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Job Applicant – Fund Accounting and Portfolio Analysis
Normally I do not use this blog as an area to advertise job openings or the resume’s of prospective job applicants, but I wanted to make an exception for a good friend of mine. If you know of any career opportunities in portfolio analysis or fund accounting, please let me know. The following is information on the candidate:
- Education: MBA, CAIA Candidate
- Location Preference: Chicago, New York, San Francisco
- Duties & Responsibilities: preparation and review of monthly valuation reports, annual financial statements and regulatory filings
- Strengths & Skills: thorough understanding of accounting and administration for hedge fund and mutual fund industries;proven ability to research issues, defend positions, and communicate recommendations; critical thinking, detail oriented, with record of process improvements
Hedge Fund Audit Firms and Agreed Upon Procedures
Hedge Fund Due Diligence Firm Discusses “Agreed Upon Procedures”
We’ve published a number of thoughtful pieces on this blog from Chris Addy, president and CEO of Castle Hall Alternatives (see, for example, article on Hedge Fund Operational Issues and Failures). Today we are publishing a piece by Chris which discusses hard to value hedge fund assets (so called Level III assets). In certain situations hedge fund audit firms will be engaged to perform an “Agreed Upon Procedures” review of the pricing of these assets. As discussed in the article below, agreed upon procedures engagements do not provide hedge fund investors with a great deal of comfort with regard to the pricing of these assets. It is unclear whether in the future investors will push back with regard to such engagements and require more robust pricing audits. The problem with more robust procedures, obviously, is increased cost (because of increased liability for the audit firms).
Managers who are engaging audit firms pursuant to agreed upon procedures should be aware that they may face tougher questions from investors going forward.
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Agreed Upon Procedures
A number of our recent posts have focused on the challenges of the hedge fund administrator‘s role in relation to security valuation. We will, of course, return to this topic – but, in the meantime, wanted to focus on some of the alternatives to administrator pricing.
One of the more common comments from today’s administrators is that, while an admin may be able to price Level I and Level II securities, they do not necessarily have information to price Level III instruments. (To recap, the US accounting standard FAS 157 divides portfolios into three levels, being Level I, liquid instruments readily priced from a pricing feed (typically exchange traded); Level II, instruments priced using inputs from “comparable” securities (essentially mark to model, albeit with mainstream models); and Level III, everything else.)
This leaves investors with a challenge – if administrators cannot price Level III instruments, who can? Moreover, to repeat one of our frequent comments, it is self evident that if a hedge fund manager wishes to deliberately mismark securities, they would most likely misprice a Level III instrument. It is, of course, very hard to fake the price of IBM common stock, but much easier to mismark emerging market private loans.
Two of the most common tools available to hedge fund managers looking for third party oversight over pricing for Level III instruments – assuming the administrator has washed their hands of the problem – are third party pricing agents and auditor agreed upon procedures, or “AUP”. We will return to the strengths and weaknesses of third party pricing agents in a subsequent post, but wanted to focus this discussion on AUP.
In an Agreed Upon Procedures engagement, the auditor completes specific procedures which have been dictated by the client. The procedures are specified and the auditor then prepares a report outlining the findings of that specific work.
We have two comments here: the first is to take a high level view as to the adequacy of these procedures, and the second is to dig a little more deeply into the actual audit guidance that covers this type of work.
Our first comment is, unfortunately, an Emporer Has No Clothes observation. The significant majority of hedge fund AUP engagements we have seen require the auditor to test a fund’s pricing on a quarterly basis. This usually involves (i) obtaining a portfolio list from the investment manager and (ii) testing the pricing support for those positions.
There are, however, generally two snags. Firstly, many AUP only test a sample of prices, not the whole portfolio. Sample testing clearly provides much less assurance than a price review of all positions: the administrator, for example, is usually expected to price the entire book (would any investor accept a NAV which has been priced on a “sample” basis???)
The bigger problem, however, is the type of testing completed by the auditor. In way, way too many cases, the auditor tests security prices back to the manager’s own pricing support and makes no attempt to obtain independent pricing information.
This type of work is, clearly, somewhere between minimal and absolutely no value for investors. If the auditor receives a spreadsheet from the manager showing the matrix of broker quotes received, how does the auditor know that the manager has not adjusted that spreadsheet to exclude quotes which were uncomfortably low? Even more importantly, if all the auditor does is to check prices back to pieces of paper in the manager’s own pricing file, how does the auditor know that those pieces of paper are genuine? As we have said before, and will keep on saying, it only costs $500 to buy a copy of Adobe Photoshop if you are of a mind to alter documentation.
When discussing this type of work, the manager typically notes that, if the auditor was to complete a full, independent pricing review, it would be too costly and too time consuming to be practical on a quarterly basis. A full, GAAP audit review is, of course, performed at year end – this does include independent pricing (although – investor fyi – auditors will still only sample test many portfolios.)
While these are fair points, it remains the case that this type of AUP provides minimal protection against pricing fraud. In the meantime, the manager gets the marketing benefit of being able to claim enhanced scrutiny and oversight from a Big 4 firm each quarter.
Which leads to our second point. Why would an auditor accept to complete agreed upon procedures when any reasonable accountant would rapidly conclude that the typical scope of these AUP provide pretty much nil controls assurance? Why does the auditor not insist that, if their name is to be associated to this work, then the procedures must be meaningful and sufficient to meet an actual control standard?
To this point, the actual audit standard applicable to AUP is available here. The standard states:
An agreed-upon procedures engagement is one in which a practitioner is engaged by a client to issue a report of findings based on specific procedures performed on subject matter. The client engages the practitioner to assist specified parties in evaluating subject matter or an assertion as a result of a need or needs of the specified parties. Because the specified parties require that findings be independently derived, the services of a practitioner are obtained to perform procedures and report his or her findings. The specified parties and the practitioner agree upon the procedures to be performed by the practitioner that the specified parties believe are appropriate. Because the needs of the specified parties may vary widely, the nature, timing, and extent of the agreed upon procedures may vary as well; consequently, the specified parties assume responsibility for the sufficiency of the procedures since they best understand their own needs. In an engagement performed under this section, the practitioner does not perform an examination or a review, as discussed in section 101, and does not provide an opinion or negative assurance. Instead, the practitioner’s report on agreed-upon procedures should be in the form of procedures and findings.
In practice, this all gets horribly circular. Per the standard, a client requests an auditor to complete AUP to assist “specified parties” to “evaluate subject matter or an assertion”. In our case, the assertion would be “are hard to value securities valued correctly at quarter end.”
However, the specified party is usually the manager itself, making the client and specified party the same person. The particular trick applied, in many cases, is for the auditor to seek to prevent the investor from actually seeing the AUP in the first place! However, if the investor is to have access to the AUP, the auditor universally requires the investor to sign a Catch 22 document which requires the investor to acknowledge that the AUP are “sufficient for their needs”. So, even if the investor believes that the AUP are not “sufficient for their needs” – which is hardly a long stretch – the investor has to sign that the procedures are sufficient if they are to even see the auditor’s work. With this magic piece of paper, the auditor has met its requirements and can sleep easy. Meanwhile, the auditor will send a bill to – guess who – the fund, meaning that investors have, once more, had to foot the bill.
As always, Caveat Emptor.
www.castlehallalternatives.com
Hedge Fund Operational Due Diligence
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Related hedge fund law articles:
- Hedge Fund Due Diligence
- Hedge Fund Auditor
- Hedge Fund Investors Overview
- Hedge Fund Law Firm
- Hedge Fund Fee Discussion
- ERISA versus Hedge Funds
Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs Hedge Fund Law Blog and can be reached directly at 415-868-5345.
GIPS Compliance Information For Hedge Funds
Hedge Funds and GIPS Compliance
The Chartered Financial Analysts (CFA) Institute has spearheaded and implemented the Global Investment Performance Standards (GIPS) for investment managers as a means of establishing a higher standard for compliance with measurement and reporting of hedge fund performance. GIPS standards set forth a universal set of guidelines and standards for measuring, calculating, and presenting aggregate gain and loss percentages in discretionary, managed investment accounts. Compliance with GIPS standards is voluntary, but it helps investment managers to attract and retain institutional investors who may require a higher standard for disclosure and accurate reporting.
What is GIPS?
The reporting and measuring standards from which GIPS originated were developed by CFA Institute beginning in the late 1980’s and have been gradually modified and reevaluated over the years. While the CFA Institute initiated and funded the development of GIPS, the GIPS Executive Committee is responsible for maintaining the standards. The key provision of GIPS is the requirement to include all of a firm’s fee-paying, discretionary amounts in a ‘composite’, or an aggregate of portfolios that share common investment objectives or strategies. The goal of using composites is to ensure ease of comparability between firms due to enhanced consistency. To further aid the comparison of fund performance, the standards specifically disallow ‘nondiscretionary’ accounts from being included in the composites (where certain client restrictions render the fund’s performance more reflective of the clients’ decisions than the managers’ decisions). Understanding and adhering to strict composite construction requirements is critical to GIPS compliance.
When should a Manager use GIPS?
There are several advantages to complying with GIPS and getting third-party verification. First and foremost is the added credibility of your hedge fund brought on by the claim of compliance (to be used in presentations, marketing materials, advertising, service agreements, etc.). This credibility can help reinforce investor trust and create new relationships with new prospective clients. Secondly, the level of consistency brought on by adherence to GIPS creates a more cohesive set of procedures regarding the calculation and presentation of performance. Thirdly, compliance with GIPS can assist firms with keeping up with the requirements of the SEC and avoid encountering claims of fraudulent conduct. This is especially important for managers who may have had a prior track record with such claims or have had any actions brought against them by the SEC – incorporating GIPS compliance standards into the hedge fund practice will vindicate these managers of their past and help rebuild investor trust.
Twelve Steps to GIPS Compliance
The following procedure has been recommended by GIPS Execute Committee members in order to establish an effective compliance program for your firm.
- Management support. Management must make a commitment of time and resources to bring the firm into compliance.
- Know the Standards. Assign individuals or teams to review and familiarize themselves with the Standards and to complete each subsequent step.
- Define the firm. The definition should accurately reflect how the entity is held out to the public and will determine the scope of firm wide assets under management.
- Define investment discretion. The Standards use the term “discretion” more broadly than just whether or not a manager can place trades for a client. Defining investment discretion is an important step in determining whether or not accounts must be included in a composite.
- Identify all accounts under management within the defined firm over the past five years, or since firm inception if less than five years. This should include all discretionary and nondiscretionary accounts, including terminated relationships.
- Determine if your firm has the appropriate books and records to support historical discretionary account performance.
- Separate the list of accounts into groups based on discretionary status, investment mandate, and/or other criteria. These groups will be the foundation for your composites.
- List and define the composites that will be constructed.
- Document your firm’s policies and procedures for establishing and maintaining compliance with the Standards.
- Document reasons for composite membership changes throughout each account’s history and reasons for nondiscretionary status, if applicable.
- Calculate composite performance and required annual statistics.
- Develop fully compliant marketing materials.
How to Get Started
As of 2007, 28 countries have adopted the GIPS standards or have had their local performance reporting standards endorsed by the GIPS Executive Committee. Formally recognized in 29 major financial markets, GIPS compliances enables investment firms to fairly compete throughout the world and provides a standard framework to ensure that funds’ performance figures are directly comparable. Although it is in the best interest of any investment firm that wants to compete effectively and fairly to adhere to the GIPS standards, the issue for most firms is how to accomplish this successfully and cost-efficiently. For many firms, this may require adding GIPS experts to staff or turning to outside professionals, depending on the firm’s size, available resources, and overall business strategy. There are many GIPS service providers, including software vendors and verification/consulting firms, that can help investments firms become and remain GIPS compliant.
To help you select a service provider to help your firm get started with compliance efforts, you can refer to the list of GIPS Service Providers. You can also find the full text of the GIPS standards here.
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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:
Tech Royalty Starts New Venture Capital Fund
New Investment Fund Focuses on Tech Start Ups
New Trend Emerges in Silicon Valley
The first quarter of 2009 marked the lowest level of investment since 1997, according to the National Venture Capital Associates. The Venture industry in particular has suffered as the number of IPOs and acquisitions has plummeted. In the Silicon Valley, where some of the recessionary fog is now lifting, investors and entrepreneurs have a chance to invest in the market and take advantage of the low valuations. With technology and software tools driving down the cost of starting a tech company by more than 100 times compared with a few decades ago, the potential for a new era of technology investment is emerging. Marc Andreessen, recognized by the venture capital community as an entrepreneurial visionary, has announced the formation of a new fund attempting to take advantage of this new trend.
Marc Andreesen – Industry Icon
Andreessen’s fund, Andreessen Horowitz, is co-founded with Ben Horowitz, an affiliate and partner from their former venture – Netscape. Andreessen moved to Silicon Valley and co-founded Netscape with entrepreneur Jim Clark, funded by blue-chip venture fund Kleiner Perkins. Almost instantly Netscape exploded into a business with enormous profit potential, with this 1995 IPO stock offered at $28 grew up to $75 by the close of trading. However, the glory of Netscape was short-lived, as Microsoft surfaced into the same competitive space and won the battle. Soon thereafter, the investment industry experienced the now-famous dot-com bust, which all but froze the technology industry. Andreessen continued to build his reputation in the Silicon Valley as a well-connected entrepreneur who served as an invaluable vessel of knowledge to other entrepreneurs (i.e. Mark Zuckerberg, CEO of Facebook) in terms of how to build and manage a strong technology company. Now, Andreessen has joined forces with his former colleague, Horowitz, to introduce a new fund that will focus its investment strategies on a diversified portfolio of emerging startups in technology sector.
The New Fund – Strategies and Setbacks
One reason the new fund has the industry buzzing is the sheer amount of financial backing it brings in a time where investor confidence is low. Through a few institutional investors and several key industry players, Andreessen Horowitz was able to pull in approximately $300 million in funds, which amounts to less than one third the size of the biggest boom-year venture funds and qualified Andreessen Horowitz to be regarded as the most prominent fund raised in 2009.
The Andreessen Horowitz investment strategy includes investing in 60-70 startups and having deal days meeting with at least 5-10 companies per day, offering the partners a constant vantage point to target and isolate industry shifts and evaluate what new innovations may be profitable. The fund’s strategy of investing in a myriad of startups does pose potential problems, such as truly tracking and backing the potential downfall of one or several of these many companies, and monitoring potential conflicts where the fund invests in two startup companies that eventually become direct competitors of one another (e.g. Facebook and Twitter). In response to how he plans to guard against such potential setbacks, Andreessen says that he will extensively research and disclose all potential conflicts and take measures to protect confidential information.
What this Means for the Investment Industry
As Andreessen attempts to restore investor confidence by capitalizing on the new rapid emergence of startup technology companies, the hope of generating large, ‘Netscape-esque’ returns sets a new optimistic tone for an otherwise risk-averse financial community. If successful, the new fund could potentially lift the cloud of doubt that looms over the investment industry by employing a strategy that both embraces cutting-edge innovation and provides even the smallest industry players the opportunity to have their ideas seen and heard by renowned industry veterans.
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Please contact us if you have any questions or are interested in starting a hedge fund. Other related hedge fund law articles include:
Hedge Funds with $25MM of AUM to Register Under Commissioner Aguilar’s Plan
SEC Commissioner Aguilar Proposes Registration For Funds with as little as $25MM of AUM
Just today I had an opportunity to review the transcript of a speech by SEC Commissioner Aguilar in which he advocates that funds with as little as $25MM of AUM should register with the SEC. Such a low threshold for registration is troubling in a number of ways. Most importantly is the impact registration would have on the SEC immediately and in the future. As we have seen most vividly over the past year, the SEC is overextended and underfunded. The SEC’s ability to adequately deal with the 9,000 to 12,000 hedge funds which would come under its jurisdicition is suspect. Registration aside, how will an agency which was not able to sniff out a Bernie Madoff be able to oversee such a large industry without making it cost prohibitive for funds to operate? The money required to oversee these funds is likely to be substantial and will probably not be coming from Congress which means the cost of such a regulatory and oversight system will likely fall onto the managers themselves and then of course to the investors.
As we talk about regulation of the hedge fund industry, there is also the question of regulatory resources. Any future registration of hedge fund advisers and/or hedge funds will require that the SEC receive increased resources to provide effective oversight. We will need to hire staff and implementing new technology to effectively deal with a large and complex industry. To that end, I have previously called for Congress to pass legislation establishing the SEC as a self-funded agency, similar to the way other financial regulators are funded — such as the Federal Reserve Bank, the FDIC, OTS and OCC. This would help to solve the problem.
To the extent that funds are registering and reporting to the SEC, I encourage Congress to couple the authority increasing the SEC’s jurisdiction with the appropriate self-funding mechanism to allow us to provide effective oversight.
This is not to say I am not against reasonable, reasoned and fiscally responsible oversight and regulation. I believe that systemic stability is critically important for the long term viability of the hedge fund industry as well as the capital markets. In this vein, I think that Aguilar’s statement below represents the type of structures which would contribute to increased stability while minimizing regulation where it is not necessary.
Perhaps a tiered approach to registration, based on a fund’s potential to affect the market, would make sense. At the lowest tier would be small funds. These funds could be subject to a simple recordkeeping requirement as to positions and transactions, kept in a standardized format, to permit the SEC to efficiently oversee their activities. As funds grow in size, different standards may be appropriate.
While I do not agree with many of the points regarding regulation the Commissioner discussed in the speech reprinted below, I do believe that the Commissioner does a good job at identifying issues which should be discussed publicly as regulators and industry participants move towards creating a reasonable regulatory regime.
Please feel free to include your comments below.
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Speech by SEC Commissioner:
Hedge Fund Regulation on the Horizon — Don’t Shoot the Messenger
by
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
Spring 2009 Hedgeworld Fund Services Conference
New York, New York
June 18, 2009
Thank you for that kind introduction. I am pleased to be here with you at the Spring 2009 Hedgeworld Fund Services Conference. This conference is timely given the current discussion regarding potential regulation of the hedge fund industry. Let me say at the outset, as is customary, my remarks today are my own and do not necessarily reflect the views of my fellow Commissioners or of the Commission staff.
My experience with the securities industry began in the late 1970’s. After three years with the SEC, I’ve spent the bulk of my 30 years as a lawyer focusing on the capital markets. Most of those years where in private practices in large law firms, although I spent most of the 90’s and the early part of this decade as General Counsel and Head of Compliance of a large global asset manager. While I’ve spent much of my professional career involved in capital formation though public and private offerings, a substantial portion has been spent working in the investment management industry, and I have worked with hedge funds.
As we all know, there has been much speculation about the impact of hedge fund activity on the broader capital markets. For example, there are questions about whether hedge funds may have contributed to the market turmoil and how hedge funds may have contributed to the demise of Bear Stearns, Lehman Brothers and others. Additionally, it is also not clear whether the lack of oversight of the industry resulted in large amounts of risk to the market through the use of short sales and derivatives, such as credit default swaps.
This year’s conference takes place at a key moment in the history of hedge funds. While hedge funds have remained largely unregulated, this seems to be coming to an end. All over the world, legislators, regulators, investor groups, industry representatives and others are loudly calling for the industry to be regulated.
In the United States, the calls for regulation are motivated by concerns that market integrity has been harmed and that systemic risk arose as a result of the exemptions and exclusions from the federal securities laws that permitted a private market to thrive in ways that may have harmed the public markets. In fact, the market turmoil clearly demonstrated that the private fund market does impact the broader capital markets. This does not mean that all fund activity must be equally regulated, but hedge funds, especially large ones, are thought to require greater regulatory oversight.
My goal with my remarks today is to:
- First, lay out a current state of affairs regarding the hedge fund industry;
- Second, describe the calls for regulation of the industry; and
- Third, discuss key considerations that need to be assessed as hedge fund regulation moves forward.
Multiple Voices Calling For Regulation
The hedge fund industry looks very different today than from where it started. Since the first hedge fund was organized by Alfred Jones in 1949 with $100,000, the industry has exponentially grown both in number of funds and in number of assets under management. In recent years, this growth has been fueled in part by institutional investors, such as endowments, foundations, insurance companies, and pension plans. To give you an idea of the growth, it is believed that the industry managed around $38 billion in 1990, $625 billion in 2002, and reached $1.9 trillion at the end of 2007, although that the number decreased to $1.3 trillion at the end of 2008. It is still incredible growth from the $100,000 start.
The industry’s growth, and the concerns over the impact of hedge funds on the marketplace, has created a renewed call for regulation in the U.S. and abroad. For example, the European Commission recently proposed to regulate the managers of hedge funds and all private equity funds with 100 million euros in assets under management. The proposed regulations would require extensive disclosure of risk management procedures and other aspects of fund governance.
In the U. S., a few years ago the SEC unsuccessfully attempted to regulate hedge funds. More recently, in March of this year, Treasury Secretary Timothy Geithner testified about his plan to more tightly oversee hedge funds. In addition, there recently have been at least a half-dozen bills introduced in Congress requiring regulation of the hedge fund industry. Just this past Tuesday, Senator Jack Reed introduced a bill that would require that advisers to hedge funds, and to certain other investment pools, to register with the SEC. And yesterday, of course, the Obama Administration released a draft white paper that, among other things, proposes that advisers to large hedge funds register with the SEC, and that very large advisers be subject to additional federal supervision by the Federal Reserve Board.
What are the concerns underlying the call for government oversight? I will tell you what we are hearing. The concerns touch on the classic financial regulatory interests: such as market integrity concerns, systemic risk concerns, and investor protection concerns. This state of affairs is what you would expect when markets are inextricably integrated and the impact of hedge funds is significant, but their actions and their risks are opaque. Simply stated, regulators, legislators and the public have little credible information as to who is out there and what they are doing.
Market Integrity Concerns
Let’s start with the SEC’s responsibility to maintain fair and orderly markets. One of the concerns about hedge funds involves how hedge fund operations impact upon the fairness and the integrity of the broader market. The lack of transparency and oversight over hedge funds gives rise to a number of concerns — for example, market integrity concerns about the nature and extent of counterparty risk, concerns about whether hedge funds engage in insider trading, and questions about how hedge funds drive the demand for derivatives, such as CDSs, as well as how they impact the demand for securitized products.
As a predicate for discussion, let’s be clear about the significant market activity of hedge funds. For example, hedge funds reportedly account for more than 85% of the distressed debt market, and more than 80% of certain derivatives markets. Moreover, although hedge funds represent just 5% of all U.S. assets under management, they account for about 30% of all U.S. equity trading volume. In 2006, there were estimates that hedge funds were responsible for as much as half of the daily trading volume on the New York Stock Exchange.
Because hedge funds are not subject to leverage or diversification requirements, hedge fund managers can more easily take concentrated positions that can impact the market. For example, an entire fund or even multiple funds advised by the same hedge fund manager can be invested in a single position.
In addition, hedge funds are major players in the capital markets for reasons other than trading activity. As this audience knows well, hedge funds have significant business relationships with the largest regulated commercial and investment banks — and act as trading counterparties for a wide range of OTC derivatives and other financing transactions.
Counterparty Risk Concerns
Clearly, for all these reasons and others, hedge funds are significant players in the capital markets. As significant players, hedge funds are one source of counterparty risk, and this risk can be amplified by their leverage and opacity.
Today, commercial banks and prime brokers are called upon to bear and manage the credit and counterparty risks that hedge fund leverage creates. Up until now, it has been assumed that market discipline would effectively prevent hedge funds from detrimentally impacting the capital markets or from posing systemic risk. A January 2008 GAO Report, however, identified several concerns with that theory.[1] For example, the report noted that hedge funds use multiple prime brokers and questioned whether any single prime broker has a complete picture of a hedge fund client’s total leverage. Accordingly, the stress tests and other tools that a prime broker uses to monitor a given counterparty’s risk profile only incorporate the positions known to that particular prime broker. Thus, no single prime broker has the whole picture.
The GAO Report also stated that some counterparties may lack the capacity to assess risk exposures because of the complex financial instruments and secret investment strategies that some hedge funds use.
Unfortunately, the GAO Report also indicates that counterparties facing these structural limitations may have also actively relaxed credit standards in order to attract and retain hedge fund clients in response to fierce competition.
In each of these instances, the risks of hedge funds are being externalized to the regulated market — prime brokers, banks, and their shareholders each were asked to bear the costs of managing hedge fund risks. A concrete example you may remember was when two Bear Stearns-sponsored hedge funds collapsed in 2007. Merrill Lynch, one of the prime brokers, had to absorb an enormous loss because it could only sell the funds’ collateral for a fraction of its purported value.
It’s been obvious that the regulatory oversight of hedge funds has not matched their level of market activity. This difference has led to other concerns affecting market integrity.
Risks of Insider Trading Create Market Wide Concerns
For example, in addition to concerns about counterparty risk, there have also been concerns about hedge funds engaging in insider trading. Clearly, there has been an increase in the number of insider trading cases brought by the Commission that have involved hedge funds. Admittedly, it is incredibly difficult for the Commission to assess the frequency of insider trading because of the opacity of hedge funds and the investments they make, especially in OTC derivatives. Moreover, when you couple this with the fragmented nature of the securities markets and the broad potential for hedge funds to obtain inside information, it is a tough oversight situation indeed. Hedge funds who participate in private placements, talk with trading desks, and maintain connections with the street are, in many cases, in a position to obtain inside information and to use it in a way that traditional surveillance may not detect. This potential for insider trading has been well publicized and public investors are concerned about the possible effects on market fairness and integrity.
Hedge Funds And The Demand For CDS and Securitized Products
Additionally, hedge funds were significant players in the exponential growth in the now much maligned credit default swaps market. As the market to create CDSs grew, there were funds that bought these instruments for reasons that made sense. For example, in 2005 there were hedge funds who noticed that the U.S. housing market was weakening and they bought CDS instruments on the protection buyer side. A logical move.
On the other hand, it is well known that the credit risk reflected by CDSs is equal to multiples of the actual credit risk of the underlying bond market. How did that happen? Many CDSs were heralded as hedging tools — they were supposed to transfer risk to parties that could bear it from parties that could not. Now we see only too clearly that this was not the case. Instead, many CDSs actually created risk, rather than hedged risk. Hedge funds that sought to create profits from leveraged risk may have played a crucial role driving the growth in these products.
Systemic Risks
The concerns about hedge funds and market integrity often go hand in hand with concerns about systemic risk. In their current form, hedge funds pose a systemic risk threat to our financial system in several ways. First, hedge funds have such significant assets under management that some fear that the loss of one or more large firms could potentially reverberate throughout the capital markets. In addition, if a counterparty fails to effectively withstand a hedge fund loss, then the failure of the counterparty could itself threaten market stability.
There is also the issue that can occur when several hedge funds take the same position, whether through coordination or simply through similar trading strategies. These funds can have a large impact on the market when they adjust their positions en masse.
Thus, the concerns that the lack of oversight over the hedge fund industry may present to market integrity and to systemic risks seem to be well founded.
Investor Protection
In addition to concerns about market integrity, the SEC is also responsible for investor protection. Given the increase in complaints from hedge fund investors this has taken on a more immediate importance.
One of the underlying principles behind the idea that hedge funds could operate with little to no regulatory requirements was that interests in the funds were only sold in private offerings to wealthy investors. These investors were thought to be sufficiently “sophisticated” to protect their interests, and to be able to engage in effective arms-length negotiation in order to achieve fair and equitable terms.
I firmly believe that truly sophisticated investors in private deals should be held accountable to the terms that they knowingly negotiate — and if an investment were to go bad, they should bear the loss.
However, with the recent market turmoil and the ongoing economic upheaval that has caused trillions in wealth to vanish, millions of jobs to disappear and the liquidation of over 1,500 hedge funds, serious concerns have been raised about whether these wealthy and sophisticated investors are truly able to protect their interests. There seems to be evidence that these “sophisticated investors” may not have fully appreciated the risks they were taking. Perhaps it may make sense for the definitions of who qualifies as “sophisticated” under our rules to be reconsidered. For example, maybe the criteria for sophistication should focus on more relevant attributes — such as focusing on actual investment experience.
In any case, recent events have challenged the assumption that investors and market discipline can be relied upon to control the risks of hedge funds. And this is not surprising. First, these investors are typically passive and there is no legal obligation for hedge fund investors to monitor hedge fund activity. Second, even if investors wanted to actively monitor the investment, the nature of hedge fund activity and the information available may not currently support such a role.
Valuation and Performance
For example, it may be impossible for an investor to know the actual value of a hedge fund’s portfolio. Hedge funds are not subject to reporting requirements and because many instruments held by a hedge fund are illiquid or opaquely-priced OTC products, any information that is reported could be hard to evaluate.
Related to the concern of how a fund values its assets, is a hedge fund’s performance information — another hard to evaluate metric for investors. Without regulation, the only performance information that hedge funds provide is voluntary.
This quote by Harry Liem, a pension consultant, seems to sum it up when he said “It’s like someone walking into a casino and saying ‘I want everyone to come forward and tell me how much you have won or lost.’ Probably only the winners will come forward . . .”[2]
Not Being Able to Redeem
There is also the issue of investors not being able to redeem their investments from a fund. In recent times, due to the large amount of redemption requests and the current lack of an ability to raise cash, there are hedge fund managers who have put up gates and have restricted investors’ ability to redeem their monies. Although gates can benefit investors by giving the manager more time to sell off portfolio positions, for some investors it appeared to be a surprise.
On top of that, several hedge fund managers froze funds but continued to charge management fees on money that investors cannot access. Orin Kramer, a hedge fund manager, described the situation by stating: “It’s like telling someone at a hotel that they can’t check out and then charging them for the privilege of staying.”[3]
Let me be clear. I’m not saying that these situations are per se illegal. To the extent that sophisticated and qualified investors agreed to provisions providing for gates and the ongoing charge of management fees, one could say that investors walked into these agreements with open eyes.
However, because for the most part hedge funds are not registered with the SEC, we are not able to adequately oversee how they are operating. Moreover, this lack of transparency makes it difficult to assess whether the relationship between an investor and the hedge funds adviser, is functioning in the manner that underlie the presumptions that led to the exemptions.
Some recent reports do tend to show that investors are beginning to take their own initiatives, and give some indication that what investors may be willing to agree to in the future may be different. For example, a recent memo from CalPERS stated that it would no longer partner with managers whose fee structures result in a clear misalignment of interest between managers and investors. Moreover, more investors are now asking that hedge funds run assets in “managed accounts,” where their money is held separately and the holdings are transparent.
As you may expect based on concerns including ones I have mentioned, hedge fund investors have been calling the Commission in unprecedented numbers
Increased Cases Involving Hedge Funds
In fact, the Commission has more investigations involving hedge funds than ever before, and the number of cases actually brought also is increasing. In the first 4 months of 2009, the Commission filed 25 cases related to hedge funds. In contrast, we brought 19 cases in all of 2008, 24 in all of 2007, and 16 in 2006. Our cases cover the waterfront, charging everything from offering fraud and insider trading, to misrepresentations about performance and to misrepresentations about the actual due diligence undertaken. We are also seeing more cases involving conflicts of interest and outright theft of assets
Nature of Regulation
I have just laid out for you some of the concerns that are generally driving the calls for greater regulation and oversight of the hedge fund industry. Maybe even more important, it appears that some of the assumptions justifying the industry’s exclusion from regulation and oversight may be on faulty ground. As a result, it seems certain that regulation of the hedge fund industry is coming. But here is the harder question — what should it look like?
There are a number of questions as to exactly how, and to what extent, hedge funds may have contributed to the economic crisis and how they contributed to the overall systemic risk of the financial markets. To that end, I applaud Congress and President Obama for providing for an independent, bi-partisan Financial Crisis Inquiry Commission. By investigating and analyzing what happened, we can better assess whether the regulatory proposals should move forward.
Since coming to the Commission, I have been a vocal advocate for the Commission’s mission to protect investors, provide for fair and orderly markets, and promote capital formation. All aspects of this mission guide my thoughts as we consider the appropriate framework to regulate hedge funds.
Because of the size, complexity and market-wide impact of the hedge funds industry, potential regulation would need to be both comprehensive and flexible. Something not always easy to achieve.
I believe that the SEC must be an active participant in this process. Please remember that the SEC has been overseeing industry participants — such as, investment companies, investment advisers and broker-dealers — for over 69 years. The Commission staff has unsurpassed expertise in this area. Congress should take advantage of this expertise by providing the Commission with a broad mandate to oversee hedge funds. The Commission could then scale its regulation in a flexible manner to deal with the regulatory concerns of market integrity, investor protection, and, in coordination with other regulators, systemic risk.
Working with hedge fund advisers and with hedge fund investors, I am confident that we can find an appropriate balance.
As you know, there has been a general discussion over whether hedge fund advisers and/or hedge funds should register. In my mind, hedge funds advisers with over $25 million in assets should register with the Commission, but that may not be enough. Many hedge fund advisers are currently registered with the SEC but we still lack a complete picture of what is going on in the industry. Some have suggested that hedge funds should also register. Others have suggested that it may be appropriate to apply limited concepts from within the Investment Company Act of 1940 to hedge funds — what some have called a “40 Act-lite” regime.
Perhaps a tiered approach to registration, based on a fund’s potential to affect the market, would make sense. At the lowest tier would be small funds. These funds could be subject to a simple recordkeeping requirement as to positions and transactions, kept in a standardized format, to permit the SEC to efficiently oversee their activities. As funds grow in size, different standards may be appropriate.
For funds that could significantly affect the market, it may be appropriate to require more than recordkeeping. For example, it may be appropriate to think through whether some of the risk limitation concepts built into the Investment Company Act make sense to apply to these hedge funds — such as imposing limits on leverage.
Of course, these are only a few suggestions. Many others have been made — and others will follow — as the discussion turns from “whether to regulate” to “how to regulate.” The nature of the business of hedge funds is trading, and this necessarily requires interaction with the public marketplace — and the larger the investment fund, the greater the potential impact on the overall capital markets. When the hedge industry has the ability to significantly impact the market or other market participants, the public interest needs to be protected. A lesson of this economic crisis is that the U.S. regulatory interest in hedge funds arises because of the impact of the funds on the financial market, regardless of the sophistication of its investors or the number of investors.
When discussing “how to regulate,” it is clear to me that regulation is more than the bare requirements of registering and reporting — it should also include inspection authority. To have a chance to prevent problems before they occur, the SEC has to be able to inspect all hedge fund advisers, and the funds that they manage, and otherwise engage in oversight through surveillance systems. The public expects nothing less.
Greater Resources to SEC to Provide Effective Oversight
As we talk about regulation of the hedge fund industry, there is also the question of regulatory resources. Any future registration of hedge fund advisers and/or hedge funds will require that the SEC receive increased resources to provide effective oversight. We will need to hire staff and implementing new technology to effectively deal with a large and complex industry. To that end, I have previously called for Congress to pass legislation establishing the SEC as a self-funded agency, similar to the way other financial regulators are funded — such as the Federal Reserve Bank, the FDIC, OTS and OCC. This would help to solve the problem.
To the extent that funds are registering and reporting to the SEC, I encourage Congress to couple the authority increasing the SEC’s jurisdiction with the appropriate self-funding mechanism to allow us to provide effective oversight.
Conclusion
In conclusion, I am confident that regulation of the hedge fund industry can be done right — in a way that balances the needs of the industry with the needs of investors and the needs of the market. And if it is, it will be a good thing for all of us. The Congressional Oversight Panel’s Special Report on Regulatory Reform4 said it best with the following summary:
“By limiting the opportunities for deception and allowing for the necessary trust to develop between interconnected parties, regulation can enhance the vitality of the markets. Historically, new regulation has served that role.
For example, as the money manager Martin Whitman has observed, far from stifling the markets, the new regulations of the Investment Company Act enabled the targeted industry to flourish:
“’Without strict regulation, I doubt that our industry could have grown as it has grown, and also be as prosperous as it is for money managers. Because of the existence of strict regulation, the outside investor knows that money managers can be trusted. Without that trust, the industry likely would not have grown the way it had grown.’”[5]
The lack of transparency, potential imbalance of power between investors and managers, and impact on the entire capital market are driving the calls to regulate the hedge fund industry. The hedge fund industry has a lot to offer in determining how these calls are answered. Addressing these issues in an intelligent and rational manner is important, and ultimately will result in a stronger and more vibrant hedge fund industry. I welcome the ongoing discussion.
Thank you for inviting me here today.
Endnotes
[1] GAO Report: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention is Needed. January 2008. pg 27.
[2] Why people love to hate those risky hedge funds; An investment option that only the super rich can afford, by Naomi Rovnick. South China Morning Post Ltd. March 1, 2009.
[3] Hedge Funds, Unhinged by Louise Story. New York Times. January 18, 2009.
[4] Congressional Oversight Panel’s Special Report on Regulatory Reform: Modernizing the American Financial Regulatory System: Recommendations for Improving Oversight, Protecting Consumers, and Ensuring Stability. January 2009. pgs 18-19
[5] Letter from Third Avenue Funds Chairman of the Board Martin J. Whitman to Sharheolders, at 6 (Oct. 31, 2005) (online at www.thirdavenuefunds.com/ta/documents/sl/shareholderletters-05Q4.pdf).
http://www.sec.gov/news/speech/2009/spch061809laa.htm
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Please contact us if you have any questions or would like to learn how to start a hedge fund. Other related hedge fund law articles include:
- MFA Supports Hedge Fund Registration
- Geither Urges Regulation of Hedge Funds
- Obama and Hedge Fund Regulation
- GAO Report on Hedge Fund Due Diligence
- Start Up Hedge Fund Presentation
- Hedge Fund Transparency Act
- Hedge Fund Adviser Registration Act of 2009
- Forex Hedge Fund
Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.
Private Fund Transparency Act of 2009
Another Bill Introduced in Senate to Regulate Hedge Funds
Congress now has three separate bills regarding hedge fund registration. The most recent bill is called the Private Fund Transparency Act of 2009 and was introduced by U.S. Senator Jack Reed (D-RI) on June 16, 2009.
I will continue to update this post over time, but for now I have included the text of a press release from Senator Reed on the proposed bill.
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June 16, 2009
Press Release
Reed Introduces Bill to Regulate Hedge Funds
WASHINGTON, DC — In an effort to strengthen financial oversight of hedge funds and other private investment funds, U.S. Senator Jack Reed (D-RI), today introduced the Private Fund Transparency Act of 2009, which will help protect investors, identify and mitigate systemic risk, and prevent fraud. This legislation amends the Investment Advisers Act of 1940 to require advisers to hedge funds, private equity funds, venture capital funds, and other private investment pools to register with the Securities and Exchange Commission (SEC).
“Hedge funds have played an important role in providing liquidity to our financial system and improving the efficiency of capital markets. But as their role has grown so have the risks they pose. This bill provides the SEC with long-overdue authority to examine and collect data from this key industry. It also authorizes the SEC to share this data with other federal agencies in order to create a system-wide approach to identifying and mitigating risks,” said Reed, who chairs the Banking Subcommittee on Securities, Insurance, and Investment.
Private funds are not currently subject to the same set of standards and regulations as banks and mutual funds, reflecting the traditional view that their investors are more sophisticated and therefore require less protection. This has enabled private funds to operate largely outside the framework of the financial regulatory system even as they have become increasingly interwoven with the rest of the country’s financial markets. As a result, there is no data on the number and nature of these firms or ability to calculate the risks they pose to America’s broader economy.
“The financial crisis is a stark reminder that transparency and disclosure are essential in today’s marketplace. Improving oversight of hedge funds and other private funds is vital to their sustainability and to our economy’s stability. These statutory changes will help modernize our outdated financial regulatory system, protect investors, and prevent fraud,” concluded Reed.
Specifically, the Private Fund Transparency Act of 2009 will:
- Require all hedge fund and other investment pool advisers that manage more than $30 million in assets to register as investment advisers with the SEC. The remaining smaller funds will continue to fall under state oversight.
- Provide the SEC with the authority to collect information from the hedge fund industry and other investment pools, including the risks they may pose to the financial system.
- Authorize the SEC to require hedge funds and other investment pools to maintain and share with other federal agencies any information necessary for the calculation of systemic risk.
- Clarify other aspects of SEC’s authority in order to strengthen its ability to oversee registered investment advisers.
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There have been two other proposed bills:
Additionally, I recommend you read about Obama’s plans for hedge fund regulation.
Northwest Hedge Fund Society Event
Green Hedge Fund Discussion
The Northwest Hedge Fund Socitey will be having an event on Thursday, May 21 at 6pm. I will be attending this event and in Seattle that day as well.
Event Details:
This event is generously sponsored by EzeCastle Integration and NorthPoint Trading Partners, LLC. Eze Castle Integration is the market leader in outsourced IT technology and services for hedge funds and other specialty investment-management firms. NorthPoint Trading Partners offers industry-leading prime brokerage services to Hedge Funds as well as Long-only Asset Managers. The firm has a reputation for exceptional client service and competitive pricing. Through their multiple clearing relationships, fund managers have the advantage of choosing clearing and custody services from the industry’s largest global providers.
Moderator:
- John Kilpatrick, Managing Member, Greenfield Advisors LLC
Panelists:
- Mark Cox, CEO, New Energy Fund LP
- Gautam Barua, Partner, Aclaria Capital
- Steve Hall, Managing Director, Vulcan Ventures
- John Siegler, Managing Director, Ridgecrest Capital Partners
Location:
The Harbor Club: 801 Second Avenue, Suite 17, Seattle, WA 98104
Important Information Regarding Parking:
Parking is available in the Norton Building Garage below the club. However, please note that valet parking is effective until 6:30 each evening. If you park here during the valet hours and stay through the end of the event, your keys will be brought to the club’s front desk when the garage converts to standard parking.
The Norton Building Garage can fill up quickly. As an alternative, the Harbor Club recommends the CPS Parking located at 721 1st Avenue.
· Free for Members
· Non-member fee: $75
Hedge Fund Regulation Hearing May 7
Congress Looks to Regulate Hedge Funds
According to an article by Reuters, the U.S. House Financial Services Committee will be holding a hearing on hedge fund regulation. The meeting is expected to be held on May 7. The HouseFinancial Services Committee website has not yet announced the hearing. We will keep up to date on this issue and will publish any updates below.
Related hedge fund law stories include:
NFA Branch Office Designation
CPO and CTA Information on Branch Offices
Many commodity pool operators and commodity trading advisors are large enough that they have more than one central office. Even small CPOs and CTAs may have more than one central office. In these situations the CPO or CTA is deemed to have both a main office as well as one or more branch offices. A branch office will need to have a branch office manager who has taken the Series 30 exam.
What is a “branch office” for CFTC / NFA Purposes?
The term “branch office” is not really defined in any meaningful way in the Commodities Exchange Act but the CFTC Regulation 166.4 specifically discusses branch offices. The NFA too has promulgated rules on branch offices (see below) and has also published an Interpretive Release on Branch Offices (see below). The Interpretive Release gives the best definition of what exactly a branch office is:
Any location, other than the main business address at which an FCM, IB, CPO or CTA employs persons engaged in activities requiring registration as an AP, is a branch office. This is true even if there is only one person at the location.
Series 30 Exam for Branch Office Managers
Each branch office must have an Associated Person who is licensed as a branch office manager. According to the NFA Interpretive Release:
Each location must have a branch office manager, and that person’s status as a branch office manager should be listed in the Registration Categories section of the person’s Form 8-R even if previously listed as a principal in the Registration Categories section of the person’s Form 8-R. Each branch office must have a different manager.
Each branch office manager must pass a proficiency exam called the Series 30 exam unless the branch office manager is sponsored by a registered broker-dealer and is qualified to act as a branch office manager under the rules of either the New York Stock Exchange or the Financial Industry Regulatory Authority. The NFA has provided the following overview of the Series 30 exam requirement:
NFA must receive evidence that individuals applying to be a branch office manager have passed the Series 30. However, NFA will not require evidence that they have passed the Series 30 if, since the date they last ceased acting as a branch office manager, there has not been a period of two consecutive years during which they have not been registered as an AP. Additionally, individuals whose sponsor is a registered broker-dealer may, in lieu of the Series 30, provide proof that they are qualified to act as a branch office manager or designated supervisor under the rules of FINRA.
The Series 30 exam is called the Branch Manager Exam – Futures. The exam is 50 questions long (multiple choice and true/false) and applicants must answer at least 70% correct in order to pass. It is broken up into eleven main parts and the applicants will have 1 hour to complete the exam. For more information, please see our detailed discussion about the Series 30 exam.
Other Branch Office Issues
The CPO or CTA, as well as the branch office manager, must be aware of a couple very important issues with regard to the branch office:
1. Branch office cannot be a separate corporation.
2. Branch office APs must be paid directly by the Member firm.
Hypothetical Example
A typical question we receive involves whether certain activity (even activity out of a home office) rises to the level of a branch office. Generally the answer is going to be, if you have to ask then it will probably be considered a branch office. Please note that the NFA has taken a very hard stance on this issue – I have had conversations with NFA examiners when they specifically questioned me regarding the activities of a firm. Additionally, the following bold text is part of the NFA Interpretive Release:
IF YOUR FIRM CURRENTLY HAS PERSONS OPERATING OUT OF LOCATIONS OTHER THAN ITS MAIN BUSINESS ADDRESS, THOSE LOCATIONS MUST IMMEDIATELY BE REPORTED TO NFA BY FILING AN UPDATE ELECTRONICALLY TO THE FIRM’S FORM 7-R AND BY ADDING BRANCH OFFICE MANAGER STATUS ON EACH BRANCH OFFICE MANAGER’S FORM 8-R.
Application to Forex Managers
Managers who trade in the off-exchange spot forex markets may be subject to reqistration requirements in the near future. If this is the case then it is likely that those firms which register and become NFA Members will need to adhere to the branch office rules as well. This means that a forex branch office manager would likely need to have Series 3, Series 30 and Series 34 exam licenses.
Conclusion
CPO and CTA managers should be very aware of this potential issue. If there are questions regarding a branch office, the manager should immediately speak with an attorney.
Various laws and rules which are applicable are provided below. Please contact us if you have a question on this issue or if you would like to start a hedge fund, CPO or CTA. If you would like more information, please see our articles on starting a hedge fund. Other related hedge fund law articles include:
- How to register as a CPO or CTA
- CPO Exemptions
- CTA Exemptions
- Hedge Fund Licenses
- Forex Hedge Fund Articles
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Below are some various primary sources on branch offices.
CFTC Regulation § 166.4
Branch offices.
Each branch office of each Commission registrant must use the name of the firm of which it is a branch for all purposes, and must hold itself out to the public under such name. The act, omission or failure of any person acting for the branch office, within the scope of his employment or office, shall be deemed the act, omission or failure of the Commission registrant as well as of such person.
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[¶ 9002] REGISTRATION REQUIREMENTS; BRANCH OFFICES
(Staff, September 6, 1985; revised July 1, 2000 and December 9, 2005)
INTERPRETIVE NOTICE
Form 7-R, Branch Offices
Any location, other than the main business address at which an FCM, IB, CPO or CTA employs persons engaged in activities requiring registration as an AP, is a branch office. This is true even if there is only one person at the location. If the firm has one or more branch offices, NFA’s registration records on the firm must include the names of all persons who are branch office managers. Each location must have a branch office manager, and that person’s status as a branch office manager should be listed in the Registration Categories section of the person’s Form 8-R even if previously listed as a principal in the Registration Categories section of the person’s Form 8-R. Each branch office must have a different manager.
The address must also be given for each branch office. A P.O. Box is not sufficient. Anyone with a status as branch office manager must also be currently registered as an AP or have applied for such registration. Whenever a new branch office is established it must be reported, with all the required information, to NFA by filing an update electronically to the firm’s Form 7-R. The closing of an existing branch office should also be reported by filing an update electronically to the firm’s Form 7-R.
IF YOUR FIRM CURRENTLY HAS PERSONS OPERATING OUT OF LOCATIONS OTHER THAN ITS MAIN BUSINESS ADDRESS, THOSE LOCATIONS MUST IMMEDIATELY BE REPORTED TO NFA BY FILING AN UPDATE ELECTRONICALLY TO THE FIRM’S FORM 7-R AND BY ADDING BRANCH OFFICE MANAGER STATUS ON EACH BRANCH OFFICE MANAGER’S FORM 8-R.
NFA may take disciplinary action against any Member which fails to properly list all of its offices.
An important point to recognize is that a branch office may not itself be a separate corporation or partnership. CFTC Regulation 166.4 requires each branch office to use the name of the firm of which it is a branch for all purposes and to hold itself out to the public under such name. Also, in CFTC Interpretive Letter No. 84-10 (May 29, 1984) it was concluded that a branch office could not maintain a separate identity from the Member. One obvious conclusion to be drawn from this information is that each AP in a branch office must be paid directly by the Member. Payment through any intermediary would lead to the assumption that the intermediary would be required to register as an IB.
The requirement that a branch office hold itself out to the public under the name of the Member is intended to ensure that customers are always aware of the Member with which they are doing business. It is necessary that any branch office AP, even one operating out of a residence or an unrelated place of business, make sure that customers understand who they are doing business with.
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[¶ 5053] RULE 2-7. BRANCH OFFICE MANAGERS AND DESIGNATED SECURITY FUTURES PRINCIPALS.
[Adopted effective September 30, 1992. Effective date of amendments: January 28, 1994; August 21, 2001; December 9, 2005; and December 17, 2007.]
(a) No Member shall allow an Associate to be a branch office manager unless:
(1) The Associate has taken and passed the “Branch Manager Exam-Futures”: Provided, however, that any Associate who subsequently ceases acting as a branch manager will not be required to retake and pass the examination in order to resume acting as a branch manager unless after acting as a branch manager the Associate was not registered in any capacity for a period of more than two years; or
(2) The Associate is sponsored by a registered broker-dealer and is qualified to act as a branch office manager under the rules of either the New York Stock Exchange or the Financial Industry Regulatory Authority.
(b) Each Member registered as a broker-dealer under Section 15(b)(11) of the Exchange Act must have at least one designated security futures principal. No such Member shall designate a person as a security futures principal unless:
(1) The person is a partner, officer, director, branch office manager or supervisory employee of the Member;
(2) The person is a Member or an Associate of the Member as defined in Bylaw 301(b); and
(3) The person has taken and passed the “Branch Manager Exam-Futures.”
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[¶ 9019] COMPLIANCE RULE 2-9: SUPERVISION OF BRANCH OFFICES AND GUARANTEED IBS
(Board of Directors, October 6, 1992; revised July 24, 2000)
INTERPRETIVE NOTICE
NFA Compliance Rule 2-9 places a continuing responsibility on every Member to diligently supervise its employees and agents in all aspects of their futures activities. Rule 2-9 applies not only to the supervision of branch office operations, but also imposes a direct duty on guarantor FCMs to supervise the activities of their guaranteed IBs. NFA Compliance Rule 2-23 provides that a guarantor FCM may be held jointly and severally subject to discipline by NFA for violations of NFA rules committed by the FCM’s guaranteed IBs. In practice, NFA’s Business Conduct Committee has charged FCMs under Rule 2-23 only where it appears that the guarantor failed to diligently supervise its guaranteed IBs.
NFA recognizes that, given the differences in the size of and complexity of the operations of NFA Members, there must be some degree of flexibility in determining what constitutes “diligent supervision” for each firm. It is NFA’s policy to leave the exact form of supervision to the Member, thereby providing the Member with flexibility to design procedures that are tailored to the Member’s own situation. Nevertheless, NFA’s Board of Directors believes that it is appropriate to provide Members with specific minimum standards for a supervisory program for branch offices and guaranteed IBs (“remote locations”) and therefore issues the following Interpretive Notice.
Though Members may tailor their supervisory procedures to meet their particular needs, any adequate program for supervision must include procedures for performing day-to-day monitoring and surveillance activities, conducting on-site visits of remote locations and conducting ongoing training for firm personnel. The firm’s policies and procedures, including those for the supervision of branch offices and guaranteed IBs, should be in written form. Firm personnel and guaranteed IB personnel should be provided a copy of the appropriate policies and procedures relating to their duties, and be aware of the firm’s requirements. A copy of all policies and procedures should be on file with the branch office or guaranteed IB. All supervisory personnel should be knowledgeable of the firm’s requirements for supervision.
I. Day-to-Day Monitoring
On a regular basis a Member should perform a number of supervisory procedures in order to monitor the business being conducted in its remote locations. The extent of the supervision depends on a number of factors, including the volume of trading, the experience of the personnel, the nature of the customers, the trading strategies followed by the office or certain APs, the number of customer complaints and the length of time that the office has conducted business with the firm. Repeated problems in any particular area should heighten the level of scrutiny and follow-up by the main office or guarantor.
The procedures to review the day-to-day activities of an office should include the following areas.
Hiring. An adequate program for supervision must include thorough screening procedures for prospective employees to ensure they are qualified and to determine the extent of supervision the person would require if hired. The appropriate documentation to support any “yes” answers on the Form 8-R should be obtained and reviewed for potential disqualifying information. Derogatory information, which the applicant may have submitted in connection with any past regulations, should be obtained from NFA.1 Prior employers should be contacted to confirm the person’s previous work experience.
In connection with the review of the person’s prior work experience, a prospective employer should check for any futures-related disciplinary proceedings against the person’s prior employer.2 This information should be used by the prospective employer to determine the extent of supervision a particular applicant would require after he or she is hired.
Due Diligence Check of Guaranteed IBs. Guarantor FCMs must do a due diligence inquiry before entering into a guarantee agreement. The due diligence review must include a check to ensure that the IB is properly registered. The FCM’s due diligence review should also include inquiries concerning the disciplinary history of the IB and the disciplinary and employment history of the IB’s principals and APs. This type of information could be helpful to a prospective guarantor in determining the types of difficulties, if any, experienced by an IB, its principals and APs in the past and the extent of supervision which may be required of that IB under a guarantee agreement. For example, if the APs at a certain IB have received their futures training and experience at a firm or firms that have been subject to serious disciplinary actions by NFA or the CFTC, that IB may well require more supervision. Both registration and disciplinary information is readily available from NFA.3
Registration. Records of commissions payable to or generated by the branch office or guaranteed IB should be broken down by sales person and should be frequently reviewed to ensure that no commissions are being paid to unregistered individuals.
Customer Information. NFA Compliance Rules require each Member to adopt and enforce procedures regarding customer information and risk disclosure. The procedures for opening new accounts should require that the appropriate account documentation, including an acknowledgment of receipt of the required risk disclosure statement, be forwarded to the main office or guarantor.4 The documentation should be reviewed to ensure that the appropriate supervisory personnel approved the account. The information obtained from a customer should be reviewed to determine whether additional risk disclosure should have been provided to the customer. For any customer who should have received additional risk disclosure, the main office or guarantor should ensure that additional disclosure has been given and that such disclosure has been documented. It may also be necessary to contact the customer to verify that the disclosure was provided and that the customer understood its meaning. Notwithstanding these procedures, a firm may wish to require that all new account information and documentation be forwarded to the main office or guarantor for approval before trading commences in the account.
Account Activity. The trading activity in customer and AP personal accounts should be reviewed and analyzed on a regular basis in order to highlight those accounts which may require further scrutiny. There are a number of calculations and comparisons which can be performed to flag accounts for follow-up or further monitoring. For example, significant losses, commission charges or number of trades should be reviewed for inappropriate trading strategies. The reason for error and correction entries to trading accounts should be investigated, especially if there appears to be a pattern of errors or corrections made by an office. Commission-to-equity ratios should be calculated for discretionary accounts to detect possible excessive trading. In order to identify improper trade allocations for discretionary accounts or front running, the trading results in an AP’s personal account should be compared to the trading gains and losses in his or her customer accounts. Profitable customer accounts for a given AP should be reviewed for possible preferential treatment.
Appropriate supervisory personnel at the remote location should be notified of questionable account activity. Measures should be taken to follow up, such as reviewing order tickets and trade blotters, discussing the activity with the broker or contacting the customer.
Discretionary Accounts. NFA Compliance Rule 2-8 contains detailed requirements concerning the supervision and review of discretionary accounts. The written customer authorization and customer acknowledgment for third-party account controllers should be forwarded to the main office or guarantor. 5 Confirmation of the registration history of APs of FCMs and IBs exercising discretion should be made to ensure that they have been properly registered for the requisite two-year minimum.
Promotional Material. NFA Members are required by rule to adopt and enforce procedures regarding communications with the public. All promotional material should be submitted by the branch office or guaranteed IB to the home office or guarantor for review and approval prior to its first use. Review and approval of the material should be documented by the appropriate supervisory personnel.
Customer Complaints. An adequate system for handling customer complaints should require that a written record of all complaints be maintained, and that complaints which meet certain criteria be sent to the main office or guarantor. Notification of the main office of customer complaints may be based on factors including the seriousness of the allegations of wrong-doing, the monetary amount involved, and which APs or principals are subjects of the complaints. If the remote location is responsible for resolving customer complaints, the home office or guarantor should also be notified of the outcome of resolved complaints. Notwithstanding these criteria, a firm may wish to consider having all customer complaints received by a remote location submitted to the main office.
The main office or guarantor should review the complaints for possible rule violations. It should also compare the allegations in the complaint for similarity to other complaints received against the same individuals or office. Such a review may detect a pattern of sales practice or other abuses.
The status of unresolved complaints should be periodically reviewed to ensure that the branch office or guaranteed IB has promptly responded to complainants.
II. On-Site Visits
In addition to day-to-day supervisory procedures, adequate supervision of the personnel who do work in the main office must also include periodic on-site inspections. As a general matter, NFA would expect these on-site inspections of guaranteed IBs or branch offices to be performed annually.
Members should develop written procedures for the on-site review process including detailed steps to be followed during the visit. This will help ensure that the review process is performed in a consistent manner and will not vary due to the involvement of different personnel in the review process. A Member’s supervisory procedures should also address the number of visits to be made to a branch office or guaranteed IB. The frequency and nature of the visits, as well as whether the visit will be announced or unannounced, will depend on a number of factors including: the amount of business generated; the number of customer complaints received; the previous training and experience of the branch office personnel; and the frequency and nature of problems or concerns that arise as the result of day-to-day monitoring and surveillance of the office’s activities. The personnel who make the visits should be qualified to perform examinations and knowledgeable of the industry and the nature of the firm’s business. Such personnel should be able to perform their work with an independent, objective perspective.
The length of time between visits to the remote location coupled with the size and scope of its operation also plays a role in determining the procedures for on-site review of records and account documentation.6 In reviewing a smaller operation, it is feasible to conduct a comprehensive review of the remote location’s records and documents over the entire time period between visits, while reviewing a larger scale operation may require the selection of a sample of records and documents for given time intervals. The selection of samples should be accomplished on a random basis, for example, selecting every third account for review for randomly selected time periods.
Promptly after the completion of an on-site visit, a written report should be prepared and its findings discussed with the branch office and regional managers or guaranteed IB’s principals and supervisory personnel. Follow-up procedures should also be performed to ensure that any deficiencies revealed during an on-site visit are promptly corrected. The written procedures for the on-site examination should include steps to review the following areas:
Customer Order Procedures. An on-site visit to a remote location should include a review of procedures for handling and recording customer orders. The individuals responsible for accepting customer orders should be identified and a sample of a order tickets should be selected for review. NFA recommends that order tickets be prenumbered and that the on-site review test to ensure that all order tickets within the chosen samples are accounted for. The order ticket review should also confirm that all order tickets are properly time stamped and that all information required by CFTC Regulation 1.35 is included. If option orders are placed by the branch office or guaranteed IB, those order tickets should be reviewed to ensure that they contain the additional information required by CFTC Regulation 1.35.
Discretionary Accounts. If a branch office or guaranteed IB handles discretionary accounts, the supervisory visit should confirm that the branch office or guaranteed IB identifies discretionary orders as such and that the firm’s procedures regarding the supervision of discretionary trading activity are followed. In the event a branch office or guaranteed IB enters block orders, those orders should be reviewed to confirm that customer orders are not included with proprietary orders and that nondiscretionary customer orders are not included with discretionary customer orders. Split fills should be reviewed to ensure that they have been allocated according to established procedures.
Sales Practices. The on-site visit should include a review of sales solicitation practices as well as any promotional material utilized. A suggested starting point for review of the sales solicitation practices of a branch office or guaranteed IB is to identify the persons involved in sales solicitation and to confirm that they are properly registered. The individuals conducting the on-site review should also monitor sales solicitations while at the branch office or guaranteed IB. Interviews with selected customers should be conducted concerning the solicitation process and the handling of the customer’s account. The individuals at the branch office or guaranteed IB responsible for supervising sales solicitations should be identified, and the method by which sales solicitations are supervised should be reviewed for adequacy.
The branch office or guaranteed IB’s promotional material, including sales solicitation scripts, must be approved by appropriate supervisory personnel. Therefore, an on-site visit should be designed to ensure that the branch or guaranteed IB is not using any promotional material that has not received prior approval. If the main office or guarantor has not approved the promotional material, it should be reviewed during the on-site visit.
Customer Complaints. The on-site review should include steps to confirm that all complaints requiring notification have been reported to the main office.
Handling of Customer Funds. In order to assure that customer funds are being properly handled by a branch office, the on-site review should determine whether the branch office accepts funds from customers and, if so, whether appropriate bank accounts, including segregated accounts for customer funds, have been established by authorized personnel. In addition, for guaranteed IBs, the on-site review should confirm that if funds are accepted from customers, they are received in the name of the FCM. The branch office or guaranteed IB should make copies of any customer checks that they deposit into a qualifying or branch bank account. The check copies should be reviewed during the visit to ensure that the branch office or guaranteed IB only accepts checks made payable to the FCM. In addition, third-party checks should be scrutinized to ensure that no customers are acting as unregistered FCMs or CPOs. If the guaranteed IB receives customer funds in the FCM’s name, the review should confirm that the proper authorization to do so exists, that appropriate bank accounts are maintained and that proper procedures for forwarding the funds have been established and are followed. For both branch offices and guaranteed IBs, the flow of customer funds in a sample of accounts should be reviewed to determine that all funds have been timely transmitted and properly credited.
Proprietary Trading. To the extent feasible, there should be a separation of duties between persons handling customer orders and firm employees or principals trading for the firm’s proprietary accounts or their own accounts to prevent misuse of non-public information or the occurrence of other trading abuses.
III. Ongoing Training
A Member’s supervisory responsibilities include the obligation to ensure that its employees are properly trained to perform their duties. Procedures must be in place to ensure that employees receive adequate training to abide by industry rules and regulations and to properly handle customer accounts and that APs have completed the ethics training required by CFTC Regulation 3.34. Employees must be educated on developments and changes in the markets, futures products, rules and regulations, technology, and firm policies and procedures. The formality of a training program will depend on the size of the firm and the nature of its business. The individuals responsible for providing the training must be qualified to do so.
Certain APs may require training for soliciting and handling customer accounts. If an AP has previously worked at firms closed through an enforcement action for sales fraud and has therefore received his or her training from such firms, that AP may need specialized training in proper sales practices.
This Notice is intended to specify minimum supervisory standards for branch offices and guaranteed IBs. A failure to adhere to the requirements specified in this Notice will be deemed a violation of NFA Compliance Rule 2-9.
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1 The detailed explanation of any “yes” answers on an 8-R is treated as nonpublic information; however, it is available to prospective employers under NFA Registration Rule 701(c). See Interpretive Notice at ¶9010.
2 Information concerning futures-related disciplinary proceedings can be obtained by checking the BASIC system on NFA’s web site at www.nfa.futures.org, sending a request to NFA through the “contact” feature of the web site, or calling NFA’s Information Center at (800) 621-3570. See Interpretive Notice at ¶9010.
3Registration Information is also available by checking the BASIC system on NFA’s web site at www.nfa.futures.org, sending a request to NFA through the “contact” feature of the web site, or calling NFA’s Information Center at (800) 621-3570. See Interpretive Notice at ¶9007.
4 NFA Rules require that a guaranteed IB maintain a record of the information obtained from a customer and a copy of the risk disclosure acknowledgment. A branch office may wish to keep copies of this information for its files.
5 NFA Rules require that a guaranteed IB maintain a record of the written customer authorization and customer acknowledgments for third-party account controllers. A branch office may wish to keep copies of this information for its files.
6 If a visit is prompted by awareness of a particular problem at a remote location or if a problem is discovered during a routine visit, the Member must ensure that the scope of the review is adequate to thoroughly examine the problem area.
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[¶ 9007] COMPLIANCE WITH NFA BYLAW 1101
(Staff, March 19, 1987; revised July 1, 2000)
INTERPRETIVE NOTICE
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6. Members should ensure that their branch offices are not separately incorporated entities. The CFTC Division of Trading and Markets has issued an interpretive letter stating that branch offices which are separately incorporated entities are required to be registered as introducing brokers;