Tag Archives: investment adviser

Obama Moves Forward with Hedge Fund Registration Legislation

Bart Mallon, Esq.
http://www.hedgefundlawblog.com

Treasury Announces New “Private Fund Investment Advisers Registration Act of 2009”

After much discussion in the press over the last 8 to 10 months abut the possibility for hedge fund registration, the Treasury today announced the Obama Administration’s bill which requires managers to “private funds” to register with the SEC. This registration requirement would apply to managers of all funds relying on the Section 3(c)(1) or Section 3(c)(7) which includes managers to private equity and venture capital funds. Additionally, all registered managers would need to provide the SEC with certain reports on the funds which they manage.

The Treasury release is below and can be found here. We will post the text of the new act shortly. [Update: we have just published the text of the Private Fund Investment Advisers Registration Act of 2009.]

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Fact Sheet: Administration’s Regulatory Reform Agenda Moves Forward: Legislation for the Registration of Hedge Funds Delivered to Capitol Hill

Continuing its push to establish new rules of the road and make the financial system more fair across the board, the Administration today delivered proposed legislation to Capitol Hill to require all advisers to hedge funds and other private pools of capital, including private equity and venture capital funds, to register with the Securities and Exchange Commission (SEC). In recent years, the United States has seen explosive growth in a variety of privately-owned investment funds, including hedge funds, private equity funds, and venture capital funds. At various points in the financial crisis, de-leveraging by such funds contributed to the strain on financial markets. Because these funds were not required to register with regulators, the government lacked the reliable, comprehensive data necessary to monitor funds’ activity and assess potential risks in the market. The Administration’s legislation would help protect investors from fraud and abuse, provide increased transparency, and provide the information necessary to assess whether risks in the aggregate or risks in any particular fund pose a threat to our overall financial stability.

Protect Investors From Fraud And Abuse

Require Advisers To Private Investment Funds to Register With The SEC. Although some advisers to hedge funds and other private investment funds are required to register with the Commodity Futures Trading Commission (CFTC), and some register voluntarily with the SEC, current law generally does not require private fund advisers to register with any federal financial regulator. The Administration’s legislation would, for the first time, require that all investment advisers with more than $30 million of assets under management to register with the SEC. Once registered with the SEC, investment advisers to private funds will be subject to important requirements such as:

Substantial regulatory reporting requirements with respect to the assets, leverage, and off-balance sheet exposure of their advised private funds
Disclosure requirements to investors, creditors, and counterparties of their advised private funds
Strong conflict-of-interest and anti-fraud prohibitions
Robust SEC examination and enforcement authority and recordkeeping requirements
Requirements to establish a comprehensive compliance program

Require Increased Disclosure Requirements. The Administration’s legislation would require that all investment funds advised by an SEC-registered investment adviser be subject to recordkeeping requirements; requirements with respect to disclosures to investors, creditors, and counterparties; and regulatory reporting requirements.

Protect Financial System From Systemic Risk

Monitor Hedge Funds For Potential Systemic Risk. Under the Administration’s legislation, the regulatory requirements mentioned above would include confidential reporting of amount of assets under management, borrowings, off-balance sheet exposures, counterparty credit risk exposures, trading and investment positions, and other important information relevant to determining potential systemic risk and potential threats to our overall financial stability. The legislation would require the SEC to conduct regular examinations of such funds to monitor compliance with these requirements and assess potential risk. In addition, the SEC would share the disclosure reports received from funds with the Federal Reserve and the Financial Services Oversight Council. This information would help determine whether systemic risk is building up among hedge funds and other private pools of capital, and could be used if any of the funds or fund families are so large, highly leveraged, and interconnected that they pose a threat to our overall financial stability and should therefore be supervised and regulated as Tier 1 Financial Holding Companies.

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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. Mallon P.C. helps hedge fund managers to register as investment advisors with the SEC or the state securities divisions. If you are a hedge fund manager who is looking to start a hedge fund or register as an investment advisor, please contact us or call Mr. Mallon directly at 415-296-8510. Other related hedge fund law articles include:

Net Capital Requirement for State Registered Hedge Fund Managers

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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

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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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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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Hedge Fund Fraud Discussion

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With all of the talk lately of new hedge fund regulations proposed by Obama and the likelihood of investment adviser registration for hedge fund managers, the focus has remained squarely on how to avoid hedge fund fraud situations and another Madoff. The following post is from the blog by Rick Bookstaber who is a very well decorated author within the investment management industry. Please feel free to leave your comments on this post below.

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The 7 Habits of Highly Suspicious Funds

Note: This post will appear in The Journal of Investment Management

You’ve heard this story before: A trader at a bank is knocking the cover off the ball. His success garners political power within the bank. He creates a fiefdom that insulates him from the rest of the firm; his trading group explodes in size. He lives a conspicuous, extravagant lifestyle. His ego alienates the management and intimidates the support staff. Then the trader hits a rough patch. He uses all the tricks in the book to keep his poor results under wraps while he tries to find a way to recoup. Everyone is gunning for him, so he has to get back into the black, and fast.

How does he try to do that? He ratchets up his risk. He knows he won’t be able to turn it around fast enough if he plays it prudently, whereas there is some chance to stay in the game if he bets it all on 00, or better yet, if he levers up as much as he can, borrows all the money he can get his hands on, and then bets all of that on 00. If he loses, well, he was going to be gone anyway, so he may as well try for the big time.

That is one of the reasons there are risk managers. Risk managers know to put extra focus on traders who are struggling and, for that matter, on traders who seem to have an eerily hot hand. Especially if those traders have the ability to lever and to obscure their risk through the use of sophisticated instruments.

This story is now primed to play out in the hedge fund space. How many hedge funds do you know that more or less fit this description: A hedge fund manager had a run of great returns. His fund has grown by leaps and bounds. He has doubled his staff year after year in anticipation of even greater things to come. He has enjoyed a Page Six lifestyle; he is the belle of the ball, his dance card always filled. But now his kingdom is under siege. Assets under management have dropped precipitously due to redemptions layered on top of poor trading results. The investors that remain are demanding reductions in management fees. Incentive fees are gone until he scales the wall to get back to high water mark. With the way his operation has ballooned, he realizes that if he doesn’t make serious returns over the next few years, he will be crushed under the costs and the dwindling asset base.

What does he do? If he follows the same course as the trader at the bank, he will try to find ways to take on more risk. Of course, any investment fund might face the same temptation, but hedge funds have more tools at their disposal to make good on the try. Hedge funds can lever, delve into wide-ranging and risky markets and readily employ the so-called innovative securities to increase risk in ways that are difficult to discern. And unlike the trader at the bank, the hedge fund can operate without anyone seeing what it is doing. No one is looking over its shoulder at the trading positions each night.

Is the risk management in place to deal with this scenario? Here are seven “habits” that an investor should look out for:

1. No independent risk reporting.

One lesson that has been driven home from Madoff is not to trust the numbers coming out of any fund. Or, at least, trust but verify. If things go wrong and that is what you relied on, you will look like a fool, or worse. The risk numbers must come from having a third party getting the fund’s positions and doing the analysis.

The risk reporting must go beyond the VaR numbers to include measures of leverage, concentration, degree of diversification and size in markets (to assess liquidity risk). Again, all independently provided.

The diversification and concentration are necessary because, as we now know all too well, the relationships between markets can change. These risk measures cannot be calculated simply by knowing how many markets the fund is trading. It is critical to know how linked the markets are; how concentrated positions are when aggregated across similar markets. With globalization, diversification opportunities aren’t what they used to be. And in any case, it isn’t much value to be active in twenty markets if two-thirds of the positions are in three or four markets that are closely related.

2. A change for the worse in the critical risk numbers.

When you get independent reporting, don’t stop with looking at these numbers as they stand today. Demand to know what they have been over the past years. Have the risk statistics changed for the worse? Have they been different than what was represented by the fund’s own, internally generated reports? For example, is the third-party view of leverage, liquidity or diversification as favorable as has been represented by the fund itself, both now and historically?

3. Increased use of derivatives.

In my recent Senate testimony, I said that derivatives are the weapon of choice for gaming the system. Among other things, derivatives can be used to hide increases in leverage. Their complexity and difficulty in marking means that they also can more easily hide losses. There should be extra concern if the fund has only recently decided to start using derivatives and swaps.

4. High level of secrecy.

Does the fund have a monolithic, scripted presence to outside investors? Does it obscure its approach with secret formulas and strategies? Does it invoke its need for secrecy to justify limiting access to essential risk information and to its production staff? If so, you might want to get ready for a Madoff moment.

5. Growth in headcount and lifestyle.

This is the firm’s equivalent of the trader’s lifestyle. The fund’s principles can stretch the envelope in terms of personal lifestyle, and, unlike their banker cousins, their firm is their own domain. They can get an “edifice complex”. If a firm has become bloated, if it has a growing cost base that forces it to be impatient, then it will be more desperate to swing for the fences.

6. Decline in assets under management.

This speaks to motive. The more assets have declined – or are projected to decline with expected redemptions – the greater the stress for the fund, and the more tempting to ratchet up the risk.

Related to this, is the fund far below high water mark? Hedge funds make money from fixed management fees based on assets under management and incentive fees based on the return they generate for their clients. Most hedge funds only start collecting the incentive fees after they get back to high water mark. If a hedge fund is thirty percent below high water market, it may need years of strong returns before any money starts ringing up in the incentive fee register.

7. Lackluster performance in recent years.

Most everyone was lackluster this past year. So you should look back at the recent performance before the 2008 debacle. A comparison of the performance over the past three to five years versus the performance in the more distant past can be an indicator of a failure of the fund’s inherent strategy. It could be that the space has become too crowded and competitive, that the fund has become too large to take advantage of inefficiencies, or that the inefficiencies the fund has focused on have closed down. This creates a pressure to reach. If things have been slowly petering out, if alpha has been diminishing, then more leverage and risk is needed to get back up to the target.

Or, in desperation, the fund might try something new. So a related phenomenon will be style drift or a move into new markets and strategies. Style drift can be an indication that the bread and butter strategy is not pulling its weight. Is there movement toward new markets, a.k.a. ‘new opportunities’. Is an equity fund hiring expertise to gear up in credit, is a macro fund starting to trade volatility?

Not everyone standing in the shadows is a mugger. And sometimes a cigar is just a cigar. Although “habits” like a lack of independent reporting are pretty obvious weaknesses, others, such as exploring new trading strategies, might be justifiable. But these are warning signs that justify deeper questioning and tighter oversight.

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Please contact us if you have any questions on the above article. Other related hedge fund law blog articles include:

Private Fund Transparency Act of 2009 Text of Statute

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Text of New Hedge Fund Registration Bill

Earlier we posted a press release about the Private Fund Transparency Act and that it would subject hedge fund managers to registration with the SEC. Below is the actual text of the statute.

We will be bringing an in depth analysis of changes and consequences of this bill in the next couple of days.

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Private Fund Transparency Act of 2009 (Introduced in Senate)

S 1276 IS

111th CONGRESS

1st Session

S. 1276

To require investment advisers to private funds, including hedge funds, private equity funds, venture capital funds, and others to register with the Securities and Exchange Commission, and for other purposes.

IN THE SENATE OF THE UNITED STATES

June 16, 2009

Mr. REED introduced the following bill; which was read twice and referred to the Committee on Banking, Housing, and Urban Affairs

A BILL

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

SECTION 1. SHORT TITLE.

This Act may be cited as the `Private Fund Transparency Act of 2009′.

SEC. 2. DEFINITION OF FOREIGN PRIVATE ADVISERS.

Section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a)) is amended by adding at the end the following:

`(29) The term `foreign private adviser’ means any investment adviser who–

`(A) has no place of business in the United States;

`(B) during the preceding 12 months has had–

`(i) fewer than 15 clients in the United States; and

`(ii) assets under management attributable to clients in the United States of less than $25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; and

`(C) neither holds itself out generally to the public in the United States as an investment adviser, nor acts as an investment adviser to any investment company registered under the Investment Company Act of 1940, or a company which has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940, and has not withdrawn its election.’.

SEC. 3. ELIMINATION OF PRIVATE ADVISER EXEMPTION; LIMITED EXEMPTION FOR FOREIGN PRIVATE ADVISERS.

Section 203(b)(3) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(b)(3)) is amended to read as follows:

`(3) any investment adviser that is a foreign private adviser;’.

SEC. 4. COLLECTION OF SYSTEMIC RISK DATA; ANNUAL AND OTHER REPORTS.

Section 204 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-4) is amended–

(1) in subsection (a), by adding at the end the following: `The Commission is authorized to require any investment adviser registered under this title to maintain such records and submit such reports as are necessary or appropriate in the public interest for the supervision of systemic risk by any Federal department or agency, and to provide or make available to such department or agency those reports or records or the information contained therein. The records of any company that, but for section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, would be an investment company, to which any such investment adviser provides investment advice, shall be deemed to be the records of the investment adviser if such company is sponsored by the investment adviser or any affiliated person of the investment adviser or the investment adviser or any affiliated person of the investment adviser acts as underwriter, distributor, placement agent, finder, or in a similar capacity for such company.’; and

(2) adding at the end the following:

`(d) Confidentiality of Reports- Notwithstanding any other provision of law, the Commission shall not be compelled to disclose any supervisory report or information contained therein required to be filed with the Commission under subsection (a). Nothing in this subsection shall authorize the Commission to withhold information from Congress or prevent the Commission from complying with a request for information from any other Federal department or agency or any self-regulatory organization requesting the report or information for purposes within the scope of its jurisdiction, or complying with an order of a court of the United States in an action brought by the United States or the Commission. For purposes of section 552 of title 5, United States Code, this subsection shall be considered a statute described in subsection (b)(3)(B) of such section 552.’.

SEC. 5. ELIMINATION OF PROVISION.

Section 210 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-10) is amended by striking subsection (c).

SEC. 6. CLARIFICATION OF RULEMAKING AUTHORITY.

Section 211(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-11) is amended–

(1) by striking the second sentence; and

(2) by striking the period at the end of the first sentence and inserting the following: `, including rules and regulations defining technical, trade, and other terms used in this title. For the purposes of its rules and regulations, the Commission may–

`(1) classify persons and matters within its jurisdiction and prescribe different requirements for different classes of persons or matters; and

`(2) ascribe different meanings to terms (including the term `client’) used in different sections of this title as the Commission determines necessary to effect the purposes of this title.’.

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Form U4 and Form U5 Amendments

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NASAA Requests Comments on Proposed Changes

Form U4 is the form used by Investment Advisory firms to register investment advisor representatives with their firm. It is also used by broker-dealers to register reps with their firms. Form U5 is used by both IA and BD firms to terminate a representative’s employment with such firm. While I have not reviewed the changes to the forms in depth, the summary discussion (reprinted below) sounds reasonable. We may be submitting comments on these proposals in the future as we discuss with other industry participant – please let us know if you have strong thoughts one way or another on the proposed changes.

The press release and discussion are both reprinted below. For more information, please visit the NASAA site here. Please also review our recommended articles at the very bottom of this page.

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Notice for Request for Comment on Amendments to Forms U4 and U5 and Proposed Guidance for Filings by Investment Adviser Representatives

The proposed changes have been published by both FINRA and the SEC for public comment. On May 13, 2009, the SEC approved the proposed changes. NASAA is now publishing the amended forms for further review and comment by its members and other interested parties in anticipation of adoption of the revised forms by the NASAA membership.

In addition, this notice includes suggested guidance for states in responding to inquiries regarding the impact of the revisions on filings by investment adviser representatives.

The comment period begins June 9, 2009, and will remain open for 14 days. Accordingly, all comments should be submitted on or before June 23, 2009.

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NOTICE FOR REQUEST FOR COMMENT ON AMENDMENTS TO THE UNIFORM APPLICATION FOR SECURITIES INDUSTRY REGISTRATION OR TRANSFER (FORM U4), THE UNIFORM TERMINATION NOTICE FOR SECURITIES INDUSTRY REGISTRATION (FORM U5), AND PROPOSED GUIDANCE FOR FILINGS BY INVESTMENT ADVISER REPRESENTATIVES.

The NASAA CRD/IARD Steering Committee and the CRD/IARD Forms and Process Committee have worked with FINRA, regulators, and representatives of the financial services industry in developing amendments to the Form U4 and Form U5. The proposed changes have been published by both FINRA and the SEC for public comment. On May 13, 2009, the SEC approved the proposed changes. NASAA is now publishing the amended forms for further review and comment by its members and other interested parties in anticipation of adoption of the revised forms by the NASAA membership.

In addition, this memo includes suggested guidance for states in responding to inquiries regarding the impact of the revisions on filings by investment adviser representatives.

Questions or comments regarding the revised forms should be directed to the following individuals:
Melanie Lubin
Office of the Attorney General
Division of Securities
200 Saint Paul Place
Baltimore, Maryland 21202-2020
(410) 576-6360
[email protected]

Pam Epting
Office of Financial Regulation
200 East Gaines Street
Tallahassee, Florida 32399-0372
(850) 410-9819
[email protected]

Joseph Brady
NASAA
750 First Street, NE
Suite 1140
Washington, DC 20002
202-737-0900
[email protected]

The comment period begins June 9, 2009, and will remain open for fourteen (14) days. Accordingly, all comments should be submitted to the individuals noted above on or before June 23, 2009.

Summary of Proposed Changes to Registration Forms

The SEC recently approved amendments for Forms U4 and U5 (“the Forms”). These changes fall into the following categories.

Willful Violations. Additional questions have been added to Form U4 in order to enable regulators to identify more readily individuals and firms subject to a particular category of statutory disqualification pursuant to Section 15(b)(4)(D) of the Exchange Act.
Revision to Arbitration and Civil Litigation Question. Changes were made to the text of the question on the Form U4 regarding disclosure of arbitrations or civil litigation to elicit reporting of allegations of sales practice violations made against a registered person in arbitration or litigation in which that person was not named as a party to the arbitration or litigation.
Revision to Monetary Threshold. The monetary threshold for reporting settlements of customer complaints, arbitrations or civil litigation on the Forms has been raised from $10,000 to $15,000.
Date and Reason for Termination. The definition of “Date of Termination” in the Form U5 has been revised in order to enable firms to amend the “Date of Termination” and the “Reason for Termination” subject to certain conditions.
Technical Amendments. Certain technical and clarifying changes were made to the Forms.

The SEC approved these amendments effective May 18, 2009, except the new disclosure questions regarding willful violations, which become effective 180 days later on November 14, 2009. Firms will be required to amend Form U4 to respond to the new disclosure questions the first time they file Form U4 amendments for registered persons after May 18, 2009, at which time they may provide provisional “no” answers. However, firms must provide final answers to the questions no later than November 14, 2009.

Revisions Regarding Willful Violations.

The amendments modify the Forms to enable regulators to query the CRD system to identify persons who are subject to disqualification as a result of a finding of a willful violation. Specifically, the amendments add additional questions to existing Questions 14C and 14E on Form U4. Question 14C, which inquires about SEC and Commodity Futures Trading Commission (CFTC) regulatory actions, adds three new questions regarding willful violations. Similarly, Question 14E, which concerns findings by a self-regulatory organization, adds three identical questions. The Form U4 Regulatory Action Disclosure Reporting Page (DRP) will continue to elicit specific information regarding the status of the events reported in response to these questions.

Adding new disclosure questions to Form U4 requires firms to amend such forms for all their registered persons. To ensure that firms have appropriate time to populate the forms accurately, the SEC delayed the effective date for the new regulatory action disclosure questions for 180 days until November 14, 2009. This schedule will provide firms with up to 180 days from the release date to answer the regulatory action disclosure questions. Additionally firms, at their discretion, can file provisional “no” answers to the six new regulatory action questions during the 180-day period between the release date and the effective date. During this time, the regulatory action disclosure questions will appear in the CRD system in a manner designed to indicate that such questions are not effective until 180 days from the release date and that any answers provided in response to such questions are provisional until such time as those questions become effective. Any “no” answers filed in response to the new regulatory action disclosure questions during such 180-day period that are not amended before November 14, 2009, will become final, and the firm and subject registered person will be deemed to have represented that the person has not been the subject of any finding addressed by the question(s). If a firm determines that a registered person must answer “yes” to any part of Form U4 Questions 14C or 14E, the amendment filings must include completed DRP(s) covering the proceedings or action reported.

With respect to Form U5, the amendments did not alter Question 7D (Regulatory Action Disclosure), but added new Question 12C to the Form U5 Regulatory Action DRP. As of May 18, 2009, firms that answer “yes” to Question 7D on Form U5 will be required to provide more detailed information about the regulatory action in Question 12C of the DRP. For regulatory actions in which the SEC, CFTC or an SRO is the regulator involved, Question 12C requires firms to answer questions eliciting whether the action involves a willful violation. These questions correspond to the questions added to the Form U4. A firm will not be required to amend Form U5 to answer Question 12C on the DRP and/or add information to a Form U5 Regulatory Action DRP that was filed previously unless it is updating a regulatory action that it reported as pending on the current DRP.

Revisions to the Arbitration and Civil Litigation Disclosure Question.

The Forms have been revised to require the reporting of allegations of sales practices violations made against registered persons in a civil lawsuit or arbitration in which the registered person is not a named party. Specifically, Question 14I on Form U4 and Question 7E on Form U5 were amended to require the reporting of alleged sales practice violations made by a customer against persons identified in the body of a civil litigation complaint or an arbitration claim, even when those persons are not named as parties. The new questions apply only to arbitration claims or civil litigation filed on or after May 18, 2009. A firm is required to report a “yes” answer only after it has made a good-faith determination after a reasonable investigation that the alleged sales practice violation(s) involved the registered person.

Revisions to the Monetary Threshold.

The current monetary threshold for settlements of customer complaints, arbitrations or litigation was set in 1998 and has not been adjusted since that time. The changes to the Forms include raising the existing reporting threshold from $10,000 to $15,000 to reflect more accurately the business criteria (including the cost of litigation) firms consider when deciding to settle claims. This change is reflected in Question 14I on Form U4 and Question 7E on Form U5.

Revisions Regarding “Date of Termination” and “Reason for Termination.”

Revisions to Form U5 provide that the date to be provided by a firm in the “Date of Termination” field is the “date that the firm terminated the individual’s association with the firm in a capacity for which registration is required.” The amendments further clarify that, in the case of full terminations, the “Date of Termination” provided by the firm will continue to be used by regulators to determine whether an individual is required to requalify by examination or obtain an appropriate waiver upon reassociating with a firm. Revisions to Form U5 also clarify that the relevant SRO or jurisdiction determines the effective date of termination of registration. The rule change also permits a firm, as of May 18, 2009, to amend the “Date of Termination” and “Reason for Termination” fields in a Form U5 it previously submitted, but in such cases it requires the firm to provide a reason for each amendment. To monitor such amendments, including those reporting terminations for cause, FINRA will notify other regulators and the broker-dealer with which the registered person is currently associated (if the person is associated with another firm) when a date of termination or reason for termination has been amended. The original date of termination or reason for termination will remain in the CRD system in form filing history.

Technical Revisions.

The Forms were amended to make various clarifying, technical and conforming changes generally intended to clarify the information elicited by regulators and to facilitate reporting by firms and regulators. For example, the amendments eliminated as unnecessary certain cross-references in the Forms. Additionally, certain “free text” fields were converted to discrete fields. The amendments also add to Section 7 of Form U5 (Disclosure Questions) an optional “Disclosure Certification Checkbox” that will enable firms to affirmatively represent that all required disclosure for a terminated person has been reported and the record is current at the time of termination. Checking this box will allow the firm to bypass the process of re-reviewing a person’s entire disclosure history for purposes of filing Form U5 in situations in which disclosure is up to date at the time of the person’s termination. The amendments make additional technical changes to the Forms. For example, they incorporate the definition of “found” from the Form U4 Instructions into the Form U5 instructions; provide more detailed instructions regarding the reporting of an internal review (conducted by the firm); and clarify how an individual may file comments to an Internal Review DRP.

Guidance Regarding U4 Filings for Investment Adviser Representatives.

As explained above, the questions added to items 14C and 14E have been approved by the SEC but the effectiveness of the questions has been delayed until November 14, 2009. The questions currently appear on the form in a manner designed to indicate that they are not currently effective. Further, the answers to the questions currently default to “no” and will continue to do so until they become effective later this year unless a filer manually selects a “yes” answer. The delayed effective date coupled with the default “no” answer is a temporary accommodation in order to give filers an opportunity to determine the appropriate answers to the new questions.

The CRD/IARD Steering Committee has received inquiries regarding how investment adviser representatives should respond to these questions. It is the Steering Committee’s recommendation that state and territorial securities regulators handle the filings for investment adviser representatives in the same manner as broker-dealer agents who file on or after May 18, 2009. That is, investment adviser representatives should be allowed to file provisional responses to the questions contained in 14C and 14E on the Form U4 until such time as the questions become effective on November 14, 2009.

Forms.

Copies of the revisions as approved by the SEC are attached.

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

Hedge Fund Due Diligence Firm Drops Ball, Receives Fine

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In what represents an unbelievable screw-up, professed hedge fund due diligence firm Hennessee Group was charged by the SEC with not performing the due diligence it supposedly provided to hedge fund investors who used their services. According to the SEC Administrative Order, Henessee did not perform certain key elements of the due diligence process which they advertised to potential clients. Because of the lack of due diligence, Henessee recommended investing into the fraudulent Bayou hedge fund.

A few of the more interesting parts of the release include the following:

From February 2003 through August 2005, approximately forty clients of Hennessee Group invested a total of over $56 million in the Bayou funds after receiving Hennessee Group’s recommendations. Most of those monies were lost and dissipated by Bayou’s principals, who defrauded their investors by fabricating Bayou’s performance in client account statements, periodic newsletters, and year-end financial statements that included a phony audit opinion fabricated by one of Bayou’s principals.

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Hennessee Group and Gradante, in their capacities as investment advisers, owed fiduciary duties to their clients to perform the services that they represented they would provide and to disclose all material departures from the representations that they made to their clients. Despite their representations about their services, with regard to the Bayou Funds and the funds’ management, Hennessee Group and Gradante did not perform two of the five elements of the due diligence evaluation that they had represented to their clients they would undertake. In addition, Hennessee Group and Gradante failed to adequately respond to information that they received that suggested that the identity of Bayou’s outside auditor was in doubt and that there existed a potential conflict of interest between one of Bayou’s principals and its purported outside auditor.

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With regard to Bayou, Hennessee Group, at Gradante’s direction, failed to perform two elements of the due diligence evaluation that Hennessee Group had told its clients and prospective clients that it would do: (1) a portfolio/trading analysis; and (2) a verification of Bayou’s relationship with its purported independent auditor. By not conducting the entire due diligence evaluation that it had advertised, and by failing to disclose to clients that its evaluation of Bayou deviated from its prior representations, Hennessee Group and Gradante rendered the prior representations about the due diligence process materially misleading and breached their fiduciary duties to Hennessee Group’s clients.

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In the fall of 2002, Bayou refused to provide Hennessee Group with the prime brokerage reports that Hennessee Group had requested. However, instead of insisting that Bayou provide the reports as a condition of potentially being recommended, Hennessee Group proceeded to the next phases of due diligence. Gradante decided that a portfolio/trading analysis was irrelevant for a day-trading fund like Bayou, which stated in marketing materials that it held securities positions for brief periods of time and converted positions to cash prior to each day’s market closing.

As a result, Hennessee Group did not obtain or evaluate any quantitative information about Bayou’s portfolio characteristics, investment and trading strategies, or risk management discipline. Instead of confirming Bayou’s results and processes through an analysis of Bayou’s historical trading data to determine whether the fund was, in fact, executing its purported “high-velocity” day-trading strategy and utilizing appropriate risk management techniques, Gradante and Hennessee Group relied entirely on Bayou’s uncorroborated representations and purported rates of return that Bayou had provided during its initial information-gathering phases.

Hennessee Group never told the clients to whom it recommended Bayou that it had not conducted a portfolio/trading analysis on the funds. By failing to disclose this information in connection with its recommendation of Bayou, Hennessee Group left those clients with the misleading impression that it had conducted a portfolio, trading, and risk management evaluation of Bayou and that Bayou had satisfied Hennessee Group’s purported standards. In so doing, Hennessee Group and Gradante breached their fiduciary duties to Hennessee Group’s clients.

I have written a number of posts about proper hedge fund due diligence and am always surprised how haphazardly investments are made into some hedge funds. Over the past six to eight months I have also been surprised that so many sophisticated and savvy investors would be duped by frauds like Madoff… but I guess if those gatekeepers who are paid to help investors research managers are asleep at the wheel we can’t really expect much more from investors.

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

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SEC Charges Investment Adviser That Recommended Bayou Hedge Funds to Clients

FOR IMMEDIATE RELEASE
2009-86

Washington, D.C., April 22, 2009 — The Securities and Exchange Commission today charged New York-based investment adviser Hennessee Group LLC and its principal Charles J. Gradante with securities law violations for failing to perform their advertised review and analysis before recommending that their clients invest in the Bayou hedge funds that were later discovered to be a fraud.

In a settled administrative proceeding, the Commission issued an order finding that Hennessee Group and Gradante did not perform key elements of the due diligence that they had represented they would conduct prior to recommending investments in the Bayou hedge funds. The SEC also finds that they failed to conduct a reasonable investigation into red flags concerning Bayou. Hennessee Group and Gradante routinely represented to clients and prospective clients that they would not recommend investments in hedge funds that did not satisfy all phases of their due diligence evaluation.

“Forewarned is forearmed — investment advisers must make good on their promises or face the consequences of vigorous SEC enforcement action,” said Robert Khuzami, Director of the SEC’s Division of Enforcement.

“As the Commission found, these investment advisers failed to honor the representations they made to their clients and did not disclose these material departures from their advertised services,” said Antonia Chion, Associate Director of the SEC’s Division of Enforcement. “The advice that clients receive from hedge fund consultants is especially critical when the hedge funds are neither regulated nor transparent.”

According to the Commission’s order, approximately 40 clients invested millions of dollars in the Bayou hedge funds from February 2003 through August 2005 after the Hennessee Group recommended those investments. Most of the money was lost through trading or dissipated by Bayou’s principals, who defrauded their investors by fabricating Bayou’s performance in client account statements and year-end financial statements. The SEC charged the managers of the Bayou hedge funds with fraud in 2005.

The Commission’s order finds that Hennessee Group and Gradante failed to conduct the portfolio and trading analysis that it had advertised to clients. Instead of analyzing Bayou’s results and processes through a review of Bayou’s historical trading methods to determine whether the fund was, in fact, successfully executing its purported day-trading strategy, Hennessee Group and Gradante decided not to perform any analysis after Bayou refused to produce its trading data. They relied entirely on Bayou’s uncorroborated representations about its strategy and its purported rates of return.

The Commission’s order also finds that despite conflicting reports from Bayou about the identity of their independent auditor, Hennessee Group and Gradante failed to verify Bayou’s relationship with its auditor. In fact, the accounting firm that purportedly conducted Bayou’s annual audit was a non-existent entity fabricated by one of Bayou’s principals, who was identified in publicly available state accountancy board records as the registered agent for the bogus accounting firm.

According to the Commission’s order, Hennessee Group and Gradante also failed to respond to red flags concerning Bayou that came to their attention while they were monitoring Bayou on behalf of their clients. In particular, they failed to inquire or investigate when Bayou provided contradictory responses regarding the identity of its auditor or to adequately inquire about a rumor that one of Bayou’s principals was affiliated with Bayou’s purported outside auditing firm.

The Commission’s order finds that Hennessee Group and Gradante violated Section 206(2) of the Advisers Act. The order requires Hennessee Group and Gradante to pay $814,644.12 in disgorgement and penalties, and to cease and desist from committing or causing further violations. The parties also are required to adopt policies to ensure adequate disclosures in the future and to provide copies of the Commission’s Order to all current and prospective clients for a period of two years.

Hennessee Group and Gradante consented to the entry of the Commission’s order without admitting or denying the findings.
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For more information, contact:
Antonia Chion
Associate Director, SEC’s Division of Enforcement
(202) 551-4842
Yuri B. Zelinsky
Assistant Director, SEC’s Division of Enforcement
(202) 551-4769

Investment Advisor Fraud

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Another Investment Advisor Ponzi Scheme

In the wake of the Madoff scandal the SEC is taking out other fraudulent investment advisory firms. The release below details a south Florida investment advisor who perpetrated a multi-million dollar ponzi scheme. As we noted in Lessons in Hedge Fund Due Diligence, it is so important for investors to conduct proper due diligence on their investment advisors or hedge fund managers. Continue reading →

Illinois Hedge Fund Law – Various Laws and Regulations

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Perhaps not surprising, Illinois has a very well developed Securities Division website which provides its investment advisors (and potential investment advisors) with many informative articles. In this article we have reprinted three separate resources which we found helpful for potential hedge fund managers located in Illinois.

The first resource provides a basic overview of investment advisors and the separation of regulatory jurisdiction between the federal government and the states. This resource is glib on whether hedge fund managers in Illinois need to register as investment advisors with the state – generally they do not. For those managers which are registered with Illinois, the second resource provides an overview of the potential for on-site examinations of the manager’s business. The final resource provides an overview of the different fees which an advisor registered (or notice filed) in Illinois will need to pay. Continue reading →