Category Archives: News and Commentary

Form D filing now done online

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Earlier this year the SEC approved the formation of an automated filing system for Form D. As noted in this article on Form D, the filing must be made with the SEC 15 days after the first sale of hedge fund interests. While the launch of the new online system was supposed to make it easier for small companies (including hedge funds) to make the filing, in implementation it is a two-step, potentially cumbersome process. In the next few weeks after we make some of these filings, I will be able to rate the new SEC Form D online filing system. The press release below announcing the new system can be found here.

SEC Launches Voluntary Online Filing System for Form D to Reduce Burden on Smaller Companies

Securities and Exchange Commission today began accepting filings of Form D through the Internet as part of the agency’s overall efforts to reduce unnecessary paper filings and regulatory burdens, particularly for smaller companies.

The new rules providing for online filing and simplification of Form D notices were approved by Commission at the end of last year. Form D filings are made mostly by smaller companies, and notify the SEC of sales of securities in private and certain other non-registered offerings of securities. Many states also require Form D notice filings.

“With electronic filing, the information available in Form D filings will now be far more accessible to all users,” said John White, Director of the Division of Corporation Finance. “We look forward to hearing from voluntary filers over the next six months about their experiences as we prepare to move to the mandatory system next spring.”

The SEC’s new Form D online filing system features simplified and updated information requirements and is voluntary until March 16, 2009. Companies and funds required to file Form D notices may continue to file them on paper until that date, following either the old or new information requirements. Guidance on the Form D filing process with the new system as well as more information about filing and amending a Form D notice are available on the SEC Web site.

Form D filers are encouraged to use the voluntary system and inform SEC staff about their experiences. The SEC staff expects adjustments will be made to the system to increase its utility and user-friendliness before the online filing of Form D becomes mandatory. Filers can report their experiences to the SEC’s Office of Small Business Policy in its Division of Corporation Finance at (202) 551-3460 or [email protected].

The SEC staff is continuing to work with the North American Securities Administrators Association (NASAA) to link its Form D filing system with a system built by state securities regulators that would accept state Form D filings. No timetable has been adopted for linking the two systems. (Press Rel. 2008-199)

SEC comments on Lehman Bankruptcy

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From the SEC website.  The release can be found here.

Statement Regarding Recent Market Events and Lehman Brothers (Updated)
FOR IMMEDIATE RELEASE
2008-198

Washington, D.C., Sept. 15, 2008 — The decision by Lehman Brothers Holdings Inc. to file for protection under Chapter 11 of the bankruptcy laws is expected to lead to the winding down of Lehman Brothers Inc., its U.S. regulated broker-dealer, outside of bankruptcy. The accounts of Lehman’s U.S. retail securities customers are with the broker-dealer. In cases such as this, Lehman Brothers’ customers will benefit from their extensive protections under SEC rules, including segregation of customer securities and cash as well as insurance by the Securities Investor Protection Corporation. These safeguards are designed to ensure that a broker-dealer’s customers will be protected.

In the weeks ahead, SEC staff who have been on-site at the U.S. broker-dealer will remain in place to oversee the orderly transfer of customer assets to one or more SIPC-insured brokerage firms. The holding company bankruptcy filing does not affect in any way the SIPC protection applicable to the firm’s customers.

The SEC is also coordinating with overseas regulators to protect Lehman’s customers and to maintain orderly markets.

“For several days, we have worked closely with regulators around the world including the FSA in the United Kingdom, the BaFin in Germany, and the FSA in Japan, as well as our counterparts in other markets around the world, to coordinate our actions in the interest of orderly markets,” said SEC Chairman Christopher Cox. “In doing so we have also worked closely with the Treasury and the Federal Reserve and market participants. We are committed to using our regulatory and supervisory authorities to reduce the potential for dislocations from Lehman’s unwinding, and to maintain the smooth functioning of the financial markets.”

In furtherance of these objectives, the SEC is focused on ensuring that customers of the U.S. broker-dealer, which is not part of the bankruptcy filing, remain protected through, among other means, enforcing continued compliance with the SEC net capital and customer asset protection rules, and with SEC requirements that the U.S. broker-dealer conduct its affairs so as to minimize the effect of the holding company’s bankruptcy on customers, and that it ensure access to customer cash and securities.

In the meantime, Lehman Brothers Holdings Inc. will continue to operate while the bankruptcy process facilitates the reconciliation of claims and the realization of value from its assets in an orderly fashion.

Customers of Lehman Brothers Inc. may contact the SEC’s Office of Investor Education and Advocacy for individual assistance at [email protected]

Survey of hedge fund administrators

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As a hedge fund attorney I am often asked for referrals to hedge fund administrators. There are many very good administration firms that I have worked with in the past – for both small and large clients. The administration firms I would recommend for a larger client are not necessarily the same firms I would recommend for smaller clients. For either small or large hedge fund clients I will usually give the client two or three different administrators to talk with. Ultimately a start up hedge fund manager must be comfortable with the contact person at his administration firm and must also be comfortable with the fees that the administrators will charge – after the hedge fund launch most hedge fund managers will be communicating more with the administrator than the lawyer so it is important that the manager has a good relationship with the administrator.

Below is a press release which details a recent survey of hedge fund administrators. The survey comes from the Global Custodian website and can be found here.

Uncertain Markets Fail To Dent Appreciation of Hedge Fund Administrators

LONDON (2 September 2008) – Despite industry-wide anxiety about market conditions, more hedge fund administrators than ever took part in the annual Global Custodian survey of client perceptions of service quality and value. Nearly 1,200 responses were received from clients of 56 hedge fund administrators.

“Despite the consolidation which has taken place in the industry, and difficult investment and financing markets, we still attracted responses for well over 50 hedge fund administrators this year,” says Dominic Hobson, editor in chief of Global Custodian. “This is only one measure among many of the buoyant conditions in the alternative investment administration industry. Our survey also picked up signs of capacity constraints, limits on client size, high rates of staff turnover and expansion into new territories. These are all problems of success. The industry is clearly in a rude state of health.”

Despite the challenges they face, the average scores awarded by clients to their administrators are also up across the board, fuelled by a response rate that surged 25% this year.

“However, the headline scores are not the sole measure of success in the survey,” adds Dominic Hobson. “There are also large differences between providers in terms of the number, size and types of client they seek to service, which is why we divided the providers into separate peer groups this year.” The new peer group rating category facilitates comparisons between providers of similar size and structure.

In the first peer group, consisting of the largest and most international administrators, Citco Fund Services continues to top the annual survey. On the biggest turnout of any provider, Citco raised its scores in all but one question, further cementing the company’s long-held domination of the top spot in the survey.

“This survey is recognized as the most important, comprehensive annual survey of our industry,” says William Keunan, Citco’s director, fund services. “We are delighted with the top rated accolade, in particular as it comes directly from so many of our clients.”

In the same peer group, scores also rose significantly at Citi, Fortis Prime Fund Solutions and PNC Global Investment Servicing.

Peer Group 1 – Overall Scores

Provider (Total Scores)

  1. Citco Fund Services 6.36
  2. Goldman Sachs Administrative Services 6.23
  3. IFS, A State Street Company 6.11
  4. PNC Global Investment Servicing 6.03
  5. HSBC Securities Services 6.03
  6. CACEIS 5.96
  7. Citi 5.76
  8. UBS GAM -Fund Services 5.75
  9. GlobeOp Financial Services 5.65
  10. Fortis Prime Fund Solutions 5.51
  11. JPMorgan Hedge Fund Services 5.14

Peer Group Overall 5.93

Administrators were divided into peer groups based on similar size and structure to facilitate comparisons among administrators

In the second peer group, which consists of smaller and often new providers with a limited international presence, scores rose significantly for AIS Fund Administration, CIBC Bank and Trust Company, Equity Fund Services and Fulcrum Fund Services, which recently agreed a merger with Butterfield Fund Services.

But it was Kaufman Rossin Fund Services that dominated the second peer group, with an impressive debut in the 13th consecutive annual survey. The company grew out of a Florida accounting firm, allowing it to grow without taking in third party investors or taking on acquisitions, and it is now larger than the average small provider, with more than $18 billion in AuA.

“These survey results clearly reflect that our strategy of controlled growth, hiring ahead of the curve and leveraging technology enables us to exceed the expectations of our clients and the industry,” says Jorge DeCardenas, a co-founding director at Kaufman Rossin.

“Our outstanding service professionals and increasing institutional client base means that KRFS is very well positioned to continue this growth while maintaining our reputation for service,” adds Keith Sharkey, a co-founding director at Kaufman Rossin.

In addition to Kaufman Rossin, several other firms made their debut in the survey as rated providers for the first time this year, including the publicly listed GlobeOp Financial Services and Quintillion (Ireland).

Peer Group 2 – Overall Scores

Provider (Total Scores)

  1. Kaufman Rossin Fund Services 6.59
  2. ATC Fund Services 6.59
  3. AIS Fund Administration 6.49
  4. Pinnacle Fund Administration LLC 6.44
  5. Fulcrum Fund Services 6.42
  6. Quintillion [Ireland] 6.31
  7. Equity Fund Services 6.28
  8. Kingsway Taitz 6.25
  9. Trinity Fund Administration Ltd 6.23
  10. CIBC Bank and Trust Company Ltd 6.08
  11. LaCrosse Global Fund Services 5.98
  12. Circle Partners 5.95
  13. OpHedge Investment Services 5.82
  14. Daiwa Securities Global Asset Services 5.64
  15. Spectrum Global Fund Administration 5.43

Peer Group Overall 6.15

Administrators were divided into peer groups based on similar size and structure to facilitate comparisons among administrators

Even as several firms featured in the survey in the past have consolidated, the number of rated providers rose from 20 to 26. Of the 56 providers for which responses were received, 39 received enough responses to be either rated or mentioned in the survey.

Responses increased 25% over last year to a total of 1,160 that could be fully authenticated.

In recent years, the custodian banks that have acquired hedge fund administrators have sought to adjust client lists in favor of larger and more profitable hedge fund and fund of funds groups interested in a broader array of services. At the same time, prime brokers have recognized that providing administration services can help attract and retain clients and counter the shift among hedge fund managers towards multiple prime brokerage.

“It would be surprising if the hedge fund administration industry continues to support such a large number of providers, and there is now evidence that a renewed round of consolidation is in the offing,” says Dominic Hobson. “However, the appetite to sell may be offset as well as encouraged by the depressed prices available. In any event, the buyers are likely to be different from the banks which dominated the acquisition process in the early years of this century.”

Despite the slowdown in merger and acquisition activity, the hedge fund administration industry also continues to spawn new and smaller providers through a mixture of back office spin-offs by fund management and trading houses and start-ups that aim to service the smaller funds that are being jettisoned by the major providers, or which reckon they can use expertise acquired elsewhere to support particular investment strategies.

“It is worth reiterating that, in spite of the testing conditions in the marketplace, more hedge fund managers than ever responded to the survey this year, and we were able to rate more service providers than ever before,” says Dominic Hobson. “This reflects not only the growing maturity of the survey, but also the larger role and increased importance of administrators as the hedge fund industry has attracted institutional investors.”

Although many administrators are controlled by banks, and there is demonstrable appetite among hedge funds for financing services, the number of hedge fund administrators interested in providing credit, leverage and securities lending services to clients remains small. Only six administrators were rated for credit and leverage in the survey.

However, the inclusion in the survey for the first time this year of questions on middle office services is a measure of the expanding role of hedge fund administrators. The middle office is a term open to various definitions, but the survey measures the performance of providers in terms of the usefulness of P&L reporting, efficiency of cash market trade confirmations, efficiency of OTC derivative trade confirmations, resolution of breaks unrelated to NAV calculations, ability to support multiple prime brokers, efficiency of OTC derivative processing (e.g. documentation management, expirations, re-sets etc.) and the sophistication of collateral management.

IFS, A State Street Company topped the first peer group in middle office services while Kaufman Rossin came out first among the second peer group.

“Five years ago the idea that hedge fund administrators would get involved in functions such as leverage, OTC derivative processing and collateral management was unthinkable at most firms, and controversial where it was not,” says Dominic Hobson. “But consolidation, more imaginative business strategies, a growing willingness on the part of commercial banks to challenge investment banks, and market circumstances are gradually eroding the barriers that once separated prime brokers, fund administrators and custodian banks. Chief among the factors at work is the anxiety of institutional investors in hedge fund strategies about exposure to the credit risk of the investment banks.”

The full results of the 2008 Global Custodian Hedge Fund Administration Survey appear in the Summer Plus issue of Global Custodian magazine. They are also available online (to paying subscribers only) at www.globalcustodian.com.

Contact:

Dominic Hobson, Editor-in-Chief, at [email protected] or +44 (0) 207 148 4280

Allison Cayse, Surveys Editor, at [email protected] or +1 513 574 0220

Muzaffar Karabaev, Survey Reprints/Research Enquiries, at [email protected] or +44 (0) 207 148 4289

Notes:

1. The Global Custodian Hedge Fund Administration Survey has been published annually since 1996.

2. A full list of revisions to the 2007 questionnaire can be found online in the surveys section at www.globalcustodian.com.

3. Providers were rated on a total of 71 questions divided into 12 service areas: client service and relationship management, value, fund accounting and valuation, investor services, reporting to investors, reporting to fund managers, compliance and taxation, corporate administration, fund structures, credit/leverage, middle office services and technology. Respondents graded their administrators on quality of service using a scale of 1 to 7, where 7 is excellent; 6, very good; 5, good; 4, satisfactory; 3, weak; 2, very weak; and 1, unacceptable. Scores were then weighted for the size and sophistication of the respondent and for performance on questions named as important in each service area by all respondents.

4. Global Custodian is the leading specialist magazine covering operational, administrative and distribution aspects of the securities, derivatives, fund management and institutional investment industries. The magazine is supported in each of its chosen areas of expertise by industry-leading surveys of the global custody, sub-custody, hedge fund administration, mutual fund administration, prime brokerage and securities financing businesses.

SEC files complaint against forex fraud

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Summary:

Last Wednesday the SEC filed a complaint against a forex hedge fund manager who was supposedly using a “trading robot” to generate huge returns. It turns out the forex hedge fund manager and the trading robot did not generate the outsized returns, but instead lost investor money. There are two very important items to note here:

1. It is scams like this that has the SEC and CFTC on the offensive to regulate the spot forex market.

2. Again, it is so important for all investors to do proper due diligence on managers and to make sure they know what they are investing in. These fraudsters give a bad name to all hedge fund managers and, sometimes, they can be stopped if the right questions are asked in the beginning.

SEC Release:

U.S. SECURITIES AND EXCHANGE COMMISSION
Litigation Release No. 20688 / August 22, 2008

Securities and Exchange Commission v. Royal Forex Management, LLC and Patrick H. Haxton, (U.S.D.C., Northern District of Texas, Dallas Division, Civil Action No. 3:08-CV-1467-L)

SEC Accuses Carrolton, Texas, Man of Selling Fraudulent Securities Involving Foreign Currency Trading

On August 20, 2008, the Securities and Exchange Commission filed an action in Dallas federal court to halt an alleged unregistered and fraudulent offering of securities by Patrick H. Haxton of Carrollton, Texas, and his company Royal Forex Management, LLC (“Royal”). The securities were investment contracts involving the trading of foreign currencies on the Forex market. On August 21, 2008, United States District Judge Sam A. Lindsay entered a temporary restraining order suspending the offering and orders freezing the defendants’ assets, requiring sworn accountings, prohibiting any alteration or destruction of documents and expediting discovery. The court set a hearing for September 4, 2008 to consider the Commission’s application for preliminary injunctive relief.

The defendants named in the Commission’s Complaint are: Patrick H. Haxton, age 51, of Carrollton, Texas, the owner and sole manager of Royal; and Royal Forex Management, LLC, a Texas limited liability corporation operated out of Haxton’s Carrollton home.

The Commission’s Complaint alleges that from at least June 2007 to the present Haxton, personally and through Royal, raised at least $305,000 from 8 investors in three states. Haxton offers the Forex investments through the Royal web site (www.royalforexmanagement.com), advertising on his work truck and personal contacts. Royal’s promotional materials and Haxton’s oral statements are replete with representations of phenomenal past trading returns, including claims of 400% to 500% annual returns, generated by a complex software program named “The Currency Trading Robot” (“Trading Robot”), purportedly created by Haxton. On the web site, Haxton claims to have a great history and to have been a very successful trader since 2000. Haxton and the web site also represent that there is very little risk of loss.

The Commission alleges, however, that these representations are materially false and misleading. For instance, the Commission contends that Haxton and Royal never generated the claimed phenomenal returns by trading currency. Indeed, according to the Complaint, Haxton lost a significant portion of investor funds trading foreign currencies and misappropriated the remaining funds for his own personal use. In some instances, investor funds were never traded, but were used to pay business and personal expenses.

The defendants are charged with securities fraud under Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and with conducting an unregistered offering under Section 5 of the Securities Act. The Complaint also seeks permanent injunctions, civil penalties and disgorgement of ill-gotten gains, among other relief, against each defendant.

The Commission would like to thank and acknowledge the assistance of the Texas State Securities Board in this matter.

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

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Summary:

Mark J.P. Boucher, the author of the book The Hedge Fund Edge, was involved in a hedge fund scam where he lured investors into a real-estate hedge fund which was was supposed to be secured by real property. The fund was not and investors lost millions of dollars. This underscores the necessity for hedge fund investors to protect themselves from these fraudsters by completing proper hedge fund due diligence. Please contact us if you have questions on hedge fund due diligence.

SEC Release:

Litigation Release No. 20689 / August 27, 2008
Securities and Exchange Commission v. Mark Joseph Peterson Boucher and Gary Paul Johnson,, Case No. CV 08-4088 (N.D. Cal. filed August 27, 2008); Securities and Exchange Commission v. John E. Brake,, Case No. CV 08-4089 (N.D. Cal. filed August 27, 2008)

SEC Charges Bay Area Investment Adviser, Others in Real Estate Investment Scam

The Securities and Exchange Commission today charged a Portola Valley investment adviser and newsletter publisher, Mark J.P. Boucher, with misleading clients into investing in two failed real estate development companies.

According to the Commission, Boucher helped raise around $20 million for the companies by falsely representing that the investments were secured by real estate, when in reality one of the companies owned no property, and the other owned a single property that was wholly underwater in debt. The Commission also sued the owners of each company, John E. Brake and Gary P. Johnson (both of Southern California) for misappropriating millions of dollars of investor funds to finance everything from beachfront homes to undisclosed side businesses. Boucher and Johnson have settled with the Commission without admitting or denying the allegations.

According to complaints filed today in federal district court in San Francisco, from 1999 through 2005, the defendants collectively raised about $20 million from investors based upon misrepresentations that the money would be used to fund large-scale real estate development projects and that the investments were secured by real property. In reality, the investments were not secured: one development company never owned property, and by the summer of 2002, the other company’s lone property was so heavily debt laden that its debts exceeded potential profits. In the end, neither company successfully developed a real estate project, and investors lost millions of dollars.

The Commission alleges that many investors became interested because Boucher — a hedge fund manager and the author of the book The Hedge Fund Edge — recommended the investments in a monthly newsletter he circulated to his advisory clients.

The Commission’s complaints allege that the defendants misused investor funds to pay for a wide variety of personal expenses. Among other things, Brake allegedly used investor funds to pay for a beachfront home rental in Carmel, California, luxury automobiles, a personal chauffeur, private jet travel, jewelry and designer clothing, while Johnson used investor funds to launch a failed furniture business. The Commission also alleges that Boucher used investor money to pay a portion of the mortgage on his personal residence.

Boucher, without admitting or denying the allegations in the Commission’s complaint, has agreed to a permanent injunction from further violations of Sections 17(a) and 17(b) of the Securities Act of 1933 (“Securities Act”), Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder (“Exchange Act”), and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940. Boucher will also pay a $100,000 civil penalty. In addition, Boucher has consented to the institution of public administrative proceedings against him in which he will be barred from serving as an investment adviser with a right to reapply after five years.

Johnson, without admitting or denying the allegations, has likewise agreed to a permanent injunction from further violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Johnson has also consented to an order requiring him to disgorge more than $1.8 million in ill-gotten gains and approximately $700,000 in prejudgment interest, and to pay a civil penalty of $120,000.

Brake is charged with violating Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The Commission is seeking injunctive relief, disgorgement, and civil money penalties against Brake.

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.

CFTC order levies major fine on hedge fund trader

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Summary:

The CFTC ordered a hedge fund manager who operated four commodity pools to pay more than $279 mm in restitution to prior hedge fund investors as well a $20 mm civil penalty for his fraud. The manager concealed huge losses from investors by issuing false account statements which reflected consistently profitable trades. The hedge fund manager also misappropriated some of the investor’s assets.

Press Release:

Release: 5531-08
For Release: August 19, 2008

Hedge Fund Trader Paul Eustace and Philadelphia Alternative Asset Management Co. Ordered to Pay More Than $279 Million to Defrauded Customers and More than $20 Million in Civil Monetary Penalties in CFTC Action

Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) today announced that Paul Eustace of Ontario, Canada, was ordered to pay more than $279 million in restitution and a $12 million civil penalty, based on an order that resolves a CFTC enforcement action against him for defrauding commodity pool participants in four pools that he managed.

The court also entered an order of default judgment against the commodity pool operator that Eustace controlled, the Philadelphia Alternative Asset Management Co. (PAAM), imposing permanent trading and registration bans, requiring payment of restitution of approximately $276 million, subject to offset by prior disbursements and payments by Eustace, and imposing an $8.8 million civil monetary penalty.

The supplemental consent order, entered by the Hon. Michael M. Baylson of the U.S. District Court for the Eastern District of Pennsylvania on August 13, 2008, follows a July 13, 2007 consent order of permanent injunction against Eustace that enjoins Eustace from further violations, and imposes permanent trading and registration bans.

“This concludes a successful effort by our Division of Enforcement to stop fraud in its tracks, return as much money as possible to defrauded investors, and to bring wrongdoers to justice,” said CFTC Acting Chairman Walter Lukken.

The orders arise out of a CFTC complaint filed on June 21, 2005, and later amended, against Eustace and PAAM. (See CFTC Press Release 5091-05, June 29, 2005.)

At the outset of the litigation, the CFTC’s action froze all the assets under the control of PAAM and Eustace and preserved more than $70 million for return to pool participants. The CFTC also obtained the appointment of a receiver to recover and distribute funds to defrauded participants. Through related receivership litigation, an additional $96 million has been obtained to date for the benefit of defrauded pool participants. Defendants’ restitution obligation shall be offset by any funds distributed through the receivership.

As alleged in the amended complaint, and as the 2007 consent order found, from at least the spring of 2001 through June 2005, Eustace fraudulently operated four commodity pools: the Option Capital Fund LP (Option Capital Fund); and, through PAAM, the Philadelphia Alternative Asset Fund, L.P. (LP Fund); the Philadelphia Alternative Feeder Fund LLC; and the Philadelphia Alternative Asset Fund, Ltd., an offshore fund with over $250 million in assets. During this time, Eustace incurred losses of approximately $200 million trading commodity futures and options either in accounts held in the name of the funds or in his name. Eustace concealed those losses by issuing or causing to be issued, false account statements reflecting highly and consistently profitable trading results. Eustace also misappropriated assets of the Option Capital and LP Funds and received incentive and management fees through his fraudulent operation of the pools. Eustace was also charged with fraudulent solicitation and registration violations.

The CFTC Division of Enforcement appreciates the assistance of the Ontario Securities Commission and the National Futures Association in this matter.

In December 2007, the CFTC issued a related order filing and settling failure to supervise and recordkeeping charges against MF Global, Inc. (MFG), a registered futures commission merchant, and Thomas Gilmartin, a former associated person of MFG relating to their mishandling of certain trading accounts managed by Eustace and PAAM that sustained losses of approximately $133 million. MFG and Gilmartin paid collectively $2.25 million in civil monetary penalties and Gilmartin agreed never to seek registration with the Commission. (See CFTC Press Release 5427-07, December 26, 2007.)

The following CFTC Division of Enforcement staff members are responsible for this case: Gretchen L. Lowe, Michael J. Otten, Kara Mucha, Glenn I. Chernigoff, Richard B. Wagner, and Vincent McGonagle.

Ron Insana’s failed hedge fund

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Today in the New York Times Business section, there is an article about a hedge fund run by form CNBC news anchor Ron Insana (click here for article). The article details Mr. Insana’s quest to become a fund of funds manager and the pitfalls that befell the former market commentator.

The Times does a great job at identifying many of the issues which a start up hedge fund manager will need to be aware of, especially the costs.

In truth, there are thousands of Mr. Insanas desperately trying to raise money from nondescript little offices across the country. Some of them raised $10 million, some raised $100 million or more. And, as money has gotten tighter, and the bloom has come off the hedge fund rose, some have raised none at all.

…

Although the big boys get most of the ink, Mr. Insana’s is a far more common story — and far more representative of what is happening in the land of hedge funds today.

While the landscape for a start up hedge fund manager is a difficult one, it is also one in which a manager can succeed if the manager takes the time to plan accordingly. To quote Yogi Berra, “If you don’t know where you are going, you will wind up somewhere else.”

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.

New hedge fund podcast

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I have started my hedge fund podcasts once again. Each week I’ll review the most interesting or important stories that involve the hedge fund industry and analyze how the such stories affect hedge fund managers and investors.  This week I discuss two hedge fund news stories, two SEC actions, and the CFTC’s formation of a retail forex task force.  I also discuss how to register as a CPO or CTA.

I am trying to make these podcasts as informative and interesting as possible, so please feel free to send me your comments and suggestions. I hope you like the podcast.

http://www.hedgefundcast.com/