Tag Archives: hedge fund

Hedge fund advertising – Can a hedge fund manager run a blog?

Blogs have become important tools in the investment management industry and have allowed even the most unsophisticated computer user (ahem….hedgefundlawblog….) to post useful thoughts and information for other industry participants to examine and opine upon.

Some hedge fund managers may want to use the internet and blogs to vet ideas or to discuss certain parts of their strategy, which begs the question whether such activities are legal under the federal (and state) securities laws.   As we see it, there are three central issues which a hedge fund manager must be aware of when deciding whether to blog: (i) the Regulation D rules prohibiting general solicitation, (ii) the “no holding out” requirement for investment advisor exemption, and (iii) the anti-fraud rules (no manipulation).  We will examine these issues in turn and then provide recommendations. Continue reading

New Hedge Fund Regulation – Grassley Renews Efforts to Register Hedge Funds

The race has begun.  Members of the Congress and the Senate will be jockeying for position in the new race toward hedge fund regulation.  Senator Grassley announced today that he will be reintroducing a bill to require hedge fund managers to register as investment advisors with the SEC.  The text of the full release can be found below. Continue reading

Life Settlement Hedge Funds – What is a Life Settlement?

Over the past few years life settlements have become a more attractive investment opportunity and there is an increase in the amount of hedge funds which are being formed to invest in various life settlement strategies.  This article will discuss life settlements and will introduce some of the issues which hedge fund managers should discuss with their attorney if they want to start a life settlement hedge fund.

From Viaticals to Life Settlements and Premium Finance

Life Settlements are the younger sibling to the Viatical industry which was popular in the 1980’s with regard to AIDS patients (see SEC description of Viatical’s below).  A “life settlement” usually refers to a secondary market transaction on an insurance policy.  Typically an insured will sell its insurance policy to a third party (the investor) who will pay the insured more than the cash surrender value of the policy, but less than the death benefit.  The investor will then be liable for the premium payments and will receive the death benefit upon the death of the insured. Continue reading

Banks and Hedge Fund Oversight: GAO Report

This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds. The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here. Continue reading

Hedge Funds and Anti-Money Laundering (AML) Requirements

Hedge fund managers are often confused about their anti-money laundering (AML) obligations and seem to receive different information from various sources.  In general, domestic hedge fund managers do not have any AML obligations.  Additionally, it is unlikely that domestic hedge funds will be subject to any AML requirements in the near future.

The rise of the AML regulations came from the PATRIOT ACT, which required financial institutions to adopt AML procedures.  These regulations did not apply to domestic hedge funds specifically, but the Treasury promulgated proposed rules which would have applied the AML requirements to domestic hedge funds.  The proposed rule would have required hedge funds to (i) have internal AML polices, procedures and controls, (ii) have an AML officer, (iii) have ongoing compliance training for employees and (iv) have an annual audit of the AML program.

An article by the Washington Post recently announced that the Treasury has withdrawn the proposed AML requirements for hedge funds. The article states that the central reason why the AML requirements for hedge funds did not go through is that it is unlikely that terrorist groups would use hedge funds as a way to launder money.  The article states that hedge funds may be too risky for terrorists.

This announcement does not affect other financial institutions, such as banks and broker-dealers, which have specific AML and Know Your Customer (KYC) requirements.  The fact that the proposal was withdrawn does not mean, however, that hedge funds are free from any sort of AML.  As noted above, banks and broker-dealers are subject to their own AML requirements and may require their customers (hedge funds) to also implement AML policies.  If a bank or BD does require this, then the hedge fund manager should discuss the situation with the fund’s attorney to determine the appropriate next steps.  Offshore hedge funds, too, are subject to the anti-money laundering regulations of the jurisdiction in which they are domiciled.  The withdrawal of the proposed AML requirements does not affect these offshore hedge funds.

Please also note that state securities commissions may try to require hedge funds to incorporate AML requirements.  Currently we do not know of any state securities commissions with these requirements, but Texas has tried to implement a requirement like this in the past.

Please contact us, or another hedge fund attorney, if you have any questions.  Other related HFLB articles include:

CFTC and NFA and Hedge Fund Regulation: Report by the GAO

This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds.  The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here.

The following expert provides a good summary of the roles and duties of both the U.S. Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) with regard to hedge funds and their commodities trading activities. Specifically, the report describes the central ways that these groups regulate hedge funds, including the following:

Once registered, CPOs and CTAs become subject to detailed disclosure, periodic reporting and record-keeping requirements, and periodic on-site risk-based examinations. However, regardless of registration status, all CPOs and CTAs (including those affiliated with hedge funds) remain subject to CFTC’s anti-fraud and anti-manipulation authority.

One item to note is that this report was prepared in early 2008 so it does not include the subsequent jurisdictional grant to the CFTC to regulate spot forex.  This grant was provided by the Farm Bill, passed by Congress in June of 2008 (please see CFTC announces retail forex fraud task force).  Subsequent to passing the Farm Bill the CFTC began drafting regulations (yet to be formally proposed) to require the registration of forex managers.  When the CFTC and the NFA eventually regulate the spot forex markets and require forex managers to be registered, it is likely that their duties will increase with regard to forex hedge fund managers, who are currently unregulated at the federal level.

With regard to future regulatory oversight of hedge funds by the CFTC and the NFA, there will probably not be greater mandates for registration.  One thing that could be done is to take away the CPO exemptions, but this seems unlikely.

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CFTC Can Monitor Hedge Fund Activities through Its Market Surveillance, Regulatory Compliance Surveillance, and Delegated Examination Programs:

Although CFTC does not specifically target hedge funds, through its general market and financial supervisory activities, it can provide oversight of persons registered as CPOs and CTAs that operate or advise hedge funds that trade in the futures markets. As part of its market surveillance program, CFTC collects information on market participants, regardless of their registration status, to monitor their activities and trading practices. In particular, traders are required to report their futures and options positions when a CFTC-specified level is reached in a certain contract market and CFTC electronically collects these data through its Large Trader Reporting System (LTRS).[1] CFTC also uses the futures and options positions information reported by traders through the LTRS as part of its monitoring of the potential financial exposure of traders to clearing firms, and of clearing firms to derivatives clearing organizations. CFTC collects position information from exchanges, clearing members, futures commission merchants (FCM), and foreign brokers and other traders– including hedge funds–about firm and customer accounts in an attempt to detect and deter manipulation.[2] Customers, including hedge funds, are required to maintain margin on deposit with their FCMs to cover losses that might be incurred due to price changes. FCMs also are required to maintain CFTC-imposed minimum capital requirements in order to meet their financial obligations. Such financial safeguards are put in place to mitigate the potential spillover effect to the broader market resulting from the failure of a customer or of an FCM.

According to CFTC officials, the demise (due to trading losses related to natural gas derivatives) in the fall of 2006 of Amaranth Advisors, LLC (Amaranth), a $9 billion multistrategy hedge fund, had no impact on the integrity of the clearing system for CFTC-regulated futures and option contracts. The officials said that at all times Amaranth’s account at its clearing FCM was fully margined and the clearing FCM met all of its settlement obligations to its clearinghouse. They also said that the approximate $6 billion of losses suffered by Amaranth on regulated and unregulated exchanges did not affect its clearing FCM, the other customers of the clearing FCM, or the clearinghouse.[3]

CFTC investigates and, as necessary, prosecutes alleged violators of the Commodity Exchange Act (CEA) and CFTC regulations and may conduct such investigations in cooperation with federal, state, and foreign authorities. Enforcement referrals can come from several sources, including CFTC’s market surveillance group or tips. Remedies sought in enforcement actions generally include permanent injunctions, asset freezes, prohibitions on trading on CFTC-registered entities, disgorgement of ill-gotten gains, restitution to victims, revocation or suspension of registration, and civil monetary penalties. On the basis of CFTC enforcement data, from the beginning of fiscal year 2001 through May 1, 2007, CFTC brought 58 enforcement actions against CPOs and CTAs, including those affiliated with hedge funds, for various violations.[4] A summary of the violations cited in the actions includes misrepresentation with respect to assets under management or profitability; failure to register with CFTC; failure to make required disclosures, statement, or reports; misappropriation of participants’ funds; and violation of prior prohibitions (i.e., prior civil injunction or CFTC cease and desist order).

Pursuant to CFTC-delegated authority, NFA, a registered futures association under the CEA and a self-regulatory organization, oversees the activities, and conducts examinations, of registered CPOs and CTAs.[5] As such, hedge fund advisers registered as CPOs or CTAs are subject to direct oversight in connection with their trading in futures markets.[6] More specifically, to the extent that hedge fund operators or advisers trade futures or options on futures on behalf of hedge funds, the funds are commodity pools and the operators of, and advisers to, such funds are required to register as CPOs and CTAs, respectively, with CFTC and become members of NFA if they are not exempted from registration. Once registered, CPOs and CTAs become subject to detailed disclosure, periodic reporting and record-keeping requirements, and periodic on-site risk-based examinations. However, regardless of registration status, all CPOs and CTAs (including those affiliated with hedge funds) remain subject to CFTC’s anti-fraud and anti-manipulation authority.

Our review of NFA documentation found that 29 advisers of the largest 78 U.S. hedge funds (previously mentioned) are registered with CFTC as CPOs or CTAs. In addition, 20 of the 29 also are registered with SEC as investment advisers or broker-dealers. According to NFA officials, because there is no legal definition of hedge funds, it does not require CPOs or CTAs to identify themselves as hedge fund operators or advisers. NFA, therefore, considers all CPOs and CTAs as potential hedge fund operators or advisers. According to NFA, in fiscal year 2006 NFA examined 212 CPOs, including 6 of the 29 largest hedge fund advisers registered with NFA. During the examinations, NFA staff performed tests of books and records and other auditing procedures to provide reasonable assurance that the firm was complying with NFA rules and all account balances of a certain date were properly stated and classified. Our review of four of the examinations found that 3 of the CPOs examined generally were in compliance with NFA regulations and the remaining 1 was found to have certain employees that were not properly registered with CFTC. According to examination documentation, subsequent to the examination, the hedge fund provided a satisfactory written response to NFA noting that it would soon properly register the employees.

According to an NFA official, since 2003 NFA has taken 23 enforcement actions against CPOs and CTAs, many of which involved hedge funds. Some of the violations found included filing fraudulent financial statements with NFA, not providing timely financial statements to investors, failure to register with CFTC as a CPO, failure to maintain required books and records, use of misleading promotional materials, and failure to supervise staff. The penalties included barring CPOs and CTAs from NFA membership temporarily or permanently or imposing monetary fines ranging from $5,000 to $45,000.

[1] According to CFTC officials, the LTRS captures 70 to 90 percent of the daily activity on registered futures exchanges.

[2] FCMs are individuals, associations, partnerships, corporations, or trusts that solicit or accept orders for the purchase or sale of any commodity for future delivery on or subject to the rules of any contract market or derivatives transaction execution facility; and in connection with such solicitation or acceptance of orders, accept money, securities, or property (or extend credit in lieu thereof) to margin, guarantee, or secure any trades or contracts that result or may result therefrom.

[3] In the CFTC complaint filed against Amaranth Advisors, LLC; Amaranth Advisors (Calgary), ULC, and Brian Hunter, CFTC alleged that the defendants attempted to manipulate the price of natural gas contracts on the New York Mercantile Exchange, Inc., in 2006. Complaint for Injunctive and Other Equitable Relief and Civil Monetary Penalties under the Commodity Exchange Act, CFTC v. Amaranth Advisors, LLC, No. 07-6682 (S.D.N.Y., July 25, 2007).

[4] Because “hedge fund” is not a defined term under the CEA or any other federal statute, CFTC and NFA records do not identify whether a commodity pool is a hedge fund. Thus, CFTC cannot report on the exact
number of examinations that involve hedge funds. In the event the CPO or CTA self-designates itself as a hedge fund, the Division of Enforcement typically incorporates that designation in the enforcement action, and that designation is often used in the press release notifying the public of the enforcement action.

[5] A registered CPO or CTA seeking to engage in futures business with the public or with any member of NFA must itself be a member of NFA.

[6] For the purpose of this report the term “hedge fund advisers” includes, as the context requires, CPOs, CTAs, or securities investment advisers.

Other HFLB articles include:

Hedge Fund IRA Investments

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

Can an IRA invest in a hedge fund?

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

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

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

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

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

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

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

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

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

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

HFLB Note

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

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

Hedge Fund Due Diligence 2.0

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

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

More to come on this topic …

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

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

Short Sale Ban

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

Short Sale Disclosure Requirements

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

Likely Fallout

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

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

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

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

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

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

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

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