Tag Archives: SEC

New Hedge Fund Regulations – SEC to Conduct Roundtable Today

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As I’ve mentioned previously we can expect tighter regulations in the coming months for the financial services industry in general and the hedge fund industry specifically.  To track these changes I’ve instituted a new section entitled new hedge fund regulations which I will keep updated with information.

Below the SEC is taking the first steps to decide how to move forward in this new world financial order through a series of panel discussions.  The SEC is also soliciting comments from the financial services industry on a variety of questions.  These steps are obviously necessary and should be productive if the SEC really listens to the practitioners from the industry.  The release can be found here.

SEC Roundtable on More Transparent Disclosure to Address Lessons of Current Credit Crisis
FOR IMMEDIATE RELEASE
2008-241

Washington, D.C., Oct. 7, 2008 — The Securities and Exchange Commission today announced the agenda for Wednesday’s roundtable on providing more transparency to investors that will include discussion of lessons from the current credit crisis. Among other issues, panelists will address better ways to explain complex financial instruments to investors and the marketplace, and will propose ways to provide investors with more transparent, useful, and timely access to high-quality information. The roundtable is part of the SEC’s 21st Century Disclosure Initiative (www.sec.gov/disclosureinitiative) that is fundamentally rethinking disclosure.

Panel One: The Market’s Use of Disclosure Information and the SEC’s Disclosure System

This panel will explore whether the current system of collecting and filing data for SEC disclosure obligations has kept pace with the market. It will examine how investors can get all the information they need to make increasingly complex investment decisions. It will also consider the data, technology, and processes that companies and other filers use in satisfying their SEC disclosure obligations. The panel will compare the needs and uses of investors and companies to the capabilities of the SEC’s disclosure system in an effort to better understand any gaps and inefficiencies that can lead to inaccuracies, delays, and unnecessary complexity.

  • John Bajkowski, Vice President and Senior Financial Analyst, American Association of Individual Investors
  • Robert Sorrentino, Director of Accounting Policy and External Reporting, Xerox Corp.
  • David Copenhafer, former Director of EDGAR Services, Bowne & Co., Inc.
  • Glenn Doggett, Policy Analyst, CFA Institute Centre for Financial Market Integrity
  • Paul Haaga, Jr., Vice Chairman, Capital Research and Management Co.
  • Kara Jenny, Chief Financial Officer, Bluefly, Inc.
  • Timothy Thornton, Principal, Web Services, The Vanguard Group, Inc.

Panel Two: Modernizing the SEC’s Disclosure System

This panel will consider how the SEC could better organize and operate its disclosure system so that investors could have better access to high-quality information and companies could enjoy efficiencies. In particular, the panel will discuss ways to structure disclosure data so investors can more effectively search for company data and compare investment options. The panel will describe a possible “company file system,” in which core company information would be collected in a central structured data file, and will also discuss other approaches that harness technology to better serve investors and the markets.

  • Alan Beller, Partner, Cleary Gottlieb Steen & Hamilton LLP
  • Steven Bochner, Partner, Wilson Sonsini Goodrich & Rosati
  • Esther Dyson, Chairman, EDventure Holdings
  • Joseph Grundfest, Professor of Law, Stanford Law School
  • Eric Roiter, Lecturer on Law, Harvard University Law School and Boston University School of Law
  • Liv Watson, Member, Board of Directors, IRIS
  • Hillary Sale, Chair in Corporate Finance and Law, University of Iowa College of Law
  • Douglas Chia, Senior Counsel and Assistant Corporate Secretary, Johnson & Johnson

Moderators:

  • John White, Director of SEC’s Division of Corporate Finance
  • Andrew Donohue, Director of SEC’s Division of Investment Management
  • Jim Kaput, Counsel to 21st Century Disclosure Initiative
  • Matthew Reed, Assistant Director of 21st Century Disclosure Initiative

The SEC’s roundtable will be held on Wednesday, October 8 in the auditorium of the SEC’s Washington D.C. headquarters at 100 F Street, NE from 9 a.m. until approximately 1 p.m. The roundtable will be open to the public on a first-come, first-served basis. It will be webcast live on the SEC’s Web site, and an archived version of the webcast will later be available for free download.

The Commission welcomes feedback regarding any of the topics to be addressed at the roundtable, and has issued a formal request for public comment. The Commission is particularly interested in comments responding to these questions:

General Issues

  1. Should the Commission make changes to its current forms-based disclosure system? Please explain why or why not.
  2. What are the key issues to be considered in the review of the Commission’s disclosure system? Are particular aspects of the system and process especially useful and well executed, and are particular aspects especially in need of improvement?
  3. What are the purposes of issuer disclosure from the perspective of investors, filers, and regulators?

Specific Issues

The Market’s Use of Disclosure Information

  1. How do operating and investment companies collect, summarize, analyze, file, and disseminate the information that is submitted to the Commission?
  2. How do operating and investment companies submit disclosure and reporting information to the Commission? How have these methods changed during the last 15 years, particularly after filing via EDGAR was fully implemented? How could the Commission’s system be changed to reduce burdens and create efficiencies, consistent with investor protection?
  3. How do investors retrieve and use the disclosure information that companies submit to the Commission? How could this information be better presented, and more easily retrieved and used through technological improvements?
  4. What disclosure information that companies submit to the Commission is used by investors to make investment decisions? Is any information that companies submit to the Commission not used? What information that is not required to be filed or furnished with the Commission do investors and others use to make investment decisions or give investment advice?

The Commission’s Current Disclosure Syste

  1. Does the Commission’s current disclosure system present difficulties? What difficulties can be attributed to technological problems? Which can be attributed to regulatory or statutory problems?

Modernizing the Commission’s Disclosure System

  1. How should the Commission’s disclosure system be modernized? One possibility is a company file system. What alternative systems should be considered? What different or additional benefits might these alternatives provide?
  2. How should a modern disclosure system, such as a company file system, be organized, and how could it improve the way disclosure information is submitted and used?
  3. What features should any modernized disclosure system provide in order to serve the needs of filers, investors, regulators, and other users of information? Why? Data tagging using XBRL, or eXtensible Business Reporting Language, is one way, but we understand there are other ways to structure data. What alternative ways could be used by companies to submit structured data to the Commission?
  4. What are the costs and benefits to investors and other market participants of structuring non-financial disclosures, including, for example, data tagging?
  5. What time frame would be appropriate for implementing a company file system?
  6. What benefits and costs to preparers and users of information would accompany the implementation of modernized disclosure system, such as a company file system, that requires all, or virtually all, data to be filed in a structured format? Would such a system be more useful to some investors, such as small or less sophisticated investors? Would some investors be harmed by such a system? Would larger companies benefit more than smaller companies? Would costs fall disproportionately on one group of companies?
  7. Are any changes to the Commission’s disclosure regulations required for a transition to a company file system? How could these changes be identified?

The information that is submitted for comment will become part of the public record of the roundtable. All submissions received will be posted without change. The SEC does not edit personal identifying information from submissions. Only information desired to be shared publicly should be submitted.

SEC ends CSE program for investment banks

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Last week Goldman and Merril announced that they were going to convert to bank holding companies.  A good article on  the conversion, including questions and answers, can be found here. An interesting consequence of the change is that the SEC’s Consolidated Supervised Entities (CSE) program is no longer necessary.

The CSE was a unique program where the SEC would supervise the very large investment banking firms from the inside. While the program was voluntary, it was designed to identify potential issues in the devolpmental stage.  However, because the SEC really had no authority to recieve certain reports from the investment banks, the program could only do so much and as we’ve seen, the program failed to protect against the meltdown of both Bear and Lehman.

Chairman Cox will definately take some heat for what the CSE program did not accomplish (see this article), however, it is not presently clear whether he deserves the blame.  As his statement below indicates, the SEC had no explicit governmental oversignt of the major investment banks which would allow them to really act as a regulator for these entities.   What is scary about this is that, if congress listens to Cox, there may be a rush toward over-regulation – Cox is already calling for the regulation of the currently unregulated CDS market. If there is more regulation in the future it is unclear what governmental agency will be in charge of such regulation as the SEC is already overburdened and underfunded.

The statement by Cox below can be found here.


Chairman Cox Announces End of Consolidated Supervised Entities Program
FOR IMMEDIATE RELEASE
2008-230

Washington, D.C., Sept. 26, 2008 — Securities and Exchange Commission Chairman Christopher Cox today announced a decision by the Division of Trading and Markets to end the Consolidated Supervised Entities (CSE) program, created in 2004 as a way for global investment bank conglomerates that lack a supervisor under law to voluntarily submit to regulation. Chairman Cox also described the agency’s plans for enhancing SEC oversight of the broker-dealer subsidiaries of bank holding companies regulated by the Federal Reserve, based on the recent Memorandum of Understanding (MOU) between the SEC and the Fed.

Chairman Cox made the following statement:

The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act, it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns.

Because of the lack of explicit statutory authority for the Commission to require these investment bank holding companies to report their capital, maintain liquidity, or submit to leverage requirements, the Commission in 2004 created a voluntary program, the Consolidated Supervised Entities program, in an effort to fill this regulatory gap.

As I have reported to the Congress multiple times in recent months, the CSE program was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily. The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the CSE program, and weakened its effectiveness.

The Inspector General of the SEC today released a report on the CSE program’s supervision of Bear Stearns, and that report validates and echoes the concerns I have expressed to Congress. The report’s major findings are ultimately derivative of the lack of specific legal authority for the SEC or any other agency to act as the regulator of these large investment bank holding companies.

With each of the major investment banks that had been part of the CSE program being reconstituted within a bank holding company, they will all be subject to statutory supervision by the Federal Reserve. Under the Bank Holding Company Act, the Federal Reserve has robust statutory authority to impose and enforce supervisory requirements on those entities. Thus, there is not currently a regulatory gap in this area.

The CSE program within the Division of Trading and Markets will now be ending.

Under the Memorandum of Understanding between the SEC and the Federal Reserve that was executed in July of this year, we will continue to work closely with the Fed, but focused even more clearly on our statutory obligation to regulate the broker-dealer subsidiaries of the banking conglomerates. The information from the bank holding company level that the SEC will continue to receive under the MOU will strengthen our ability to protect the customers of the broker-dealers and the integrity of the broker-dealer firms.

The Inspector General’s office also made 26 specific recommendations to improve the CSE program, which are comprehensive and worthy of support. Although the CSE program is ending, we will look closely at the applicability of those recommendations to other areas of the Commission’s work and move to aggressively implement them.

As we learned from the CSE experience, it is critical that Congress ensure there are no similar major gaps in our regulatory framework. Unfortunately, as I reported to Congress this week, a massive hole remains: the approximately $60 trillion credit default swap (CDS) market, which is regulated by no agency of government. Neither the SEC nor any regulator has authority even to require minimum disclosure. I urge Congress to take swift action to address this.

Finally, I would like to commend the extraordinary efforts of the SEC’s diligent staff, who for so many months have been working around the clock in the current market turmoil. Their dedication and commitment in behalf of investors and the American people are unequaled.

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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:

Chairman Cox talks to the Senate regarding hedge funds and the markets

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There has been so much news and volitility over the past couple of weeks that it is hard to get a feeling of where things are headed.  It seems pretty clear, however, that this in this brave new world of government sponsored capitalism there is likely to be more hedge fund regulation in the picture.  Look forward to some interesting articles that we have coming up and this article on Chairman Cox’s statements to Congress.

This morning the Securities and Exchange Comission’s Chairm Christopher Cox testified to the Sentate Committee on Banking, Housing, and Urban Affairs regarding the current market events. Pertinent excepts from the speech follow:

On the new short sale rules

Last week, by unanimous decision of the Commission and with the support of the Secretary of the Treasury and the Federal Reserve, the SEC took temporary emergency action to ban short selling in financial securities. We took this action in close coordination with regulators around the world. At the same time, the Commission unanimously approved two additional measures to ease the crisis of confidence in the markets that threatened the viability of all financial firms, and which potentially threatened the ability of our markets to function in a fair and orderly manner. The first makes it easier for issuers to repurchase their own shares on the open market, which provides an important source of liquidity in times of market volatility. The second requires weekly reporting to the SEC by hedge funds and other large investment managers of their daily short positions — just as long positions are currently reported quarterly on Form 13F.
All of these actions relying upon the Commission’s Emergency Authority under Section 12(k) of the Securities Exchange Act remain in effect until October 2, and are intended to stabilize the markets until the legislation you are crafting becomes law and takes effect.t

The Commission’s recent actions followed on the heels of new market-wide SEC rules that more strictly enforce the ban on abusive naked short selling contained in Regulation SHO. These new rules require a hard T+3 close-out; they eliminate the options market maker exception in Regulation SHO; and they have put in place a new anti-fraud rule expressly targeting fraudulent activity in short-selling transactions.

On Bear Stearns

Recently the Commission brought enforcement actions against two portfolio managers of Bear Stearns Asset Management, whose hedge funds collapsed in June of last year. We allege that they deceived their investors and institutional counterparties about the financial state of the hedge funds, and in particular the hedge funds’ over-exposure to subprime mortgage-backed securities. The collapse of the funds caused investor losses of over $1.8 billion.

On monitoring the large investment banks

The SEC’s own program of voluntary supervision for investment bank holding companies, the Consolidated Supervised Entity program, was put in place by the Commission in 2004. It borrowed capital and liquidity measurement approaches from the commercial banking world — with unfortunate results similar to those experienced in the commercial bank sector. Within this framework, prior to the spring of 2008, neither commercial bank nor investment bank risk models contemplated the scenario of total mortgage market meltdown that gave rise to, for example, the failure of Fannie Mae and Freddie Mac, as well as IndyMac and 11 other banks and thrifts this year.

…

But beyond highlighting the inadequacy of the pre-Bear Stearns CSE program capital and liquidity requirements, the last six months — during which the SEC and the Federal Reserve have worked collaboratively with each of the CSE firms pursuant to our Memorandum of Understanding — have made abundantly clear that voluntary regulation doesn’t work. There is simply no provision in the law that authorizes the CSE program, or requires investment bank holding companies to compute capital measures or to maintain liquidity on a consolidated basis, or to submit to SEC requirements regarding leverage. This is a fundamental flaw in the statutory scheme that must be addressed, as I have reported to the Congress on prior occasions.

Because the SEC’s direct statutory authority did not extend beyond the registered broker dealer to the rest of the enterprise, the CSE program was purely voluntary — something an investment banking conglomerate could choose to do, or not, as it saw fit. With each of the remaining major investment banks now constituted within a bank holding company, it remains for the Congres.s to codify or amend as you see fit the Memorandum of Understanding between the SEC and the Federal Reserve, so that functional regulation can work.

On the CDS Markets

The failure of the Gramm-Leach-Bliley Act to give regulatory authority over investment bank holding companies to any agency of government was, based on the experience of the last several months, a costly mistake. There is another similar regulatory hole that must be immediately addressed to avoid similar consequences. The $58 trillion notional market in credit default swaps — double the amount outstanding in 2006 — is regulated by no one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market. This is an area that our Enforcement Division is focused on using our antifraud authority, even though swaps are not defined as securities, because of concerns that CDS offer outsized incentives to market participants to see an issuer referenced in a CDS default or experience another credit event.

Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS. Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based.   Certainly we

SEC releases statement on protection of customer assets

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One of the major questions right now from both hedge fund investors and hedge fund managers is how safe are their assets.  I will be writing an article detailing the answer to this question over the next couple of days.

In the interim, the SEC has released a statement and so has FINRA.  I have posted a brief portion of the FINRA statement which can be found here.  I have also posted the entire SEC statement which can be found here.

FINRA Statement

In virtually all cases, when a brokerage firm ceases to operate, customer assets are safe and typically are transferred in an orderly fashion to another registered brokerage firm. Multiple layers of protection safeguard investor assets. For example, registered brokerage firms must keep their customers’ securities and cash segregated from their own so that, even if a firm fails, its customers’ assets will be safe. Brokerage firms are also required to meet minimum net capital requirements to reduce the likelihood of insolvency, and to be members of the Securities Investor Protection Corp (SIPC), which insures customer securities accounts up to $500,000. SIPC is used in those rare cases of firm failure where customer assets are missing because of theft or fraud. In other words, SIPC is the last course of action in the unlikely event that the other customer protections have failed.

SEC Statement

Statement of SEC Division of Trading and Markets Regarding the Protection of Customer Assets
FOR IMMEDIATE RELEASE
2008-216

Washington, D.C., Sept. 20, 2008 — The Securities and Exchange Commission’s Division of Trading and Markets today issued the following statement:

In recent days, Securities and Exchange Commission staff have received a number of questions from investors regarding the protection of their assets held by broker-dealers.

Customers of U.S. registered broker-dealers benefit from the extensive protections provided by the Commission rules, including the Customer Protection Rule, as well as protection by the Securities Investor Protection Corporation (SIPC). The Commission’s Customer Protection Rule requires a broker-dealer to segregate customer cash and securities from a broker-dealer’s own proprietary assets. More specifically, the rule requires that a broker-dealer keep customer cash and fully paid securities free of lien and in a safe location.

Any person who has deposited funds or securities in a securities account at a broker-dealer is a “customer” under the Customer Protection Rule. Securities customers of U.S. broker-dealers are not permitted to opt out of the protections afforded by the Customer Protection Rule. There is a technical exception for affiliates of the broker-dealer, but this exception would not affect the protections generally extended to a customer’s funds and securities deposited at the broker-dealer.

In addition to the Commission’s rules that protect securities customers, SIPC also protects securities customers up to $500,000 per customer, including a maximum of $100,000 for cash claims. To determine if your broker-dealer is a member of SIPC, or to learn more about the SIPC protections, you can check the SIPC website at www.sipc.org.

SEC to hedge funds – show us your shorts

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In a time of unprecedented moves by the federal government, the SEC is halting short sales in certain financial stocks.  The SEC is also requiring large institutional investors, such as hedge funds, to show the world their short positions.  The press release can be found here.  The list of financial stocks which cannot be shorted by hedge funds can be found here.

SEC Halts Short Selling of Financial Stocks to Protect Investors and Markets
FOR IMMEDIATE RELEASE
2008-211
Commission Also Takes Steps to Increase Market Transparency and Liquidity

Washington, D.C., Sept. 19, 2008 — The Securities and Exchange Commission, acting in concert with the U.K. Financial Services Authority, today took temporary emergency action to prohibit short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence. The U.K. FSA took similar action yesterday.

The Commission’s action will apply to the securities of 799 financial companies. The action is immediately effective.

SEC Chairman Christopher Cox said, “The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets. The emergency order temporarily banning short selling of financial stocks will restore equilibrium to markets. This action, which would not be necessary in a well-functioning market, is temporary in nature and part of the comprehensive set of steps being taken by the Federal Reserve, the Treasury, and the Congress.”

Today’s decisive SEC action calls a time-out to aggressive short selling in financial institution stocks, because of the essential link between their stock price and confidence in the institution. The Commission will continue to consider measures to address short selling concerns in other publicly traded companies.

Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets. At present, it appears that unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation. Financial institutions are particularly vulnerable to this crisis of confidence and panic selling because they depend on the confidence of their trading counterparties in the conduct of their core business.

Given the importance of confidence in financial markets, today’s action halts short selling in 799 financial institutions. The SEC’s emergency order, pursuant to its authority in Section 12(k)(2) of the Securities Exchange Act of 1934, will be immediately effective and will terminate at 11:59 p.m. ET on Oct. 2, 2008. The Commission may extend the order beyond 10 business days if it deems an extension necessary in the public interest and for the protection of investors, but will not extend the order for more than 30 calendar days in total duration.

The Commission notes today’s similar announcement by the U.K. FSA. The SEC and FSA are consulting on an ongoing basis with regard to short selling matters and will continue to cooperate in carrying out regulatory actions.

The Commission also has taken the following steps to address the recent market conditions:

  • Temporarily requiring that institutional money managers report their new short sales of certain publicly traded securities. These money managers are already required to report their long positions in these securities.
  • Temporarily easing restrictions on the ability of securities issuers to re-purchase their securities. This change will give issuers more flexibility to buy back their securities, and help restore liquidity during this period of unusual and extraordinary market volatility.

The Commission may consider additional steps as necessary to protect the integrity and quality of the securities markets and strengthen investor confidence.

Form D filing now done online

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Earlier this year the SEC approved the formation of an automated filing system for Form D. As noted in this article on Form D, the filing must be made with the SEC 15 days after the first sale of hedge fund interests. While the launch of the new online system was supposed to make it easier for small companies (including hedge funds) to make the filing, in implementation it is a two-step, potentially cumbersome process. In the next few weeks after we make some of these filings, I will be able to rate the new SEC Form D online filing system. The press release below announcing the new system can be found here.

SEC Launches Voluntary Online Filing System for Form D to Reduce Burden on Smaller Companies

Securities and Exchange Commission today began accepting filings of Form D through the Internet as part of the agency’s overall efforts to reduce unnecessary paper filings and regulatory burdens, particularly for smaller companies.

The new rules providing for online filing and simplification of Form D notices were approved by Commission at the end of last year. Form D filings are made mostly by smaller companies, and notify the SEC of sales of securities in private and certain other non-registered offerings of securities. Many states also require Form D notice filings.

“With electronic filing, the information available in Form D filings will now be far more accessible to all users,” said John White, Director of the Division of Corporation Finance. “We look forward to hearing from voluntary filers over the next six months about their experiences as we prepare to move to the mandatory system next spring.”

The SEC’s new Form D online filing system features simplified and updated information requirements and is voluntary until March 16, 2009. Companies and funds required to file Form D notices may continue to file them on paper until that date, following either the old or new information requirements. Guidance on the Form D filing process with the new system as well as more information about filing and amending a Form D notice are available on the SEC Web site.

Form D filers are encouraged to use the voluntary system and inform SEC staff about their experiences. The SEC staff expects adjustments will be made to the system to increase its utility and user-friendliness before the online filing of Form D becomes mandatory. Filers can report their experiences to the SEC’s Office of Small Business Policy in its Division of Corporation Finance at (202) 551-3460 or [email protected].

The SEC staff is continuing to work with the North American Securities Administrators Association (NASAA) to link its Form D filing system with a system built by state securities regulators that would accept state Form D filings. No timetable has been adopted for linking the two systems. (Press Rel. 2008-199)

What is a qualified client? Qualified client definition

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UPDATE: the below article is based on the old “qualified client” definition.  The new “qualified client” definition can be found in full here, and the SEC order increase the asset thresholds can be found here.  As a gross summary, the new definition of a qualified client is:

  • entity or natural person with at least $1,000,000 under management of the advisor, OR
  • entity or natural person who has a net worth of more than $2,100,000

For the second test above, natural persons exclude the value of (and debt with respect to) their primary residence (assuming the primary residence is not under water).

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Certain hedge fund managers need to be registered as investment advisors with the SEC or with the state securities commission of the state which they reside in.  For SEC-registered investment advisors, and most state registered advisors, the investors in their hedge fund will need to be “qualified clients” in addition to the requirement that such investors are also accredited investors.  While many accredited investors will also be qualified clients, this might not always be the case because the qualified client defintion requires a higher net worth than the accredited investor definition.  Hedge fund managers who are required to have investors who are both accredited investors and qualified clients cannot charge performance fees to those investors who do not meet the qualified client definition.  Individual investors will generally need to have a $1.5 million net worth in order to be considered a “qualified client.”

The definition of “qualified client” comes from rules promulgated by the SEC under the Investment Advisors Act of 1940, specifically Rule 205-3.  That rule provides:

The term qualified client means:

1. A natural person who or a company that immediately after entering into the contract has at least $750,000 under the management of the investment adviser;

2. A natural person who or a company that the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either:

a. Has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $1,500,000 at the time the contract is entered into; or

b. Is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 at the time the contract is entered into; or

3. A natural person who immediately prior to entering into the contract is:

a. An executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser; or

b. An employee of the investment adviser (other than an employee performing solely clerical, secretarial or administrative functions with regard to the investment adviser) who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser, provided that such employee has been performing such functions and duties for or on behalf of the investment adviser, or substantially similar functions or duties for or on behalf of another company for at least 12 months.

SEC comments on Lehman Bankruptcy

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From the SEC website.  The release can be found here.

Statement Regarding Recent Market Events and Lehman Brothers (Updated)
FOR IMMEDIATE RELEASE
2008-198

Washington, D.C., Sept. 15, 2008 — The decision by Lehman Brothers Holdings Inc. to file for protection under Chapter 11 of the bankruptcy laws is expected to lead to the winding down of Lehman Brothers Inc., its U.S. regulated broker-dealer, outside of bankruptcy. The accounts of Lehman’s U.S. retail securities customers are with the broker-dealer. In cases such as this, Lehman Brothers’ customers will benefit from their extensive protections under SEC rules, including segregation of customer securities and cash as well as insurance by the Securities Investor Protection Corporation. These safeguards are designed to ensure that a broker-dealer’s customers will be protected.

In the weeks ahead, SEC staff who have been on-site at the U.S. broker-dealer will remain in place to oversee the orderly transfer of customer assets to one or more SIPC-insured brokerage firms. The holding company bankruptcy filing does not affect in any way the SIPC protection applicable to the firm’s customers.

The SEC is also coordinating with overseas regulators to protect Lehman’s customers and to maintain orderly markets.

“For several days, we have worked closely with regulators around the world including the FSA in the United Kingdom, the BaFin in Germany, and the FSA in Japan, as well as our counterparts in other markets around the world, to coordinate our actions in the interest of orderly markets,” said SEC Chairman Christopher Cox. “In doing so we have also worked closely with the Treasury and the Federal Reserve and market participants. We are committed to using our regulatory and supervisory authorities to reduce the potential for dislocations from Lehman’s unwinding, and to maintain the smooth functioning of the financial markets.”

In furtherance of these objectives, the SEC is focused on ensuring that customers of the U.S. broker-dealer, which is not part of the bankruptcy filing, remain protected through, among other means, enforcing continued compliance with the SEC net capital and customer asset protection rules, and with SEC requirements that the U.S. broker-dealer conduct its affairs so as to minimize the effect of the holding company’s bankruptcy on customers, and that it ensure access to customer cash and securities.

In the meantime, Lehman Brothers Holdings Inc. will continue to operate while the bankruptcy process facilitates the reconciliation of claims and the realization of value from its assets in an orderly fashion.

Customers of Lehman Brothers Inc. may contact the SEC’s Office of Investor Education and Advocacy for individual assistance at [email protected]

Investment Advisor faces fine and injuction for unauthorized leverage

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As a hedge fund lawyer one of my most important jobs is to help keep the client out of any trouble and to help the manager deal with any potential issues before they become issues.

Below is a classic example of an investment manager who did not adequately describe his investment program (and the risks). One of the more important parts of the hedge fund start up process is to create an investment program which accurately describes the trading which the fund will engage in. While many offering documents include very broad language allowing a manager to make changes to the investment program, gross or wholesale changes should be communicated to the investor (potentially with the right to redeem the interests, depending on the hedge fund’s terms and structure). The highlighted language below emphasizes the point that descriptions of a hedge fund’s investment program should be accurate, as well as the point that hedge fund managers should never lie or intentionally mislead their clients.

The full release can be found here.

Release:

U.S. SECURITIES AND EXCHANGE COMMISSION
Litigation Release No. 20713 / September 11, 2008
SEC v. Mark D. Lay and MDL Capital Management, Inc., Civil Action No. 08-CV-1269 (DSC) (W.D. Pa.)
SEC Charges Mark D. Lay and MDL Capital Management, Inc. With Defrauding Ohio Bureau of Workers’ Compensation

The Securities and Exchange Commission announced that today it filed securities fraud charges in the United States District Court for the Western District of Pennsylvania against Mark D. Lay of Aliquippa, Pennsylvania, and MDL Capital Management, Inc. (“MDL Capital”), an investment adviser registered with the Commission and located in Pittsburgh, Pennsylvania. Lay was the Chairman, CEO and Chief Investment Strategist of MDL Capital and part-owner of MDL Capital. Without admitting or denying the allegations of the Complaint, Lay and MDL Capital have consented to the entry of a final judgment permanently enjoining them from engaging in the violations set forth below, and ordering other relief

The Commission’s Complaint alleges that, between February 2004 and November 2004, Lay and MDL Capital defrauded their advisory client, the Ohio Bureau of Workers’ Compensation, in connection with the Bureau’s investment of public money in the MDL Active Duration Fund, Ltd., a hedge fund affiliated with and managed by Lay and MDL Capital. The Bureau transferred approximately $200 million from its advisory account managed by MDL Capital and Lay to the hedge fund pursuant to an agreement that those assets would be conservatively leveraged.

The Complaint further alleges that MDL Capital and Lay exposed Bureau funds to unauthorized and undisclosed risk by substantially exceeding a 150% leverage guideline, at one point using leverage of over 21,000% in the hedge fund. As a result, the Bureau incurred losses of approximately $160 million. During the course of the fraud, Lay repeatedly lied to and misled the Bureau as to the reasons for and amount of the losses as well as the excessive leverage Lay was using.

In October 2007, based on these same facts, Lay was convicted in the Northern District of Ohio of criminal mail fraud, wire fraud and investment adviser fraud. Lay is currently serving a 12 year prison sentence.

The Complaint alleges that Lay and MDL Capital violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940. Subject to the Court’s approval, the final judgment imposes permanent injunctions against MDL Capital and Lay and orders them to pay $1,544,195 in disgorgement and prejudgment interest, but waives payment of these amounts, and does not impose civil penalties, based on the defendants’ sworn statements of financial condition.

SEC Charges Investment Adviser with Cherry-Picking

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So many of the investment advisory rules and regulations are based on common sense principles.  The story below is another example of a manager not using common sense with regard to the allocation of trades between different accounts.  Using a hedge fund’s assets to pay personal expenses is blatantly illegal.  Unfortunately there are too many of these cases out there and investors must do everything they can to protect themselves from such hedge fund frauds.  (One way to do this is through a hedge fund manager background check which is part of the hedge fund due diligence process.)

The article below can be found here.

SEC Charges Investment Adviser with Cherry-Picking

On September 9, the Commission charged James C. Dawson with securities fraud and investment adviser fraud, for orchestrating a cherry-picking scheme in which he allocated profitable trades to his personal account at the expense of his clients. Dawson is the investment adviser to a hedge fund, Victoria Investors, and individual clients.

The Commission’s complaint, filed in the U.S. District Court for the Southern District of New York, alleges that from April 2003 through October 2005, Dawson allocated profitable trades to his personal account by purchasing securities throughout the day in a single account and allocating the trades amongst his clients and his personal account after he saw whether the trades were profitable. The Commission’s complaint further alleges that Dawson used Victoria Investors’ funds to pay for personal and family expenses. Dawson did not tell his clients -Victoria Investors or his individual clients – about his cherry-picking scheme, and did not tell Victoria Investors that he was using fund assets for his personal expenses.

The Commission alleges that Dawson violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Investment Advisers Act. The Commission seeks an order permanently enjoining Dawson from violating these provisions of the federal securities laws, and seeks disgorgement of ill-gotten gains and losses avoided, plus prejudgment interest, and civil penalties against Dawson. [SEC v. James C. Dawson, 08 Civ. 7841 (SDNY) (WCC)] (LR-20707)