Category Archives: Legal Resources

Hedge fund author fined $100k by the SEC for fraudulent hedge fund

CTA registration requirement and exemption

Question: does my commodity/futures trading firm need to register as a CTA?

Answer: Generally Section 6m(1) of the Commodities Exchange Act (“CEA”) requires that any person (or firm) which falls within the definition of a CTA be registered as such. Section 6m(1) of the CEA states:

“It shall be unlawful for any commodity trading advisor or commodity pool operator, unless registered under this chapter, to make use of the mails or any means or instrumentality of interstate commerce in connection with his business as such commodity trading advisor or commodity pool operator”

The Commodities Exchange Act (“CEA”) specifically defines a Commodity Trading Adviser (“CTA”) as:

“any person who– (i) for compensation or profit, engages in the business of advising others, either directly or through publications, writings, or electronic media, as to the value of or the advisability of trading in– (I) any contract of sale of a commodity for future delivery made or to be made on or subject to the rules of a contract market or derivatives transaction execution facility; (II) any commodity option authorized under section 6c of [the CEA]; or (III) any leverage transaction authorized under section 23 of [the CEA]; or (ii) for compensation or profit, and as part of a regular business, issues or promulgates analyses or reports concerning any of the activities referred to in clause (i)”

Because the above definition is quite broad, Congress specifically excluded certain groups from the definition. These groups include:

any bank or trust company or any person acting as an employee thereof;
any news reporter, news columnist, or news editor of the print or electronic media, or any lawyer, accountant, or teacher;
any floor broker or futures commission merchant;
the publisher or producer of any print or electronic data of general and regular dissemination, including its employees;
the fiduciary of any defined benefit plan that is subject to the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1001 et seq.);
any contract market or derivatives transaction execution facility; and
such other persons not within the intent of this paragraph as the Commission may specify by rule, regulation, or order.

I have previously discussed how to register as a CTA in the article titled How to register as a CPO or CTA.

Question: are there any exemptions from CTA registration?

Answer: Yes. Section 6m(1) of the CEA states:

That the [registration] provisions of this section shall not apply to any commodity trading advisor who, during the course of the preceding twelve months, has not furnished commodity trading advice to more than fifteen persons and who does not hold himself out generally to the public as a commodity trading advisor. [emphasis added]

To fall within the above exemption, both elements must be met. That is, the CTA must

have less than 15 clients over the preceeding 12 months and
not hold himself out generally to the public as a CTA

The question then becomes what does “holding out” as a CTA entail?

The CFTC views “holding oneself out as a CTA” to include such conduct as promoting advisory services through mailings, directory listings, and stationery, or otherwise initiating contact with prospective clients. Thus, unless a CTA restricts his clients to family, friends, and existing business associates, a CTA generally will be viewed as holding himself out to the public as a CTA and would not be able to claim the exemption from registration in Section 6m(1).

The CFTC specifically gave such guidance in the following letter.

CFTC Letter No. 97-26
March 26, 1997
Division of Trading & Markets

Re: Section 4m(1): Exemption from CTA Registration

Dear [_______]:

This is in response to your letter dated January 29, 1997 to the Division of Trading and Markets (the “Division”) of the Commodity Futures Trading Commission (the “Commission”), whereby you inquire as to whether you may claim an exemption from registration as a commodity trading advisor (“CTA”) pursuant to Section 4m(1) [now 6m(1)] of the Commodity Exchange Act (the “Act”). *

Based on your letter, we understand the pertinent facts to be as follows. You intend to sell subscriptions to a fax service (the “Service”) entitled “A”, of which you are the sole designer. The Service will provide subscribers with buy and sell recommendations for Eurodollar futures and option contracts traded on “X”.

Section 4m(1) [now 6m(1)] of the Act generally requires that a person who provides commodity interest trading advice to the public must register as a CTA. Section 4m(1) does, however, provide an exemption from registration as a CTA for a person who satisfies two conditions: (1) during the course of the preceding twelve months, he has not furnished commodity trading advice to more than fifteen persons; and (2) he does not hold himself out generally to the public as a CTA. The Division views “holding oneself out as a CTA” to include such conduct as promoting advisory services through mailings, directory listings, and stationery, or otherwise initiating contact with prospective clients.** Thus, unless a CTA restricts his clients to family, friends, and existing business associates, a CTA generally will be viewed as holding himself out to the public as a CTA and would not be able to claim the exemption from registration in Section 4m(1) [now 6m(1)]. This is true whether or not the CTA is advising fifteen or fewer persons, since in order to qualify for the Section 4m(1) exemption, the CTA must satisfy both conditions. [Emphasis added]

Thus, if you plan to solicit clients other than immediate family members, friends, and business associates, you would be holding yourself out as a CTA and would be required to register as such prior to marketing the Service. You would also be required to comply with all other provisions of the Act and Commission’s regulations thereunder applicable to registered CTAs, including Section 4b and Section 4o,*** the antifraud provisions of the Act, Part 4 of the Commission’s regulations applicable to CTAs, and the reporting requirements for traders set forth in Parts 15, 18, and 19 of the Commission’s regulations.

The advice provided herein is based upon the representations that you have made to us. Any different, changed or omitted facts or conditions might require us to reach a different conclusion. In this connection, we request that you notify us immediately in the event your activities change in any way from those as represented to us.

If you have any questions concerning this correspondence, please feel free to contact me or Monica S. Amparo, an attorney on my staff, at (202) 418-5450.

Very truly yours,

Susan C. Ervin

Chief Counsel

* 7 U.S.C. §6m(1) (1994).

** Division of Trading and Markets Interpretative Letter 91-9, [1990-1992 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 25,189 (Dec. 30, 1991). We have enclosed a copy of this letter for your reference.

*** 7 U.S.C. §§ 6b and 6o (1994).

SEC fines adviser and revokes registration

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The SEC fined an investment adviser and revoked its registration because of willful refusal to follow simple investment adviser rules such as updating form ADV and submitting to a reasonable examination of its books and records.

From SEC website:

Commission Declares Decision as to Amaroq Asset Management, LLC and Dwight Andre Sean O’Neal Jones Final

The decision of an administrative law judge ordering Amaroq Asset Management, LLC, and Dwight Andree Sean O’Neal Jones to cease and desist from committing or causing any violations or future violations of Section 204 of the Investment Advisers Act of 1940 and Advisers Act Rule 204-1 has been declared final. The law judge further ordered that the registration of Amaroq Asset Management, LLC be revoked; that Dwight Andree Sean O’Neal Jones be barred from association with any investment adviser, with a right to apply for association after one year; and ordered that Jones pay a civil penalty in the amount of $15,000.

The law judge concluded that Jones willfully aided and abetted and was a cause of Amaroq’s failure to: (1) file annual amendments to Form ADV; (2) promptly update its Form ADV to reflect its current business address; (3) submit to a reasonable examination and failing to furnish copies of the required books and records in connection with the scheduled examination. The law judge found that Jones showed indifference and/or a series of broken promises, when Commission attorneys repeatedly and explicitly informed him of the law’s requirements, thereby demonstrating extreme recklessness. (Rel. IA-2770) Finality Order; File No. 3-12822)

For final decision, click here.

SEC to replace ancient EDGAR database

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Summary:

On Tuesday the SEC announced that a new company filing database which will be faster and easier to use than the current EDGAR system. The new system is called IDEA, short for Interactive Data Electronic Applications. With IDEA, investors will be able to instantly collate information from thousands of companies and forms, and create reports and analysis on the fly, in any way they choose.

Press Release:

SEC Announces Successor to EDGAR Database
“IDEA” Will Make Company and Fund Information Interactive
FOR IMMEDIATE RELEASE
2008-179

Washington, D.C., Aug. 19, 2008 — Securities and Exchange Commission Chairman Christopher Cox today unveiled the successor to the agency’s 1980s-era EDGAR database, which will give investors far faster and easier access to key financial information about public companies and mutual funds.

The new system is called IDEA, short for Interactive Data Electronic Applications. Based on a completely new architecture being built from the ground up, it will at first supplement and then eventually replace the EDGAR system. The decision to replace EDGAR marks the SEC’s transition from collecting forms and documents to making the information itself freely available to investors to give them better and more up-to-date financial disclosure in a form they can readily use.

Currently, most SEC filings are available only in government-prescribed forms through EDGAR. Investors looking for information must sift through one form at a time, and then re-keyboard the information — a painstaking task. With IDEA, investors will be able to instantly collate information from thousands of companies and forms, and create reports and analysis on the fly, in any way they choose.

IDEA will ensure that both the SEC and the investors who rely upon the financial reporting the agency demands are ready for the new world of financial disclosure that will soon arrive when financial information is presented in interactive data format. The SEC has formally proposed requiring U.S. companies to provide financial information using interactive data beginning as early as next year, and separately has proposed requiring mutual funds to submit their public filings using interactive data.

“IDEA will ensure that the SEC continues to stay ahead of the needs of investors,” said Chairman Cox. “This new SEC resource powered by interactive data will give investors far faster, more accurate, and more meaningful information about the companies and mutual funds they own. IDEA’s launch represents a fundamental change in the way the SEC collects and publishes company and fund information – and in the way that investors will be able to use it.”

Interactive data relies on computer “tags,” similar in function to bar codes, which identify individual items in a company’s financial disclosures. With every number on an income statement or balance sheet individually labeled, information about thousands of companies contained on thousands of forms could be easily searched on the Internet, downloaded into spreadsheets, reorganized in databases, and put to any number of other comparative and analytical uses by investors, analysts, journalists, and financial intermediaries.

The ease with which interactive data will make financial information available also is expected to generate many new Web-based services and products for investors.

As he unveiled the new IDEA platform at a Washington news conference today, Chairman Cox announced that the IDEA logo will begin to appear immediately on the SEC’s Web site as the agency transitions to making IDEA the new primary source for all SEC filings. Companies’ interactive data filings are expected to be available through IDEA beginning late this year.

Investors and others who currently use EDGAR will be able to continue doing so for the indefinite future. During the transition to IDEA, investors will be able to take advantage of new interactive, IDEA-like features that will be grafted onto EDGAR in the short run. This will make it possible for investors to tap IDEA’s advanced search capabilities, and to use the information from EDGAR within spreadsheets and analytical software – something that was never possible with EDGAR. The EDGAR database also will continue to be available as an archive of company filings for past years.

“When Congress created the SEC, and even when EDGAR was launched, the markets worked on paper and by mail. Today, the marketplace works online and by e-mail,” explained disclosure and transparency expert Dr. William D. Lutz, who is leading the SEC’s 21st Century Disclosure Initiative. “Companies and investors alike compile, analyze, and produce information and reports electronically. With the move to an electronic data-based filing system, the SEC will not only keep pace with the markets, but will provide investors with a dynamic system they can use to get the information they need, rather than having to wade through an avalanche of paper forms, legalese, and doublespeak.”

David Blaszkowsky, Director of the SEC’s Office of Interactive Disclosure, added, “After 75 years of document-based static financial reporting, whether in paper documents or in electronic equivalents, it is exciting to see the SEC poised to cross the ‘data threshold’ and help investors receive financial information that is dynamic, usable and ready to go as they make their investment decisions. And when the investor wins, so does the public company, fund, or other filer who simultaneously benefits from greater transparency and trust in our markets. By tapping the power of interactive data to tear down barriers to quick and meaningful investment information, markets can become fairer and more efficient while investors can possess far better quality data than was ever possible before.”

DOL tells ERISA plan to monitor hedge fund valuation practices

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I came across this ERISA hedge fund article last night and found it to be very interesting. This article highlights an issue that is plaguing the hedge fund industry – how to value illiquid and other hard to value assets. This issue has come to the forefront over the last year as the bank and large hedge funds have posted huge losses due to improper valuation of assets. More to come on this issue. The orginal article can be found here: www.castlehallalternatives.com.

ERISA vs. the Hedge Fund Industry

According to Pensions and Investment, the Boston office of the US Department of Labor (the “DOL”) recently issued a letter to an (unidentified) US Pension Plan subject to ERISA (the Employee Retirement Income Security Act) stating that the plan was in violation of ERISA regulations. The DOL is responsible for monitoring – and sanctioning – ERISA plans and, in their letter, threatened legal action if the plan in question did not remedy the noted violations.

The problem?

When valuing hedge funds and other alternative assets for purposes of the Plan’s annual filing, the pension investor had apparently relied upon valuations provided by the underlying funds’ general partners and, in some cases, on audited financial statements for those funds.

This is, of course, standard practice for many hedge fund investors. It appears, however, that this approach could create a major roadblock for ERISA plans.

According to the DOL, “it is incumbent on the Plan Administrator to establish a process to evaluate the fair market value of any hard to value assets held by the Plan. Such a process would include a complete understanding of the underlying investments and the fund’s investment strategy. In addition, the Plan Administrator must have a thorough knowledge of the general partner’s valuation methodology to ensure that it comports with the fund’s written valuation provisions and reflects fair market value. A process which merely uses the general partner’s established value for all funds without additional analysis may not insure that the alternative investments are valued at fair market value.”

In other words, the entity which has to value all assets – and especially hard to value assets – is the pension investor subject to ERISA. There is no way of dodging this poison chalice – the ERISA investor cannot simply rely on the hedge fund’s own valuation.

This is an enormously challenging obligation, particularly in the context of the severe fiduciary standards set by ERISA. Indeed, the DOL position raises a broad question – is it even possible for ERISA plans (or indeed any hedge fund investor) to meet this duty of care?

We have three observations.

Firstly, very few hedge funds provide position level transparency. However, it is stating the obvious to say that, without position level transparency, it is impossible for an ERISA investor (or any other investor for that matter) to have a “complete” understanding of the underlying investments and the fund’s investment strategy. Moreover, even if managers do provide position information, how can investors ensure that it is timely and accurate? The best solution to the transparency issue is a managed account – as such, would one outcome of the DOL’s position, if enforced, be for ERISA plans to only invest through managed account structures?

Secondly, the DOL states that ERISA plans must have a “thorough knowledge of the general partner’s valuation methodology”. However, in practice, most hedge fund offering documents have deliberately vague and unspecific clauses as to valuation and calculation of the net asset value, especially in relation to hard to value instruments. To add salt to the wound, every prospectus we have ever read includes a final caveat along the lines of “notwithstanding the above policies, the general partner (or the Board of directors in “consultation” with the investment manager for an offshore fund) may elect any “alternative method” of fair valuation. “ There is hence very limited specificity as to valuation procedures in virtually all hedge fund offering materials, and certainly insufficient information to provide a “thorough knowledge” of the valuation methodology which will be applied.

If the prospectus gives an inadequate description of the valuation process, investors need to turn to supplementary information from the hedge fund manager. At this point, however, things get worse – many hedge fund managers have not developed any internal, written valuation policy at all. For those funds which do have a valuation document, there is no standardization, and many valuation policies remain uncomfortably vague and unspecific (although, in fairness, we congratulate the minority of managers who have some stepped up and do furnish investors with comprehensive valuation information.)

The worst case is when a manager does have a valuation document, but will not provide it to the investor. Ironically, the worst culprits in this situation are some of the industry’s largest and most well known hedge fund managers. The issue is liability: hedge fund lawyers now appear to advise managers that the more information provided to investors, the more the potential liability. (As an aside, we recently spoke with the CFO of a large hedge fund: he noted that the sight of the Bear Stearns hedge fund managers being led away in ‘cuffs had resulted in urgent calls from the firm’s lawyers, advising the manager to reduce the amount of information it provided to investors.)

The third area of concern is the ongoing assumption by many investors, including many ERISA plans, that third party administrators assume responsibility for valuing hedge fund portfolios. As such, the administrator, it is perceived, can provide the necessary independence in the valuation process.

Not so fast. As we have noted before, much of today’s administration industry is now emphatic that they perform only the services of a “calculation agent” not a “valuation agent”. This is a relatively mute point when dealing with exchange traded securities, but it is an enormous issue when looking at a hedge fund which trades hard to value instruments (it goes without saying that we need help to value exotic CDOs, not IBM stock).

As a “calculation agent”, many administrators have amended their legal contracts to retain the right to “consult with” the manager and, indeed, accept prices from the hedge fund manager without further verification. Again, we hate to make an “emperor has no clothes” comment, but this is obviously nonsense: taking prices from the manager is like a police officer issuing speeding tickets on the basis of asking drivers how fast they were going.

These issues, in our mind, share a common theme. In recent years, with an ever-accelerating pace, we have watched the legal pendulum which defines how investors and hedge fund managers transact drift ever further in favor of the manager at the expense of the investor. It is trite, but uncomfortably accurate, to say that, in today’s hedge fund industry, no-one wants to be responsible for anything. Everyone is instead seeking to be indemnified to the point of invulnerability.

And this is the disconnect between the hedge fund industry and DOL. ERISA establishes onerous standards of fiduciary responsibility, deliberately designed to make those responsible for ERISA plans accountable, responsible and liable for their actions. Today’s hedge funds, however, are increasingly structured to ensure the lowest possible degree of accountability and liability on the part of pretty much everyone involved.

Against this background, we will watch with great interest ongoing developments as the DOL monitors ERISA plans with material hedge fund portfolios. The question, of course, is whether investing in opaque, uncommunicative hedge funds (even when they are some of the largest in the world) is too close to pushing a square peg in a round hole for investors who do operate within a strict fiduciary framework.

How to register as a CPO or a CTA

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Many hedge fund managers choose to utilize futures and/or commodities in their trading purposes. Generally such managers will need to register as commodity pool operators (“CPO”) and as commodity trading advisors (“CTA”). The hedge fund itself will be deemed to be a commodity pool. For purposes of the Commodities Exchange Act (“CEA”), a future and commodity are functionally equal as it relates to hedge fund manager registration. Registration as a CPO or a CTA is an often overlooked part of the hedge fund formation process. Your attorney should discuss the requirements for registration and whether any exemptions from registration are available.

In addition to hedge fund managers, retail foreign exchange (“Forex”) managers may very soon be required to register because of the recently passed “Farm Bill.” The retail Forex markets have been very loosely regulated and the CFTC and NFA have been clamoring for authority to regulate this are of the markets. Accordingly, this article will give you the basics on how to register as a CPO and/or a CTA.

A very general outline of the CPO registration process is as follows:

Prerequisite – the Series 3 exam

Each CPO or CTA firm will need to have at least one Associated Person (AP). Generally an AP will be anyone in the firm who has contact with clients in something more than a purely administrative or clerical role. All managers and non-clerical employees will be APs. All APs must have passed the Series 3 exam. Information on the Series 3 exam:

Series 3 (National Commodity Futures Examination)
Cost: $95
Number of Questions: 120 True/False and Multiple Choice
Subject Matter: (part 1) Market knowledge and (part 2) U.S. regulations
Time: 2 hours 30 minutes
Passing Score: 70% for each part

Like the Series 65 exam, I highly recommend you spend plenty of time studying for the exam. If you would like some suggestions on various study guides, please let me know.

Filing the application forms with the NFA

During this process your compliance professional will: gain access to the NFA’s registration system on your behalf, input certain basic information on the Form 7-R (for your CPO/CTA firm) and Form 8-R (for the initial AP) – generally you will provide this information to your compliance professional prior to completing these forms, and submit the 7-R and 8-R on your firms behalf.

After the Form 7-R and 8-R have been submitted you will need to pay for registration ($200 registration fee for the CPO or CTA; $85 for each associated person or principal; $750 for NFA membership (this is an annual fee)). After payment has been submitted, the NFA will review your application. Typically registration should be complete within about 3-5 weeks. The next step will be to have your disclosure document approved by the NFA – your compliance professional can help you with this process.

You will be able to check on your registration through the NFA’s BASIC system.

Definitions

According to the CFTC website, the definition of CPO and CTA are as follows:

Commodity Pool Operator (CPO): A person engaged in a business similar to an investment trust or a syndicate and who solicits or accepts funds, securities, or property for the purpose of trading commodity futures contracts or commodity options. The commodity pool operator either itself makes trading decisions on behalf of the pool or engages a commodity trading advisor to do so.

Commodity Trading Advisor (CTA): A person who, for pay, regularly engages in the business of advising others as to the value of commodity futures or options or the advisability of trading in commodity futures or options, or issues analyses or reports concerning commodity futures or options.

Associated Person (AP): An individual who solicits or accepts (other than in a clerical capacity) orders, discretionary accounts, or participation in a commodity pool, or supervises any individual so engaged, on behalf of a futures commission merchant, an introducing broker, a commodity trading advisor, a commodity pool operator, or an agricultural trade option merchant.

The Series 65 Exam

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If you are a hedge fund manager in certain states (California and Texas are two prominent examples) then your management firm will need to be registered as an investment adviser with your state’s Securities Commission. In all states, the prerequisite for such registration is that the firm have at least one investment adviser representative who has passed certain qualifying exams (the Series 65 exam or the Series 7 and Series 66) or have certain designations (CFA, CFP, etc).

This post intends to give you an overview of the Series 65 exam and some thoughts on taking and passing this exam.

The Series 65 basics

What: a three-hour (maximum) 140 question computer based exam which focuses on the following topic areas: economics and analysis; investment vehicles; investment recommendations and strategies; and legal and regulatory guidelines, including prohibition on unethical business practices. The exam features 10 ungraded questions (which can appear anywhere within the test) and an examinee needs to correctly answer 89 of 130 graded questions (70%).

Where: you will take the exam at either a Pearson-Vue or Prometric testing station.

When: you will sign up to take the exam at a time of your choosing on either the Pearson or Prometric website. It is recommended you schedule the exam at least a week prior to the date you plan to take it.

Why: it is required for a person to become registered as an investment adviser representative.

How to sign up

You will typically register for the Series 65 by submitting a Form U-4 through the IARD system or by submitting a Form U-10 online. Your law firm or your compliance consultant can help steer you through this process. Also feel free to contact us if you have any questions.

The cost to take the exam is $120. There may also be some state and IARD fees if you are signing up for the exam through the Form U-4 process.

How to study for the exam

I recommend to all of my clients that they put a pretty good effort into studying. I have seen a good portion of very smart hedge fund managers fail the exam on the first try. The central reason, in my opinion, is lack of a diligent study program. While the Series 65 is not a college chemistry exam, it still covers a lot of information which is probably new to the manager. Accordingly, I recommend that a manager set aside at least 40 hours to prepare for the exam. During the preparation phase, I recommend the following:

Get a study guide and read the guide from front to back. I read my study guide from front to back while I actively created notecards as I read each chapter. Doing so takes much longer, but afterward I was able to keep the notecards in my pocket and review them whenever I had free time, which kept the material fresh in my mind.

I used the Kaplan study guide. I am partial to the Kaplan study guides and have exclusively used these guide when studying for the various securities exams I have taken – I have passed the Series 3, Series 7, Series 24, Series 65 and Series 66 exams. The major frustration with the Kaplan guide is that it contained many errors. However, I think that Kaplan does the best job of preparing practice questions which will be very similar (if not exactly the same) to what you are likely to see on the exam. There are some other study guides out there like the “Pass the 65,” however, I have not found a guide which presents the information in a simple, matter-of-fact way like the Kaplan materials.

Other study options include various multi-media and internet applications. Kaplan also has a full-day class you can take from an instructor.

Take two to three practice exams. I took two Kaplan practice exams. After taking each exam, I examined the answer to every question, including the ones I correctly answered. This review process really helped me to solidify my understanding of the material. [Note: you may need to take more than two practice exams to feel comfortable with your knowledge base. If this is the case, I highly recommend taking more practice exams.]

Get a good night of rest the night before the exam. I always scheduled my exams in the morning. This way I can get the exam out of the way early and I do not need to be anxious during the day. I try to get a good night’s sleep the night before. At this point, it is not going to help your exam performance to stay up into the morning trying to cram.

Day of exam

Make sure you wake up early enough to be awake and alert. You should eat a proper breakfast. Allow extra time to get to the testing site. Pearson and Prometric have different rules about when you are supposed to show up at the testing site. A good rule of thumb is 45 minutes prior to your testing time. When you get to the testing site, you will sign in and the proctor will give you the rules of the testing site. Be ready to take everything out of your pockets and to take your jacket off (it is advisable to dress in layers as the testing rooms are often kept at very cool temperatures). You will likely be nervous before the test – I took the opportunity after signing in and before the test time to review a few of the more important note cards before I put them in my provided locker. This kept my mind busy, calmed my nerves, and gave me a little extra bit of confidence that I could answer the questions on the exam.

The exam

The exam is a computer-based exam so the first five minutes or so you’ll be given an on-line demonstration of the manner in which to answer questions and mark them for review. After this demonstration, the exam will start. The first ten to fifteen questions will generally be easier than the questions which come in the middle of the exam – don’t get too complacent. The middle of the exam will drag on and during this time there were many questions which I was not sure about and there were a lot of questions where I had to give a best guess. At about 2/3 of the way through the exam, I thought that I was going to fail for sure. Be aware of this, it happened to me in almost every single FINRA exam which I took.

Because the exam is so long – 180 minutes – you may need to use the restroom during the middle. If this is the case don’t hesitate to take some time for a break. During these breaks I would take some time to grab a drink of water and take a few deep breaths. When you get back, complete the last half or third of the exam in a methodical manner. If you encounter a question which you do not have a clue about how to answer, either guess and move on or guess and mark the question for review. Do not spend an inordinate amount of time trying to come to the correct answer – there are enough questions which you will know the answers to and it is most important that you get to those questions without being flustered. Remember also that the final 15 to 20 questions are generally going to be easier.

When you have answered all of the questions you will have the option to go back over your answers and to change any of your previous answers. It is recommended that you do not make any changes unless you are positive that your new answer is correct. Once you have certified that you are satisfied with your present answers the computer will ask you to confirm that you wish to proceed. When you confirm, the computer will begin to process your answers. During this minute or so your heart will race as adrenaline pumps through you. The screen will then tell you if you have passed or not.

If you don’t pass

Some people will not pass this exam – I have spent plenty of time on the phone talking to managers who almost passed. If you don’t pass it is not the end of the world. The major drawback of not passing the exam is that you will have to wait 30 days to take the exam again. If time is of the essence, this drawback could be the difference between an on-time hedge fund launch and the dreaded delay. As such, I always stress to the client that it is much better to be overprepared than underprepared. You will thank yourself for those extra few hours when you have passed the exam. If you do not pass the exam on the second try, you will need to wait 60 days to take the exam again.

***UPDATE FOR MAY 2010***

As many of you know, the Series 65 exam changed in 2010 and it is now much more difficult to pass. I have heard more stories from people this year about not passing than I did last year. Also a concern is that the study guides are not spending enough time on the new emphasis in the exam. For instance, one person I just spoke with mentioned that there were many more questions on trusts and pensions than were covered in the study guides. As always I recommend you get an up to date study guide and take at least two practice exams before taking the actual exam.

Filing Form D

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While hedge funds are not generally “regulated,” they are subject to the requirements of the Securities Act of 1933 (and potentially Regulation D). Generally this will mean that each hedge fund will have to file a Form D with (1) the SEC and (2) each state in which the fund has an investor. Form D must be filed with the SEC within 15 days of the first sale to the investor, each state will have different requirements.

In addition to the Form D, each state will generally require the partnership to submit a Form U-2 and the payment of an administrative fee. These administrative fees can range from $75 to $500; a few states may charge more. (Note: the fund itself, not the management company, will typically pay for this expense.) These items will generally need to be submitted to each state within 15 days of the date of the first sale in each state (note: New York requires its Form 99 to be filed prior to a first subscription from a New York resident).

The firm which submits these filings on your behalf will typically need the following information for each subscription:

Residence of investor
Amount of subscription
Whether the investor is “accredited” or not

Start-up hedge fund timeline | How to Start a Hedge Fund

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Starting a Hedge Fund Timeline

Many prospective hedge fund managers know that they would like to start a hedge fund but have not gone through the process necessary to understand what the process is like or how long it will take. For some managers the process is painless, for others the process is more time consuming and frustrating than they would like. Unfortunately, the timing of an actual fund launch cannot usually be determined with absolute certainty and will depend upon, in large part, your program and your service providers.

A good rule of thumb (for managers who do not need to register as investment advisers with their states) is that the fund formation process should take about 2 months. Often a fund can be up in running in a month or less, but to be on the safe side, I recommend 2 months.* If you need to register with a state, you are going to want to add anywhere from 3 – 6 weeks to the process.**

* It is not unheard of to have funds up and running in a couple of weeks. I’ve had a fund up and running in 4 days. If I need to work with a manager on an extremely tight deadline, this can probably be done in 2 to 3 days, depending on the availability of outside service providers.

** States like California will be closer to 3 weeks (UPDATE: CA is now taking two months to register investment advisers 08-18-09); states like Texas are going to be closer to 6 weeks.

In general the timeline might look like this:

Day 1 – Discussion with legal counsel regarding the structure of your fund (fees, contribution provisions, withdrawal provisions, other items to be included in the legal documents). During this time you will also discuss your investment program and your background.

Day 7-10 – Delivery of offering documents. During this time your legal team should respond to you with your legal documents. Your hedge fund’s legal documents will include the following:

Private placement memorandum
Limited partnership agreement (or limited liability company operating agreement)
Subscription documents

Don’t be scared when you first review these offering documents – they will usually be around 100 pages. Some very large fund offering documents might be up to 200 page or more in length.

Day 10-14 – Review of your offering documents. During this time you should be reviewing the offering documents and familiarizing yourself with their provisions. You will need to understand what all of the legal provisions in your documents mean. If you don’t understand a concept or phrase – mark it down and be sure to ask your attorney. Remember, these are your legal documents and you paid very good money for them – you should know what they say.

Day 17 – Discussion with legal counsel regarding offering documents. You should take about an hour (sometimes it is more or less) to discuss the key points of your offering documents with your legal counsel. You should bring up items which you have questions on and your lawyer should run down the key points of the offering documents with you.

Day 24 – Delivery of revised offering documents. Your legal team should be able to deliver you revised offering documents within about a week. At this time the offering documents are very close to being complete. You should review the documents to make sure that all your questions have been addressed and your changes incorporated. If the revised wording does not make sense, let your attorney know as soon as possible.

At this point these offering documents are in good enough shape to send to your administrator and your auditor (if you decide to name an auditor in the offering documents). In addition, you should begin the account application process with your broker or prime broker.

Day 24-30 – Begin finalizing service provider contracts and make sure all service providers are on the same page. The brokerage account application can potentially be a stumbling block in the process. Certain brokers have certain due diligence requirements which must be met before the account will be ready for live trading. You might not know of these requirements beforehand or the broker’s compliance department may come back with extra requirements – you never know what might be required. For example: one fund was not allowed to have the word “Fund” in their name if they started with less than $2 million in AUM. Another fund was not allowed to clear through a certain prime broker because the managing member of the management company did not have enough experience in the eyes of the clearing broker. While stories like this are the exception rather than the rule, the brokerage account opening process is the most uncertain in terms of time.

Day 30-45 – Last minute prep work with lawyers and service providers. The auditors or administrators may have some minor comments for the lawyers on the offering documents. Some of these service providers may require certain disclaiming language regarding the services which will be provided. It is not uncommon for these requested modifications to be passed on directly to the attorney, sometimes these requests will go through you. Your lawyer will send you finalized offering documents during this time.

Day 46-60 – Begin getting ready for trading. You should make sure that everything is in place for a smooth first day – make sure you know when and how you will be doing your trading. Make sure you will have assets in the brokerage account on Day 1. Make sure your computers will be working.

Keys to remember during the process

Start early. Give yourself too much time.
Be responsive to all emails and phone calls.
Keep the lines of communication open with your service providers. This is your fund and you are paying your service providers good money. They should be responsive to you and should answer all of your questions. If you do not get the response you would like it is your responsibility to discuss this with your service providers.
Be patient.

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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:

Bart Mallon, Esq. has written most all of the articles which appear on the Hedge Fund Law Blog. Mr. Mallon’s legal practice, Cole-Frieman & Mallon LLP, 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 have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.

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