Tag Archives: hedge fund

Net Capital Requirement for State Registered Hedge Fund Managers

Overview of Net Capital Requirement and Bond Alternative

Hedge fund managers who need to register as investment advisors in their state of residence often have to deal with the net capital requirement issue. Usually there will be two separate net capital requirements for the investment advisor (meaning the fund’s management company) depending on the nature of the advisor’s business:

Advisors with Discretionary Authority – $10,000
Advisors with Custody – $35,000

[Note: these requirements do not usually apply to forex hedge fund managers unless such managers are also registered as investment advisors.]

Generally all state-registered hedge fund managers will have discretionary authority of the hedge fund’s investments so most advisors will need to maintain the $10,000 requirement. Also, most hedge fund managers will also be deemed to have “custody” of the fund assets because they will either have direct access to the hedge fund’s bank account or because they will directly deposit their management fees from the fund’s brokerage account. Accordingly, most state-registered hedge fund managers will need to maintain the more burdensome $35,000 net capital requirement. There is no requirement to combine the $10,000 with the $35,000 for managers with both discretionary authority and custody – in these situations the manager will only need to maintain the $35,000.

Investment Advisor Bond

As an alternative to maintaining a firm net capital according to the rules above, some states will allow hedge fund managers to post a bond in the required amount instead. Not all states will allow a manager to post a bond instead, so you should be sure to talk with your hedge fund attorney or compliance professional before you begin the process of securing a bond.

Securing the Bond

There are a number of groups out there that can underwrite these sorts of bonds for the money managers. The fees for such bonds will be anywhere from $250 to $1,000, depending on a number of factors including the credit history of the managing member of the fund management company. It will generally take anywhere from a few days to a couple of weeks to secure the bond and from there, the manager will likely need to show proof to the state securities division that the bond has been secured in the appropriate amount.

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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. Cole-Frieman & Mallon LLP will also help state based Investment Advisors to register with their state securities division. If you are a hedge fund manager who is looking to start a hedge fund or an investment advisor looking to register, please call Mr. Mallon directly at 415-296-8510.

California Investment Advisor FAQ

2 Replies

California Based Hedge Fund Managers Receive Answers to Common Questions

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

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

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

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

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

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

2) How are “assets under management” determined?

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

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

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

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

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

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

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

(3)Management practices.

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

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

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

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

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

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

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

5) What is an “investment adviser representative?”

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

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

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

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

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

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

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

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

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

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

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

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

(1) Employment –

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Please refer to CCR Section 260.235.2 for more information.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Change in Form of Organization:

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

Change in Legal Status:

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

Change in Composition of a Partnership:

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

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

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

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

Acquisitions:

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

Consolidations:

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

Division of Dual Registrants:

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

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

22) What are my minimum financial requirements?

Investment advisers who:

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

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

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

24) How is financial net worth determined?

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

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

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

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

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

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

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

The submitted interim financial reports should contain:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Form ADV:

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

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

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

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

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

34) Who can be an independent party?

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

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

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

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

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

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

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

Hedge Funds with $25MM of AUM to Register Under Commissioner Aguilar’s Plan

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SEC Commissioner Aguilar Proposes Registration For Funds with as little as $25MM of AUM

Just today I had an opportunity to review the transcript of a speech by SEC Commissioner Aguilar in which he advocates that funds with as little as $25MM of AUM should register with the SEC. Such a low threshold for registration is troubling in a number of ways. Most importantly is the impact registration would have on the SEC immediately and in the future. As we have seen most vividly over the past year, the SEC is overextended and underfunded. The SEC’s ability to adequately deal with the 9,000 to 12,000 hedge funds which would come under its jurisdicition is suspect. Registration aside, how will an agency which was not able to sniff out a Bernie Madoff be able to oversee such a large industry without making it cost prohibitive for funds to operate? The money required to oversee these funds is likely to be substantial and will probably not be coming from Congress which means the cost of such a regulatory and oversight system will likely fall onto the managers themselves and then of course to the investors.

As we talk about regulation of the hedge fund industry, there is also the question of regulatory resources. Any future registration of hedge fund advisers and/or hedge funds will require that the SEC receive increased resources to provide effective oversight. We will need to hire staff and implementing new technology to effectively deal with a large and complex industry. To that end, I have previously called for Congress to pass legislation establishing the SEC as a self-funded agency, similar to the way other financial regulators are funded — such as the Federal Reserve Bank, the FDIC, OTS and OCC. This would help to solve the problem.

To the extent that funds are registering and reporting to the SEC, I encourage Congress to couple the authority increasing the SEC’s jurisdiction with the appropriate self-funding mechanism to allow us to provide effective oversight.

This is not to say I am not against reasonable, reasoned and fiscally responsible oversight and regulation. I believe that systemic stability is critically important for the long term viability of the hedge fund industry as well as the capital markets. In this vein, I think that Aguilar’s statement below represents the type of structures which would contribute to increased stability while minimizing regulation where it is not necessary.

Perhaps a tiered approach to registration, based on a fund’s potential to affect the market, would make sense. At the lowest tier would be small funds. These funds could be subject to a simple recordkeeping requirement as to positions and transactions, kept in a standardized format, to permit the SEC to efficiently oversee their activities. As funds grow in size, different standards may be appropriate.

While I do not agree with many of the points regarding regulation the Commissioner discussed in the speech reprinted below, I do believe that the Commissioner does a good job at identifying issues which should be discussed publicly as regulators and industry participants move towards creating a reasonable regulatory regime.

Please feel free to include your comments below.

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Speech by SEC Commissioner:
Hedge Fund Regulation on the Horizon — Don’t Shoot the Messenger
by

Commissioner Luis A. Aguilar

U.S. Securities and Exchange Commission
Spring 2009 Hedgeworld Fund Services Conference
New York, New York

June 18, 2009

Thank you for that kind introduction. I am pleased to be here with you at the Spring 2009 Hedgeworld Fund Services Conference. This conference is timely given the current discussion regarding potential regulation of the hedge fund industry. Let me say at the outset, as is customary, my remarks today are my own and do not necessarily reflect the views of my fellow Commissioners or of the Commission staff.

My experience with the securities industry began in the late 1970’s. After three years with the SEC, I’ve spent the bulk of my 30 years as a lawyer focusing on the capital markets. Most of those years where in private practices in large law firms, although I spent most of the 90’s and the early part of this decade as General Counsel and Head of Compliance of a large global asset manager. While I’ve spent much of my professional career involved in capital formation though public and private offerings, a substantial portion has been spent working in the investment management industry, and I have worked with hedge funds.

As we all know, there has been much speculation about the impact of hedge fund activity on the broader capital markets. For example, there are questions about whether hedge funds may have contributed to the market turmoil and how hedge funds may have contributed to the demise of Bear Stearns, Lehman Brothers and others. Additionally, it is also not clear whether the lack of oversight of the industry resulted in large amounts of risk to the market through the use of short sales and derivatives, such as credit default swaps.

This year’s conference takes place at a key moment in the history of hedge funds. While hedge funds have remained largely unregulated, this seems to be coming to an end. All over the world, legislators, regulators, investor groups, industry representatives and others are loudly calling for the industry to be regulated.

In the United States, the calls for regulation are motivated by concerns that market integrity has been harmed and that systemic risk arose as a result of the exemptions and exclusions from the federal securities laws that permitted a private market to thrive in ways that may have harmed the public markets. In fact, the market turmoil clearly demonstrated that the private fund market does impact the broader capital markets. This does not mean that all fund activity must be equally regulated, but hedge funds, especially large ones, are thought to require greater regulatory oversight.

My goal with my remarks today is to:

First, lay out a current state of affairs regarding the hedge fund industry;
Second, describe the calls for regulation of the industry; and
Third, discuss key considerations that need to be assessed as hedge fund regulation moves forward.

Multiple Voices Calling For Regulation

The hedge fund industry looks very different today than from where it started. Since the first hedge fund was organized by Alfred Jones in 1949 with $100,000, the industry has exponentially grown both in number of funds and in number of assets under management. In recent years, this growth has been fueled in part by institutional investors, such as endowments, foundations, insurance companies, and pension plans. To give you an idea of the growth, it is believed that the industry managed around $38 billion in 1990, $625 billion in 2002, and reached $1.9 trillion at the end of 2007, although that the number decreased to $1.3 trillion at the end of 2008. It is still incredible growth from the $100,000 start.

The industry’s growth, and the concerns over the impact of hedge funds on the marketplace, has created a renewed call for regulation in the U.S. and abroad. For example, the European Commission recently proposed to regulate the managers of hedge funds and all private equity funds with 100 million euros in assets under management. The proposed regulations would require extensive disclosure of risk management procedures and other aspects of fund governance.

In the U. S., a few years ago the SEC unsuccessfully attempted to regulate hedge funds. More recently, in March of this year, Treasury Secretary Timothy Geithner testified about his plan to more tightly oversee hedge funds. In addition, there recently have been at least a half-dozen bills introduced in Congress requiring regulation of the hedge fund industry. Just this past Tuesday, Senator Jack Reed introduced a bill that would require that advisers to hedge funds, and to certain other investment pools, to register with the SEC. And yesterday, of course, the Obama Administration released a draft white paper that, among other things, proposes that advisers to large hedge funds register with the SEC, and that very large advisers be subject to additional federal supervision by the Federal Reserve Board.

What are the concerns underlying the call for government oversight? I will tell you what we are hearing. The concerns touch on the classic financial regulatory interests: such as market integrity concerns, systemic risk concerns, and investor protection concerns. This state of affairs is what you would expect when markets are inextricably integrated and the impact of hedge funds is significant, but their actions and their risks are opaque. Simply stated, regulators, legislators and the public have little credible information as to who is out there and what they are doing.

Market Integrity Concerns

Let’s start with the SEC’s responsibility to maintain fair and orderly markets. One of the concerns about hedge funds involves how hedge fund operations impact upon the fairness and the integrity of the broader market. The lack of transparency and oversight over hedge funds gives rise to a number of concerns — for example, market integrity concerns about the nature and extent of counterparty risk, concerns about whether hedge funds engage in insider trading, and questions about how hedge funds drive the demand for derivatives, such as CDSs, as well as how they impact the demand for securitized products.

As a predicate for discussion, let’s be clear about the significant market activity of hedge funds. For example, hedge funds reportedly account for more than 85% of the distressed debt market, and more than 80% of certain derivatives markets. Moreover, although hedge funds represent just 5% of all U.S. assets under management, they account for about 30% of all U.S. equity trading volume. In 2006, there were estimates that hedge funds were responsible for as much as half of the daily trading volume on the New York Stock Exchange.

Because hedge funds are not subject to leverage or diversification requirements, hedge fund managers can more easily take concentrated positions that can impact the market. For example, an entire fund or even multiple funds advised by the same hedge fund manager can be invested in a single position.

In addition, hedge funds are major players in the capital markets for reasons other than trading activity. As this audience knows well, hedge funds have significant business relationships with the largest regulated commercial and investment banks — and act as trading counterparties for a wide range of OTC derivatives and other financing transactions.

Counterparty Risk Concerns

Clearly, for all these reasons and others, hedge funds are significant players in the capital markets. As significant players, hedge funds are one source of counterparty risk, and this risk can be amplified by their leverage and opacity.

Today, commercial banks and prime brokers are called upon to bear and manage the credit and counterparty risks that hedge fund leverage creates. Up until now, it has been assumed that market discipline would effectively prevent hedge funds from detrimentally impacting the capital markets or from posing systemic risk. A January 2008 GAO Report, however, identified several concerns with that theory.[1] For example, the report noted that hedge funds use multiple prime brokers and questioned whether any single prime broker has a complete picture of a hedge fund client’s total leverage. Accordingly, the stress tests and other tools that a prime broker uses to monitor a given counterparty’s risk profile only incorporate the positions known to that particular prime broker. Thus, no single prime broker has the whole picture.

The GAO Report also stated that some counterparties may lack the capacity to assess risk exposures because of the complex financial instruments and secret investment strategies that some hedge funds use.

Unfortunately, the GAO Report also indicates that counterparties facing these structural limitations may have also actively relaxed credit standards in order to attract and retain hedge fund clients in response to fierce competition.

In each of these instances, the risks of hedge funds are being externalized to the regulated market — prime brokers, banks, and their shareholders each were asked to bear the costs of managing hedge fund risks. A concrete example you may remember was when two Bear Stearns-sponsored hedge funds collapsed in 2007. Merrill Lynch, one of the prime brokers, had to absorb an enormous loss because it could only sell the funds’ collateral for a fraction of its purported value.

It’s been obvious that the regulatory oversight of hedge funds has not matched their level of market activity. This difference has led to other concerns affecting market integrity.

Risks of Insider Trading Create Market Wide Concerns

For example, in addition to concerns about counterparty risk, there have also been concerns about hedge funds engaging in insider trading. Clearly, there has been an increase in the number of insider trading cases brought by the Commission that have involved hedge funds. Admittedly, it is incredibly difficult for the Commission to assess the frequency of insider trading because of the opacity of hedge funds and the investments they make, especially in OTC derivatives. Moreover, when you couple this with the fragmented nature of the securities markets and the broad potential for hedge funds to obtain inside information, it is a tough oversight situation indeed. Hedge funds who participate in private placements, talk with trading desks, and maintain connections with the street are, in many cases, in a position to obtain inside information and to use it in a way that traditional surveillance may not detect. This potential for insider trading has been well publicized and public investors are concerned about the possible effects on market fairness and integrity.

Hedge Funds And The Demand For CDS and Securitized Products

Additionally, hedge funds were significant players in the exponential growth in the now much maligned credit default swaps market. As the market to create CDSs grew, there were funds that bought these instruments for reasons that made sense. For example, in 2005 there were hedge funds who noticed that the U.S. housing market was weakening and they bought CDS instruments on the protection buyer side. A logical move.

On the other hand, it is well known that the credit risk reflected by CDSs is equal to multiples of the actual credit risk of the underlying bond market. How did that happen? Many CDSs were heralded as hedging tools — they were supposed to transfer risk to parties that could bear it from parties that could not. Now we see only too clearly that this was not the case. Instead, many CDSs actually created risk, rather than hedged risk. Hedge funds that sought to create profits from leveraged risk may have played a crucial role driving the growth in these products.

Systemic Risks

The concerns about hedge funds and market integrity often go hand in hand with concerns about systemic risk. In their current form, hedge funds pose a systemic risk threat to our financial system in several ways. First, hedge funds have such significant assets under management that some fear that the loss of one or more large firms could potentially reverberate throughout the capital markets. In addition, if a counterparty fails to effectively withstand a hedge fund loss, then the failure of the counterparty could itself threaten market stability.

There is also the issue that can occur when several hedge funds take the same position, whether through coordination or simply through similar trading strategies. These funds can have a large impact on the market when they adjust their positions en masse.

Thus, the concerns that the lack of oversight over the hedge fund industry may present to market integrity and to systemic risks seem to be well founded.

Investor Protection

In addition to concerns about market integrity, the SEC is also responsible for investor protection. Given the increase in complaints from hedge fund investors this has taken on a more immediate importance.

One of the underlying principles behind the idea that hedge funds could operate with little to no regulatory requirements was that interests in the funds were only sold in private offerings to wealthy investors. These investors were thought to be sufficiently “sophisticated” to protect their interests, and to be able to engage in effective arms-length negotiation in order to achieve fair and equitable terms.

I firmly believe that truly sophisticated investors in private deals should be held accountable to the terms that they knowingly negotiate — and if an investment were to go bad, they should bear the loss.

However, with the recent market turmoil and the ongoing economic upheaval that has caused trillions in wealth to vanish, millions of jobs to disappear and the liquidation of over 1,500 hedge funds, serious concerns have been raised about whether these wealthy and sophisticated investors are truly able to protect their interests. There seems to be evidence that these “sophisticated investors” may not have fully appreciated the risks they were taking. Perhaps it may make sense for the definitions of who qualifies as “sophisticated” under our rules to be reconsidered. For example, maybe the criteria for sophistication should focus on more relevant attributes — such as focusing on actual investment experience.

In any case, recent events have challenged the assumption that investors and market discipline can be relied upon to control the risks of hedge funds. And this is not surprising. First, these investors are typically passive and there is no legal obligation for hedge fund investors to monitor hedge fund activity. Second, even if investors wanted to actively monitor the investment, the nature of hedge fund activity and the information available may not currently support such a role.

Valuation and Performance

For example, it may be impossible for an investor to know the actual value of a hedge fund’s portfolio. Hedge funds are not subject to reporting requirements and because many instruments held by a hedge fund are illiquid or opaquely-priced OTC products, any information that is reported could be hard to evaluate.

Related to the concern of how a fund values its assets, is a hedge fund’s performance information — another hard to evaluate metric for investors. Without regulation, the only performance information that hedge funds provide is voluntary.

This quote by Harry Liem, a pension consultant, seems to sum it up when he said “It’s like someone walking into a casino and saying ‘I want everyone to come forward and tell me how much you have won or lost.’ Probably only the winners will come forward . . .”[2]

Not Being Able to Redeem

There is also the issue of investors not being able to redeem their investments from a fund. In recent times, due to the large amount of redemption requests and the current lack of an ability to raise cash, there are hedge fund managers who have put up gates and have restricted investors’ ability to redeem their monies. Although gates can benefit investors by giving the manager more time to sell off portfolio positions, for some investors it appeared to be a surprise.

On top of that, several hedge fund managers froze funds but continued to charge management fees on money that investors cannot access. Orin Kramer, a hedge fund manager, described the situation by stating: “It’s like telling someone at a hotel that they can’t check out and then charging them for the privilege of staying.”[3]

Let me be clear. I’m not saying that these situations are per se illegal. To the extent that sophisticated and qualified investors agreed to provisions providing for gates and the ongoing charge of management fees, one could say that investors walked into these agreements with open eyes.

However, because for the most part hedge funds are not registered with the SEC, we are not able to adequately oversee how they are operating. Moreover, this lack of transparency makes it difficult to assess whether the relationship between an investor and the hedge funds adviser, is functioning in the manner that underlie the presumptions that led to the exemptions.

Some recent reports do tend to show that investors are beginning to take their own initiatives, and give some indication that what investors may be willing to agree to in the future may be different. For example, a recent memo from CalPERS stated that it would no longer partner with managers whose fee structures result in a clear misalignment of interest between managers and investors. Moreover, more investors are now asking that hedge funds run assets in “managed accounts,” where their money is held separately and the holdings are transparent.

As you may expect based on concerns including ones I have mentioned, hedge fund investors have been calling the Commission in unprecedented numbers

Increased Cases Involving Hedge Funds

In fact, the Commission has more investigations involving hedge funds than ever before, and the number of cases actually brought also is increasing. In the first 4 months of 2009, the Commission filed 25 cases related to hedge funds. In contrast, we brought 19 cases in all of 2008, 24 in all of 2007, and 16 in 2006. Our cases cover the waterfront, charging everything from offering fraud and insider trading, to misrepresentations about performance and to misrepresentations about the actual due diligence undertaken. We are also seeing more cases involving conflicts of interest and outright theft of assets

Nature of Regulation

I have just laid out for you some of the concerns that are generally driving the calls for greater regulation and oversight of the hedge fund industry. Maybe even more important, it appears that some of the assumptions justifying the industry’s exclusion from regulation and oversight may be on faulty ground. As a result, it seems certain that regulation of the hedge fund industry is coming. But here is the harder question — what should it look like?

There are a number of questions as to exactly how, and to what extent, hedge funds may have contributed to the economic crisis and how they contributed to the overall systemic risk of the financial markets. To that end, I applaud Congress and President Obama for providing for an independent, bi-partisan Financial Crisis Inquiry Commission. By investigating and analyzing what happened, we can better assess whether the regulatory proposals should move forward.

Since coming to the Commission, I have been a vocal advocate for the Commission’s mission to protect investors, provide for fair and orderly markets, and promote capital formation. All aspects of this mission guide my thoughts as we consider the appropriate framework to regulate hedge funds.

Because of the size, complexity and market-wide impact of the hedge funds industry, potential regulation would need to be both comprehensive and flexible. Something not always easy to achieve.

I believe that the SEC must be an active participant in this process. Please remember that the SEC has been overseeing industry participants — such as, investment companies, investment advisers and broker-dealers — for over 69 years. The Commission staff has unsurpassed expertise in this area. Congress should take advantage of this expertise by providing the Commission with a broad mandate to oversee hedge funds. The Commission could then scale its regulation in a flexible manner to deal with the regulatory concerns of market integrity, investor protection, and, in coordination with other regulators, systemic risk.

Working with hedge fund advisers and with hedge fund investors, I am confident that we can find an appropriate balance.

As you know, there has been a general discussion over whether hedge fund advisers and/or hedge funds should register. In my mind, hedge funds advisers with over $25 million in assets should register with the Commission, but that may not be enough. Many hedge fund advisers are currently registered with the SEC but we still lack a complete picture of what is going on in the industry. Some have suggested that hedge funds should also register. Others have suggested that it may be appropriate to apply limited concepts from within the Investment Company Act of 1940 to hedge funds — what some have called a “40 Act-lite” regime.

Perhaps a tiered approach to registration, based on a fund’s potential to affect the market, would make sense. At the lowest tier would be small funds. These funds could be subject to a simple recordkeeping requirement as to positions and transactions, kept in a standardized format, to permit the SEC to efficiently oversee their activities. As funds grow in size, different standards may be appropriate.

For funds that could significantly affect the market, it may be appropriate to require more than recordkeeping. For example, it may be appropriate to think through whether some of the risk limitation concepts built into the Investment Company Act make sense to apply to these hedge funds — such as imposing limits on leverage.

Of course, these are only a few suggestions. Many others have been made — and others will follow — as the discussion turns from “whether to regulate” to “how to regulate.” The nature of the business of hedge funds is trading, and this necessarily requires interaction with the public marketplace — and the larger the investment fund, the greater the potential impact on the overall capital markets. When the hedge industry has the ability to significantly impact the market or other market participants, the public interest needs to be protected. A lesson of this economic crisis is that the U.S. regulatory interest in hedge funds arises because of the impact of the funds on the financial market, regardless of the sophistication of its investors or the number of investors.

When discussing “how to regulate,” it is clear to me that regulation is more than the bare requirements of registering and reporting — it should also include inspection authority. To have a chance to prevent problems before they occur, the SEC has to be able to inspect all hedge fund advisers, and the funds that they manage, and otherwise engage in oversight through surveillance systems. The public expects nothing less.

Greater Resources to SEC to Provide Effective Oversight

As we talk about regulation of the hedge fund industry, there is also the question of regulatory resources. Any future registration of hedge fund advisers and/or hedge funds will require that the SEC receive increased resources to provide effective oversight. We will need to hire staff and implementing new technology to effectively deal with a large and complex industry. To that end, I have previously called for Congress to pass legislation establishing the SEC as a self-funded agency, similar to the way other financial regulators are funded — such as the Federal Reserve Bank, the FDIC, OTS and OCC. This would help to solve the problem.

To the extent that funds are registering and reporting to the SEC, I encourage Congress to couple the authority increasing the SEC’s jurisdiction with the appropriate self-funding mechanism to allow us to provide effective oversight.

Conclusion

In conclusion, I am confident that regulation of the hedge fund industry can be done right — in a way that balances the needs of the industry with the needs of investors and the needs of the market. And if it is, it will be a good thing for all of us. The Congressional Oversight Panel’s Special Report on Regulatory Reform4 said it best with the following summary:

“By limiting the opportunities for deception and allowing for the necessary trust to develop between interconnected parties, regulation can enhance the vitality of the markets. Historically, new regulation has served that role.
For example, as the money manager Martin Whitman has observed, far from stifling the markets, the new regulations of the Investment Company Act enabled the targeted industry to flourish:

“’Without strict regulation, I doubt that our industry could have grown as it has grown, and also be as prosperous as it is for money managers. Because of the existence of strict regulation, the outside investor knows that money managers can be trusted. Without that trust, the industry likely would not have grown the way it had grown.’”[5]

The lack of transparency, potential imbalance of power between investors and managers, and impact on the entire capital market are driving the calls to regulate the hedge fund industry. The hedge fund industry has a lot to offer in determining how these calls are answered. Addressing these issues in an intelligent and rational manner is important, and ultimately will result in a stronger and more vibrant hedge fund industry. I welcome the ongoing discussion.

Thank you for inviting me here today.

Endnotes

[1] GAO Report: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention is Needed. January 2008. pg 27.

[2] Why people love to hate those risky hedge funds; An investment option that only the super rich can afford, by Naomi Rovnick. South China Morning Post Ltd. March 1, 2009.

[3] Hedge Funds, Unhinged by Louise Story. New York Times. January 18, 2009.

[4] Congressional Oversight Panel’s Special Report on Regulatory Reform: Modernizing the American Financial Regulatory System: Recommendations for Improving Oversight, Protecting Consumers, and Ensuring Stability. January 2009. pgs 18-19

[5] Letter from Third Avenue Funds Chairman of the Board Martin J. Whitman to Sharheolders, at 6 (Oct. 31, 2005) (online at www.thirdavenuefunds.com/ta/documents/sl/shareholderletters-05Q4.pdf).

http://www.sec.gov/news/speech/2009/spch061809laa.htm

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

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

Consumer Financial Protection Agency Act of 2009

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As part of the new Obama financial regulation plan, which includes potentially the registration of hedge fund managers with the SEC, the Whitehouse has sent a draft to congress of the new Consumer Financial Protection Agency Act of 2009 (CFPAA of 2009). The act would create a new government agency which would have some interaction with both the SEC and the CFTC. A full version of the draft can be found here: Consumer Financial Protection Agency Act of 2009. Additionally, you can find President Obama’s statement with regard to this new agency reprinted below. For more information, please also see Jim Hamilton’s website.

More posts about this new act and what it will mean to hedge funds will be forthcoming.

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THE WHITE HOUSE

Office of the Press Secretary
EMBARGOED UNTIL 6:00 AM ET,

SATURDAY, June 20, 2009

WEEKLY ADDRESS: President Obama Highlights Tough New Consumer Protections

WASHINGTON – In his weekly address, President Barack Obama explained the necessity of his proposed Consumer Financial Protection Agency. It is clear that one of the major causes of the current economic crisis was a breakdown of oversight leading to widespread abuses in the financial world. The Consumer Financial Protection Agency will have the sole job of looking out for the financial interests of ordinary Americans by banning unfair practices and enforcing the rules. This is the type of reform that will attack the causes of the current crisis and prevent further crises from taking place.

The audio and video will be available at 6:00am Saturday, June 20, 2009 at www.whitehouse.gov.

Prepared Remarks of President Barack Obama
Weekly Address
June 20, 2009

As we continue to recover from an historic economic crisis, it is clear to everyone that one of its major causes was a breakdown in oversight that led to widespread abuses in the financial system. An epidemic of irresponsibility took hold from Wall Street to Washington to Main Street. And the consequences have been disastrous. Millions of Americans have seen their life savings erode; families have been devastated by job losses; businesses large and small have closed their doors.

In response, this week, my administration proposed a set of major reforms to the rules that govern our financial system; to attack the causes of this crisis and to prevent future crises from taking place; to ensure that our markets can work fairly and freely for businesses and consumers alike.

We are going to promote markets that work for those who play by the rules. We’re going to stand up for a system in which fair dealing and honest competition are the only way to win. We’re going to level the playing field for consumers. And we’re going to have the kinds of rules that encourage innovations that make our economy stronger – not those that allow insiders to exploit its weaknesses for their own gain.

And one of the most important proposals is a new oversight agency called the Consumer Financial Protection Agency. It’s charged with just one job: looking out for the interests of ordinary Americans in the financial system. This is essential, for this crisis may have started on Wall Street. But its impacts have been felt by ordinary Americans who rely on credit cards, home loans, and other financial instruments.

It is true that this crisis was caused in part by Americans who took on too much debt and took out loans they simply could not afford. But there are also millions of Americans who signed contracts they did not always understand offered by lenders who did not always tell the truth. Today, folks signing up for a mortgage, student loan, or credit card face a bewildering array of incomprehensible options. Companies compete not by offering better products, but more complicated ones – with more fine print and hidden terms. It’s no coincidence that the lack of strong consumer protections led to abuses against consumers; the lack of rules to stop deceptive lending practices led to abuses against borrowers.

This new agency will have the responsibility to change that. It will have the power to set tough new rules so that companies compete by offering innovative products that consumers actually want – and actually understand. Those ridiculous contracts – pages of fine print that no one can figure out – will be a thing of the past. You’ll be able to compare products – with descriptions in plain language – to see what is best for you. The most unfair practices will be banned. The rules will be enforced.

Some argue that these changes – and the many others we’ve called for – go too far. And I welcome a debate about how we can make sure our regulations work for businesses and consumers. But what I will not accept – what I will vigorously oppose – are those who do not argue in good faith. Those who would defend the status quo at any cost. Those who put their narrow interests ahead of the interests of ordinary Americans. We’ve already begun to see special interests mobilizing against change.

That’s not surprising. That’s Washington.

For these are interests that have benefited from a system which allowed ordinary Americans to be exploited. These interests argue against reform even as millions of people are facing the consequences of this crisis in their own lives. These interests defend business-as-usual even though we know that it was business-as-usual that allowed this crisis to take place.

Well, the American people did not send me to Washington to give in to the special interests; the American people sent me to Washington to stand up for their interests. And while I’m not spoiling for a fight, I’m ready for one. The most important thing we can do to put this era of irresponsibility in the past is to take responsibility now. That is why my administration will accept no less than real and lasting change to the way business is done – on Wall Street and in Washington. We will do what is necessary to end this crisis – and we will do what it takes to prevent this kind of crisis from ever happening again.

Thank you.

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

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

Hedge Fund Law Blog Statistics | June 2009

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Most Read Hedge Fund Law Articles for June

I wanted to take a little time to thank all of the people who read this blog and who take the time to comment on articles or send me questions – your interaction helps make this site more informative and a better resource for everyone. If you have any questions related to any of the articles, I ask you send them to me through the contact form. If you have an RSS reader, please consider subscribing to the hedge fund law RSS feed to stay up to date on the new content posted in this site.

Hedge Fund Visitors for June 2009

According to Google Analytics, the following is the information on the number and people who have visited the website during the past month:

Visits – 14,744 (of these 10,472 were new visitors)
Absolute Unique Visitors – 11,415
Pageviews – 33,031
Top Nations – United States, United Kingdom, India, Canada, Hong Kong, Switzerland, France, Australia, Singapore, Germany

Top 10 Hedge Fund Law Stories for June 2009

According to Google Analytics, the following is a list of the most popular hedge fund articles for the month of June:

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

Hedge Fund Domain Names

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Picking a domain name for your hedge fund website

Start up hedge fund managers always have the difficult task of thinking up a new, good names for their management company and hedge fund (see Naming Your Hedge Fund). This difficulty is compounded by the fact that the desired name may not be available to use in the state which the management company resides (or with regard to the fund, in Delaware). An added difficulty is thinking of a name that also has a good available website domain available.

Why Have a Hedge Fund Website?

Website domains are now an integral part of the hedge fund package. Hedge fund investors are becoming more technology savvy and many communications can be done over the internet or through a website. This means that the process of setting up a fund can potentially be more demanding (depending on the launch and the needs of the potential hedge fund investors) – not only must managers have all of the back end business operations and legal infrastructure in place, but the manager must also understand, implement and maintain an appropriate web presence. The foundation for a strong web presence starts with the domain name.

Finding a Hedge Fund Domain Name

While we would all love to have a great one word domain name, it probably is not going to happen (unless you want to shell out a ton of cash). Even good two word domain names are going to be taken. To find out if a desired domain name is taken, you can go to any domain agent like www.godaddy.com. If you search for your domain and don’t find what you are looking for, there are a couple of different options to get a domain you are happy with –

1. Modify your search parameters – if the domain you are trying to get is taken, you can change the wording of the name you are looking for. If you cannot find a suitable

Company name: XYZ Capital Management, LLC
Desired domain: www.xyz.com (not available)
Other options: www.xyzcapital.com, www.xyzcapitalmanagement.com, www.xyzcapitalmangementcompany.com, www.xyzcapmanagement.com, www.xyzcapitalmgmt.com, www.xyzcapmgmt.com

For other thoughts on changing the name or spelling, see this Business Week article on company domain names.

2. Buy the desired domain name – if the domain name is taken by a person or a company, you can contact that person or company directly or through a domain agent and try to purchase the domain. I would expect that for a good domain name it will cost at least $2,000 upwards to $10,000. Premium names of course can be sold for much higher amounts. There are also a number of groups out there which domain squat – one group that has a number of hedge fund management company domain names is www.namethat.com.

Other notes

Price – the domain name will cost about $10 a year from a group like GoDaddy.
Length of time – I recommend buying a domain name for long period of time. I would say the minimum length should be 5 years.
.com or .net? – always go with a .com domain name
Compliance – there are no compliance issues which jump out at me right away, but I will keep thinking of this issue. Obviously if you host a website at the domain you will need to make sure that all marketing done is within the rules, see Hedge Fund Website Rules
Hosting – there are a number of ways you can host your domain name and I will be dealing with this issue in a later article on technology for hedge fund managers

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

Hedge Fund Regulation Principles

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IOSCO Pushes Securities Regulators to Adopt Registration Provisions

Over the past few months we have been highlighting the Congressional attempts to regulate and/or register hedge funds and more recently have discussed the Obama hedge fund registration plan. However, we have not discussed what is happening internationally. Like the in the US, other major financial centers around the world have suffered from the economic downturn and have begun looking towards greater regulation of the financial system – this of course means greater regulation of hedge funds and registration for hedge fund managers.

There has been much discussion, both in the US and abroad, about world-wide principles for regulation. There would be obvious benefits for some sort of international standards for all parts of the financial system, but there would need to be an unprecedented amount of cooperation between the various financial regulatory agencies which seems like an insurmountable task. However, one group, the International Organization of Securities Commissions’ (IOSCO), is doing its best to act as a sort of communicator of best practices that financial regulatory systems should integrate into new regulations which are expected to be proposed in many jurisdictions.

Below I have published a press release announcing the IOSCO’s report on hedge fund oversight. The full 26 page report, IOSCO Hedge Fund Regulation Report, tackles some of the high level issues which regulatory bodies should consider when drafting new hedge fund regulations. It will be interesting to see how this report is received in the different jurisdictions throughout the world.

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IOSCO/MR/12/2009
Madrid, 22 June 2009

IOSCO publishes principles for hedge funds regulation

The International Organization of Securities Commissions’ (IOSCO) Technical Committee has today published Hedge Funds Oversight: Final Report which contains six high level principles that will enable securities regulators to address, in a collective and effective way, the regulatory and systemic risks posed by hedge funds in their own jurisdictions while supporting a globally consistent approach.

The report, which was prepared by the Task Force on Unregulated Entities (Task Force), recommends that all securities regulators apply the principles in their regulatory approaches.

The six high level principles are:

Hedge funds and/or hedge fund managers/advisers should be subject to mandatory registration;
Hedge fund managers/advisers which are required to register should also be subject to appropriate ongoing regulatory requirements relating to:
1. Organisational and operational standards;
2. Conflicts of interest and other conduct of business rules;
3. Disclosure to investors; and
4. Prudential regulation.
Prime brokers and banks which provide funding to hedge funds should be subject to mandatory registration/regulation and supervision. They should have in place appropriate risk management systems and controls to monitor their counterparty credit risk exposures to hedge funds;
Hedge fund managers/advisers and prime brokers should provide to the relevant regulator information for systemic risk purposes (including the identification, analysis and mitigation of systemic risks);
Regulators should encourage and take account of the development, implementation and convergence of industry good practices, where appropriate;
Regulators should have the authority to co-operate and share information, where appropriate, with each other, in order to facilitate efficient and effective oversight of globally active managers/advisers and/or funds and to help identify systemic risks, market integrity and other risks arising from the activities or exposures of hedge funds with a view to mitigating such risks across borders.

Kathleen Casey, Chairman of the Technical Committee, said:

“Securities regulators recognise that the current crisis in financial markets is not a hedge fund driven event. Hedge funds contribute to market liquidity, price efficiency, risk distribution and global market integration. Nevertheless the crisis has given regulators the opportunity to consider the systemic role hedge funds may play and the way in which we deal with the regulatory risks they may pose to the oversight of markets and protection of investors.

“The application of these principles, in a collective, cooperative and efficient way, can provide regulators with the tools to obtain sufficient, relevant information in order to address the regulatory and systemic risks posed by hedge funds.”

The Task Force was chaired by the CONSOB of Italy and the Financial Services Authority of the United Kingdom. It was established in November 2008 to support the initiatives undertaken by the G-20 to restore global growth and achieve reforms in the world’s financial systems.

The Task Force will continue to work to support the implementation of these standards by its members and to deal with future regulatory issues that may arise in relation to hedge funds. It will act as the contact point with prudential regulators and banking standards setters, as well as other regulatory bodies such as the Joint Forum and the hedge fund industry in relation to the development and implementation of industry standards of best practice.

NOTES FOR EDITORS

1. Hedge Funds Oversight – Final Report of the Technical Committee of IOSCO is available on IOSCO’s website.

2. Hedge Funds Oversight – Consultation Report of the Technical Committee of IOSCO was published on 30 April 2009.

3. IOSCO is recognized as the leading international policy forum for securities regulators. The organization’s wide membership regulates more than 95% of the world’s securities markets and IOSCO is the international cooperative forum for securities regulatory agencies. IOSCO members regulate more than one hundred jurisdictions and its membership is steadily growing.

4. The Technical Committee, a specialised working group established by IOSCO’s Executive Committee, is made up of eighteen agencies that regulate some of the worlds larger, more developed and internationalized markets. Its objective is to review major regulatory issues related to international securities and futures transactions and to coordinate practical responses to these concerns. Ms. Kathleen Casey, Commissioner of the United States Securities and Exchange Commission is the Chairman of the Technical Committee. The members of the Technical Committee are the securities regulatory authorities of Australia, Brazil, China, France, Germany, Hong Kong, India, Italy, Japan, Mexico, the Netherlands, Ontario, Quebec, Spain, Switzerland, United Kingdom and the United States.

5. IOSCO aims through its permanent structures:

to cooperate together to promote high standards of regulation in order to maintain just, efficient and sound markets;
to exchange information on their respective experiences in order to promote the development of domestic markets;
to unite their efforts to establish standards and an effective surveillance of international securities transactions;
to provide mutual assistance to promote the integrity of the markets by a rigorous application of the standards and by effective enforcement against offenses.

MEDIA ENQUIRIES
Greg Tanzer
Direct Line + 34 91 417 5549
Email: [email protected]
Website: www.iosco.org

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Other related hedge fund law articles include:

Forex Trading Software | Meta Trader 4

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(www.hedgefundlawblog.com)

Meta Trader 4 – Online Forex Trading Platform

Meta Trader 4 is an online trading complex designed to provide broker services to customers at forex, futures and CFD markets. This is a whole-cycle complex, which means that the trader will not need any other software to organize his/her broker services when using Meta Trader 4. The platform includes all necessary components for brokerage services via internet including the back office and dealing desk. Currently, over 250 brokerage companies and banks worldwide have chosen this solution to meet their high standards of business performance.

The different functions and options of this system, allow great flexibility in trading. The MetaQuotes Language 4 allows users to incorporate their own strategies through the Expert Advisors, enabling the markets to be monitored automatically so not requiring constant supervision. The standard list of technical indicators may be expanded with the opportunity to add custom indicators as needed, and real time demos are accessible through more than 35 brokerages free of charge.

Meta Trader 4 attempts to supply the sufficient information and tools in order to make the Forex traders’ decisions more appropriate and easy. The program has a simple and user friendly interface that allows traders to monitor their transactions and their account as well as performing technical analysis and develop Forex trading strategies of their own. In addition, the platform provides continuous real-time information and sophisticated technical analysis tools.

The cost of Meta Trader 4 is substantially lower than the alternative cost of creating a similar product, and is therefore a viable financial proposition to most financial institutions. Installation of the system into the full operational mode will take no more than one day, therefore saving a considerable amount of time for end users.

MetaTrader 4 is a premier business solution for broker companies, banks, financial companies, and dealing centers. In addition to the points discussed above, the main advantages of the system are:

1. Coverage of financial markets

The trading platform MetaTrader 4 covers all brokerage and trading activities at Forex, Futures and CFD markets.

2. Multicurrency basis:

The system is designed on a multicurrency basis. It means that any currency can serve as a general currency used in the operation of the whole complex in any country and with any national currency.

3. Economy and productivity:

Implemented data transfer and processing protocols are notable for their economy. It makes it possible to support several thousands of traders through a single server with the following configuration: Pentium 4 2 GHz, 512 DDR RAM, 80 GB HDD. New protocols reduce both the demands on datalink and their operational cost.

4. Reliability:

In the case of damage to the historical data, the complex has backup and restoration systems. Also, the implemented synchronization allows to restore damaged historical databases within several minutes with the help of another MetaTrader 4 server.

5. Safety:

To provide safety, all the information exchanged between parts of the complex is encrypted by 128-bit keys. Such solution guarantees safekeeping of information transferred and leaves no chance for a third person to use it. A built-in DDoS-attacks guard system raises the stability of operation of the server and the system as a whole.
A new scheme of system working operation was created especially for DDoS-attacks resistance. With its help, you can hide the real IP-address of the server behind a number of access points (Data Centers). Data Centers also have a built-in DoS-attacks protection system; they can recognize and block such attacks. During distributed attacks at the system, only Data Centers are attacked; MetaTrader 4 Server continues its operation in regular mode. Thus, Data Centers increase the system’s stability to DoS and DDoS attacks.
The implemented mechanisms of rights sharing make it possible to organize the security system with more effectiveness and to reduce the probability of ill-intentioned actions of company staff.

6. Multilingual support:

MetaTrader 4 supports different languages, and a MultiLanguage Pack program is included into distributive packages. It provides translation of all program interfaces into any language. With the help of MultiLanguage Pack you can easily create any language and integrate it into the program. This feature of the system will bring MetaTrader 4 nearer to end-users in any country of the world.

7. Application Program Interfaces:

MetaTrader 4 Server API makes it possible to customize the work of platform to meet your requirements. API can solve a wide range of problems:

– creating additional analyzers for finding a trend of monthly increase of traders;
– creating applications of integration into other systems;
– extending the functionality of the server;
– implementing its own system work control mechanisms;
– and do much more.

8. Integration with web-services:

To provide traders with services of higher quality, the system supports the integration with web services (www, wap). This feature allows real-time publishing of quotations and charts on your site, dynamic tables containing contest results and much more.

9. Flexibility of the system:

The platform possesses a wide range of customizable functions. You can set all parameters, from trade session time to detailed properties of financial instruments of each user groups.

10. Subadministration:

Subadministration mechanisms allow leading many Introducing Brokers on one server quite easily. For processing all accounts and orders of the clients of your IBs, you will need one server only.

Overall, the newly released Meta Trader 4 platform is equipped to address a full range of account management needs and serves as a user-friendly front-end trading interface for dealings in the Forex, CFD, and futures markets.

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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:

Forex Hedge Fund Articles
Forex Hedge Fund Overview
Forex Registration Requirements (please also see our other website on Forex Registration)
Forex Disclosure Documents Part I
Due Diligence
Offshore hedge fund considerations

CFTC Chairman Speaks to MFA

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Chairman Gary Gensler Discusses Over-the-Counter Derivatives Regulation and Hedge Funds

CFTC Chairman Gary Gensler has been busy lately testifying before Congress and now speaking to the Managed Futures Association. His remarks to the MFA, which can be found here and which are reprinted in full below, mirror his earlier statements to the Congress regarding the regulation of OTC derivates and hedge fund registration (see Congress and Regulators Discuss OTC Derivatives). Gensler’s comments are generally seen as reasonable but aggressive and we are seeing an increase in the political power of the CFTC in general and vis-a-vis the SEC (with respect to certain issues at least). I am very interested in how these issues will play out in the political process over the next few month.

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Commodity Futures Trading Commission
Office of External Affairs
Three Lafayette Centre
1155 21st Street, NW
Washington, DC 20581
202.418.5080

Remarks of Chairman Gary Gensler Before the Managed Funds Association, Chicago, Illinois

June 24, 2009

Thank you for that introduction, Richard. I greatly appreciate the invitation to speak to the Managed Funds Association at this critical time in our nation’s economy. The last time the two of us were together with a crowd of this size, I was testifying as an Undersecretary at the Department of the Treasury before your Committee in the U.S. House of Representatives. Once again, we’re together discussing challenges facing our financial system and possible solutions.

As President Obama announced exactly one week ago, we must urgently enact broad regulatory reforms of our financial system. The President’s proposal offers bold reforms seeking to prevent the financial breakdowns that led to our current crisis. It is sweeping in scope, cutting across the financial system to provide greater oversight, transparency and accountability.

Today I would like to focus on two key areas: regulation of over-the-counter derivatives and hedge funds.

Over-the-Counter Derivatives

We must establish a regulatory regime to cover the entire over-the-counter derivatives marketplace.
This will help the American public by: One – lowering systemic risk. Two – providing transparency and efficiency in markets. Three – ensuring market integrity by preventing fraud, manipulation, and other abuses. And four – protecting the retail public.

This new regime should govern 100% of OTC derivatives no matter who is trading them or what type of derivative is traded, standardized or customized. That includes interest rate swaps, currency swaps, commodity swaps, equity swaps, credit default swaps or those which cannot yet be foreseen.

I envision this will require two complementary regimes — one for regulation of the dealers and one for regulation of the market functions. Together, with both of these, we will ensure that the entire derivatives marketplace is subject to comprehensive regulation.

The current financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system. The costs to the public from the failure of these firms has been staggering, $180 Billion of American taxpayer financial support for AIG alone. The AIG subsidiary that dealt in derivatives – AIG Financial Products –was not subject to any effective federal regulation. Nor were the derivatives dealers affiliated with Lehman Brothers, Bear Stearns, and other investment banks. As such, all derivatives dealers need to be subject to robust federal regulation.

Regulation of the dealers should set capital standards and margin requirements to lower risk. We also must set business conduct standards. These standards would guard against fraud, manipulation, and other market abuses. Additionally, they would lower risk by setting important back office standards for timely and accurate confirmation, processing, netting, documentation, and valuation of all transactions. Lastly, we must also mandate recordkeeping and reporting to promote transparency and to allow the CFTC and SEC to vigorously enforce market integrity.

By fully regulating the institutions that trade or hold themselves out to the public as derivative dealers we ensure that all OTC products, both standardized and customized, are subject to robust oversight. Particular care should be given to ensure that no gaps exist between the regulation of standardized and customized products. Customized derivatives, though allowed, would be subject to capital, margin, business conduct and reporting standards. Customized derivatives, however, are by their nature less standard, less liquid and less transparent. Therefore, I believe that higher capital and margin requirements for customized products are justified.

Beyond regulating the dealers, I believe that we must mandate the use of central clearing and exchange venues for all standardized derivatives. Derivatives that can be moved into central clearing should be cleared through regulated central clearing houses and brought onto regulated exchanges or regulated transparent electronic trading systems.

Requiring clearing will promote market integrity and lower risks. Individual firms will become less interconnected as OTC transactions are netted out through centralized clearing. Furthermore, mandated clearing will bring the discipline of daily valuation of transactions and the posting of collateral.

I also would like to highlight three essential features for OTC central clearinghouses:

Governance arrangements should be transparent and incorporate a broad range of viewpoints from members and other market participants,
Central counterparties should be required to have fair and open access criteria that allow any firm that meets objective, prudent standards to participate regardless of whether it is a dealer or a trading firm, and
Finally, in order to promote clearing and achieve market efficiency through competition, OTC derivatives should be fungible and able to be transferred between one exchange or electronic trading system to another.

Market transparency and efficiency would be further improved by requiring the standardized part of the OTC markets onto fully regulated exchanges and fully regulated transparent electronic trading systems. Experience has shown that President Franklin Roosevelt’s approach is correct. To function well, markets must be properly-regulated and transparent. They simply cannot police themselves nor remain in the dark.

Regulated exchanges and regulated transparent trading systems will bring much needed transparency to OTC markets. Market participants should be able to see all of the bids and offers. A complete audit trail of all transactions on the exchanges or trade execution systems should be available to the regulators. Through a trade reporting system there should be timely public posting of the price, volume and key terms of completed transactions.

Market regulators should have authority to impose recordkeeping and reporting requirements and to police the operations of all exchanges and electronic trading systems to prevent fraud, manipulation and other abuses.

The CFTC should have the ability to impose position limits, including aggregate limits, on all persons trading OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets that the CFTC oversees. Such position limit authority should clearly empower the CFTC to establish aggregate position limits across markets in order to ensure that traders are not able to avoid position limits in a market by moving to a related exchange or market, including international markets.

To fully achieve these objectives, we must enact both of these complementary regimes. Regulating both the traders and the markets will ensure that we cover both the actors and the stages that may create significant risks.

Hedge Funds

The second topic that I would like to discuss is regulation of hedge funds. President Obama has called for advisers to hedge funds and other investment funds to register with the SEC under the Investment Advisers Act. Advisers should be required to report information on the funds they manage that is sufficient to assess whether any fund poses a threat to financial stability.

The Commodity Exchange Act (CEA) currently provides that funds trading in the futures markets register as Commodity Pool Operators (CPO) and file annual financials with the CFTC. Over 1300 CPOs, including many of the largest hedge funds, are currently registered with and make annual filings to the CFTC. It will be important that the CFTC be able to maintain its enforcement authority over these entities as the SEC takes on important new responsibilities in this area.

This financial crisis also gave new meaning to the term “run on the bank”. Upon hearing those words, most of us would conjure up the image of the citizens of Bedford Falls standing outside George Bailey’s Savings and Loan in the movie It’s a Wonderful Life. Last year, we witnessed the modern version of this in a number of ways. A harsh lesson of the crisis occurred when a significant number of hedge funds sought to pull securities and funds from their prime brokers, contributing to uncertainty and the destabilization of the financial system.

You may be aware of proposals being discussed by the International Organization of Securities Commissions (IOSCO) regarding the relationship between hedge funds and their prime brokerages and banks, which will require new oversight and rules of the road. Here at home, we should seriously consider similar principles to best guard against runs on liquidity by hedge funds.

In an effort to harmonize financial market oversight, the President requested the CFTC and SEC to provide a report to Congress by September 30, 2009. We will identify existing differences in statutes and regulations with respect to similar types of financial instruments, explain if differences are still appropriate, and make recommendations for changes. In developing recommendations for harmonization we will seek broad input from the public, other regulators, and market users.

Before closing, I would like to mention Chairman Levin’s report on wheat convergence released today by the Senate Permanent Subcommittee on Investigations. Chairman Levin’s report is a significant contribution to discussions regarding the potential effects of index trading in the wheat market and other commodity futures markets. As the Commission continues our own analysis and appropriate regulatory responses, Chairman Levin’s recommendations will be carefully considered.
I would like to thank you again for having me here today, and I am happy to take questions.

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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:

Form U4 and Form U5 | Information About the Uniform Registration Forms for Broker-Dealers and Investment Advisors

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Purpose of the Forms and Discussion of Recently Approved Changes & Requirements

The Financial Industry Regulatory Authority (FINRA), is the largest independent regulator for all securities firms doing business in the United States, and is the entity designated as the filing depository by the U.S. Securities and Exchange Commission for purposes of the Investment Advisers Act of 1940. There are currently six different Uniform Registration Forms that are used to file information with FINRA. The Form U4 (Uniform Application for Broker-Dealer Registration) and the Form U5 (Uniform Termination Notice for Security Industry Registration) are used by broker-dealers to register, and terminate the registrations of, associated persons with self-regulatory organizations (SROs), and jurisdictions.

Representatives of broker-dealers and investment advisers use Form U4 to register with the states and with self-regulatory organizations (e.g., FINRA). Forms are filed electronically by their employing firms using the Central Registration Depository (Web CRD or IARD). Broker-dealer agents and investment adviser representatives have an obligation to update previously filed Forms U4 with any new information required to be disclosed. FINRA makes information filed on Form U4 publicly available through its BrokerCheck program.

Broker-dealers and investment advisers use Form U5 to terminate a representative’s registration in a particular jurisdiction or with a particular self-regulatory organization. Firms terminating the registration of an associated person must respond to a series of disclosure questions. Firms also have the obligation to update previously filed Forms U5 if they become aware of new disclosure information.

As discussed above, Form U4 and Form U5 filings (initial applications. termination notices, and amendments) will generally be made electronically through Web CRD or IARD. However, some individuals may need to file the form on paper, including: agents of issuers, certain persons filing with stock exchanges, and certain investment adviser representatives. In addition, NASD Rule 1013 requires the submission of certain paper Forms U4 along with an initial membership application.

The SEC recently approved amendments to Forms U4 and U5 that were proposed by FINRA that call for significant changes to disclosure questions on the Forms, including the addition of questions about certain regulatory actions. The new amendments to the Forms include:

New regulatory action questions that will enable FINRA and other regulators to identify more readily persons subject to a particular category of “statutory disqualification” under the federal securities laws and the FINRA By-Laws. Among the items that would cause a person to become subject to a statutory disqualification are “willful” violations of the federal securities laws, the Commodity Exchange Act, or the rules of the Municipal Securities Rulemaking Board. Under the proposed rule changes, both Forms U4 and U5 would be amended to add questions requiring disclosure of findings of “willful” violations.
New questions that require firms to report allegations of sales practice violations made against a registered person in an arbitration or litigation in which the registered person is not a named party. Under the new amendment, reporting would be required if the registered person was either named in or could reasonably be identified from the body of the arbitration claim or civil litigation as a registered person who was involved in one or more of the alleged sales practice violations.
An increase in the monetary threshold for reporting settlements of customer complaints, arbitrations or litigation from $10,000 to $15,000.
The clarification that the date to be provided by a firm in the “date of termination” field is the “date the firm terminated the individual’s association with the firm in a capacity for which registration is required.” Under the new amendment, a firm would be permitted to change the date of and reason for termination, but would be required to state a reason for the change.

The revised Forms were implemented in Web CRD on May 18, 2009. The effective date for most of these changes is May 18, 2009 (the “release date”). The effective date for the new regulatory action disclosure questions will be 180 days from the release date, or November 14, 2009.

Key Items Regarding the Forms Changes:

Invalidation of Pending Form Filings Upon Web CRD System Shutdown:

Implementation of the revised “form versions” will cause all pending (in-process) Form U4 and U5 filings that are not submitted to Web CRD prior to system shutdown on Friday, May 15, 2009, to become invalidated (i.e., converted to a read-only mode). Firm users that still need to submit the information on those invalidated filings will need to recreate the filings using the new forms.

Form U4 Amendments Required:

All registered persons are required to answer new regulatory action disclosure summary questions the next time they file a Form U4 amendment or no later than 180 days following the release date.

Copies of the revised Forms and instructions are available 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: