Category Archives: Laws

CFTC Amends CPO Reporting Regulations

CFTC Regulation 4.22 Amended

Earlier this year the Commodities Futures Trading Commission (“CFTC”) proposed amendments to certain Part 4 Regulations. Last week, after a lengthy comment and revision period, the CFTC published the amendments in the Federal Register. The effective date of the amendments is December 9, 2009 and will apply to commodity pool annual reports for fiscal years ending December 31, 2009 and later. [HFLB note: as we have discussed earlier, spot forex hedge fund managers generally are not required to be registered as forex CPOs with the CFTC. However, when the forex registration rules go into effect, such forex CPOs are going to need to be aware of these reporting requirements.]

The following press release can be found here. The full discussion of the CFTC’s amendment making process and the amendments can be found in Federal Register at 74 FR 57585. For more information regarding commodity trading and regulation, please see our CTA/CPO Registration and Compliance Guide.

The full amended text of CFTC Regulation 4.22 is reprinted below.

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Release: 5746-09
For Release: November 9, 2009

CFTC Adopts Amendments to Reporting Requirements for Commodity Pool Operators

Washington, DC —The Commodity Futures Trading Commission (CFTC) has adopted amendments to its regulations regarding periodic and annual reporting requirements applicable to commodity pool operators (CPOs). The amendments:

specify detailed information that must be included in the periodic account statements and annual reports for commodity pools with more than one series or class of ownership interest;
clarify that the periodic account statements must disclose either the net asset value per outstanding participation unit in the pool or the total value of a participant’s interest or share in the pool;
extend the time period for filing and distributing annual reports of commodity pools that invest in other funds;
codify existing Commission staff interpretations regarding the proper accounting treatment and financial statement presentation of certain income and expense items in the periodic account statements and annual reports;
codify exemptions staff has provided to CPOs that operate offshore funds that elected to use non-United States GAAP in the preparation of pool financial statements;
streamline annual reporting requirements for pools ceasing operation; and
clarify and update several other requirements for periodic and annual reports prepared and distributed by CPOs.

The amendments will become effective 30 days from publication in the Federal Register; changes that affect annual reporting requirements will be applicable to commodity pool annual reports for fiscal years ending December 31, 2009 and later.

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Full Text of Regulation 4.22 (effective December 9, 2009)

PART 4—COMMODITY POOL OPERATORS AND COMMODITY TRADING ADVISORS
Subpart B—Commodity Pool Operators

§ 4.22 Reporting to pool participants.

(a) Except as provided in paragraph (a)(4) or (a)(6) of this section, each commodity pool operator registered or required to be registered under the Act must periodically distribute to each participant in each pool that it operates, within 30 calendar days after the last date of the reporting period prescribed in paragraph (b) of this section, an Account Statement, which shall be presented in the form of a Statement of Operations and a Statement of Changes in Net Assets, for the prescribed period. These financial statements must be presented and computed in accordance with generally accepted accounting principles consistently applied. The Account Statement must be signed in accordance with paragraph (h) of this section.

(1) The portion of the Account Statement which must be presented in the form of a Statement of Operations must separately itemize the following information:

(i) The total amount of realized net gain or loss on commodity interest positions liquidated during the reporting period;

(ii) The change in unrealized net gain or loss on commodity interest positions during the reporting period;

(iii) The total amount of net gain or loss from all other transactions in which the pool engaged during the reporting period, including interest and dividends earned on funds not paid as premiums or used to margin the pool’s commodity interest positions;

(iv) The total amount of all management fees during the reporting period;

(v) The total amount of all advisory fees during the reporting period;

(vi) The total amount of all brokerage commissions during the reporting period;

(vii) The total amount of other fees for commodity interest and other investment transactions during the reporting period; and

(viii) The total amount of all other expenses incurred or accrued by the pool during the reporting period.

(2) The portion of the Account Statement that must be presented in the form of a Statement of Changes in Net Assets must separately itemize the following information:

(i) The net asset value of the pool as of the beginning of the reporting period;

(ii) The total amount of additions to the pool, whether voluntary or involuntary, made during the reporting period;

(iii) The total amount of withdrawals from and redemption of participation units in the pool, whether voluntary or involuntary, for the reporting period;

(iv) The total net income or loss of the pool during the reporting period;

(v) The net asset value of the pool as of the end of the reporting period; and

(vi)(A) The net asset value per outstanding participation unit in the pool as of the end of the reporting period, or

(B) The total value of the participant’s interest or share in the pool as of the end of the reporting period.

(3) The Account Statement must also disclose any material business dealings between the pool, the pool’s operator, commodity trading advisor, futures commission merchant, or the principals thereof that previously have not been disclosed in the pool’s Disclosure Document or any amendment thereto, other Account Statements or Annual Reports.

(4) For the purpose of the Account Statement delivery requirement, including any Account Statement distributed pursuant to §4.7(b)(2) or 4.12(b)(2)(ii), the term “participant” does not include a commodity pool operated by a pool operator that is the same as, or that controls, is controlled by, or is under common control with, the pool operator of a pool in which the commodity pool has invested.

(5) Where the pool is comprised of more than one ownership class or series, information for the series or class on which the account statement is reporting should be presented in addition to the information presented for the pool as a whole; except that, for a pool that is a series fund structured with a limitation on liability among the different series, the account statement is not required to include consolidated information for all series.

(6) A commodity pool operator of a pool that meets the conditions specified in paragraph (d)(2)(i) of this section and has filed notice pursuant to paragraph (d)(2)(ii) of this section may elect to follow the same accounting treatment with respect to the computation and presentation of the account statement.

(b) The Account Statement must be distributed at least monthly in the case of pools with net assets of more than $500,000 at the beginning of the pool’s fiscal year, and otherwise at least quarterly; Provided, however, That an Account Statement for the last reporting period of the pool’s fiscal year need not be distributed if the Annual Report required by paragraph (c) of this section is sent to pool participants within 45 calendar days after the end of the fiscal year. The requirement to distribute an Account Statement shall commence as of the date the pool is formed as specified in paragraph (g)(1) of this section.

(c) Except as provided in paragraph (c)(7) or (c)(8) of this section, each commodity pool operator registered or required to be registered under the Act must distribute an Annual Report to each participant in each pool that it operates, and must electronically submit a copy of the Report and key financial balances from the Report to the National Futures Association pursuant to the electronic filing procedures of the National Futures Association, within 90 calendar days after the end of the pool’s fiscal year or the permanent cessation of trading, whichever is earlier; Provided, however, that if during any calendar year the commodity pool operator did not operate a commodity pool, the pool operator must so notify the National Futures Association within 30 calendar days after the end of such calendar year. The Annual Report must be affirmed pursuant to paragraph (h) of this section and must contain the following:

(1) The net asset value of the pool as of the end of each of the pool’s two preceding fiscal years.

(2)(i) The net asset value per outstanding participation unit in the pool as of the end of each of the pool’s two preceding fiscal years, or (ii) The total value of the participant’s interest or share in the pool as of the end of each of the pool’s two preceding fiscal years.

(3) A Statement of Financial Condition as of the close of the pool’s fiscal year and preceding fiscal year.

(4) Statements of Operations, and Changes in Net Assets, for the period between (i) The later of: (A) The date of the most recent Statement of Financial Condition delivered to the National Futures Association pursuant to this paragraph(c); or (B) The date of the formation of the pool; and (ii) The close of the pool’s fiscal year, together with Statements of Operations, and Changes in Net Assets for the corresponding period of the previous fiscal year.

(5) Appropriate footnote disclosure and such further material information as may be necessary to make the required statements not misleading. For a pool that invests in other funds, this information must include, but is not limited to, separately disclosing the amounts of income, management and incentive fees associated with each investment in an investee fund that exceeds five percent of the pool’s net assets. The management and incentive fees associated with an investment in an investee fund that is less than five percent of the pool’s net assets may be combined and reported in the aggregate with the income, management and incentive fees of other investee funds that, individually, represent an investment of less than five percent of the pool’s net assets. If the commodity pool operator is not able to obtain the specific amounts of management and incentive fees charged by an investee fund, the commodity pool operator must disclose the percentage amounts and computational basis for each such fee and include a statement that the CPO is not able to obtain the specific fee amounts for this fund;

(6) Where the pool is comprised of more than one ownership class or series, information for the series or class on which the financial statements are reporting should be presented in addition to the information presented for the pool as a whole; except that, for a pool that is a series fund structured with a limitation on liability among the different series, the financial statements are not required to include consolidated information for all series.

(7) For a pool that has ceased operation prior to, or as of, the end of the fiscal year, the commodity pool operator may provide the following, within 90 days of the permanent cessation of trading, in lieu of the annual report that would otherwise be required by § 4.22(c) or § 4.7(b)(3):

(i) Statements of Operations and Changes in Net Assets for the period between—

(A) The later of: (1) The date of the most recent Statement of Financial Condition filed with the National Futures Association pursuant to this paragraph (c); or (2) The date of the formation of the pool; and (B) The close of the pool’s fiscal year or the date of the cessation of trading, whichever is earlier; and

(ii)(A) An explanation of the winding down of the pool’s operations and written disclosure that all interests in, and assets of, the pool have been redeemed, distributed or transferred on behalf of the participants;

(B) If all funds have not been distributed or transferred to participants by the time that the final report is issued, disclosure of the value of assets remaining to be distributed and an approximate timeframe of when the distribution will occur. If the commodity pool operator does not distribute the remaining pool assets within the timeframe specified, the commodity pool operator must provide written notice to each participant and to the National Futures Association that the distribution of the remaining assets of the pool has not been completed, the value of assets remaining to be distributed, and a time frame of when the final distribution will occur.

(C) If the commodity pool operator will not be able to liquidate the pool’s assets in sufficient time to prepare, file and distribute the final annual report for the pool within 90 days of the permanent cessation of trading, the commodity pool operator must provide written notice to each participant and to National Futures Association disclosing:

(1) The value of investments remaining to be liquidated, the timeframe within which liquidation is expected to occur, any impediments to liquidation, and the nature and amount of any fees and expenses that will be charged to the pool prior to the final distribution of the pool’s funds;

(2) Which financial reports the commodity pool operator will continue to provide to pool participants from the time that trading ceased until the final annual report is distributed, and the frequency with which such reports will be provided, pursuant to the pool’s operative documents; and

(3) The timeframe within which the commodity pool operator will provide the final report.

(iii) A report filed pursuant to this paragraph (c)(7) that would otherwise be required by this paragraph (c) is not required to be audited in accordance with paragraph (d) of this section if the commodity pool operator obtains from all participants written waivers of their rights to receive an audited Annual Report, and at the time of filing the Annual Report with National Futures Association, certifies that it has received waivers from all participants. The commodity pool operator must maintain the waivers in accordance with § 1.31 of this chapter and must make the waivers available to the Commission or National Futures Association upon request.

(8) For the purpose of the Annual Report distribution requirement, including any annual report distributed pursuant to §4.7(b)(3) or 4.12(b)(2)(iii), the term “participant” does not include a commodity pool operated by a pool operator that is the same as, or that controls, is controlled by, or is under common control with, the pool operator of a pool in which the commodity pool has invested; Provided, That the Annual Report of such investing pool contain financial statements that include such information as the Commission may specify concerning the operations of the pool in which the commodity pool has invested.

(d)

(1) The financial statements in the Annual Report must be presented and computed in accordance with generally accepted accounting principles consistently applied and must be audited by an independent public accountant. The requirements of § 1.16(g) of this chapter shall apply with respect to the engagement of such independent public accountants, except that any related notifications to be made may be made solely to the National Futures Association, and the certification must be in accordance with § 1.16 of this chapter, except that the following requirements of that section shall not apply:

(i) The audit objectives of § 1.16(d)(1) concerning the periodic computation of minimum capital and property in segregation;

(ii) All other references in § 1.16 to the segregation requirements; and

(iii) Section 1.16(c)(5), (d)(2), (e)(2), and (f).

(2)

(i) The financial statements in the Annual Report required by this section or by § 4.7(b)(3) may be presented and computed in accordance with International Financial Reporting Standards issued by the International Accounting Standards Board if the following conditions are met:

(A) The pool is organized under the laws of a foreign jurisdiction;

(B) The Annual Report will include a condensed schedule of investments, or, if required by the alternate accounting standards, a full schedule of investments;

(C) The preparation of the pool’s financial statements under International Financial Reporting Standards is not inconsistent with representations set forth in the pool’s offering memorandum or other operative document that is made available to participants;

(D) Special allocations of ownership equity will be reported in accordance with § 4.22(e)(2); and

(E) In the event that the International Financial Reporting Standards require consolidated financial statements for the pool, such as a feeder fund consolidating with its master fund, all applicable disclosures required by generally accepted accounting principles for the feeder fund must be presented with the reporting pool’s consolidated financial statements.

(ii) The commodity pool operator of a pool that meets the conditions specified in this paragraph (d)(2) may claim relief from the requirement in paragraph (d)(1) of this section by filing a notice with the National Futures Association, within 90 calendar days after the end of the pool’s fiscal year.

(A) The notice must contain the name, main business address, main telephone number and the National Futures Association registration identification number of the commodity pool operator, and name and the identification number of the commodity pool.

(B) The notice must include representations regarding the pool’s compliance with each of the conditions specified in § 4.22(d)(2)(A) through (D), and, if applicable, (E); and

(e)

(1) The Statement of Operations required by this section must itemize brokerage commissions, management fees, advisory fees, incentive fees, interest income and expense, total realized net gain or loss from commodity interest trading, and change in unrealized net gain or loss on commodity interest positions during the pool’s fiscal year. Gains and losses on commodity interests need not be itemized by commodity or by specific delivery or expiration date.

(2)

(i) Any share of a pool’s profits or transfer of a pool’s equity which exceeds the general partner’s or any other class’s share of profits computed on the general partner’s or other class’s pro rata capital contribution are ‘‘special allocations.’’ Special allocations of partnership equity or other interests must be recognized in the pool’s Statement of Operations in the same period as the net income, interest income, or other basis of computation of the special allocation is recognized. Special allocations must be recognized and classified either as an expense of the pool or, if not recognized as an expense of the pool, presented in the Statement of Operations as a separate, itemized allocation of the pool’s net income to arrive at net income available for pro rata distribution to all partners.

(ii) Special allocations of ownership interest also must be reported separately in the Statement of Partners’ Equity, in addition to the pro-rata allocations of net income, as to each class of ownership interest.

(3) Realized gains or losses on regulated commodities transactions presented in the Statement of Operations of a commodity pool may be combined with realized gains or losses from trading in non-commodity interest transactions, provided that the gains or losses to be combined are part of a related trading strategy. Unrealized gains or losses on open regulated commodity positions presented in the Statement of Operations of a commodity pool may be combined with unrealized gains or losses from open positions in non-commodity positions, provided that the gains or losses to be combined are part of a related trading strategy.

(f)

(1)

(i) In the event the commodity pool operator finds that it cannot distribute the Annual Report for a pool that it operates within the time specified in paragraph (c) of this section without substantial undue hardship, it may file with the National Futures Association an application for extension of time to a specified date not more than 90 calendar days after the date as of which the Annual Report was to have been distributed. The application must be made by the pool operator and must:

(A) State the name of the pool for which the application is being made;

(B) State the reasons for the requested extension;

(C) Indicate that the inability to make a timely filing is due to circumstances beyond the control of the pool operator, if such is the case, and describe briefly the nature of such circumstances;

(D) Contain an undertaking to file the Annual Report on or before the date specified in the application; and

(E) Be filed with the National Futures Association prior to the date on which the Annual Report is due.

(ii) The application must be accompanied by a letter from the independent public accountant answering the following questions:

(A) What specifically are the reasons for the extension request?

(B) Do you have any indication from the part of your audit completed to date that would lead you to believe that the commodity pool operator was or is not meeting the recordkeeping requirements of this part 4 or was or is not complying with the §4.20(c) prohibition on commingling of property of any pool with the property of any other person?

(iii) Within ten calendar days after receipt of an application for an extension of time, the National Futures Association shall:

(A) Notify the commodity pool operator of the grant or denial of the requested extension, or

(B) Indicate to the pool operator that additional time is required to analyze the request, in which case the amount of time needed will be specified.

(2) In the event a commodity pool operator finds that it cannot obtain information necessary to prepare annual financial statements for a pool that it operates within the time specified in either paragraph (c) of this section or § 4.7(b)(3)(i), as a result of the pool investing in another collective investment vehicle, it may claim an extension of time under the following conditions:

(i) The commodity pool operator must, within 90 calendar days of the end of the pool’s fiscal year, file a notice with the National Futures Association, except as provided in paragraph (f)(2)(v) of this section.

(ii) The notice must contain the name, main business address, main telephone number and the National Futures Association registration identification number of the commodity pool operator, and name and the identification number of the commodity pool.

(iii) The notice must state the date by which the Annual Report will be distributed and filed (the ‘‘Extended Date’’), which must be no more than 180 calendar days after the end of the pool’s fiscal year. The Annual Report must be distributed and filed by the Extended Date.

(iv) The notice must include representations by the commodity pool operator that:

(A) The pool for which the Annual Report is being prepared has investments in one or more collective investment vehicles (the ‘‘Investments’’);

(B) For all reports prepared under paragraph (c) of this section and for reports prepared under § 4.7(b)(3)(i) that are audited by an independent public accountant, the commodity pool operator has been informed by the independent public accountant engaged to audit the commodity pool’s financial statements that specified information required to complete the pool’s annual report is necessary in order for the accountant to render an opinion on the commodity pool’s financial statements. The notice must include the name, main business address, main telephone number, and contact person of the accountant; and

(C) The information specified by the accountant cannot be obtained in sufficient time for the Annual Report to be prepared, audited, and distributed before the Extended Date.

(D) For unaudited reports prepared under § 4.7(b)(3)(i), the commodity pool operator has been informed by the operators of the Investments that specified information required to complete the pool’s annual report cannot be obtained in sufficient time for the Annual Report to be prepared and distributed before the Extended Date.

(v) For each fiscal year following the filing of the notice described in paragraph (f)(2)(i) of this section, for a particular pool, it shall be presumed that the particular pool continues to invest in another collective investment vehicle and the commodity pool operator may claim the extension of time; Provided, however, that if the particular pool is no longer investing in another collective investment vehicle, then the commodity pool operator must file electronically with the National Futures Association an Annual Report within 90 days after the pool’s fiscal year-end accompanied by a notice indicating the change in the pool’s status.

(vi) Any notice or statement filed pursuant to this paragraph (f)(2) must be signed by the commodity pool operator in accordance with paragraph (h) of this section.

(g)

(1) A commodity pool operator may initially elect any fiscal year for a pool, but the first fiscal year may not end more than one year after the pool’s formation. For purposes of this section, a pool shall be deemed to be formed as of the date the pool operator first receives funds, securities or other property for the purchase of an interest in the pool.

(2) If a commodity pool operator elects a fiscal year other than the calendar year, it must give written notice of the election to all participants and must file the notice with the National Futures Association within 90 calendar days after the date of the pool’s formation. If this notice is not given, the pool operator will be deemed to have elected the calendar year as the pool’s fiscal year.

(3) The commodity pool operator must continue to use the elected fiscal year for the pool unless it provides written notice of any proposed change to all participants and files such notice with the National Futures Association at least 90 days before the change and the National Futures Association does not disapprove the change within 30 days after the filing of the notice.

(h)

(1) Each Account Statement and Annual Report, including an Account Statement or Annual Report provided pursuant to §4.7(b) or 4.12(b), must contain an oath or affirmation that, to the best of the knowledge and belief of the individual making the oath or affirmation, the information contained in the document is accurate and complete; Provided, however, That it shall be unlawful for the individual to make such oath or affirmation if the individual knows or should know that any of the information in the document is not accurate and complete.

(2) Each oath or affirmation must be made by a representative duly authorized to bind the pool operator, and

(i) for the copy of a commodity pool’s Annual Report submitted to the National Futures Association, such representative shall satisfy the required oath or affirmation through compliance with the National Futures Association’s electronic filing procedures, and

(ii) for a commodity pool Account Statement or Annual Report distributed to participants, a facsimile of the manually signed oath or affirmation of such representative may be used so long as the manually signed original is retained in accordance with §4.23.

(3) For each manually signed oath or affirmation, there must be typed beneath the signed oath or affirmation:

(i) The name of the individual signing the document;

(ii) The capacity in which he is signing;

(iii) The name of the commodity pool operator for whom he is signing; and

(iv) The name of the commodity pool for which the document is being distributed.

(i) The Account Statement or Annual Report may be distributed to a pool participant by means of electronic media if the participant so consents; Provided, That prior to the transmission of any Account Statement or Annual Report by means of electronic media, a commodity pool operator must disclose to the participant that it intends to distribute electronically the Account Statement or Annual Report or both documents, as the case may be, absent objection from the participant, which objection, if any, the participant must make no later than 10 business days following its receipt of the disclosure.

(Approved by the Office of Management and Budget under control number 3038–0005)

(Secs. 2(a)(1), 4c(a)–(d), 4d, 4f, 4g, 4k, 4m, 4n, 8a, 15 and 17, Commodity Exchange Act (7 U.S.C. 2, 4, 6c(a)–(d), 6f, 6g, 6k, 6m, 6n, 12a, 19 and 21; 5 U.S.C. 552 and 552b))

[46 FR 26013, May 8, 1981, as amended at 46 FR 63035, Dec. 30, 1981; 47 FR 57011, Dec. 22, 1982; 52 FR 41986, Nov. 2, 1987; 65 FR 81334, Dec. 26, 2000; 67 FR 77411, Dec. 18, 2002; 68 FR 47234, Aug. 8, 2003; 68 FR 52837, Sept. 8, 2003; 71 FR 8942, Feb. 22, 2006]

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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 as well as the forex registration website. He can be reached directly at 415-868-5345.

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

Hedge Funds and Insider Trading after Galleon

1 Reply

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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Section 204A | Investment Advisers Act of 1940

1 Reply

Section 204A — Prevention of Misuse of Nonpublic Information

Every investment adviser subject to section 204 shall establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such investment adviser’s business, to prevent the misuse in violation of this Act or the Securities Exchange Act of 1934, or the rules or regulations thereunder, of material, nonpublic information by such investment adviser or any person associated with such investment adviser. The Commission, as it deems necessary or appropriate in the public interest or for the protection of investors, shall adopt rules or regulations to require specific policies or procedures reasonably designed to prevent misuse in violation of this Act or the Securities Exchange Act of 1934 (or the rules or regulations thereunder) of material, nonpublic information.

H.R. 3818 | Hedge Fund Registration

8 Replies

Bart Mallon, Esq. (http://www.hedgefundlawblog.com)

Private Fund Investment Advisers Registration Act of 2009 (text of act)

Below is the final text of the hedge fund registration bill as passed by the House Financial Services Commission.

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111th CONGRESS

1st Session

H. R. 3818

To amend the Investment Advisers Act of 1940 to require advisers of certain unregistered investment companies to register with and provide information to the Securities and Exchange Commission, and for other purposes.

IN THE HOUSE OF REPRESENTATIVES

October 15, 2009

Mr. KANJORSKI introduced the following bill; which was referred to the Committee on Financial Services

A BILL

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the `Private Fund Investment Advisers Registration Act of 2009′.

SEC. 2. DEFINITIONS.

Section 202(a) of the Investment Advisers Act of 1934 (15 U.S.C. 80b-2(a)) is amended by adding at the end the following new paragraphs:

`(29) PRIVATE FUND- The term `private fund’ means an investment fund that–

`(A) would be an investment company under section 3(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(a)) but for the exception provided from that definition by either section 3(c)(1) or section 3(c)(7) of such Act; and

`(B) either–

`(i) is organized or otherwise created under the laws of the United States or of a State; or

`(ii) has 10 percent or more of its outstanding securities by value owned by United States persons.

`(30) FOREIGN PRIVATE FUND ADVISER- The term `foreign private fund adviser’ means an investment adviser who–

`(A) has no place of business in the United States;

`(B) during the preceding 12 months has had–

`(i) fewer than 15 clients in the United States; and

`(ii) assets under management attributable to clients in the United States of less than $25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in the public interest or for the protection of investors; and

`(C) neither holds itself out generally to the public in the United States as an investment adviser, nor acts as an investment adviser to any investment company registered under the Investment Company Act of 1940, or a company which has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940 (15 U.S.C. 80a-53) and has not withdrawn such election.’.

SEC. 3. ELIMINATION OF PRIVATE ADVISER EXEMPTION; LIMITED EXEMPTION FOR FOREIGN PRIVATE FUND ADVISERS; LIMITED INTRASTATE EXEMPTION.

Section 203(b) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(b)) is amended–

(1) in paragraph (1), by inserting `, except an investment adviser who acts as an investment adviser to any private fund,’ after `any investment adviser’;

(2) by amending paragraph (3) to read as follows:

`(3) any investment adviser that is a foreign private fund adviser;’;

(3) in paragraph (5), by striking `or’ at the end; and

(4) in paragraph (6)–

(A) in subparagraph (A), by striking `or’;

(B) in subparagraph (B), by striking the period at the end and adding `; or’; and

`(C) a private fund.’.

SEC. 4. COLLECTION OF SYSTEMIC RISK DATA.

Section 204 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-4) is amended–

(1) by redesignating subsections (b) and (c) as subsections (c) and (d), respectively; and

(2) by inserting after subsection (a) the following new subsection:

`(b) Records and Reports of Private Funds-

`(1) IN GENERAL- The Commission is authorized to require any investment adviser registered under this Act to maintain such records of and file with the Commission such reports regarding private funds advised by the investment adviser as are necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk as the Commission determines in consultation with the Board of Governors of the Federal Reserve System. The Commission is authorized to provide or make available to the Board of Governors of the Federal Reserve System, and to any other entity that the Commission identifies as having systemic risk responsibility, those reports or records or the information contained therein. The records and reports of any private fund, to which any such investment adviser provides investment advice, maintained or filed by an investment adviser registered under this Act, shall be deemed to be the records and reports of the investment adviser.

`(2) REQUIRED INFORMATION- The records and reports required to be maintained or filed with the Commission under this subsection shall include, for each private fund advised by the investment adviser–

`(A) the amount of assets under management;

`(B) the use of leverage (including off-balance sheet leverage);

`(C) counterparty credit risk exposures;

`(D) trading and investment positions;

`(E) trading practices; and

`(F) such other information as the Commission, in consultation with the Board of Governors of the Federal Reserve System, determines necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

`(3) OPTIONAL INFORMATION- The Commission may require the reporting of such additional information from private fund advisers as the Commission determines necessary. In making such determination, the Commission may set different reporting requirements for different classes of private fund advisers, based on the particular types or sizes of private funds advised by such advisers.

`(4) MAINTENANCE OF RECORDS- An investment adviser registered under this Act is required to maintain and keep such records of private funds advised by the investment adviser for such period or periods as the Commission, by rule or regulation, may prescribe as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

`(5) EXAMINATION OF RECORDS-

`(A) PERIODIC AND SPECIAL EXAMINATIONS- All records of a private fund maintained by an investment adviser registered under this Act shall be subject at any time and from time to time to such periodic, special, and other examinations by the Commission, or any member or representative thereof, as the Commission may prescribe.

`(B) AVAILABILITY OF RECORDS- An investment adviser registered under this Act shall make available to the Commission or its representatives any copies or extracts from such records as may be prepared without undue effort, expense, or delay as the Commission or its representatives may reasonably request.

`(6) INFORMATION SHARING- The Commission shall make available to the Board of Governors of the Federal Reserve System, and to any other entity that the Commission identifies as having systemic risk responsibility, copies of all reports, documents, records, and information filed with or provided to the Commission by an investment adviser under this subsection as the Board, or such other entity, may consider necessary for the purpose of assessing the systemic risk of a private fund. All such reports, documents, records, and information obtained by the Board, or such other entity, from the Commission under this subsection shall be kept confidential.

`(7) DISCLOSURES OF CERTAIN PRIVATE FUND INFORMATION- An investment adviser registered under this Act shall provide such reports, records, and other documents to investors, prospective investors, counterparties, and creditors, of any private fund advised by the investment adviser as the Commission, by rule or regulation, may prescribe as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

`(8) CONFIDENTIALITY OF REPORTS- Notwithstanding any other provision of law, the Commission shall not be compelled to disclose any report or information contained therein required to be filed with the Commission under this subsection. Nothing in this paragraph shall authorize the Commission to withhold information from the Congress or prevent the Commission from complying with a request for information from any other Federal department or agency or any self-regulatory organization requesting the report or information for purposes within the scope of its jurisdiction, or complying with an order of a court of the United States in an action brought by the United States or the Commission. For purposes of section 552 of title 5, United States Code, this paragraph shall be considered a statute described in subsection (b)(3)(B) of such section.’.

SEC. 5. ELIMINATION OF DISCLOSURE PROVISION.

Section 210 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-10) is amended by striking subsection (c).

SEC. 6. EXEMPTION OF AND REPORTING BY VENTURE CAPITAL FUND ADVISERS.

Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3) is amended by adding at the end the following new subsection:

`(l) Exemption of and Reporting by Venture Capital Fund Advisers- The Commission shall identify and define the term `venture capital fund’ and shall provide an adviser to such a fund an exemption from the registration requirements under this section. The Commission shall require such advisers to maintain such records and provide to the Commission such annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors.’.

SEC. 7. CLARIFICATION OF RULEMAKING AUTHORITY.

Section 211 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-11) is amended–

(1) by amending subsection (a) to read as follows:

`(a) The Commission shall have authority from time to time to make, issue, amend, and rescind such rules and regulations and such orders as are necessary or appropriate to the exercise of the functions and powers conferred upon the Commission elsewhere in this title, including rules and regulations defining technical, trade, and other terms used in this title. For the purposes of its rules and regulations, the Commission may–

`(1) classify persons and matters within its jurisdiction based upon, but not limited to–

`(A) size;

`(B) scope;

`(C) business model;

`(D) compensation scheme; or

`(E) potential to create or increase systemic risk;

`(2) prescribe different requirements for different classes of persons or matters; and

`(3) ascribe different meanings to terms (including the term `client’) used in different sections of this title as the Commission determines necessary to effect the purposes of this title.’; and

(2) by adding at the end the following new subsection:

`(e) The Commission and the Commodity Futures Trading Commission shall, after consultation with the Board of Governors of the Federal Reserve System, within 6 months after the date of enactment of the Private Fund Investment Advisers Registration Act of 2009, jointly promulgate rules to establish the form and content of the reports required to be filed with the Commission under sections 203(i) and 204(b) and with the Commodity Futures Trading Commission by investment advisers that are registered both under the Investment Advisers Act of 1940 (15 U.S.C. 80b-1 et seq.) and the Commodity Exchange Act (7 U.S.C. 1 et seq.).’.

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Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. Cole-Frieman & Mallon LLP helps hedge fund managers to register as investment advisors with the SEC or the state securities divisions. If you are a hedge fund manager who is looking to start a hedge fund or register as an investment advisor, please contact us or call Mr. Mallon directly at 415-868-5345.

Hedge Fund Audit Firms and Agreed Upon Procedures

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Hedge Fund Due Diligence Firm Discusses “Agreed Upon Procedures”

We’ve published a number of thoughtful pieces on this blog from Chris Addy, president and CEO of Castle Hall Alternatives (see, for example, article on Hedge Fund Operational Issues and Failures). Today we are publishing a piece by Chris which discusses hard to value hedge fund assets (so called Level III assets). In certain situations hedge fund audit firms will be engaged to perform an “Agreed Upon Procedures” review of the pricing of these assets. As discussed in the article below, agreed upon procedures engagements do not provide hedge fund investors with a great deal of comfort with regard to the pricing of these assets. It is unclear whether in the future investors will push back with regard to such engagements and require more robust pricing audits. The problem with more robust procedures, obviously, is increased cost (because of increased liability for the audit firms).

Managers who are engaging audit firms pursuant to agreed upon procedures should be aware that they may face tougher questions from investors going forward.

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Agreed Upon Procedures

A number of our recent posts have focused on the challenges of the hedge fund administrator‘s role in relation to security valuation. We will, of course, return to this topic – but, in the meantime, wanted to focus on some of the alternatives to administrator pricing.

One of the more common comments from today’s administrators is that, while an admin may be able to price Level I and Level II securities, they do not necessarily have information to price Level III instruments. (To recap, the US accounting standard FAS 157 divides portfolios into three levels, being Level I, liquid instruments readily priced from a pricing feed (typically exchange traded); Level II, instruments priced using inputs from “comparable” securities (essentially mark to model, albeit with mainstream models); and Level III, everything else.)

This leaves investors with a challenge – if administrators cannot price Level III instruments, who can? Moreover, to repeat one of our frequent comments, it is self evident that if a hedge fund manager wishes to deliberately mismark securities, they would most likely misprice a Level III instrument. It is, of course, very hard to fake the price of IBM common stock, but much easier to mismark emerging market private loans.

Two of the most common tools available to hedge fund managers looking for third party oversight over pricing for Level III instruments – assuming the administrator has washed their hands of the problem – are third party pricing agents and auditor agreed upon procedures, or “AUP”. We will return to the strengths and weaknesses of third party pricing agents in a subsequent post, but wanted to focus this discussion on AUP.

In an Agreed Upon Procedures engagement, the auditor completes specific procedures which have been dictated by the client. The procedures are specified and the auditor then prepares a report outlining the findings of that specific work.

We have two comments here: the first is to take a high level view as to the adequacy of these procedures, and the second is to dig a little more deeply into the actual audit guidance that covers this type of work.

Our first comment is, unfortunately, an Emporer Has No Clothes observation. The significant majority of hedge fund AUP engagements we have seen require the auditor to test a fund’s pricing on a quarterly basis. This usually involves (i) obtaining a portfolio list from the investment manager and (ii) testing the pricing support for those positions.

There are, however, generally two snags. Firstly, many AUP only test a sample of prices, not the whole portfolio. Sample testing clearly provides much less assurance than a price review of all positions: the administrator, for example, is usually expected to price the entire book (would any investor accept a NAV which has been priced on a “sample” basis???)

The bigger problem, however, is the type of testing completed by the auditor. In way, way too many cases, the auditor tests security prices back to the manager’s own pricing support and makes no attempt to obtain independent pricing information.

This type of work is, clearly, somewhere between minimal and absolutely no value for investors. If the auditor receives a spreadsheet from the manager showing the matrix of broker quotes received, how does the auditor know that the manager has not adjusted that spreadsheet to exclude quotes which were uncomfortably low? Even more importantly, if all the auditor does is to check prices back to pieces of paper in the manager’s own pricing file, how does the auditor know that those pieces of paper are genuine? As we have said before, and will keep on saying, it only costs $500 to buy a copy of Adobe Photoshop if you are of a mind to alter documentation.

When discussing this type of work, the manager typically notes that, if the auditor was to complete a full, independent pricing review, it would be too costly and too time consuming to be practical on a quarterly basis. A full, GAAP audit review is, of course, performed at year end – this does include independent pricing (although – investor fyi – auditors will still only sample test many portfolios.)

While these are fair points, it remains the case that this type of AUP provides minimal protection against pricing fraud. In the meantime, the manager gets the marketing benefit of being able to claim enhanced scrutiny and oversight from a Big 4 firm each quarter.

Which leads to our second point. Why would an auditor accept to complete agreed upon procedures when any reasonable accountant would rapidly conclude that the typical scope of these AUP provide pretty much nil controls assurance? Why does the auditor not insist that, if their name is to be associated to this work, then the procedures must be meaningful and sufficient to meet an actual control standard?

To this point, the actual audit standard applicable to AUP is available here. The standard states:

An agreed-upon procedures engagement is one in which a practitioner is engaged by a client to issue a report of findings based on specific procedures performed on subject matter. The client engages the practitioner to assist specified parties in evaluating subject matter or an assertion as a result of a need or needs of the specified parties. Because the specified parties require that findings be independently derived, the services of a practitioner are obtained to perform procedures and report his or her findings. The specified parties and the practitioner agree upon the procedures to be performed by the practitioner that the specified parties believe are appropriate. Because the needs of the specified parties may vary widely, the nature, timing, and extent of the agreed upon procedures may vary as well; consequently, the specified parties assume responsibility for the sufficiency of the procedures since they best understand their own needs. In an engagement performed under this section, the practitioner does not perform an examination or a review, as discussed in section 101, and does not provide an opinion or negative assurance. Instead, the practitioner’s report on agreed-upon procedures should be in the form of procedures and findings.

In practice, this all gets horribly circular. Per the standard, a client requests an auditor to complete AUP to assist “specified parties” to “evaluate subject matter or an assertion”. In our case, the assertion would be “are hard to value securities valued correctly at quarter end.”

However, the specified party is usually the manager itself, making the client and specified party the same person. The particular trick applied, in many cases, is for the auditor to seek to prevent the investor from actually seeing the AUP in the first place! However, if the investor is to have access to the AUP, the auditor universally requires the investor to sign a Catch 22 document which requires the investor to acknowledge that the AUP are “sufficient for their needs”. So, even if the investor believes that the AUP are not “sufficient for their needs” – which is hardly a long stretch – the investor has to sign that the procedures are sufficient if they are to even see the auditor’s work. With this magic piece of paper, the auditor has met its requirements and can sleep easy. Meanwhile, the auditor will send a bill to – guess who – the fund, meaning that investors have, once more, had to foot the bill.

As always, Caveat Emptor.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

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Investment Adviser Representative Registration Requirement

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Employees of Registered IAs Must Generally be Registered

State-registered investment advisory firms need to make sure that their employees who are deemed to be “investment advisory representatives” are appropriately registered. This means that any employee (or owner) of the IA firm who provides investment advice or who has supervisory authority will generally need to be registered with the state as a representative of the firm. In order to register, the applicant will need to have certain qualifications and generally the series 65 will be sufficient for these purposes.

There are consequences for not properly registering employees as investment advisor representatives. In an earlier article on whether IA firms can have silent owners, we discussed the fact that many state administrators have the power to censure or fine IA firms if they do not follow the registration rules. I recently stumbled across an example of a state taking such an action.

In the attached [intentionally removed], the Texas State Securities Board (“Board”) concluded that the “unregistered employee” of the registered investment advisory firm provided investment advice to IA clients for compensation and that the IA firm failed to maintain a supervisory system reasonably designed to ensure compliance with the Texas Securities Act and Board Rules. The Board reprimanded the IA firm and also ordered an administrative fine of $5,000. The firm was required to comply with the Act and Board Rules moving forward.

The two important take-aways from this order are:

Always make sure employees are registered or clearly exempt from registration, and
Always ensure that you have an up-to-date compliance program that helps to ensure that the firm will operate within all applicable laws and regulations.

We always recommend that registered IA firms discuss any registration and compliance related matters with an experienced investment management attorney with detailed knowledge of the laws of the state where the firm is registered.

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CTA and CPO Registration and Compliance Guide

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Practical guidance for CTA and CPO firms

Commodity Trading Advisors (CTAs) and Commodity Pool Operators (CPOs) have been contacting me with greater regularity and we have decided to provide those firms with more detailed information on their registration and compliance requirements. Over the course of the next few weeks we will be continually updating this page with more legal and business guidance for CTAs and CPOs. Specifically, we will be providing information on the following topics:

CTA and CPO Registration – this article discusses the how-to’s of registration with the CFTC. The article details the general requirements for firms, principals, and associated persons. Included in this discussion is information on CTA/CPO exam requirements and an overview of the registration process through the NFA’s electronic registration system.

CTA and CPO Registration Exemptions – while the Commodities Exchange Act will generally require CTA and CPO firms to register with the CFTC, there are some important exemptions from the registration provisions. Review this article to see if your firm might be able to claim an exemption from the registration provisions.

CTA and CPO Compliance Overview – CTAs and CPOs are subject to a number of laws, regulations and rules. Not only must CTAs and CPOs follow CFTC laws and regulations, but as Members of the NFA, these groups must also follow all of the rules developed by the NFA. We will be discussing compliance best practices, major examination issues, major deadlines and the CTA/CPO compliance manual. Being prepared for an NFA examination is of great importance.

Recent NFA Actions against CTA and CPO Managers – the NFA and the CFTC have been quite active lately. In this article we will be discussing some of the most recent actions against NFA member firms. This article will also provide common-sense advice on what managers can do the protect themselves from examination deficiencies.

Important NFA Rules for CTA and CPO Firms – there are a number of rules which the NFA has regarding the conduct of CTAs and CPOs. In general CTAs and CPOs must hold themselves out with the utmost professionalism. This article will detail this and other important NFA rules.

CTA and CPO advertising – there are a number of important rules regarding advertising for CTAs and CPOs. CPOs, especially, must be careful about advertising because of the restrictions under Rule 506 of Regulation D, an exemption that many CPOs utilize in offering their fund interests. Websites will be touched upon in this post and will also be discussed in greater depth in a subsequent posting.

CTA and CPO websites – many CTA firms utilize the internet to advertise their services. CPO firms will also sometimes have a (minimal) internet presence. This article will detail the considerations that both CTA and CPO firms face when creating and maintaining an internet presence and how to deal with internet based inquiries from potential investors.

NFA Exam Requirements for CTAs and CPOs – individuals of NFA member firms will generally need to have a Series 3 exam license and potentially a Series 30 exam. Some individuals may need to have a Series 31 exam license and, potentially in the future, forex CTAs and CPOs will need to have a Series 34 exam license. This article will discuss these exams and the process an individual will go through in order to register to take the exams.

CTA Expo Blog – the unofficial blog of the CTA Expo most recently held in October of 2009. Information for CTA managers on business, legal and compliance issues. Included is a directory of CTA firms and service providers.

Forex CTAs and CPOs – the regulatory light has been focused on retail spot forex managers recently. Read this article to get up to speed on recent CFTC and NFA pronouncements regarding this area of the industry. We will also provide information on Forex IBs and Forex FCMs.

In addition to the above topics we are hoping to add others over time. We welcome all feedback and encourage you to leave comments below. We will also attempt to answer CTA and CPO frequently asked questions.

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.

Purchasing an ERISA Fidelity Bond

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Information on How to Buy ERISA Bond

Purchasing an ERISA Fidelity Bond is essentially the same as purchasing a fidelity bond for an investment advisory firm and this article is meant to serve as guide as to cost and timing to secure one of these bonds.

Overview

Generally a manager will need to make sure that the bond is for 10% of the amount of the ERISA assets (subject to a minimum bond requirement of $1,000). This means that if the ERISA assets in the fund are $1MM, the manager will need to have a bond for at least $100,000.

However, the maximum bond amount with regard to any one plan is $500,000. This means that if the manager has ERISA assets in the fund (from one plan) of $6MM, the manager will only need to have a bond in the amount of $500,000 with respect to that plan.

Generally, if the manager had two plans in his fund – one with $6MM in assets and one with $2MM in assets, the manager would need to have $700,000 worth of coverage ($500,000 and $200,000 respectively). The best way to accomplish this is to have separate bonds for the separate ERISA plans invested in the fund.

Cost of ERISA Bond

A bond consultant or insurance broker will generally be able to provide a quote for the ERISA coverage needs. The costs are fairly reasonable – generally around $200 to $400 for every $100,000 of coverage per year. For newly formed management companies, the amount of the bond may be based on the personal credit score of an officer of such management company.

Application Process and Timing

ERISA bonds are fairly easy to purchase and can be delivered quickly. The application process is generally pretty basic – applications will require basic information about the management company, the fund and/or the officer(s) of the management company. Different bond companies will require different information or have different application processes or procedures.

In my experience, managers have been able to secure a bond within about a week of submitting an application. If you are a manager that is likely to receive an allocation from an ERISA plan, the best practice is to have the bond in place prior to the time that the ERISA assets are wired to the fund account. Accordingly, the manager should take care to make sure the bonding company has all necessary information in order to place the bond by the necessary time.

Other Notes

As with other sensitive areas of hedge fund law (like taxation) managers should take extra care when dealing with ERISA investors and ERISA requirements. I always recommend discussing any ERISA issues with an ERISA specialist.

Please also see our disclaimer with regard to the information presented on this website.

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Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs Hedge Fund Law Blog. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. If you are a hedge fund manager who is looking to start a hedge fund or if you are a current hedge fund manager with questions about ERISA, please contact us or call Mr. Mallon directly at 415-868-5345. Other related hedge fund law articles include:

Hedge Funds and Insider Trading

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Hedge Fund Manager/Trader Settles Charges with SEC

Insider trading cases pop up every now and again and most cases do not warrant highlighting – post-Boesky everyone in the securities industry is well aware that trading on inside information is illegal. However, it warrants emphasis that the SEC will crack down on hedge fund managers or traders involved with insider trading and the penalties are harsh. The individuals (including a hedge fund manager) involved in the action described in the SEC litigation release reprinted below were subject to fines and disgorgement, of course, but were also barred from the securities industry. The severity of such a penalty underscores the importance of understanding and abiding by the insider trading rules.

As noted below, trading on insider information is illegal under both civil (Section 17(a) of the 1933 act, Section 10(b) of the 1934 act, and Rule 10b-5 thereunder) and criminal laws (generally securities fraud, but depending on the facts charges may also include wire fraud and commercial bribery).

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U.S. Securities and Exchange Commission
Litigation Release No. 21244
October 8, 2009

SEC v. Mitchel S. Guttenberg, Erik R. Franklin, David M. Tavdy, Mark E. Lenowitz, Robert D. Babcock, Andrew A. Srebnik, Ken Okada, David A. Glass, Marc R. Jurman, Randi E. Collotta, Christopher K. Collotta, Q Capital Investment Partners, LP, DSJ International Resources Ltd. (d/b/a Chelsey Capital), and Jasper Capital LLC, C.A. No. 07 CV 1774 (S.D.N.Y) (PKC)

Three Defendants in Wall Street Insider Trading Ring Settle SEC Charges

The Securities and Exchange Commission announced today that on September 29, 2009, the Honorable P. Kevin Castel, United States District Judge for the Southern District of New York, entered final judgments against defendants Erik R. Franklin, Q Capital Investment Partners, LP (“Q Capital”), and David M. Tavdy, in SEC v. Guttenberg, et al., C.A. No. 07 CV 1774 (S.D.N.Y.), an insider trading case the Commission filed on March 1, 2007. The Commission’s complaint alleged illegal insider trading in connection with two related schemes in which Wall Street professionals serially traded on material, nonpublic information tipped by insiders at UBS Securities LLC (“UBS”) and Morgan Stanley & Co., Inc. (“Morgan Stanley”), in exchange for cash kickbacks.

The Commission’s complaint alleged that from 2001 through 2006, Mitchel S. Guttenberg, an executive director in the equity research department of UBS, illegally tipped material, nonpublic information concerning upcoming UBS analyst upgrades and downgrades to two Wall Street traders, Franklin and Tavdy, in exchange for sharing in the illicit profits from their trading on that information. The complaint also alleged that Franklin was a downstream tippee in another scheme in which, in 2005 and 2006, Randi Collotta, an attorney who worked in the global compliance department of Morgan Stanley, illegally tipped material, nonpublic information concerning upcoming corporate acquisitions involving Morgan Stanley’s investment banking clients.

The complaint alleged that Franklin illegally traded on the inside information for two hedge funds he managed, Lyford Cay Capital, LP and Q Capital, and in his personal accounts. Tavdy illegally traded on the inside information (i) for Andover Brokerage, LLC and Assent LLC, registered broker-dealers where Tavdy was a proprietary trader, (ii) in his own personal account, (iii) in the accounts of a relative and friend, and (iv) in the accounts of Jasper Capital LLC, a day-trading firm with which Tavdy was associated. Franklin and Tavdy also had downstream tippees who traded on the inside information. Without admitting or denying the allegations in the complaint, Franklin, Q Capital, and Tavdy settled the Commission’s insider trading charges.

Franklin and Q Capital consented to the entry of a final judgment which (i) permanently enjoins them from violating Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”), Rule 10b-5 thereunder, and Section 17(a) of the Securities Act of 1933 (“Securities Act”); and (ii) orders, on a joint and several liability basis, disgorgement of $5,400,000, with all but $290,000 waived based on a demonstrated inability to pay. In a related administrative proceeding, Franklin consented to the entry of a Commission order barring him from future association with any broker, dealer, or investment adviser. In a parallel criminal case, Franklin previously pled guilty to charges of securities fraud and conspiracy to commit securities fraud and is awaiting sentencing. U.S. v. Erik Franklin, No. 1:07-CR-164 (S.D.N.Y.).

Tavdy consented to the entry of a final judgment which (i) permanently enjoins him from violating Section 10(b) of the Exchange Act, Rule 10b-5 thereunder, and Section 17(a) of the Securities Act; and (ii) orders him to pay disgorgement of $10,300,000. In a related administrative proceeding, Tavdy consented to the entry of a Commission order barring him from future association with any broker or dealer. In a parallel criminal case, Tavdy previously pled guilty to charges of securities fraud and conspiracy to commit securities fraud, and was sentenced to 63 months in prison. U.S. v. Mitchel Guttenberg and David Tavdy, No. 1:07-CR-141 (S.D.N.Y.).

The Commission also announced that Samuel W. Childs, Jr., a former general securities principal at Assent LLC, consented to a Commission order barring him from future association with any broker or dealer, based on his criminal conviction for conspiracy to commit securities fraud, wire fraud and commercial bribery. U.S. v. Samuel W. Childs, Jr. and Laurence McKeever, No. 1:07-CR-142 (S.D.N.Y.). In that case, the criminal indictment alleged that Childs accepted bribes from traders at Assent LLC in exchange for not reporting their illegal trading to Assent management.

The Commission acknowledges the assistance and cooperation of the U.S. Attorney’s Office for the Southern District of New York and the Federal Bureau of Investigation.

For further information, see Litigation Release Nos. 20022 (March 1, 2007), 20367 (November 20, 2007), 20725 (September 18, 2008), and 21086 (June 16, 2009).

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Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs Hedge Fund Law Blog. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. If you are a hedge fund manager who is looking to start a hedge fund or if you are a current hedge fund manager with questions about the securities laws, please contact us or call Mr. Mallon directly at 415-868-5345. Other related hedge fund law articles include: