Hedge Fund IRA Investments

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Individual retirement account (IRA) investments into hedge funds are increasing rapidly.  Below are some common questions hedge fund managers have about potential investments by IRAs.

Can an IRA invest in a hedge fund?

Generally yes, however the IRA and the hedge fund must make sure to follow certain regulations which a manager should discuss with a hedge fund attorney.    A manager should not accept IRA investments into the hedge fund without first discussing this with his lawyer.

How does an IRA actually make the investment into the hedge fund?

Each IRA investment into the hedge fund needs to be made by the custodian of the IRA.  That is, the beneficial owner of the IRA cannot simply take the money out of his IRA account and then place the money in the hedge fund – this would be deemed to be a withdrawal from the IRA and would be subject to very negative tax consequences.

In order to avoid these negative tax consequences the custodian needs to directly transfer the IRA assets to the hedge fund.  Typically this is done through a self directed IRA account at a brokerage firm.  Many brokerage firms do not have these self directed programs in place.  If the brokerage firm does not have such a program in place the beneficial owner of the IRA would need to transfer the IRA to another custodian which does.  Our law firm has worked with many custodians who have these programs and we can make recommendations.

Each custodian has different requirements for an investment into a hedge fund from an IRA.  Typically the hedge fund manager is going to need to fill out a few pages of paperwork with the custodian and provide custodian with the fund’s offering documents.  After the custodian’s compliance department has reviewed the paperwork, the custodian will be able to make the investment into the fund on behalf of the IRA.  During this process the hedge fund manager is going to be spending time talking with the custodian and the compliance department.  Additionally the law firm may need to be involved with the process as well; however, this is usually to a much lesser extent.

Are there any other issues with IRA investments into hedge funds?

Yes.  There are many issues which a hedge fund manager should be aware of which include the following:

1.  The manager should be sure that the hedge fund and the management company do not engage in any prohibited transactions with respect to the fund and the IRA.  [More on this in a later article.]

2.  The manager should make sure that if it uses any sort of leverage that such activities are clearly discussed in the fund’s offering documents.  In certain circumstances where there is leverage, an IRA could be subject to tax on its unrelated business taxable income or UBTI.

3.  The manager should make sure that the fund does not stray from its investment program.  IRA are not allowed to make certain investments like investments in life insurance policies (life settlements).
As noted in an earlier article on hedge funds and ERISA, while IRAs are not specifically ERISA assets, they do count towards the 25% threshold and thus the manager needs to be aware of the amount of IRA and other ERISA assets in the hedge fund.

HFLB Note

Because of the gravity of the tax consequences to potential IRA investors, please contact your hedge fund attorney or accountant if you have specific questions about IRA investments into your fund.  Additionally, savvy hedge fund investors will usually want to make sure that their own tax advisors have reviewed the hedge fund offering documents before investing in the fund.

Please contact us if you have any questions on the above.  Also, please read our disclaimer with regard to discussions about tax items.

Hedge Fund UBTI (unrelated business taxable income)

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

What is UBTI and why is it important?

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

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

Do short sales give rise to UBTI?

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

What are the tax code provisions dealing with UBTI?

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

Section 511 – provides for a tax on UBTI

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

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

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

Third Party Marketing Press Release

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Hedge Fund Third Party Marketing Firm, Agecroft Partners, Hires 5th Managing Director

Hedge fund third party marketing firm, Agecroft Partners which recently received the 2008 Third Party Marketer of the Year award, has hired its 5th Managing Director, Jarratt Ramsey. Jarratt spent the last 11 years at multi-billion dollar hedge fund Chesapeake Capital Management. Jarratt’s responsibilities will include: assisting with due diligence on potential hedge funds the firm may represent and introducing the firm’s hedge fund clients to large institutional investors located within the Northern region of the United States.

Richmond, VA (PRWEB) October 6, 2008 — Hedge fund third party marketing firm, Agecroft Partners which recently received the 2008 Third Party Marketer of the Year award, has hired its 5th Managing Director, Jarratt Ramsey. Jarratt spent the last 11 years at multi-billion hedge fund Chesapeake Capital Management. Jarratt’s responsibilities will include: assisting with due diligence on potential hedge funds the firm may represent and introducing the firm’s hedge fund clients to large institutional investors located within the Northern region of the United States.

“Jarratt is a wonderful addition to our firm. Our business model is to introduce large well established hedge funds in a consultative manner to institutional investors. It is imperative that the members of our firm are highly technically competent. Jarratt’s educational and professional experiences are very impressive. Furthermore, his knowledge of the hedge fund industry, and security markets should give him a lot of credibility with large institutional investors,” stated Agecroft Partners’ Managing Partner Don Steinbrugge.

Agecroft Partners is a global consulting and third party marketing firm for hedge funds. It was founded by Donald A Steinbrugge, CFA, a Founding Principal of Andor Capital Management when it was the 2nd largest hedge fund firm in the world. Don was also Head of Institutional Sales for Merrill Lynch Investment Managers. Agecroft Partners, LLC is a Member FINRA and SIPC.

Treasury Announces Method of Selecting Asset Managers

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The U.S. Department of the Treasury (Treasury) will use the following procedures to select asset managers for the portfolio of troubled assets, pursuant to the authorities given to the Treasury in the Emergency Economic Stabilization Act of 2008 (Act).

Securities vs. Whole Loans. The Treasury will select asset managers of securities separately from asset managers of mortgage whole loans, but in each case these procedures will apply. Securities asset managers will handle Prime, Alt-A, and Subprime residential mortgage backed securities (MBS), commercial MBS, and MBS collateralized debt obligations, and possibly other types of securities acquired to promote market stability. Whole loan asset managers may handle a range of products, including residential first mortgages, home equity loans, second liens, commercial mortgage loans, and possibly other types of mortgage loans acquired to promote market stability.

Financial Agents. Asset managers will be financial agents of the United States, and not contractors. The Act authorizes the Secretary of the Treasury (Secretary) to designate “financial institutions as financial agents of the Federal Government, and such institutions shall perform all such reasonable duties related to this Act as financial agents of the Federal Government as may be required.” As financial agents, asset managers will have a fiduciary agent-principal relationship with the Treasury with a responsibility for protecting the interests of the United States.

Organizational Eligibility. Financial Institutions are eligible to be designated as financial agents of the United States. The Act defines “Financial Institution” to mean “any institution, including, but not limited to, any bank, savings association, credit union, security broker or dealer, or insurance company, established and regulated under the laws of the United States or any State, territory, or possession of the United States, the District of Columbia, Commonwealth of Puerto Rico, Commonwealth of Northern Mariana Islands, Guam, American Samoa, or the United States Virgin Islands, and having significant operations in the United States, but excluding any central bank of, or institution owned by, a foreign government.”

Open Notice. Prospective financial agents will be solicited through the issuance of a public notice, posted on the Treasury website, requesting that interested and qualified Financial Institutions submit a response. The notice will describe the asset management services sought by the Treasury, set forth the rules for submitting a response, and list the factors that will be considered in selecting Financial Institutions. The notice will also include minimum qualifications, such as years of experience and minimum assets under management, and eligibility requirements, such as a clean audit opinion. The Treasury will release one notice for securities asset managers, and a separate notice for whole loan asset managers.

Reviewing Responses and Second Phase. The Treasury will evaluate the initial responses from all interested and qualified Financial Institutions, and will invite certain candidates to continue to the second phase of the financial agent selection process. This second phase, and subsequent phases, may be conducted under confidentiality agreements to facilitate information exchange, but consistent with the public disclosure and transparency provisions of the Act. In the second phase, the prospective financial agents will provide additional information about their expertise, as well as asset management strategies, risk management, and performance measurement. This phase may include telephone conversations to allow questioning by and of the Treasury.

Final Phase and Selection. The Treasury will evaluate the responses from the second phase candidates, and will determine whether a candidate will continue to be considered. In this last stage, a Financial Institution may be required to conduct face-to-face discussions on portfolio scenarios, public policy goals, and statutory requirements, and to respond to interview questions to assess the capabilities of prospective individuals to be assigned to manage assets. Following any face-to-face meetings, the Treasury will make final selections of the Financial Institutions to be designated as asset managers.

Financial Agency Agreement. Financial Institutions selected to be asset managers must sign a Financial Agency Agreement with the Treasury, a copy of which will be provided for review during the second stage of the selection process. The Financial Institution’s willingness to enter into the standard Financial Agency Agreement, with the established terms and conditions currently applied to financial agents of the United States, will be among the factors used in evaluating the Financial Institution.

Evaluations and Decisions. At each stage in the selection process, personnel from the Offices of the Fiscal Assistant Secretary and the Assistant Secretary for Financial Markets, and possibly additional personnel within the Offices of Domestic Finance and Economic Policy, will evaluate the candidate submissions and make recommendations to the head of the Office of Financial Stability, who will make the final decision.

Multiple Managers. The Treasury expects to designate multiple asset managers and submanagers to obtain the proper expertise in different asset types and different segments of the mortgage credit market. However, the Treasury may not, in its discretion, select all asset managers at the same time, but rather in some sequence that matches the Treasury’s asset acquisition schedule and project plan for the portfolio. For example, an asset manager for whole loans may not be selected at the same time as an asset manager for MBS, or a primary manager may be selected prior to a sub-manager. Furthermore, as business requirements evolve, the Treasury may issue additional notices in the future to select more asset managers, consistent with the process set forth in this document.

Small and Minority- And Women-Owned Businesses. The Treasury will issue separate notices, consistent with these procedures, specifically to identify smaller and minority- and women-owned Financial Institutions that do not meet the minimum qualifications for current assets under management in the initial notices. Such Financial Institutions will be designated as sub-managers within the portfolio.

Urgency and Timeline. Given the urgent need to implement the Troubled Assets Relief Program quickly, the selection process for asset managers may involve extremely short deadlines for submitting information and for traveling to Washington, D.C. for meetings or interviews.

Costs of Applying. The Treasury will not reimburse or otherwise compensate a prospective asset manager for expenses or losses incurred in connection with the selection process.

Hedge Fund CPO Exemptions

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

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

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

Rule 4.13(a)(1) – closely held pool

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

1.    Manager operates only one pool at a time;

2.    Manager does not receive any form of compensation;

3.    Manager does not advertise; and

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

Please see Rule 4.13(a)(1).

Rule 4.13(a)(2) – small pool

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

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

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

Please see Rule 4.13(a)(2).

Rule 4.13(a)(3) – deminimus rule

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

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

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

3.    One of the following tests is met:

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

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

Please see Rule 4.13(a)(3).

Rule 4.13(a)(4) – all QEPs

NOTE: THIS EXEMPTION IS NO LONGER AVAILABLE FOR MANAGERS

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

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

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

Please see Rule 4.13(a)(4).

Rule 4.5 Exemption

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

Please see Rule 4.5.

Rule 4.7 Exemption

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

Please see Rule 4.7.

Rule 4.12 Exemption

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

Please see Rule 4.12.

Hedge Fund Stories and Analysis for the Week of October 5, 2008

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This past week has seen no shortage in the amount of articles on the hedge fund industry and the effect of the market and governmental events.  Below I’ve highlighted a few stories which I found particularly interesting and relevant for hedge fund managers.  Additionally, I think the following are points which hedge fund managers should be particularly aware of in light of recent events.

1. Hedge Fund Offering Documents are important. Most hedge fund offering documents are written very broadly and give the manager wide latitude in managing the fund.  The stories below highlight the important powers given to hedge fund managers.

2. Managers should start thinking of long term business continuity planning. While no one wants to think about and discuss what would happen during if the fund does have negative performance during the year, a well prepared manager will have a plan in place.  The stories below on blocked redemptions and re-negotiation of fees is showing us that managers were not prepared for the possibility of running a fund during lean times.  Managers should potentially think about retaining some performance fees in the management company so that they will be able to keep the doors open while trying to claw back to the high watermark.  Additionally, I believe that hedge fund due diligence will begin to include questions on how a manager would deal with a negative year.

Blocked Hedge Fund Withdrawals

A central concern for many market watchers (and investors) is whether hedge funds will have huge redemptions which would spark a sell off over the next couple of months.  We’ve seen some interesting items.  First, there is a fund which is actually blocking investor withdrawals in order to protect remaining investors from a fire sale of the fund’s assets (see story).

Restructure of Hedge Fund Performance Fees

As hedge fund managers see that the is the likliehood of negative returns this year, and the looming hedge fund high watermark provision, managers are rushing to cut deals with investors so that the funds can stay alive for the foreseeable future. According to a Wall Street Journal story, investors in the UK hedge fund RAB Capital agreed to “a three-year lockup in exchange for a management fee of 1% of assets and performance fee of 15% of returns, instead of 2% and 20%.”  The Stamford advocate reported that Camulos Capital LLC, a Greenwich-based hedge fund, and Ore Hill, a New York-based fund, among others, have restructured their fees to keep investors in their respective funds.

ABL Hedge Funds to step into the role of the banks?

If you listen to the news, and even the presidential candidates, you’ll hear about the “impending doom” in the banking industry – how mom and pop shops will not be able to get any loans to keep their business afloat.  While there have been many anectodes which suggest that this is, and is not, the case, it is likely that the banks will choose to pass on certain types of riskier loans, creating a great opportunity for non-traditional forms of finance.  Asset based lending is a hedge fund strategy in which the manager will make loans to business which will be backed by certain collateral, whether a receivable or some other physical asset.

I believe that we are going to see the launch of several asset based lending funds in the next few months and into the next year.  If the current banking climate remains how it is, asset based lending hedge funds might even become the next neighborhood banking center.  I have also previously written about the popularity of asset based lending hedge funds.

Hedge Fund Due Diligence 2.0

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We hear about the “web 2.0” and today’s San Francisco Chronicle used the term “Wall Street 2.0” which made me wonder what the hedge fund industry will look like after this mess clears itself over the next couple of months.  First, it is obvious that there is going to be government regulation of some sort over the hedge fund industry which I will be detailing over the coming weeks and months.  Additionally, investors are going to need to take proactive steps to protect their investments and hedge fund due diligence will become a greater part of the hedge fund industry – I’m dubbing this “Hedge Fund Due Diligence 2.0”.

Hedge Fund Due Diligence 2.0 is likely to include more questions on the hedge fund manager’s business acumen and operations.  The current crisis has showed us, in numerous circumstances, that hedge fund managers were simply not prepared to handle a complete market crisis.  Hedge fund managers already have to answer in depth questions relating to risk management policies and procedures, but these questions will likely become more in depth.  Specifically, Hedge Fund Due Diligence 2.0 will likely inquire into a manager’s specific cash management policies.  While this might be viewed as digging into the manager’s operational business (as opposed to just the managers performance results), it is necessary to protect an investor’s investment in the event that a high watermark provision is implicated.

More to come on this topic …

Hedge Fund Attorney

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What does a hedge fund attorney do for a start-up hedge fund?

A hedge fund attorney is the first service provider a start-up hedge fund manager will likely contact.  The hedge fund attorney will listen to the manager and discuss the investment program.  From here the hedge fund attorney will begin drafting the hedge fund’s offering documents and may also suggest the other service providers the manager should talk to (including the administrator, auditor, and brokers or prime brokers).  After the offering documents have been finalized, the hedge fund attorney will help the manager with many of the logistical items which need to be addressed before the fund begins doing business.

Once the fund has started trading, the hedge fund manager may need the hedge fund attorney to do the following items:

–    Blue sky filings
–    Provide updates on relevant hedge fund laws
–    Revise the offering documents if necessary
–    Draft side letter agreements for certain investors
–    Make 13F filings on behalf of the manager
–    Make Form SH filings on behalf of the manager
–    Consult with the manager if investors have certain needs
–    Consult with the manager to start a new fund
–    Review marketing and other promotional materials
–    Answer hedge fund related questions
–    Help prepare manager for investment advisor or commodity pool operator audits (if necessary)
–    Hedge fund due diligence, potentially

In addition to the above, the hedge fund attorney is going to be a resource for the manager and the fund on an ongoing basis.  Hedge fund lawyers that have been around for a while and who have launched all sorts of funds will have generally experienced most issues that will arise in the hedge fund context.

What else does a hedge fund attorney do?

Besides drafting offering documents for the client, a hedge fund lawyer needs to understand what is going on in the industry.  As such the hedge fund attorney will spend a good portion of his day researching issues for clients, talking with service providers to see what are the developing trends within the industry, talking with regulators to see what are some of the things they are focusing on, in addition to other items.  Your hedge fund attorney should have an ear to the ground and understand the issues that affect you from both a business and regulatory perspective.

Hedge fund attorney – boutique or big firm?

Hedge fund attorneys usually work for either (i) boutique law firms that focus on securities law or the investment management industry or (ii) very large regional or national law firms.  Generally both types of attorneys are competent, produce good documents, and have the requisite knowledge of the industry.  In general, you will be looking at a cost issue.  Hedge fund formation costs can be high and if you use a very large law firm the legal costs could be double or more.

If you are a very large fund which will have over a billion dollars in assets during the first year of operation, you are probably going to go with the very large law firms that have very good reputations for hedge fund work.  Funds smaller than this may decide to go with the boutique firm for cost savings purposes, but they may also decide to go with the large law firms if they feel that there is need to show “name brand” service providers in their offering documents.  This might be the case if these funds are going to be shopping around for very large institutional investors during the first six months of operations.

Another issue to consider is who will be your contact person at the law firm.  Many start-up hedge funds choose to go with the boutique law firm because of the direct access to partners.  At the large law firms, most client matters are handled at the associate level and the partner may only talk to the manager once or twice.

Above all, the most important item when choosing a hedge fund attorney is to make sure you are comfortable with the attorney and his knowledge of the industry.  When starting out, the hedge fund start-up process can take up to two or more months depending on the complexity of the project, so you will want to make sure you have a good working relationship with your attorney.

Hedge Fund Formation Legal Fees

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Question: How much does it cost to establish a hedge fund?

Answer: The costs of starting a hedge fund can vary considerably depending on the manager and the manager’s circumstances.  A start up hedge fund manager will need to consider the hedge fund start up costs which will include legal costs, administration costs and set up fees, bank fees, prime brokerage fees, rent, etc.  This article will detail hedge fund legal fees.

Hedge Fund Formation Legal Fees

The central legal fees for a start up hedge fund manager are the costs associated with preparing the offering documents for the hedge fund.  Most law firms who provide these services will charge on a flat fee basis, depending on the novelty and scope of the project.  The cost breakdown is, generally, as follows:

Large brand name New York based law firm: $35,000 – $75,000

Midsize law firm with known hedge fund practice: $25,000-$45,000

Small or boutique hedge fund law firm: $15,000-$30,000

The above are very large fee ranges, but for managers with very basic hedge fund strategies (say a long-short large cap investment strategy) you are looking at the lower end of the fee range.  If the strategy is more esoteric or if there are many structural issues (especially liquidity and valuation issues), then the costs will be more.  Additionally, if the strategy has certain ERISA or tax issues then the cost is going to be more.

The costs above generally do not include filing fees for entity incorporation, fees for investment advisor registration, or any blue sky filing fees.

Please note that you may find groups out there which provide hedge fund offering documents for lower prices.  As when selecting any attorney, price should not be the only determining factor.  There are also offering document software sources out there which purport to create offering documents for your fund for under $5,000 – do not use such services.  The legal documents provided by hedge fund lawyers are designed to protect you as the manager and any off the shelf solution is not going to be able to provide the customized legal advice you will need to be properly protected.  I have personally seen some of these documents and they are woefully inadequate.

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

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

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

Short Sale Ban

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

Short Sale Disclosure Requirements

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

Likely Fallout

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

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

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

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

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

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

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

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