Category Archives: Legal Resources

Section 3(c)(1) Hedge Funds

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Almost all hedge funds which trade securities are deemed to be “investment companies” under the Investment Company Act of 1940.  All “investment companies” are required to register under the Investment Company Act (like all mutual funds must do) unless the “investment company” falls within an exemption from the registration provisions.

There are two separate exemptions from the registration provisions of the Investment Company Act.  This post deals with the more common Section 3(c)(1) exemption which generally requires that the hedge fund have 100 or fewer investors.

Not Owned by More Than 100 Investors

A 3(c)(1) hedge fund is exempt under the Investment Company Act provided that the fund is beneficially owned by not more than 100 investors and is not making a public offering of its securities.  The actual text of Section 3(c)(1) provides:

None of the following persons is an investment company within the meaning of this title: Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities. Such issuer shall be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) [15 USCS § 80a-12(d)(1)(A)(i), (B)(i)] governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer. For purposes of this paragraph:

(A) Beneficial ownership by a company shall be deemed to be beneficial ownership by one person, except that, if the company owns 10 per centum or more of the outstanding voting securities of the issuer, and is or, but for the exception provided for in this paragraph or paragraph (7), would be an investment company, the beneficial ownership shall be deemed to be that of the holders of such company’s outstanding securities (other than short-term paper).

(B) Beneficial ownership by any person who acquires securities or interests in securities of an issuer described in the first sentence of this paragraph shall be deemed to be beneficial ownership by the person from whom such transfer was made, pursuant to such rules and regulations as the Commission shall prescribe as necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this title, where the transfer was caused by legal separation, divorce, death, or other involuntary event.

Certain Look Through Rules

Part A above provides “look through” provisions for certain entity investors.  This rule provides that if another 3(c)(1) hedge fund (the “Investor Fund”) owns more than 10% of another 3(c)(1) hedge fund (the “Investee Fund”) then the Investee Fund would count all of the investors of the Investor Fund as investors as well.  This rule is designed to prevent the pyramiding of 3(c)(1) funds to avoid the application of the mutual fund registration rules.  Through various no-action letters the SEC has provided further guidance in this area which we will be writing about shortly.

Types of 3(c)(1) Investors

Generally speaking investors in Section 3(c)(1) hedge funds will be both accredited investors and qualified clients.  A 3(c)(1) fund must limit its investors to qualified clients if it wants to charge a performance fee.

Other related articles include:

For more information on mutual funds in general, mutual fund investment programs and investing in mutual funds, please see investing in no load mutual funds.  No load mutual funds are funds which do not have a front or back end load because the distribution fees are usually paid through section 12b-1 fees.

Please contact us if you have any questions.

Section 3(c)(7) Hedge Funds

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Almost all hedge funds which trade securities are deemed to be “investment companies” under the Investment Company Act of 1940.  All “investment companies” are required to register under the Investment Company Act (like all mutual funds must do) unless the “investment company” falls within an exemption from the registration provisions.

In addition to the Section 3(c)(1) exemption discussed in a previous post, this article describes the section 3(c)(7) exemption.

A 3(c)(7) hedge fund is exempt under the Investment Company Act and must comply with two basic requirements: (1) the fund can have only qualified purchasers as investors and (2) the fund can have no more than 499 investors.  These requirements are detailed below.

Qualified Purchaser Requirement

There are two exemptions from the Investment Company Act registration provisions for hedge funds.  Under the first regulation, each investor must be a qualified purchaser.  Section 3(c)(7) states:

None of the following persons is an investment company within the meaning of this title: any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. Securities that are owned by persons who received the securities from a qualified purchaser as a gift or bequest, or in a case in which the transfer was caused by legal separation, divorce, death, or other involuntary event, shall be deemed to be owned by a qualified purchaser, subject to such rules, regulations, and orders as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Generally, a qualified purchaser is an individual with a liquid net worth of $5 million or an institution with a net worth of $25 million. You will notice that in additional to the qualified purchaser requirement, the fund cannot make a public offering of its securities.  Because almost all hedge funds are offered pursuant to the Regulation D offering rules, this requirement will always be met.

500 or Fewer Investors

Unlike the Section 3(c)(1) exemption which limits the amount of investors in this type of fund, the Section 3(c)(7) exemption does not contain any such limit on the amount of qualified purchasers who can invest in the fund. However, hedge funds are subject to all of the federal securities laws which include the Securities Exchange Act of 1934.  Under the Exchange Act, Section 12(g)(1) provides that a Section 3(c)(7) hedge fund would be required to register under the Exchange Act as a reporting company if the hedge fund had more than $10,000,000 in assets and 500 or more investors.  As 3(c)(7) hedge funds are available only to qualified purchasers, the $10 million in assets would be an easy threshold to meet and this is why 3(c)(7) funds are limited to 499 investors.

While registration under Exchange Act is not as onerous as under the Securities Act of 1933, it is still undesirable for hedge fund managers.  If a hedge fund manager did register under the Exchange Act (which some have chosen to do, although mostly in the non-securities context), the fund would become a “reporting company” and would need to submit certain periodic reports to the SEC.  Because these reports are time consuming and expensive to produce, most 3(c)(7) hedge funds will specifically state that no more than 499 investors may participate in the offering.

Other related articles include:

Please contact us if you have any questions.

Hedge Fund Side Letters

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The side letter is one of the most important items for a hedge fund manager.  While the hedge fund will run pursuant to the terms of the hedge fund offering documents drafted, the side letter will give the manager some flexibility to go outside the terms of the documents for certain investors.

A hedge fund side letter is simply an agreement between the hedge fund manager and the investor that outlines different terms that will apply to the investor’s investment into the fund.  The side letter is drafted by the hedge fund attorney and will be signed by the investor at the same time that the investor signs the hedge fund subscription documents.

Overview of side letter provisions

Below are some of the reasons a hedge fund manager may use a side letter arrangement

Reduced Fees – the hedge fund manager will reduce or waive the management fees or performance fees for the investor.

Lock-up and liquidity – the hedge fund manager may reduce or waive the lock-up for a specific investor.  The manager may also allow for greater liquidity (i.e. monthly withdrawals instead of quarterly withdrawals).

Information – the manager may agree to provide an investor with greater informational rights such as the ability to request a description of the exact positions of the fund at any given time.

Most favored nation’s clause – this allows an investor to get the best deal that the manager gives to any other investor.  This clause is usually reserved for very large or very early investors.

There are many different ways which any of the above concepts can be implemented into the side letter and generally it will depend on the business points negotiated by the manager and the investor.  As an alternative to a hedge fund investment and side letter arrangement, an investor may simply enter into a separately managed account (known as a “SMA”) arrangement with the hedge fund manager.

Side letters and raising money for the hedge fund

The hedge fund side letter can be an important tool for raising assets.  Typically the letter will be used to entice early investors to invest in the fund; it can also be used to attract investors who will contribute a large amount of assets to the fund.  The side letter can also be used to try to get a current investor to contribute more assets to the fund.

What the SEC says about side letters

During the late part of 2007 and the early part of 2008, there was a lot of chatter within the hedge fund industry that the SEC would increase its investigation of hedge fund side letters.  Presumably they would have tried to accomplish this through audits of hedge fund managers registered as investment advisors.  While there was much concern within the industry at the time, that concern has subsided as the market events of 2008 began to take on greater importance.

Testimony from SEC regarding hedge fund side letters

The following comes from testimony by a SEC official to Congress regarding hedge funds and side letters:

Side Letter Agreements. Side letters are agreements that hedge fund advisers enter into with certain investors that give the investors more favorable rights and privileges than other investors receive. Some side letters address matters that raise few concerns, such as the ability to make additional investments, receive treatment as favorable as other investors, or limit management fees and incentives. Others, however, are more troubling because they may involve material conflicts of interest that can harm the interests of other investors. Chief among these types of side letter agreements are those that give certain investors liquidity preferences or provide them with more access to portfolio information. Our examination staff will review side letter agreements and evaluate whether appropriate disclosure of the side letters and relevant conflicts has been made to other investors.

ERISA considerations

Hedge funds which are ERISA hedge funds will need to be careful about their side letter activities and should always consult with their hedge fund attorney before entering into such arrangements.  Specifically, the Department of Labor is concerned about different informational rights, especially with regard to plans which have subordinated rights.

If you have any questions regarding side letters, please contact us.

Overview of Investment Advisers Act of 1940

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One of the most important set of the federal securities laws which relate to hedge fund managers is the Investment Advisers Act of 1940 (Investment Advisers Act).  The Investment Advisers Act provides the manner in which investment advisers will register with the SEC, provides the laws that must be followed as an investment advisor, and makes it illegal for both registered and unregistered investment advisors to act fraudulently toward any investors.

If a hedge fund manager is registered as an investment advisor with the SEC then the manager should make sure he understands all parts of the Investment Advisers Act. Below I’ve highlighted and discussed those provisions which are most important to a hedge fund manager.  The entire act can be found here: Investment Advisers Act of 1940.

Definition of Investment Adviser

The term investment adviser is very broad.  Section 202(a)(11) provides:

“Investment adviser” means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities;

but does not include

(A) a bank, or any bank holding company as defined in the Bank Holding Company Act of 1956, which is not an investment company, except that the term “investment adviser” includes any bank or bank holding company to the extent that such bank or bank holding company serves or acts as an investment adviser to a registered investment company, but if, in the case of a bank, such services or actions are performed through a separately identifiable department or division, the department or division, and not the bank itself, shall be deemed to be the investment adviser;

(B) any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession;

(C) any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore;

(D) the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation;

(E) any person whose advice, analyses, or reports relate to no securities other than securities which are direct obligations of or obligations guaranteed as to principal or interest by the United States, or securities issued or guaranteed by corporations in which the United States has a direct or indirect interest which shall have been designated by the Secretary of the Treasury, pursuant to section 3(a)(12) of the Securities Exchange Act of 1934, as exempted securities for the purposes of that Act; or

(F) such other persons not within the intent of this paragraph, as the Commission may designate by rules and regulations or order.

Pre-requiste for Registration

Only those managers which manage at least $25 million in assets are eligible to register with the SEC.  If a manager has less than $25 million of assets under management, then the manager will be subject only to the registration with the managers state of residence (if required).  Specifically Section 203A(a)(1)(A) provides:

No investment adviser that is regulated or required to be regulated as an investment adviser in the State in which it maintains its principal office and place of business shall register under section 203, unless the investment adviser – has assets under management of not less than $ 25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; …

Investment Adviser Registration Requirement

In general, all investment advisors must register with the SEC pursuant to Section 203(a).

Except as provided in subsection (b) and section 203A, it shall be unlawful for any investment adviser, unless registered under this section, to make use of the mails or any means or instrumentality of interstate commerce in connection with his or its business as an investment adviser.

Exemption from registration

While the definition of investment adviser is sufficiently broad to include most all hedge fund managers, there is a widely used exemption from the registration provisions.  Section 203(b)(3) provides:

The provisions of subsection (a) [the registration provisions noted above] shall not apply to … any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under title I of this Act, or a company which has elected to be a business development company pursuant to section 54 of title I of this Act and has not withdrawn its election. For purposes of determining the number of clients of an investment adviser under this paragraph, no shareholder, partner, or beneficial owner of a business development company, as defined in this title, shall be deemed to be a client of such investment adviser unless such person is a client of such investment adviser separate and apart from his status as a shareholder, partner, or beneficial owner;

There are two important items to note here.  First, the investment adviser cannot have more than 15 clients over a 12 month rolling period.  A hedge fund counts as a single client for these purposes.  Second, the investment adviser

Prohibited Transactions

The act has very strong anti-fraud provisions.  Most SEC actions against investment advisers will be based on this section of the act.  Section 206, in full, provides:

It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly –

(1) to employ any device, scheme, or artifice to defraud any client or prospective client;

(2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;

(3) acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction. The prohibitions of this paragraph (3) shall not apply to any transaction with a customer of a broker or dealer if such broker or dealer is not acting as an investment adviser in relation to such transaction;

(4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative. The Commission shall, for the purposes of this paragraph (4) by rules and regulations define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.

Other Important Sections

There are other important sections to the act which include the following:

Section 204 – Record Keeping Requirements

Section 205 – Investment Advisory Contracts

Section 222 – State Regulation of Investment Advisers

Hedge Funds in the BVI – new requirement to submit annual information

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The British Virigin Islands (BVI) is a popular jurisdiction for many offshore hedge funds to be located.  The BVI is known to have good financial oversight and relatively reasonable offshore hedge fund formation fees.  Over the past year the BVI Financial Services Commission (FSC) has become more involved in hedge fund oversight as political pressure increases.  It is expected that the BVI’s Mutual Funds Law will undergo changes within the next 6 months to a year because of this political pressure.

In addition, on September 9 the FSC surprisingly announced that BVI hedge funds (known as “mutual funds” in the BVI) will need to submit a yearly Annual Return to the FSC which provides information about the fund to the FSC.  This is a new requirement for all BVI based hedge funds.  Before this year the FSC had a voluntary mutual funds survey which requested information similar to the information requested in the Annual Return.  Certain closed end funds (generally private equity funds established in the BVI) will not need to submit the Annual Return.

BVI Annual Return Requirement

The items a fund will need to submit are:

–    Basic information on the fund and its service providers, including the registered agent
–    Financial information including:

Beginning NAV
Total subscriptions
Total redemptions
Net income/ net loss
Dividends/ distributions
Ending NAV
Year end gross assets

–    General description of the fund’s asset allocation (but not individual positions)

The Annual Return will need to be submitted to the FSC by June 30 of 2009.  Funds which do not submit the Annual Return by that date may face an enforcement action.

A sample Annual Return can be found here: sample-annual-return

What this means for offshore hedge funds

With regard to this new requirement, current BVI funds are going to need to complete the Annual Return.  While the Annual Return will not be a huge resource drain, it will take some time to complete.  Generally most of the questions can be answered fairly quickly by the hedge fund manager or by an assistant.  Some of the information may require input from the hedge fund administrator and potentially the hedge fund attorney as well.

In the future, this seems to be the first step towards greater scrutiny and disclosure requirements from offshore hedge fund jurisdictions.  However, it is unclear whether this will affect the number of start up funds which will be based in the BVI as the intrusion is relatively mild.  However, it may mean that other offshore jurisdictions such as Nevis, Guernsey and Dubai become more popular in the future.

Please see guidance from here from Maples and Calder, an offshore law firm: BVI Annual Return Requirement

Hedge Fund UBTI (unrelated business taxable income)

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Hedge fund investors are always cognizant of the potential tax consequences of an investment into a hedge fund.  One of the issues which a hedge fund manager should be aware of is the concept of unrelated business taxable income or UBTI.

What is UBTI and why is it important?

As it relates to a tax-exempt investor in a hedge fund, UBTI is debt financed income derived by the hedge fund which does not relate to the activities of the tax-exempt investor.  As hedge funds are “flow through” vehicles, the designation of income as UBTI flows through the tax-exempt investor.  This is important because the tax-exempt investor must pay tax (called the unrelated business income tax or UBIT) on that portion of the income received by the fund which is UBTI.  UBTI is generally going to be taxed at a 35% rate.
Is there a way to get around UBTI?

There are two ways to make sure that tax-exempt investors do not receive any UBTI.  The first and most obvious is to make sure that the fund will use no leverage.  Because this might not be an option for some hedge funds, and because these funds would like to receive assets from tax-exempt entities, another option is for the fund to create an offshore hedge fund (either through a side by side structure or a master feeder structure).  In these structures that income does not “flow-through” to the investors like with the domestic hedge fund, but rather the income is paid to the investors through a dividend which is generally not taxable to a tax-exempt organization.  Using an offshore structure in this manner is often described as using a “blocker” because the UBTI is blocked out.

Do short sales give rise to UBTI?

Short sales alone do not give rise to UBTI.  The IRS has specifically provided guidance to the hedge fund community on this issue.  Please see Revenue Rule 95-8.  However, if a hedge fund borrowed money to engage in the short sale, this would probably give rise to UBTI.  If the fund utilizes short sales and engages in no leverage activities, then the there will likely be no UBTI with regard to the short sales.

What are the tax code provisions dealing with UBTI?

The following are links to the tax code dealing with UBTI:

Section 511 – provides for a tax on UBTI

Section 512 – defines UBTI and provides for the pass through treatment of UBTI to tax-exmpt investors in a fund (see 512(c))

Section 513 – provides a definition for “unrelated trade or business.”

Section 514 – provides additional definitional support for determining the amount of UBTI under section 512.

Hedge Fund CPO Exemptions

[Editor’s note: this article will be updated shortly.  Please note that 4.13(a)(4) is no longer available for managers.  05-121-17]

As I’ve detailed before, under the Commodities Exchange Act (CEA), hedge funds which invest in commodities/ futures or in other hedge funds which invest in commodities/ futures are deemed to be commodity pools.  The managers of these commodity pools will need to be registered as commodity pool operators (CPOs) unless the manager fits within an exemption from the registration provisions. For more information on registration with the National Futures Association (NFA), please see article on how to register as a CPO.

There are a few rules under the CEA exemptions from the registration provisions which I have detailed below.  Many will not be applicable to the average hedge fund manager.  Generally hedge fund managers are going to rely on 4.13(a)(3) below, or if the fund is a 3(c)(7) hedge fund, then they may rely on 4.13(a)(4).  The CPO exemptions are:

Rule 4.13(a)(1) – closely held pool

This rule provides relief from CPO registration if all of the following provisions are met:

1.    Manager operates only one pool at a time;

2.    Manager does not receive any form of compensation;

3.    Manager does not advertise; and

4.    Manager is not otherwise required to register with the NFA

Please see Rule 4.13(a)(1).

Rule 4.13(a)(2) – small pool

This rule provides relief from CPO registration if the following provisions are met:

1.     The manager does not operate any pools which have 15 or more investors (excluding the manager and certain related persons); and

2.    The total gross capital contributions in all pools operated or intended to be operated by the manager do not in the aggregate exceed $400,000 (certain capital contributions, including those of the manager, will not be counted for the purposes of this rule)

Please see Rule 4.13(a)(2).

Rule 4.13(a)(3) – deminimus rule

This rule provides relief from CPO registration if the following provisions are met:

1.    The commodity pool interests are exempt from registration under the Securities Act of 1933, and such interests are offered and sold without marketing to the public in the United States;

2.    All of the investors in the pool must be an accredited investors (or similar qualification as specified in the rule); and

3.    One of the following tests is met:

a.    The aggregate initial margin and premiums required to establish such positions, determined at the time the most recent position was established, will not exceed 5 percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into; or

b.    The aggregate net notional value of such positions, determined at the time the most recent position was established, does not exceed 100 percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into.

Please see Rule 4.13(a)(3).

Rule 4.13(a)(4) – all QEPs

NOTE: THIS EXEMPTION IS NO LONGER AVAILABLE FOR MANAGERS

This rule provides relief from CPO registration if the following provisions are met:

1.    The commodity pool interests are exempt from registration under the Securities Act of 1933, and such interests are offered and sold without marketing to the public in the United States; and

2.    Investors must generally be qualified purchasers.  (HFLB note: the definition makes reference to qualified eligible persons but in this case it will generally include only those investors who are qualified purchasers.)

Please see Rule 4.13(a)(4).

Rule 4.5 Exemption

Certain management entities which are already registered with other regulatory bodies do not need to also be registered as a CPO with the NFA.  Some of these entities include managers to registered mutual funds, insurance companies, banks and ERISA fiduciaries.  A CPO claiming rule 4.5 exemption must file of notice of the exemption with the NFA and make certain disclosures to the investors in the pool.

Please see Rule 4.5.

Rule 4.7 Exemption

Registered CPOs must adhere to certain disclosure and reporting requirements as specified in the rules under the CEA.  With regard to certain commodity pools which they manage, managers may want to consider running certain funds under the “lite-touch” rule 4.7 which allows CPOs to run their fund pursuant to lighter regulations.  Specifically, the CPO would be exempt from the specific requirements of Rule 4.21, Rule 4.22(a) and (b), Rule 4.24, Rule 4.25 and Rule 4.26 with respect to each exempt pool.  To claim this exemption all of the investors in the commodity pool must be qualified eligible persons which generally will mean that they are qualified purchasers.  CPOs claiming rule 4.5 exemption must still file of notice of the exemption with the NFA.

Please see Rule 4.7.

Rule 4.12 Exemption

Like the rule 4.7 exemption, the rule 4.12 exemption is for registered CPOs.  While under 4.7 there is no limitation to the amount of commodities held by the pool, rule 4.12 limits the amount of commodities held to 10% of the pools assets and requires that all commodity trading be solely incidental to securities trading activity.  Under this exemption the CPO will need to file a notice with the NFA and will need to adhere to certain disclosure regulations. Both the 4.7 and 4.12 exemptions are used less often than the 4.13 exemptions.

Please see Rule 4.12.

Overview of hedge fund short sale rules and likely fallout from recent events

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I received a request today to talk about hedge fund short sales and the likely fallout from the recent market disruptions and the failed bailout bill.

Short Sale Ban

The SEC has banned short sales on 800 individual securities.  These securities are generally within the financial services industry.  The ban on shorting these securities ends at 11:59 p.m. ET on Oct. 2, 2008. The SEC may extend the ban beyond this date if it deems an extension necessary in the public interest and for the protection of investors, but the SEC will not extend the ban for more than 30 calendar days in total duration.  (The SEC press release can be found here.)

Short Sale Disclosure Requirements

For hedge fund managers who are subject to 13F filings (i.e. those managers who manage $100mm or more), such managers will need to disclose their short positions by filing Form SH with the SEC.  More information on this can be found at 13F questions and answers or at the SEC’s website here. Please click here to view form-sh

Likely Fallout

There is so much uncertainty in the air right now.  Congress is having trouble trying to find some way to unfreeze the credit markets and money managers are just trying to find a way to stay afloat.  Additionally, as I mentioned this morning, investors are getting worried and are pulling cash out of hedge funds.  They way I see it, there are many scenarios which are likely to play out in the next couple of weeks and months:

1. Hedge fund redemptions – many investors are scared and are looking for safety right now.  While some managers are doing phenomenal in this wildly votile market, most are not and have not been doing well for much of the year.  I think that we’ll see in the coming days stories of large amounts of redemptions.

2. Hedge fund closures – as I discussed previously, because of the problems with the hedge fund high watermark, you are going to see money managers face the difficult decision of whether or not to keep their fund running.  Undoubtedly many managers will choose to close down their funds because of lack of capital (from redemptions and/or losses) or because they are too far under to make any money in the coming year.

3. Hedge fund regulation – while hedge funds have not faced the front page criticisms that the large investment banks and other financial institutions have seen over the past few weeks, the lawmakers have already began calling for investigations into the cause of this mess.  These investigations are likely to focus on systemic risks and how hedge funds may have contributed to the current market crisis.  As these reports begin spilling out over the next few weeks and months, I believe hedge funds will be a prime target and you are likely hear lawmakers facing re-election calling for more regulation.  [Please also note, Congress has indicated that it is more than willing to require more regulation of the financial markets as evidenced by its willingness to allow the CFTC to begin regulating the retail spot forex market.  For more information, please see this note from the CFTC. ]

4. Hedge fund start ups – over the next couple of months as funds begin to close down, successful traders will decide to go and start up their own hedge funds.  For these traders the transition to hedge fund manager will be difficult, but they will be able to be successful if they can find investors willing to invest in a start up hedge fund manager.  These traders will need to talk with a hedge fund attorney in order to get started with the hedge fund formation process.

5. Hedge fund due diligence will increase – hedge fund due diligence is one of the areas that is set to grow quickly.  I expect that investors, especially smaller institutional investors, will require greater risk management disclosure from hedge funds.  A simple manager back ground check is no longer going to be sufficient.

6. Hedge fund consolidations – while every now and again I will hear something about hedge fund consolidation, it never really seems to happen in any sort of large scale way.  This year may be different as smaller firms with decent track record decide to merge with more established funds with greater risk management procedures.

Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include:

Hedge Fund 13F Filings

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Many people talk about watching hedge funds through their 13F filings. A 13F filing is a quarterly report filed with the SEC by “institutional investment managers.” The reports include the name and number of the securities owned by the hedge fund. The term “institutional investment manager” means those managers who exercise discretion over $100 million or more in Section 13(f) securities. Typically a hedge fund attorney will help the manager file Form 13F.

A summary of Form 13F requirements from the SEC is below and can be found on the SEC’s website here.

Form 13F—Reports Filed by Institutional Investment Managers

Institutional investment managers who exercise investment discretion over $100 million or more in Section 13(f) securities must report their holdings on Form 13F with the SEC.

In general, an institutional investment manager is: (1) an entity that invests in, or buys and sells, securities for its own account; or (2) a person or an entity that exercises investment discretion over the account of any other person or entity. Institutional investment managers can include investment advisers, banks, insurance companies, broker-dealers, pension funds, and corporations. Section 13(f) securities generally include equity securities that trade on an exchange or are quoted on the Nasdaq National Market, some equity options and warrants, shares of closed-end investment companies, and some convertible debt securities. The shares of open-end investment companies (i.e., mutual funds) are not Section 13(f) securities.

Form 13F requires disclosure of the names of institutional investment managers, the names of the securities they manage and the class of securities, the CUSIP number, the number of shares owned, and the total market value of each security.

You can search for and retrieve Form 13F filings using the SEC’s EDGAR database. To find the filings of a particular money manager, use the “Companies & Other Filers” search under “General Purpose Searches” and enter the money manager’s name. To see all recently filed 13Fs, use the “Latest Filings” search function and enter “13F” in the “Form Type” box.

The securities that institutional investment managers must report on Form 13F are found on what is known as the Official List of Section 13(f) Securities. The Official List is published quarterly and is available for free on the SEC’s website. It is not available in paper copy format or on computer disk.

You can learn more about Form 13F filings, as well as obtain a copy of the Form and instructions, and the applicable statutory and regulatory provisions, by reading Frequently Asked Questions About Form 13F prepared by the SEC’s Division of Investment Management.

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Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

CFTC Fines Hedge Funds for Failure to File Annual Report with NFA

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Certain hedge funds which trade futures and/or commodities as part of their investment program are deemed to be commodity pools and the hedge fund management company must register with the NFA as a commodity pool operator (CPO).  Registered CPOs must file annual reports with the NFA and such reports must be sent to investors in the fund.  Generally this will need to be done within either 45 or 90 days after the end of the fund’s fiscal year.  If a CPO needs extra time to file the report, it can request an extension from the CFTC.

In the cases below, each of the CPOs had filed for and were granted extensions.  Even with these extensions, however, they were not able to file their reports.  The NFA evidently takes such an infraction very seriously as the fines were stiff – ranging from $75,000 to $135,000.  Such a potential monetary penalty should make CPOs especially eager to file the appropriate reports on time.

CFTC Rule 4.22 includes the following major provisions.

  • 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
  • Annual Report must be sent to pool participants within 45 calendar days after the end of the fiscal year
  • financial statements in the Annual Report must be presented and computed in accordance with generally accepted accounting principles consistently applied and must be certified by an independent public accountant

If you are a hedge fund manager registered as a CPO you should make sure you understand this and other CFTC rules.  If you have any questions on the rules or other CPO requirements, including possible CPO exemptions, you should have a conversation with your attorney so that you know what needs to be filed and when so that you can avoid harsh fines like the ones below.

The CFTC release below can be found here.

Release: 5555-08
For Release: September 24, 2008

CFTC Sanctions Four Registered Commodity Pool Operators for Failing to File Timely Commodity Pool Reports with the National Futures Association

Mansur Capital Corp., Persistent Edge Management, LLC, Stillwater Capital Partners, Inc., and Stillwater Capital Partners, LLC Ordered to Pay a Total of $330,000 in Civil Monetary Penalties

Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) today simultaneously filed and settled charges against four registered commodity pool operators (CPOs), charging them with failing to distribute to investors and file with the National Futures Association (NFA) one or more of their respective commodity pools’ annual reports in a timely manner. Mansur Capital Corporation of Chicago, Persistent Edge Management, LLC of San Francisco, California, and Stillwater Capital Partners, Inc. and Stillwater Capital Partners, LLC, both of New York, were charged in the CFTC action.

The CFTC orders require the CPOs to pay civil monetary penalties in the following amounts: Mansur, $75,000; Persistent Edge, $120,000; and Stillwater I and Stillwater II to jointly and severally pay $135,000.

Under CFTC regulations, CPOs are required to file annual reports with the NFA and distribute them to each pool participant. This must be done within a prescribed period after the close of their pools’ fiscal years. An annual report is designed to “provide [pool] participants with the information necessary to assess the overall trading performance and financial condition of the pool.” (See Commodity Pool Operators and Commodity Trading Advisors, Final Rules, 44 Fed. Reg. 1918 [CFTC Jan. 8, 1979], re the adoption of Rule 4.22.) According to the CFTC orders, without timely reporting, the CFTC’s goal of providing pool participants with complete and necessary data is hampered.

The CFTC orders find that each of the four CPOs operated one or more commodity pools, including pools that operated as funds-of-funds. While each of the CPOs had obtained extensions of the prescribed deadlines for various pools and reporting years, each failed to timely comply with its obligations, in violation of CFTC regulations.

The following CFTC Division of Enforcement staff are responsible for this case: Camille M. Arnold, Alan I. Edelman, Ava M. Gould, Susan J. Gradman, James H. Holl, III, Diane M. Romaniuk, Scott R. Williamson, Rosemary Hollinger, Gretchen Lowe, and Richard B. Wagner.

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