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Four CFTC Actions against CPOs and CTAs

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This past week and a half has proven to be a busy time for the CFTC’s enforcement divisions as a number of actions have been released to the public.  The four actions below showcase the unlawful and unsavory behavior of four groups.  Specifically, two of the actions below provide details of two more Ponzi schemes and the other two actions involve misrepresentations and lies.  As we’ve discussed before hedge fund investors have many tools to protect themselves from these sorts of actions.  Simple hedge fund due diligence will go a long way towards protecting an investment.

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Release: 5612-09
For Release: February 11, 2009

CFTC Orders Former Bank Trader and New York City Resident to Pay $360,000 Penalty in Connection with False Trading Reports Submitted to His Former Employer, Bank of America

Washington, DC — The U.S. Commodity Futures Trading Commission (CFTC) today settled charges against Michael Moster for submitting false reports to the Bank of America in Chicago, where he once worked as a trader, and ordered Moster to pay a $360,000 civil penalty.

The CFTC issued an order on February 11, 2009, which finds that, during a three-day period in January 2004, Moster, a former proprietary trader for the Bank of America, falsely reported to the bank that he purchased 4,000 Treasury futures contracts to conceal the risk associated with large unauthorized positions in Treasury bonds that he established over the same time period, by making it appear as if the long futures position hedged the Treasury bond risk. By the following week, the fictitious trades inflated the value of his trading book by over $12 million, the order finds. The sale of Moster’s unauthorized Treasury bond position resulted in a loss of approximately $12.2 million to the Bank of America.

Based upon the same conduct, Moster pled guilty on September 18, 2008, to a one-count violation of making false entry into the books and records of a bank in the Southern District of New York. Under the criminal sentencing guidelines, Moster will be required to make full restitution of the over $12 million loss he caused to the Bank of America. The CFTC’s order recognizes the restitution made in the context of the criminal case and provides that Moster must pay and satisfy any criminal restitution obligation before his payment of the CFTC civil monetary penalty.

The following CFTC Division of Enforcement staff members are responsible for this case: Ken Koh, Todd Kelly, Peter Haas, Paul Hayeck, and Joan Manley.

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Release: 5610-09
For Release: February 10, 2009

CFTC Seeks Freeze of Assets in Oklahoma Ponzi Scheme Involving Over $30 Million

Mark Trimble of Edmond, Oklahoma Posted Profits, While Losing Millions in Phidippides Capital Hedge Fund

Washington, DC – The Commodity Futures Trading Commission (CFTC) announced that today it filed an enforcement action against Mark S. Trimble, of Edmond, Oklahoma, and his company, Phidippides Capital Management LLC (PCM), with offices in Oklahoma City. Trimble, who controlled Phidippides, also managed a private hedge fund named Phidippides Capital LP, which the CFTC’s complaint alleges was a Ponzi scheme.

CFTC Seeks Court Order Freezing Defendants’ Assets

In conjunction with the filing of the complaint today in the U.S. District Court for the Western District of Oklahoma, the CFTC is seeking a statutory restraining order freezing defendants’ assets and preserving records. Trimble has consented to the entry of an asset freeze order.

The CFTC’s complaint alleges that, from at least 2005 to the present, Trimble and PCM operated a $34 million hedge fund with approximately 60 investors and traded partly in the name of Phidippides Capital, a Delaware company incorporated by Trimble. Since at least October 2007, Trimble and PCM allegedly issued false account statements, failed to disclose the fund’s actual multi-million trading losses, and operated the fund as a Ponzi scheme, paying participant redemptions based on the fund’s fabricated profitability. Additionally, defendants allegedly received over $1 million in management fees based on false reports of trading profits.

Trimble Used Email to Notify Investors that He Had Not Been “Honest” About the Fund’s Trading Results

According to the complaint, Trimble’s activities were exposed in late January 2009, after Trimble provided the Federal Bureau of Investigation a fictitious 2008 year-end trading account showing millions of dollars in trading profits that did not square with actual trading statements issued by Trimble’s brokerage firm that disclosed millions of dollars in trading losses. Trimble subsequently stated in an email sent to his brokerage firm, and addressed to “Family, Friends, and Clients,” that he had not been “honest” about the hedge fund’s trading results, explaining: “The reason our balances are off is because I could not look myself in the mirror and face all of you and notify you that in the last quarter of 2008 we lost all the profits for the year and then some.”

Stephen J. Obie, CFTC Acting Director of the Division of Enforcement commented: “Through the swift action of CFTC staff, millions of dollars have been frozen, which ultimately we will seek to return to the victims Trimble deceived by his scheme. The CFTC continues to zealously prosecute these lecherous schemes, so that as many assets can be preserved as possible as we fulfill our vital mission to protect customers from fraud and abuse.”

The CFTC’s complaint seeks civil monetary penalties, disgorgement of ill-gotten gains, restitution to defrauded customers, and injunctive relief, among other sanctions.

The CFTC appreciates the assistance of the Securities and Exchange Commission and the Financial Crimes Enforcement Network.

The following CFTC Division of Enforcement staff members are responsible for this case: Rosemary Hollinger, Scott Williamson, Richard Wagner, and Ken Hampton. CFTC Auditors Thomas J. Bloom, Shauna Wright-Regas, and Lauren Corn also are working on this matter.

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Release: 5609-09
For Release: February 6, 2009

CFTC Obtains Judgment Against Albert E. Parish and Parish Economics LLC for Operating a Commodity Pool Scam in CFTC Anti-Fraud Action

Parish Currently Serving a Sentence of More than 24 years in Federal Prison for Related Criminal Violations

Washington, DC — The U.S. Commodity Futures Trading Commission (CFTC) announced today that the Honorable David C. Norton of the U.S. District Court for the District of South Carolina entered an order settling charges alleging that Albert E. Parish and Parish Economics LLC, both of Charleston, South Carolina, lied to customers and misappropriated millions of dollars in customer funds (see CFTC Press Release 5320-07, April 19, 2007).

According to the order entered on February 2, 2009, between 1986 and March 2007, Parish and Parish Economics fraudulently solicited approximately $40 million in investments for their commodity futures pool. Parish and Parish Economics misrepresented to pool participants that funds would be invested in commodity futures when, in reality, Parish misappropriated the vast majority of funds for his personal use. Parish and Parish Economics also provided false futures account statements to pool participants and failed to provide required pool disclosure documents.

The order permanently bars Parish and Parish Economics from further violating certain provisions of the Commodity Exchange Act and the CFTC’s regulations and from engaging in any commodity-related activity. Parish is currently serving a sentence of more than 24 years in federal prison for related criminal violations. In lieu of an award of restitution and civil monetary penalties, the order recognizes that Parish will be subject to a criminal judgment restitution obligation in excess of $40 million.

The CFTC would like to thank James A. Rue of the Securities and Exchange Commission and John H. Douglas of the U.S. Attorney’s Office for the District of South Carolina for their assistance in this matter.

The following CFTC Division of Enforcement staff members are responsible for this case: Jo Mettenburg, Jeff Le Riche, Charles Marvine, Donald Nash, Rick Glaser, and Richard Wagner.

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Release: 5608-09
For Release: February 5, 2009

CFTC Charges Minnesota Resident Charles “Chuck” E. Hays and His Company, Crossfire Trading, LLC, with Running a $5.5 Million Ponzi Scheme

Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) filed an enforcement action today against Charles “Chuck” E. Hays and Crossfire Trading, LLC (Crossfire), both of Rosemount, Minnesota, charging them with fraud and misappropriation in connection with a commodity pool Ponzi scheme.

In conjunction with the filing of the complaint today in the U.S. District Court for the District of Minnesota, the CFTC is seeking a statutory restraining order freezing defendants’ assets and preserving records.

The CFTC’s complaint alleges that, from January 2006 to the present, Hays and his company, Crossfire, a purported commodity pool, fraudulently solicited and accepted more than $5.5 million from at least three individuals and a charitable foundation for the purpose of trading stock index and crude oil futures.

Hays, according to the complaint, convinced at least one person to invest in Crossfire by representing verbally and in fabricated account statements — issued on Crossfire’s letterhead — that Crossfire earned consistent profits trading commodity futures with no losing months. However, as charged in the complaint, Crossfire has never had an active commodity futures trading account. Additionally, in an attempt to alleviate at least two investors’ suspicions as to what Hays was actually doing with their money, Hays provided an account statement for the Crossfire pool fabricated to appear as if it were issued by a legitimate brokerage company by using that brokerage’s letterhead. This false account statement indicated that Crossfire maintained a trading account at the brokerage with over $37 million. As alleged, that account is nonexistent.

Furthermore, the complaint charges Hays with misappropriating investor funds to purchase a $4 million yacht, and for other purposes.

“Hays ran his Ponzi scheme from his yacht, but was grounded when the tide turned as Federal authorities exposed this egregious fraud,” said CFTC Acting Director of Enforcement Stephen J. Obie.

The CFTC complaint seeks orders requiring the defendants to provide the CFTC with continuing access to books and records and to make an accounting with information necessary to determine the actual amounts of net contributions and profits or losses. The CFTC also requests that the court issue orders of preliminary and permanent injunction against the defendants, a return of alleged ill-gotten gains, repayments to defrauded investors, monetary penalties, and other relief.

The CFTC appreciates the assistance of the United States Attorney’s Office for the District of Minnesota, the Department of Justice, the United States Postal Inspection Service, and the Federal Bureau of Investigation in this action. Hays was arrested this morning by Federal authorities.

The following CFTC Division of Enforcement staff is responsible for this case: Susan Gradman, Neville Hedley, Judith McCorkle, Venice Bickham, Scott Williamson, Rosemary Hollinger, and Richard Wagner.

Hedge Fund Law Questions

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Recently I have received a few good hedge fund law questions.  Please remember that these answers are general discussions of the law and should not be a substitute for actual legal advice.  This discussion does not form an attorney-client relationship, please see our disclaimer.

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Question: [with reference to the new Hedge Fund Registration article] So what’s to say a hedge fund can’t just become the outside advisor to a series of managed accounts?  If so, does the fund still need to register?

Answer:  Many hedge fund management companies do provide individual account management outside of the hedge fund.  Typically this is described as hedge fund separately managed accounts. There are many reasons why a manager may have such accounts, including the fact that many large institutional investors require that their assets be managed in this way.

With regard to registration, yes a manager may have to register as an investment advisor if he manages separately managed accounts outside of the hedge fund.  There are two separate levels of registration – State and SEC.  Generally the SEC does not require a manager to register unless the manager has 14 or less clients over the last 12 months.  This generally means that a hedge fund manager can have 13 separately managed account clients (in addition to the hedge fund) without implicating the SEC registration requirements (see Hedge Fund Registration Exemption).  However, states are free to adopt their own registration laws and many would require a manager with 5 separately managed account clients (in addition to the hedge fund) to register as an investment advisor with the state securities commission.

Each manager’s situation is unique and if the manager has specific questions regarding his legal or registration status he should discuss with legal counsel.  Additionally, if the Hedge Fund Transparency Act is passed, it is likely that hedge fund managers with $50 million or more of AUM will need to register as investment advisors with the SEC.

Question:  Regarding the 3c7 Funds, does the counting of investors require a ‘look through’?  I.e. If an qualified investor was a Fund of Funds, would the counting up to the limit of 500 investors require counting the underlying investor of the Fund of Funds?

Answer: If the investing fund was also a Section 3(c)(7) hedge fund then there would be no “look through.”  If the investing fund was a Section 3(c)(1) hedge fund then there would be certain issues which the Section 3(c)(1) would need to take into consideration.  We will be writing a post about this issue shortly.

Question: What happens if you are NOT an accredited investor, but you have already been allowed to invest into a hedge fund that requires you to be an accredited investor?

Answer: I am not quite sure how this would happen but I believe there might be two separate ways.  First, the investor may have lied in the hedge fund subscription documents.  The subscription documents require the investor to make certain representations regarding the investor’s net worth.  Generally hedge fund managers have no duty to inquire further about the representations made in the subscription documents.  If this happens then generally the investor will not receive the protections under the law for non-accredited investors.

Second, the investor may have been an accredited investor at the time the subscription documents were signed and, because of outside circumstances, the investor later becomes a non-accredited investor.  In this instance the newly non-accredited investor should immediately contact the hedge fund manager and inform him of the new circumstances.

Question: Can you recommend a cost-effective (cheap) administrator for a hedge fund start up?

Answer: Yes.  It is common for me to provide clients with recommendations for all service providers including hedge fund administrators.  There are many hedge fund administration firms and there are many low cost providers which I can put you in touch with.  Usually I will want to get to know you and your firm before I make recommendations.  If you are interested, please contact us now.

Two Separate CPOs Subject to NFA Action

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In two separate actions the NFA has effectively shut down two separate Commodity Pool Operators who were operating in the Northeast.  The press releases are reprinted below.

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For Immediate Release

NFA takes emergency enforcement action against New York commodity pool operator

February 9, Chicago – National Futures Association (NFA) announced today, that it has taken an emergency enforcement action against Mark E. Bloom, a Commodity Pool Operator (CPO) located in New York City. Bloom has failed to cooperate with NFA in its investigation of allegations that Bloom and North Hills Management, LLC, operated an illegal commodity pool, and exercised unlawful control over $8 million which was given to them by a charitable trust and a corporation owned by that trust for the purpose of making investments on their behalf. North Hills Management, LLC is a former CPO and Commodity Trading Advisor Member of NFA of which Bloom was principal. The Member Responsibility Action (MRA) is deemed necessary to protect the commodity futures markets, pool participants, customers and other NFA Members.

Effective immediately, the MRA suspends Bloom from NFA membership and associate membership indefinitely. The MRA also prohibits Bloom from soliciting or accepting any customer or pool participant funds or placing trades for pools that he operates. Additionally, Bloom and any other person acting on his behalf, is prohibited from disbursing or transferring any funds from any accounts which he owns or controls without prior approval from NFA. NFA Members who carry accounts in the name of, controlled by or advised by Bloom are prohibited from disbursing funds to Bloom or to any entity or account controlled by him without prior NFA approval. The MRA provides that it will remain in effect until such time Bloom has demonstrated to NFA that he is in complete compliance with all NFA Requirements. Bloom may request a hearing before an NFA Hearing Panel.

NFA is the premier independent provider of innovative and efficient regulatory programs that safeguard the integrity of the futures markets.

For more information contact:
Larry Dyekman (312) 781-1372, [email protected]
Karen Wuertz (312) 781-1335, [email protected]

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For Immediate Release

NFA bars New Jersey commodity pool operator

February 9, Chicago – National Futures Association (NFA) has ordered Progressive Investment Funds (Progressive), a Commodity Pool Operator located in Glenrock, New Jersey, to withdraw from NFA membership and not reapply. Victor E. Cilli, Progressive’s sole principal, also agreed to withdraw from NFA membership. If Cilli reapplies for NFA membership in the future, his application will be subject to certain conditions, including a requirement that he pay a $10,000 fine. The Decision, issued by an NFA Hearing Panel, is based on a Complaint filed in August 2008 and a settlement offer submitted by Progressive and Cilli.

The Complaint charged that Progressive and Cilli had failed to produce certain books and records requested by NFA as part of an inquiry relating to a pool operated by Progressive. NFA previously issued a Member Responsibility Action against Progressive and Cilli in June 2008. See previous press release.
NFA is the premier independent provider of innovative and efficient regulatory programs that safeguard the integrity of the futures markets.

For more information contact:

Larry Dyekman (312) 781-1372, [email protected]
Karen Wuertz (312) 781-1335, [email protected]

Related hedge fund law articles include:

Grassley Clarifies Hedge Fund Registration Act

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Investors in Hedge Fund Won’t Need to Disclose Names and Addresses

As we have discussed in many posts, Senators Grassley and Levin have introduced legislation which would require hedge funds to be regulated under the Investment Company Act.  The legislation would also require hedge fund managers to be registered as investment advisors with the SEC under the Investment Advisors Act.  The name of the act is the Hedge Fund Transparency Act of 2009.

As I pointed out in this post, one of the more controversial parts of the bill was the requirement that the fund disclose the names and current addresses of each investors in the hedge fund.  The specific provision provides:

“The information form required…shall be filed at such time and in such manner as the Commission shall require, and shall…include… the name and current address of…each natural person who is a beneficial owner of the investment company.”  The information shall “be made available by the Commission to the public at no cost and in an electronic, searchable format.”  (See new Section 6(g)(2) of the Investment Company Act as described in Section 2(b) of the bill)

However, the plain words of the statue, apparently, aren’t what they mean.  Senator Grassley has recently stated that the disclosure of names and addresses only applies to the hedge fund managers.  The Wall Street Journal recently ran this piece which states:

“The bill requires disclosure of a hedge fund’s beneficial owners, who profit from the fees generated in operating the fund,” and not the names of outside clients, the senators said in a joint statement Thursday.

We disagree with this statement and we humbly recommend that the bill be amended if there was an intent which is different from the plain language meaning of the bill.  Additionally, there are other parts of the bill which deserve clarification if any re-writes occur.  Specifically we believe that new Section 6(g)(1), as described in Section 2(b) of the bill, would require the hedge fund itself to register as an investment advisor with the SEC.  We believe the intent is for the hedge fund management company, instead, to register with the SEC and accordingly Section 2(b) of the bill should be rewritten.

As an open note to Senators Grassley and Levin, we would be happy to provide input on future revisions of this bill.

Hedge Fund Books and Records Requirement

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Hedge Fund Regulation May Include Rule 204-2

As we have discussed, hedge fund regulation legislation has been introduced as the Hedge Fund Transparency Act.  This legislation calls for hedge funds to maintain such books and records that the SEC would require.  It is likely that the books and records required by the SEC would be substantially similar to the records required for SEC-registered investment advisors.  Those requirements are laid out in Rule 204-2 under the Investment Advisers Act.  We have provided the full text of the rule below.

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Rule 204-2 – Books and Records to Be Maintained by Investment Advisers

a. Every investment adviser registered or required to be registered under section 203 of the Act shall make and keep true, accurate and current the following books and records relating to its investment advisory business:

1. A journal or journals, including cash receipts and disbursements, records, and any other records of original entry forming the basis of entries in any ledger.

2. General and auxiliary ledgers (or other comparable records) reflecting asset, liability, reserve, capital, income and expense accounts.

3. A memorandum of each order given by the investment adviser for the purchase or sale of any security, of any instruction received by the investment adviser concerning the purchase, sale, receipt or delivery of a particular security, and of any modification or cancellation of any such order or instruction. Such memoranda shall show the terms and conditions of the order, instruction, modification or cancellation; shall identify the person connected with the investment adviser who recommended the transaction to the client and the person who placed such order; and shall show the account for which entered, the date of entry, and the bank, broker or dealer by or through whom executed where appropriate. Orders entered pursuant to the exercise of discretionary power shall be so designated.

4. All check books, bank statements, cancelled checks and cash reconciliations of the investment adviser.

5. All bills or statements (or copies thereof), paid or unpaid, relating to the business of the investment adviser as such.

6. All trial balances, financial statements, and internal audit working papers relating to the business of such investment adviser.

7. Originals of all written communications received and copies of all written communications sent by such investment adviser relating to (i) any recommendation made or proposed to be made and any advice given or proposed to be given, (ii) any receipt, disbursement or delivery of funds or securities, or (iii) the placing or execution of any order to purchase or sell any security: Provided, however, (a) That the investment adviser shall not be required to keep any unsolicited market letters and other similar communications of general public distribution not prepared by or for the investment adviser, and (b) that if the investment adviser sends any notice, circular or other advertisement offering any report, analysis, publication or other investment advisory service to more than 10 persons, the investment adviser shall not be required to keep a record of the names and addresses of the persons to whom it was sent; except that if such notice, circular or advertisement is distributed to persons named on any list, the investment adviser shall retain with the copy of such notice, circular or advertisement a memorandum describing the list and the source thereof.

8. A list or other record of all accounts in which the investment adviser is vested with any discretionary power with respect to the funds, securities or transactions of any client.

9. All powers of attorney and other evidences of the granting of any discretionary authority by any client to the investment adviser, or copies thereof.

10. All written agreements (or copies thereof) entered into by the investment adviser with any client or otherwise relating to the business of such investment adviser as such.

11. A copy of each notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication that the investment adviser circulates or distributes, directly or indirectly, to 10 or more persons (other than persons connected with such investment adviser), and if such notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication recommends the purchase or sale of a specific security and does not state the reasons for such recommendation, a memorandum of the investment adviser indicating the reasons therefor.

12.

i. A copy of the investment adviser’s code of ethics adopted and implemented pursuant to Rule 204A-1 that is in effect, or at any time within the past five years was in effect;

ii. A record of any violation of the code of ethics, and of any action taken as a result of the violation; and

iii. A record of all written acknowledgments as required by Rule 204A-1(a)(5) for each person who is currently, or within the past five years was, a supervised person of the investment adviser.

13.

i. A record of each report made by an access person as required by Rule 204A-1(b), including any information provided under paragraph (b)(3)(iii) of that rule in lieu of such reports;

ii. A record of the names of persons who are currently, or within the past five years were, access persons of the investment adviser; and

iii. A record of any decision, and the reasons supporting the decision, to approve the acquisition of securities by access persons under Rule 204A-1(c), for at least five years after the end of the fiscal year in which the approval is granted.

iv. An investment adviser shall not be deemed to have violated the provisions of this paragraph (a)(13) because of his failure to record securities transactions of any advisory representative if he establishes that he instituted adequate procedures and used reasonable diligence to obtain promptly reports of all transactions required to be recorded.

14. A copy of each written statement and each amendment or revision thereof, given or sent to any client or prospective client of such investment adviser in accordance with the provisions of Rule 204-3 under the Act, and a record of the dates that each written statement, and each amendment or revision thereof, was given, or offered to be given, to any client or prospective client who subsequently becomes a client.

15. All written acknowledgments of receipt obtained from clients pursuant to Rule 206(4)-3(a)(2)(iii)(B) and copies of the disclosure documents delivered to clients by solicitors pursuant to Rule 206(4)-3.

16. All accounts, books, internal working papers, and any other records or documents that are necessary to form the basis for or demonstrate the calculation of the performance or rate of return of any or all managed accounts or securities recommendations in any notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication that the investment adviser circulates or distributes, directly or indirectly, to 10 or more persons (other than persons connected with such investment adviser); provided, however, that, with respect to the performance of managed accounts, the retention of all account statements, if they reflect all debits, credits, and other transactions in a client’s account for the period of the statement, and all worksheets necessary to demonstrate the calculation of the performance or rate of return of all managed accounts shall be deemed to satisfy the requirements of this paragraph.

17.

i. A copy of the investment adviser’s policies and procedures formulated pursuant to Rule 206(4)-7(a) of this chapter that are in effect, or at any time within the past five years were in effect, and

ii. Any records documenting the investment adviser’s annual review of those policies and procedures conducted pursuant to Rule 206(4)-7(b) of this chapter.

b. If an investment adviser subject to paragraph (a) of this section has custody or possession of securities or funds of any client, the records required to be made and kept under paragraph (a) of this section shall include:

1. A journal or other record showing all purchases, sales, receipts and deliveries of securities (including certificate numbers) for such accounts and all other debits and credits to such accounts.

2. A separate ledger account for each such client showing all purchases, sales, receipts and deliveries of securities, the date and price of each purchase and sale, and all debits and credits.

3. Copies of confirmations of all transactions effected by or for the account of any such client.

4. A record for each security in which any such client has a position, which record shall show the name of each such client having any interest in such security, the amount or interest of each such client, and the location of each such security.

c.

1. Every investment adviser subject to paragraph (a) of this section who renders any investment supervisory or management service to any client shall, with respect to the portfolio being supervised or managed and to the extent that the information is reasonably available to or obtainable by the investment adviser, make and keep true, accurate and current:

i. Records showing separately for each such client the securities purchased and sold, and the date, amount and price of each such purchase and sale.

ii. For each security in which any such client has a current position, information from which the investment adviser can promptly furnish the name of each such client, and the current amount or interest of such client.

2. Every investment adviser subject to paragraph (a) of this section that exercises voting authority with respect to client securities shall, with respect to those clients, make and retain the following:

i. Copies of all policies and procedures required by Rule 206(4)-6.

ii. A copy of each proxy statement that the investment adviser receives regarding client securities. An investment adviser may satisfy this requirement by relying on a third party to make and retain, on the investment adviser’s behalf, a copy of a proxy statement (provided that the adviser has obtained an undertaking from the third party to provide a copy of the proxy statement promptly upon request) or may rely on obtaining a copy of a proxy statement from the Commission’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system.

3. A record of each vote cast by the investment adviser on behalf of a client. An investment adviser may satisfy this requirement by relying on a third party to make and retain, on the investment adviser’s behalf, a record of the vote cast (provided that the adviser has obtained an undertaking from the third party to provide a copy of the record promptly upon request).

4. A copy of any document created by the adviser that was material to making a decision how to vote proxies on behalf of a client or that memorializes the basis for that decision.

5. A copy of each written client request for information on how the adviser voted proxies on behalf of the client, and a copy of any written response by the investment adviser to any (written or oral) client request for information on how the adviser voted proxies on behalf of the requesting client.

d. Any books or records required by this section may be maintained by the investment adviser in such manner that the identity of any client to whom such investment adviser renders investment supervisory services is indicated by numerical or alphabetical code or some similar designation.

e.

1. All books and records required to be made under the provisions of paragraphs (a) to (c)(1)(i), inclusive, and (c)(2) of this rule (except for books and records required to be made under the provisions of paragraphs (a)(11), (a)(12)(i), (a)(12)(iii), (a)(13)(ii), (a)(13)(iii), (a)(16), and (a)(17)(i) of this section), shall be maintained and preserved in an easily accessible place for a period of not less than five years from the end of the fiscal year during which the last entry was made on such record, the first two years in an appropriate office of the investment adviser.

2. Partnership articles and any amendments thereto, articles of incorporation, charters, minute books, and stock certificate books of the investment adviser and of any predecessor, shall be maintained in the principal office of the investment adviser and preserved until at least three years after termination of the enterprise.

3.

i. Books and records required to be made under the provisions of paragraphs (a)(11) and (a)(16) of this rule shall be maintained and preserved in an easily accessible place for a period of not less than five years, the first two years in an appropriate office of the investment adviser, from the end of the fiscal year during which the investment adviser last published or otherwise disseminated, directly or indirectly, the notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication.

ii. Transition rule. If you are an investment adviser to a private fund as that term is defined in Rule 203(b)(3)-1, and you were exempt from registration under section 203(b)(3) of the Act prior to February 10, 2005, paragraph (e)(3)(i) of this section does not require you to maintain or preserve books and records that would otherwise be required to be maintained or preserved under the provisions of paragraph (a)(16) of this section to the extent those books and records pertain to the performance or rate of return of such private fund or other account you advise for any period ended prior to February 10, 2005, provided that you were not registered with the Commission as an investment adviser during such period, and provided further that you continue to preserve any books and records in your possession that pertain to the performance or rate of return of such private fund or other account for such period.

f. An investment adviser subject to paragraph (a) of this section, before ceasing to conduct or discontinuing business as an investment adviser shall arrange for and be responsible for the preservation of the books and records required to be maintained and preserved under this section for the remainder of the period specified in this section, and shall notify the Commission in writing, at its principal office, Washington, D.C. 20549, of the exact address where such books and records will be maintained during such period.

g. Micrographic and electronic storage permitted.

1. General. The records required to be maintained and preserved pursuant to this part may be maintained and preserved for the required time by an investment adviser on:

i. Micrographic media, including microfilm, microfiche, or any similar medium; or

ii. Electronic storage media, including any digital storage medium or system that meets the terms of this section.

2. General requirements. The investment adviser must:

i. Arrange and index the records in a way that permits easy location, access, and retrieval of any particular record;

ii. Provide promptly any of the following that the Commission (by its examiners or other representatives) may request:

A. A legible, true, and complete copy of the record in the medium and format in which it is stored;

B. A legible, true, and complete printout of the record; and

C. Means to access, view, and print the records; and

iii. Separately store, for the time required for preservation of the original record, a duplicate copy of the record on any medium allowed by this section.

3. Special requirements for electronic storage media. In the case of records on electronic storage media, the investment adviser must establish and maintain procedures:

i. To maintain and preserve the records, so as to reasonably safeguard them from loss, alteration, or destruction;

ii. To limit access to the records to properly authorized personnel and the Commission (including its examiners and other representatives); and

iii. To reasonably ensure that any reproduction of a non-electronic original record on electronic storage media is complete, true, and legible when retrieved.

h.

1. Any book or other record made, kept, maintained and preserved in compliance with Rule 17a-3 and Rule 17a-4 under the Securities Exchange Act of 1934, which is substantially the same as the book or other record required to be made, kept, maintained and preserved under this section, shall be deemed to be made, kept maintained and preserved in compliance with this section.

2. A record made and kept pursuant to any provision of paragraph (a) of this section, which contains all the information required under any other provision of paragraph (a) of this section, need not be maintained in duplicate in order to meet the requirements of the other provision of paragraph (a) of this section.

i. As used in this section the term “discretionary power” shall not include discretion as to the price at which or the time when a transaction is or is to be effected, if, before the order is given by the investment adviser, the client has directed or approved the purchase or sale of a definite amount of the particular security.

j.

1. Except as provided in paragraph (j)(3) of this section, each non-resident investment adviser registered or applying for registration pursuant to section 203 of the Act shall keep, maintain and preserve, at a place within the United States designated in a notice from him as provided in paragraph (j)(2) of this section true, correct, complete and current copies of books and records which he is required to make, keep current, maintain or preserve pursuant to any provisions of any rule or regulation of the Commission adopted under the Act.

2. Except as provided in paragraph (j)(3) of this section, each nonresident investment adviser subject to this paragraph (j) shall furnish to the Commission a written notice specifying the address of the place within the United States where the copies of the books and records required to be kept and preserved by him pursuant to paragraph (j)(1) of this section are located. Each non-resident investment adviser registered or applying for registration when this paragraph becomes effective shall file such notice within 30 days after such rule becomes effective. Each non-resident investment adviser who files an application for registration after this paragraph becomes effective shall file such notice with such application for registration.

3. Notwithstanding the provisions of paragraphs (j)(1) and (2) of this section, a non-resident investment adviser need not keep or preserve within the United States copies of the books and records referred to in said paragraphs (j)(1) and (2), if:

i. Such non-resident investment adviser files with the Commission, at the time or within the period provided by paragraph (j)(2) of this section, a written undertaking, in form acceptable to the Commission and signed by a duly authorized person, to furnish to the Commission, upon demand, at its principal office in Washington, D.C., or at any Regional Office of the Commission designated in such demand, true, correct, complete and current copies of any or all of the books and records which he is required to make, keep current, maintain or preserve pursuant to any provision of any rule or regulation of the Commission adopted under the Act, or any part of such books and records which may be specified in such demand. Such undertaking shall be in substantially the following form:

The undersigned hereby undertakes to furnish at its own expense to the Securities and Exchange Commission at its principal office in Washington, D.C. or at any Regional Office of said Commission specified in a demand for copies of books and records made by or on behalf of said Commission, true, correct, complete and current copies of any or all, or any part, of the books and records which the undersigned is required to make, keep current or preserve pursuant to any provision of any rule or regulation of the Securities and Exchange Commission under the Investment Advisers Act of 1940. This undertaking shall be suspended during any period when the undersigned is making, keeping current, and preserving copies of all of said books and records at a place within the United States in compliance with Rule 204-2(j) under the Investment Advisers Act of 1940. This undertaking shall be binding upon the undersigned and the heirs, successors and assigns of the undersigned, and the written irrevocable consents and powers of attorney of the undersigned, its general partners and managing agents filed with the Securities and Exchange Commission shall extend to and cover any action to enforce same.

and

ii. Such non-resident investment adviser furnishes to the Commission, at his own expense 14 days after written demand therefor forwarded to him by registered mail at his last address of record filed with the Commission and signed by the Secretary of the Commission or such person as the Commission may authorize to act in its behalf, true, correct, complete and current copies of any or all books and records which such investment adviser is required to make, keep current or preserve pursuant to any provision of any rule or regulation of the Commission adopted under the Act, or any part of such books and records which may be specified in said written demand. Such copies shall be furnished to the Commission at its principal office in Washington, D.C., or at any Regional Office of the Commission which may be specified in said written demand.

4. For purposes of this rule the term non-resident investment adviser shall have the meaning set out in Rule 0-2(d)(3) under the Act. [Editor’s note: There is no paragraph (d) to Rule 0-2. The term non-resident is defined in Rule 0-2(b)(2).]

k. Every investment adviser that registers under section 203 of the Act after July 8, 1997 shall be required to preserve in accordance with this section the books and records the investment adviser had been required to maintain by the State in which the investment adviser had its principal office and place of business prior to registering with the Commission.

Hedge Fund Registration Quick Facts

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Hedge Fund Transparency Act of 2009 Overview

This article provides an overview of the major provisions of the Hedge Fund Transparency Act of 2009.  There are two major things that the HFTA does: (1) increases regulation of hedge funds under the Investment Company Act and (2) requires hedge funds to adopt anti-money laundering programs.

Changes under the Investment Company Act

The HFTA replaces Section 3(c)(1) of the Investment Company Act  with a new Section 6(a)(6).  Section 3(c)(7) is replaced by new Section 6(a)(6).  These new sections, which are functionally equivalent to Section 3(c)(1) and Section 3(c)(7) respectively, will exempt hedge funds from the mutual fund regulations that are found in the Investment Company Act, provided that the hedge funds comply with the provisions of Section 6(g).

Section 6(g) applies to hedge funds with assets under management (AUM) of $50 million or more.  Those hedge funds which have less than $50 million of AUM will not be subject to Section 6(g).  Section 6(g) requires:

1.  The hedge fund manager to register with the SEC.  (HFLB note: I believe the statute is not clearly written.  It seems that the hedge fund itself would be required to register with the SEC which does not make sense.)

2.  Maintain certain books and records as required by the SEC.  This requirements is likely to look like the current books and records rule of the Investment Advisors Act (Rule 204-2), for more background please see article on Investment Advisor Compliance Information.

3.  Cooperate with the SEC with regard to any request for information or examination.

4.  File the following information with the SEC on a no less than annual basis:

a.  The name and current address of each investor in the fund.

b.  The name and current address of the primary accountant and broker of the fund.

c.  An overview of the fund’s ownership structure.

d.  An overview of the fund’s affiliations, if any, with financial institutions.

e.  A statement of the fund’s terms (i.e. minimum investment).

f.  Other information including the total number of investors and the current value of the fund’s assets.

The SEC is charged with issuing forms and guidance on the implementation of the above.  Such forms and guidance must be issued within 180 days from the enactment of the HFTA.

New AML Requirements

The HFTA requires the Secretary of the Treasury (in consultations with the Chairman of the SEC and the Chairman of the CFTC) to establish AML requirements for hedge funds.  The bill sets aggressive timelines for drafting and implementation of the rules.

Hedge Fund Transparency Act Analysis

In the current politically charged environment it is not surprising that a hedge fund regulation law is being contemplated.  What is interesting, however, is the way that Grassley and Levin have chosen to regulate hedge funds.  The prior hedge fund registration rule, promulgated by the SEC, was enacted under the Investment Advisors Act – in essence requiring hedge fund managers (and not the hedge fund itself) to register as Investment Advisors with the SEC.  The Hedge Fund Transparency Act does not follow this path – instead, it regulates hedge funds under the Investment Company Act by modifying the current exemptions which hedge funds enjoy under the act.  In essence the changes subject hedge funds to a kind of light version of the mutual fund regulations.  In this way Congress is going past previous registration by regulating the hedge fund vehicle, as well as the hedge fund management company through the registration requirement.

While it is no surprise that regulation and registration has reached the hedge fund industry, one aspect of the bill is surprising.  The act would require hedge funds to disclose the names and addresses of each investor in the fund.  These names and addresses would be made available to the general public through an electronic searchable format to be developed by the SEC.  Hedge fund investors are notoriously protective of their privacy and I cannot imagine that there will not be pushback by the hedge fund industry on this point.

Another consequence of investment advisor registration is that hedge fund managers (if not currently regulated by the state in which their business resides) may be subject to certain state investment advisory rules including a “notice” filing requirement.  Depending on the nature of the management company’s business, some employees may need to register as investment advisor representatives at the state level which generally requires an employee to have passed the Series 65 exam.  We will keep you updated on this possibility as we learn more about the HFTA over time.

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Please contact us if you have any questions releted to this post or registering your management company as an investment advisor with the SEC.  Other related posts include:

Hedge Fund Transparency Act Text

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Below is the actual text of the Hedge Fund Transparency Act.  (For the bill with page and line numbers please see: Hedge Fund Transparency Act (pdf)).

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111TH CONGRESS
1ST SESSION
S.

To require hedge funds to register with the Securities and Exchange Commission, and for other purposes.

IN THE SENATE OF THE UNITED STATES

Mr. GRASSLEY (for himself and Mr. LEVIN) introduced the following bill; which was read twice and referred to the Committee on

A BILL

To require hedge funds to register with the Securities and Exchange Commission, and for other purposes.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the “Hedge Fund Transparency Act”.

SEC. 2. HEDGE FUND REGISTRATION REQUIREMENTS.

(a) DEFINITION OF INVESTMENT COMPANY.—Section 3(c) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)) is amended—(1) by striking paragraph (1); (2) by striking paragraph (7); (3) by redesignating paragraphs (2) through (6) as paragraphs (1) through (5), respectively; and (4) by redesignating paragraphs (8) through (14) as paragraphs (6) through (12), respectively.

(b) ADDITIONAL EXEMPTIONS.—Section 6 of the Investment Company Act of 1940 (15 U.S.C. 80a-6) is amended—(1) in subsection (a), by adding at the end the following:

“(6)(A) Subject to subsection (g), any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons, and which is not making and does not presently propose to make a public offering of its securities.

“(B) For purposes of this paragraph and paragraph (7), beneficial ownership—

“(i) by a company shall be deemed to be beneficial ownership by one person, except that, if the company owns 10 percent or more of the outstanding voting securities of the issuer, and is or, but for the exemption provided for in this paragraph or paragraph (7), would be an investment company, the beneficial ownership shall be deemed to be that of the holders of the outstanding securities (other than short-term paper) of such company; and

“(ii) by any person who acquires securities or interests in securities of an issuer described in this paragraph shall be deemed to be beneficial ownership by the person from whom such transfer was made, pursuant to such rules and regulations as the Commission shall prescribe as necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this title, where the transfer was caused by legal separation, divorce, death, or any other involuntary event.

“(7)(A) Subject to subsection (g), any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of the acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. Securities that are owned by persons who received the securities from a qualified purchaser as a gift or bequest, or in a case in which the transfer was caused by legal separation, divorce, death, or any other involuntary event, shall be deemed to be owned by a qualified purchaser, subject to such rules, regulations, and orders as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

“(B) Notwithstanding subparagraph (A), an issuer is exempt under this paragraph if—”(i) in addition to qualified purchasers, outstanding securities of that issuer are beneficially owned by not more than 100 persons who are not qualified purchasers, if—”(I) such persons acquired any portion of the securities of such issuer on or before September 1, 1996; and “(II) at the time at which such persons initially acquired the securities of such issuer, the issuer was exempt under paragraph (6); and “(ii) prior to availing itself of the exemption provided by this paragraph—

“(I) such issuer has disclosed to each beneficial owner that future investors will be limited to qualified purchasers, and that ownership in such issuer is no longer limited to not more than 100 persons; and

“(II) concurrently with or after such disclosure, such issuer has provided each beneficial owner with a reasonable opportunity to redeem any part or all of their interests in the issuer, notwithstanding any agreement to the contrary between the issuer and such persons, for the proportionate share of that person of the net assets of the issuer.

“(C) Each person that elects to redeem under subparagraph (B)(ii)(II) shall receive an amount in cash equal to the proportionate share of that person of the net assets of the issuer, unless the issuer elects to provide such person with the option of receiving, and such person agrees to receive, all or a portion of the share of that person in assets of the issuer. If the issuer elects to provide such persons with such an opportunity, disclosure concerning such opportunity shall be made in the disclosure required by subparagraph (B)(ii)(I).

“(D) An issuer that is exempt under this paragraph shall nonetheless be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) (15 U.S.C. 80a-12(d)(1)(A)(i) and (B)(i)) relating to the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer.

“(E) For purposes of determining compliance with this paragraph and paragraph (6), an issuer that is otherwise exempt under this paragraph and an issuer that is otherwise exempt under paragraph (6) shall not be treated by the Commission as being a single issuer for purposes of determining whether the outstanding securities of the issuer exempt under paragraph (6) are beneficially owned by not more than 100 persons, or whether the outstanding securities of the issuer exempt under this paragraph are owned by persons that are not qualified purchasers. Nothing in this subparagraph shall be construed to establish that a person is a bona fide qualified purchaser for purposes of this paragraph or a bona fide beneficial owner for purposes of paragraph (6).”; and

(2) by adding at the end the following:

“(g) LIMITATION ON EXEMPTIONS FOR LARGE INVESTMENT COMPANIES.—

“(1) IN GENERAL.—An investment company with assets, or assets under management, of not less than $50,000,000 is exempt under subsection (a)(6) or (a)(7) only if that company—

“(A) registers with the Commission;
“(B) files an information form with the Commission under paragraph (2);
“(C) maintains such books and records as the Commission may require; and
“(D) cooperates with any request for information or examination by the Commission.

“(2) INFORMATION FORM.—The information form required under paragraph (1) shall be filed at such time and in such manner as the Commission shall require, and shall—

‘(A) be filed electronically;
“(B) be filed not less frequently than once every 12 months;
“(C) include—
“(i) the name and current address of—
“(I) each natural person who is a beneficial owner of the investment company;
“(II) any company with an ownership interest in the investment company; and
“(III) the primary accountant and primary broker used by the investment company;
“(ii) an explanation of the structure of ownership interests in the investment company;
“(iii) information on any affliation that the investment company has with another financial institution;
“(iv) a statement of any minimum investment commitment required of a limited partner, member, or other investor;
“(v) the total number of any limited partners, members, or other investors; and
“(vi) the current value of—
“(I) the assets of the investment company; and
“(II) any assets under management by the investment company; and

“(D) be made available by the Commission to the public at no cost and in an electronic, searchable format.”.

SEC. 3. IMPLEMENTING GUIDANCE AND RULES.

(a) FORMS AND GUIDANCE.—Not later than 180 days after the date of enactment of this Act, the Securities and Exchange Commission shall issue such forms and guidance as are necessary to carry out this Act.

(b) RULES.—The Securities and Exchange Commission may make a rule to carry out this Act.

8 SEC. 4. ANTI–MONEY LAUNDERING OBLIGATIONS.

(a) PURPOSE.—It is the purpose of this section to safeguard against the financing of terrorist organizations and money laundering.

(b) IN GENERAL.—An investment company that relies on paragraph (6) or (7) of section 6(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-6(a)(6) and (7)), as amended by this Act, as the basis for an exemption under that Act shall establish an anti-money laundering program and shall report suspicious transactions under subsections (g) and (h) of section 5318 of title 31, United States Code.

(c) RULEMAKING.—

(1) IN GENERAL.—The Secretary of the Treasury, in consultation with the Chairman of the Securities and Exchange Commission and the Chairman of the Commodity Futures Trading Commission, shall, by rule, establish the policies, procedures, and controls necessary to carry out subsection (b).

(2) CONTENTS.—The rule required by paragraph (1)—

(A) shall require that each investment company that receives an exemption under paragraph (6) or (7) of section 6(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-6(a)(6) and (7)), as amended by this Act, shall—

(i) use risk–based due diligence policies, procedures, and controls that are reasonably designed to ascertain the indentity of and evaluate any foreign person (including, where appropriate, the nominal and beneficial owner or beneficiary of a foreign corporation, partnership, trust, or other foreign entity) that supplies or plans to supply funds to be invested with the advice or assistance of such investment company; and

(ii) be subject to section 5318(k)(2) of title 31, United States Code; and (B) may incorporate elements of the proposed rule for unregistered investment companies published in the Federal Register on September 26, 2002 (67 Fed. Reg. 60617) (relating to anti–money laundering programs).

(3) PUBLICATION DATE.—The Secretary of the Treasury, shall—

(A) propose the rule required by this subsection not later than 90 days after the date of enactment of this Act; and

(B) issue the rule required by this subsection in final form not later than 180 days after the date of enactment of this Act.

(d) EFFECTIVE DATE.—Subsection (b) shall take effect 1 year after the date of enactment of this Act, whether or not a final rule is issued under subsection (c), and the failure to issue such rule shall in no way affect the enforceability of this section.

SEC. 5. TECHNICAL CORRECTIONS.

(a) SECURITIES ACT OF 1933.—Section 3(a) of the Securities Act of 1933 (15 U.S.C. 77c(a)) is amended—(1) in paragraph (2)—(A) by striking “section 3(c)(3)” and inserting “section 3(c)(2)”; and (B) by striking “section 3(c)(14)” and inserting “section 3(c)(12)”; (2) in paragraph (4), by striking “section 3(c)(10)(B)” and inserting “section 3(c)(8)(B)”; and (3) in paragraph (13), by striking “section (3)(c)(14)” and inserting “section 3(c)(12)”.

(b) SECURITIES EXCHANGE ACT OF 1934.—The Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) is amended—

(1) in section 3(a) (15 U.S.C. 78c(a))—(A) in paragraph (12)(A)—(i) in clause (iii), by striking “section 3(c)(3)” and inserting “section 3(c)(2)”; (ii) in clause (v), by striking “section 3(c)(10)(B)” and inserting “section 3(c)(8)(B)”; and (iii) in clause (vi), by striking “section 3(c)(14)” and inserting “section 3(c)(12)”; (B) in paragraph (12)(C), by striking “section 3(c)(14)” and inserting “section 3(c)(12)”; and (C) in paragraph (54)(A)—(i) in clause (ii), by striking “exclusion from the definition of investment company pursuant to section 3(c)(7)” and inserting “exemption under section 6(a)(7)”; and (ii) in clause (vii), by striking “section 3(c)(2)” and inserting “section 3(c)(1)”; (2) in section 3(g) (15 U.S.C. 78c(g)) by striking “section 3(c)(14)” each place that term appears and inserting “section 3(c)(12)”; and (3) in section 12(g)(2) (15 U.S.C. 78l(g)(2))—(A) in subparagraph (D), by striking “section 3(c)(10)(B)” and inserting “section 3(c)(8)(B)”; and (B) in subparagraph (H), by striking “section 3(c)(14)” and inserting “section 3(c)(12)”.

(c) INVESTMENT COMPANY ACT OF 1940.—The Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.) is amended—

(1) in section 2(a)(51) (15 U.S.C. 80a-2(a)(51))—(A) in subparagraph (A)(i), by striking “excepted under section 3(c)(7)” and inserting “exempt under section 6(a)(7)”; and (B) in subparagraph (C)—(i) by striking “that, but for the exceptions provided for in paragraph (1) or (7) of section 3(c), would be an investment company (hereafter in this paragraph referred to as an ‘excepted investment company’)” and inserting “that is exempt under paragraph (6) or (7) of section 6(a) (hereafter in this paragraph referred to as an ‘exempt investment company’)”; (ii) by striking “section 3(c)(1)(A)” and inserting “section 6(a)(6)(B)(i)”; and (iii) by striking “excepted” each place that term appears and inserting “any exempt”;

(2) in section 6 (15 U.S.C. 80a-6)—(A) in subsection (a)—(i) in paragraph (2), by striking “section 3(c)(1)” and inserting “section 6(a)(6)”; and (ii) in paragraph (5)(A)(iv), by striking “that would be an investment company except for the exclusions from the definition of the term ‘investment company’ under paragraph (1) or (7) of section 3(c)” and inserting “that is exempt under paragraph (6) or (7) of section 6(a)”; and (B) in subsection (f), by striking “excluded from the definition of an investment company by section 3(c)(1)” and inserting “exempt under section 6(a)(6)”;

(3) in section 7(e) (15 U.S.C. 80a-7(e)), by striking “section 3(c)(10)(B)” and inserting “section 3(c)(8)(B)”; and

(4) in section 30 (15 U.S.C. 80a-29) in each of subsections (i) and (j), by striking “section 3(c)(14)” each place that term appears and inserting “section 3(c)(12)”.

(d) INVESTMENT ADVISERS ACT OF 1940.—The Investment Advisers Act of 1940 (15 U.S.C. 80b-1 et seq.) is amended—

(1) in section 203(b) (15 U.S.C. 80b-3(b))—(A) in paragraph (4) by striking “section 3(c)(10)” each place that term appears and inserting “section 3(c)(8)”; and (B) in paragraph (5), by striking “section 3(c)(14)” and inserting “section 3(c)(12)”; and (2) in section 205(b) (15 U.S.C. 80b-5(b))— (A) in paragraph (2)(B), by striking “section 3(c)(11)” and inserting “section 3(c)(9)”; and (B) in paragraph (4), by striking “excepted from the definition of an investment company under section 3(c)(7)” and inserting “exempt under section 6(a)(7)”.

(e) INTERNAL REVENUE CODE OF 1986.—Section 851(a)(2) of the Internal Revenue Code of 1986 (relating to the definition of regulated investment company) is amended by striking “section 3(c)(3)” and inserting “section 3(c)(2)”.

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Please contact us if you would like more information on hedge fund registration, or if you would like our firm to help you with the hedge fund registration process.  Other related hedge fund law articles include:

Hedge Fund Fees | Discussion of Future Trends

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The following article is by Christopher Addy, President and CEO of Castle Hall Alternatives, a hedge fund due diligence firm.  We have published a number of pieces by Mr. Addy in the past (please see Hedge Fund Due Diligence Issues, Issues for Hedge Fund Administrators to Consider and ERISA vs. the Hedge Fund Industry).  The following post can be found here.

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Hedge Fund Fees: Is It Worth It To Pay For A Star Hedge Fund?

An article in the current week’s edition of the Economist asks whether one-and-ten will become the new two-and-twenty.

The discussion notes that there will be clear fee pressure on fund of funds.  We will return to the question of fund of funds in a later post: as a quick precis of our views, while Madoff has raised long overdue questions about whether fund of funds really complete due diligence (saying no always gets in the way of making money) we still see plenty of room for fund of funds who genuinely can serve as expert intermediaries.  Fund of funds as a provider of expertise rather than a provider of capacity, and, separately, fund of funds offering funds of managed accounts, both seem like valid models going forward.

For single strategy managers, the Economist makes several points in a single paragraph:

“Those funds with excellent records will manage to maintain their fee rates. Big diversified managers with mediocre performance will have to cut fees to hold on to their assets. Given the “high watermarks” in place, which require that losses be recouped before performance fees can be charged, they may struggle to retain top staff, although they should at least be able to stay in business. The real threat is to smaller operators—half of all hedge funds manage less than $100m. Lower management fees may not cover their fixed costs, such as salaries, accommodation and IT. The era of hedge-fund managers being unable to pay the rent may soon be dawning.”

While these points are valid, we remain very unconvinced by the argument that “those funds with excellent records will manage to maintain their fee rates.”  More precisely, we agree that the largest funds with good performance will likely keep their fee schedules: but we are unconvinced that those fees are worth it when they are above 2 and 20.

If 2008 has shown us anything, it’s that – as we noted in our last post – you can’t rely on a “best of the best” hedge fund to deliver guaranteed performance.

Plenty of articles have been published commenting on the relative performance of some of the industry’s largest funds – Bloomberg in this piece commented on a variety of funds: while there were winners such as Paulson, Brevan Howard and Winton, there were also plenty of losers, notably Citadel.  Another excellent Bloomberg article on Fortress noted that the firm’s Drawbridge Global Macro was down -26% while Drawbridge Special Opportunities lost 18%.  This article from early November commented on performance from a number of funds: it only got worse by year end.  Any hedge fund investor looking down their portfolio sees the same pattern of apparently random winners and losers among what were previously Top 100, star managers.

Ex post, therefore, some big funds funds have proved themselves to be worth their fees.  Plenty of them, however, have proved not to be.  Investors couldn’t predict the winners and losers beforehand during this market crisis: will they somehow be better at picking the big hedge funds that will be winners rather than losers when we have the next Black Swan event?  Why should investors pay, ex ante, excess fees to any hedge fund based solely on a historical track record?

This line of thinking raises some broader questions.  From our side, we have always been very skeptical of the largest hedge funds.  Indeed, back in early November 2007 we wrote a post called “People are spooked…so let’s invest in big hedge funds.  Is there really a flight to quality?” In that post, we wrote the following:

“This redirection of capital inflows [towards the biggest hedge funds] does seem to be driven by institutional investors.  If we were to ask ourselves, however, what are the three most important issues for institutions considering a hedge fund allocation, we expect the answer would be:

1) Transparency
2) Fees
3) Independent oversight

But…the Top 25 hedge funds now receiving such large allocations of institutional capital have the most restrictive transparency, the highest fees and no independent oversight (virtually all do not appoint an independent administrator, meaning that investors must rely on the manager to calculate each NAV and price all the assets with no third party check.)

We’re really puzzled by this paradox – there’s obviously a big difference between what institutions say they want, and what they are prepared to invest in.

Why is this?  Obviously, there’s strength in numbers, and it’s easy to justify an allocation to a firm if pretty much everyone else in the industry has already invested.  But, to point out the obvious again, the Bear Stearns funds were run by the Wall Street house with the reputation for the greatest expertise in mortgage and structured securities available in the industry.  Amaranth was one of the most sophisticated multi strategy funds available.  Sowood was formed by superstar managers from the Harvard Management Company.  Basis Capital in Australia had the highest possible, 5 star rating from Standard & Poors.  The list goes on, and on.

The lesson, therefore, is simple and obvious: do not to take anything for granted.  Certainly, asking hard questions – and being prepared to walk away – would have served potential investors in the above funds well.  This is not the last time hedge fund investors will learn this lesson.”

Well yes.

As we noted nearly 18 months ago, the biggest firms typically have the highest fees, have limited transparency and often don’t have independent oversight over their NAVs.  We would also add that it is typically the largest firms that ask for the longest lock ups: investors who signed up in ’06 and ’07 to 3 and 5 year lock classes must be pretty unhappy right now.  Moreover, the biggest firms usually have the tightest gates and most restrictive redemption provisions in their offering documents: 2008 has shown that many (most?) of the industry’s largest funds have chosen to suspend redemptions, impose involuntary restructurings etc.

Where does that leave investors?  We don’t deny that some of the largest hedge funds remain deeply resourced, highly skilled money managers.  On the other hand, our point is not to write off the small guy.

For many reasons, we believe that there is a real value in being a “bigger fish in a smaller sea”.  Thinking of operational issues, a larger investor in a smaller fund has so much more leverage:

  • Power to negotiate fees
  • Power to influence the terms of the offering document, and particularly to impact provisions related to gates, suspensions, side pockets etc.
  • Better operational transparency
  • Ability to engage in a constructive dialogue about operational controls: smaller funds are, for example, much more likely to have an administrator.  Smaller managers typically also give more information about their procedures, enabling investors to get a better understanding of key controls such as valuation.  Moreover, if a small firm needs to improve, they are much more likely to listen to a large, strategic investor – in fact, they are much more likely to listen full stop.

Investing in a smaller hedge fund – particularly now – gives the investor much better power to enter into that investment in a spirit of partnership.  It also provides more flexibility on the way in and on the way out.  That is massively different from going to a large multi strat and still facing an unappetizing menu of terms such as a 3 year lock class, a 8% rolling quarterly redemption provision, a 2 and 25, 3 and 30 fee structure et al et al.

One of the questions we always ask ourselves when we visit a hedge fund is about the culture of the manager.  Put simply, does it feel as if the manager thinks we are doing him a favor by giving him our capital, or is there a sense that the manager feels he is doing us a favor by letting us in.

Right now, we would always pay less for a receptive manager than pay more for a fund which still thinks that that we need them more than they need us.

www.castlehallalternatives.com
Hedge Fund Operational Due Diligence

Hedge Fund Tearsheets

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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:

Hedge Funds and OTC Products

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Some hedge funds use OTC products as part of their main investment strategy, or as a supplement to their main strategy.  In either event, there are a number of issues which hedge fund managers should consider when they decide to utilize OTC products within an investment strategy.  First and foremost, the OTC investment strategy should be adequately described in the hedge fund’s offering documents.  Secondly, the manager should consider the “back office” requirements for processing the OTC investments.  The following article gives a good background of the OTC processing requirements and issues.

Please contact us if you have any questions or you are interested in starting a hedge fund.

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The 5 Pillars of OTC Processing
Ron Tannenbaum, co-founder, GlobeOp Financial Services

As the OTC derivatives market expands in volume, complexity and sector interest, many funds face equally complex post-trade processing challenges in terms of operational processes & efficiencies. Can the key elements of a successful operational infrastructure to support a competitive OTC strategy be defined?

As a significant opportunity for alpha, the growing attraction of OTC derivatives is confirmed both at the industry level and on the “production floor”.  Supplementing Morse’s recent focus group confirmation that 64% of firms increased derivative contracts volume in the last 6 months, new trades by GlobeOp’s OTC clients in the same period increased 100%; monthly open positions increased 18%.

GlobeOp: Daily Average OTC Trade Volume

GlobeOp Monthly OTC open positions by Product Type, August 2008

In addition to traditional hedge fund activity, mutual funds liberated by the UCITS III directive are also increasingly including OTC derivatives in their trading strategies.  Exponential OTC volume growth, combined with the current market turbulence, is challenging in-house operational systems as never before. Legacy and “bolt-on” software systems struggle to communicate with each other. Spreadsheets strain to handle volumes and complexity they were never designed for, increasing the risk of error with each update. In parallel with portfolios becoming more complex, funds are facing increased investor pressure to demonstrate enhanced operational control, independent valuation, higher levels of disclosure and more transparent performance reporting. For many funds, processing derivatives internally quickly becomes cumbersome, inefficient and error-prone, increasing operational risk instead of delivering competitive advantage.

Is a water-tight process for OTC trade processing possible and if so what would it look like?
Eight years of daily OTC processing has provided GlobeOp with a crystallized perspective of the elements essential to a fund’s requirement for effective OTC derivative post-trade processing. Five core, integrated processes are needed to manage, track and report on trades end–to-end throughout their lifecycle:

  • Trade capture
  • Operations
  • Valuations
  • Collateral management
  • Documentation

Rigorous, reliable, daily reconciliation underpins much of the process, while scalability in terms of people and technology is needed to respond nimbly and promptly to trade volume growth, new products or unexpected market events.

The 5 Pillars

Trade capture – real-time, cross-product

Trade data entry sounds such a basic process that it is often underestimated as the cause of many issues further along the process. Incomplete and/or inaccurate detail risks being created when data is aggregated into an internal system from disparate silos or when bolt-on software is unable to communicate completely with front office configurations or legacy systems.

Also, due to their bilateral nature, derivative instruments do not always have established identifier codes, making them more difficult to process than securities with their standard ISIN, CUSIP or Bloomberg reference codes.

A real-time, cross-product, electronic trade capture environment can support the trading desk in developing and trading new OTC products.  Trades should only ever be recorded once, to eliminate the risk of errors associated with manual entry and spreadsheets.

Operations – the litmus test

Trade operations are the ‘litmus test’ of the entire process, encompassing the settlement of trades and reconciliation of cash and securities positions associated with individual derivatives transactions. Having cash and securities obligations in position at the time of settlement are essential to efficiently transferring ownership and moving funds.

Valuations – transparency, independence

The challenge of accurate, independent valuation can be addressed by pricing models that can adapt to new and complex instruments, and that are tolerance-checked against counterparty prices and other external industry and data sources.

Depending only on counterparty prices due to either insufficient valuation expertise or technology can increase the risk of a domino of delays to timely and reliable trade reconciliation, NAVs and investor reporting or returns.

Mutual funds face an additional regulatory dimension to their valuation challenges. In exchange for reducing mutual fund barriers to OTC derivative trading, the February 2007 UCITS III directive placed a high premium on transparent and independent valuation and risk management.

The requirement for mutual funds to demonstrate their ability to provide fully independent daily valuations and risk analytics can affect both mutual funds and their custodian bank. A mutual fund’s back office is often well-equipped to manage the long-only investments the fund traditionally makes. Operational knowledge, systems, models and capacity for complex derivatives is, however, either absent or insufficient. This is compounded when, as we have seen repeatedly, most mutual funds also initially tend to significantly underestimate their derivative trading volume,

Thus challenged, and to meet the UCITS lll independence criteria, the mutual fund turns to its custodian bank, its historic provider of a wide range of support services. While willing in spirit, most custodian banks quickly recognize that complex OTC trade processing, valuation and risk analytics exceed both their expertise and spreadsheet-based systems.

Collateral management – exposure management

Current market turbulence has sharpened the spotlight on the value of real-time, online collateral management to accurate trading and exposure management. What collateral is on the books, with whom, at what rate, for how long? What pledges are held vs. outstanding? Accurate, transparent collateral reporting will remain vital to the front office for months to come.

Effective collateral management usually includes ensuring the fund is net present value collateralised with each of its counterparties on a daily basis. In addition, an integrated facility should ensure appropriate movement of cash and securities to support revaluations and margin calls.

Documentation – integrated STP

According to recent ISDA statistics, approximately 60% of the hedge fund industry’s OTC instruments are still confirmed manually. This is not only time-consuming, but it also increases the incidence of error and leaves funds vulnerable to compliance risk, due to the high level of positions which remain based on verbal agreements. Integrated, straight-through-processing (STP) for managing, exchanging and storing trade documentation better enables both trade partners to reconcile economic terms with counterparties and meet auditor and regulatory compliance obligations.

Conclusion

A successful OTC trading strategy requires underpinning by an integrated platform of people, processes and technology that deliver post-trade processing and reporting that enables the fund to focus on its core objective of generating investor returns and expanding the capital base.

Informal industry estimates indicate that building an internal OTC processing infrastructure involves significant fund investment in cost and time — up to $50 million and five years of testing and development. Often unspoken are the risks that continued market and fund strategy evolution may result in a design neither suitable or scalable for long-term requirements, or able to deliver sufficient economy of scale.

The attraction of OTC derivative instrument strategies remains robust. As funds consider their future strategies, recent market events have only served to reinforce the need for post-trade processing and infrastructures whose key deliverables are:

  • Data and document management across the lifecycle of the trade that is timely, transparent, accurate, reconciled and real-time
  • Robust, scalable, online support
  • Independent, risk-based valuation that is tolerance-checked within well defined limits.