Category Archives: Legal Resources

CFTC and NFA and Hedge Fund Regulation: Report by the GAO

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This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds.  The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here.

The following expert provides a good summary of the roles and duties of both the U.S. Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) with regard to hedge funds and their commodities trading activities. Specifically, the report describes the central ways that these groups regulate hedge funds, including the following:

Once registered, CPOs and CTAs become subject to detailed disclosure, periodic reporting and record-keeping requirements, and periodic on-site risk-based examinations. However, regardless of registration status, all CPOs and CTAs (including those affiliated with hedge funds) remain subject to CFTC’s anti-fraud and anti-manipulation authority.

One item to note is that this report was prepared in early 2008 so it does not include the subsequent jurisdictional grant to the CFTC to regulate spot forex.  This grant was provided by the Farm Bill, passed by Congress in June of 2008 (please see CFTC announces retail forex fraud task force).  Subsequent to passing the Farm Bill the CFTC began drafting regulations (yet to be formally proposed) to require the registration of forex managers.  When the CFTC and the NFA eventually regulate the spot forex markets and require forex managers to be registered, it is likely that their duties will increase with regard to forex hedge fund managers, who are currently unregulated at the federal level.

With regard to future regulatory oversight of hedge funds by the CFTC and the NFA, there will probably not be greater mandates for registration.  One thing that could be done is to take away the CPO exemptions, but this seems unlikely.

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CFTC Can Monitor Hedge Fund Activities through Its Market Surveillance, Regulatory Compliance Surveillance, and Delegated Examination Programs:

Although CFTC does not specifically target hedge funds, through its general market and financial supervisory activities, it can provide oversight of persons registered as CPOs and CTAs that operate or advise hedge funds that trade in the futures markets. As part of its market surveillance program, CFTC collects information on market participants, regardless of their registration status, to monitor their activities and trading practices. In particular, traders are required to report their futures and options positions when a CFTC-specified level is reached in a certain contract market and CFTC electronically collects these data through its Large Trader Reporting System (LTRS).[1] CFTC also uses the futures and options positions information reported by traders through the LTRS as part of its monitoring of the potential financial exposure of traders to clearing firms, and of clearing firms to derivatives clearing organizations. CFTC collects position information from exchanges, clearing members, futures commission merchants (FCM), and foreign brokers and other traders– including hedge funds–about firm and customer accounts in an attempt to detect and deter manipulation.[2] Customers, including hedge funds, are required to maintain margin on deposit with their FCMs to cover losses that might be incurred due to price changes. FCMs also are required to maintain CFTC-imposed minimum capital requirements in order to meet their financial obligations. Such financial safeguards are put in place to mitigate the potential spillover effect to the broader market resulting from the failure of a customer or of an FCM.

According to CFTC officials, the demise (due to trading losses related to natural gas derivatives) in the fall of 2006 of Amaranth Advisors, LLC (Amaranth), a $9 billion multistrategy hedge fund, had no impact on the integrity of the clearing system for CFTC-regulated futures and option contracts. The officials said that at all times Amaranth’s account at its clearing FCM was fully margined and the clearing FCM met all of its settlement obligations to its clearinghouse. They also said that the approximate $6 billion of losses suffered by Amaranth on regulated and unregulated exchanges did not affect its clearing FCM, the other customers of the clearing FCM, or the clearinghouse.[3]

CFTC investigates and, as necessary, prosecutes alleged violators of the Commodity Exchange Act (CEA) and CFTC regulations and may conduct such investigations in cooperation with federal, state, and foreign authorities. Enforcement referrals can come from several sources, including CFTC’s market surveillance group or tips. Remedies sought in enforcement actions generally include permanent injunctions, asset freezes, prohibitions on trading on CFTC-registered entities, disgorgement of ill-gotten gains, restitution to victims, revocation or suspension of registration, and civil monetary penalties. On the basis of CFTC enforcement data, from the beginning of fiscal year 2001 through May 1, 2007, CFTC brought 58 enforcement actions against CPOs and CTAs, including those affiliated with hedge funds, for various violations.[4] A summary of the violations cited in the actions includes misrepresentation with respect to assets under management or profitability; failure to register with CFTC; failure to make required disclosures, statement, or reports; misappropriation of participants’ funds; and violation of prior prohibitions (i.e., prior civil injunction or CFTC cease and desist order).

Pursuant to CFTC-delegated authority, NFA, a registered futures association under the CEA and a self-regulatory organization, oversees the activities, and conducts examinations, of registered CPOs and CTAs.[5] As such, hedge fund advisers registered as CPOs or CTAs are subject to direct oversight in connection with their trading in futures markets.[6] More specifically, to the extent that hedge fund operators or advisers trade futures or options on futures on behalf of hedge funds, the funds are commodity pools and the operators of, and advisers to, such funds are required to register as CPOs and CTAs, respectively, with CFTC and become members of NFA if they are not exempted from registration. Once registered, CPOs and CTAs become subject to detailed disclosure, periodic reporting and record-keeping requirements, and periodic on-site risk-based examinations. However, regardless of registration status, all CPOs and CTAs (including those affiliated with hedge funds) remain subject to CFTC’s anti-fraud and anti-manipulation authority.

Our review of NFA documentation found that 29 advisers of the largest 78 U.S. hedge funds (previously mentioned) are registered with CFTC as CPOs or CTAs. In addition, 20 of the 29 also are registered with SEC as investment advisers or broker-dealers. According to NFA officials, because there is no legal definition of hedge funds, it does not require CPOs or CTAs to identify themselves as hedge fund operators or advisers. NFA, therefore, considers all CPOs and CTAs as potential hedge fund operators or advisers. According to NFA, in fiscal year 2006 NFA examined 212 CPOs, including 6 of the 29 largest hedge fund advisers registered with NFA. During the examinations, NFA staff performed tests of books and records and other auditing procedures to provide reasonable assurance that the firm was complying with NFA rules and all account balances of a certain date were properly stated and classified. Our review of four of the examinations found that 3 of the CPOs examined generally were in compliance with NFA regulations and the remaining 1 was found to have certain employees that were not properly registered with CFTC. According to examination documentation, subsequent to the examination, the hedge fund provided a satisfactory written response to NFA noting that it would soon properly register the employees.

According to an NFA official, since 2003 NFA has taken 23 enforcement actions against CPOs and CTAs, many of which involved hedge funds. Some of the violations found included filing fraudulent financial statements with NFA, not providing timely financial statements to investors, failure to register with CFTC as a CPO, failure to maintain required books and records, use of misleading promotional materials, and failure to supervise staff. The penalties included barring CPOs and CTAs from NFA membership temporarily or permanently or imposing monetary fines ranging from $5,000 to $45,000.

[1] According to CFTC officials, the LTRS captures 70 to 90 percent of the daily activity on registered futures exchanges.

[2] FCMs are individuals, associations, partnerships, corporations, or trusts that solicit or accept orders for the purchase or sale of any commodity for future delivery on or subject to the rules of any contract market or derivatives transaction execution facility; and in connection with such solicitation or acceptance of orders, accept money, securities, or property (or extend credit in lieu thereof) to margin, guarantee, or secure any trades or contracts that result or may result therefrom.

[3] In the CFTC complaint filed against Amaranth Advisors, LLC; Amaranth Advisors (Calgary), ULC, and Brian Hunter, CFTC alleged that the defendants attempted to manipulate the price of natural gas contracts on the New York Mercantile Exchange, Inc., in 2006. Complaint for Injunctive and Other Equitable Relief and Civil Monetary Penalties under the Commodity Exchange Act, CFTC v. Amaranth Advisors, LLC, No. 07-6682 (S.D.N.Y., July 25, 2007).

[4] Because “hedge fund” is not a defined term under the CEA or any other federal statute, CFTC and NFA records do not identify whether a commodity pool is a hedge fund. Thus, CFTC cannot report on the exact
number of examinations that involve hedge funds. In the event the CPO or CTA self-designates itself as a hedge fund, the Division of Enforcement typically incorporates that designation in the enforcement action, and that designation is often used in the press release notifying the public of the enforcement action.

[5] A registered CPO or CTA seeking to engage in futures business with the public or with any member of NFA must itself be a member of NFA.

[6] For the purpose of this report the term “hedge fund advisers” includes, as the context requires, CPOs, CTAs, or securities investment advisers.

Other HFLB articles include:

SEC and Registered Hedge Fund Investment Advisors: Report by the GAO

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This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds.  The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here.

There are many important items in the except below.  While many hedge fund investment advisors are no longer registered with the SEC because the hedge fund registration rule was vacated by a circuit court judge, many hedge fund managers are registered.  As I have done with certain previous articles (see SEC Emphasizes IA Compliance for Hedge Funds), I believe that the following excerpt should be required reading for all investment advisor chief compliance officers (CCOs). The article discusses, the areas which the SEC examiners are likely to emphasize during an examination.  Such areas include: soft dollars, prime brokerage, calculation of the performance fee, valuation of hedge fund assets, and custody of hedge fund assets.

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GAO Report Provides Insight into Potential Future Hedge Fund Regulation

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As we have discussed previously, hedge funds, and the investment management industry, are likely to face increasing regulations in the future.  As we look toward Congressional testimony by hedge funds (see Congress to talk with Hedge Funds on November 12) and by other government officials, we have decided to look back at previous GAO reports to see what issues the GAO identified as important.

The U.S. Government Accountability Office has released two reports this year on hedge funds.  The first report (released in February of 2008) described the current hedge fund regulatory regime and some of the risks the current system posed.  The second report (released in September of 2008) focused on some of the issues which pension plans must consider when investing in hedge funds.  I’ve provided a brief overview of the objectives of the two studies below.

Additionally, this week we are going to examine the February report as it includes many of the issues which have surfaced because of the recent market events, especially with regard to counterparty risk.  A list of the topics we will discuss this week include (links activated as soon as articles are published):

The GAO Hedge Fund Reports

Hedge Funds: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention Is Needed

GAO-08-200 Released February 25, 2008  (for full report, please see PDF)

According to the preamble, “This report (1) describes how federal financial regulators oversee hedge fund-related activities under their existing authorities; (2) examines what measures investors, creditors, and counterparties have taken to impose market discipline on hedge funds; and (3) explores the potential for systemic risk from hedge fund-related activities and describes actions regulators have taken to address this risk.”

Defined Benefit Pension Plans: Guidance Needed to Better Inform Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity

GAO-08-692 Released September 10, 2008 (for full report, please see PDF please also see an earlier article we released on this report entitled Hedge Fund and Pension Report Issued by GAO)

GAO was asked to examine (1) the extent to which plans invest in hedge funds and private equity; (2) the potential benefits and challenges of hedge fund investments; (3) the potential benefits and challenges of private equity investments; and (4) what mechanisms regulate and monitor pension plan investments in hedge funds and private equity.

Other Related HFLB articles include:

The Series 7 Exam

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The Series 7 exam, also known as the General Securities Representative Examination, is the central exam which brokers need to pass before accepting commissions from clients.  The exam allows brokers to engage in the following trasactions through the broker-dealer firm they are registered with: solicitation, purchase, and/or sale of all securities products, including corporate securities, municipal securities, municipal fund securities, options, direct participation programs, investment company products, and variable contracts.

In order to take the exam a person must be sponsored by a FINRA registered broker-dealer; some states used to sponsor the series 7 but I am not aware of any states which currently sponsor individuals for the exam. In order for a broker-dealer firm to register a person to take the exam, the broker-dealer will need to collect information on the person to fill out the Form U4 which will be submitted to FINRA through the CRD system.  The information that will be requested includes: prior addresses, prior securities industry affiliations, prior work history, among other items.

Overview of the Series 7 Exam

Questions: 260 multiple choice questions (10 questions do not count toward total)

Cost: $250 (usually paid by the sponsoring firm)

Time: 6 hours (two 3 hour sessions – bathroom breaks allowed; manadatory minimum 30 minute break between sessions)

Topic Areas: Prospecting for and Qualifying Customers, Evaluating Customer Needs and Objectives, Providing Customers with Investment Information and Making Suitable Recommendations, Handling Customer Accounts and Account Records, Understanding and Explaining the Securities Markets’ Organization and Participants to Customers, Processing Customer Orders and Transactions, Monitoring Economic and Financial Events, Performing Customer Portfolio Analysis and Making Suitable Recommendations

Passing score: 70%

Testing centers: Pearson or Prometric

Process to register: BD submits U4 through FINRA’s CRD system

Prerequisite: none

After the Series 7 Exam

It is often said that the perfect score on the Series 7 is 70% because that is the score where you studied just enough to pass.  I would not recommend studying just enough because I have heard of people who have not passed the exam.  If you do not pass you will be able to take the exam again.

If you do pass the Series 7 you will also need to pass the Series 63 in order to become a licensed broker in most states.  In addition you will need to submit fingerprint cards to your firm’s compliance officer who will then send them into FINRA for filing.  You should discuss this step with your firm’s compliance officer.  I have also included information on the Series 7 from the SEC below, you can also find the same information on the SEC’s site here.

Series 7 Examination

Individuals who want to enter the securities industry to sell any type of securities must take the Series 7 examination—formally known as the General Securities Representative Examination. Individuals who pass the Series 7 are eligible to register with all self-regulatory organizations to trade.

The Financial Industry Regulatory Authority (FINRA) administers the Series 7 examination. For more information, visit FINRA’s website where you can learn about the Series 7 exam and its qualification and registration process.

Other related HFLB articles include:

Schedule 13D

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Below is information from the SEC’s website on Schedule 13D which can be found here.  Generally, hedge fund managers who must file Schedule 13D will have their hedge fund attorney submit this filing for them on their behalf.  Additionally, there may be other legal issues which arise and so it is advisable for the manager to discuss all aspects of an investment subject to the filing requirements of Section 13(d) of the Securities Exchange Act.

Schedule 13D

Schedule 13D is commonly referred to as a “beneficial ownership report.” The term “beneficial owner” is defined under SEC rules. It includes any person who directly or indirectly shares voting power or investment power (the power to sell the security).

When a person or group of persons acquires beneficial ownership of more than 5% of a voting class of a company’s equity securities registered under Section 12 of the Securities Exchange Act of 1934, they are required to file a Schedule 13D with the SEC. (Depending upon the facts and circumstances, the person or group of persons may be eligible to file the more abbreviated Schedule 13G in lieu of Schedule 13D.)

Schedule 13D reports the acquisition and other information within ten days after the purchase. The schedule is filed with the SEC and is provided to the company that issued the securities and each exchange where the security is traded. Any material changes in the facts contained in the schedule require a prompt amendment. The schedule is often filed in connection with a tender offer.

You can find the Schedules 13D for most publicly traded companies in the SEC’s EDGAR database. You can learn how to use EDGAR to find information about companies. You can find an HTML version of the Schedule and download a PDF version for easier printing.

For more information, please contact us.  Additional information can be found:

Hedge Fund Capital – How to Raise Assets for a Hedge Fund

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The biggest issue for start up hedge funds (and also established hedge fund managers) is how to grow assets under management.  Growing a hedge fund’s capital base is very important because increased AUM mean both increased management fees and performance fees (assuming the fund has positive performance returns).   This article focuses on traditional avenues of raising capital for a hedge fund.

Raising Hedge Fund Capital – Friends and Family

Most hedge funds raise capital to start up through their friends and families.  Often this can be a significant sum, other times it can be relatively small.  I have seen some hedge funds start with as little as $500,000 and sometimes less.  Often, after a hedge fund has a few months of performance (assuming again positive performance) these friends and family members will invest more money.  Other friends and family members, who did not originally invest, may also decided to invest.  Family members of investors may also be persuaded to invest in the hedge fund.

Generally investments from friends and family are completed fairly quickly and through less formal conversations than from other types of investors.  However, the hedge fund manager must always make sure that the friends and family have the fund’s offering documents and have made the appropriate representations in the subscription documents.

After an initial investment from friends and family, it is important for a start up manager to focus on the trading as it is most important to have a good 6-12 month track record that you will be able to market to other potential investors.

Raising Hedge Fund Capital – High Net Worth Individual Investors

High net worth investors (generally qualified purchasers as well as some qualified clients and accredited investors) often invest in hedge funds.  High net worth investors will usually have legal and investing teams which will vet the managers and the strategy.  Usually there will at least be a minimum amount of due diligence requests on the manager and the fund.  Managers can be introduced to high net worth investors through their own networks or through other channels such as hedge fund conferences, hedge fund databases or through other means.

Raising Hedge Fund Capital – Institutional Investors

Institutional investors will occasionally invest in hedge funds with a track record shorter than one year.  Generally in these cases the hedge fund sticks out to them for various reasons.  Such reasons might be that the hedge fund performance was just spectacular, or the institutional investor likes the way the particular investment strategy fits within the institution’s allocation design, or the hedge fund manager may have a strong pedigree which appeals to the institutional investor.

Whatever the reason, getting an investment from an institutional investors is usually a longer and more in depth process than receiving money from friends and family or from a high net worth investor.  The hedge fund manager will need to first establish a meeting with the institutional investor.  Generally the meeting will be at the office of the institution and the manager will have a certain amount of time to give his pitch, usually through a pitchbook presentation.  Some managers of the institution will look carefully at these presentations; others will not even open the cover.  However, the hedge fund manager should be ready to answer any number of different questions from the institution regarding the program.  Such questions will likely cover the following topics: risk management procedures, expected performance in down markets, performance analytics, etc.  The hedge fund manager should act composed and answer each question directly and completely – this is the time for the manager to show his knowledge of the investment strategy and sell the strategy to others.

Either before or after the meeting with the institution, the hedge fund manager will likely be asked to complete some basic due diligence.  I’ve outlined a sample request in this article: Institutional Hedge Fund Due Diligence.  After the institution has interviewed and vetted a manager it may take some time before the institution actually invests in the fund.  This happens for a variety of reasons and the hedge fund manager is urged to stay patient during the process.

Non-tradtional forms of raising hedge fund capital

I will be discussing other ways to raise capital in subsequent articles.  Such non-traditional ways include: utilizing the services of a third party marketer, capital introduction services, hedge fund conferences, and hedge fund databases.

Legal Implications of Raising Capital for a Hedge Fund

As most hedge fund managers know, under the Regulation D offering rules managers cannot raise capital through any type of general advertising or solicitation.  This means that they cannot: buy advertising in any financial publications, advertise generally on the internet (but please see article on Hedge Fund Websites), cold call potential investors and or engage in other similar activities.  Additionally, hedge fund managers, and others raising money for hedge funds, must be aware of and abide by all broker-dealer regulations.  This is a very important issue, so please discuss it with your hedge fund attorney (please see Guide to Broker-Dealer Registration).

Please contact us if you have a story on raising capital for you hedge fund – we would like to hear your story and potentially profile your fund on our blog.  Other articles which are related to items in this article include:

Hedge Fund Manager Fined and Banned for a Year for “Portfolio Pumping”

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This is another example of a hedge fund manager acting with incredible audacity.

Last week the SEC issued a release detailing an action taken against a hedge fund manager for his “portfolio pumping” practices.  Bascially the manager was caught buying a large amount of shares through another fund he ran in order to boost the price of the thinly traded security.  The manager then charged higher management fees based on the inflated price of the securities.  The manager was fined $100,000 and ordered to disgorge the higher management fee of $80,000.

The end of the release states that the adviser will be allowed to reapply for association with an investment advisor for a year, but I believe the damage has been done.  If this manager does start another fund, proper hedge fund due diligence will show this SEC action which by itself should send investors running for the door.  In this case the hedge fund manager ruined his career for a few thousand dollars.

The release can be found in full here.

SEC Charges San Francisco Hedge Fund Adviser for “Portfolio Pumping”
FOR IMMEDIATE RELEASE
2008-251

Washington, D.C., Oct. 16, 2008 — The Securities and Exchange Commission today charged San Francisco investment adviser MedCap Management & Research LLC (MMR) and its principal Charles Frederick Toney, Jr. with reporting misleading results to hedge fund investors by engaging in a practice known as “portfolio pumping.”

The SEC alleges that Toney made extensive quarter-end purchases of a thinly-traded penny stock in which his fund was heavily invested, more than quadrupling the stock price and allowing him to report artificially inflated quarterly results to fund investors. Without admitting or denying the SEC’s allegations, MMR and Toney have agreed to settle the charges by paying financial penalties and agreeing to an order barring Toney from acting as an investment adviser for at least one year.

“Fund investors relied on MMR and Toney to abide by their fiduciary duties and put the fund’s interests ahead of their own,” said Marc J. Fagel, Regional Director of the SEC’s San Francisco Regional Office. “Instead, Toney engaged in trading activity which hid his poor performance.”

According to the SEC’s order, MedCap Partners L.P. (MedCap), a hedge fund run by MMR and Toney, was suffering from dramatic losses and facing increasing redemptions from fund investors by September 2006. Over the last four days of the month, Toney — through a separate fund that MMR managed — placed numerous buy orders for a thinly-traded over-the-counter stock in which MedCap already was heavily invested. Toney’s buying pressure caused the stock price to more than quadruple, from $0.85 to $3.72.

The SEC alleges that because the stock represented over one-third of MedCap’s holdings, the brief boost in its price inflated MedCap’s reported value by $29 million, masking what would otherwise have been a 40 percent quarterly loss for MedCap. Immediately after the quarter ended, Toney reported to MedCap’s investors that the fund’s investments had begun to “bounce” and that the fund’s performance was improving. Toney failed to disclose that this “bounce” was almost entirely the result of his four-day purchasing spree. Following MMR’s brief buying activity, both the stock price and MedCap’s asset value declined to their previous levels.

According to the SEC’s order, at the same time, MMR charged fees to the fund based on the inflated quarter-end asset value.

The Commission found that MMR and Toney breached their fiduciary duties to MedCap and to MMR’s other fund in which the penny stock was acquired. Toney and MMR, without admitting or denying the Commission’s findings, have agreed to cease and desist from violating the antifraud provisions of the Investment Advisers Act of 1940. MMR also will disgorge the higher management fees it received due to the inflated fund asset value, plus interest — an amount totaling $70,633.69 — and receive a Commission censure. Toney also has agreed to a bar from association with any investment adviser with the right to reapply after one year, and to pay a $100,000 penalty.

Other releated articles:

Please contact us if you have questions or if you would like to discuss.

NFA to Begin Regulating FOREX

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The last unregulated space within the hedge fund industry was the retail foreign exchange (“Forex”) market.  As of November 30 of this year, many hedge fund managers which invest in the spot forex markets will need to be registered with the NFA.  More analysis on this to follow.

The press release and the new NFA rules follow below.

Notice I-08-26

October 16, 2008

Effective Date of NFA Compliance Rules 2-41 and 2-42: Disclosure by Forex Pool Operators and Trading Advisors

NFA has received notice that the Commodity Futures Trading Commission has approved NFA Compliance Rules 2-41 and 2-42. The new rules will become effective on November 30, 2008. Accordingly, after November 30th Members that manage forex accounts on behalf of customers or offer pools trading forex must provide prospective clients and pool participants with a disclosure document that has been filed with NFA prior to use. The new rules only apply if the forex pool or the person for whom the forex account is being managed is not an eligible contract participant as defined in Section 1a(12) of the Commodity Exchange Act. A forex pool, however, may not claim to be an eligible contract participant by virtue of Section 1a(12)(A)(v)(II) or (III) of the Commodity Exchange Act.

The disclosure document must provide disclosures similar to those currently required under CFTC Part 4 regulations. Finally, a Member operating a pool subject to the new rules must provide periodic (monthly or quarterly) account statements and an annual report to the pool participants.

Copies of the new rules are attached for your convenience. Additionally, NFA’s February 29, 2008, submission letter to the CFTC contains a more detailed explanation of the changes. You can access an electronic copy of the submission letter at http://www.nfa.futures.org/news/newsRuleSubLetter.asp?ArticleID=2101.

Questions concerning these changes should be directed to Mary McHenry, Senior Manager, Compliance ([email protected] or 312-781-1420) or Susan Koprowski, Manager, Compliance ([email protected] or 312-781-1288).

COMPLIANCE RULES

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Part 2 – RULES GOVERNING THE BUSINESS CONDUCT OF MEMBERS REGISTERED WITH THE COMMISSION

* * *

RULE 2-41. FOREX POOL OPERATORS AND TRADING ADVISORS

(a) Pool Operators. Except for Members who meet the criteria in Bylaw 306(b) and Associates acting on their behalf, any Member or Associate operating or soliciting funds, securities, or property for a pooled investment vehicle that is not an eligible contract participant as defined in Section 1a(12) of the Act must comply with this section (a) if it enters into or intends to enter into any transaction described in NFA Bylaw 1507(b)(1) except as described in NFA Bylaw 1507(b)(3). For purposes of this section, a pooled investment vehicle may not claim to be an eligible contract participant by virtue of Section 1(a)(12)(A)(v)(II) or (III) of the Act.

(1) For each such pooled investment vehicle, the Member or Associate must prepare a Disclosure Document and must file it with NFA at least 21 days before soliciting the first potential pool participant that is not an eligible contract participant.

(2) The Member or Associate must deliver the Disclosure Document to a prospective pool participant who is not an eligible contract participant no later than the time it delivers the subscription agreement for the pool. Any information delivered before the Disclosure Document must be consistent with the information in the Disclosure Document.

(3) The Disclosure Document must comply with the requirements in CFTC Regulations 4.24, 4.25, and 4.26 as if operating a pool trading on-exchange futures contracts. The term “commodity interest” in those regulations should be read to include forex transactions, and the Risk Disclosure Statement required by CFTC Regulation 4.24(b)(1) must be replaced by the following if the pool does not trade on-exchange contracts and must be added as a separate statement if the pool trades both on-exchange contracts and forex.

RISK DISCLOSURE STATEMENT

YOU SHOULD CAREFULLY CONSIDER WHETHER YOUR FINANCIAL CONDITION PERMITS YOU TO PARTICIPATE IN A POOLED INVESTMENT VEHICLE. IN SO DOING, YOU SHOULD BE AWARE THAT THIS POOL ENTERS INTO TRANSACTIONS THAT ARE NOT TRADED ON AN EXCHANGE, AND THE FUNDS THE POOL INVESTS IN THOSE TRANSACTIONS MAY NOT RECEIVE THE SAME PROTECTIONS AS FUNDS USED TO MARGIN OR GUARANTEE EXCHANGE-TRADED FUTURES AND OPTIONS CONTRACTS. IF THE COUNTERPARTY BECOMES INSOLVENT AND THE POOL HAS A CLAIM FOR AMOUNTS DEPOSITED OR PROFITS EARNED ON TRANSACTIONS WITH THE COUNTERPARTY, THE POOL’S CLAIM MAY NOT RECEIVE A PRIORITY. WITHOUT A PRIORITY, THE POOL IS A GENERAL CREDITOR AND ITS CLAIM WILL BE PAID, ALONG WITH THE CLAIMS OF OTHER GENERAL CREDITORS, FROM ANY MONIES STILL AVAILABLE AFTER PRIORITY CLAIMS ARE PAID. EVEN POOL FUNDS THAT THE COUNTERPARTY KEEPS SEPARATE FROM ITS OWN OPERATING FUNDS MAY NOT BE SAFE FROM THE CLAIMS OF OTHER GENERAL AND PRIORITY CREDITORS.

FOREX TRADING CAN QUICKLY LEAD TO LARGE LOSSES AS WELL AS GAINS. SUCH TRADING LOSSES CAN SHARPLY REDUCE THE NET ASSET VALUE OF THE POOL AND CONSEQUENTLY THE VALUE OF YOUR INTEREST IN THE POOL. IN ADDITION, RESTRICTIONS ON REDEMPTIONS MAY AFFECT YOUR ABILITY TO WITHDRAW YOUR PARTICIPATION IN THE POOL.

INVESTMENTS IN THE POOL MAY BE SUBJECT TO SUBSTANTIAL CHARGES FOR MANAGEMENT, ADVISORY, AND BROKERAGE FEES, AND THE POOL MAY NEED TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETING OR EXHAUSTING ITS ASSETS. THIS DISCLOSURE DOCUMENT CONTAINS A COMPLETE DESCRIPTION OF EACH EXPENSE (SEE PAGE [insert page number]) AND A STATEMENT OF THE PERCENTAGE RETURN NECESSARY TO BREAK EVEN, THAT IS, TO RECOVER THE AMOUNT OF YOUR INITIAL INVESTMENT (SEE PAGE [insert page number]).

THIS BRIEF STATEMENT CANNOT DISCLOSE ALL THE RISKS AND OTHER FACTORS NECESSARY TO EVALUATE YOUR PARTICIPATION IN THIS POOL. THEREFORE, BEFORE YOU DECIDE TO PARTICIPATE YOU SHOULD CAREFULLY REVIEW THIS DISCLOSURE DOCUMENT, INCLUDING A DESCRIPTION OF THE PRINCIPAL RISK FACTORS OF THIS INVESTMENT (SEE PAGE [insert page number]).

NATIONAL FUTURES ASSOCIATION HAS NEITHER PASSED UPON THE MERITS OF PARTICIPATING IN THIS POOL NOR THE ADEQUACY OR ACCURACY OF THIS DISCLOSURE DOCUMENT.

(b) Trading Advisors. Except for Members who meet the criteria in Bylaw 306(b) and Associates acting on their behalf, any Member or Associate managing, directing or guiding, or soliciting to manage, direct, or guide, accounts or trading on behalf of a client that is not an eligible contract participant as defined in Section 1a(12) of the Act by means of a systematic program must comply with this section (b) if it intends to manage, direct, or guide the client’s account or trade in transactions described in NFA Bylaw 1507(b).

(1) The Member or Associate must prepare a Disclosure Document and must file it with NFA at least 21 days before soliciting the first potential client that is not an eligible contract participant.

(2) The Member or Associate must deliver the Disclosure Document to a prospective client who is not an eligible contract participant no later than the time it delivers the agreement to manage, direct, or guide the client’s account or trading. Any information delivered before the Disclosure Document must be consistent with the information in the Disclosure Document.

(3) The Disclosure Document must comply with the requirements in CFTC Regulations 4.34, 4.35, and 4.36 as if managing, directing, or guiding accounts or trading in on-exchange futures contracts. The term “commodity interest” in those regulations should be read to include forex transactions, and the Risk Disclosure Statement required by CFTC Regulation 4.34(b)(1) must be replaced by the following if the managed, directed, or guided account or trading will not include transactions in on-exchange contracts and must be added as a separate statement if it will include transactions in both on-exchange contracts and forex.

RISK DISCLOSURE STATEMENT

THE RISK OF LOSS IN FOREX TRADING CAN BE SUBSTANTIAL. YOU SHOULD THEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. IN CONSIDERING WHETHER TO TRADE OR TO AUTHORIZE SOMEONE ELSE TO TRADE FOR YOU, YOU SHOULD ALSO BE AWARE OF THE FOLLOWING:

FOREX TRANSACTIONS ARE NOT TRADED ON AN EXCHANGE, AND THOSE FUNDS DEPOSITED WITH THE COUNTERPARTY FOR FOREX TRANSACTIONS MAY NOT RECEIVE THE SAME PROTECTIONS AS FUNDS USED TO MARGIN OR GUARANTEE EXCHANGE-TRADED FUTURES AND OPTIONS CONTRACTS. IF THE COUNTERPARTY BECOMES INSOLVENT AND YOU HAVE A CLAIM FOR AMOUNTS DEPOSITED OR PROFITS EARNED ON TRANSACTIONS WITH THE COUNTERPARTY, YOUR CLAIM MAY NOT RECEIVE A PRIORITY. WITHOUT A PRIORITY, YOU ARE A GENERAL CREDITOR AND YOUR CLAIM WILL BE PAID, ALONG WITH THE CLAIMS OF OTHER GENERAL CREDITORS, FROM ANY MONIES STILL AVAILABLE AFTER PRIORITY CLAIMS ARE PAID. EVEN CUSTOMER FUNDS THAT THE COUNTERPARTY KEEPS SEPARATE FROM ITS OWN OPERATING FUNDS MAY NOT BE SAFE FROM THE CLAIMS OF OTHER GENERAL AND PRIORITY CREDITORS.

THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN FOREX TRADING CAN WORK AGAINST YOU AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO LARGE LOSSES AS WELL AS GAINS.

MANAGED ACCOUNTS MAY BE SUBJECT TO SUBSTANTIAL CHARGES FOR MANAGEMENT AND ADVISORY FEES AND THE ACCOUNT MAY NEED TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETING OR EXHAUSTING ITS ASSETS. THIS DISCLOSURE DOCUMENT CONTAINS A COMPLETE DESCRIPTION OF EACH FEE TO BE CHARGED TO YOUR ACCOUNT BY THE ACCOUNT MANAGER. (SEE PAGE [insert page number]).

THIS BRIEF STATEMENT CANNOT DISCLOSE ALL THE RISKS AND SIGNIFICANT ASPECTS OF THE FOREX MARKETS. THEREFORE, YOU SHOULD CAREFULLY REVIEW THIS DISCLOSURE DOCUMENT BEFORE YOU TRADE, INCLUDING THE DESCRIPTION OF THE PRINCIPAL RISK FACTORS OF THIS INVESTMENT (SEE PAGE [insert page number]).

NATIONAL FUTURES ASSOCIATION HAS NEITHER PASSED UPON THE MERITS OF PARTICIPATING IN THIS TRADING PROGRAM NOR THE ADEQUACY OR ACCURACY OF THIS DISCLOSURE DOCUMENT.

RULE 2-42. FOREX POOL REPORTING

(a) Except for Members who meet the criteria in Bylaw 306(b), any Member operating a pool that trades forex must comply with the requirements in CFTC Regulation 4.22 in the same manner as would be applicable to the operation of a pool trading on-exchange futures contracts. The term “commodity interest” in that regulation should be read to include forex transactions.

(b) A Member may file with NFA a request for an extension of time in which to file the annual report in the same form as provided for in CFTC Regulation 4.22(f).

Differences between the Series 65 and the Series 66

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Hedge fund managers who must register as investment advisor representatives with the SEC (through notice filings) or the state securities commission will need to have the proper FINRA exam licenses. Generally this means that the hedge fund manager will need to have passed the Series 65 exam within two years of registration (or the license must not have been inactive for two years prior to the registration).

However, if a manager has a Series 7 exam license, he will only need to take the Series 66 exam instead of the Series 65. This would generally be a good idea because the Series 66 exam is easier than the Series 65 exam and managers should be able to pass the Series 66 with less effort than the Series 65. I have detailed below the different requirements for the Series 65 versus the Series 66

Series 65 Exam

  • 140 multiple choice questions
  • 10 pre-test; 130 count towards score
  • 180 minutes to take the exam
  • Must achieve a 72% to pass
  • Test covers: economics and analysis; investment vehicles; investment recommendations and strategies; and legal and regulatory guidelines, including prohibition on unethical business practices.
  • NASAA test outline link.

Series 66 Exam

  • 110 multiple choice questions
  • 10 pre-test; 100 count towards score
  • 150 minutes to pass the exam
  • Must achieve 72% to pass
  • Test covers: much of the material included on the Series 65, but it does not include the product, analysis and strategy questions that are a large part of the Series 65.
  • NASAA test outline link.

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Overview of New Form D for Hedge Funds

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As we noted in a previous post about filing Form D online, Form D has been changed and I believe that the new Form D is a great improvement and is more appropriate for hedge fund offerings.  As we’ve noted before, many of the securities laws were drafted in the 1930s and 1940s and have not been overhauled to accommodate the current practices within the securities industry.  With the new Form D, we see a giant step forward and commend the SEC on producing a form which asks questions which are appropriate for both operating businesses and hedge funds.

The new Form D is cleaner and easier to read.  There is plenty of space for explanations if a hedge fund’s structure does not exactly fit the parameters of a specific question.  The new Form D also has great instructions on how to complete the various items.

Please note that hedge fund managers should have a hedge fund lawyer or compliance person complete and submit Form D on their behalf.  The SEC expects that each Form D will take approximately 4 hours to complete.  Please click to view a copy of the new Form D .

Items by Item run through of the new Form D is below:

Item 1. Issuer’s Identity – background information on the issuer including name, entity type, year of organization.

Item 2. Principal Place of Business and Contact Information

Item 3. Related Persons – should include the hedge fund manager;  additionally there is a continuation page where the manager will include key members of the management entity.

Item 4. Industry Group – there is a specific box for hedge or other investment funds.  This is a significant improvement over the old Form D which did not include anything like this.

Item 5. Issuer Size – hedge funds will now provide an aggregate net asset value range, which is a more appropriate inquiry.

Item 6. Federal Exemptions and Exclusions Claimed – here most hedge funds will check at least a couple of boxes, your attorney or compliance professional will be able to help you with this.

Item 7. Type of Filing – you will provide information on whether this is a new filing or an amendment to a previous filing.  The instructions to the Form D provide a list of times when it is necessary to file an amendment.

Item 8. Duration of Offering – generally hedge fund interests are offered on a continual bases and the hedge fund will accordingly indicate that the offering will last greater than one year.

Item 9. Type(s) of Securities Offered – the hedge fund will typically check two boxes here.

Item 10. Business Combination Transaction

Item 11. Minimum Investment – old Form D also required this information

Item 12. Sales Compensation – if a hedge fund uses a broker or a third party marketer to raise money then the hedge fund will need to provide certain information on the broker or third party marketer.

Item 13. Offering and Sales Amounts – here hedge funds will typically check “Indefinite” where appropriate.

Item 14. Investors – the SEC requests information on whether there have been sales to persons who are not accredited investors (typically referred to as non-accredited investors)

Item 15.  Sales Commissions and Finders’ Fees Expenses – here the hedge fund will provide more information on the transactions discussed in Item 12.

Item 16. Use of Proceeds

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