CTA and CPO Registration Form 8-R Changes

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Fingerprint Information Now Required in Form 8-R

As discussed below, the information which is included on an AP or Principal’s Fingerprint Cards (sex, race, eye color, etc) will now be part of the NFA Form 8-R.  Additionally, the NFA will now make certain notifications to NFA member firms with respect to their application.

The full notice from the NFA is reprinted below.

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Fingerprint Card Demographic Information and Email Notifications Enhancements

The Spring 2010 NFA Member Newsletter reported an Online Registration System (ORS) enhancement that will require fingerprint card demographic information (such as sex, race, eye color, hair color, height and weight) be entered on the Form 8-R application. This enhancement is scheduled to be deployed on June 17, 2010. The fingerprint card demographic information is used to conduct a criminal background check with the U.S. Federal Bureau of Investigations (FBI). Because this information is already collected on the FBI fingerprint card, it may be helpful to have the fingerprint card available when completing the Form 8-R application.

Collecting this information in the Form 8-R applications will allow NFA to electronically submit fingerprint cards to the FBI in a timelier manner by downloading the fingerprint card demographic information directly from the 8-R form.

A view and update page are also being developed to display and update, if necessary, the fingerprint card demographic information. These pages can be accessed using the “View Registration Information” or “Update/Withdraw Registration Information” menu under the “Personal Profile” section.

For Form 8-R applications completed prior to the implementation of this enhancement, the demographic fields on the view and update pages will be blank. However, this information is not required to be completed until such time as a new Form 8-R application is filed.

In addition to the fingerprint card demographic information enhancement, we have also added two new notification types to the NFA E-mail Notification Service:

  1. Firm or Individual registered, temporary licensed, approved or conditioned
  2. Firm Account Balance is below $1000

The Security Manager of the firm can add the new notification types for existing email recipients or can add and/or delete recipient(s) to receive email notifications by clicking on “NFA E-mail Notification Service” under the “Security” tab in ORS.

If you have any questions concerning this matter, please contact the Information Center by phone at 312-781-1410 or 800-621-3570 or send an email to [email protected]. Representatives are available Monday through Friday from 8:00 a.m. to 5:00 p.m. CST.

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Cole-Frieman & Mallon LLP provides comprehensive hedge fund start up and regulatory support for commodity pool operators.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Positive 2010 Outlook for Investors and Hedge Funds

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In March, Deutsche Bank’s Hedge Fund Capital Group presented a closer look at the current status of the hedge fund industry in its “2010 Alternative Investment Survey” report (see press release).  The report focuses on responses from 606 investors.  42% of the respondents were Fund of Funds, 21% were asset management companies, 12% were family offices/high net worth individuals, and the remaining group consisted of corporations, foundations and endowments, insurance companies, investment consultants, private banks, and private and public pensions.

This article summarizes the 2010 outlook from investors and the increasing relevance of the seeding business.  In particular, it presents the strategies being favored/disfavored, regional markets being favored/disfavored, predicted allocation amounts, and other information related to due diligence and reasons for investing in hedge funds.

For the most part, investors are optimistic about 2010 and money is flowing back into the industry.  Strategies for this year reflect concerns about the lack of transparency and protection in uncertain markets in 2008 and 2009.  Investors are making choices that ride on renewed confidence in the industry and that favor reduced volatility.

Investors

Investors Generally Optimistic for the Future

Investor sentiment about how the hedge fund industry will fare in 2010 has greatly improved.  In 2009, 41% predicted net asset outflows of over $150 billion and 30% predicted outflows of over $200 billion.  In contrast, 73% of investors surveyed this year predict net asset inflows of over $100 billion and fewer than 2% are predicting outflows.  Consistent with those percentages, investors are also predicting a positive 2010 performance on the leading indices (S&P500, MSCI World, and MSCI EM).

Favored and Disfavored Strategies

Surveyed investors predict that some of the best strategies for 2010 are global macro, equity long/short, distressed, and event driven.  In fact, equity long/short makes up the largest portion of hedge fund assets.  51% of investors plan to add assets to this strategy (an increase from 31% in 2009), 38% plan to maintain their assets in the strategy, and 5% plan to reduce assets.  Event driven also performed very well in 2009 with 42% of surveyed investors now planning to add assets to this strategy and 41% planning to maintain their assets.  Investor interest in merger arbitrage has also jumped greatly from 6% intending to increase exposure to 26% in 2010.  While 29% of investors planned to reduce exposure in 2009, only 4% now seek to reduce exposure.

The strategies that are anticipated to perform the worst in 2010 include cash, volatility arbitrage, CTA, convertible arbitrage, market neutral, and asset backed securities.  Market neutral was one of the worst strategies for 2009 when other strategies were bouncing back.  The percentage of investors seeking to add assets to this strategy has decreased from 26% in 2008 to only 17% this year.  In terms of cash allocation, only 3% of investors plan to increase exposure (a drop from 13% last year), 43% plan to maintain their assets, and a whopping 32% plan to reduce their assets.

Regional Allocations

Overall, investors predict that the Asia region (excluding Japan) will perform the best in 2010 and the Western European region will perform the worst.  This year, 45% of investors plan to invest in Asian (excluding Japan) funds–a significant jump from only 18% in 2009.  Interest in investing in Chinese and Japanese funds is high compared with other countries.  The percentage of investors that do not plan to allocate to each country is 22% and 23% respectively. In contrast, 52% of investors do not plan to allocate in Russia, 44% do not plan to allocate in Eastern and Central Europe (excluding Russia), and 37% of investors do not plan to allocate in India.

Surveyed investors expressed a similar interest in the Emerging Markets, with 38% wanting to increase exposure, 38% wanting to maintain exposure, and only 6% wanting to reduce exposure.  These findings are in response to the strong 2009 returns after a rough 2008 that saw many Emerging Market funds close.  In contrast, investors anticipate the Western European region will not fare well–with 56% seeking to maintain their current assets, 23% seeking to increase exposure, and 12% seeking to reduce exposure.

Hedge Funds

Investors are increasingly investing in hedge funds.  In fact, 76% of consultants surveyed indicated that their clients were increasing allocations to this investment vehicle.   When asked what the main benefit of investing in hedge funds was, 68% of the investors surveyed indicated that hedge funds provide “better risk adjusted returns.”  This benefit is particularly valuable in a volatile and uncertain market.   “Diversification,” which was previously the number one answer, remains a close second.

Amount Currently Invested in Hedge Funds

Currently, over 50% of surveyed investors still manage less than $1 billion in hedge funds.  The Hedge Fund Capital Group expressed concern about this figure, explaining that more than $1 billion AUM is often necessary to build the institutional infrastructure for greater investments and to perform vigorous due diligence.  On the other side of the range, the number of investors with under $100 million invested in hedge funds is decreasing.  The Hedge Fund Capital Group explains that these funds have likely simply shut down due to the economy and inability to attract institutional investors, pension funds, endowments, and other larger investors.

A majority of surveyed investors have track records of investing in hedge funds for longer than five years (only 17% have less than 5 years), with nearly all of those with 15 or more years of experience based in North America, compared with their European and Asian investor bases.

Hedge Fund Managers

Since 2008 and in part due to the market, investors have been reducing the number of managers they use.  They have also started disfavoring portfolios that are too diverse due to the fact that due diligence requirements are now more costly and timely.  In addition to reducing the number of managers investors place their money with, investors are also preferring to place their money in larger hedge funds with AUMs of over $1 billion.  Those investors focused on managers with smaller AUMs are generally based in Asia or Europe.

Allocations

In 2009, most investors made 5-10 initial allocations.  Those investors who made over 10 initial allocations in 2009 were concentrated in Europe–a total of 54%.  But in terms of follow-on allocations, U.S. based investors led the pack, with 50% making over 30 follow-on allocations.

Redemptions

Despite generally positive performance last year, investors are continuing to make redemptions–the Hedge Fund Capital Group explains this as a result of those managers who have not performed during the market bounce or those that froze assets and their investors are only now able to begin redeeming.  The investors that have made the most partial redemptions–30 or more in the last year, were primarily fund of funds and private banks.  This finding is consistent with the perception that these investors are performance chasers.

Available Cash to Allocate

Compared with 2009, surveyed investors are generally holding less cash.  50% of investors are either fully invested or only holding 0-5% cash.  But the good news is that 29% have 10% or more cash available for investment.

Following up on the previous findings, surveyed investors are confident for 2010.  Those that predict they will be fully invested in the next six months increased from 18% to 21%.  Those that predict they will hold 0-5% cash increased from 32% to 39%, demonstrating a goal of investing more.

Hedge Fund Managers

Challenges and Assessing a Manager

In terms of the biggest challenges investors faced in 2009 and 2010, “selecting and monitoring manager” posed the biggest challenge, with “lack of transparency” also ranking highly.  This year, “investments frozen with a manager” was a new category and also ranked very high.  When assessing a hedge fund manager, investors used to cite the 3Ps: performance, philosophy, and pedigree.   While those qualities continue to be important, investors have increasingly focused on risk management and transparency.     This reflects greater caution and less reliance merely on manager pedigree.  Performance ranks first, risk management ranks second, and philosophy ranks third in terms of importance.

Length of Due Diligence Process

The due diligence process has gotten more costly and timely.  For most investors–over 50%, need 3-6 months to conduct due diligence of a manager.  This statistic is consistent over the last three years.  The percentage of investors who can complete this in less than 3 months has increased slightly and so has the percentage of those who need 7-12 months.

Seeding Business

The institutionalization of hedge fund investing is making it increasingly difficult for new launches to attract investors. While a minimum of $50 million AUM was once sufficient, the critical minimum is now $100 million.  Emerging managers are therefore increasingly turning to the seeding business “to overcome the hurdle of reaching the critical size to gain visibility and profitability.”  17% of the investors surveyed seed managers.  The majority of seeders are U.S. based–59%, with 30% in Europe, 9% in Asia, and 2% in Australia.  Funds of funds are the primary investors that seed, with asset management companies and high net worth individuals following.

45% of fund of funds seed managers, followed 26% of asset management companies and 17% of family office/high net worth individuals.

There are three seeding business models: (1) revenue split, (2) equity split, and (3) platform.  Under the revenue split model, seeders provide capital in exchange for participation in management and incentive fees.  Nearly half of seeders surveyed use this model.  Seeders provide capital in exchange for equity ownership and generally take active partnership role under the equity split model.  19% of seeders surveyed adopt that model.  Finally, under the platform model, established hedge funds and financial institutions provide capital and “turnkey” solutions in exchange for profit share.  Only 9% of seeders surveyed adopt the platform model.  Before a manager turns to the seeding business, it should consider the support offered by the seeder, including the form of operations, risk management, marketing, strategic assistance and business development, and compliance and legal support.  In addition to providing funding, well-respected seeders can also provide reputational capital.

For the most part, the average seeding ticket ranges from $25 million to $75 million, with fewer under $10 million and even fewer greater than $100 million.

Consultants

6% of the surveyed investors consider themselves to be investment consultants.  The findings show that there has been an increasing presence of such consultants in the hedge fund industry.  These firms serve as the “bridge between investment managers and pension funds.”  The largest percentage of the consultants’ client base is the family office/high net worth individuals, followed by government funds, and fund of funds.

Hedge fund investors are also more frequently turning to consultants to perform extensive due diligence.  These investors do not have the resources to perform increasingly rigorous due diligence and rely on consultants.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP provides comprehensive hedge fund start up and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Audit Issues from Due Diligence Provider

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The following article is written by Chris Addy, president and CEO of Castle Hall Alternatives which is a hedge fund due diligence firm.

For funds raising assets from institutional investors, the due diligence process will be quite familiar and Chris describes some of the frustrations from the investor/due diligence standpoint.  I would imagine that these issues will continue to arise as more service providers strive to find ways to limit their potential future liability.  Please feel free to comment below.

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A recap on some audit issues

Looking back over our posts over the past year or so, we’ve commented on a number of issues which impact investors’ due diligence procedures when thinking about the audit process, the financial statements, and the auditor themselves.

We thought it would be useful to recap on a group of issues which continue to be troubling:

1) And why can’t the auditor identify themselves?

Back in November, we commented on the challenge of getting the Big 4 audit firms to admit that they are, actually, the auditor of the fund in question.  In the six months since then, practices appear to have standardized: typically, the Big 4 will now provide a form response, but only after the investor has signed an extensive disclaimer letter.  The slight snag?  The disclaimer is usually so wide ranging that it appears to materially impact the investors’ ability to sue the auditor in the event of audit failure (which, of course, is the idea).  We advise our clients not to sign it.

As a counterpoint, it is worth noting – and forcefully reminding the Big 4 – that every other auditor on the planet makes the confirmation process smooth and effective.  Castle Hall is particularly appreciative of the responsiveness and professionalism of Rothstein Kass each time we make an audit confirmation request.  In fact, that reminds me…do I actually need a Big 4 auditor?

2) And it’s pretty much the same for SAS 70s..

Unfortunately, the SAS 70 process is pretty much the same – it is becoming increasingly difficult for the end investor to obtain a copy of the SAS 70 document for many administrators.  This is, of course, despite the fact that the SAS 70 is now a key marketing point in the admin industry.

It’s particularly annoying when the SAS 70 is stated only to available (i) to the auditors of (ii) the administrator’s clients, the funds.  The first point makes the SAS 70 process seem more than a little self serving, as the auditors give each other work for the sake of it.  The second raises the broader issue (and one of our favorite topics) of who exactly is the administrator’s client – the fund or the investor?

A particular black mark goes to those administrators who will not provide investors with a copy of the SAS 70 under any circumstances, and insist on providing a summary of the SAS 70…prepared by themselves.  And exactly how is the investor supposed to place any reliance on that?

An honorable mention in the hall of shame must go, however, to those administrators who try to charge the costs of their SAS 70 review through to their fund clients as an out of pocket expense.  In other words, the admin expects the funds’ shareholders’ to pay for their own SAS 70.

And no, we still can’t see it.

3) Who distributes the financial statements?

While the confirmation issue above is tediously annoying, thinking practically, the risk that a hedge fund simply fabricates a relationship with PwC or KPMG is pretty remote.  What is more likely is that a reputable audit firm has been appointed and completes their work…but a manager then elects to change some or all of the financial statements and gives investors a set of fake accounts.  As we have said before, a copy of Adobe photoshop only costs $500.

The double irony is that, even with the audit confirmation we discussed above, the auditor does not send the investor the accounts directly.  There is, therefore, no way of getting a direct confirmation from the auditor that the accounts in your possession are, in fact, genuine.

One suggestion we have heard would be, in the offshore world at least, for investors to access financial statements direct from the Cayman Monetary Authority (perhaps via a secure website with appropriate authorizations).  This would draw on the requirement that the fund auditors must give the Cayman authority a copy of the (genuine) accounts themselves.  An excellent idea….Cayman?

As a more immediate solution, we are always anxious to confirm that the fund administrator receives the audited financials direct from the auditor and thereafter sends them to investors.  This is a great control – it ensures that the financial statements are authentic, and it also unequivocally confirms the identity of the auditor at the same time.

The snag?  While this is crucially important, administrators seem pretty casual about the whole process.  Admins are generally happy to do this, but only if a fund asks for this “service”, and many admins are certainly far from proactive on this topic.  There are some admins, mind you, that don’t want to get involved (we came across one admin that had decided, on a related point, that they would not send offering memos to investors.)

In our mind, this is a vital control and should be mandatory for every administrator.  Getting the financials from the admin is just as important as ensuring that the investor monthly NAV statements come from the admin and not from the manager.

4) And who is the audit report addressed to?

Another particular bugbear is the obsession of one of the Big 4 audit firms in Cayman to change the addressee of the audit report from “to the board of directors and shareholders” to just “to the board of directors”.  The objective, of course, is transparent and predictable – the auditor is looking to enhance the concept of privity and assert that the firm only has a relationship with the Board and no relationship – none, never, nada – with the investor.

The irony here – the directors who are now the sole recipient of the audit are usually our rent a director friends who sit on a few hundred other hedge fund boards.  And does anyone really think – including the partner at the Big 4 firm signing the opinion – that these guys really have time to read every set of audited financial statements from cover to cover?

One solution here – could the Cayman regulator mandate that the audit opinion must be addressed to the shareholders in order to be meet Cayman requirements?  Again, this would be a small change that would send a very helpful, investor friendly signal from this jurisdiction.

5) In fact, do you even have to leave the office?

A final observation reflects what seems to be an emerging trend over the past audit cycle – certain auditors (and certain offices of certain auditors in particular) seem to be adopting a desk fieldwork process.  We have recently completed due diligence on a number of funds – albeit usually long short equity – when both the administrator and the manager stated that the audit team had never came on site to do any audit work.  All work was done remotely from the auditor’s own offices.

Now, aside from the fact that fieldwork is called fieldwork for a reason (er…you’re in the field) we see this as a worrying trend.  It stands to question that the quality of the audit is not the same if you never look the individual responsible for preparing the accounts in the eye.

As a counterpoint to our observations, we do continue to recognize that the audit process is ever more challenging and that many skilled professionals work incredibly hard, especially during busy season. As just one example, we were recently speaking with the audit partner of a Big 4 firm discussing FIN 48 – a tortuous challenge for the profession.

At the same time, the audit process is critical for investors and we’re certainly entitled to ask tough questions – we are “sophisticated”, after all.

It’s also worth noting that the auditors’ ever increasing fees are, of course, borne by the end allocator.  We’re happy to pay….provided we get good value.  Net net, the hedge fund audit profession would certainly be well served to make things a little easier for the person cutting the pay cheque.

www.castlehallalternatives.com
Hedge Fund Operational Due Diligence
“Risk Without Reward” is a trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP is one of the top hedge fund law firms and provides comprehensive formation and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

For more articles by Chris Addy, please see the Castle Hall Alternatives post where we have listed our reprinted articles.

State Budget Shortfalls and Investment Adviser Registration

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Financial Reform Bill May Devastate Overburdened State Securities Divisions

As many states are facing huge budget shortfalls, government services have been cutback and certain states have furloughed workers in certain divisions. In a number of states (including California) these budget cuts have affected the state securities divisions and accordingly the many state securities divisions are running dangerously lean. For example, I just recently talked with an examiner in the Oregon Division of Finance and Corporate Securities regarding a state blue sky filing for a hedge fund manager. The examiner told me that because of budget cuts and furlough days, the division will not even have a chance to review the blue sky filing we submit for five months! (Of course, they will cash the check immediately.)

This is obviously a huge issue and is only one instance of a state which does not currently have the resources to adequately perform oversight of the investment and securities activity which occur within its borders. In fact, many states currently don’t have the staff or expertise to adequately oversee the investment advisers and brokers registered with their securities division. While this is troubling, the problem is only going to get worse if the Financial Reform Bill proceeds as currently drafted.

While many have lauded the Senate bill, which will require hedge fund registration for managers with $100MM in AUM or more, an important issue has been overlooked. All investment advisers (in addition to hedge fund managers) with AUM of less than $100MM will be subject to state and not SEC registration. The $100MM threshold is an increase from the current threshold of $25MM. This means that a financial planner overseeing $90MM in assets (which was previously subject to SEC registration and periodic examination) will now be subject to regulation, generally, by the state in which that manager resides.

This means that if the financial reform bill goes through as currently drafted in the senate, the states are suddenly going to be responsible for overseeing a larger pool of managers. Even though the state will have increased responsibility, it is unlikely that state budgets will provide the securities divisions with more funding to properly oversee the new managers the divisions will be responsible for regulating. We find this troubling for investor protection reasons and for manager business continuity – that is, managers would be better off registered at the SEC level and subject to examination by SEC staff better trained (presumably) than state regulators.

We concede that the SEC has its own problems with funding and this provision allows them to focus on larger, more systemically important managers. However, we believe that states are going to be greatly burdened by the increase in jurisdictional oversight. Accordingly, we believe either Congress or the SEC provide a grandfathering provision which would allow current managers who exceed the $25MM threshold (but not the new $100MM threshold) to register or remain registered with the SEC.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP is one of the top hedge fund law firms and provides comprehensive formation and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Hedge Fund Events June 2010

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The following are various hedge fund events happening this month.  Please email us if you would like us to add your event to this list.

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June 1

June 1

June 2

June 2

June 6-8

June 7-9

June 7-9

June 8

June 8

  • Sponsor: Roundtable Forum
  • Event: Roundtable Forum
  • Location: London, United Kingdom

June 8-9

June 8-9

June 8-9

  • Sponsor: MFA (Managed Funds Association)
  • Event: Forum 2010
  • Location: Chicago, Illinois

June 9

June 9-10

June 9-10

June 10

June 10

June 10

June 10

June 10

June 10

June 13-15

June 14-17

  • Sponsor: ICBI (The International Centre for Business Information)
  • Event: GAIM International 2010
  • Location: Monaco

June 15

  • Sponsor: Woodfield LLC
  • Event: Hedge Fund Networking Event
  • Location: Denver, Colorado

June 15

June 15

June 15-17

  • Sponsor: IIR (Institute for International Research)
  • Event: Family Office Forum
  • Location: Chicago, Illinois

June 16

June 16-17

June 16-18

June 17-18

June 20-22

June 21-22

June 22

June 22

June 22

  • Sponsor: FRA (Financial Research Associates, LLC)
  • Event: Hedge Fund Tax 101
  • Location: New York, New York

June 22-23

June 22-24

  • Sponsor: ISLA (International Securities Lending Association) /AFME (Association for Financial Markets in Europe)
  • Event: Securities Lending Conference
  • Location: Berlin, Germany

June 23-25

June 24

June 24-25

June 28-30

June 28-July 1

June 29-30

June 30

June 30

June 30

June 30-July 1

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Bart Mallon, Esq. runs the hedge fund law blog and provides hedge fund information and manager registration services through Cole-Frieman &  Mallon LLP He can be reached directly at 415-868-5345.

Hedge Fund Law Blog Notes For Week

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Adviser Registration, Accredited Investors, Carried Interest, Insider Trading, Cap and Trade

Below are some thoughts on some of the major issues over the last couple of weeks.

Have a great Memorial Day Weekend!

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Hedge Fund Regulation and Registration – While the Private Fund Investment Advisers Registration Act of 2010 was passed this month in the Senate, there has not been as much discussion in the news about this issue and manager registration.  I expected that we would hear more, especially with regard to the following issues:

  • Section 407 – Exemption of VC Funds
  • Section 408 – Exemption from Reporting Requirements for Private Equity Funds
  • Section 410 – State Authority for Managers with AUM of up $100MM (this is generally a bad idea in my opinion and we will be writing a post about this soon…)
  • Section 412 – Adjusting Definition of Accredited Investor (see also below)

I imagine we will hear more as the Senate and House begin to reconcile their two bills and before President Obama signs the final Financial Reform bill into law, which some think may happen before the July 4th holiday.

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Definition of Accredited Investor – The Senate version of the Financial Reform bill will change the definition of an “accredited investor” in the future.  Generally “accredited investors” are those individuals with a net worth of $1,000,000.  Under current regulations, individuals can include the equity in their private residence when determining their net worth.  In the future, they will need to exclude the equity in their private residence when determining their net worth.  This potentially may have a deleterious effect on the hedge fund industry, but also on other industries which rely on private placements.

According to some sources, at least one Senator is asking that the definition of accredited investor be expanded to include state and local governments.  I agree with this approach – if the Senate is taking the time to mess with the definition right now then the Senate should spend a little time addressing other issues.  For instance, the definition of accredited investor should also be expanded to include Native American Tribes.  I have specifically talked with the SEC staff about this issue a couple of years ago and they have categorically refused to issue a no-action or other interpretive release on this issue – we believe that now is the time to include Native American Tribes in the definition of accredited investor.

For more information, please see the Native American Capital, LP policy briefing and the National Congress of American Indians letter to the SEC on this issue.

See also Perkins Coie discussion of this issue.

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Carried-Interest Issue -it looks like the carried interest tax laws will be changing in 2011.  In addition to hedge fund managers, managers to other pooled investment vehicles will be greatly affected (such as VC and private equity fund managers, as well as real estate fund managers).  The change in the laws will likely affect more VC and PE managers than hedge fund managers because of the nature of the underlying gains in the respective investment vehicles (VC and PE fund managers typically have mostly long term capital gains and hedge fund managers may have a combination of long term and short term capital gains).  There is likely to be a large number of industry groups which come out in opposition to the changes in the next couple of weeks.

We do not agree with the proposed changes – it seems as though Congress is specifically attacking an easy target  in the investment management community.

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Insider Trading Issue – just today the SEC announced an insider trading case brought against a hedge fund manager Pequot Capital Management, Inc., and its Chairman and CEO Arthur Samberg.  This issue has been thoroughly discussed most recently after the Galleon affair.  Hedge funds managers and compliance personnel need to be even more vigilant about establishing comprehensive compliance programs and making sure that traders are not engaging in insider trading.  Please see our previous thoughts on Hedge Funds and Insider Trading.

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Green Tech/ Cap and Trade – clean and green tech continue to gain traction in the investment management industry as a bill which would create federal carbon cap and trade system was introduced recently.  Next weekend the South Asian Bar in San Francisco will have a panel discussion. entitled “Green 2 Green: Carbon Credits, Renewable Energy Certificates and the New Markets driving the Clean Energy Economy”.  According to the program,

Attendees will receive a quick primer on market-based regulatory responses to climate change designed to foster the development of renewable power plants and spur long term investment in clean and sustainable energy. Panelists will address state and federal legislation setting green house gas emission caps, establishing renewable portfolio standards, and creating new markets for carbon credits and renewable energy certificates. We’ll discuss the regulatory origins and key characteristics of these and other green commodities, as well as the structure and rules of markets created to transition industry and consumers from the present carbon economy toward tomorrow’s clean energy economy.

Mallon P.C. will be represented at the panel discussion so please come and talk to us there.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP works with many managers who invest in various commodities and with groups who work in the clean tech space.  Mallon P.C. is a top hedge fund law firm which provides comprehensive formation and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Private Fund Investment Advisers Registration Act of 2010

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Full Text of PFIARA of 2010 (requiring Hedge Fund Registration)

The following is the full text of the Private Fund Investment Advisers Registration Act of 2010 which was part of the recently passed Senate financial regulation bill.  The central part of this act eliminates the Section 203(b)(3) exemption for registration for hedge fund managers (see Section 403).  The act also requires hedge fund managers to provide the SEC with certain information about their trading program and investment positions (see Section 404).

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TITLE IV—REGULATION OF ADVISERS TO HEDGE FUNDS AND OTHERS

SEC. 401. SHORT TITLE.

This title may be cited as the ‘‘Private Fund Investment Advisers Registration Act of 2010’’.

SEC. 402. DEFINITIONS.

(a) INVESTMENT ADVISERS ACT OF 1940 DEFINITIONS.—Section 202(a) of the Investment Advisers Act of1940 (15 U.S.C. 80b–2(a)) is amended by adding at the end the following:

‘‘(29) The term ‘private fund’ means an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a–3), but for section 3(c)(1) or 3(c)(7) of that Act.

‘‘(30) The term ‘foreign private adviser’ means any investment adviser who—

‘‘(A) has no place of business in the United States;

‘‘(B) has, in total, fewer than 15 clients who are domiciled in or residents of the United States;  on DSKH9S0YB1PROD with BILLS

‘‘(C) has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the investment adviser of less than $25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; and

‘‘(D) neither—

‘‘(i) holds itself out generally to the public in the United States as an investment adviser; nor

‘‘(ii) acts as—

‘‘(I) an investment adviser to any investment company registered under the Investment Company Act of 1940; or

‘‘(II) a company that has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940 (15 U.S.C. 80a–53), and has not withdrawn its election.’’.

(b) OTHER DEFINITIONS.—As used in this title, the terms ‘‘investment adviser’’ and ‘‘private fund’’ have the same meanings as in section 202 of the Investment Advisers Act of 1940, as amended by this title.

SEC. 403. ELIMINATION OF PRIVATE ADVISER EXEMPTION; LIMITED EXEMPTION FOR FOREIGN PRIVATE ADVISERS; LIMITED INTRASTATE EXEMPTION.

Section 203(b) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3(b)) is amended—

(1) in paragraph (1), by inserting ‘‘, other than an investment adviser who acts as an investment adviser to any private fund,’’ before ‘‘all of whose’’;

(2) by striking paragraph (3) and inserting the following:

‘‘(3) any investment adviser that is a foreign private adviser;’’; and

(3) in paragraph (5), by striking ‘‘or’’ at the end; (4) in paragraph (6), by striking the period at the end and inserting ‘‘; or’’; and (5) by adding at the end the following: ‘‘(7) any investment adviser, other than any entity that has elected to be regulated or is regulated as a business development company pursuant to section 54 of the Investment Company Act of 1940 (15 U.S.C. 80a–54), who solely advises— ‘‘(A) small business investment companies that are licensees under the Small Business Investment Act of 1958; ‘‘(B) entities that have received from the Small Business Administration notice to proceed to qualify for a license as a small business investment company under the Small Business Investment Act of 1958, which notice or license has not been revoked; or ‘‘(C) applicants that are affiliated with 1 or more licensed small business investment companies described in subparagraph (A) and that have applied for another license under the Small Business Investment Act of 1958, which application remains pending.’’.

SEC. 404. COLLECTION OF SYSTEMIC RISK DATA; REPORTS; EXAMINATIONS; DISCLOSURES.

Section 204 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–4) is amended—

(1) by redesignating subsections (b) and (c) as subsections (c) and (d), respectively; and

(2) by inserting after subsection (a) the following:

‘‘(b) RECORDS AND REPORTS OF PRIVATE FUNDS.—

‘‘(1) IN GENERAL.—The Commission may require any investment adviser registered under this title—

‘‘(A) to maintain such records of, and file with the Commission such reports regarding, private funds advised by the investment adviser, as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk by the Financial Stability Oversight Council (in this subsection referred to as the ‘Council’); and

‘‘(B) to provide or make available to the Council those reports or records or the information contained therein.

‘‘(2) TREATMENT OF RECORDS.—The records and reports of any private fund to which an investment adviser registered under this title provides investment advice shall be deemed to be the records and reports of the investment adviser.

‘‘(3) REQUIRED INFORMATION.—The records and reports required to be maintained by a private fund and subject to inspection by the Commission under this subsection shall include, for each private fund advised by the investment adviser, a description of—

‘‘(A) the amount of assets under management and use of leverage;

‘‘(B) counterparty credit risk exposure;

‘‘(C) trading and investment positions;

‘‘(D) valuation policies and practices of the fund;

‘‘(E) types of assets held;

‘‘(F) side arrangements or side letters, whereby certain investors in a fund obtain more favorable rights or entitlements than other investors;

‘‘(G) trading practices; and

‘‘(H) such other information as the Commission, in consultation with the Council, determines is necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk, which may include the establishment of different reporting requirements for different classes of fund advisers, based on the type or size of private fund being advised.

‘‘(4) MAINTENANCE OF RECORDS.—An investment adviser registered under this title shall maintain such records of private funds advised by the investment adviser for such period or periods as the Commission, by rule, may prescribe as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk.

‘‘(5) FILING OF RECORDS.—The Commission shall issue rules requiring each investment adviser to a private fund to file reports containing such information as the Commission deems necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

‘‘(6) EXAMINATION OF RECORDS.—

‘‘(A) PERIODIC AND SPECIAL EXAMINATIONS.—The Commission—

‘‘(i) shall conduct periodic inspections of all records of private funds maintained by an investment adviser registered under this title in accordance with a schedule established by the Commission; and

‘‘(ii) may conduct at any time and from time to time such additional, special, and other examinations as the Commission may prescribe as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk.

‘‘(B) AVAILABILITY OF RECORDS.—An investment adviser registered under this title shall make available to the Commission any copies or extracts from such records as may be prepared without undue effort, expense, or delay, as the Commission or its representatives may reasonably request.

‘‘(7) INFORMATION SHARING.—

‘‘(A) IN GENERAL.—The Commission shall make available to the Council copies of all reports, documents, records, and information filed with or provided to the Commission by an investment adviser under this subsection as the Council may consider necessary for the purpose of assessing the systemic risk posed by a private fund.

‘‘(B) CONFIDENTIALITY.—The Council shall maintain the confidentiality of information received under this paragraph in all such reports, documents, records, and information, in a manner consistent with the level of confidentiality established by the Commission pursuant to paragraph (8). The Council shall be exempt from section 552 of title 5, United States Code, with respect to any information in any report, document, record, or information made available, to the Council under this subsection.’’.

‘‘(8) COMMISSION CONFIDENTIALITY OF REPORTS.—Notwithstanding any other provision of law, the Commission may not be compelled to disclose any report or information contained therein required to be filed with the Commission under this subsection, except that nothing in this subsection authorizes the Commission—

‘‘(A) to withhold information from Congress, upon an agreement of confidentiality; or

‘‘(B) prevent the Commission from complying with—

‘‘(i) a request for information from any other Federal department or agency or any self-regulatory organization requesting the report or information for purposes within the scope of its jurisdiction; or

‘‘(ii) an order of a court of the United States in an action brought by the United States or the Commission.

‘‘(9) OTHER RECIPIENTS CONFIDENTIALITY.— Any department, agency, or self-regulatory organization that receives reports or information from the Commission under this subsection shall maintain the confidentiality of such reports, documents, records, and information in a manner consistent with the level of confidentiality established for the Commission under paragraph (8).

‘‘(10) PUBLIC INFORMATION EXCEPTION.—‘‘(A) IN GENERAL.—The Commission, the Council, and any other department, agency, or self-regulatory organization that receives information, reports, documents, records, or information from the Commission under this subsection, shall be exempt from the provisions of section 552 of title 5, United States Code, with respect to any such report, document, record, or information. Any proprietary information of an investment adviser ascertained by the Commission from any report required to be filed with the Commission pursuant to this subsection shall be subject to the same limitations on public disclosure as any facts ascertained during an examination, as provided by section 210(b) of this title.

‘‘(B) PROPRIETARY INFORMATION.—For purposes of this paragraph, proprietary information includes—

‘‘(i) sensitive, non-public information regarding the investment or trading strategies of the investment adviser;

‘‘(ii) analytical or research methodologies;

‘‘(iii) trading data;

‘‘(iv) computer hardware or software containing intellectual property; and

‘‘(v) any additional information that the Commission determines to be proprietary.

‘‘(11) ANNUAL REPORT TO CONGRESS.—The Commission shall report annually to Congress on how the Commission has used the data collected pursuant to this subsection to monitor the markets for the protection of investors and the integrity of the markets.’’.

SEC. 405. DISCLOSURE PROVISION ELIMINATED.

Section 210(c) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–10(c)) is amended by inserting before the period at the end the following: ‘‘or for purposes of assessment of potential systemic risk’’.

SEC. 406. CLARIFICATION OF RULEMAKING AUTHORITY.

Section 211 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–11) is amended—

(1) in subsection (a), by inserting before the period at the end of the first sentence the following:

‘‘, including rules and regulations defining technical, trade, and other terms used in this title, except that the Commission may not define the term ‘client’ for purposes of paragraphs (1) and (2) of section 206 to include an investor in a private fund managed by an investment adviser, if such private fund has entered into an advisory contract with such adviser’’; and

(2) by adding at the end the following:

‘‘(e) DISCLOSURE RULES ON PRIVATE FUNDS.—The Commission and the Commodity Futures Trading Commission shall, after consultation with the Council but not later than 12 months after the date of enactment of the Private Fund Investment Advisers Registration Act of 2010, jointly promulgate rules to establish the form and content of the reports required to be filed with the Commission under subsection 204(b) and with the Commodity Futures Trading Commission by investment advisers that are registered both under this title and the Commodity Exchange Act (7 U.S.C. 1a et seq.).’’.

SEC. 407. EXEMPTION OF VENTURE CAPITAL FUND ADVISERS.

Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3) is amended by adding at the end the following:

‘‘(l) EXEMPTION OF VENTURE CAPITAL FUND ADVISERS.—No investment adviser shall be subject to the registration requirements of this title with respect to the provision of investment advice relating to a venture capital fund. Not later than 6 months after the date of enactment of this subsection, the Commission shall issue final rules to define the term ‘venture capital fund’ for purposes of this subsection.’’.

SEC. 408. EXEMPTION OF AND RECORD KEEPING BY PRIVATE EQUITY FUND ADVISERS.

Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3) is amended by adding at the end the following:

‘‘(m) EXEMPTION OF AND REPORTING BY PRIVATE EQUITY FUND ADVISERS.—

‘‘(1) IN GENERAL.—Except as provided in this subsection, no investment adviser shall be subject to the registration or reporting requirements of this title with respect to the provision of investment advice relating to a private equity fund or funds.

‘‘(2) MAINTENANCE OF RECORDS AND ACCESS BY COMMISSION.—Not later than 6 months after the date of enactment of this subsection, the Commission shall issue final rules—

‘‘(A) to require investment advisers described in paragraph (1) to maintain such records and provide to the Commission such annual or other reports as the Commission taking into account fund size, governance, investment strategy, risk, and other factors, as the Commission determines necessary and appropriate in the public interest and for the protection of investors; and

‘‘(B) to define the term ‘private equity fund’ for purposes of this subsection.’’.

SEC. 409. FAMILY OFFICES.

(a) IN GENERAL.—Section 202(a)(11) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–2(a)(11)) is amended by striking ‘‘or (G)’’ and inserting the following:

‘‘; (G) any family office, as defined by rule, regulation, or order of the Commission, in accordance with the purposes of this title; or (H)’’.

(b) RULEMAKING.—The rules, regulations, or orders issued by the Commission pursuant to section 202(a)(11)(G) of the Investment Advisers Act of 1940, as added by this section, regarding the definition of the term ‘‘family office’’ shall provide for an exemption that—

(1) is consistent with the previous exemptive policy of the Commission, as reflected in exemptive orders for family offices in effect on the date of enactment of this Act; and

(2) recognizes the range of organizational, management, and employment structures and arrangements employed by family offices.

SEC. 410. STATE AND FEDERAL RESPONSIBILITIES; ASSET THRESHOLD FOR FEDERAL REGISTRATION OF INVESTMENT ADVISERS.

Section 203A(a)(1) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3a(a)(1)) is amended —

(1) in subparagraph (A)—

(A) by striking ‘‘$25,000,000’’ and inserting ‘‘$100,000,000’’; and

(B) by striking ‘‘or’’ at the end;

(2) in subparagraph (B), by striking the period at the end and inserting ‘‘; or’’; and

(3) by adding at the end the following:

‘‘(C) is an adviser to a company that has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940, and has not withdrawn its election.’’.

SEC. 411. CUSTODY OF CLIENT ASSETS.

The Investment Advisers Act of 1940 (15 U.S.C. 80b–1 et seq.) is amended by adding at the end the following new section:

‘‘SEC. 223. CUSTODY OF CLIENT ACCOUNTS.

‘‘An investment adviser registered under this title shall take such steps to safeguard client assets over which such adviser has custody, including, without limitation, verification of such assets by an independent public accountant, as the Commission may, by rule, prescribe.’’.

SEC. 412. ADJUSTING THE ACCREDITED INVESTOR STANDARD FOR INFLATION.

The Commission shall, by rule—

(1) increase the financial threshold for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, by calculating an amount that is greater than the amount in effect on the date of enactment of this Act of $200,000 income for a natural person (or $300,000 for a couple) and $1,000,000 in assets, as the Commission determines is appropriate and in the public interest, in light of price inflation since those figures were determined; and

(2) adjust that threshold not less frequently than once every 5 years, to reflect the percentage increase in the cost of living.

SEC. 413. GAO STUDY AND REPORT ON ACCREDITED INVESTORS.

The Comptroller General of the United States shall conduct a study on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds, and shall submit a report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of such study not later than 1 year after the date of enactment of this Act.

SEC. 414. GAO STUDY ON SELF-REGULATORY ORGANIZATION FOR PRIVATE FUNDS.

The Comptroller General of the United States shall—

(1) conduct a study of the feasibility of forming a self-regulatory organization to oversee private funds; and

(2) submit a report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of such study, not later than 1 year after the date of enactment of this Act.

SEC. 415. COMMISSION STUDY AND REPORT ON SHORT SELLING.

(a) STUDY.—The Division of Risk, Strategy, and Financial Innovation of the Commission shall conduct a study, taking into account current scholarship, on the state of short selling on national securities exchanges and in the over-the-counter markets, with particular attention to the impact of recent rule changes and the incidence of—

(1) the failure to deliver shares sold short; or

(2) delivery of shares on the fourth day following the short sale transaction.

(b) REPORT.—The Division of Risk, Strategy, and Financial Innovation shall submit a report, together with any recommendations for market improvements, including consideration of real time reporting of short sale positions, to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of the study conducted under subsection (a), not later than 2 years after the date of enactment of this Act.

SEC. 416. TRANSITION PERIOD.

Except as otherwise provided in this title, this title and the amendments made by this title shall become effecttive 1 year after the date of enactment of this Act, except 5 that any investment adviser may, at the discretion of the investment adviser, register with the Commission under the Investment Advisers Act of 1940 during that 1-year period, subject to the rules of the Commission.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP is a hedge fund law firm which provides comprehensive formation and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

UCITS Hedge Funds

1 Reply

Overview of UCITS Hedge Funds

Bryan Goh of the blog Ten Seconds Into The Future has let us repost his article on UCITS hedge funds.  We have posted a number of articles from Bryan, see end of post, and believe that he has some great industry insight (see especially here and here).

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What are UCITS?

UCITS are funds that comply with the European Directive for retail open-ended investment funds, are incorporated and authorised by the regulator in an EEA member state and can be distributed throughout the European Economic Area.

UCITS is a framework to standardise rules for the authorisation, supervision, structure and activities of collective investment undertakings in the EEA and so to enable them to be marketed throughout the EEA.

To be UCITS a fund must be open-ended, liquid, well-diversified, invest only in certain ‘eligible’ assets (namely quoted securities, money market instruments, deposits, certain derivatives and units in other UCITS) and can only employ limited leverage.

Why would a hedge fund manager offer a UCITS version of their fund?

Managers who are able to offer their strategies in UCITS format will be able to access a large universe of investors attracted by the UCITS brand in Europe, globally, and particularly in the Asia.

The transparency, liquidity and regulatory oversight required in a UCITS addresses investor concerns in a post-Madoff, post-credit 2008 crunch environment.

A UCITS lies outside the scope of the European draft Alternative Investment Fund Managers Directive which is likely to impact unregulated offshore hedge funds in yet undefined ways. This is potentially beneficial as the AIFM Directive is likely to impose constraints on European investors investing in third-country funds, which would include those domiciled in offshore jurisdictions such as Cayman Islands and Bermuda.

What is the process of launching a UCITS?

It’s complicated but it can be largely outsourced. Below is a list of the main features of UCITS. It all sounds complicated and laborious but a competent partner will be able to take most of the initial and ongoing burden away so that the fund manager can concentrate on managing money in as uninterrupted and unmodified a fashion as possible.

Fund Structures:

There are several fund structures available to UCITS. These include Unit Trusts, which are familiar vehicles and preferred by certain Asian investors such as Japanese, Variable Capital Companies, which are the OEICs and SICAVs and will look similar to a hedge fund structure with additional segregation of assets ex prime broker and Contractual Funds which are niche structures which are more complex to administer and market.

Management Companies:

The structure and indeed the existence of a management company is based on the tax planning of the investment manager. A Management Company brings with it minimum capital requirements, oversight and accounting and consolidation requirements. Roughly speaking, a UCITS Management Company needs to have 125,000 EUR of capital as a minimum plus 2 basis points per EUR of AUM over 250 million. This capital cannot be held on the group Holdco balance sheet and must be invested in liquid investments.

Sponsors:

There are some onerous capital requirements on Sponsors.

  • In Ireland the capital requirement is 635,000 EUR.
  • In Luxembourg the capital requirement is 7.5 million EUR.
  • These are largely unwritten rules.
  • A sponsor can be rented.

Legal Documentation:

  • There are rules for the prospectus
  • There is a simplified prospectus
  • Constitutional documentation, memoranda and articles.
  • Legal contracts:

– IMA
– Administration Agreement
– Custody Agreement
– Distribution Agreement

  • Business Plan and Substance Application
  • Risk Management Process

The Business Plan and Substance Application:

  • Constitutional documents
  • Capital requirements
  • Probity and competence of directors
  • Suitability of qualifying shareholders and organizational structure
  • Conduct of business
  • Board meetings – Frequency and content – minimum of 4 in the domicile.
  • Managerial functions
  • Frequency and content of reporting
  • Exception reporting
  • Escalation measures

The managerial functions require at least 2 Conducting Officers or Dirigeants.  These can be:

  • Employees (usually not)
  • Directors of the UCITS can assume these functions
  • UCITS can appoint consultants.
  • In Ireland a board can be collectively appointed. In Luxembourg individuals have to be named.

The managerial functions include:

  • Appointment of Chairman
  • Frequency of board meetings
  • Distinguishing between decisions for the board versus the conducting officers
  • Compliance monitoring.

– Investment breaches
– Pricing errors
– Complaints
– AML issues

  • Risk Management

– Investment risk
– Use of Derivatives
– Pricing issues
– Reconciliation
– Failed trades

  • Performance Monitoring

– Performance metrics
– Benchmarks – especially if VaR relative to benchmark is used as a formal exposure metric
– Explanation of unusual performance
– Outlook
– A bi annual detailed commentary for inclusion in the financial statements

  • Finance Control

– Management company and fund financial statements
– Annual audit process
– Monthly management accounts of Management Company and Fund

  • Monitoring Capital

– Monthly review of capital adequacy.

  • Supervision of service providers

– UCITS requires regular ongoing due diligence on the Administrator, Custodian, and other service providers.

Eligible Markets and Securities:

List of Eligible Assets

  • Transferable Securities (TS)
  • Money Market Instruments (MMI)
  • TS and MMI with a derivative element (example Convertible Bonds)
  • Financial Derivative Instruments (FDI)
  • Open ended Collective Investment Schemes (CIS)
  • Deposits with credit institutions
  • Ancillary liquid assets
  • Financial indices
  • Repos, reverse repos, stock lending

List of non eligible assets

Direct or indirect investments in

  • Commodities
  • Real estate
  • Private equity
  • Hedge funds
  • Non financial indices
  • Short selling of MMI
  • Anything that circumvents the investment limits of the UCITS directive

Note that exposure to the above can be gained through financial indices on the underlyings.

Transferable Securities:

Generally:

  • Max loss limited to cost
  • Liquid
  • Regular, accurate reliable pricing
  • Negotiable

Closed end funds:

  • Corporate governance has to be robust
  • Asset manager subject to national regulation

Money Market Instruments
Generally:

  • Normally dealt in on the money markets
  • Liquid
  • Can be accurately valued

If not dealt in on a regulated market:

  • Meet certain issue/issuer criteria
  • Information available for a credit assessment
  • Freely transferable

Derivatives:

  • Underlyings consist of:

– TS, MMI, CIS, FDI, deposits, financial indices,
– Interest rates
– FX rates
– Currencies

  • Do not expose UCITS to risks it could not otherwise assume
  • Does not cause deviation from investment objectives
  • Does not result in the delivery of underlying which is not an Eligible Asset

Shorting comes in under derivatives on TS and financial indices. It will allow shorting equities and bonds via CDS.
OTC derivatives are allowed. There are requirements on the counterparty.

  • The counterparty must provide valuations
  • The counterparty must provide unwind

Collective Investment Schemes:

UCITS funds can invest in Collective Investment Schemes provided

  • The underlying CIS does not itself invest more than 10% of NAV in another CIS (UCITS or otherwise)
  • The CIS is diversified
  • The CIS is liquid
  • There is a 30% limit on exposure to non UCITS CIS even if they comply with the above
  • Non UCITS CIS must be subject to some form of supervision equivalent to UCITS, with sufficient investor protection

Financial Indices:

  • Automatically eligible if the constituents are themselves eligible
  • All other indices require separate regulator approval

– Requires sufficient diversification
– Be an adequate benchmark for the reference market
– Appropriately published
– Must have independent management from the management of the UCITS

A number of bespoke indices have emerged that appear to game this rule. The indices resemble bespoke, alpha optimized portfolios instead of an index representative of some class of assets.

Hedge fund investable indices are eligible provided:

  • No backfill used in their construction
  • No payments are made to the index provider from the index constituents
  • Index construction is objective and systematic
  • UCITS must perform adequate due diligence on the quality of the index

Repos, Reverse Repos and Stock Lending

  • UCITS can enter into repos and reverse repos and stock lending. Conditions apply.
  • Collateral must be posted.

Diversification:

Unsatisfied with the almost universal concept of diversification, UCITS has adopted the term Risk Spreading.

Unlisted Securities:

  • Limit of 10% of NAV in unlisted securities.
  • Additional 10% of NAV in recently unlisted securities destined to list in less than 12 months
  • Limit does not apply to certain 144A securities provided they list within a year
  • Bonds with a liquid market traded between regulated broker dealers and are subject only to general limits

5/10/40 Rule:

  • 10% NAV issuer limit across capital structure.
  • For positions exceeding 5% NAV issuer limit, the aggregate shall not exceed 40% of NAV.

For bonds issued by EU credit institutions subject to special public supervision

  • 25% NAV issuer limit across capital structure.
  • For positions exceeding 5% NAV issuer limit, the aggregate shall not exceed 80% of NAV.

For Index Trackers, there are looser limits.

  • Max 20% NAV issuer limit. 35% in exceptional circumstances. (e.g. 0005 HK in the HSI Index)
  • Index must be:

– Sufficiently diversified
– Represent an adequate benchmark
– Published appropriately
– Independently managed of the UCITS

Control Limits:

  • Max 10% of non voting shares of any issuer
  • Max 10% of debt securities of any issuer
  • Max 10% of money market instruments of any issuer

Government Securities:

  • 35% NAV issuer limit (from 10%) for TS and MMI issued by:
  • EU member state and their local authorities

– Non Member State
– Public international body of which at least one member state is a member

  • Exempt from 5/40 rule

Up to 100% of NAV may be invested in TS, MMIs issued by a member state or their local authority, non member state or public international body if:

  • Held over 6 or more different issues
  • Limit 30% per single issue
  • Intention to use these limits and target issuers is disclosed in constitution and offering docs
  • Limited to OECD / Investment Grade (quite independent of each other these days)
  • Gilt Funds for example can be UCITS compliant and invest in 1 single issuer. (not quite investment grade these days)

Investments in Other Collective Investment Schemes:

  • Max 20% of NAV in a single CIS
  • Max 30% of NAV aggregate in non UCITS CIS (to remain ourselves UCITS)
  • Underlying CIS limited to no more than 10% in other CIS in aggregate (prevents FOFOF layering)
  • Max 25% of units of a single CIS (control issue)

General:

  • 20% NAV limit in issuer exposure across their capital structure, net. Includes TS, MMIs, cash, OTC counterparty, exposure via derivatives
  • Max 5% in warrants
  • No uncovered short sales
  • Limits do not apply to the exercise of subscription rights

Borrowing Limits:

  • The Fund can borrow up to 10% of NAV for temporary purposes.
  • Credit balances may not be offset against borrowing in calculating the percent borrowed.
  • Leveraged is achieved through derivatives.

Risk Management:

Risk Management Process:

  • A fund using Derivatives must submit to the Regulator a detailed Risk Management Process (RMP)
  • The RMP will set out the list of derivatives that will be used, the controls, processes, systems and personnel involved in the management and monitoring of risk relating to these derivatives.
  • Material changes to the RMP need regulator re-approval.

Level of Sophistication:

  • The Fund may self classify itself as Sophisticated or Non-Sophisticated.
  • The Regulator may disagree
  • Sophisticated funds are required to implement VaR
  • Non Sophisticated funds can use commitment or (delta) notional exposure
  • Self classifying as Non Sophisticated exempts a fund from the use of VaR but can impose restrictive notional leverage limits
  • Self classifying as Sophisticated allows more latitude in definition of leverage within a VaR framework

Global Exposure:

  • Total gross exposure including derivatives is limited to 200% NAV
  • Synthetic shorting is allowed
  • Physical shorting is not allowed

Commitment Approach:

  • Notional value
  • Global exposure is NIL for funds using derivatives purely for hedging or risk reduction purposes
  • Options can be treated on delta adjusted basis
  • Purchased and sold derivatives can be netted only if there is explicit netting arrangements with the Custodian or counterparties

VaR:

VaR model based on:

  • 99% confidence interval
  • Max 1 month holding period
  • Min 1 year historical observations
  • Stress tests and back tests must be applied
  • Adequate internal controls, staffing and experience are required
  • Description of VaR model and 3rd party verification
  • VaR may be specified as a multiple of a benchmark. That multiple is limited to 200%.

Position Exposure:

  • Limits are defined on total exposure aggregating direct, indirect and derivative exposure.
  • Except for certain Index based derivatives.

Counterparty Exposure:

  • Counterparty risk is limited to 5% of NAV for OTCs and 10% for EU or equivalent credit institutions.
  • All derivative exposures to the same OTC counterparties must be aggregated and an “add on” for future credit exposure based on Market Value (Ireland) and Notional (Luxembourg).
  • Counterparty risk can be reduced by the fund receiving collateral from the counterparty.
  • Positive and negative positions can be netted but only if there are formal netting agreements with the counterparty.

Liquidity:

  • A UCITS must re-purchase or redeem its units at the request of the unit holder.
  • Minimum frequency is twice a month. (Note that there is no specification on when in the month.)
  • Maximum notice until payout of cash is 14 days.
  • A UCITS can have a 10% gate per redemption date, thus a maximum 20% gate per month.

Feasible Strategies:

The following strategies are feasible under UCITS:

  • Long short equity
  • Long short credit – liquid markets only
  • Convertible arbitrage
  • Global Macro
  • Fixed income arbitrage – definitions of leverage need to be addressed
  • Commodity index funds – there is no question of physical of derivatives on underlying commodities. Only commodity indices are eligible.
  • CTA and Managed Futures
  • Event Driven
  • Funds of UCITS Funds
  • Structured and guaranteed products
  • ETFs

The following are not recommended for UCITS and fall foul of UCITS liquidity and valuation requirements: Less liquid credit strategies, distressed debt, mezzanine, private equity strategies, small and micro cap strategies.

A Final Word:

For the hedge fund manager, UCITS provides a delivery channel to a different investor base diversifying business risk. It also addresses investor concerns about the operational and fraud risks that plagued parts of the offshore unregulated industry in 2008. In addition, it provides a potential means of dodging the AIFM directive. There will be managers who see UCITS as a convenient dodge and an easier path to raising capital, and there will be those who see it for what it is; the evolution of European mutual fund legislation to ensure better investor protection while providing investors more choice. It is important that managers comply with the spirit of the law as well as the letter. The risk to UCITS as a brand is that it is abused by some managers which abuse the market uncovers in the usual discontinuous fashion and the fallout tars all UCITS with the same brush.

UCITS is designed for liquid strategies. Shoe-horning illiquid strategies into UCITS is a very bad idea. Not many people are aware that UCITS has a gating facility. This is an emergency feature for when normally liquid markets seize up. To run an illiquid portfolio in a UCITS in the hope that the gate provision is never needed is irresponsible on the part of the manager and the service providers who help to bring that UCITS to market.

UCITS is designed for low to moderate leverage strategies. The Sophisticated Fund classification which measures leverage in terms of VaR allows liquid strategies where delta notional exposure is not an appropriate measure of leverage admission as a UCITS. It is not there so that a highly levered and risky strategy can be slipped into a UCITS.

UCITS is designed for portfolios of eligible assets which are eligible by virtue of their liquidity, price discovery and transparency. It is designed so that the UCITS can feasibly supply the represented liquidity, provide an accurate and representative valuation of assets and not carry surprisingly large liabilities on the balance sheet which unexpectedly erode the value of the Net Asset Value.

Use with care.

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Cole-Frieman & Mallon LLP is a hedge fund law firm which provides comprehensive formation and regulatory support to hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Disclosure Document Guidance for CTAs and CPOs

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NFA Provides Overview of Manager Background (Bio) Disclosure Requirements

CFTC registered CTAs and CPOs need to have their disclosure documents reviewed by the NFA prior to using those documents to solicit clients or investors.  As any manager who has gone through this NFA review process understands, the NFA will take their time to scrutinize the documents.  One issue which comes up again and again is the background information that must be disclosed for any principals or managers disclosed in the disclosure document.  Managers should take note of the following points:

  1. Each bio must include a complete and detailed business background for the last 5 years (any gaps must be explained);
  2. Business background further back than 5 years does not need to be disclosed; and
  3. If a manager chooses to mention anything that happened in the manager’s business background further back than 5 years, the manager must disclose all subsequent employment.

The third point is really the most important for this discussion.  Let’s say a manager makes a general reference that he has been in the investment management business for 16 years – that means that the manager will need to provide a description of each job, including dates of employment (month and year) over the last 16 years.  Because in practice this would lead to ridiculously long bios (for some managers), it is generally recommended to leave the bio to the last 5 years so that the bio is manageable.

The NFA recently released a member notice, reprinted below, discussing this issue and the various questions that arise.  The following NFA Notice can be found here.

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Notice I-10-12

May 11, 2010

NFA provides guidance for disclosure of business background information by commodity pool operators and commodity trading advisors

In 1997, the Commodity Futures Trading Commission (CFTC) delegated the review of disclosure documents submitted by commodity pool operators (CPO) and commodity trading advisors (CTA) to NFA. The Division of Clearing and Intermediary Oversight (DCIO) performs periodic oversight of NFA’s implementation of its delegated authority. As part of these reviews, DCIO staff has communicated to NFA its expectations as to the type and breadth of information that must be disclosed regarding the background of CTAs, CPOs, and relevant individuals. NFA is providing the following guidance to clarify the requirements of the applicable regulations regarding the disclosure of business background.

CFTC Regulations 4.24 and 4.34 require that disclosure documents include, for the previous five years from the date of the document, the business backgrounds of the CTA, the CPO, the major CTAs, the CPOs of major investee pools, the pool’s trading manager, and each principal of the foregoing who participates in making trading or operational decisions, or supervises persons so engaged. For each of the persons listed above, the document must include employers, business associations, or ventures (including the starting and ending month and year) for the same five year period, as well as a discussion of the duties performed by the person for each. When disclosing business background information, the discussion must be complete for the entire five year period. Any gaps in time must be explained.

Examples of disclosures within the most recent five year period:

Ms. Smith attended ABC University and graduated in June 2005 with a degree in Economics. In August 2008, she joined XYZ LP as an associated person.

The business background must disclose what Ms. Smith was doing during the period between June 2005 and August 2008. Additionally, if XYZ LP is not the entity for which the disclosure document has been prepared, a description of its main business must be included.

Mr. Jones has been a listed principal of XYZ Company, a commodity trading advisor, since January 2005. In 2007 Mr. Jones began publishing a monthly newsletter entitled “The Trading Corner,” which outlines Jones’ trading research in the energy markets.

The business background must disclose Mr. Jones’ duties at XYZ Company. The month in which Mr. Jones began publishing his newsletter and the name and main business of the employer, if any, for whom the newsletter is being published must also be disclosed.

Mrs. Green was registered as an associated person of LMN LLC, a commodity pool operator from March 2008 until May 2008. In June 2008, she formed PQR Limited Partnership (PQR), a commodity pool operator which became registered on November 1, 2008. Mrs. Green became a registered AP and listed principal of PQR on November 1, 2008.

The business background must be complete for the last five years. Specifically, it must disclose what Mrs. Green was doing prior to March 2008. Mrs. Green’s and PQR’s activities between June 2008 (when she formed PQR) and November 2008 (when she and the firm became registered) must also be disclosed.

As noted above, CFTC Regulations mandate disclosure of business background information for only the last five years from the date of the disclosure document. DCIO has advised NFA, however, that if a CTA or CPO elects to provide business background information beyond the previous five year period it must provide this information in the same level of detail as that required for the last five years. DCIO has further directed that a general reference regarding the length of an entity’s or individual’s experience or involvement in an industry serves to extend the time period for which disclosures must be made.

The following is an example of a disclosure recently submitted to NFA and an explanation as to why it would not comply with the above stated policy:

Example of disclosure beyond the most recent five year period:

Mr. Brown has been in the futures industry since October 1982 or Mr. Brown has over twenty eight years of management experience.

Mr. Brown’s business background must be disclosed from October 1982 to the present. The disclosure must be complete for the entire period including the name and main business of each employer, the nature of the duties performed for each employer, and the starting and ending dates (month and year) of employment, including an explanation of any gaps in employment.

CPOs and CTAs are encouraged to review their existing disclosure documents in light of DCIO’s guidance and make any necessary changes prior to submitting subsequent filings of the document. If you have any questions concerning this notice or disclosure documents generally, please contact Mary McHenry, Senior Manager, Compliance ([email protected] or 312-781-1420) or Kaitlan Chi, Manager, Compliance ([email protected] or 312-781-1219).

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Other related hedge fund law blog posts include:

Cole-Frieman & Mallon LLP is a hedge fund law firm which provides CTAs and CPOs with comprehensive formation and regulatory support.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

CPO Quarterly Filing Reminder

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NFA Rule 2-46 Filing Due Monday May 17th

NFA Rule 2-46 requires most registered CPOs to submit certain information to the NFA on a quarterly basis.  The filing is due within 45 days of the end of each quarter.  The filing date for CPOs which were active in the first quarter is Monday May 17th.

Mallon P.C. provides comprehensive services for CPO managers and can help with the quarterly Rule 2-46 filing.  Please contact us if you have any questions.

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Other related hedge fund law blog posts include:

Cole-Frieman & Mallon LLP can provide CPOs with comprehensive support during the filing process.  Bart Mallon, Esq. can be reached directly at 415-868-5345.