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NASAA Applauds Obama’s Recent Directive on State Agency Preemption

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President of the NASAA Sends Letter to President Obama in Support of Limiting Preemption of State Regulation

In a letter dated June 9th, 2009, Fred Joseph, President of the North American Securities Administration (NASAA), applauded President Obama  for his efforts to control preemption of state law in the area of securities regulation.

On May 20th, President Obama issued a directive setting limits on regulatory preemption of state regulation, largely in an effort to expand the authority of state regulatory officials to regulate many aspects of the securities markets and detect potential misconduct.

In his letter, Joseph writes that despite the proven century-long track record of investor protection by state securities regulators,  Congress has still passed legislation over the years that has preempted state regulation and curtailed the authority of state officials in protecting both investors and consumers.

Joseph writes,

” Federal agencies have compounded the problem by extending the scope of preemption beyond Congressionally intended boundaries and in ways that pose serious threats to investor and consumer protections under state law.”

To further address what many regard as the most urgently needed reform, the NASAA endorses the creation of a Systemic Risk Council, comprised of representatives from all federal and state regulators in securities, banking, and insurance, and tasked with the responsibility for monitoring and limited the accumulation of risk in the financial markets.

The entire text of letter by the NASAA to President Obama is included below, and can also be found here.

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NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION, INC.
750 First Street, NE, Suite 1140
Washington, D.C. 20002
202/737-0900
Fax: 202/783-3571
www.nasaa.org

June 9, 2009

President Barack Obama
The White House
1600 Pennsylvania Avenue NW
Washington, DC 20500

Dear Mr. President:

On behalf of our nation’s state securities regulators, the North American Securities Administrators Association1 applauds your effort to reverse the anti-investor preemption policies of previous administrations.

Your May 20 directive setting limits on regulatory preemption impressively affirms the vital role that state regulators play in protecting the health, safety, and financial security of citizens throughout the United States. You have sent a strong signal that our nation’s citizens are served best when the state-federal partnership works harmoniously and with mutual respect to “provide independent safeguards for the public.” Furthermore, we sincerely appreciate your recognition that states have frequently been more aggressive than the national government in protecting the public’s interest.

In the area of securities regulation, the states have a century-long track record of investor protection. One of the hallmarks of state securities regulation is its proven ability to detect misconduct, both large and small, in the early stages. Our members enjoy a unique proximity to investors and to the industry participants within their state borders. As a result, state securities regulators are often the first to investigate and uncover our nation’s latest and most damaging frauds. Examples include investigating the role of investment banks in the Enron fraud, exposing profound conflicts of interest among Wall Street stock analysts, addressing late trading and market timing in mutual funds, and recently helping to ensure that investors receive over $50 billion in redemptions for frozen auction rate securities that had been marketed as safe and liquid investments.

And yet, over a number of years, there has been a concerted effort to preempt state regulation. In the securities field, much of that effort has originated in Congress. For example, in 1996, Congress passed the National Securities Markets Improvement Act (NSMIA), which dramatically curtailed the authority of our members to regulate many aspects of the securities markets, ranging from private offerings under Regulation D to investment advisers with over $25 million in assets under management.

As your recent order recognizes, federal agencies have compounded the problem by extending the scope of preemption beyond Congressionally intended boundaries and in ways that pose serious threats to investor and consumer protections under state law. Two striking examples are found in the banking area.

The Office of the Comptroller of the Currency (OCC) has repeatedly adopted regulations that aggressively preempt the states’ authority to protect consumers through licensing requirements or enforcement actions. The impact has been felt largely in the mortgage lending field—where illegal underwriting practices helped trigger the current financial crisis. In a case now pending before the U.S.

1 NASAA is the oldest international organization devoted to investor protection. Its membership consists of the securities administrators in the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada, and Mexico.

Supreme Court, the Second Circuit aptly characterized the OCC as an agency that “accretes a great deal of regulatory authority to itself at the expense of the states through rulemaking lacking any real intellectual rigor or depth.” Clearing House Ass’n, L.L.C. v. Cuomo, 510 F.3d 105,119 (2d Cir. 2007) (although upholding the OCC’s limits on state visitorial powers under binding precedent). In the Cuomo case, the OCC actually sought an injunction to prevent the New York Attorney General’s Office from investigating discriminatory lending practices by various national banks and their operating subsidiaries.

The Office of Thrift Supervision (OTS) has also issued broadly preemptive regulations. Relying on those rules, the OTS has taken the position that even independent agents used by thrift institutions to market mortgages or certificates of deposit are immune from all substantive state regulations aimed a protecting consumers. The OTS’s opinion was articulated in an October 25, 2004 opinion letter. The OTS position has a direct impact on our members, to the extent it authorizes thrifts to market securities products, such as jumbo CDs, without complying with the licensing requirements applicable under state securities laws.

These examples and others affirm the need not only to rein in, but also to reverse, instances of state law preemption. An important corollary is making sure that the states are adequately represented in any regulatory reforms that your administration and Congress may fashion to address our current economic crisis. Plainly, our system of financial services regulation must be more effective. The enormous challenge of regulating our financial markets can only be met through the combined efforts of state and federal regulators, working together to protect both investors and the integrity of the marketplace. Any regulatory reforms should incorporate this guiding principle.

For that reason, to address what many regard as the most urgently needed reform, we endorse the creation of a Systemic Risk Council, comprised of representatives from all federal and state regulators in securities, banking, and insurance, and tasked with the responsibility for monitoring and limiting the accumulation of risk in our financial markets. With our unique position on the frontlines of investor protection, state regulators are essential to the success of any remedy aimed at controlling systemic risk. We provide ground-level detection by gathering a huge volume of information through examinations of industry participants and complaints from investors. When that information reveals risks and abuses, we take appropriate action. The Council approach, with full state representation, takes advantage of these strengths. We would ask that you carefully evaluate the benefits of this model as you weigh alternative solutions to the difficult problem of systemic risk.

NASAA is committed to working with your Administration and the 111th Congress to ensure that the nation’s financial services regulatory structure undergoes the important changes that are necessary to enhance protections for Main Street investors. Your recent directive on agency preemption is a very important step, and as you move forward with other regulatory reforms, we hope you will continue to recognize the enormous value of state regulation in our system of federalism.

Sincerely,

Fred Joseph
President North American Securities Administrators Association
Colorado Securities Commissioner

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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:

Hedge Fund Investors – What are investors looking for?

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Are Hedge Fund Managers Lowering Fees?

There are a few common topics which have been coming up lately in my conversations with managers.  Of these probably the question of greatest interest deals with what sort of fee structure investors are looking for right now and what kinds of fee concessions are manages granting to investors.  In the article below Bryan Goh (First Avenue Partners) addresses these issues and shares his thoughts on the hedge fund industry after a recent conference.  This article was reprinted from Byan’s blog called Ten Seconds Into the Future by Bryan – I highly recommend this blog for all hedge fund managers.  [Another blog I highly recommend is Compliance Building by Doug Cornelius.  This blog will be a great resource for anyone interested in issues involving compliance issues.]

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The month of June is replete with hedge fund conferences. Conferences earlier this year were either poorly attended, or else investors attended them for the free breakfast or lunch, a chance to commiserate with fellow sufferers of the global financial crisis/hedge fund witch hunt. What a differences a couple of months of rising markets make.

I recently attended the Goldman Sachs European Hedge Fund conferences held in London a couple of days ago. Over 50 hedge fund managers attended to present their funds and a rough count of what must have been over 300 investor groups showed up if not to allocate soon then at the very least to window shop.

The quality of managers was in general very high. Perhaps the weaker managers had been washed out or were facing legacy issues and thus not investable, there was clearly a Darwinian dynamic at work. The organizers would have been very selective as well so as not to waste investors time. Or maybe it was just that Goldman Sachs simply had a bigger client base and could move further into the right tail of quality. Or, dare I say it, Goldman’s clients were of a better quality. I don’t know, all I know is what I saw. 5o over managers, all to a greater degree, investable if one was so inclined to their strategies.

Many established managers previously closed to new investment, or usually reluctant to be presenting at capital introduction events were presenting. Only recently, Israel Englander’s much vaunted Millennium was out looking for new capital at a number of conferences around the globe. These managers have experienced outflows of capital, redemptions which may be uncorrelated to the quality of their performance in 2008, and find that they have capacity to replace this exiting capital, as well as are faced with rich opportunity sets upon which to capitalize and thus have improved capacity.

Panel upon panel of strategy specific discussions were held and all well attended. Investors were clearly looking for new ideas, a sign of recovering risk appetite and the need to put capital to work. In every discussion, the macro landscape was an issue of great importance. At each panel, regardless of the uncorrelated or non-directional nature of the strategy from event driven to market neutral strategies, moderators and panel members were clearly focusing on the macro landscape, on regulation, on government intervention, and how these would impact the functioning of markets in which they invested. One thing was clear, there was no consensus as to the health of the global economy. Goldman Sach’s Head of Global Economic Research Jim O’Neill was of the opinion that the worst was over and that a V shaped recovery was underway. His team forecasts better than expected growth from economies like the BRICs driving global growth. Hedge fund manager’s, however, were almost evenly split 50:50 between bulls and bears, with the bears with the slight edge in extra time. Student’s of Murphy’s Law and other dynamic system theories will tell you that this is a healthy balance and likely to prolong current trends whether rising or falling and that reversals occur when the balance is jeopardized one way or the other.

What was really interesting for this observer, was that despite the lack of consensus over economic growth and market direction, each manager saw immense investment opportunities in their own particular strategies and markets. This would appear to be an inconsistency at best and more cynically, disingenuity at worst. Not so, in my view.

Of all the strategies represented at the conference, there was consensus among the respective manager groups, that the opportunities for profit generation were great. Equity long short, Distressed Debt, Merger Arbitrage, Volatility, Multi Strats. They all saw ways that they could make money, yet none of them could agree on whether the economy had stabilized, whether growth would resume or falter, whether inflation would rise or sink into deflation, whether markets would rise and fall. There is a larger lesson for students of economics, but that is not our aim here.

One can argue that macro leads micro, I’m not quite sure how yet, but in the narrower context of this discussion, micro leads macro. What these managers are individually telling us is that there are micro strategies that can be profitable. A macro analysis of the strategies that these managers employ will simply not be granular enough to capture the opportunities they talk about. And yet, when sufficient numbers of them make money, when sufficient capital is put to work in these opportunities, the macro structure of the trades becomes evident. This is the natural evolution of strategy.

Fees and Terms:

The industry has been debating if there has been any fee compression in the wake of the financial crisis of 2008, and hedge funds’ apparently failure to perform as advertised. I have defended the performance of hedge funds through the initial stages of the crisis, but that is the subject of another discussion. At the Goldman conference, there was definitely a growing number of managers charging less than the usual 2 and 20. 1.5 and 15, and even 1 and 10, fees were seen. Encouragingly, I met a handful of managers who were either considering or in the process of establishing a holdback provision with a vesting period, on performance fees, whereby a portion (say 50%) of a year’s performance fees are held in escrow and a negative performance fee is applicable to the amound held back.

Liquidity terms were also a lot more logical. Illiquid strategies did not shy away from lock ups, while well performing or big name hedge funds with liquid portfolios and strategies, passed on that liquidity to investors. Some managers went as far as to formally exclude so-called gates, restrict suspension of NAV rights to specific circumstances, and specify side pocket provisions more explicitly. It appears that the events of 2008 have precipitated a much welcome self regulatory campaign.

Strategies:

Equity long short managers were in abundance, naturally, given their market share of the hedge fund industry. The diversity of styles within what many consider a relatively simple strategy makes it a very interesting area to analyse and invest. There are managers who are driven by the philosophy that fundamentals, that is earnings, cash flow generation, financial strength, matter most in determining valuations. There are those who are traders, for which fundamentals are secondary, and what matters most is how a stock’s price has behaved and is behaving. Still others, have a macro or thematic approach, and apply these to equity investing. The trading style managers were bullish, arguing that increased volatility and dispersion in equity returns represented opportunity for profit. It also represents opportunity for loss as well of course. Alpha can be negative. Some of them were bullish on the market, some were bearish on the market, but there was general enthusiasm for the opportunity to trade. Fundamentally driven stock pickers were similarly upbeat about their strategy, arguing that the last 6 months have seen a wholesale disposal of risk followed by in the last 6 weeks, a reversal of this risk aversion, and that such large systemic moves create mispricings in individual companies which they seek to exploit. As always there were some very clever approaches to equity long short. There was a manager who had a very strong macro view, and invested a lot of time in macro research, then researched company fundamentals in an attempt to understand the impact of macro developments on company fundamentals. There was another manager which analysed only audited financials and ignored all street and interim data, and then built sophisticated models to obtain their own interim numbers. All these various managers had credible reasons why their approaches would work. In 2005, I would not have believed them; today I am a lot less skeptical.

Convertible Arbitrage managers were conspicuously absent from the conferences. The best performing strategy in 2009, albeit the worst performing strategy in 2008, convertible arbitrageurs were too busy making money from the market to attend a capital introductions event. Moreover, who would listen, they would argue, most investors having being burnt in 2005 and then again in 2008. There are good reasons why the strategy is working and is likely to work further, but the managers were too busy working it than selling it. Good for them.

Distressed Debt has been a preferred strategy since late 2007. That, however, was an expensive false start. By the end of 2008, with insufficient defaults and a catastrophic dislocation in credit markets from LIBOR to swaps, from ABS to corporate, from cash to synthetics, distressed debt managers had suffered considerable losses. Rational, no memory investing would have suggested getting back into distressed investing in 2009 and to their credit, investors have been bullish on distressed investing once again. A number of surveys taken in 1Q 2009 ranked distressed investing as one of the top 3 hedge fund strategies among investors for 2009.

One of the least favored strategies, if investor survey’s are to be believed, is merger arbitrage. It may surprise one to learn that on a rolling 12 month basis, merger arbitrage has been one of the best performing hedge fund strategies, behind global macro and CTAs. Merger arbitrage, or risk arb, was well represented at the Goldman conference and it was clear that risk arbitrageurs were very much excited about the opportunities before them.

Since July 2008, M&A transactions numbered over 5000 representing over 1 trillion USD in value, and deal flow continues on the back of cashed up corporate buyers seeking strategic assets, distressed sales from corporate restructurings, distressed sellers and government interventions. Company’s are happier to do deals in rising stock markets and easing financing conditions. Also, BRICs and other EM markets outbound transactions have been strong and remain an area of considerable potential growth.

Deal spreads have been volatile. The dislocation of markets in 2008 represent a stepwise repricing of an over arbitraged space. Deal spreads of circa 10-11% blew out to 50 – 60% before settling at current levels of 15 – 20% IRR.

The financial crisis of 2008 has also reduced the number of participants leading to a much less crowded space. Bank prop desks have exited or significantly reduced their books and hedge fund capital dedicated to risk arb has shrunk more than proportionately to the industry. Many risk arb funds drifted into a much too early play in distressed credit as quite often the resources if not the skill sets are the same. M&A very often wanders into litigation and distressed investing is very much about litigation. While a pure risk arb strategy would have done relatively well in the last 12 months, the contamination from a catastrophic credit strategy has hurt many multi strategy funds with large risk arb books resulting in poor performance and redemptions. The reduced capital employed in risk arb not only results in wider deal spreads but allows more time for analysis and deal selection leading to more selective participation.

A renaissance for hedge funds:

Since hedge fund indices have been compiled, that is 1990, until the present, with the exception of 1998 and 2008, hedge funds have steadily generated positive absolute returns. These returns have seen varying correlations to the returns of other traditional asset classes such as equities and bonds, as well as varying information ratios over time. From 2005 to 2007 hedge funds’ returns exhibited increasing correlation to traditional asset classes, decreasing returns to invested capital, increasing inter strategy correlations and increasing leverage. These features are interrelated and are directly related to the amount of capital dedicated to hedge fund strategies.

With more capital deployed in arbitrage and relative value strategies, continuous risk was more evenly distributed, volatility was dampened, volatility of volatility and correlations was also dampened, credit spreads converged, other arbitrage and relative value spreads also converged. The only way to maintain return on equity was to increase the level of leverage, a practice eminently feasible in an environment of cheap credit. Return on capital at risk, however, compressed to unsustainably low levels.

Such periods of calm accumulate imbalances for discontinuities. It would seem that a protracted reduction in continuous risk results in an accumulation of gap risk. In 2008, that gap risk was crystallized resulting in a discontinuous reduction in systemic leverage and thus capital employed  in arbitrage and a concomitant system wide widening of arbitrage and relative value spreads.

This is one of the more plausible explanations for why, in an economy clearly in decline, with recovery highly uncertain and non-robust, with differing opinions and outlook for financial markets, arbitrageurs are optimistic about their profit generation potential across almost all, if not all, hedge fund strategies.

Arbitrageurs will be required once again to police arbitrage and relative value spreads to bring convergence to no-arbitrage pricing, to bring relative value valuations in line and to aid in the efficient allocation of capital. In a sense, and to a certain extent, the real economy is reliant on the arbitrageur in the healing process, and therefore, one factor for the rate of recovery, or repair, of the real economy, will be the rate at which capital is redeployed to take advantage of mispricings and other arbitrage opportunities.

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Please feel free to comment below or contact me if you have any questions or would like more information on starting a hedge fund.

NASAA Takes Sides on Proposed Hedge Fund Legislation

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Endorses House Bill Over the Grassley-Levin Hedge Fund Bill

Last week the North American Securities Administrators Association (NASAA) announced its support of the Hedge Fund Adviser Registration Act of 2009, a house bill introduced earlier this year by Representatives Capuano and Castle.  The Hedge Fund Adviser Registration Act is one of two bills introduced in Congress which would effectively require many unregistered hedge fund managers to register with the SEC.  The other bill, the Hedge Fund Transparency Act, was introduced into the Senate by Senators Grassley and Levin.  While the Adviser Registration Act would close what some are calling a loophole in the Investment Advisers Act of 1940, the Transparency Act would create a whole new regime for regulating hedge fund entities (as opposed to the management company).  The Transparency Act also came under fire earlier this year for being poorly drafted.

The NASAA support was announced in the release we have reprinted below.  If you have any questions on this issue, please feel free to contact us.  Related hedge fund registration articles include:

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May 28, 2009

NASAA Supports the Hedge Fund Adviser Registration Act of 2009 (H.R. 711)

Legislation Would Require Hedge Fund Advisers to Register with SEC

WASHINGTON (May 28, 2009) – The North America Securities Administrators Association (NASAA) today endorsed proposed bipartisan legislation that would require hedge fund advisers to register with the Securities and Exchange Commission under the Investment Advisers Act of 1940.

The Hedge Fund Adviser Registration Act of 2009 (H.R. 711), sponsored by Reps. Michael E. Capuano (D-MA) and Michael Castle (R-DE), addresses one of NASAA’s Core Principles for Financial Services Regulatory Reform – closing regulatory gaps.

“NASAA appreciates the efforts of Rep. Capuano and Rep. Castle to promote the regulation of hedge fund advisers in a manner that will provide greater transparency to the marketplace while not overburdening the hedge fund industry,” said NASAA President and Colorado Securities Commissioner Fred Joseph. “Advisers to hedge funds should be subject to the same standards of examination as other investment advisers.”

Because they qualify for a number of exemptions to federal and state registration and disclosure laws, hedge funds remain largely unregulated today. The SEC has attempted to require hedge fund managers to register as investment advisers, but that effort was overturned by a U.S. Court of Appeals decision. “Given the need for greater oversight and transparency in many corners of the financial services industry in the wake of the market meltdown, Congress should give the SEC explicit statutory authority to regulate hedge fund advisers as investment advisers,” Joseph said.

Joseph noted that the Managed Funds Association, which represents the hedge fund industry, now supports the registration of investment managers – including hedge fund managers – with the SEC. “This is a step in the right direction,” Joseph said. “While hedge funds did not cause the current economic and financial crisis facing the United States, they, along with the rest of the shadow banking industry, played a role. This reason alone is enough to require greater regulation of all parties in question.”

Joseph said NASAA will continue to press Congress for additional reforms of the hedge fund industry, including granting the SEC authority to require hedge funds to disclose their portfolios, including positions, leverage amounts and identities of counterparties, to the appropriate regulators; and appropriating the necessary funds to ensure that the regulators are sufficiently equipped, in terms of personnel and technology, to provide meaningful analysis of this data and to exercise proper oversight over hedge funds.

NASAA is the oldest international organization devoted to investor protection. Its membership consists of the securities administrators in the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada and Mexico.

For more information:
Bob Webster, Director of Communications
202-737-0900

NFA Cracks Down on CPO Fraud with New Compliance Rule

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Proposes Amendments to Compliance Rule 2-45

The National Futures Association (NFA) proposed new amendments to Compliance Rule 2-45 regarding prohibition of loans by pools to commodity pool operators and related parties.  The amendment states that no Member CPO may permit a commodity pool to use any means to make a direct or indirect loan or advance of pool assets to the CPO or any other affiliated person or entity.  The amendment is proposed in response to a recent NFA investigation which revealed that CPOs  had misappropriated pool funds through improper loans from pools to the CPOs or related entities.  The full NFA proposal can be viewed below.

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May 27, 2009
Via Federal Express

Mr. David Stawick
Office of the Secretariat
Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st Street, N.W.
Washington, DC 20581

Re: National Futures Association: Prohibition of Loans by Pools to Commodity Pool Operators and Related Parties – Proposed Adoption of Compliance Rule 2-45

Dear Mr. Stawick:

Pursuant to Section 17(j) of the Commodity Exchange Act, as amended, National Futures Association (“NFA”) hereby submits to the Commodity Futures Trading Commission (“CFTC” or “Commission”) proposed Compliance Rule 2-45 regarding prohibition of loans by pools to commodity pool operators and related parties. This proposal was approved by NFA’s Board of Directors (“Board”) on May 21, 2009. NFA respectfully requests Commission review and approval.

PROPOSED AMENDMENTS

(additions are underscored)

COMPLIANCE RULES

* * *

PART 2 – RULES GOVERNING THE BUSINESS CONDUCT OF MEMBERS REGISTERED WITH THE COMMISSION

* * *

RULE 2-45. PROHIBITION OF LOANS BY COMMODITY POOLS TO CPOS AND AFFILIATED ENTITIES.

No Member CPO may permit a commodity pool to use any means to make a direct or indirect loan or advance of pool assets to the CPO or any other affiliated person or entity.

EXPLANATION OF PROPOSED AMENDMENTS

In February, NFA took two Member Responsibility Actions (“MRAs”) against three NFA Member commodity pool operators (“CPOs”). Although the basis of both MRAs was the CPOs’ failure to cooperate with NFA in an investigation, the limited investigation that NFA was able to perform revealed that the CPOs had misappropriated pool funds through improper loans from pools to the CPOs or related entities. The CFTC charged all three of the CPOs with misappropriating pool assets through improper loans, and all three were charged criminally with fraud.

These two matters are not the first instances of CPOs misappropriating pool participant funds through direct or indirect loans from a pool to the CPO or a related entity. Over the years, there have been a number of regulatory actions involving this type of fraud. Given the significant losses suffered by pool participants as a result of these improper loans, NFA is proposing to prohibit direct or indirect loans from commodity pools to the CPO or any affiliated person or entity.

NFA staff discussed this matter with NFA’s CPO/CTA Advisory Committee, which supported prohibiting loans because it believes that absent extraordinary circumstances there is no legitimate reason for a pool to make a direct or indirect loan to its CPO or a related party. The Committee indicated, however, that participants, including a CPO’s principal, should not be prevented from borrowing against their equity interest in the pool.

NFA Compliance Rule 2-45 provides for a complete prohibition of direct or indirect loans or any advance of pool assets between a pool and its CPO or any other affiliated person or entity. NFA recognizes that there may be circumstances where a carve out to this prohibition may be appropriate, such as where a CPO permits participants, including a pool’s general partner, to borrow against their equity interest in the pool in lieu of a withdrawal, provided that the loan is collateralized by the participant’s interest in the pool. NFA believes that these types of situations are best handled on a case by case basis, with the CPO seeking a no-action letter from NFA.

NFA respectfully requests that the Commission review and approve proposed Compliance Rule 2-45 regarding prohibition of loans by pools to commodity pool operators and related parties.

Respectfully submitted,

Thomas W. Sexton
Senior Vice President and General Counsel

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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:


Proposed Amendments to the Investment Advisers Act: SEC Requests Feedback

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The Securities and Exchange Commission (SEC) is proposing certain amendments to the custody rule under the Investment Advisers Act of 1940 and related forms. Due to the complexity of the various impositions placed on industry professionals by the proposed amendments, the SEC is formally requesting feedback from industry professionals regarding the impact of the new legislation.

Specifically, the amendments address Rules 206(4)-2 and 204-2, and Forms ADV and ADV-E. The amendments are summarized in the bullet points below:

Rule 206(4)-2: All registered investment advisers:

  • must have a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients
  • must undergo an annual surprise audit examination by an independent accountant
  • is presumed to have custody over any clients’ assets that are maintained by the advisers ‘related persons’, so long as those assets are in connection with the advisory services
  • must obtain or receive an annual internal control report, if the adviser also acts as a qualified custodian over client assets
  • must inform the SEC within one business day of finding any material discrepancies during an audit examination

Rule 204-2: All registered investment advisers:

  • must maintain a copy of an internal control report for five years from the end of the fiscal year in which the internal control report is finalized

Form ADV:  All registered investment advisers:

  • must report all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to client funds
  • must report the dollar amount of client assets and the number of clients of which he/she has custody
  • must identify and provide detailed information regarding the accountants that perform the audits/examinations and prepare internal control reports

Form ADV-E: All PCAOB-registered accountants:

  • must file Form ADV-E with the SEC within 120 days of the completion of the audit examination
  • must submit Form ADV-E to the SEC within four business days of his/her resignation, dismissal from, or other termination of the engagement, accompanied by a statement that includes details of the resignation

All comments to the proposed amendments must be received by the SEC on or before July 28, 2009.  Please contact us if you have any questions on the above proposed amendments or would like to start a hedge fund.  Additionally, we will be submitting our comments to the SEC with regard to the proposed amendments and would like to know what you think as well – please comment below.

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For further information regarding the proposed amendments, please refer to the more detailed abstract below.  The full text of the proposed rules can be found here.

SEC Proposed Custody Amendments Abstract

The Securities and Exchange Commission (SEC) is proposing certain amendments to the custody rule under the Investment Advisers Act of 1940 and related forms, with the intent to enhance the protections afforded to clients’ assets under the Advisers Act when an advisor has custody of client funds or securities. These amendments are proposed as a response to a number of recent enforcement actions against investment advisors alleging fraudulent conduct, including misappropriation or other misuse of investor assets.  Specifically, the amendments address Rules 206(4)-2 and 204-2, and Forms ADV and ADV-E. Due to the complexity of the various impositions placed on industry professionals by the proposed amendments, the SEC is formally requesting feedback from industry professionals regarding the impact of the new legislation.

Rule 206(4)-2, also known as the ‘custody rule’, seeks to protect clients’ funds and securities in the custody of registered advisers from misuse or misappropriation by requiring advisers to implement certain controls. The current rule requires registered advisers to maintain their clients’ assets in separate identifiable accounts with a qualified custodian, such as a broker-dealer or bank. Presently, advisors may comply with the rule by either a) having a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients or alternatively b) the advisor sending his/her own quarterly account statements to clients and undergoing an annual surprise audit examination by an independent public accountant. Similarly, an adviser to a pooled investment vehicle may currently comply with the rule by having the pool audited annually by an independent public accountant and distributing the audited financials to the investors in the pool within 120 days of the end of the pool’s fiscal year.

The proposed amendments to Rule 206(4)-2 aim to codify both of the above mentioned compliance alternatives by requiring  that all registered advisers having custody of client assets must a) have a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients and b) undergo an annual surprise examination.  The amendments also explicitly state that an adviser is presumed to have custody over any clients’ assets that are maintained by the advisers ‘related persons’, so long as those assets are in connection with the advisory services. The SEC additionally proposes that if an independent qualified custodian does maintain client assets, but rather the advisor or a related person him/herself serves as a qualified custodian for the client, then the advisor must obtain or receive from the related person an annual internal control report which would include a) an opinion from an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB), and b) a description of the relevant controls in place relating to custodial services and the objectives of these controls, as well as  the accountant’s tests of operating effectiveness and the test results. Lastly, the newly amended rule would also require the adviser and the accountant to inform the SEC within one business day of finding any material discrepancies during an examination that may assist in protecting advisory client assets. Together, these revisions to Rule 206(4)-2 are designed to strengthen the controls relating to the advisors’ custody of client assets and deter advisors from fraudulent activity.

Rule 204-2, governing record maintenance, presently requires that investment advisors obtain or receive a copy of an internal control report from its related person.  The proposed amendment to this rule would additionally require the advisor to maintain the copy for five years from the end of the fiscal year in which the internal control report is finalized. This amendment to Rule 204-2 is designed to further implement safeguards to protect clients’ assets and offset custody-related risks.

Form ADV, which outlines the data to be reported to the SEC by investment advisors, has also been amended to provide the SEC with additional data and more complete information from the perspective of the advisor. Currently, Item 7 of Part1A requires advisers to report on Schedule D of Form ADV each related person that is an investment adviser, and permits advisers to report the names of related person broker-dealers.  The new amendment modifies Item 7 to require an advisor to report all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to client funds. Similarly, Item 9 of Part1A currently requires advisers to report whether they or a related person have custody of client funds. The new amendment to Item 9 requires an adviser to report the dollar amount of client assets and the number of clients of which he/she has custody. Other reporting duties to be implemented under the new amendments include: a) whether a qualified custodian sends quarterly account statements to investors in pooled investment vehicles managed by the adviser, b) whether these account statements are audited, c) whether the adviser’s clients’ funds  are subject to a surprise examination and the month in which the last examination commenced, and d) whether an independent PCAOB-registered accountant prepare an internal control report when the adviser is also acting as a qualified custodian for the clients’ funds. Schedule D of Form ADV would also be amended to require additional reporting duties of the adviser, including: a) identifying the accountants that perform the audits/examinations and prepare internal control reports, b) providing information about the accountants including address, PCAOB registration, and inspection status, c) indicating the type of engagement (audit, examination, or internal control report), and d) indicating whether the accountant’s report was unqualified.  These proposed amendments to Form ADV are designed to allow the SEC to better monitor compliance with the requirements of Rules 206(4)-2 and 204-2 and better assess the compliance risks of an adviser.

Form ADV-E, which outlines the data to be reported to the SEC by designated accountants, has also been amended to provide the SEC with additional data and more complete information to the SEC from the perspective of the accountant. Currently, the rule requires this form to be filed within 30 days of the completion of the examination, accompanied by a certificate confirming that the accountant completed an examination of the funds and describing the nature and extent of the examination. The SEC proposes to amend this rule governing Forms ADV and ADV-E to extend the grace period within which the forms must be submitted to a period of 120 days from the time of the examination. Based on SEC observations, an adviser’s surprise examination may sometimes continue for an extended period of time, warranting this extension. Additionally, the amendment requires that the accountant submit Form ADV-E to the SEC within four business days of his/her resignation, dismissal from, or other termination of the engagement, accompanied by a statement that includes a) the date of such resignation, dismissal or termination, b) the accountant’s name, address and contact information, and c) an explanation of any problems relating to examination scope or procedure that contributed to such resignation, dismissal or termination. This proposed amendment to Form ADV-E is designed to provide the SEC with the information necessary to further evaluate the need for an examination to determine whether the clients’ assets are at risk.

The SEC strongly urges investment advisors, public auditors/accountants, and related professionals in the field of securities and investments to review the proposed amendments to the Advisers Act and submit relevant feedback that may assist the Commission in analyzing the effectiveness, efficiency, and feasibility of the proposed amendments as well as the possible impact of these new legislative measures on the global marketplace. While all proposed amendments are designed to provide additional safeguards to client funds or securities under adviser custody, the potential ramifications of their enforcement is currently being assessed. Comments may be submitted in electronically via the Commission’s internet comment form (http://www.sec.gov/rules/proposed.shtml), via e-mail to [email protected], or via the Federal eRulemaking Portal (http:/www.regulations.gov). Paper comments can be sent in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. All comments to the proposed amendments must be received by the SEC on or before July 28, 2009.  All submissions must refer to File Number S7-09-09, and will be made available to the public via the Commission’s Internet Website: http://www.sec.gov/rule/proposed.shtml.

CPO Exemption for Fund of Hedge Funds

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As we have discussed previously, if a hedge fund manager invests fund assets in commodity interests (including futures), then the manager will generally need to be registered as a commodity pool operator (CPO) with the Commodity Futures Trading Commission (CFTC).  The registration requirement also applies to fund of fund (FOF) managers who allocate assets to underlying hedge funds which themselves invest in commodity interests.  There are a number of CPO exemptions available to hedge fund managers.  Likewise, there are two exemptions which may be applicable to fund of fund managers who allocate to funds CPOs or exempt CPOs. Continue reading →

SEC Proposes More Onerous Custody Rules For Hedge Fund Managers

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Hedge Funds to be Subject to “Surprise Exams”

In addition to the likelihood of hedge fund registration, the SEC is now proposing to have “gatekeepers” to make sure that investment advisors are not engaged in any fraudulent behavior.  When and if such a requirement is adopted, it will further burden investment advisors with more paperwork.  “Surprise exams” could also be disastrous to the small investment advisory shops which would need to divert resources from trading and operations to dealing with such surprise exams.  At all levels of the investment advisory spectrum this will increase costs.

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SEC Proposes Rule Amendments to Strengthen Safeguards of Investor Funds Controlled by Investment Advisers

FOR IMMEDIATE RELEASE
2009-109

Washington, D.C., May 14, 2009 — The Securities and Exchange Commission today proposed rule amendments to substantially increase protections for investors who entrust their money to investment advisers.

The SEC is seeking public comment on the proposed measures, which are intended to ensure that investment advisers who have “custody” of clients’ funds and securities are handling those assets properly. In some recent SEC enforcement actions, firms and principals have been charged with misusing clients’ money and covering up their illicit activities by distributing false account statements showing non-existent funds. The additional safeguards proposed by the SEC include a yearly “surprise exam” of investment advisers performed by an independent public accountant to verify client assets. In addition, when an adviser or an affiliate directly holds client assets, a custody control review would have to be conducted by a PCAOB-registered and inspected accountant.

“These new safeguards are designed to decrease the likelihood that an investment adviser could misappropriate a client’s assets and go undetected,” said SEC Chairman Mary Schapiro. “That’s because an independent public accountant will be looking over their shoulder on at least an annual basis.”

Andrew J. Donohue, Director of the SEC’s Division of Investment Management, added, “The amendments proposed by the Commission today would significantly strengthen controls over client assets held by registered investment advisers — especially when those assets are held directly by the adviser itself or a related person of the adviser.”

Unlike banks or broker-dealers, investment advisers generally do not have physical custody of their clients’ funds or securities. Instead, client assets are typically maintained with a broker-dealer or bank (a “qualified custodian”), but the adviser still may be deemed to have custody because the adviser has authority to withdraw their clients’ funds held by the qualified custodian. Or the qualified custodian may be affiliated with the adviser, which may give the adviser indirect access to client funds.

The SEC’s proposed rule amendments, if adopted, would promote independent custody and enable independent public accountants to act as third-party monitors.

One proposed amendment would require all registered advisers with custody of client assets to undergo an annual “surprise exam” by an independent public accountant to verify those assets exist.

Another proposed amendment would apply to investment advisers whose client assets are not held or controlled by a firm independent of the adviser. In such cases, the investment adviser will be required to obtain a written report — prepared by a PCAOB-registered and inspected accountant — that, among other things, describes the controls in place, tests the operating effectiveness of those controls, and provides the results of those tests. These reports are commonly known as SAS-70 reports. This review would have to meet PCAOB standards — providing an important level of quality control over the accountants performing the review.

The proposed measures also would include reporting requirements designed to alert the SEC staff and investors to potential problems at an adviser, and provide the Commission with important information for risk assessment purposes. An adviser would be required to disclose in public filings with the Commission, among other things, the identity of the independent public accountant that performs its “surprise exam,” and amend its filings to report if it changes accountants. The accountant would have to report the termination of its engagement with the adviser and, if applicable, any problems with the examination that led to the termination of its engagement. If the accountants find any material discrepancies during the surprise examination, they would have to report them to the Commission.

The proposed amendments also would require that all custodians holding advisory client assets directly deliver custodial statements to advisory clients rather than through the investment adviser, and that advisers opening custody accounts for clients instruct those clients to compare account statements they receive from the custodian with those received from the adviser. These additional safeguards would make it more difficult for an adviser to prepare false account statements, and more likely that clients would find discrepancies.

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Public comments on today’s proposed rule amendments must be received by the Commission within 60 days after their publication in the Federal Register.

The full text of the proposed rule amendments will be posted to the SEC Web site as soon as possible.

http://www.sec.gov/news/press/2009/2009-109.htm

MFA Supports Hedge Fund Registration

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MFA Lobbyist Testifies to Congress Regarding Hedge Fund Registration

In a somewhat surprising move, the MFA stated to Congress today that it supports registration for hedge fund managers.  Below is a press release regarding the statement.  The MFA also released its final written testimony to Congress which can be found here. CNBC has also produced a short news clip on this event which can be found here (note: you may have to watch a commercial for pajamagram).

I will continue reporting more on this issue and will also update this post once I have had a chance to review the written testimony.
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News Release
FOR IMMEDIATE RELEASE CONTACT:
Meg Bode
(516) 869-6610

May 7, 2009

MANAGED FUNDS ASSOCIATION ANNOUNCES SUPPORT FOR REGISTRATION OF INVESTMENT ADVISERS INCLUDING HEDGE FUNDS

WASHINGTON, DC – In testimony before the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises hearing, “Perspectives on Hedge Fund Registration,” Managed Funds Association (MFA) today announced its support for mandatory registration with the Securities and Exchange Commission (SEC), of investment advisers, including advisers to private pools of capital under the Investment Advisers Act of 1940.

Richard H. Baker, MFA President and CEO, said, “Though hedge funds were not the cause of the ongoing problems in our financial markets and our economy, MFA and our members share the commitment of policy makers to enact measures that will help restore stability to our markets, strengthen financial institutions and restore investor confidence. We believe supporting mandatory registration for investment advisers is just one of the many important steps that can be taken towards these mutually shared goals.

Baker noted, “This proposed framework goes beyond that recently called for by Treasury Secretary Geithner. The Administration’s proposal called for only the largest fund advisers to be registered for the purpose of assessing their systemic relevance. The registration regime we are supporting today, which has been driven largely by changes in markets and the growing demands of investors, is more comprehensive and will subject the vast majority of investment advisers, including the largest and those considered most systemically relevant, to the SEC’s registration requirements.

Baker’s testimony stressed that while hedge funds are important to the capital markets and the financial system, the relatively small size and scope of the industry, with approximately $1.5 trillion in assets under management, did not pose significant systemic risk. He also stressed that hedge funds are substantially less leveraged than banks, have outperformed the overall market and have not sought any federal assistance.

Baker indicated that to fulfill these additional responsibilities, without diminishing the agency’s ability to meet its core mission of investor protection, the SEC would need additional resources specifically for personnel, technology and training and recruitment.

“A registration framework that overwhelms the resources, technology and capabilities of regulators will not achieve the intended objective, and will greatly impair the ability of the regulator to fulfill their existing responsibilities, as well as their new responsibilities.”

In addition to supporting registration, MFA’s written testimony outlined several key principles that they believe Congress, the Administration and other policy makers should consider as they discuss changes to the financial regulatory system.

A copy of MFA’s written testimony is available at www.managedfunds.org.

About Managed Funds Association

MFA is the voice of the global alternative investment industry. Its members are professionals in hedge funds, funds of funds and managed futures funds, as well as industry service providers. Established in 1991, MFA is the primary source of information for policy makers and the media and the leading advocate for sound business practices and industry growth. MFA members include the vast majority of the largest hedge fund groups in the world who manage a substantial portion of the approximately $1.5 trillion invested in absolute return strategies. MFA is headquartered in Washington, D.C., with an office in New York. For more information, please visit: www.managedfunds.org.

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Bay Area Hedge Fund Roundtable Event

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Panel Discussion on State of Hedge Fund Industry

Yesterday afternoon (May 6th) the Bay Area Hedge Fund Roundtable, a group of professionals within the hedge fund industry, gathered for a panel presentation entitled “Change…Critical Legal, Tax, Acounting and Regulatory Updates You Need to Know.”  The presentation was moderated by Pamela S. Nichter (Osterweis Capital Management) and included the following panel participants:

Vincent J. Calcagno (Rothstein Kass)
Geoffrey Haynes (Shartsis Friese)
Tony Hassan (Ernst & Young)
Anita K. Krug (Howard Rice)

Presentations like these are great because they allow professionals to share insights into what is going on in different parts of the industry – many of the topics discussed allowed the panelists to really dig deep into the issues and provide some context to what is happening at both the regulatory and investor levels.  I took notes during the presentation and will summarize some of the main points discussed by each of the presenters (please don’t hold anything against the speakers if I mis-paraphrase or mis-interpret and as always nothing in this summary is tax or legal advice)…

Anita K. Krug

Anita discussed a number of the laws which have been discussed or proposed over the past 6 to 8 months including the following:

  • Barney Frank’s Recent Comments (see Reuters article)
  • Mary Shapiro’s Recent Comments (see Bloomberg article where Shapiro says she wants the ability to make rules regulating hedge funds)
  • Discussion of the Hedge Fund Transparency Act which was proposed in the Senate earlier this year (see also Overview of the Hedge Fund Transparency Act)
  • Hedge Fund Advisor Registration Act which was proposed in the House earlier this year
  • Geithner’s hedge fund proposals (see NY Times article for background information)
  • Discussion of the past short selling rules (see HFLB article) and the new short selling rules which will be closer to the old “uptick” rule (see SEC overview; note: I have not yet had an opportunity to thoroughly review these proposed rules)
  • European Rules which have been proposed which may have an effect on US based managers with EU investors (Anita raised many of the same issues which were also raised in this article)

Geoffrey Haynes and Vincent J. Calcagno

Geoffrey and Vincent went back and forth discussing some of the tax issues which managers are likely to face this year and potentially going forward.  This discussion included the following issues:

  • Discussion of the new offshore deferral rules by dint of new Section 457A of the Internal Revenue Code (see generally this alert).  Note: discussions on the ramifications of this new section to managers who currently have deferral arrangements took a majority of the time.  There are a number of issues involved including issues with side pockets, options, and non-conventional performance fee periods.
  • San Francisco Payroll Tax of 1.5% (see background on this issue here)
  • Discussion of the Levin proposal to tax the carried interest as ordinary income (see Hedge Fund Carried Tax Increase?).  [The panelists seemed to think that Congress would not vote on this bill until sometime in 2010 (if the bill was actually even voted on) with an effective date, if passed, of sometime in 2010 – the panelists did not seem to think it would be retroactively applied.]
  • Discussion of a bill which would eliminate UBTI for U.S. based non-taxable investors investing in U.S. hedge funds which utilize leverage (note: I was not aware of this bill and am not sure what bill exactly was referred to – please feel free to contact me if you know about this bill).  The panelists seemed to think this bill was likely DOA.
  • Discussion of the Stop Tax Haven Abuse Bill by Senator Levin (see Senator Levin’s press release)
  • Discussion of Obama’s Offshore Tax Plan (see generally the White House press release)

Tony Hassan

Tony discusses what is changing in the area of hedge fund operations.  Tony’s discussion of current topics was maybe one of the more important parts of the panel in terms of providing insight on current investing trends and due diligence requests.  Many of the items in this section were part of a dialogue between Tony and Vince as noted in the parenthesis below.

  • There is no secret that due diligence is a more central and important part of the investing process than it was previously.  (Tony and Vince)
  • Due diligence is also changing in many respects – at E&Y Tony has had specific requests from potential invests to send them directly the financial statements.  Of course this brings up many legal and client issues (the hedge fund, not the potential investor, is the client of E&Y) and because of this these requests are often denied. (Vince)
  • Managers are providing verified transparency “quarterly reviews” which aim to show investors that the fund’s assets are actually there.  (Vince)
  • Some funds are instituting a half-yearly audit (in addition to the end of year audit).  (Vince)
  • Some funds are instituting agreed upon procedure reports.  In these reports the auditor will come in an verify that certain procedures are being completed.  This may be especially important with regard to the valuation of the fund’s assets.  (Vince)
  • Tony noted that this is really a new form of due diligence and used the term “Hedge Fund Due Diligence 2.0” – a term I used in October of 2008 (see post).
  • Investor questions to hedge funds are changing.  While previous questions would have stopped after “Do you have a 3rd party administrator?”  Now the questioning continues – investors want to know about the administrators technical expertise, who exactly will be the account representative and what type of capital markets experience does that person or group have, what inputs will be used to value assets, etc.  Investors also want to know what sort of contingency plan is in place should the administrator fail or if there is a disaster; investors will want to know if the fund is keeping shadow books.  (Tony)
  • Tony also participated in the discussion with Pamela below with regard to managed accounts.

Pamela S. Nichter

Pamela, the moderator of the discussion, also weighted in on certain operational issues which fund managers should be prepared for in the new climate.  In general Ms. Nichter is seeing more investor requests and communications.  Now there is greater communication between the investor and the fund manager.  Ms. Nichter also discussed the trend toward greater liquidity and transparency through separate account structures.

Separate accounts are something that more and more investors are seeking but there are many considerations for managers.  Specifically separate accounts can be a drain on resources, especially if the investors request their own specific administrators or auditors.  Because of the greater amount of resources which need to go into the back office to handle what is in essence a more traditional asset management business, the manager must be ready to change the business model to a certain extent.  Specific issues will include:

  • having a robust trade allocation policy
  • understanding that there is likely to be a disparity of performance
  • potential registration issues
  • potential integration issues
  • performance reporting issues (may need to go back to GIPS)

Questions and Conclusion

After the panel finished their discussion the floor was open to questions.  During this time there were a number of good questions.  One issue focused on what will performance fees look like going forward which led to a discussion about creative performance fees (like instituting some sort of clawback provision like what is found in private equity funds).  Another issue was whether and to what extent the Managed Funds Association will be representing the industry during this time of legislative/regulatory changes.  The answer is that the MFA will be doing everything it possibly can to represent the hedge fund industry and it is our job to make sure that the MFA knows how the industry feels about many of the current legislative proposals.

Accredited Investor Net Worth Question

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Most hedge funds will require investors to be “accredited investors.”  In general, a natural person is deemed to be an accredited investor if (1) the natural person has an individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase (i.e. investment into the hedge fund) or (2) the natural person has an income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year. (See generally Accredited Investor Definition.)

One common question is “does net worth include the equity a person has in their personal residence?”  The answer is yes. The SEC specifically addressed this question in their Interpretive Release On Regulation D.  Below is the actual text from the release which is applicable to this question:

(21) Question: In calculating net worth for purposes of Rule 501(a)(6), may the investor include the estimated fair market value of his principal residence as an asset?

Answer: Yes. Rule 501(a)(6) does not exclude any of the purchaser’s assets from the net worth needed to qualify as an accredited investor.

Note the difference between accredited investors and qualified purchasers with respect to this issue.  Individuals cannot include equity in their personal residence for the purpose of meeting the “qualified purchaser” definition.

Please contact us if you have a question on this issue or if you would like to start a hedge fund.  If you would like more information, please see our articles on starting a hedge fund.  Other related hedge fund law articles include: