Category Archives: Business Issues

Hedge Funds and Insider Trading after Galleon

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By Bart Mallon, Esq. (www.colefrieman.com)

High Profile Case Highlights Issues for Hedge Fund Managers to Consider

Insider trading is now an operational issue for hedge fund managers.  The high profile insider trading case involving RR and the Galleon hedge fund has put the spotlight directly on hedge funds again and has also sparked a debate of sorts on the subject.  Given the potential severity of penalties for insider trading, it is surprising that we still periodically hear about such cases, but nevertheless it is something that is always going to be there – human nature is not going to change.

As such hedge fund managers need to be prepared to deal with this issue internally (through their compliance procedures) and also will need to be able to communicate how they have addressed this issue to both the regulators and institutional investors.  While managers always need to be vigilant in their enforcement of compliance policies and procedures, during this time of heightened insider trading awareness, managers need to be even more vigilant about protecting themselves.  As the Galleon liquidation too vividly shows, a lapse in operational oversight can and will take down an entire organization.

Insider Trading Overview and Penalties

We have discussed insider trading before, but as a general matter insider trading refers to the practice of trading securities based on material, non-public information.  Whether information is material depends on case law.  In general information will be material if “there is a substantial likelihood that a reasonable shareholder would consider it important” in making an investment decision (see TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)).  Information is non-public if it has not been disseminated in a manner making it available to investors generally. An insider is generally defined as officers, directors and employees of a company but it can also refer to a company’s business associates in certain circumstances (i.e. attorneys, accountants, consultants, and banks, and the employees of such organizations).  Additionally, persons not considered to be insiders may nevertheless be charged with insider trading if they received tips from insiders – such persons generally are referred to as tippees and the insider is generally referred to as the tipper.  [HFLB note: more information on insider trading generally can be found in the discussion of Regulation FD on the SEC website.]

The penalties for insider trading are potentially harsh – censures, cease and desist orders, fines, suspension and/or revocation of securities licenses are all potential penalties.  Depending on the severity of the insider trading there may be criminal sanctions in addition to the listed civil penalties.  Securities professionals (or other business professionals like an attorney or accountant) may jeopardize their ability to work in their industry if they are caught engaging in insider trading which, for most people, would be a large enough deterrent to engage in such activity.

Addressing Compliance Inside the Firm

Insider trading is usually addressed in the firm’s compliance policies and procedures.  Indeed, Section 204A of the Investment Adviser Act of 1940 requires SEC registered investment advisers to maintainpolicies and procedures to detect against insider trading.

Usually such policies and procedures forbid employees from trading on material non-public information (as well as “tipping” others about material non-public information).  Additionally, employees typically are required to disclose any non-public material information they receive to the chief compliance officer (“CCO”) of the firm.  The employee is generally prohibited from discussing the matter with anyone inside or outside of the firm.  The policies and procedures may require the CCO to take some sort of action on the matter.  There are a number of different ways that the CCO can handle the situation including ordering a prohibition on trading in the security (including in options, rights and warrants on the security).  The CCO may also initiate a review of the personal trading accounts of firm employees.  Usually when the CCO is informed of such information the CCO would contact outside counsel to discuss the next course of action.

Dealing with Regulators

While many large hedge fund managers are registered as investment advisors with the SEC, many still remain unregistered in reliance on the exemption provided by Section 203(b)(3).  With the Private Fund Investment Advisers Registration Act likely to be passed within the next year, managers with a certain amount of AUM (either $100 million or $150 million as it now stands) will be forced to register with the SEC.  Of course, this means that such managers will be subject to examination by the SEC and insider trading will be one of the first issues that a manager will likely deal with in an examination.

As we discussed in an earlier insider trading article, the SEC has unabashedly proclaimed war against insider trading and they will be aggressively pursuing any leads which may implicate managers.

Some compliance professionals believe that the SEC comes in with a view that the manager is guilty until proven innocent.  While I do not necessarily subscribe to this blanket viewpoint, I do believe that managers, as a best practice, should be able to show the SEC the steps they have taken to ensure that compliance with insider trading prohibitions is a top priority of the firm.  The firm and CCO should be prepared to describe their policies and structures that are in place to deal with this issue.

Institutional Standpoint

Potentially more important than how a firm deals with the SEC, is how a firm describes their internal compliance procedures to institutional investors.  The question then becomes, how are institutional investors going to address this risk with regard to the managers they allocate to – what will change?

Right now it appears a bit unclear.  Over the past week I have talked with a number of different groups who are involved hedge fund compliance, hedge fund consulting, and hedge fund due diligence and I seem to get different answers.  Some groups think that institutional investors will be focusing on this issue (as many managers know, one of the important issues for institutional investors is the avoidance of “headline risk”); other groups seem to think that this is an issue that institutional groups are not going to focus on because there are other aspects of a manager’s investment program and operations which deserve more attention.

We tend to agree more with the second opinion, but we still believe that robust insider trading compliance policies and procedures are vital to the long term success of any asset management company.  We also encourage groups to discuss their current procedures with their compliance consultant or hedge fund attorney.

Outsourcing and Technology solutions

Many large managers have implemented compliance programs which have technology solutions designed to track employee trading.  Presumably there will be technology programs developed to address this concern for manager.  Although I do not currently know of any specific outsourced or technology solutions which address this issue, I anticipate discussing this in greater depth in the future – perhaps there is some data warehousing solution.  [HFLB note: please contact us if you would like to discuss such a solution with us.]

Final Thoughts

The Galleon insider trading case could not have happened at a worse time for the hedge fund industry which is trying to put its best face forward as Congress determines its future regulatory fate.  However, increased awareness of this issue will force managers to address it from an operational standpoint which will only help these managers down the road.  While the full effect of this case will not be understood for a while, in the short term it is likely to cost managers in terms of time and cost to review and implement increased operational awareness and procedures.

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Other related hedge fund law articles:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog and the Series 79 exam website.  He can be reached directly at 415-868-5345.

Insider Trading Overview

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In light of the recent focus on insider trading, we are publishing the SEC’s discussion on Insider Trading which can also be found here.  The information below contains a broad overview of some of the important aspects which hedge fund managers should understand about the insider trading prohibitions.

For a greater background discussion on the legal precedents which helped shaped the state of law today, please see Insider Trading—A U.S. Perspective, a speech by staff of the SEC.

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Insider Trading

“Insider trading” is a term that most investors have heard and usually associate with illegal conduct. But the term actually includes both legal and illegal conduct. The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC. For more information about this type of insider trading and the reports insiders must file, please read “Forms 3, 4, 5” in our Fast Answers databank.

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information.

Examples of insider trading cases that have been brought by the SEC are cases against:

  • Corporate officers, directors, and employees who traded the corporation’s securities after learning of significant, confidential corporate developments;
  • Friends, business associates, family members, and other “tippees” of such officers, directors, and employees, who traded the securities after receiving such information;
  • Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded;
  • Government employees who learned of such information because of their employment by the government; and
  • Other persons who misappropriated, and took advantage of, confidential information from their employers.

Because insider trading undermines investor confidence in the fairness and integrity of the securities markets, the SEC has treated the detection and prosecution of insider trading violations as one of its enforcement priorities.

The SEC adopted new Rules 10b5-1 and 10b5-2 to resolve two insider trading issues where the courts have disagreed. Rule 10b5-1 provides that a person trades on the basis of material nonpublic information if a trader is “aware” of the material nonpublic information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-existing plan, contract, or instruction that was made in good faith.

Rule 10b5-2 clarifies how the misappropriation theory applies to certain non-business relationships. This rule provides that a person receiving confidential information under circumstances specified in the rule would owe a duty of trust or confidence and thus could be liable under the misappropriation theory.

For more information about insider trading, please read Insider Trading—A U.S. Perspective, a speech by staff of the SEC.

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Other related hedge fund law articles include:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog and the Series 79 exam website.  He can be reached directly at 415-868-5345.

Hedge Fund Operations During a Pandemic

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Thoughts on Business Continuity Planning

Over the past week, I have attended a couple of interesting panel discussions on the hedge fund industry.  At these events, one of the common themes was that the investment management industry is changing and hedge fund management companies need to make sure that operations are tight – this means that a management company should have developed and robust procedures for disasters including, as the article below indicates, pandemics.  It is expected that this topic will become even more important if the impact of the H1N1 virus does not abate.

The article below was provided by Lisa Smith of Eze Castle Integration, an IT solutions firm for hedge fund management companies. This article is part of our guide to Hedge Fund Business & Technical Issues.

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Business Continuity: A Look at Pandemic Response Planning
By: Lisa Smith, Certified Business Continuity Planner, Eze Castle Integration

As the last several months have unfolded, one thing has become clear: the influenza A (H1N1) virus is not going away.  After the initial panic subsided, fear and concern seemed to diminish even though the World Health Organization and U.S. Centers for Disease Control insist that the threat is not over.  Now, nearly five months since the first case of H1N1 was reported in Mexico, a pandemic has emerged as predicted.

As of November 1, 2009, 199+ countries have reported laboratory confirmed cases of pandemic influenza H1N1 2009, including over 482,000 cases and 6,000 deaths (World Health Organization).  U.S. health officials estimate that the virus could directly and indirectly affect up to 40 percent of the nationwide workforce over the next two years (Centers for Disease Control).

What does this mean for hedge funds?  It is more important than ever to ensure a firm can and will remain functional if you are affected by a pandemic. Particularly, hedge funds must be mindful of the repercussions of the virus, as a decrease in staff could cause potential downtime.

Below are six essential pandemic response steps that firms need to undertake to ensure their businesses remain at peak performance, even if an outbreak occurs in the office.

Begin response procedures BEFORE a disaster strikes.

Organizational resiliency starts by strengthening your organization during normal business operations prior to a disaster such as a pandemic.  It should not take a disaster to compel your firm to evaluate its business continuity and response processes.  One should be in place long before disasters strike.

Identify who will serve as crisis leaders and be in charge of handling situational changes that may occur, including communication to other employees about response procedures and alternative site locations.  An ideal crisis leader is someone who demonstrates good leadership skills during normal business operations and has experience dealing with crises.  Typical crisis leaders are members of the senior management team (i.e. COO, CFO or Portfolio Manager).  Firms must also ensure all employees are mentally and physically able to respond to changes, especially if they are telecommuting.

Also, certify that all employees are cross-trained within the organization; if there is a staff shortage as a result of a pandemic, employees will need to fill additional roles and responsibilities.  Non-critical employees, including business development, accounting and research analysts, may be able to take larger roles and assist during a pandemic response phase.

Develop disaster / pandemic procedures based on a variety of scenarios.

Be proactive.  As part of the planning process, create a list of potential scenarios and define your firm’s response strategies.  Impact scenarios should include both potential internal and external occurrences.

For instance, what is your response if access to your office building is restricted due to extensive H1N1 exposure?  How will you access your email, market data and portfolio management systems?  Where will employees work and how will they communicate with colleagues and counterparties?

Externally, how will you operate if your prime broker or fund administrator contacts are unavailable?  Being prepared will ensure your business operations continue seamlessly and without interruption.

Thoroughly review and modify your business’ Employee Assistance Program (EAP).

An EAP provides assistance and access to counseling services for issues in and out of the workplace.  In the event of a disaster, employees may wish to speak with a professional counselor to deal with any stress or negative emotions that have resulted from the event.  If you cannot provide a physical counseling presence, provide a list of area clinics that offer comparable services.  In advance, consider preparing educational materials that inform employees of the various stress indicators and reactions they may experience as a result of a disaster.  If employees know that support is available prior to a disaster, it will mitigate panic and stress, and they will be better able to adapt to changes in their environment.

You should also inform employees about current sick leave and family support policies in the event that someone is forced to take an extended leave of absence.

In addition to developing and strengthening your EAP, you might also consider having upper management and emergency response team leaders partake in Critical Incident Stress Management (CISM) training, which will provide advanced preparation for responding to critical situations.

Test alternate site and remote access capabilities.

If a crisis situation is directly affecting your physical workspace or your employees, you must be prepared to provide alternatives.  You may choose to move business operations to an alternate site where employees can go without risk.  An alternate site would make sense for crisis situations that are confined to specific areas, such as natural disasters, outages or other situations.

In a pandemic situation – particularly if you have had any outbreaks of illness amongst your employees – you may choose to allow employees to work remotely.  If this is a viable alternative, ensure ahead of time that you have adequate capacity and infrastructure to support multiple virtual private networks (VPN) and remote access capabilities.  Confirm the number of Citrix licenses you have available; if there are not enough to support your complete staff, you may need to consolidate responsibilities.

Review your business response plan and procedures with team members and leaders.

Develop communication notification and escalation procedures for response team leaders and assign internal notification tasks to each leader.  Identify if there are external business partners who need to be notified as well (i.e. investors, service providers, etc.).  Assign a primary and secondary spokesperson in case the public needs to be notified, and ensure the spokesperson(s) has training and experience dealing with the media.  If your spokesperson does not have training, now is the time to arrange for crisis communications training.

Test your pandemic response plan.

It is important to test your company’s response plan with leaders and response team members to ensure there are no glitches or obstacles in the event of a real disaster.  Test internal communication strategies – from response team leaders to staff members.  This can be done manually or through an automatic notification system.  You can also send employees to work at the alternate site or to work remotely to ensure there are no technical issues that can affect productivity.  It is imperative that the teams and employees are able to work together and build trusting relationships today.  A strong foundation that includes good performance and trusting relationships will enable your business to recover from any kind of crisis.

Business Continuity Professionals say that “planning” helps mitigate panic and downtime.  It takes work and resources to develop a resilient organization prior to an interruption or disaster, but it is imperative if businesses want to stay operational.  Businesses cannot function without employees that maintain knowledge and expertise to operate the business, and those employees need to know what to do during an interruption or disaster.  Without a plan, you will spend the entire time chasing the incident instead of recovering from it.

For more information, please see http://www.eci.com.

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Other related hedge fund law articles include:

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

Secondary Loan Market | LSTA Conference

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Trends for Distressed Debt Hedge Fund Managers

Distressed debt hedge funds often face a number of legal issues with regard to their investments.  Post-Lehman, understanding the rights and liabilities attached to the actual contracts has become paramount for managers.  The following article, contributed by Karl Cole-Frieman of Cole-Frieman & Mallon LLP, provides some background on a recent conference which discussed the secondary loan market.

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The LSTA Annual Conference and the Secondary Loan Market

On October 29, 2009, we attended the annual conference for the Loan Syndications and Trading Association (the “LSTA”).  Conference attendance was significantly up in 2009 from 2008, reflecting an increase in trading volume in the secondary loan market, and robust market conditions for service providers as a result of the spike in settlement on distressed documentation following Lehman’s collapse in 2008.

Secondary Loan Market Panel

Of particular interest was the panel regarding “Recent Developments in the Secondary Loan Market” moderated by Elliot Gans, Executive Vice President and General Counsel of the LSTA.  Other panelists included:

  • Linda Giannattasio, Director and Counsel in Citigroup’s Office of the General Counsel.
  • Robbin Schulsohn, Karl Cole-Frieman’s former colleague at JPMorgan Chase, where she is Executive Director and Assistant General Counsel.
  • Claire Pierce, Managing Director if Chapdelaine Credit Partners.  Claire was in-house at Bank of America for many years before joining Chapdelaine.
  • Bridget Marsh, Senior Vice President & Assistant General Counsel of the LSTA.
  • Jennifer Tallmadge, Assistant General Counsel at Bank of America.

Notably, the panel lacked a Buy Side perspective, which impacted the topics of discussion.

Buy-In/Sell-Out Provisions (“BISO”)

A relatively recent change in standard documentation for Par Trades is the inclusion in the LSTA Par/Near Par Trade Confirmation of a BISO provision for confirmations beginning February 2009.  The BISO provisions addressed the problem of counterparty risk for failure to settle a trade.   Previously, if a counterparty refused to settle a trade, there was little that the performing party could do short of litigation.  The BISO provisions, which have recently been modified, establish the circumstances under which a performing party in a Par Trade may terminate its obligations under a trade confirmation and effect a cover transaction in respect of the loans.  There is a lot of discussion about adding a BISO provision to the LSTA Distressed Trading Documents.

The panel expressed some mixed views about the success of the Par BISO provisions.  In general, the BISO provisions have been considered successful in reducing settlement times in 2009.  However, the provisions have only been in effect in a rising market, and it remains to be seen what will happen next time there is a systemic downturn in the market.  It is possible that market participants could become overwhelmed sending and responding to BISO notices.

Distressed Documents for Performing Loans

The panel also discussed the phenomenon post-Lehman of trades that settled on distressed documents for performing loans.  After the Lehman bankruptcy the loan prices fell significantly even for performing loans.  Buyers reacted by insisting that trades settle on distressed documents instead of Par documents, causing significant delays in settlements.  Generally the panel, which was dominated by Sell Side representatives, felt the market behaved irrationally in requiring distressed documents for performing loans based solely on price.  One the other hand, the distinction between par and distressed has historically been determined solely by price.  It is not clear what other objective measures loan purchasers can rely on.  From a Buy Side perspective, it might be worth spending an additional $20,000 in delayed compensation to make sure their $200,000,000 is fully protected.

Settlement Times for Loan Trades

Despite the BISO provisions in the Par confirmations, there are systemic problems causing settlement delays in 2009.  Although Linda Giannattasio indicated that 90 percent of Citibank’s par trades are settling in T+7, Elliot Gans provided raw data for 3Q 2009 that shows that problems persist.  For par trades, the average trade settled in 18 days, while the median settlement time was 11 days.  For distressed trades, the average trade settled in 45 days, while the median trades settled in 36 days.  Performing loans that trades on distressed documents post-Lehman are shifting back to Par documents, contributing to the delays.

Shift Date Rule

The LSTA plans to publish new rules for determining the “shift date,” or the date in which loans shift from Par to Distressed, and therefore must settle on distressed documents.  The existing process, which has never worked well, is that the LSTA polls dealers on the shift date.  Under the forthcoming rules, the LSTA will select the shift date and it will be binding on all parties.  Upon request, the LSTA will review trade data and other supporting material to determine the date.  Where unable to make a determination, the LSTA will assemble a Determinations Committee made up of LSTA Board members.  Elliot Gans indicated that some market participants would prefer the LSTA select a random date to the current polling system.  Nevertheless, we expect these new rules to be somewhat controversial when rolled out by the LSTA.

To find out more about the secondary loan market and other topics impacting hedge fund managers, please contact Karl Cole-Frieman of Cole-Frieman & Mallon LLP (www.colefrieman.com) at 415-352-2300 or [email protected].

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Other related hedge fund law articles include:

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

Hedge Fund Investment Adviser Insurance

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E&O or D&O Insurance For Registered Investment Advisers

Yesterday I had the opportunity to talk with an insurance broker whose business focuses on providing insurance to registered investment advisers and hedge fund managers.  This article is based on that conversation.

Insurance Premiums for Small Funds

For smaller funds (say less than $100 million in AUM) with no operational history, the minimum premium amount is likely to be in the $10,000 to $15,000 range for about $1 million in coverage.  Usually premiums will stay around those levels as the AUM grows, but at around $200 million in AUM the premiums may start to increase.  For those types of premiums you are usually looking at deductibles in the $25,000 range, which is going to be pretty standard for smaller groups.  Depending on the exact nature of the group’s business the deductible may end up being as high as $50,000 or $75,000.  Of course these are only ranges and the final premium and deductible amounts will be established based on the unique circumstance of the manager.

Hedge Fund Insurance Underwriters

While the insurance brokers are able to place policies for smaller managers at some of the major carriers like Chubb, many times they will need to have scripted policies which require the insurance carriers (groups like Lloyds) to write a policy specifically for the management company.  In these cases the premiums are likely to be on the higher end of the ranges  discussed above.

What does Insurance Cover?

The central reason that hedge fund investment advisers will buy insurance is to protect against potential claims by the limited partners.  Generally the insurance can be purchased as Errors & Omissions/Directors & Officers Liability (E&O/D&O).  While each policy will cover different acts, generally the insurance will cover the negligent acts of all past and present employees, offices and directors.  Independent contractors (such as sub-advisers and potentially, in certain circumstances hedge fund service providers) may or may not be covered under the policy.

If a lawsuit is initiated against the manager, after the deductible the insurance company will pick up all costs associated with the lawsuit up to the coverage maximum (in the case quoted above, this would be $1 million).  Because of the costly nature of litigation and because any litigation will likely be based on significant losses, it might be the case that the liability in the case exceeds the insurance coverage in which case the managers or employees may be liable for the remainder of the judgment or legal costs (see How Much E&O Should I Buy).  Many hedge funds will have exculpation and indemnification provisions which will protect officers and employees of the management company for acts done in good faith.

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Related articles from Hedge Fund Law Blog:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs Hedge Fund Law Blog.  If you are a hedge fund manager who is looking to start a hedge fund or if you have questions about your investment advisor compliance program, please contact us or call Mr. Mallon directly at 415-868-5345.

Public Comments on SEC Proposed “Pay to Play” Rules

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SEC Proposed Pay to Play Rules Draw Many Comments

Earlier this year the SEC proposed so-called “pay to play” rules which would restrict SEC registered investment advisers from managing money from state and local governments under certain circumstances.  According to the SEC press release, “the measures are designed to prevent an adviser from making political contributions or hidden payments to influence their selection by government officials.” The rule would do four major things:

  1. Restricting Political Contributions
  2. Banning Solicitation of Contributions
  3. Banning Third-Party Solicitors
  4. Restricting Indirect Contributions and Solicitations

The comment period, which ran for 60 days, produced some very good points.  As a general matter most groups opposed the proposed rules for some reason or another.  Below I have gathered some of the more interesting or important points which were raised in the comments which are publicly available here.  All of the following quotes are directly from the comments of the submitters which are identified.

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Joan Hinchman – Executive Director, President and CEO, of NSCP (National Society of Compliance Professionals Inc.)

  • The practical result of the ban will be that an adviser will be economically compelled to end its relationship with a governmental entity.
  • The ban will deprive participants and beneficiaries of public funds of well qualified advisers and drive up the cost of investment advisory services due to higher compliance costs.
  • The Rule will affect at a minimum all registered investment advisers that not only advise governmental public pension funds, but also may cover investment companies in which governmental pension funds choose to invest.
  • Advisers lacking capital to hire employees to obtain government clients or the experience and sophistication to do so would be placed at a material competitive disadvantage.

These comments can be found here.

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Jeffrey M. Stern and Robert W. Schwabe – Managing Partners of Forum Capital Securities, LLC

Forum Capital Concurs wholeheartedly with those persons and entities that have commented on the Proposed Rule to date that banning investment advisers from compensating third-party placement agents for securing capital commitments from public pension fund investors would:

  • Unfairly advantage private investment firms large enough to employ an internal marketing and investor relations staff over those firms that cannot afford to employ such a staff internally;
  • Limit the universe of investment opportunities presented to public pension funds for their consideration;
  • Deprive private investment firms of the services of legitimate placement agents that have contributed to the success of many investment advisers already existing and thriving prior to the promulgation of the Proposed Rule, thereby limiting the opportunities of new private investment firms to successfully raise funds, execute their investment strategies and grow into market leading investment firms;
  • Reduce competition within the investment advisory business in general and the various alternative investment asset classes in particular; and
  • Reduce the amount of capital available to companies that rely on private investment firms for their financial support.

These comments can be found here.

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Sue Toigo – Chairman of Fitzgibbon Toigo Associates in Los Angeles California

  • Without placement agents, the ability of emerging asset management firms, the majority of which are minority- and women-owned firms, to gain the business of the large public pension funds becomes virtually impossible.
  • Under the proposed regulation, small emerging companies will find it increasingly challenging to market their investment products to pension funds.

These comments can be found here.

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William J. Zwart – BerchWood Partners, LLC

  • Emerging managers would not be able to effectively access or approach the public entity investment community without the support of the placement agent community.

These comments can be found here.

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R. Dean Kenderdine – Executive Director and Secretary to the Board of Trustees of State Retirement and Pension System of Maryland

  • The strict outright prohibition of investment management firms’ use of placement agents to implement their marketing efforts to public pension funds would result in increased costs to the investment firms and a reduction in viable investment opportunities being presented to public pension funds.
  • Public funds will not be presented with the broadest array of investment opportunities and hinder the competitiveness of the investment management marketplace.
  • Placement agents being prohibited would have an adverse impact on our return potential and increase our cost of operations.

These comments can be found here.

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Fernando Ortiz Vaamonde – Managing Partner of ProA Capital de Inversiones

  • An outright ban on placement firms would unfairly disadvantage small- and mid-size firms, many of which are unlikely to be able to recruit and retain significant in-house fund-raising capabilities.

These comments can be found here.

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Keith Breslauer – Managing Director of Patron Capital Limited

  • With the new rule, Patron would not be able to without great difficulty, expand its investor base to include public pension plans.
  • The effect of the new rule is to harm the fund raising abilities of funds like Patron and materially impact the investing opportunities of public pension plans.

These comments can be found here.

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Brian Fitzgibbon – CEO of Fitzgibbon Toigo & CO., LLC

  • Without placement agent assistance, some of the best fund managers may never get to market.
  • A ban on placement agents is unfair, irrational and harmful to Private Equity. There will always be some corrupt public officials and organizations that want to game the system.

These comments can be found here.

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B. Jack Miller – General Motors Asset Management

  • Many partnerships are too small to have their own marketing staff and rely on third party PA’s to introduce them to investors.

These comments can be found here.

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Jake Elmhirst – Global Co-Head Private Funds Group of UBS Securities, LLC

USB strongly believes that:

  • Registered placement agents play a beneficial role in the capital markets;
  • The proposed ban would be detrimental to both private equity managers and their public pension plan investors;
  • The proposed ban in lA-291O is unnecessary and overbroad, and the Commission can regulate registered broker-dealer placement agents through other means;
  • The placement agent ban in IA-2910 purports to be modeled on MSRB Rule G-38 but is in fact inconsistent with that rule and the policies supporting it; and
  • The Commission should consider alternatives to a ban on all intermediaries, including an exemption for registered broker-dealer placement agents, and increasing regulation of properly registered placement agents.

These comments can be found here.

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Thomas P. DiNapoli – State Comptroller

  • Under the proposed SEC rule, it is not clear if the investment adviser would subsequently be prohibited from earning compensation for advisory services provided to the Fund.
  • It is important that the final rule adopted by the SEC clearly articulate what behavior is prohibited in making contributions or soliciting or coordinating payments to state or local political parties.

These comments can be found here.

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Melinda Gagyor – Fulcrum Financial Inquiry, LLC

The proposed placement agent ban should be eliminated because:

  • It will devastate the placement agent business and cause severe job losses in an already troubled economy;
  • The vast majority of emerging, small and middle-market investn1ent managers will simply not survive or be forced to operate at a huge disadvantage;
  • Pension funds will see a significant reduction in their access to potential investment opportunities; and
  • Pension funds will no longer be able to use placement agents to help them pre-screen potential investment manager candidates

These comments can be found here.

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Ron S. Geffner – Partner of Sadis & Goldberg, LLP

While we strongly support the SEC’s efforts to eliminate corruption in connection with “pay to play” practices, the proposed ban on placement agents’ solicitation of government investors is overreaching and will:

  • Deprive government investors of the benefits provided by placement agents, namely access to a broader range of potential investment opportunities and assistance with due diligence efforts, and
  • Hinder smaller advisory firms in their efforts to attract government investors, as smaller firms generally have less in-house resources and rely more on the use of placement agents in soliciting government investors.

These comments can be found here.

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Fred Gortner – Managing Director of Paladin Realty Partners, LLC

  • Without quality placement agents like Triton Pacific, emerging small and mid-cap investment management firms like ours would be forced to operate at a significant and inequitable disadvantage to larger investment managers that have the financial resources to employ large, experienced teams of investor relations and in-house placement professionals.

These comments can be found here.

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Drew Maxwell

  • Your proposed ban on placement agents will unjustly penalize a huge percentage of emerging, small, minority-owned and middle-market investment managers, as these firms rely extensively on placement agents to help them.

These comments can be found here.

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Joseph M. Velli – Chairman and Chief Executive Office of BNY ConvergEx Group, LLC

  • While we believe that the general ban on third-party solicitors is unnecessary, we are concerned in particular about the vagueness of the rule’s definition of “related person”.
  • We believe it is critical for the SEC to clarify the test for control included in the definition of “related person”.

These comments can be found here.

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Frode Strand-Nielsen – Managing Partner of FSN Capital Partners A.S.

  • It would be highly challenging for us to raise capital from international in institutions unless we had the assistance of a legitimate placement agent.
  • If you take away the role of a placement agent, you will deprive firms like ours of the ability to raise capital in the United States, and you will also seriously impair the pension funds’ capacity to invest with the best private equity firms internationally.

These comments can be found here.

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Mark G. Heesen – President of National Venture Capital Association

  • It is in the interest of the entire venture capital community if firms retain the option of using placement agents for marketing to all potential investors, including public pension funds.

These comments can be found here.

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Richard H. Hurd, Jr. – President of Strategic Capital Partners

  • We know first hand the value that qualified placement agents can provide particularly to emerging, small and mid-cap investment management firms. Without such services, smaller firms have limited access to the institutional market. Likewise, pension fund will be prohibited from participating in the entrepreneurial strategies and success of companies like ours.

These comments can be found here.

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Other related hedge fund law articles:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs Hedge Fund Law Blog.  If you are a hedge fund manager who is looking to start a hedge fund or if you have questions about your investment advisor compliance program, please contact us or call Mr. Mallon directly at 415-868-5345.

Data Warehouse Implementation | Hedge Fund IT Solutions

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Deloitte & Netik Conference – Asset Management: Managing and scaling your reference, market and portfolio data

This article is part of our guide to Hedge Fund Business & Technical Issues.

On October 29, 2009 I attended an event at San Francisco’s Omni Hotel put on by Deloitte and Netik.  The event featured a panel discussion with the following panelists:

  • Brian Lott – Executive Vice President, Operations, Netik
  • Michael Smith – Senior Manager, Deloitte & Touche LLP
  • Joseph Clark – Market Data Manager, MSCI Barra
  • James Wu – Product Manager, MSCI Barra
  • Moderated by Ray Iler – Northwest Pacific Hedge Fund Leader, Deloitte & Touche LLP

The discussion was quite interesting and was most appropriate for hedge fund managers who have a need for transparency into their positions and who also need the ability to quickly manipulate large amounts of data.  Coming into this discussion I was not aware of any of the issues involved with data warehouse implementation.  I am sure that much of this discussion went over my head, but I did the best I could to summarize the points made by the various panelists.  As always, any errors or confusion found below is likely attributable to me solely.  [HFLB note: I have not checked with any of the panelists regarding my summary of their comments.]

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Data Warehouse Hedge Fund Discussion

[Moderator questions in italics.]

Ray Iler started the panel discussion by stating that investors and regulators want more information, generally for risk management purposes.

Michael Smith – pending investment adviser registration will mean that managers need to make sure their data systems are ready to handle SEC requests for information, SEC audits and most importantly investor requests for data.  Data warehouses help asset managers to reconcile their various data inputs (especially with regard to multi-custodial relationships).

Brian Lott – regulation is going to drive what “transparency” means.  Old systems were not designed for the way that business is now done – data warehouses now allow managers to bring all information into a central repository and helps the manager to have a holistic view of their portfolios.  These data warehouses can also help ease the regulatory burden by speeding up the time it takes to search and categorize data.

James Wu – data warehouses give managers the ability to see and analyze portfolio and asset level risk characteristics.  These solutions allow managers to run robust reports and ad hoc queries fast.

Ray Iler asked how data warehouses can help managers such as fund of funds or hybrid funds.  [Or something to that effect.]

Brian Lott – legacy apps have not evolved quickly over time.  Data warehousing goes beyond position level down to the data below.  Prior to data warehouses there were systems which were modified to try to function like current data warehouses.  The current data warehouse system is equivalent to a hub and spoke system where the data warehouse is the hub and the various data inputs (information or fees) are the spokes.  The advantage of this hub and spoke system is the ability for managers to centralize data and then be able to analyze it.

Michael Smith – it is one thing for a manager to understand the economics of an investment at the beginning of the deal, then then understanding what is going on with that deal on an ongoing basis becomes harder.  Data warehouses allow managers with a common platform to understand their deal on a continuous basis.  One application for managers is that they could understand how their portfolio composition would change based on an investment.  Such information helps a manager to understand the investment on a continual basis.

Joseph (Joe) Clark – another thing about clients without a data warehouse is that they have a hard time trying to find the data.  A data warehouse makes finding certain data much easier.

James Wu – one of the great things about a data warehouse is that allows you to have more spokes – legacy systems which have been modified (shoehorned) to try to meet current demands often are not able to seemlessly integrate new feeds.

Michael Smith – [made a statement about Microsoft sharepoint and other solutions which make technology easier.]  Managers moving into new asset classes (say a private equity fund moving into real estate investments) should think about how cash flows and reporting are going to change from current systems.  How will this change the formatting?

Joe Clark – data from different vendors and from groups in different jurisidictions do present an issue for some managers.

Ray Iler – that is good point – what about licensing issues for the feeds into the data warehouse?

Joe Clark – It is an interesting issue that centers on the question of who owns the underlying data.  Questions arise as to how many deriviations of the data are needed before the feed provider no longer “owns” it.  It will really depend on each individual relationship.

Brian Lott – it is not standardized from vendor to vendor and the issue needs to be negotiated at each data provider.

Ray Iler – what are the costs and ROI by putting a data warehouse in place?

Brian Lott – the question becomes, how do I pitch this to the board?  It is often hard to quantify the return but recent market events have shown why it is so important for managers to understand total counterparty risk.  For instance, after the Lehman collapse a client had to go through 72 different relationships with Lehman to understand what the total exposure was – this took 3 months to complete.  Generally not until a catastropic event do you see the value at the most basic level like this.

Ray Iler – although we understand that each project is unique, are there some common implementation costs?

Brian Lott – on the data warehouse implementation, for a medium buy-side manager, you are looking at 3 months depending on complexity.  Costs will be all over the board and will depend on the licenses involved and the services requested.  It could be anywhere from $200,000 to $2 million.  On the data servicing side, it will really depend on the size and complexity of the services requested.  There is a big difference in costs with a firm with 2,000 positions versus a firm with 2 million positions.

Michael Smith – we have advised on system implementation for managers with a few hundered million to half a trillion.  Most of the time these can be straightforward implementations but sometimes they cannot and that will affect cost.  The point of the systems are to minimize trade failures, make sure accounting is properly completed, 13Fs and 13Gs are not filed incorrectly and that understanding the various risks of the business.  These factors (along with reputation risk if something goes wrong) are weighed against the cost of implementation – for each manager it will be different in terms of ROI.

James Wu – after Lehman and AIG groups don’t realize how much exposure they have to a counterparty that is failing or about to fail.  Having that information is crucial for managers.

Ray Iler – yes, investors want to see that managers have thought about these issues and right now, in this tough fundraising environment, managers have to do what investors want.  If investors want full transparency, managers need to provide it.  Now, what about in-house technology solutions versus outsourcing.  Can managers do both?

Brian Lott – it is not a one size fits all solution.  It will depend on the risk profile of the manager.  What will happen many times is a sort of hybrid between the in-house team and our outsourced solution.  While the whole data warehouse will be a good solution, the in-house compliance manager or risk manager will usually want to have some kind of final sign off and control over the system.  Accordingly, many firms have their in-house team working directly with the data warehouse in a number of ways.

Joe Clark – the hybrid system is part of the philosophy that the system should match a manager’s specific needs.

[Some thoughts from James Wu and Michael Smith which I did not catch.]

Brian Lott – because each solution is tailored to each manager it is very important that stystem integration firms and the managers understand the scope of the work to be performed.  To do this the manager really needs to understand what the end goal is.  From the end goal the provider will be able to provide dates, an implementation plan, a description of the scope of work to be performed as well as a timeline of the phases of the project implementation.  It is very important for the manager and the provider to define the exact scope of the project.

At this point the floor was opened to questions.

Question from audience

  • What are some of the general needs of some of these managers (such as insurance companies, pension funds and family office managers)?
  • In light of the recent Galleon hedge fund insider trading case, do data warehouse solutions work to help  compliance personnel search emails to detect possible illegal activity.

Networking After Discussion

After the event we had the opportunity to do some networking.  I had to run fairly quickly, but I did have a chance to talk briefly with the following people:

  • Maital S. Rasmussen who works with small and start up hedge fund managers on their marketing materials and presentations.  Specifically I talked with Maital about presentation coaching which is becoming more important for managers who are presenting in front of institutional investors.
  • Erin Brodie who is the Senior Business Development Manager of Global Accounts at Advent Software.
  • Mason Snyder of Catalina Partners, which providers business risk advisory for institutional investments.
  • Maria Hall of M.D. Hall & Company Inc., a hedge fund audit firm.

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

Hedge Fund Business & Technical Issues

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Overview

In addition to providing startup and established managers with information on various hedge fund laws and regulations, we have also provided a number of articles on the general business issues that hedge fund managers need to address.  These articles cover a number of areas and many of the articles below are from service providers to hedge funds.  Please feel free to suggest other areas for us to explore in future articles.

Hedge Fund Technology, IT and Internet Issues

  • IT Issues for Hedge Fund Managers – this article, written by a technology solutions firm, details some of the IT solutions which are available to hedge fund managers who will need to register after the new hedge fund registration rules are adopted.  These issues also apply for currently registered (SEC or state) hedge fund managers as well.
  • Data Warehouse Implementation for Hedge Funds – a summary of a panel discussion on the reasons managers should think about implementing a data warehouse system.
  • Hedge Fund Hotels – hedge fund hotels offer managers a whole suite of hosted services for turnkey back office implementation.
  • Hedge Fund Domain Names – this article discusses domain names for hedge fund managers.
  • Hedge Fund Managers and Blogs – this article discusses whether hedge fund managers can run a blog.

Hedge Fund Tax Issues

  • Proposition Q and Hedge Funds – hedge fund managers located in San Francisco should be aware of Proposition Q (a special San Francisco payroll tax) and how it will affect them and their top earners.

General Business Issues

  • Hedge Fund Employment Law Issues – this article, forthcoming, will discuss the issues that managers need to consider when they bring on employees for the first time.  While each state will have different laws and regulations which the manager will need to follow, there are general items which a manager should be prepared for including establishing a structure to pay state and federal income taxes for employees.
  • IP Licensing Agreements – this article, forthcoming, will discuss the business and legal issues involved when managers license their intellectual property to a hedge fund.
  • Hedge Fund Management Company Insurance – this article discusses the costs of insurance for hedge fund management companies.
  • Hedge Funds and Rehypothication – this article discusses rehypothication as it relates to hedge funds.
  • Prime Brokers, Margin Lock-ups and Hedge Funds – this article discusses prime broker margin lock-ups and some of the issues which managers should understand.
  • Hedge Fund Operational Issues and Failures – this article discusses a press release about a white paper released from a hedge fund due diligence firm.  The firm examines the reason why many hedge fund managers fail.
  • Hedge Fund Operations During a Pandemic – examines the issues which face managers because of the H1N1 virus.
  • Agreed Upon Procedures – hedge fund managers sometimes will engage auditors to provide “agreed upon procedures” especially with regard to their Level III assets.  This article, written by a hedge fund due diligence firm, provides some thoughts on how investor may view these procedures in the future.  Managers should be aware of how investors (or potential investors) might view these types of engagements.
  • Women and Hedge Funds – this article explores the world and opportunities for women in the hedge fund industry.
  • Naming Your Hedge Fund – this article discusses common hedge fund naming conventions.
  • Hedge Fund Best Practices – discussion of the President’s Working Group on Financial Markets (PWG) report on hedge fund best practices.
  • SIPC Customer Asset Protection – statements by FINRA and the SEC on asset protection for customers.

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

CTA Advertising and Marketing Issues to Consider

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By Bart Mallon, Esq. (www.colefrieman.com)

Marketing for Small CTAs

For small commodity trading advisory (CTA) firms, marketing and advertising the expertise of the principals is a central way to gain new clients and make more money.  This overview is for the CTA Expo 2009 program entitled Marketing for Small CTAs. The program was sponsored by Traderview and featured Frank Pusateri of Adirondack Portfolios as well as Bucky Isaacson of Future Funding Consultants. While I was unable to catch this beginning session of the CTA expo 2009, I was able to catch the last ten to fifteen minutes of the session, which I found to be particularly helpful (for small and start up CTAs) as well as interesting.  It seemed like many of the participants were engaged as well.

General Background on CTA Advertising

CTAs are allowed to market and advertise their services.  Unlike hedge fund managers, who are prohibited from marketing pursuant to Regulation D and other federal and state regulations, CTA advertising has the potential to reach a large portion of the investing population – CTAs can and should take advantage of such marketing rules.  [Note: we will be providing information at a later date regarding some of the legal and compliance issues that CTAs should be aware of when developing a marketing program.]

A good marketing program will be multi-faceted and will include a website (including potentially a blog), direct email campaigns, listings in CTA databases, and networking events among other items.  The rest of this article will focus on CTA websites.

CTA Websites and Visitor Information

One way for CTAs to advertise is to put up a good and effective website advertising the manager’s services.  While it will take the manager some time to create the initial content and layout of the website, there is relatively little additional time needed to maintain the webiste.  Many of the updating functions can be outsourced as well, so the manager can concentrate on trading.

Frank noted that he had one CTA ask him what he thought about their website which cost $50,000. Frank said that it looked good but that the CTA firm did not ask for the visitor’s name, address or telephone number and that there was no place on the website to collect that information. This represents a lost opportunity because, presumably, visitors come to your website to find out more information about you – you in essence know that the people visiting your site are potential investors. Having visitors provide you with their basic contact information is equivalent to a warm lead and if you don’t even have a way to collect this then you are wasting opportunities.

Question Period

Frank was able to answer questions from the audience. One participant asked if Frank could name a CTA firm which did a good job at marketing themselves. He mentioned that he thought Northfield Trading did a pretty good job with much of their literature and marketing materials.

Many of the same issues, which were touched on during my brief time at this session, are discussed in later sessions in greater depth. We will examine these in turn.

The next article discusses Compliance in a Changing Environment which is sponsored by Woodfield Fund Administration and which featured Kate Dressel of Strategic Compliance Solutions as well as Patty Cushing of the National Futures Association.

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This article was first printed on the CTA Expo Blog.  Mr. Mallon also runs the hedge fund law blog and is committed to providing useful and easy to understand information for CTAs and CPOs which can be found in our CTA and CPO Registration and Compliance Guide. For more information on CTA registration or compliance services please contact Bart Mallon, Esq. at 415-868-5345.