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Deal Book: New Hedge Fund with Questionable Name

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The New York Times Deal Book today ran a story about a new hedge fund named Ground Zero Strategic Commodities.  The author of the story noted that:

Putting the words “Ground Zero” in a hedge fund name may disturb many people as it undoubtedly conjures up images of the site where the World Trade Center was destroyed nearly eight years ago.

We agree.  Raising assets for hedge funds can be hard enough – a manager should try to choose a name for their fund that is not likely to put off potential investors.  We have written about hedge fund names before and while it is always advisable to try to have a name which represents the manager or strategy or outlook in some way, it should not be a distraction.

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Start a Hedge Fund in the Cayman Islands

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How to Set Up a Cayman Islands Hedge Fund

There are two main jurisdictions to establish an offshore hedge fund (either as a single hedge fund or as part of a master-feeder structure).  The two jurisdictions are the BVI and the Cayman Islands.  This article will discuss some of the features of Cayman Island based hedge fund structures.

Why the Cayman Islands?

Cayman has been the leading jurisdiction for fund formation with an estimated 80% of the world’s hedge funds domiciled there.  As of December 2008, Cayman had over 10,000 hedge funds registered with the local regulatory authority: The Cayman Islands Monetary Authority (“CIMA”).

First and foremost: establishing a fund in the Cayman Islands is easy and efficient, offering managers many competitive advantages over other jurisdictions including:

  • Non-public funds can be registered in as little as 3-5 days with CIMA and the vehicle of choice for the fund can be registered within 1 day prior to filing, if necessary;
  • Flexible statutory regimes, with an absence of exchange control provisions, that are well-established and relatively low-cost;
  • There are no restrictions on: (i) investment policy (ii) issue of equity interests (iii) prime brokers or (iv) custodians;
  • The regulatory and legislative environment is continuously evolving to strengthen the jurisdiction’s appeal for hedge funds in response to ever changing market conditions;
  • Cayman is a tax neutral jurisdiction – there are no capital gains, income, profits, withholding or inheritance taxes attaching to investment funds established there, nor to investors in such investment funds;
  • Cayman is a British Overseas Territory and as such maintains all of the security and stability associated with the British flag.  The UK remains responsible for the islands’ external affairs, defence and their legal system; and
  • The quality and expertise of the Cayman Islands local services, infrastructure and legal system is well above par.

Does Every Hedge Fund Have to be Registered with CIMA?

While most funds (90%) will be required by Cayman Islands law to register with CIMA, there are some funds that will not: those funds where the equity interests are not held by more than 15 investors who collectively have the power to appoint or remove the “operator” of the fund i.e. the director, trustee, or general partner, depending on the fund’s choice of vehicle.  For example, a private fund or closely held funds such as partners’ funds or those in incubation “testing the waters” before launching into the registered world.  These funds need not make filings or pay fees to CIMA.

All other funds must register with CIMA, pay annual fees and undergo annual auditing.

What are the CIMA Hedge Fund Registration Requirements?

1.  Incorporation/Formation of the fund vehicle.  The fund must be in the form of one of three vehicles: i) a Cayman Islands Exempted Company (most common); ii) a Unit Trust; or iii) an Exempted Limited Partnership.  (The latter is popular with US investors as the Cayman Islands Exempted Limited Partnership Law follows the equivalent legislation in Delaware.)  There must be a minimum of two (2) directors appointed to the fund – corporate or individuals.  The directors need not be local.

2.  Preparation of the fund’s Offering Document.

3.  Preparation of the fund’s constitutional documents (i.e. Memorandum and Articles of Association) to reflect the terms of the Offering Document.  This is usually done by way of amending and restating the constitutional documents after the vehicle for the fund has been properly formed (see 1 above).

4.  Preparation of the service agreements i.e. administration agreement/investment management agreement/advisory agreement etc.

5.  Preparation of the form of subscription agreement to be executed by the investors of the fund.

6.  Resolutions must be passed approving: the Offering Document, service agreements and the issue of equity interests by the fund.

7.  All of the following documents must then be submitted to CIMA:

i)    A certified copy of the fund’s certificate of incorporation (or otherwise, depending on the vehicle used);
ii)    Fund’s Offering Document;
iii)    Application Form (“Form MF1”);
iv)    Auditor’s letter of consent; (A local auditor must be appointed.  Such auditor must also sign off on the fund’s audited financial statements which are to be submitted annually to CIMA.)
v)    Administrator’s letter of consent (no requirement for local administrator);
vi)    Registration fee (approximately US$3,000 (subject to change))

What Are the Costs for CIMA Registered Funds?

The total approximate costs of setting up a Cayman Islands Hedge Fund will include: the incorporation/formation costs of the vehicle required plus the ongoing annual fee (for exempted companies); the annual administrator’s fee; the annual auditor’s fee; the initial registration fee of the fund with CIMA and an annual fee to maintain the fund’s registration, and any legal fees associated therewith.

Quotes for incorporation etc. and estimates for services may be obtained from service providers and legal counsel directly, as these will likely vary.  Legal counsel may provide recommendations for service providers upon request.

Article Written by Michelle Richie

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

Bart Mallon, Esq. has written most all of the articles which appear on the Hedge Fund Law Blog.  Mr. Mallon’s legal practice, Cole-Frieman & Mallon LLP, is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.

The Future of Hedge Funds: A Look at the Industry and Opportunities for Women

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What the Future Holds for Women in the Hedge Fund Industry

Occasionally we will have readers submit potential articles for publication on this website which is the case with the post below.  If you are interested in having your article re-published on our website, please contact us.

Hedge Fund Research, Inc. (HFRI) recently conducted a study that shows a recent increase in quarterly assets invested in the hedge fund industry as well as a rise in the number of funds.   This data leads some experts to remain hopeful that the industry as a whole can sustain the impact of the financial crisis, and it begs the question as to how newcomers to the industry will be impacted by the new the impetus for regulation and transparency.

Kelly Chesney, and industry expert and co-founder of a well-known investment management company, maintains that the move towards regulation and transparency will be a good thing for the industry as a whole, but the cost of such regulation may raise the barrier to for women trying to enter a largely male-dominated industry. Currently, only three percent of hedge funds are led by women.  Opinions vary as to how the high costs of running a fund will impact women trying to enter the industry and run their own business. Typically, smaller and newer funds will have a more difficult time trying to keep up with the rising costs of compliance given their relatively low assets under management. Opinions vary as to how the high costs of running a fund will impact women trying to enter the industry and run their own business.  Some experts, like Chesney, remain hopeful that opportunities do exist out there for women and perhaps the future will find more female hedge fund managers than we see today.

The article published by The Glass Hammer can be found here and is also reprinted in full below.

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The Future of Hedge Funds

by Liz O’Donnell (Boston)

New data from Hedge Fund Research, Inc., (HFRI) shows assets invested in the industry increased by $100 billion in the second quarter of 2009, ending at $1.43 trillion. This is the first quarterly increase in assets since second quarter of 2008. HFRI attributes the growth to gains shown during the quarter. The HFRI Fund Weighted Composite Index returned 9.13 percent. This is the best quarterly gain since the last quarter of 1999, although still below the highest peak, reached in 1997. And while investors are still redeeming capital, the pace of the redemptions has slowed from recent years.

But looking past the most current returns, what does the future hold for the hedge fund industry given the tremendous impact of the global financial crisis and amid discussions of government regulations? And what about the outlook for women? Will the recent inflow mean more opportunities or will women still be virtually missing from the industry this time next year?

“Right now hedge funds are a hot topic,” says Kelly Chesney, principal and co-founder of Pluscios Management LLC, a women-owned investment management firm. “I think they really got some negative press and sentiment last year and they are starting to turn around. There is more publicity when hedge funds don’t perform well, but they did much of what was expected.”

Following what she calls “an economic tsunami”, Chesney, and others, see consolidation and regulation as key issues that will impact the industry. “I think it will be choppy and we’ll have various events happen over the next few years. We need to be nimble and adaptive and hedge funds are good at that,” Chesney says.

Certainly the industry has already seen the beginnings of consolidation. After a rapid growth spurt, (the number of funds grew from 610 in 1990 to approximately 9,000 today) 15 percent of funds have disappeared. State Street, in its recently released report “Alternatives: New Views of the Hedge Fund Industry” says that half of all hedge funds may disappear before the crisis shakes out.

Eloise Yellen Clark, founder and CEO of OmniQuest Capital LLC, agrees consolidation will be a continuing trend. “More and more money is going to the bigger players where traditionally there was a bunch of little players. It gets awfully expensive for smaller (funds) to survive.”

As far as what the future holds, Clark says, “Everybody’s talking regulation. I really don’t think it’s a big deal and I think it’s a good idea.” Clark points out that many hedge funds and many managers are already registered with the SEC. She believes more regulation around the issue of transparency would be valuable. Of course, just how far the government takes regulation could be an issue. “On the whole, reasonable regulation that respects fair markets is good. Transparency is good. But limiting the ability to buy and sell is bad,” said Clark.

Chesney says “absolutely” regulation will be a factor moving forward. “It’s not like there hasn’t been regulation.” But that regulation could increase. “It depends on what it is,” she says. “It could be wide ranging — from every fund must register—or it could be a ban on short selling.”

Some funds are “hedging” their bets. Aimee McCarty, marketing director for Ascentia Capital Partners, LLC, says her firm closed its hedge fund and now offers a mutual fund. According to McCarty, the new product combines the benefits of hedge funds with the features of mutual funds to offer a product that is “regulated, transparent, and liquid.” AQR Capital Management LLC added a mutual fund to its product offering earlier in the year.

Diversification might spell survival for some financial firms. Chesney believes it will get more expensive to run a fund, as compliance with regulations will add a new level of management. “There will be a higher barrier to entry,” she says.

That high cost of entry might not bode well for women. Already, there are very, very few women in the hedge fund industry. Currently only three percent of hedge funds are led by a woman. A recent report from The National Council for Research on Women, which we reported on here , asserts that one of the major reasons there are so few women in the industry is that gaining access to capital is harder for women than it is for men.

Chesney says,

“Typically women who get frustrated in other industries go out and start their own thing. But it’s tougher for women on Wall Street (because of) getting assets to manage.” None the less, Chesney is hopeful about the future of women in hedge funds. “I think there are going to be a lot of opportunities.”

Clark, who currently sees very few women in the business, says: “It’s my belief that women are different in business than men. Any organization that combines that is optimal.”

Chesney agrees. “Key in any fund management is diversification.” Whether that diversification extends beyond the fund and to the fund managers, is still to be seen.

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

Hedge Funds and Bloomberg

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Many hedge fund managers were introduced to the Bloomberg terminal when they began their trading careers.  The terminal, with its iconic user interface which has changed only by small increments over time, can be found in most large asset management companies as well as in smaller groups like family offices, fund of hedge funds, hedge funds and even single manager investment advisory firms.  The breadth and depth of the Bloomberg services may be matched by other similar financial information and news services (like Thompson/Reuters), but managers and traders seem to be drawn to the Bloomber services nonetheless.  Below is an overview of information we compiled on the Bloomberg services – please feel free to share any thoughts in the comments below.

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Bloomberg Terminal Information Overview

What is Bloomberg?

The Bloomberg terminal is a computer system that enables financial professionals to access the Bloomberg Professional service through which users can monitor and analyze real-time financial market data movements and place trades. The system also provides news, price quotes, and messaging across its proprietary and secure network. Most large financial firms have subscriptions to the Bloomberg Professional service, and many exchanges charge their own additional fees for access to real-time price feeds across the terminal.

What services does Bloomberg offer?

Bloomberg offers financial professionals access to a top-of-the-line financial, regulatory, and market database. The system is of particular benefit to investors, as it allows them to simultaneously:

  1. access, process, and store information on the companies they wish to monitor;
  2. teleconference with colleagues around the world; and
  3. monitor the relationship between domestic and foreign currencies.

The activities for which Bloomberg users most commonly subscribe to the service include, but are not limited to:

  • Earnings Estimates
  • Analyst  Recommendations
  • Related Securities
  • Various graphs of a company’s stock price
  • Stock screening search: Search for equities based on user-defined criteria
  • Corporate Actions: Calendar of events that might impact markets
  • Corporate actions of a specific company
  • Broad information on U.S. Treasury and Money Markets
  • U.S. Economic surveys and releases
  • Mergers & Acquisitions Home Page
  • Current news and deals

Bloomberg Mobile, which is a free mobile application for iPhone and Blackberry users,  doesn’t offer quite the same level of functionality as the full Bloomberg terminal, but it is a beautifully designed app that provides up-to-the-minute news, stock quotes, company descriptions, and price chart and market trend analysis. The My Stocks feature is a more detailed replacement for Apple’s Stocks app. Additionally, Bloomberg Mobile takes full advantage of the iPhone’s position sensor by providing larger charts when you rotate the phone to a horizontal position.

The Bloomberg Platform & Equipment

The Bloomberg terminal implements a client-server architecture with the server running on a multiprocessor UNIX platform.  Although the look and feel of the Bloomberg keyboard is very similar to the standard computer keyboard, there are several enhancements that help a user navigate through the system.  Originally a self-contained operating system running on custom hardware, the Bloomberg Terminal now functions as an application within the Windows environment.  There are essentially three levels to the system:

(1) The Core Terminal:

This is the original system, consisting typically of 4 windows, each containing a separate instance of the terminal command line. By entering tickers and functions, data can be displayed and programs run to analyze it. This seemingly large number of windows allows users to call up several entirely different sets of data, and compare it quickly; for those users who have more than one computer display, each terminal window can be assigned independently, creating, in effect, four terminals.

(2) The Launchpad:

Launchpad is a customizable display consisting of a number of smaller windows, called ‘components’, each of which is dedicated to permanently displaying one set of data. A typical user would be a stockbroker who wishes to keep a list of 30 stocks visible at all times: Launchpad creates a small component which will show these prices constantly, saving the broker from having to check each stock independently in the terminal. Other functions, such as email inboxes, calculation tools and news tickers can be similarly displayed. The Instant Bloomberg messaging/chat tool is another Launchpad component that allows brokers to communicate instantly with other Bloomberg users.

(3) Application Programming Interface:

The final level of the Bloomberg system is the ability to export data from the terminal to 3rd party applications, such as Microsoft Excel. A user might wish to use Bloomberg data from the terminal to create his or her own calculations; by exporting the live data into another program, they can build these formulae. Bloomberg supports this through a range of add-ins which are packaged with the terminal software.

How much does Bloomberg cost?

While Bloomberg offers a great variety of services, it is relatively expensive.  Monthly rates can be as high as $1,500 – $1,800 per month.  However, as Bloomberg saw a decline in revenue over 2007 and 2008, it is to be expected that the rates will come down  by the end of 2009.  Although Bloomberg has become an institutional cornerstone in the finance world, leading competitors for electronic financial data provision include Thomson/Reuters, Morgan Stanley, FactSet Research Systems, Jackson Terminal, Advantage Data Inc., Fidessa and Dow Jones.

Conclusion

Bloomberg Terminal currently caters to more than 300,000 users worldwide, and is highly regarded by financial professionals as a powerful data-warehouse for institutional investors.  Since the relatively high ongoing cost makes it unfeasible for individual investors with relatively small amounts of capital to purchase, the product targets a unique subsector of investors with the purchasing power to enjoy the benefits of comprehensive access to the financial marketplace.

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

Hedge Fund Hotels

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Office Space, IT, Trading For Start up Hedge Funds

The term hedge fund hotel generally describes the offering of office space, IT and consulting services (including, potentially, capital introduction) for start up hedge fund managers.  Most of these relationships are established as turn-key solutions for managers which provide them the back-office infrastructure to run a hedge fund without the headaches of managing the development and maintenance of such infrastructure.  Many times the rent is discounted and the managers are encouraged to utilize the services of the group that is providing the hedge fund hotel.  Groups which typically provide these hedge fund hotel relationships include prime brokers, banks, and other hedge fund service providers or consultants.  These relationships are not without controversy and

Issues with Hedge Fund Hotels

One of the major issues with hedge fund hotels is that they will pay below market rate for office space and IT which implicates issues is similar to soft dollar issues.  Managers who use soft dollars need to be very cognizant of the conflicts of interest which may arise in soft-dollar contexts, especially if the manager has any ERISA fiduciary duties.  Likewise, managers who have hotel relationships need to be cognizant of issues related to conflicts of interests with regard to brokerage and execution.  Because managers will normally choose (and periodically review) their brokers based on a variety of criteria (such as pricing/speads/commissions, execution of orders, financial strength of the broker, available research, etc.), the fact that they receive (in certain cases) reduced rent should not influence the manner in which they decide upon brokerage.  In theory it is easy to say, but in practice it is hard to do.  As such, there have been a few recent controversy’s which have acknowledge the potential conflict of interest issues with these relationships.

Hedge Fund Hotel Controversy

In 2007 the Massachusetts Securities Division filed an action against UBS for its activities related to it running a hedge fund hotel.  Below are a couple of excerpts from the UBS Hedge Fund Hotel Administrative Complaint:

Other than hedge fund adviser, prime brokers are the primary third party service providers to hedge funds.  Prime brokers provide a suite of services essential to the successful implementation of hedge funds’ individual objectives.  Prime Brokers generate substantial revenue from those hedge fund clients in exchange for these services.  UBS competes for prime brokerage revenue in part by providing a range of benefits to the advisers of those hedge fund clients to induce the advisers to bring and keep the hedge fund business with UBS.  Among the methods UBS used to influence or reward hedge fund advisers and their principals are: Provision of office space to hedge fund advisers at rates that are substantially below market rate; Free access to information technology personnel and other office personnel; Introductions to potential new clients (that would increase management fees for the adviser); Low interest personal loans; and Tickets to sporting events and other forms of entertainment.

Unbeknownst to the pension funds, university endowments, charitable foundations, institutional investors and individuals who invest in hedge funds, the rewards for the hedge fund advisers come implicit and sometimes explicit quid pro quos.  UBS requires the hedge fund advisers to cause the hedge funds they manage to meet certain benchmarks of profitability for UBS or ensure they do not use other prime brokers.

Page 2-3 of the complaint

Later on in the complaint, the Enforcement Section of the Massachusetts Securities Division provides the following definition of prime brokerage and the fees generated by prime brokers.

“Prime Brokerage is a service provided by certain broker-dealers to facilitate the clearance of securities trades and other services to substantial retail and institutional customers, including hedge funds.  The services offered by Prime Brokers may include: trading, securities lending, margin lending, customized reporting; research; valuation; technology; operations services; and other services needed by hedge funds or other large clients.

Prime Brokers generate revenue on hedge fund business from commissions, spreads, administrative fees, ticket charges, stock loans and credit interest earned from providing position financing and arranging securities loans (“Prime Fees”).

In the Prime Brokerage relationship, the client who pays the Prime Fees is the hedge fund.  The Hedge Fund Adviser is an agent of the hedge fund, acts on behalf of the hedge fund and has fiduciary duties to the hedge fund.

Page 9 of the complaint

Conclusion

Hedge fund hotels actually can provide valuable services to start up hedge funds during a very important part of the hedge fund life cycle.  However, there are a number of disclosure issues which must be addressed and which should be discussed in detail in the hedge fund offering documents.  The managers should discuss their brokerage/hotel relationship with their hedge fund attorney who will help them to identify and properly disclose the various compliance and conflicts issues which may be present.  Additionally, when a hedge fund and manager reaches a certain place in the fund growth/lifecycle, they may want to explore paying market rates for their space and/or moving to another location.  These issues should be contemplated by management in consultation with the hedge fund attorney.

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

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

SEC Announces New Short Sale Rules

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One of the major regulatory pushes this year by the SEC has been to revamp the short sale rules.  Today the SEC announced some specific measures which are intended to curtail abusive short sales.  We will likely have more comments on this issue going forward and will publish hedge fund industry reaction.

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SEC Takes Steps to Curtail Abusive Short Sales and Increase Market Transparency
FOR IMMEDIATE RELEASE
2009-172

Washington, D.C., July 27, 2009 — The Securities and Exchange Commission today announced several actions that would protect against abusive short sales and make more short sale information available to the public.

“Today’s actions demonstrate the Commission’s determination to address short selling abuses while at the same time increasing public disclosure of short selling activities that affect our markets,” said SEC Chairman Mary Schapiro.

First, the Commission made permanent an interim final temporary rule, Rule 204T, that seeks to reduce the potential for abusive “naked” short selling in the securities market. The new rule, Rule 204, requires broker-dealers to promptly purchase or borrow securities to deliver on a short sale. The temporary rule, approved by the SEC in the fall of 2008, was set to expire on July 31.

Additional Materials

Rule 204: Amendments To Regulation SHO (Release No. 34-60388)

Second, the Commission and its staff are working together with several self-regulatory organizations (SRO) to make short sale volume and transaction data available through the SRO Web sites. This effort will result in a substantial increase over the amount of information presently required by another temporary rule, known as Temporary 10a-3T. That rule, which will expire on August 1, applies only to certain institutional money managers and does not require public disclosure.

Apart from these measures, the Commission is continuing to actively consider proposals on a short sale price test and circuit breaker restrictions.

Third, the Commission intends to hold a public roundtable on September 30 to discuss securities lending, pre-borrowing, and possible additional short sale disclosures. The roundtable will consider, among other topics, the potential impact of a program requiring short sellers to pre-borrow their securities, possibly on a pilot basis, and adding a short sale indicator to the tapes to which transactions are reported for exchange-listed securities.

Overview

Short selling often can play an important role in the market for a variety of reasons, including contributing to efficient price discovery, mitigating market bubbles, increasing market liquidity, promoting capital formation, facilitating hedging and other risk management activities, and importantly, limiting upward market manipulations. There are, however, circumstances in which short selling can be used as a tool to manipulate the market.

“Naked” Short Sales: In a “naked” short sale the investor sells shares “short” without first having borrowed them. Such a transaction is permitted because there is no legal requirement that a short seller actually borrow the shares before effecting a short sale.

But, before effecting a short sale, Rule 204T requires that the broker-dealer, as opposed to the seller, “locate” an entity that the broker reasonably believes can deliver the shares within three days after the trade — what’s known as T+3. Also, if reasonable, a broker-dealer may rely on a short seller’s assurance that the short seller has located his or her own lender that can deliver shares in time for settlement.

“Fails-to-deliver”: If an investor or its broker-dealer does not deliver shares by T+3, a “failure to deliver” occurs. Where an investor or its broker-dealer neither locates nor delivers shares, a “naked” short sale has occurred.

A “fail to deliver” can occur for legitimate reasons, such as mechanical errors or processing delays. Further, a “fail to deliver” could occur as a result of a long sale — that is the typical buy-sell transaction — as well as a short sale.

“Fails to deliver”, such as fails resulting from potentially abusive “naked” short selling, may have a negative effect on shareholders, potentially depriving them of the benefits of ownership such as voting and lending. They also may create a misleading impression of the market for an issuer’s securities.

Adopting Regulation SHO: Due to its concerns regarding persistent “fails to deliver” and potentially abusive “naked” short selling, the Commission adopted Regulation SHO, which became effective in early 2005. This regulation imposes, among other things, the requirement that broker-dealers locate a source of borrowable shares prior to selling short.

In addition, it requires that firms that clear and settle trades must purchase shares to close out these “fails to deliver” within a certain time frame, 13 days. This “close-out” requirement only applies to certain equity securities with large and persistent “fails to deliver,” known as threshold securities.

The requirement included two major exceptions: the so-called “grandfather” and “options market maker” exceptions. Both of these exceptions provided that certain “fails to deliver” in threshold securities never had to be closed out. The Commission eliminated both exceptions in August 2007 and September 2008, respectively.

Making Permanent A Rule to Curtail Naked Short Selling

Adopting Rule 204: The Commission has made permanent a temporary rule that was approved in 2008 in response to continuing concerns regarding “fails to deliver” and potentially abusive “naked” short selling. In particular, temporary Rule 204T made it a violation of Regulation SHO and imposes penalties if a clearing firm:

  • does not purchase or borrow shares to close-out a “fail to deliver”
  • resulting from a short sale in any equity security
  • by no later than the beginning of trading on the day after the fail first occurs (T+4).

Cutting Down Failures to Deliver: An analysis conducted by the SEC’s Office of Economic Analysis, which followed the adoption of the close-out requirement of Rule 204T and the elimination of the “options market maker” exception, showed the number of “fails” declined significantly.

For example, since the fall of 2008, fails to deliver in all equity securities has decreased by approximately 57 percent and the average daily number of threshold list securities has declined from a high of approximately 582 securities in July 2008 to 63 in March 2009.

Due to the success of these measures in furthering the Commission’s goals of reducing fails to deliver and addressing potentially abusive “naked” short selling, the Commission has made permanent the requirements of Rule 204T with only limited modifications to address commenters’ operational concerns.

Increasing Transparency Around Short Sales

In the fall of 2008, the Commission also adopted a short sale reporting interim rule, Rule 10a-3T. The rule requires certain market participants to provide short sale and short position information to the Commission.

The Commission made the rule temporary so that it could evaluate whether the benefits from the data justified the costs associated with the rule.

Instead of renewing the rule, the Commission and its staff, together with SROs, are working to substantially increase the public availability of short sale-related information through a series of other actions. These actions should provide a wealth of information to the Commission, other regulators, investors, analysts, academics, and the media.

Specifically, the Commission and its staff are working together with several SROs in the following areas:

  • Daily Publication of Short Sale Volume Information. It is expected in the next few weeks that the SROs will begin publishing on their Web sites the aggregate short selling volume in each individual equity security for that day.
  • Disclosure of Short Sale Transaction Information. It is expected in the next few weeks that the SROs will begin publishing on their Web sites on a one-month delayed basis information regarding individual short sale transactions in all exchange-listed equity securities.
  • Twice Monthly Disclosure of Fails Data. It is expected in the next few weeks that the Commission will enhance the publication on its Web site of fails to deliver data so that fails to deliver information is provided twice per month and for all equity securities, regardless of the fails level. For current fails to deliver information, see http://www.sec.gov/foia/docs/failsdata.htm.

Hosting a Roundtable

Finally, the Commission also is examining whether additional measures are needed to further enhance market quality and transparency, as well as address short selling abuses.

As part of its examination, the Commission intends to hold a public roundtable on Sept. 30, 2009, to solicit the views of investors, issuers, financial services firms, self-regulatory organizations and the academic community regarding a variety of trading and market related practices. The roundtable will focus on issues related to securities lending, pre-borrowing, and possible additional short sale disclosures.

The roundtable panelists will consider, among other things, additional means to foster transparency, such as adding a short sale indicator to the tapes to which transactions are reported for exchange-listed securities, and requiring public disclosure of individual large short positions. Panelists will also consider whether it would be appropriate to impose a pre-borrow or enhanced “locate” requirement on short sellers, potentially on a pilot basis. Additionally, panelists will discuss issues related to securities lending such as compensation arrangements, disclosure practices, and methods of collateral and cash-reinvestment.

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http://www.sec.gov/news/press/2009/2009-172.htm

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GIPS Compliance Information For Hedge Funds

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Hedge Funds and GIPS Compliance

The Chartered Financial Analysts (CFA) Institute has spearheaded and implemented the Global Investment Performance Standards (GIPS) for investment managers as a means of establishing a higher standard for compliance with measurement and reporting of hedge fund performance.  GIPS standards set forth a universal set of guidelines and standards for measuring, calculating, and presenting aggregate gain and loss percentages in discretionary, managed investment accounts. Compliance with GIPS standards is voluntary, but it helps investment managers to attract and retain institutional investors who may require a higher standard for disclosure and accurate reporting.

What is GIPS?

The reporting and measuring standards from which GIPS originated were developed by CFA Institute beginning in the late 1980’s and have been gradually modified and reevaluated over the years.  While the CFA Institute initiated and funded the development of GIPS, the GIPS Executive Committee is responsible for maintaining the standards.  The key provision of GIPS is the requirement to include all of a firm’s fee-paying, discretionary amounts in a ‘composite’, or an aggregate of portfolios that share common investment objectives or strategies. The goal of using composites is to ensure ease of comparability between firms due to enhanced consistency.  To further aid the comparison of fund performance, the standards specifically disallow ‘nondiscretionary’ accounts from being included in the composites (where certain client restrictions render the fund’s performance more reflective of the clients’ decisions than the managers’ decisions).  Understanding and adhering to strict composite construction requirements is critical to GIPS compliance.

When should a Manager use GIPS?

There are several advantages to complying with GIPS and getting third-party verification. First and foremost is the added credibility of your hedge fund brought on by the claim of compliance (to be used in presentations, marketing materials, advertising, service agreements, etc.).  This credibility can help reinforce investor trust and create new relationships with new prospective clients.  Secondly, the level of consistency brought on by adherence to GIPS creates a more cohesive set of procedures regarding the calculation and presentation of performance. Thirdly, compliance with GIPS can assist firms with keeping up with the requirements of the SEC and avoid encountering claims of fraudulent conduct.  This is especially important for managers who may have had a prior track record with such claims or have had any actions brought against them by the SEC – incorporating GIPS compliance standards into the hedge fund practice will vindicate these managers of their past and help rebuild investor trust.

Twelve Steps to GIPS Compliance

The following procedure has been recommended by GIPS Execute Committee members in order to establish an effective compliance program for your firm.

  1. Management support. Management must make a commitment of time and resources to bring the firm into compliance.
  2. Know the Standards. Assign individuals or teams to review and familiarize themselves with the Standards and to complete each subsequent step.
  3. Define the firm. The definition should accurately reflect how the entity is held out to the public and will determine the scope of firm wide assets under management.
  4. Define investment discretion. The Standards use the term “discretion” more broadly than just whether or not a manager can place trades for a client. Defining investment discretion is an important step in determining whether or not accounts must be included in a composite.
  5. Identify all accounts under management within the defined firm over the past five years, or since firm inception if less than five years. This should include all discretionary and nondiscretionary accounts, including terminated relationships.
  6. Determine if your firm has the appropriate books and records to support historical discretionary account performance.
  7. Separate the list of accounts into groups based on discretionary status, investment mandate, and/or other criteria. These groups will be the foundation for your composites.
  8. List and define the composites that will be constructed.
  9. Document your firm’s policies and procedures for establishing and maintaining compliance with the Standards.
  10. Document reasons for composite membership changes throughout each account’s history and reasons for nondiscretionary status, if applicable.
  11. Calculate composite performance and required annual statistics.
  12. Develop fully compliant marketing materials.

How to Get Started

As of 2007, 28 countries have adopted the GIPS standards or have had their local performance reporting standards endorsed by the GIPS Executive Committee.  Formally recognized in 29 major financial markets, GIPS compliances enables investment firms to fairly compete throughout the world and provides a standard framework to ensure that funds’ performance figures are directly comparable. Although it is in the best interest of any investment firm that wants to compete effectively and fairly to adhere to the GIPS standards, the issue for most firms is how to accomplish this successfully and cost-efficiently. For many firms, this may require adding GIPS experts to staff or turning to outside professionals, depending on the firm’s size, available resources, and overall business strategy. There are many GIPS service providers, including software vendors and verification/consulting firms, that can help investments firms become and remain GIPS compliant.

To help you select a service provider to help your firm get started with compliance efforts, you can refer to the list of GIPS Service Providers. You can also find the full text of the GIPS standards here.

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

Prime Brokers, Margin Lock-ups & Hedge Funds

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Today we have another guest post from Karl Cole-Frieman who specializes in providing legal advice to hedge funds and other alternative asset managers.  Mr. Cole-Frieman specializes in Loan Trading and Distressed Debt Transactions, ISDAs, Soft Dollars and Commission Management arrangements, and Wage and Hour Law Matters among other legal matters which hedge fund managers face on a day to day basis.
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The Margin Lock-up Returns to Prime Brokerage
By Karl Cole-Frieman, www.colefrieman.com

In 2009, the problems affecting major banks have also impacted their prime brokerage units, and accordingly there is less appetite to extend credit to hedge funds.   As the banking industry recovers, however, credit terms are beginning to loosen up again.  As a result, we are beginning to see the return of the margin lock-up for larger prime brokerage clients, who may in fact be in a stronger bargaining position for such agreements than they were a year ago.

What is a Margin Lock-up or Term Commitment?

In the most basic terms, a “margin lock-up” or a “term commitment” is a credit facility extended by a prime broker to a hedge fund or other institutional client.  The terms are used interchangeably in the industry.  Margin lock-ups prevent the prime broker from changing margin rates, collateral requirements, and often from declining to clear the hedge fund’s trades during the term of the lock-up.  For large managers, they are often 90 days, but can range from 30 days to 120 days, and perhaps even longer for the largest hedge fund managers.  Practically speaking, the way the arrangement works is that if a prime broker wants to make a change covered by the margin lock-up, they will provide the manager with the requisite notice before doing so.

Margin Lock-ups and Prime Brokerage Agreements

A margin lock-up is negotiated separately from a prime brokerage agreement, but ideally the two agreements are negotiated at the same time.  Our experience has been that it is significantly more difficult to negotiate a margin lock-up after the prime brokerage relationship has been established, and that a fund’s greatest negotiating leverage is before signing the prime brokerage agreement.

Negotiating a Margin Lock-up

There are two significant points to negotiate in a margin lock-up: (1) the scope of the commitment (and exclusions), and (2) the termination events.  For the scope of the commitment, it is essential that the commitment includes clearing trades.  Remember that a prime brokerage arrangement is a demand facility, and the prime broker can normally decide to stop clearing a hedge fund’s trades at any time and for any reason.  This is potentially highly disruptive, and could result in significant losses for a fund.  If clearing trades are covered by the margin lock-up, the prime broker will have to provide the requisite notice, which will allow time to make alternative arrangements with other counterparties.

Termination Events and Margin Lock-ups

Termination events can be very contentious in a margin lock-up negotiation.  The termination events in a margin lock-up give the prime broker the right to terminate the margin lock-up if a certain event occurs.  The prime brokers will want to negotiate off of their templates, which will initially have so many termination events it would make the margin lock-up worthless.  Managers should be wary of a completely subjective termination event, and such provisions should be negotiated out of the agreement.  For example, some prime brokers will try to insist on including a provision that it will be a termination event if the prime broker determines that it would cause the prime broker reputational risk to continue to do business with the fund.   More typical termination events include NAV triggers and key person provisions.

Bilateral Termination Events are a Secondary Consideration

Some hedge fund lawyers advocate that the termination events in a margin lock-up should not be completely unilateral, meaning, for example, that the credit rating of the prime broker should be a termination event.  We view this as a secondary consideration, and not a point to get bogged down on in the negotiation.  If a manager is concerned about the credit rating of the prime broker, they can simply move their balances.  They don’t need to terminate the lock-up – leave it in place in case the fund restores balances with that prime broker.

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

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If you are thinking of starting a hedge fund, please contact Mr. Bart Mallon, Esq. at 415-296-8510.  Other related hedge fund law and start up articles include:

Hedge Fund Auditors | Thought Piece From Castle Hall Alternatives

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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 Fees, 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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And the auditors work for….

Audit opinions of a hedge fund’s financial statements are unlikely to make the New York Times bestseller list.  As a result, we can certainly understand if the auditor’s fine print is not exactly top of the list for investor attention.  However, not all audit opinions are the same and, over time, it seems that different audit firms are quietly introducing different standards of care and attention – and, of course, liability, which is always the 800 pound gorilla.

The issue is the addressee of the audit report – or, put more simply, who the auditor works for.  In a public company, the auditors report to both the shareholders and the Board of Directors.  A quick web search gives us a couple of examples – GE and Goldman Sachs (don’t laugh at the Level III assets, by the way).

In a hedge fund, however, sometimes the audit report mentions the shareholders, but sometimes it does not.  What seems to be a fine difference is actually very profound – exactly why would a hedge fund auditor report only to the Board of Directors and deliberately fail to address their report to the shareholders?  Adding insult to injury, of course, is the reality that the average Board of Caymanian rent-a-directors hardly acts with the same vigor and intervention as the non execs on the boards of GE and Goldman.

In our experience, certain audit firms appear to have taken a deliberate decision to direct their audit opinions, wherever possible, only to the directors.  This is a difference which applies across both US GAAP reports as well as audits completed under International Financial Reporting Standards.  Check 10 audit reports from different firms, and see what we mean.

The underlying issue – of course – is the lack of investor control.  Investors, if asked, would very likely have an opinion on this issue: but, needless to say, they are not asked.  Audit engagement letters are signed under cloak and dagger secrecy (usually because they include ever more expansive terms seeking to limit auditor liability under Caymanian law).  Thereafter, as investors and due diligence practitioners know to their ongoing annoyance, it proves incredibly difficult and pointlessly time consuming to get some auditors even to confirm that they are the auditor of record for the hedge fund in question.

In the short term, one answer would be for offshore jurisdictions such as the Cayman Islands to mandate that all audit reports filed for Caymanian hedge funds be addressed to the shareholders rather than just the Board.  If it’s good enough for GE, it should be good enough for any hedge fund.

In the bigger picture, however, this is just one question within the broad construct of Hedge Funds 2.0 post Madoff.  Unfortunately, it is only investor pressure which can enforce any change so that service providers – auditors, administrators, lawyers et al – take responsibility and recognize that their primary duty of care is to the investors that pay them.  Without that pressure, hedge funds will continue to be the asset class where everyone wants to get paid, but no-one wants to take responsibility.

www.castlehallalternatives.com
Hedge Fund Operational Due Diligence

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Other related hedge fund law and start up articles include:

Series 3 Exam | Commodities & Futures Exam Topics

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Hedge Fund Managers and the Series 3 Exam

Those managers who engage in commodities and futures trading (and who don’t qualify for an exemptions) will need to register as commodity pool operators with the CFTC and become members of the NFA.  In order to do this all owners and “associated persons” of the manager/CPO will need to take and pass the Series 3 exam.  This article provides a brief overview of the Series 3 exam for hedge fund managers.

Commodities and Futures Contracts License

The NFA requires an individual to successfully complete the Series 3 in order to become qualified to sell commodities or futures contracts.  The exam is designed for anyone who is going to act as an Associated Person, Commodity Trading Advisor, Commodity Pool Operator, Introducing Broker, or Futures Commission Merchant.  [Note: under the forex registration rules, those managers who trade in the spot forex markets will soon also need to take the Series 3 and a new exam called the Series 34 exam.]  The Series 3 is also a prerequisite to the Series 30 Futures Branch Manager exam.

The Series 3 exam is required of individuals who conduct business with the public on the U.S. futures exchanges and:

  • offer or solicit business in futures or options on futures at a futures commission merchant (FCM) or introducing broker (IB) or who supervise any such person.
  • are associated with a commodity trading advisor (CTA) who solicits discretionary accounts or who supervises persons so engaged.
  • are associated with a commodity pool operator (CPO) who solicits funds for participation in a commodity pool or who supervises such persons.

Registration Process

The NFA Series 3 Exam is administered by FINRA. There is a two-step process that a candidate must complete to be able to take the Series 3 Exam.

Step 1 – The individual must apply with FINRA to take the exam by completing and submitting an application form and payment, or by submitting the application online. The testing application form can be downloaded from the FINRA’s web site. Effective January 2, 2009, the fee for an individual to take the Series 3 National Commodity Futures Examination will be $105.

Step 2 – Once the U10 registration has been approved and processed by FINRA, a Notice of Enrollment will be emailed to the candidate. FINRA will assign a 120-day window during which the exam can be scheduled and taken. The candidate may then contact their local test center to schedule an appointment to sit for the exam. Due to the many sessions administered at testing centers, the candidate should schedule test-taking as far in advance as possible to secure an appointment on the desired date.

Testing Locations

The exam is delivered via a computer system specifically designed for the administration and delivery of computer-based testing and training. Exams are given at conveniently located test centers worldwide and an appointment to take your exam can be scheduled online or by calling your local center. For a list of test centers in your area (U.S. and International) click here.

Series 3 Exam Overview

The Series 3 Exam for commodity futures brokers is divided into two parts – futures trading theory and market regulations. Each part must be passed with a score of at least 70 percent. There are 120 total multiple choice and true/false questions, and exam takers are provided 2 hours and 30 minutes to complete the exam. The Series 3 Exam also contains 5 additional experimental questions that do not count towards the exam taker’s score, and additional time is built into the exam to accommodate for these questions.

The Series 3 exam is divided into ten topics and is graded in two main parts: Market Knowledge and Rules/Regulations. The Market Knowledge part covers the first nine of the following topics, and  consists of 85 questions. The Rules/Regulations part covers category ten, and consists of 35 questions. You must achieve a 70% on each part in order to pass the exam.

Part 1: Market Knowledge – The first part of the Series 3 exam covers the basics of the futures markets. Exam takers will need to understand futures contracts, hedging, speculating, futures terminology, futures options, margin requirements, types of orders, basic fundamental analysis, basic technical analysis and spread trading.

Part 2: Rules/Regulations – The second part of the Series 3 exam consists of market regulations. Exam takers must familiarize themselves with relevant NASD rules and regulations for this part of the exam.

Exam Topics

  1. Futures Trading Theory
  2. Margins, Limits, Settlements
  3. Orders, Accounts, Analysis
  4. Basic Hedging
  5. Financial Hedging
  6. Spreads
  7. General Speculation
  8. Financial Speculation
  9. Options
  10. Regulations

Useful Terms to Know for the Series 3 Exam

Exam takers are expected to be familiar with the following terms and definitions prior to taking the Series 3 exam. The definitions presented below have been extracted from  Investopedia.

Bucketing: A situation where, in an attempt to make a short-term profit, a broker confirms an order to a client without actually executing it. A brokerage which engages in unscrupulous activities, such as bucketing, is often referred to as a bucket shop.

Delta: The ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative. Sometimes referred to as the “hedge ratio”.

Double Top: A term used in technical analysis to describe the rise of a stock, a drop, another rise to the same level as the original rise, and finally another drop.

First Notice Day: The first day that a notice of intent to deliver a commodity can be made by a clearinghouse to a buyer in fulfillment of a given month’s futures contract.

Intrinsic Value: 1. The actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Value investors use a variety of analytical techniques in order to estimate the intrinsic value of securities in hopes of finding investments where the true value of the investment exceeds its current market value. 2. For call options, this is the difference between the underlying stock’s price and the strike price. For put options, it is the difference between the strike price and the underlying stock’s price. In the case of both puts and calls, if the respective difference value is negative, the intrinsic value is given as zero.

Inverted Market: In the context of options and futures, this is when the current (or short-term) contract prices are higher than the long-term contracts.

Long Hedge: A transaction that commodities investors undertake to hedge against possible increases in the prices of the actuals underlying the futures contracts.

Offset: 1. To liquidate a futures position by entering an equivalent, but opposite, transaction which eliminates the delivery obligation.2. To reduce an investor’s net position in an investment to zero, so that no further gains or losses will be experienced from that position.

Scalpers: A person trading in the equities or options and futures market who holds a position for a very short period of time, attempting to make money off of the bid-ask spread.

Straddle: An options strategy with which the investor holds a position in both a call and put with the same strike price and expiration date.

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