer and market.

Management Companies:

The structure and indeed the existence of a management company is based on the tax planning of the investment manager. A Management Company brings with it minimum capital requirements, oversight and accounting and consolidation requirements. Roughly speaking, a UCITS Management Company needs to have 125,000 EUR of capital as a minimum plus 2 basis points per EUR of AUM over 250 million. This capital cannot be held on the group Holdco balance sheet and must be invested in liquid investments.

Sponsors:

There are some onerous capital requirements on Sponsors.

In Ireland the capital requirement is 635,000 EUR.
In Luxembourg the capital requirement is 7.5 million EUR.
These are largely unwritten rules.
A sponsor can be rented.

Legal Documentation:

There are rules for the prospectus
There is a simplified prospectus
Constitutional documentation, memoranda and articles.
Legal contracts:

– IMA
– Administration Agreement
– Custody Agreement
– Distribution Agreement

Business Plan and Substance Application
Risk Management Process

The Business Plan and Substance Application:

Constitutional documents
Capital requirements
Probity and competence of directors
Suitability of qualifying shareholders and organizational structure
Conduct of business
Board meetings – Frequency and content – minimum of 4 in the domicile.
Managerial functions
Frequency and content of reporting
Exception reporting
Escalation measures

The managerial functions require at least 2 Conducting Officers or Dirigeants. These can be:

Employees (usually not)
Directors of the UCITS can assume these functions
UCITS can appoint consultants.
In Ireland a board can be collectively appointed. In Luxembourg individuals have to be named.

The managerial functions include:

Appointment of Chairman
Frequency of board meetings
Distinguishing between decisions for the board versus the conducting officers
Compliance monitoring.

– Investment breaches
– Pricing errors
– Complaints
– AML issues

Risk Management

– Investment risk
– Use of Derivatives
– Pricing issues
– Reconciliation
– Failed trades

Performance Monitoring

– Performance metrics
– Benchmarks – especially if VaR relative to benchmark is used as a formal exposure metric
– Explanation of unusual performance
– Outlook
– A bi annual detailed commentary for inclusion in the financial statements

Finance Control

– Management company and fund financial statements
– Annual audit process
– Monthly management accounts of Management Company and Fund

Monitoring Capital

– Monthly review of capital adequacy.

Supervision of service providers

– UCITS requires regular ongoing due diligence on the Administrator, Custodian, and other service providers.

Eligible Markets and Securities:

List of Eligible Assets

Transferable Securities (TS)
Money Market Instruments (MMI)
TS and MMI with a derivative element (example Convertible Bonds)
Financial Derivative Instruments (FDI)
Open ended Collective Investment Schemes (CIS)
Deposits with credit institutions
Ancillary liquid assets
Financial indices
Repos, reverse repos, stock lending

List of non eligible assets

Direct or indirect investments in

Commodities
Real estate
Private equity
Hedge funds
Non financial indices
Short selling of MMI
Anything that circumvents the investment limits of the UCITS directive

Note that exposure to the above can be gained through financial indices on the underlyings.

Transferable Securities:

Generally:

Max loss limited to cost
Liquid
Regular, accurate reliable pricing
Negotiable

Closed end funds:

Corporate governance has to be robust
Asset manager subject to national regulation

Money Market Instruments
Generally:

Normally dealt in on the money markets
Liquid
Can be accurately valued

If not dealt in on a regulated market:

Meet certain issue/issuer criteria
Information available for a credit assessment
Freely transferable

Derivatives:

Underlyings consist of:

– TS, MMI, CIS, FDI, deposits, financial indices,
– Interest rates
– FX rates
– Currencies

Do not expose UCITS to risks it could not otherwise assume
Does not cause deviation from investment objectives
Does not result in the delivery of underlying which is not an Eligible Asset

Shorting comes in under derivatives on TS and financial indices. It will allow shorting equities and bonds via CDS.
OTC derivatives are allowed. There are requirements on the counterparty.

The counterparty must provide valuations
The counterparty must provide unwind

Collective Investment Schemes:

UCITS funds can invest in Collective Investment Schemes provided

The underlying CIS does not itself invest more than 10% of NAV in another CIS (UCITS or otherwise)
The CIS is diversified
The CIS is liquid
There is a 30% limit on exposure to non UCITS CIS even if they comply with the above
Non UCITS CIS must be subject to some form of supervision equivalent to UCITS, with sufficient investor protection

Financial Indices:

Automatically eligible if the constituents are themselves eligible
All other indices require separate regulator approval

– Requires sufficient diversification
– Be an adequate benchmark for the reference market
– Appropriately published
– Must have independent management from the management of the UCITS

A number of bespoke indices have emerged that appear to game this rule. The indices resemble bespoke, alpha optimized portfolios instead of an index representative of some class of assets.

Hedge fund investable indices are eligible provided:

No backfill used in their construction
No payments are made to the index provider from the index constituents
Index construction is objective and systematic
UCITS must perform adequate due diligence on the quality of the index

Repos, Reverse Repos and Stock Lending

UCITS can enter into repos and reverse repos and stock lending. Conditions apply.
Collateral must be posted.

Diversification:

Unsatisfied with the almost universal concept of diversification, UCITS has adopted the term Risk Spreading.

Unlisted Securities:

Limit of 10% of NAV in unlisted securities.
Additional 10% of NAV in recently unlisted securities destined to list in less than 12 months
Limit does not apply to certain 144A securities provided they list within a year
Bonds with a liquid market traded between regulated broker dealers and are subject only to general limits

5/10/40 Rule:

10% NAV issuer limit across capital structure.
For positions exceeding 5% NAV issuer limit, the aggregate shall not exceed 40% of NAV.

For bonds issued by EU credit institutions subject to special public supervision

25% NAV issuer limit across capital structure.
For positions exceeding 5% NAV issuer limit, the aggregate shall not exceed 80% of NAV.

For Index Trackers, there are looser limits.

Max 20% NAV issuer limit. 35% in exceptional circumstances. (e.g. 0005 HK in the HSI Index)
Index must be:

– Sufficiently diversified
– Represent an adequate benchmark
– Published appropriately
– Independently managed of the UCITS

Control Limits:

Max 10% of non voting shares of any issuer
Max 10% of debt securities of any issuer
Max 10% of money market instruments of any issuer

Government Securities:

35% NAV issuer limit (from 10%) for TS and MMI issued by:
EU member state and their local authorities

– Non Member State
– Public international body of which at least one member state is a member

Exempt from 5/40 rule

Up to 100% of NAV may be invested in TS, MMIs issued by a member state or their local authority, non member state or public international body if:

Held over 6 or more different issues
Limit 30% per single issue
Intention to use these limits and target issuers is disclosed in constitution and offering docs
Limited to OECD / Investment Grade (quite independent of each other these days)
Gilt Funds for example can be UCITS compliant and invest in 1 single issuer. (not quite investment grade these days)

Investments in Other Collective Investment Schemes:

Max 20% of NAV in a single CIS
Max 30% of NAV aggregate in non UCITS CIS (to remain ourselves UCITS)
Underlying CIS limited to no more than 10% in other CIS in aggregate (prevents FOFOF layering)
Max 25% of units of a single CIS (control issue)

General:

20% NAV limit in issuer exposure across their capital structure, net. Includes TS, MMIs, cash, OTC counterparty, exposure via derivatives
Max 5% in warrants
No uncovered short sales
Limits do not apply to the exercise of subscription rights

Borrowing Limits:

The Fund can borrow up to 10% of NAV for temporary purposes.
Credit balances may not be offset against borrowing in calculating the percent borrowed.
Leveraged is achieved through derivatives.

Risk Management:

Risk Management Process:

A fund using Derivatives must submit to the Regulator a detailed Risk Management Process (RMP)
The RMP will set out the list of derivatives that will be used, the controls, processes, systems and personnel involved in the management and monitoring of risk relating to these derivatives.
Material changes to the RMP need regulator re-approval.

Level of Sophistication:

The Fund may self classify itself as Sophisticated or Non-Sophisticated.
The Regulator may disagree
Sophisticated funds are required to implement VaR
Non Sophisticated funds can use commitment or (delta) notional exposure
Self classifying as Non Sophisticated exempts a fund from the use of VaR but can impose restrictive notional leverage limits
Self classifying as Sophisticated allows more latitude in definition of leverage within a VaR framework

Global Exposure:

Total gross exposure including derivatives is limited to 200% NAV
Synthetic shorting is allowed
Physical shorting is not allowed

Commitment Approach:

Notional value
Global exposure is NIL for funds using derivatives purely for hedging or risk reduction purposes
Options can be treated on delta adjusted basis
Purchased and sold derivatives can be netted only if there is explicit netting arrangements with the Custodian or counterparties

VaR:

VaR model based on:

99% confidence interval
Max 1 month holding period
Min 1 year historical observations
Stress tests and back tests must be applied
Adequate internal controls, staffing and experience are required
Description of VaR model and 3rd party verification
VaR may be specified as a multiple of a benchmark. That multiple is limited to 200%.

Position Exposure:

Limits are defined on total exposure aggregating direct, indirect and derivative exposure.
Except for certain Index based derivatives.

Counterparty Exposure:

Counterparty risk is limited to 5% of NAV for OTCs and 10% for EU or equivalent credit institutions.
All derivative exposures to the same OTC counterparties must be aggregated and an “add on” for future credit exposure based on Market Value (Ireland) and Notional (Luxembourg).
Counterparty risk can be reduced by the fund receiving collateral from the counterparty.
Positive and negative positions can be netted but only if there are formal netting agreements with the counterparty.

Liquidity:

A UCITS must re-purchase or redeem its units at the request of the unit holder.
Minimum frequency is twice a month. (Note that there is no specification on when in the month.)
Maximum notice until payout of cash is 14 days.
A UCITS can have a 10% gate per redemption date, thus a maximum 20% gate per month.

Feasible Strategies:

The following strategies are feasible under UCITS:

Long short equity
Long short credit – liquid markets only
Convertible arbitrage
Global Macro
Fixed income arbitrage – definitions of leverage need to be addressed
Commodity index funds – there is no question of physical of derivatives on underlying commodities. Only commodity indices are eligible.
CTA and Managed Futures
Event Driven
Funds of UCITS Funds
Structured and guaranteed products
ETFs

The following are not recommended for UCITS and fall foul of UCITS liquidity and valuation requirements: Less liquid credit strategies, distressed debt, mezzanine, private equity strategies, small and micro cap strategies.

A Final Word:

For the hedge fund manager, UCITS provides a delivery channel to a different investor base diversifying business risk. It also addresses investor concerns about the operational and fraud risks that plagued parts of the offshore unregulated industry in 2008. In addition, it provides a potential means of dodging the AIFM directive. There will be managers who see UCITS as a convenient dodge and an easier path to raising capital, and there will be those who see it for what it is; the evolution of European mutual fund legislation to ensure better investor protection while providing investors more choice. It is important that managers comply with the spirit of the law as well as the letter. The risk to UCITS as a brand is that it is abused by some managers which abuse the market uncovers in the usual discontinuous fashion and the fallout tars all UCITS with the same brush.

UCITS is designed for liquid strategies. Shoe-horning illiquid strategies into UCITS is a very bad idea. Not many people are aware that UCITS has a gating facility. This is an emergency feature for when normally liquid markets seize up. To run an illiquid portfolio in a UCITS in the hope that the gate provision is never needed is irresponsible on the part of the manager and the service providers who help to bring that UCITS to market.

UCITS is designed for low to moderate leverage strategies. The Sophisticated Fund classification which measures leverage in terms of VaR allows liquid strategies where delta notional exposure is not an appropriate measure of leverage admission as a UCITS. It is not there so that a highly levered and risky strategy can be slipped into a UCITS.

UCITS is designed for portfolios of eligible assets which are eligible by virtue of their liquidity, price discovery and transparency. It is designed so that the UCITS can feasibly supply the represented liquidity, provide an accurate and representative valuation of assets and not carry surprisingly large liabilities on the balance sheet which unexpectedly erode the value of the Net Asset Value.

Use with care.

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Other HFLB articles reposted from Bryan:

San Francisco Futures Professionals March Meeting | March 16, 2010

Hedge Fund Marketing – Building a Strong Brand Identity

NFA Provides Social Networking Compliance Guidance

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Member Firms Subject to Increased Oversight & Compliance Responsibilities

In early December the National Futures Association (“NFA”) submitted two proposed amendments proposed amendments to the Commodity Futures Trading Commission (“CFTC”) regarding NFA Member Firms and their use of the internet and social media networks. The amendments focus on communications by firms over the internet in various capacities including blogs, chat rooms, forums, and various social media websites (i.e. Facebook, Twitter, etc). While these amendments will increase the oversight responsibilities for Member Firms, it makes sense for the NFA to alert members to their responsibilities with regard to these growing forms of communication. This post describes the two amendments, application to forex managers, the NFA social media podcast and the impact these amendments are likely to have on all NFA Member firms. The NFA’s Notice to Members on this issue is also reprinted at the end of this post.

Overview of Amendments

Amendment to Rule 2-29

Rule 2-29 was broadened by the following changes (underline and strikethrough):

(h) Radio and Television Advertisements.

No Member shall use or directly benefit from any radio or television advertisement or any other audio or video advertisement distributed through media accessible by the public if the advertisement that makes any specific trading recommendation or refers to or describes the extent of any profit obtained in the past that can be achieved in the future unless the Member submits the advertisement to NFA’s Promotional Material Review Team for its review and approval at least 10 days prior to first use or such shorter period as NFA may allow in particular circumstances.

By broadening the rule the NFA effectively is requiring Member Firms to make sure all audio and video internet advertising (i.e. podcasts, youtube, voiceover presentations, etc) be reviewed prior to use. Effectively groups who have used these channels to market their services will need to (i) have all such media reviewed by the NFA or (ii) take all media off of the internet.

Interpretive Notice: Internet Communication & Social Media

This interpretive notice is not so much an amendment of an existing Interpretive Notice as it is simply the creation of a new notice. The full Interpretive Notice can be found in the proposed amendments link above, but I have also reprinted some of the more interesting parts of the notice:

The form of communication does not change the obligations of Members and Associates who host or participate in these groups, and electronic communications must comply with Compliance Rules 2-9, 2-29, 2-36, and 2-39.

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Therefore, content generated by the Member or Associate is subject to the requirements of NFA Compliance Rules 2-29, 2-36, or 2-39. The same is true for futures, options, or forex content written by a Member or Associate and posted on a third party’s site.

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Members should have policies regarding employee conduct. These policies could require employees to notify the employer if they participate in any on-line trading or financial communities and provide screen names so that the employer can monitor employees’ posts periodically. Alternatively, the policy could simply prohibit participation in such communities. The Member must, of course, take reasonable steps to enforce whatever policies it adopts.

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The issue becomes more complicated for user-generated comments responding to a Member or Associate’s blog and for Members and Associates who host chat rooms or forums. What is their responsibility for posts from customers or others over whom the Member or Associate has no direct control? When inadequately monitored, social networking sites may contain misleading information, lure customers into trades that they would not normally make, or be used in an attempt to manipulate prices.

The biggest take-away is that the NFA is expecting NFA Members to integrate a social media awareness into their current compliance program. Accordingly, compliance programs (especially those parts dealing with Compliance Rules 2-9, 2-29, 2-36, and 2-39) will need to be updated appropriately to reflect the requirements of the Interpretive Notice. Member Firms will also need to vigillantly follow their new/revised compliance procedures and monitor their employees – it will be very easy for the NFA to do simple internet searches and potentially “catch” firms who do not adequately comply the Interpretive Release.

Issues for Forex Managers

Forex is specifically discussed throughout the Interpretive Notice so it is clear that the NFA’s intent is to make sure that forex communications, especially, are subject to monitoring and oversight. Currently this rule applies to those firms who are NFA Member Firms (currently registered) and, in the future, after the forex registration rules have been adopted, it will apply to all registered forex firms (CTAs, CPOs, IBs and FDMs/FCMs). The NFA has made it clear before that forex managers/traders are in the NFA’s regulatory cross-hairs and this Interpretive Notice reinforces that impression.

NFA Podcast on Social Media

The NFA has produced a podcast titled “Use and Supervision of Online Social Networking Communication” and can be found with other NFA produced podcasts. This podcast is helpful to provide Member Firms with some helpful guidance on some of the major issues to consider when developing a social media policy to comply with the Interpretive Notice and Rule amendment. There are a number of considerations that firms will need to make and the social media policy must be tailored to the business practices of the firm. There are likely to be a number of hot button issues which will develop regarding Member Firms and this policy, especially concerning oversight of associated persons. The podcast also hints at one of the big compliance issues which managers should be aware of – the reposting of content. Because internet posts are routinely “scraped” from the original website and reposted on other websites, Member Firms should be aware of this issue and create appropriate procedures.

It is recommended that compliance officers listen to this podcast when developing their social media compliance policies and procedures.

Impact on NFA Members

I view these amendments as relatively major – because so many firms use the internet for marketing and because prior NFA rules essentially did not address the issues of social networks there has been a bit of a regulatory gap. However, I do think that the NFA is doing the right thing by publicly notifying Member Firms that this will be a compliance issue going forward – this is much better than a retroactive interpretation of existing NFA compliance rules. One thing I think that member firms should be especially concerned with is potential liability for what 3rd parties do with information which is posted online. On the podcast, the NFA specifically suggested that firms should be policing their content and actively follow how it might be used by 3rd parties which is obviously problematic given the way the internet works.

Because these amendments affect both a current NFA Rule as well as the NFA’s Interpretive Releases, these amendments may make their way (eventually) onto the various exams (Series 3, Series 30, Series 34 especially).

These rules are also likely to create a compliance nightmare for many firms which have utilized the internet previously (and social media specifically).

Compliance Recommendations

The safest approach to social media compliance for all NFA Member Firms is to not allow the use any social media websites or other means of internet communication which would subject the firm to have a robust social media policy (including record retention policy for such media). It will be much less costly to put a blanket prohibition on these types of activities than to develop and monitor such a policy. For those firms who are willing to spend the time and money to implement a policy, such firms should make sure that all major aspects of the amendments are included in the policy. Such items to consider will include: internet and social media content review, recordkeeping and storage, oversight of employees (including spot-checking internet posts and activity), and reposting review procedures, among other issues to consider. It will be absolutely critical to make sure the policy addresses all issues raised in the Interpretive Notice and podcast because the NFA has not minced words – this is going to be a hot-button issue and it will be something the NFA will actively pursue during examinations.

Of course we will be able to provide greater guidance over the next few months as we see how the NFA handles this issue during and outside of examinations.

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Notice to Members I-10-01

January 5, 2010

Effective Dates of NFA Requirements Regarding On-Line Advertising and Social Networking Groups

NFA has received notice from the Commodity Futures Trading Commission (“CFTC”) that NFA may make effective certain proposed amendments regarding the use of internet and on-line social networking groups when communicating with the public. The Interpretive Notice entitled “Use of On-Line Social Networking Groups to Communicate with the Public” makes clear that on-line communications are subject to the same standards as other types of communications with the public and provides guidance to Members to meet their responsibilities in this area. The Interpretive Notice became effective on December 24, 2009.

A related amendment to Compliance Rule 2-29(h) requires that any audio or video distributed through media accessible by the public (e.g., through the internet) that makes any specific trading recommendation or refers to the extent of profit previously obtained or achievable in the future must be submitted to NFA for review and approval at least 10 days prior to first use. In this way the amendment subjects certain on-line advertising to the same requirements as similar television and radio advertising. To allow Members sufficient time to submit these types of advertisements to NFA for approval, the amendment becomes effective as of February 1, 2010. Accordingly, any audio or video advertisements that a Member posts on-line after January 31, 2010, must have been previously reviewed and approved by NFA.

NFA’s December 8, 2009, submission letter to the CFTC contains a more detailed explanation of the changes. You can access an electronic copy of the submission letter at: http://www.nfa.futures.org/news/PDF/CFTC/CR2-29_IntNotc_re_OnLine_Social_Networking_120209.pdf.

Questions concerning these changes should be directed to Sharon Pendleton, Director, Compliance ([email protected] or 312-781-1401) or Michael A. Piracci, Senior Attorney ([email protected] or 312-781-1419).

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Other related hedge fund law blog articles include:

If you are a manager or firm that needs to register as a CTA or CPO, or if you are contemplating registration, please contact Bart Mallon, Esq. of Cole-Frieman & Mallon LLP at 415-868-5345.

NFA Annual Questionnaire

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Reminder to NFA Member Firms

As part of the annual processes and procedures NFA Members will need to make sure that they complete the NFA Annual Questionnaire. As discussed below in the NFA’s most recent notice to members, it is important that NFA Members complete the questionnaire because some of the answers will appear as BASIC entries sometime within the first half of 2010 (for an image of this, please see Notice to Members I-10-02, reprinted in full below). Below we have provided an overview of the major items which are addressed on the questionnaire. NFA Members are urged to complete the NFA’s Self Exam Checklist prior to logging in to complete the questionnaire.

Questionnaire Items

The annual questionnaire actually requires the NFA Member to provide fairly detailed information on the nature of the Member’s business and the extent in which the Member participates in certain aspects of the industry such as trading in the forex markets. Each firm will need to complete a section called “Firm & DR Information” as well as one section (or multiple sections if applicable) devoted to CTA, CPO, IB, or FCM specific questions. Below we’ve outlined the major categories.

CTA Questionnaire

The central part of the CTA questionnaire focuses on information related to the trading program. Such information requested includes: nominal AUM, forex account information, number of accounts trading Securities Futures Products (SFPs)*, most recent disclosure document date, whether any exemptions exist, types of investors, etc.

* A securities futures contract is a legally binding agreement between two parties to purchase or sell in the future a specific quantity of shares of a single equity security or narrow-based securities Index (e.g. products traded on One Chicago or NQLX). It does not include broad-based indices such as the S&P 500 or Dow.

CPO Questionnaire

The central part of the CPO questionnaire focuses on information related to the commodity pool. Such information requested includes: pool trading information, question on restrictions (if any), forex trading information (if applicable), SFP trading (if applicable), most recent disclosure document date, whether any exemptions exist, etc.

Firm & DR Information

In the Firm & DR Information section you will need to include certain information on the preparer (name, title, phone, email) and you will need to complete firm information and disaster recovery information.

Firm Information

For the firm information there are a number of questions regarding the number of accounts to which the firm is currently providing advice, whether the firm is engaged in forex activities, the extent to which the firm utilizes advertising (tv/radio, print, internet), and/or whether the firm is registered in other capacity. Importantly, there is a question regarding whether the firm has completed the self-exam checklist within the last 12 months.

Disaster Recovery Information

All NFA Member firms are required to have addressed disaster recovery. For the purposes of the questionnaire, Members are required to provide primary and secondary contact information. Specifically, the instructions are as follows:

For purposes of business continuity and disaster recovery, members are required to provide NFA with the name and contact information for one or two persons who NFA can contact during an emergency. Since this information will serve as an alternative contact in the event you are unable to continue doing business at your main location, the contact information that you provide should be different from that of your main location.

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Notice to Members I-10-02

January 6, 2010

Reminder to all Members to complete new questions in Annual Questionnaire assessing Member’s futures-related and off-exchange forex business

On November 30, 2009, NFA issued Notice to Members I-09-21 [HFLB Note: reprinted directly below] requesting all Members to complete a series of new questions located in the Annual Questionnaire assessing their futures-related business. Although some NFA Members have complied with this request, many have not. It is critical that Members access and complete questions in the Firm and DR Information section of the Annual Questionnaire as soon as possible. This applies not only to Members trading on-exchange futures products but also Members trading in the off-exchange foreign currency (forex) market.

Beginning in early 2010 NFA’s BASIC system will display information reflecting whether firms are actively engaged in futures-related business activity or not. If the questions are not answered, the answers will default to no activity, which is what will be displayed in BASIC, as illustrated below.

For additional information and instructions on accessing the Annual Questionnaire, click here.

If you have any questions, please contact NFA’s Information Center at 800-621-3570 or 312-781-1410.

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Notice I-09-21

November 30, 2009

NFA adds new questions to Annual Questionnaire to assess Member’s futures-related business

NFA has approximately 500 firms that are NFA Members but have represented to NFA via their Annual Questionnaire that they are not doing any business that requires membership (“Inactive firms”). Almost universally, these Members indicate that they maintain their membership because they may do business in the future.

Since 2006, NFA has taken several Member Responsibility Actions against Member firms that had told NFA they were inactive. These actions were taken after NFA obtained information from reviewing the internet, through contacts with other NFA Members, and by receiving customer complaints suggesting that these firms were in fact active.

Due to these disciplinary actions, NFA’s Board of Directors requested that beginning in early 2010 NFA’s BASIC system display information reflecting whether firms are actively engaged in futures-related business activity or not. Presumably, if a Member is identified in BASIC as not conducting futures-related business, this will raise a “red flag” to potential customers who are being solicited by an Inactive Firm.

Specifically, BASIC will contain information regarding whether or not the Member has on-exchange customer accounts, manages customer accounts, operates pools, is engaged in retail off-exchange foreign currency activities and/or is soliciting customer business. This information will be based solely on information that Member firms provide in their responses to the questions in the Firm and DR Information section of the Annual Questionnaire.

NFA has re-designed this portion of the Annual Questionnaire by adding new questions and moving certain questions from other sections. Firms may update the answers in the Firm and DR Information section of the Annual Questionnaire at any time.

It is critical that Members access and complete questions in the Firm and DR Information section of the Annual Questionnaire as soon as possible. If the questions are not answered, the answers will default to no activity, which is what will be displayed in BASIC.

Please follow these instructions to access the Annual Questionnaire and provide the required information.

1. Open the Questionnaire system using this link: https://www.nfa.futures.org/AppEntry/Redirect.aspx?app=SPECIAL_QUESTION

2. Enter your ORS ID and password to logon.

3. From the “Online Questionnaire Index” screen, select “Firm and DR Information” under “Questionnaire Type.” (In addition, if you have not completed your most recent Questionnaire, you should update the previous version at this time.)

4. Update the Preparer Information on the next screen, if necessary, and then click “Next.”

5. To respond to this special request,

a. Answer the questions listed at the top of the screen under the heading “Please address the following questions regarding you firm’s business operations”.

b. After answering the applicable question(s), scroll to the bottom of the screen and click the “Submit Filing” button.

c. The system will then confirm that you submitted the updated Questionnaire to NFA.

If you have any questions about this Notice, please contact NFA’s Information Center at 800.621.3570 or 312.781.1410.

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Other articles related to CTAs and CPOs include:

If you are a manager or firm that needs to register as a CTA or CPO, or if you are contemplating registration, please contact Bart Mallon, Esq. of Cole-Frieman & Mallon LLP at 415-868-5345.

Fund Appreciation Rights

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Alternative Hedge Fund Compensation Structure

At the very beginning of this year there was much discussion about the hedge fund compensation structure in light of the horrible returns from 2008. Many funds lost money but managers aren’t typically subject to the same types of clawback provisions as private equity fund managers. Additionally some funds had to close shop because of talent retention issues or because the manager realized that reaching a previous high water mark would take too long. Generally investors who have lost money will prefer to stay in a fund (all else being equal) because of the high water mark – when investors go into a new fund, there high water mark is their initial investment which means they are going to be subject to hedge fund performance fees sooner than in a fund which has previously lost money.

FAR Alternative

As an alternative to the traditional performance fee/ allocation structure, some hedge funds are instituting a different compensation structure called fund appreciation rights (FARs). Generally this structure provides a more aligned incentive structure for the manager. Essentially the FARs provide an option like mechanism for the manager. This option also has the potential to allow the manager to defer recognition of income which may be an added tax benefit for the manager. [Note: a longer discussion on this issue will be forthcoming shortly.]

Issues with FARs

FARs are new. It is not known how many groups have implemented FARs or whether they will catch on (or become the next standard). It is likely that any movement in this area will be driven by the demand (if any) by institutional investors for such products. FARs are also untested and it is not clear how they will be viewed by the IRS. As we have recently seen, there has been a big push to disallow the tax advantages of the performance allocation to hedge fund managers and in the current political climate it is likely that the IRS will scrutinize such transactions.

We will continue to research and report on this and other tax structures for hedge fund managers.

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Weekly Hedge Fund News Stories | November 30 – December 4

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Below are a list of some of the news stories which caught my attention this week.

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Hedge Fund Carried Interest Tax “Loophole” Repeal? – the hedge fund carried interest “loophole” is again being discussed as a potential issue to be addressed by Congress before the end of the year. One proposal introduced by Representative Levin (R) has reportedly passed the House twice but is meeting opposition in the Senate. Watch for a bill to be included as a last minute rider. For more background, see articles by Boston.com and Reuters.

Wall Street “Transaction Tax” Introduced in House – A group of Congressmen introduced legislation to tax Wall Street. According to a press release by Representative Peter DeFazio (D-OR), investment transactions (including stocks, futures, swaps, CDSs, and options) will be subject to “small” transaction taxes which could raise up to $150 billion a year. The tax would not apply to certain groups like IRAs, mutual funds, and HSAs. See also a SIFMA press release which discusses this issue.

Florida to Invest $500MM in Hedge Funds – managers who are looking for an allocation from a large pension plan should look toward Florida which is looking to get into hedge funds. According an article on Pension & Investments, Florida has hired Cambridge Associates as a consultant to help with the search.

Positive November for Hedge Funds – Hedge fund managers gained an average of 1.8% in November according to this Market Watch article.

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Hedge Funds, the Secondary Market and PTP Issues

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Secondary Hedge Fund Market Poses Issues for Fund Managers

Recently there have been a number of groups springing up to provide a secondary hedge fund market. While such platforms provide investors with a potential avenue to get out of their illiquid investment (the investment in the fund may be illiquid for a number of reasons including the imposition of a gate provision), they pose problems for the hedge fund manager who will have to deal with the mechanical issues involved in a transfer of the fund interests. Additionally, as noted in the article below, the manager may have to worry about the PTP issues involved with such potential transfer.

The following article was written by Doug Cornelius of the Compliance Building blog and is reprinted with permission. All links in the article are from the original.

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Classification of Private Funds as Publicly Traded Partnerships

Due to the increasing incidence of fund investors who want to transfer their investment fund interests, private investment funds face a risk of being classified as publicly traded partnerships. That would mean the fund would become taxable as a corporation.

A bad result.

Under Internal Revenue Code § 7704, a partnership will be classified as a publicly traded partnership if (1) the fund interests are traded on an established securities market or (2) the fund interests are readily tradable on a secondary market or its substantial equivalent.

The big problem is determining when you have a “substantial equivalent” of a secondary market. Under the regulations, the IRS uses a facts and circumstances test to determine if “partners are readily able to buy, sell, or exchange their partnership interests in a manner that is comparable, economically, to trading on an established securities market.” You hate to get into a facts and circumstances discussion with the IRS.

Fortunately there are some safeguards in the implementing regulations at 26 C.F.R. § 1.7704-1.

Involvement of the Partnership

For purposes of section 7704(b), interests in a partnership are not readily tradable on a secondary market or the substantial equivalent unless (1) The partnership participates in the establishment of the market or (2) The partnership recognizes any transfers made on the market by (i) redeeming the transferor partner or (ii) admitting the transferee as a partner.

Since most fund partnerships require the general partner to approve the the transferee and then admit the transferee, they are unlikely to be able to take advantage of this safe harbor.

De Minimis Trading Safeharbor

The focus of a fund should be on the 2% de minimis safe harbor. 26 C.F.R. § 1.7704-1(j) provides for interests in a partnership to be deemed not readily tradable on a secondary market or the substantial equivalent thereof if the sum of the percentage interests in partnership capital or profits transferred during the taxable year of the partnership does not exceed 2 percent of the total interests in partnership capital or profits.

You want avoid having more than 2 percent of the partnership interests changing hands each tax year.

If you get close to that number there are several transfers that are disregarded transfers for this safeharbor, including:

block transfers by a single partner of more than 2% of the total interests
intrafamily transfers
transfers at death
distributions from a qualified retirement plan
Transfers by one or more partners of interests representing 50 percent or more of the total interests in partnership

Private Placement Safeharbor

The regulations deem a transfer to not be a trade if it was a private placement. But the regulations have their own definition of a private placement: (1) the issuance of the partnership interests had to be exempt from registration under the Securities Act of 1933, and (2) the partnership does not have more than 100 partners at any time during the tax year of the partnership. 26 C.F.R. § 1.7704-1(h)

The first prong should be straight-forward for most private funds. The trickier part is the second prong. In some circumstances the IRS can look through the holder of a partnership interest to its beneficial owners and expand the number of partners to include the beneficial holders of that interest.

Passive Income Safeharbor

If a fund is determined to be a Publicly Traded Partnership, it will nonetheless not be taxed as a corporation if 90% or more of the fund’s gross income is passive-type income. [26 U.S.C. § 7704(c)] Passive-type income generally includes dividends, real property rents, gains from the sale of real property, income from mining and oil and gas properties, gains from the sale of capital assets held to produce income, and gains from commodities (not held primarily for sale in the ordinary course of business), futures, forwards, or options with respect to commodities. The income test is on a taxable year basis and must be have been met each prior year.

References:

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Please also see the post on hedge fund compliance and twitter which includes another reprint of a Compliance Building article.

Other related hedge fund law articles include:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog. He can be reached directly at 415-868-5345.

Series 65 and Series 66 Passing Grade Increased

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IA Exams Pass Rates Expected to Plummet

The North American Securities Administrators Association (“NASAA”) recently announced that the two central investment advisor exams (the Series 65 and the Series 66) will become even more difficult. Starting January 1, 2010 candidates will need to attain a score of 72% in order to pass the Series 65 exam and a 75% in order to pass the Series 66 exam. NASAA did not make any statements on its website or at its Annual Conference earlier this year about the change or the reason for the change.

I had a chance to talk with Chuck Lowenstein of Kaplan Financial Education about the announcement. “The exams have been oddities,” said Lowenstein, “everything else in the business requires a 70% to pass and the 65 had been kind of weird at 68.5% and the 66 as well at 71%. With these new numbers, NASAA has entered new territory. I suspect pass rates will plummet, unless they feel that the new exams will be so much easier (never happened in the past) that they need to bump up the minimum.”

Chuck went on to discuss the likely future performance for people taking the exams. “Based on our students’ performance, this will have a devastating effect on the overall pass rate. A significant percentage of exam takers pass with little room to spare and bumping the requirements by 4 or 5 questions on these exams (the 68.5% on the 65 was 89 correct – 72% is 93.6 questions so they’ll either round up to 94 or down to 93, that has not yet been disclosed) is going to catch many exam takers.”

We do not recommend that exam takers study any differently for the exam, but we urge all potential exam takers make sure they are adequately prepared. If an applicant does not pass the 65 or 66 on the first try, they will need to wait 30 days to take the exam again which will obviously have an effect on the timing of a hedge fund launch.

For more information please see NASAA’s post on the Series 65 and Series 66 exams.

Thank you to Chuck Lowenstein for bringing this issue to my attention.

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Hedge Fund Manager Registration to Cost Taxpayers $140 Million (at least)