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Cole-Frieman & Mallon LLP Quarterly Newsletter | 2nd Quarter 2010

Below is our quarterly newsletter.  If you would like to be added to our distribution list, please contact us.

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July 31, 2010
www.colefrieman.com

Clients and Friends,

We take this opportunity to provide you with a brief overview of the major items we have reported on over the last quarter.  While we are a little late with the newsletter, the past couple of weeks have been especially busy with the passage of the Dodd-Frank reform bill.  There will be continuous rulemaking and proposals over the course of the next 12 months and this newsletter will provide an overview of the issues which we will be discussing in the future.  Also, please be sure to skim the ongoing compliance update below to make sure your firm is up to date with compliance.

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Financial Reform Bill – The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed by President Obama on July 21, 2010, will meaningfully change the investment management industry in a number of ways. Important changes include:

  • Manager Registration – Managers to hedge funds and private equity funds will generally be required to  register with the SEC by July 21, 2011 if they have $150 million or more in AUM.
  • Accredited Investor Definition – The definition of accredited investor has changed. Now, investors cannot include the value of their primary residence when computing net worth. The qualified client definition may also be changed in the future.
  • BD Fiduciary Standard – The SEC will study and potentially institute a fiduciary standard for broker-dealer representatives.
  • Increased State Regulation of Investment Advisers – Previously, the states only had jurisdiction over managers up to $25 million of AUM. Now the states have jurisdiction over managers with up to $100 million of AUM. We have provided our comments on the increase in state regulatory jurisdiction in light of state budget shortfalls.
  • Regulation of the OTC Derivatives Markets – Previously unregulated contacts (like credit default swaps) will be subject to a clearing requirement. There will be much written on this over the next few months as the CFTC and SEC begin establishing a framework for such clearing.
  • Imposition of Position Limits on Certain Commodities (see below)

In addition to the changes to the securities and commodities laws, there will be a number of rulemaking initiatives by both the SEC and CFTC which will augment the statutory language of the bill.

Busy, Busy SEC – Notwithstanding preparations for the Dodd-Frank bill, the SEC has been especially busy over the last quarter.  The big news was obviously the Goldman settlement, but there were a number of other SEC initiatives as well. These include:

New ADV Part 2 Released – The SEC just released the requirements for the new Form ADV Part 2 which will now be publicly available through the SEC’s Advisor Search program.  New Part 2 will require registered managers to provide a narrative of their investment program and other relevant information. Managers also need to provide investors with supplements detailing certain background information about the representative directing an investor’s account.  Most currently registered managers are required to post a new Part 2 during the first quarter of 2011.

Pay to Play Rule Adopted – The SEC adopted new Rule 206(4)-5 under the Investment Advisers Act prohibiting certain political contributions by investment advisory firms.  Firms are urged to update their compliance policies and procedures to account for the new rule.

Advisor Representative Disclosures – The SEC updated its Advisor Search program so that information on investment adviser representatives will now be publicly available online.  Prior to the update, disciplinary and other background information was only publicly available to the extent it was disclosed on the adviser’s Form ADV.

Futures/ Commodities Issues – Like the SEC, the CFTC has been very busy over the last quarter and will continue to be busy proposing rules under the Dodd-Frank bill. Accordingly, there are a number of interesting items concerning both the CFTC and NFA. These include:

Position Limits – Dodd-Frank mandates the CFTC to impose position limits across different markets including traditional futures markets, agricultural markets, and with respect to certain swap instruments. The CFTC will be releasing orders or proposed rules establishing limits within 180 days for energy commodities and within 270 days for agricultural commodities.  Position limits will affect commodities transactions that have previously qualified for broad statutory exemptions and traders will need to closely monitor trading activity to avoid violating the limits when they are established and implemented.

CFTC Releases Report on NFA – The CFTC audited the NFA in 2009 to gauge how successfully the self regulatory organization implemented certain CFTC regulations.  The CFTC noted a number of areas where the NFA should improve procedures.  We have already seen some of the suggestions implemented and, accordingly, the registration process (in certain instances) is taking a little longer than usual.

CTA & CPO Disclosure Document Bios – For CTAs and CPOs registering with the CFTC, one area where the NFA seems to spend considerable time is the biography portion of the disclosure documents.  Because of common deficiencies with respect to the biographies (or manager backgrounds), the NFA released guidance on how this part of a disclosure document should be completed.

Form 8-R Revised – Form 8-R applications for principal and associated person registration has been revised to include demographic information on the registrant.  The newly added information includes sex, race, eye color, hair color, height and weight.  The purpose of the additions was to help speed up the background check process for principals and associated persons.

NFA Forex Workshop Announced – In expectation of the CFTC finalizing the forex registration rules for forex CTAs, CPOs and IBs, the NFA is conducting a registration and compliance workshop for forex managers.  The workshop will take place on September 25th, 2010 at Caesar’s Palace in Las Vegas. NFA staff will be on hand to discuss the registration process and to take questions from managers.

Other Notes

Hedge Fund Carried Interest – Every few months the taxation of the carried interest becomes a political football.  Early in the quarter it looked like the carried interest tax would be changed as part of an unemployment extension bill.  However, that bill never passed and the proposal to tax the carried interest as ordinary income died.  We expect to probably hear another proposal like this in the next 12 to 18 months.

Hedge Fund Court Case – Earlier this year a court case was decided in favor of a hedge fund manager when that manager suspended redemptions and was subsequently sued by an investor.  We discussed the facts of the case and the manager takeaways.

Ongoing Compliance – At the end of every quarter, managers should take time to address any ongoing compliance matters.  Managers who are registered in any capacity (state, SEC or CFTC) should review their compliance calendar or policies and procedures to ensure that all quarterly compliance matters are completed.  Additionally managers should always be sure to complete all state blue sky filings and commodity pool operators should make sure they complete their Rule 2-46 quarterly filings.

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For assistance with any compliance, registration, or planning issues with respect to any of the above topics, please contact Bart Mallon of Mallon P.C. (www.mallonpc.com) at 415-868-5345 or [email protected]

Cole-Frieman & Mallon LLP is a hedge fund law firm with a national client base and is focused on the investment management industry.  Our clients include hedge fund managers, investment advisers, commodity advisors, and other investment managers.  We also provide general business and start up legal advice and have an emerging practice in real estate and cleantech.

150 Spear Street, Suite 825
San Francisco, CA 94105
Telephone: (415) 352-2300
Fax: (646) 619-4800

Cole-Frieman & Mallon LLP Quarterly Newsletter | 1st Quarter 2010

Below is our quarterly newsletter.  If you would like to be added to our distribution list, please contact us.

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April 1, 2010
www.colefrieman.com

Cole-Frieman &  Mallon LLP Quarterly Newsletter

Clients and Friends,

We take this opportunity to provide you with a brief overview of the major items we have reported on over the last quarter.  We have also provided a list of some of the major compliance issues that managers should be aware of during this time period.

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New Quarterly Reporting Rule for CPOs – new NFA Rule 2-46, which became effective on March 31, 2010, requires registered commodity pool operators (including registered CPOs managing 4.7 or 4.12 pools) to provide a quarterly report to the NFA through the NFA’s EasyFile system.  Managers will report information on key relationships, a statement of the change in the fund’s NAV, monthly ROR, and a schedule for major investments.  The report will need to be filed within 45 days of March 31 and the process will be familiar to those groups who have filed their annual returns with the NFA previously.

For a complete overview of the new rule, click here.

Proposed Forex Regulations – for forex managers, the announcement of the CFTC’s proposed forex regulations was the major topic of conversation over the last quarter.  The proposed regulations include a number of new requirements for forex managers: (i) registration requirements for forex CTAs, CPOs, and IBs; (ii) net capital requirements for forex dealers; (iii) reduction in leverage from 100:1 to 10:1; and, (iv) a guarantee requirement for all forex IBs.

Overview of the proposed regulations can be found here.

Mallon P.C. comments on the proposed regulations can be found here.

Compliance Reminders

Form D Update – managers should be aware that for continuous offerings (most hedge funds), Form D needs to be updated on an annual basis.  Managers who have not updated Form D within the last year should check whether the fund’s Form D needs to be updated. For more information please click here.

Blue Sky Filings – managers need to make sure they are up to date with all blue sky filings.  Mallon P.C. has a team devoted to blue sky filings and compliance and is happy to answer any questions you may have. For more information on blue sky filings, please click here.

Investment Advisers – investment advisers should have completed their annual update of Form ADV through the IARD system by March 31, 2010 for 2009.  Managers who have not done this yet will need to do so immediately. Additionally, some states will require managers to submit other information such as updated financials. The requirements for California registered investment advisers can be found here.

CFTC Registrants – managers who are registered with the CFTC and members of the NFA have a number of yearly compliance requirements.  Generally these managers will have already done the following: (i) submitted annual reports (if required to be filed with the NFA); (ii) sent out a physical copy of their privacy policy to all investors/clients; (iii) completed the yearly NFA Self-Exam Checklist; and, (iv) updated their compliance policies and procedures accordingly.  Some CFTC registrants will have a requirement to review the procedures with respect to bunched orders on a quarterly basis.

Cleantech & Carbon – a recent 100 Women in Hedge Funds event focused on the cleantech industry and how hedge funds and VC funds are looking at investments in this space.  We wrote a summary of the event and were encouraged by the turnout and industry participation.  We look forward to greater interest in this sector by hedge funds.  Additionally, we are closely watching Congress as cap and trade legislation and energy bills become a topic of consideration.  We will continue to monitor any cap and trade legislation and will report on how this may impact the investment management industry.

2nd Quarter Events – New York CTA Expo April 21 – Mallon P.C. sponsors the CTA Expo which was established in 2008 to help professional capital raisers and allocators identify futures trading talent and to promote investing in managed futures. It is a one day conference consisting of speakers and panels combined with a schedule of thirty minute presentations by individual CTAs.  The New York event will take place on April 21, 2010 at the CME Group Building.  For more information, please see the CTA Expo website.

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For assistance with any compliance, registration, or planning issues on any of the above topics, please contact Bart Mallon of Cole-Frieman & Mallon LLP (www.colefrieman.com) at 415-868-5345 or [email protected]

Cole-Frieman & Mallon LLP is a law firm with a national client base and is focused on the investment management industry.  Our clients include hedge fund managers, investment advisers, commodity advisors, and other investment managers.  We also provide general business and start-up legal advice and have an emerging practice in real estate and cleantech.

Cole-Frieman & Mallon LLP
150 Spear Street, Suite 825
San Francisco, CA 94105
Telephone: (415) 352-2300
Fax: (646) 619-4800

Hedge Fund Investors Asking for More Meaningful Communication

Clients are demanding that investment managers communicate more than just data

The following white paper was released by BK Communications Group, a company which provides outsourced marketing and client communications solutions for the asset management industry.  According to a recent survey of institutional hedge fund investors, clients largely prefer that managers take the call for transparency one level further and communicate to them in a meaningful way that explains what they’re doing with the funds.  Popular forms of communication adopted by investment firms include pitch-books, websites, and personal contact.  According to a report by McKinsey & Co., providing full transparency and enhancing communication efforts can be useful in client retention and future asset gathering.

The executive summary and highlights of the paper is re-printed in full below as well as a link to the paper.

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BKCG White Paper
June 2009
The New Transparency: Words

Clients are demanding that investment managers communicate more than just data

Executive Summary

Transparency has typically been equated with access to data (trade, exposure, valuation, etc.), but the financial crisis and fund scandals have led clients, investors, as well as regulators to demand more. Major surveys and anecdotal evidence indicate communication is now in demand. Clients want managers to put the numbers in context, to explain what they’re doing, to communicate on a clear and meaningful basis. This expanded transparency can help retain clients and strategically position a firm for future asset gathering, both by building a brand associated with full transparency and by ensuring that all touchpoints – from pitchbooks to websites to personal contact – are fully in place and high quality. Investment firms must carefully examine how they currently communicate, decide on any adjustments that must be made, and determine whether they have the internal capabilities and resources to execute on those adjustments.

Highlights

  • Communication is the new transparency. Data alone is no longer sufficient. Clients want managers to put the numbers in context, to explain what they’re doing, to communicate on a clear and meaningful basis
  • SEI/Greenwich Associates’ global survey of institutional investors finds investors will “intensify their scrutiny of investment processes” and increasingly emphasize client reporting and communications.
  • Preqin’s survey of 50 institutional hedge fund investors finds that events of the past 12 months have led 43% of respondents to expect “increased transparency and understandable strategy.”
  • Providing full transparency can be a way of helping to retain clients and strategically position a firm for future asset gathering. McKinsey & Co’s major report (“The Asset Management Industry in 2010”) concludes that “winning asset managers will be those who forge a superior reputation and capabilities for service and sophisticated advice.”
  • Communications transparency can be approached strategically, to ensure an investment firm’s brand is associated with openness and clarity, and to establish a reputation for thought leadership, as this is associated with mastery of core competence.
  • Communications transparency can also be approached tactically by making sure that all touchpoints – from pitchbooks to websites to personal contacts – are fully in place and high quality.
  • Many investment firms are shedding internal resources that are not profit centers, including communications personnel, or are hesitant to bring on those resources – leaving them without the necessary skills, or bandwidth, for an appropriate level of communications.

For the full report, please see BKCG Transparency White Paper

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

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.

Hedge Funds and Rehypothication

Ongoing Legal Issues For Hedge Fund Managers

While many of the posts on this blog deal with start-up and regulatory issues that hedge fund managers face, we also are aware that there are many ongoing legal issues which affect the business of the fund.  Below is a guest post from Karl Cole-Frieman on hedge fund rehypothication and the prime brokerage relationship.

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What is Rehypothication?
By Karl Cole-Frieman, www.colefrieman.com

One of the most frequent questions that I am asked these days is to explain the term “rehypothication” in the context of a prime brokerage agreement.  The concept of rehypothication has been imbedded in the credit arrangements of prime brokerage agreements for years, but until 2008 and the collapse of Bear Sterns and Lehman Brothers, it was rarely discussed (except by certain lawyers who negotiate these agreements).  In the simplest terms, hypothication is the posting of securities or other collateral to a prime broker in exchange for credit or margin.  Rehypothication is the further pledging or lending by the prime broker of the already hypothecated securities or other collateral by the customer for its own purposes.

Prime Brokerage and Rehypothication

In modern prime brokerage, rehypothication is deeply ingrained in the business model of the major prime brokers.  Typically, hedge fund customer assets are rehypothicated to other banks to raise cash for the prime brokers.  Allowing the prime brokers to rehypothicate assets has historically kept down the cost of borrowing money for hedge fund managers.  In recent years, hedge funds have benefited from this arrangement by obtaining very cheap margin pricing.

Bankruptcy of a Prime Broker

The problem for hedge fund managers is that if there is a bankruptcy filing of their prime broker, hedge funds may have difficulty getting their rehypothicated assets back, particularly if these assets are held by the prime broker’s London affiliate, as the UK has more relaxed rules regarding rehypothication.  A number of highly successful managers had to literally shut their doors in September 2008 because their assets were tied up in Lehman Brothers’ London affiliate.  Lehman filed for bankruptcy in September 2008, and Pricewaterhouse Coopers, Lehman’s European administrator, currently estimates that assets may be returned to clients in the first quarter of 2010 – a year and a half later.

Hedge Fund Managers and Rehypothication

It is important for hedge fund managers to understand this concept of rehypothication for several reasons.  First, managers need to take ownership of their prime brokerage arrangements and understand them in general.  It has been my experience that many managers that take extreme care in making portfolio decisions pay absolutely no attention to their prime brokerage or custody arrangements.  As the events of 2008 demonstrated, they do so at their peril.  Imagine being up for the year, and then losing everything because the manager neglected to monitor their prime brokerage and custody arrangements.

Second, investors are asking about it.  The concept of rehypothication entered the hedge fund vernacular in 2008 and is here to stay.  Investors now frequently ask about rehypothication, and other prime brokerage concepts/arrangements, in due diligence, and there are a lot of misconceptions about the term.  Nevertheless, especially in the current environment, a lack of understanding about prime brokerage, custody, etc . . . can make the difference in receiving an allocation from an investor or cause a manager to fail operational due diligence.  Managers need to be prepared to discuss these concepts and be aware of the terms in their own prime brokerage agreements.

To find out more about rehypothication and other topics relating to prime brokerage or custody, please contact Karl Cole-Frieman of Cole-Frieman & Mallon LLP (www.colefrieman.com) at 415-352-2300 or [email protected]

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Other related hedge fund law and start up articles include:

California Investment Advisor FAQ

California Based Hedge Fund Managers Receive Answers to Common Questions

As I have discussed many times before, each state securities division has different rules and regulations.  In addition, each state has different interpretations of those rules and regulations. This makes it difficult for hedge fund managers to really know exactly what is required in each state unless they have representation from a specialized compliance group or hedge fund attorney.  Many securities regulators, also, do not completely understand their own rule and regulations and are not able to provide any sort of practicle advice to hedge fund managers regarding their obligations.  While not surprising, this lack of ability to provide general straight-forward answers to managers is what creates the need for specialized advice.  Some states however are recognizing that there are common questions which arise and that it makes sense to provide answers to those common questions and the FAQ below, provided by the California State Securities Regulation Division is a step in the right direction towards increasing the dialogue between regulators and market participants.

The following summary is also very helpful for manager because it discusses some of the nuances of California law as it relates to investment advisors who are also hedge fund managers.  Specifically the FAQ below deals with the issue of “custody,” the net worth requirements and the 120% net worth.  Also discussed is the “gatekeeper” issue (also known as the independant secondary signer service).

The entire text of the FAQ is reprinted below.  Please see below for additional hedge fund articles and please also see our guide to state hedge fund laws.

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1) What responsibilities do I have as an investment adviser?

As an investment adviser, you are a “fiduciary” to your advisory clients. This means that you have a fundamental obligation to act in the best interests of your clients and to provide investment advice in your clients’ best interests. You owe your clients a duty of undivided loyalty and utmost good faith. You should not engage in any activity in conflict with the interest of any client, and you should take steps reasonably necessary to fulfill your obligations. You must employ reasonable care to avoid misleading clients and you must provide full and fair disclosure of all material facts to your clients and prospective clients.

So, what is considered material? Generally, facts are “material” if a reasonable investor would consider them to be important. It is something a client would want to consider in determining whether to hire the adviser or follow the adviser’s recommendations. You must eliminate, or at least disclose, all conflicts of interest that might incline you to render advice that is not in the best interest of the client. If you do not avoid a conflict of interest that could impact the impartiality of your advice, you must make full and frank disclosure of the conflict. You cannot use your clients’ assets for your own benefit or the benefit of other clients. Departure from this fiduciary standard may constitute “fraud” upon your clients.

2) How are “assets under management” determined?

In determining the amount of your assets under management, include the securities portfolios for which you provide continuous and regular supervisory or management services as of the date of filing Form ADV. You provide continuous and regular supervisory or management services with respect to an account if:

(1)  You have discretionary authority over and provide ongoing supervisory or management services  with respect to the account; or

(2)  You do not have discretionary authority over the account, but you have an ongoing  responsibility to select or make recommendations, based upon the needs of the client, as to  specific securities or other investments the account may purchase or sell and, if such  recommendations are accepted by the client, you are responsible for arranging or effecting the  purchase or sale.

Other factors: You should also consider the following factors in evaluating whether you provide  continuous and regular supervisory or management services to an account:

(a)Terms of the advisory contract.
If you agree in an advisory contract to provide ongoing management services, this suggests that  you provide these services for the account. Other provisions in the contract, or your actual  management practices, however, may suggest otherwise.

(b)Form of compensation.
If you are compensated based on the average value of the client’s assets you manage over a  specified period of time, this suggests that you provide continuous and regular supervisory or  management services for the account.
If you receive compensation in a manner similar to either of the following, this suggests you do  not provide continuous and regular supervisory or management services for the account:

(a) You are compensated based upon the time spent with a client during a client visit; or
(b) You are paid a retainer based on a percentage of assets covered by a financial plan.

(3)Management practices.

The extent to which you actively manage assets or provide advice bears on whether the services  you provide are continuous and regular supervisory or management services. The fact that you  make infrequent trades (e.g., based on a “buy and hold” strategy) does not mean your services  are not “continuous and regular.”

3) Our firm is registered with the SEC or another state. Must we also register with the Department of Corporations?

SEC registered advisers with more than five clients who are residents of California must make a notice filing with the Department.

Other states registered investment advisers with a place of business in this state or more than five clients who are residents of California must also registered with the Department.

4) How does a firm convert from being a state-registered to an SEC-registered investment adviser or vice versa?

From State to SEC: To convert from being a state-registered adviser to being an SEC-registered adviser on the IARD system, mark the filing type “Apply for registration as an investment adviser with the SEC.” After the SEC approves your registration you should file a “Partial ADV-W” to withdraw your state registration(s). Do not file your Partial ADV-W until your application for SEC registration is approved or you will be unregistered and may be unable to conduct your business during this period of time.

From SEC to State: To convert from being a SEC-registered adviser to being a state-registered adviser, mark the filing type “Apply for registration as an investment adviser with one or more states.” After your state registration has been approved, then you should file a “Partial ADV-W” to withdraw your SEC registration. Do not file your Partial ADV-W until your state registration application(s) is approved by the Department or you will be unregistered and cannot conduct your business during this period of time.

5) What is an “investment adviser representative?”

An investment adviser representative (“IAR”), sometimes referred to as a registered adviser (“RA”), or associated person is defined in Code Section 25009.5(a) as any partner, officer, director of (or a person occupying a similar status or performing similar functions) or other individual, except clerical or ministerial personnel, who is employed by or associated with, or subject to the supervision and control of, an investment adviser that has obtained a certificate or that is required to obtain a certificate under this law, and who:

(1) Makes any recommendations or otherwise renders advice regarding securities,
(2) Manages accounts or portfolios of clients,
(3) Determines which recommendations or advice regarding securities should be given,
(4) Solicits, offers, or negotiates for the sale or sells investment advisory services, or
(5) Supervises employees who perform any of the foregoing.

Important: Each officer, director or partner exercising executive responsibility (or persons occupying a similar status or performing similar functions) or each person who owns 25% or more is presumed to be acting as an IAR or associated person.

6) I have an investment adviser representative who performs advisory services on behalf of my firm and is under my supervision. Does the investment adviser representative need to be registered with the Department?

Yes, investment adviser representatives must be registered with the Department if they have a place of business in California.

Important: This applies to both state (California and other states) and SEC registered investment advisers. Investment adviser representatives located in California or who have clients who are residents of California (whether they work for SEC, other states, or California’s registered investment adviser firms), must be registered with the Department.

7) How does my firm register individuals and what are the employment requirements?

Firms register individuals by completing Form U-4 through the electronic Central Registration Depository (“CRD”). Upon employment of an individual as an IAR, the investment adviser must obtain a properly executed Form U-4, evidence that the IAR meets the qualification requirements of CCR §260.236, and have the responsibility and duty to ascertain by reasonable investigation the good character, business reputation, qualifications, and experience of an individual upon employment or engagement as an IAR.

8) What are the qualification requirements for investment adviser representatives?

Each IAR, except those employed or engaged by an investment adviser solely to offer or negotiate for the sale of investment adviser services, must qualify by passing the examination(s) as specified in CCR §260.236(a). The examination requirements are the Uniform Investment Adviser Law Examination (“2000 Series 65”) passed on or after January 1, 2000; or the General Securities Representative Examination (“Series 7”) and Uniform Combined State Law Examination (“2000 Series 66”). Waivers and exemptions to the examination requirements may be found in subsection (b) and (c) of CCR §260.236, respectively. Individuals who hold in good standing an approved professional designation meet the exemption found in (c)(3) of CCR §260.236.

When a U-4 is filed to register someone as an IAR, the CRD will automatically open a Series 65 exam window if the individual is not shown as already having passed the exam, is not already licensed by another jurisdiction, or does not qualify for an automatic exam waiver.

9) What are the filing requirements for a firm who has an investment adviser representative?

(1) Employment –

Upon employment of an IAR, Form U-4, including any Disclosure Reporting  Page(s), should  be completed in accordance with the form instructions. The form is to be filed  with, and the  reporting fee paid to, CRD in accordance with its procedures. The filing of Form U- 4 with  CRD does not constitute an automatic approval of the filing by the Commissioner. The  investment adviser should not consider an IAR “registration” approved until approved by the  Commissioner and notification of the approval has been received through CRD.

(2) Changes – Within 30 days of any changes to Form U-4, an amendment to Form U-4 is to be  filed. The amendment is to be filed directly with CRD in accordance with its procedures.

(3)Termination – Within 30 days of termination of an IAR, Form U-5 is to be filed in accordance  with the form instructions. Form U-5 is to clearly state the reason(s) for termination. This form is  to be filed directly with CRD in accordance with its procedures.

10) What are the fees associated with registering an investment adviser representative?

The registration fee for each IAR is $25. This fee is paid to the Department through the IARD system. There is no annual renewal fee for an IAR.

There is also an annual filing fee of $30 for 2008 (subject to change for future years) that is paid to FINRA for the processing of forms for each IAR. FINRA charges this fee and the Department does not receive any portion of this.

11) Are owners and executive officers considered investment adviser representatives (IAR)? If so, how should I report owners and executive officers of my advisory firm to the Department?

All direct owners and executive officers should be reported on Schedule A of Form ADV and indirect owners should be reported on Schedule B of Form ADV.

Since officers, directors or partners who exercise executive responsibilities (or persons who occupy similar status or perform similar functions), or persons who own 25% or more are presumed to be IARs, a Form U-4 and a $25 reporting fee should be filed for each such individual through the Central Registration Depository (“CRD”).

A paper filing of Form U-4 should be filed directly with the Department for all other officers, directors or partners, or persons who own 10% or more who are not reported as IARs through the CRD.

12) I solicit clients for an investment adviser and receive referral fees for business I send to an investment adviser. Must I register?

Solicitors must be registered either as an investment adviser representative under a registered investment advisory firm or obtain their own independent registered investment adviser certificate.

13) I solely refer clients to registered investment advisers, what qualification requirements are there for solicitors?

Individuals who are reported as an IAR under an investment adviser solely to offer or negotiate for the sale of investment adviser services are exempted from the qualification requirements. However, solicitors seeking their independent registered investment advisory license must be qualified.

14) I’m a Certified Public Accountant (CPA) and refer my clients to third-party investment advisers for referral fees, what qualifications and requirements must I follow?

A special case arises when a CPA acts as referring agent. Like a solicitor, the CPA must be registered either as an investment adviser representative under a registered investment advisory firm or obtain their own independent registered investment adviser certificate. The difference is that the CPA must be qualified by passing the examinations, unless waived or exempted, even if the CPA is to be reported as an investment adviser representative under a registered investment advisory firm. This is because, according to the California Business and Profession Code and the Board of Accountancy, in order for a CPA to receive compensation from a referral, the CPA must provide a professional service related to the product or services that will be provided to the client by the third-party service provider. In addition, the CPA must maintain independence and provide full disclosure of its referral arrangement to the clients.

Please refer to California Business and Profession Code, Section 5061 and California Board of Accountancy, Article 9, Section 56 for more information.

15) Must I have a written contract with my clients? If yes, what information should my advisory contracts contain?

Yes. Advisers providing services pursuant to advisory contracts that are written are considered to promote fair, equitable, and ethical principles. Advisory contracts with clients must be in writing and, at a minimum, must disclose:

(1) The services to be provided;
(2) The term of the contract;
(3) The advisory fee or the formula for computing the fee amount or the manner of calculation  of the amount of the prepaid fee to be returned in the event of contract termination or  nonperformance;
(4) Whether the contract grants discretionary power to the adviser or its representatives; and
(5) That the contract will not be assigned without the consent of the client.

Please refer to CCC Section 25234 and CCR Section 260.238 for more information.

Important: The Form ADV may not specifically request certain information, however; it is the adviser’s fiduciary duty to disclose all material information in order not to mislead clients, so that the client can make informed decisions about entering into or continuing the advisory relationship.

During the Department examination, examiner will view perceived conflicts from the point of view of the customer: Was the disclosure or lack of disclosure a factor in the client’s decision to use an adviser’s services or ratify an adviser’s recommendations? Was the customer misled? Was the customer placed at a disadvantage or taken unfair advantage of as a result of the conflict and the adviser’s lack of disclosure? The burden of proof lies with the adviser.

16) I provide financial planning services to my clients. What disclosure information must I provide in my advisory contracts for my clients?

Financial planners should provide proper disclosures relating to any inherent conflict of interest that may result from any compensation arrangements connected with the financial planning services that are in addition to the financial planning fees and other financial industry activities or affiliations.

Advisers who provide financial planning services and receive compensation (e.g. commissions, fees) from the sale of securities, insurance, real estate or other product or services recommended in the financial plan, or otherwise has a conflict of interest, must deliver to the financial planning clients a notice in writing containing at least the information found below (in addition to the disclosure items in Question 15 at the time of entering into a contract for, or otherwise arranging for the provision of, the delivery of a financial plan:

(1) A conflict exists between the interests of the investment adviser or associated person and  the interests of the client, and
(2) The client is under no obligation to act on the investment adviser’s or associated person’s  recommendation. Moreover, if the client elects to act on any of the recommendations, the  client is under no obligation to effect the transaction through the investment adviser or the  associated person when such person is employed as an agent with a licensed broker-dealer or is  licensed as a broker-dealer or through any associate or affiliate of such person.

This statement may be included in the advisory contract or Schedule F of Form ADV, which for the latter, the client must acknowledge receipt of the disclosure.

Please refer to CCR Section 260.235.2 for more information.

17) When am I required to update my Form ADV?

Form ADV should always contain current and accurate information. Please note that Part 1A and Part 2 contain some similar questions and must be answered consistently. Therefore, both parts must be updated. In addition to your annual updating amendment, you must amend your Form ADV by filing additional amendments, referred to as “other-than-annual amendments,” during the year. If there are material changes to the Form ADV, an “other-than-annual amendment” should be filed within 30 days of the change.

Important: Advisers are recommended to utilize the tables found at the end of this packet to determine if a change to certain items in Form ADV requires prompt amendments. Because questions asked in Part 1 and 2 are similar, a table is also provided that references these questions. Advisers should make sure that the answers to cross-referenced items are answered the same.

Important: Any amendments to Parts 1 and 2 of Form ADV should be electronically filed through the IARD system.

REMEMBER: You must also amend your Form ADV each year by filing an “annual updating amendment” within 90 days after the end of your fiscal year. When you submit your annual updating amendment, you must update your responses to all items in Parts 1 and 2 of Form ADV.

18) Can Part 2 of Form ADV be filed electronically through the IARD system?

Yes, Form ADV Part 2 along with Schedule F must be filed through the IARD system. However, unlike Form ADV Part 1, Part 2 must be completed offline and uploaded to the IARD system. The form must be submitted in a text searchable pdf format in order to be accepted by the IARD system.

IARD system instructions for filing Part 2 of Form ADV can be found on the IARD web site at http://www.iard.com/part2instructions.asp .

An editable PDF version of Form ADV Part 2 with Schedule F can be obtained from the following website:

http://www.nasaa.org/Industry_Regulatory_Resources/Uniform_Forms.

19) Do I need to file an annual updating amendment for Part 2 of Form ADV when there are no changes with the information provided?

Yes, an annual updating amendment of Form ADV Parts 1 and 2 through the IARD system is required regardless of any changes in the business or with the information provided. When filing an annual updating amendment, the IARD system allows advisers to utilize the “Confirm” brochure option to confirm that brochures on file are still current, without having to upload a new version of the PDF file.

Specific instructions for filing Part 2 of Form ADV can be obtained from the IARD website at: http://www.iard.com/pdf/ADV_Part_II_Firm_User_90.pdf .

20) Should I file a new application with the Department if I change my sole proprietorship to a corporation?

No, if there is no practical change in control or management only an amendment to the application is necessary. Successors may file an amendment only if the succession results from a change: 1) in form of organization; 2) in legal status; or 3) in the composition of a partnership.

Change in Form of Organization:

This in an internal reorganization or restructuring. For example, a corporation has two affiliated entities, A and B. A is registered as an IA and provides advisory services. B does bookkeeping and does not perform advisory functions. Now, the corporation decides that B should now be performing advisory services and A should provide bookkeeping. In this situation, B may file an amendment of its predecessor’s application because there is no change in control, since the corporation hasn’t change and the beneficial owners remain the same.

Change in Legal Status:

This is a result of a change in the state of incorporation or a change in the form of the business. For example, a sole proprietorship converts it business to a corporation. This also does not involve a change of control.

Change in Composition of a Partnership:

This involves the death, withdrawal, or addition of a partner in the partnership and is not considered a change in control of the partnership.

To file the Amendment: Successors should check “Yes” to Part 1A, Item 4A; enter the date of succession in Part 1A, Item 4B; and complete Schedule D, Section 4 about the acquired firm information. The successor will keep the same CRD number and the predecessor should NOT file Form ADV-W.

21) Should I file a new application if I am an unregistered person acquiring an existing registered investment adviser?

Yes, successors must file a new application for registration when the succession involves a change in control or management. The following types of successions require the filing of a new application:

Acquisitions:

Acquiring a preexisting investment adviser business by an unregistered person involving a change of control or management.

Consolidations:

When two or more registered investment advisers combine their businesses and decide to conduct their new business through a new unregistered entity.

Division of Dual Registrants:

An entity registered as both an IA and BD that decides to separate one of its functions to an unregistered entity.

These types of successions must be filed by a new application for registration. Setting up an IARD account is the first step in the registration process. Once an adviser establishes an IARD account, the adviser can access Form ADV on IARD and submit it electronically through IARD to the Department. On Form ADV, the successor should check “Yes” to Part 1A, Item 4A; enter the date of the succession in Part 1A, Item 4B; and complete Schedule D, Section 4 about the acquired firm information. A new CRD number will be issued upon approval. Once approved, the predecessor files Form ADV-W to withdraw its license from the Department.

22) What are my minimum financial requirements?

Investment advisers who:

(1) Have custody of client funds or securities must maintain at all times a minimum net worth of  $35,000.
(2) Have discretionary authority over client funds or securities but do not have custody of client  funds or securities must maintain at all times a minimum net worth of $10,000.
(3) Accept prepayment of fees more than $500 per month and six or more months in advance  must maintain at all times a positive net worth.

23) If I am an investment adviser and also a broker-dealer, do I need to meet the minimum net worth requirements for investment advisers?

No, the minimum financial requirements do not apply if the investment adviser is also licensed as a broker-dealer under Code Section 25210, or is registered with the SEC.

24) How is financial net worth determined?

“Net worth” should be calculated as the excess of assets over liabilities, as determined by generally accepted accounting principles. The following items should not be included in the calculation of assets: prepaid expenses (except as to items properly classified as current assets under generally accepted accounting principles), deferred charges, goodwill, franchise rights, organizational expenses, patents, copyrights, marketing rights, unamortized debt discount and expense, and all other assets of intangible nature; home, home furnishings, automobiles, and any other personal items not readily marketable in the case of an individual; advances or loans to stockholders and officers in the case of a corporation, and advances or loans to partners in the case of a partnership.

The Department has created a Minimum Financial Requirement Worksheet which advisers may utilize when computing their net worth, which can be obtained from the Department’s website at: http://www.corp.ca.gov/forms/pdf/2602372.pdf .

25) What happens if I do not meet the net worth requirement?

As a condition of the right to continue to transact business in this state, advisers must notify the Department of any net worth deficiency by the close of the next business day following the discovery that the net worth is less than the minimum required.
After transmitting such notice, advisers must file by the close of the next business day a report of financial condition, including the following:

(1)A trial balance of all ledger accounts;
(2) A statement of all client funds or securities which are not segregated;
(3) A computation of the aggregate amount of client ledger debit balance; and
(4) A statement as to the number of client accounts.

26) When computing my financial net worth on the Minimum Financial Requirement Worksheet provided by the Department, I notice that there is a “120% Test”. What is this 120% of minimum net worth requirement test?

An adviser who is subject to the minimum financial requirement must file interim financial reports with the Department within 15 days after its net worth is reduced to less than 120% of its net worth requirement. The first interim report shall be filed within 15 days after its net worth is reduced to less than 120% of its required minimum net worth, and should be as of a date within the 15-day period. Additional reports should be filed within 15 days after each subsequent monthly accounting period until three successive months’ reports have been filed that show a net worth of more than 120% of the firm’s required minimum net worth.

The submitted interim financial reports should contain:

(1) A Statement of Financial Condition (Balance Sheet);
(2) Minimum Financial Requirement Worksheet; and
(3) A verification form.

27) Do I need to file financial reports to the Department?

An adviser who is subject to the minimum financial requirements must file annual financial reports with the Department within 90 days after its fiscal year-end. The submitted annual financial reports should contain:

(1) A Statement of Financial Condition (Balance Sheet & Income Statement) that must be  prepared in accordance with generally accepted accounting principles;

(2) Supporting schedule containing the computations of the minimum financial requirement.  The Department has supplied a Minimum Financial Requirement Worksheet which advisers may  utilize, and which may be obtained from the Department’s website:
http://www.corp.ca.gov/forms/pdf/2602372.pdf ; and
(3) A verification form must accompany the financial statements. The verification form must: (a)  affirmatively state, to the best knowledge and belief of the person making the verification, that  the financial statements and supporting schedules are true and correct; and (b) be signed under  penalty of perjury. The verification form can be obtained from the Department’s website at:
http://www.corp.ca.gov/forms/pdf/2602412b.pdf

Important: Advisers who have custody of client funds or securities must file audited financial statements prepared by an independent certified public accountant along with the supporting schedule of the net worth computation and the verification form. Please refer to Question # 30 for other requirements pertaining to investment advisers with custody of client funds or securities.

28) I obtain the client’s permission before executing trades, but the brokerage firm will accept my instructions when trading on client accounts. Would I be considered to have discretionary authority?

An investment adviser will not be deemed to have discretionary authority over client accounts when it places trade orders with a broker-dealer pursuant to a third party trading agreement if all the following are met:

(1) The investment adviser has executed a separate investment adviser contract exclusively with  its client which acknowledges that the investment adviser must secure client permission prior to  effecting securities transactions for the client in the client’s brokerage account(s), and
(2) The investment adviser in fact does not exercise discretion with respect to the account,  maintains a log (date and time) or other documents each time client permission is obtained for  transaction, and
(3) A third party trading agreement is executed between the client and a broker-dealer which  specifically limits the investment adviser’s authority in the client’s broker-dealer account to the  placement of trade orders and deduction of investment adviser fees.

29) How is custody of client funds or securities determined?

A person will be deemed to have custody if said person directly or indirectly holds client funds or securities, has any authority to obtain possession of them, or has the ability to appropriate them. Also see Questions 30 through 33, below, for additional information on making custody determinations.

30) What are the requirements for advisers who have custody of client funds and/or securities?

Advisers deemed to have custody of client funds and securities are subject to the following custodial requirements:
(1) $35,000 minimum net worth requirement of CCR Rule 260.237.2,
(2) Surprise verification requirement of CCR Rule 260.237(e), and
(3) Audited financial statements requirement of CCR Rule 260.241.2.

31) I deduct advisory fees directly from the clients’ custodial accounts. Do I have custody of client funds and securities? If yes, are there any procedures I may follow to be exempted from the financial requirements and surprise verification?

Yes and Yes. The Department takes the position that any arrangement under which the adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian upon the adviser’s instruction to the custodian is deemed to have custody of client funds and securities.

Safeguarding Procedures: The Department allows advisers who have this type of payment arrangement to be exempted from the requirements of: (1) $35,000 minimum net worth; (2) audited financial statements; and (3) surprise verification if all of the following procedures are administered:

(1) The client must provide written authorization permitting direct payment from an account  maintained by a custodian who is independent of the adviser;
(2) The adviser must send a statement to the client showing the amount of the fee, the value of  the client’s assets upon which the fee was based, and the specific manner in which the fee was  calculated;
(3) The Adviser must disclose to clients that it is the client’s responsibility to verify the accuracy  of the fee calculation, and that the custodian will not determine whether the fee is properly  calculated; and
(4) The custodian must agree to send the client a statement, at least quarterly, showing all  disbursements from the account, including advisory fees.

Form ADV Disclosure: Advisers who follow the safeguarding procedures for direct fee deduction should respond accordingly on the following sections of their Form ADV:

  • Form ADV: Part 1A, Item 9 (A) – Yes
  • Part 1A, Item 9 (B) – Yes
  • Part 1B, Item 2 I (1) – Yes
  • Part 1B, Item 2 I (1) (a) – Yes
  • Part 1B, Item 2 I (1) (b) Yes
  • Part 1B, Item 2 I (1) (c) – Yes
  • Part 2, Item 14 – No

Important: This exemption does not relieve the advisers from the net worth requirements, which may be lowered to $10,000, or the filing of unaudited financial statements.

32) I manage a limited partnership (LP) and am the general partner of the LP. Am I considered to have custody? If yes, are there any procedures I may follow to receive an exemption from the financial requirements and surprise verification?

Yes and Yes. The Department takes the position that an adviser with any capacity (such as a general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle) that gives the adviser legal ownership of or access to client funds or securities is deemed to have custody of client funds and securities.

Safeguarding Procedures: An investment adviser acting as a general partner of a limited partnership (or a comparable position for another type of pooled investment vehicle) may receive partnership funds or securities directly from the partnership’s account held by an independent custodian without complying with the surprise audit requirement of CCR Rule 260.237(e), audited financial statements requirement of CCR Rule 260.241.2, and higher net worth requirement of CCR Rule 260.237.2 if all the partnership assets are administered as follows:

(1) One or more independent banks or brokerage firms must hold the partnership’s funds and  securities in the name of the partnership.
(2) Funds received by the partnership for subscriptions must be deposited by the subscriber  directly with the custodian.
(3) The partnership must engage an independent party to approve all fees, expenses, and capital  withdrawals from the pooled accounts.
(4) Each time the general partner makes a payment or withdrawal request, it must  simultaneously send to the independent party and the custodian a statement showing: (a) the  amount of the payment or withdrawal; (b) the value of the partnership’s assets on which the fee  or withdrawal is based; (c) the manner in which the payment or withdrawal is calculated; and (d)  the amount in the general partner’s capital account before and after the withdrawal.
(5) The general partner must also give the independent party sufficient information to allow the  representative to determine that the payments comply with the partnership agreement. The  custodian may transfer funds from the partnership account to the general partner only with the  written authorization of the independent party, and only if the custodian receives a copy of the  written request from the general partner.
(6) The custodian must provide quarterly statements to the partnership and the independent  party.

Form ADV Disclosure: Advisers who follow the safeguarding procedures for pooled investment vehicles should respond accordingly on the following sections of their Form ADV:

Form ADV:

  • Part 1A, Item 9 (A)
  • Part 1A, Item 9 (B)
  • Part 1B, Item 2 I (2)
  • Part 1B, Item 2 I (2) (a)
  • Part 2, Item 14

Important: This exemption does not relieve advisers from the net worth requirement, which may be lowered to $10,000, or from the requirement to file unaudited financial statements.

33) I inadvertently received securities or checks from my advisory clients. Do I have custody?

Yes. To avoid having custody, you must return the securities to the sender promptly within two business days of receiving them. In the case of checks received inadvertently, the adviser must forward the checks to the third party within two business days of receipt.

Important: You are also required to keep accurate records of the securities and funds you received and returned. Such records should contain the description of the checks/securities, when and from whom they were received, where they were sent, and a record of how they were returned.

34) Who can be an independent party?

For purposes of the safeguarding procedures for pooled investment vehicles, an independent party must:

(1) Be a certified public accountant (CPA) or an attorney in good standing with the California  State Bar;
(2)Act as a gatekeeper for the payment of fees, expenses, and capital withdrawals from the  pooled investment;
(3) Not control, and is not controlled by or under common control with the adviser; and
(4) Not have, and have had within the past two years, a material business relationship with the  investment adviser.

35) An accounting firm acts as the independent CPA that audits annually my pooled investment vehicle. May the accounting firm also act as the independent representative for the investors in the pooled investment vehicle?

No, this accounting firm is not acceptable as an independent representative. The independent representative may not have, or have had within the past two years, a material business relationship with the adviser. Also, the purpose for this safeguard is for the independent representative to act as the agent for an advisory client and is thus obliged to act in the best interest of the advisory client, limited partner, member or other beneficial owner. When the CPA sent audited financial statements of the pooled investment vehicle, it would be, in essence, sending itself its own audit results. This is not in the best interest of the investors in the pooled investment vehicle and is not allowed.

Important: Alternatively, if the accounting firm audits the investment adviser’s financial statements or prepares tax filings for the pooled investment vehicle and its investors, the result would be the same. That is, the accounting firm would not satisfy the independence criteria since it has a material business relationship with the adviser

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

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  Mallon P.C. will also help California based Investment Advisors to register with the California Securities Regulation Division.  If you are a hedge fund manager who is looking to start a hedge fund or an investmen advisor looking to register, please call Mr. Mallon directly at 415-296-8510.

Hedge Fund Start Up Presentation

How to Start a Hedge Fund in 2009

Below is a link to a powerpoint presentation in which I detail the background information a hedge fund manager must have prior to starting the hedge fund formation process.  The presentation is designed to familiarize a manager with the process of forming a fund while identifying potential issues which the manager should be aware of during the process.

The presentation is 18 slides long and is about 40 minutes.  I will also be posting a video here shortly.

Hedge Fund Presentation with Voice

Starting a hedge fund in 2009 (voice) (voice-over powerpoint)

For more viewing options, please see our Hedge Fund Lawyer youtube profile.

Hedge Fund Presentation without Voice
Starting a Hedge Fund

Thoughts on Hedge Fund Offering Documents

FAQs on Offering Documents

I recently read an article by a hedge fund administration firm which discussed hedge fund offering documents and start up hedge fund expenses.  I thought this was an interesting topic and one which is popular with many of my start up clients.  Below I discuss some of the common questions regarding the offering documents and also provide reasons why a start up manager should use my law firm for starting a hedge fund.

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Offering documents are just boilerplate – why are they so expensive?

This is a common misperception.  Offering documents (if done correctly) are not merely boilerplate where the attorney pops in the fund name and the address – offering documents are a tailored to the specific needs of the client based on the client’s investment program and fund structure.

For instance, there are at least 12 different questions related to the management fee and performance fee/ performance allocation.  There are at least 22 different questions related to the fund’s contribution periods and withdrawal periods.  This level of customization does not come from a boilerplate form.  Furthermore, many of these questions or options may have specific implications for the manager’s business either from a legal standpoint or a business standpoint.  Many times the lawyer will need to have an in-depth discussion with the manager to help the manager determine which option is right for the fund.

Why are offering documents so long?

Offering documents are long – there is no getting around it.  The structure of the offering documents are determined by the federal and state securities laws and thus there is not really any wiggle room.  While it is often said that the hedge fund industry is “not regulated” or “lightly regulated” there are many hedge fund laws and regulations which managers must follow.   These laws dictate many aspects of the documents and are why offering documents are so long (and also why offering documents from different firms are structured so similarly).

In this prior post, discussing “Prospectus Creep” we discussed the length of offering documents:

4.  Is the Prospectus written for the Manager or the Investor?

Castle Hall discusses the interesting phenomenon of “Prospectus Creep” or basically the lengthening of hedge fund offering documents as hedge fund lawyers add more clauses to the documents which are designed to protect the managers.  Castle Hall notes that “today’s offering documents are typically drafted to give maximum freedom of action for the manager and often permit unrestricted investment activities. Investors are also faced with offering documents which list every possible risk factor in an attempt to absolve the manager from responsibility under virtually all loss scenarios.”

HFLB: We agree that offering documents can be long and that often they contain a long list of risk factors associated with the investment program.  The purpose of the offering documents is to explain the manager’s investment program and if the manager truly has a “kitchen sink” investment program, then all of the disclosures and risk factors are a necessary part of the offering documents.  However we also feel that hedge fund offering documents should accurately describe the manager’s proposed investment program and that if the manager has a very specific strategy, he should provide as much detail to the investors as possible.


Can I draft offering documents myself?  I have a friend who has some documents I think I can modify.

No.  You should never draft offering documents yourself.  I have seen countless examples of people who have tried to draft their own offering documents based on another fund.  Many times these people will ask me to “check the documents.”  Ninety-five percent of the time a brief skim of the documents will reveal major errors that cannot simply be fixed with a 2 hour review.   In most all occasions the documents will need to be completely scrapped.

Are all law firm offering documents the same?

No, but law firm documents are all very similar.

It is an interesting phenomenon in the hedge fund legal world that attorneys are always interested in (or obsessed with) reading the other law firms offering documents. As one of those lawyers that is very interested in the differences between the offering documents, I have studied the documents from most all of the major hedge fund law firms including the firms listed below which are considered to be the best in the industry.

  • Sidley Austin
  • Shartsis Friese
  • Seward & Kissel
  • Kleinberg, Kaplan, Wolff & Cohen
  • Katten Muchin Rosenman
  • Schulte Roth & Zabel
  • Akin Gump Strauss Hauer & Feld
  • K&L Gates

I have probably read through 500 different offering documents (many from the same large law firms) and have found most documents to be quite similar. For the most part with a name brand firm you are going to get a quality product that is probably pretty equal to another large or name brand law firm.  These documents will very likely protect you in all of the necessary ways.

However, that is not to say that all large law firm offering documents are perfect.  I have seen offering documents which cost over $70,000 with typos and errors.  Many times expensive offering documents are sloppy in certain respects – I expect this is because many large law firms use inexperienced associate attorneys to draft the offering documents.

Does price equal quality?

Not necessarily.  While you are less likely to receive white glove service from a document shop, BigLaw does not necessarily equate to fine quality – especially for small and start up managers.  In a large law firm you are going to probably initially talk with a partner about your program who will then relay the information to an associate who will be in charge of your project.  This means that your offering documents are likely drafted by an overworked associate who has relatively little experience.

I always recommend a start up manager ask the law firm who will be drafting the offering documents and how much experience the person has.  Many large law firms will say that an associate will draft the documents but the partner will review prior to finalization.  I find it hard to believe that a partner will review offering documents – many times this is not true.

Low cost offering documents – are you getting less quality?

In some cases yes, but in the case of my law firm documents the answer is a resounding NO.  While my firm will charge around $13,000 to $18,000 for offering documents (considered to be on the lower end), this does not mean that the quality of my work is less than any other firm.

As I have mentioned before on this site, I have worked with a substantial number of start up hedge funds and have drafted the offering documents or worked on around 150 funds.   Also, I have spent a great deal of time dissecting offering documents from a large number of firms.  My dedication to completely understanding the offering documents, along with my passion for the industry and helping managers with their business issues makes my services a compelling alternative to other firms which may cost more.

Additionally, I value the client relationship and always strive to return emails and phone calls promptly.

Conclusion

While the offering documents are the tangible item which you receive from your hedge fund lawyer, it is not the only part of the representation.  The offering documents are not valuable as objects, but really as a representation of the prior experience of the attorney who prepared those documents for your fund, based on your needs.

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

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about becoming registered as a CPO or CTA, please call Mr. Mallon directly at 415-296-8510.

Hedge Fund Tearsheets

Marketing Your Fund with a One-Pager

In addition to hedge fund pitchbooks, managers will market their hedge funds through one page tearsheets.  Hedge fund tearsheets are basically a snapshot of a hedge fund’s performance over time, as of a certain date.   There are a growing number of companies out there which will produce tearsheets for managers, but many managers will be able to produce their own tearsheets internally.  This article will discuss the common items found in most hedge fund tearsheets and will also provide an example of a tearsheet.

Overview of Tearsheets

Like the pitchbook, the tearsheet contains much of the manager’s contact information, as well as information on the terms of the fund and the fund’s performance.  Below are some features which are common to most tearsheets:

Management Company Information – the management company will usually be named on the tearsheet.  Usually the address as well the contact information for the firm will also be included.

Fund Information – the name of the fund is typically displayed near the top of the tearsheet.  Other fund information usually includes: assets under management (AUM), leverage (not strictly necessary), fees (management and performance), and investment objective/strategy discussion.

Logo – many hedge fund management companies, and sometime the fund itself, will have a logo.  In such event the logo is usually incorporated into the tearsheet.

Performance Results – there are a number of charts and graphs which show the fund’s investment returns over a certain period of time.  A fund’s metrics are also discussed (alpha, beta, standard deviation, correlation, sharpe ratio, drawdown information, % of up/ down months, etc.).   It is common for these returns to be compared to a comparable index and/or to the S&P 500.  Performance results are usually shown in a graph figure.  Monthly performance figures, growth charts, statistical analysis, risk-return scattergram, and other visual representations of the performance data may also be utilized.

Written Summary/ Discussion (optional) – sometimes managers will choose to provide a written discussion of the fund’s performance results for the period.  This can be incorporated into the tearsheet or can be provided to investors as a separate document.  Some managers choose to have more frequent tearsheets (e.g. monthly) and less frequently written discussions (e.g. quarterly or yearly).

Legal Disclaimer – a legal disclaimer should be included with all tearsheets.  The tearsheets should also be reviewed by an attorney for legal compliance.  While many tearsheets do not have the legal disclaimer, we do not recommend this practice as a tearsheet is a manager communication which will need to include the appropriate performance disclosures (see Hedge Fund Performance Reporting).

Optional – naming of the individual fund managers and providing biographical information such managers; including famous quotes, news articles, or quotes from news articles, etc.

Sample Hedge Fund Tearsheet

Our firm has prepared a sample hedge fund tearsheet (forthcoming).  [HFLB note: please see the Fairfield Greenwich tearsheets which are great examples of hedge fund tearsheets – please note that these tearsheets have a very long legal disclaimer.]

Preparing Tearsheets

There are a number of firms which provide tearsheet preparation services.  In addition to providing analysis, statistical calculations and graph preparation, these firms help to make the tearsheets aesthetically pleasing.  Normally these arrangements are done on a flat fee basis.

Our firm can help you with the preparation of the tearsheets or can provide advice on the look and feel of a tearsheet which you have prepared.  Please contact us if you have any questions on this or other hedge fund start up issues.  Related articles include:

Washington DC Hedge Fund Law

Starting a hedge fund in the District of Columbia

In DC, things are starting to get back to normal post-election.  Hedge fund and investment managers who are located in DC, however, will generally need to be registered as investment advisors with the Department of Insurance, Securities and Banking (ISB).  I’ve reviewed the DC investment advisory rules and have found that they have the standard investment advisory definition and, generally, no exemption from the registration provisions for hedge fund managers.  This means that start up hedge fund managers with a place of business in DC will need to register as an investment advisor with the ISB.  The ISB website is fairly helpful and provides links to good information regarding registration.  I have posted one of these resources below, dealing wih the filing requirements for DC investment advisory registration.  Continue reading

Annual Reminder for CPOs and CTAs

Commodity Firms Need to Complete Annual Regulatory Information

The NFA recently released a regulatory reminder to firms which are registered as commodity pool operators and/or commodity trading advisors.  The reminder reminds CPOs and CTAs that there are certain annual regulatory items which a firm must complete in order to remain in good standing with the NFA.  I have reprinted these two releases below.  As a summary, the reports emphasize:

  1. Firms must complete an annual update and questionnaire.  Firms must pay of yearly dues to the NFA (which can be done online).  Firms should also make sure that all employees are appropriately registered as Associated Persons, as necessary.
  2. Firms should review the NFA Self Exam checklist to ensure compliance.
  3. Firms should send Privacy Policy to all investors/ clients.
  4. Firms should review and test the Disaster Recovery Plan.  If necessary, adjustments should be made.
  5. Firms should review Ethics Training Procedures.   If necessary, appropriate ethics training should be provided.
  6. Firms should file any new exemption notices with the NFA, if necessary.
  7. Firms should review their Disclosure Document.  As a reminder, the Disclosure Document must be no more than 9 months old and reviewed by the NFA.  If the CPO or CTA firm also trades in the off-exchange forex markets, the Disclosure Document must incorporate the new forex rules which were adopted on November 30, 2008 (see NFA Compliance Rule 2-41 on post regarding NFA to Begin Regulating Forex).
  8. (For CTAs) If the firm places bunched orders, the firm must conduct (and document) quarterly analysis of the of order allocation method.  The order allocation method must be fair and equitable.
  9. (For CPOs)  Firms must distribute the pool’s Annual Report to investors; Annual Report must also be submitted to the NFA.

Many of the above items can be done online.  Many of the above items should be overseen by a hedge fund/ securities attorney or an experienced NFA compliance consultant.  Please contact us if you would like more information on our annual NFA compliance packages which can be modified based on your needs.  We can also provide compliance support on an hourly basis. Continue reading