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Cole-Frieman & Mallon 2021 Half Year Update

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July 13, 2021

Clients, Friends, Associates:

We hope that this message finds you well and that you are enjoying the first months of summer. As we move into the third quarter, we would like to provide you with a brief overview of some items that we hope will help you stay on top of the business and regulatory landscape in the coming months. We are also delighted to report our firm and Co-Managing Partner, Karl Cole-Frieman, were highlighted as leading crypto and blockchain lawyers by Business Insider. For additional firm updates, please follow us on LinkedIn. 

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SEC Matters

SEC Revises Qualified Client Threshold. The SEC recently published an order approving adjustments to the tests which define a “Qualified Client” under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Specifically, the “net worth” threshold has been increased from $2,100,000 to $2,200,000 and the dollar amount for the “assets-under-management” test has been raised from $1,000,000 to $1,100,000. The Qualified Client threshold is critically important for investment advisers because in nearly all jurisdictions, including for SEC registered investment advisers, performance fees and incentive allocations can only be charged to investors who are Qualified Clients. The new definitions become effective August 16, 2021 (the “Effective Date”), but will not be applied retroactively to contractual relationships existing as of such date. Additionally, an investor who satisfied the previous Qualified Client test and who subscribed for interests in a private fund prior to the Effective Date will remain subject to any applicable performance fees, and may make additional subscriptions (subject to performance fees) without needing to satisfy the new threshold amounts.

All investment advisers should promptly update their subscription documents to ensure that new investors who agree to make investments on or after the Effective Date have provided accurate representations regarding their Qualified Client status.

SEC adopts Marketing Rule (replaces Advertising Rule and Cash Solicitation Rule). On May 4, 2021, the SEC adopted new marketing rules for investment advisers. The new rules drastically overhaul and replace the prior cash solicitation and advertising rules applicable to investment advisers, their marketing materials, and their advertising practices to replace. SEC no-action letters pertaining to the prior cash solicitation rule will be nullified as the rule is being rescinded in practice. The most significant changes include the allowance of testimonials and endorsements, which under the prior rules were conditionally permitted to be used in advisers’ marketing materials. The new marketing rule now permits such use only if the adviser complies with specific disclosure, oversight, and disqualification provisions. Third-party ratings are now also permitted, though, just like testimonials and endorsements, they are subject to detailed disclosure and other presentation criteria.

The new marketing rule also overhauls how investment advisers can utilize social media. The SEC created concepts of “adoption” and “entanglement” with respect to posts on social media and, depending on whether an investment adviser has “adopted” a social media post or “entangled” itself in one, there are a series of rules applicable to each such post. More importantly, social media posts of persons associated with an investment adviser can also be viewed as the investment adviser’s communication or advertisement. Thus, investment advisers should adopt policies and procedures which distinguish their associated persons’ personal social media posts from those of the investment adviser. 

Specific rules and guidance now apply to various types of performance advertising, including gross, net, hypothetical, related, and extractive performance. Many of these rules now codify prior SEC no-action letter guidance on these topics. 

Investment advisers have some room to breathe since the compliance period for these new marketing rules begins on November 4, 2022.

SEC Brings Action for Defrauding Investors in Scheme Involving Pre-IPO Shares. On April 27, 2021, the SEC charged a former broker barred by FINRA with fraudulently raising funds. The complaint alleges that the defendant solicited investors by claiming to purchase shares of notable “unicorn” companies prior to their initial public offerings. However, the defendant failed to invest the funds and instead stole the money, using it to pay family members and purchase a Maserati. The defendant is charged with violating the antifraud provisions of Section 10(b) of the Securities and Exchange of 1934 and Rule 10b-5 thereunder and Section 17(a) of the Securities Act of 1933. 

SEC Announces Partially Settled Charges After Investment Adviser Fails to Report Bad Investments. On April 15, 2021, the SEC filed a complaint against the co-founder and COO of an investment adviser for violating the anti-fraud provisions of the Securities Exchange Act of 1934 and the Securities Act of 1933. The SEC alleges the defendant defrauded hedge fund clients by creating fake “performing” loans to replace defaulted loans in order to hide losses. The SEC further alleges that the defendant created liquidity or met redemption requests by selling overvalued loans to new investors to pay off earlier investors. Collectively, the series of fraudulent acts hid tens of millions of losses. The SEC has already obtained final judgement against the investment adviser itself, requiring it to pay in excess of $35 million in prejudgement interest and disgorgement.

SEC Brings Action for Failure to Follow Stated Investment Criteria. In a recent enforcement action, the SEC has alleged that a Texas-based registered investment advisor (“RIA”) defrauded investors by failing to follow stated investment criteria. The complaint alleges that the principal along with its investment adviser representative (“IAR”) targeted older and unsophisticated investors with promises of high returns from secure investments in “proven” companies which met the firm’s stated investment criteria. However, the complaint goes on to allege that the firm only invested in high-risk and fraudulent companies which were affiliated with and owned by the firm’s principal and/or his older brother. The SEC alleges that this Texas-based RIA made materially false and misleading statements to investors about expected financial returns and the financial health of these companies. Moreover, the principal and his older brother allegedly falsified the financial documents of their companies to inflate their assets, misused funds for their own benefit, failed to make adequate disclosures of the conflicts of interests, failed to comply with rules governing the custody of client assets, and overall violated federal securities laws, including antifraud provisions. The SEC is seeking permanent injunctive relief, disgorgement of ill-gotten gains plus prejudgement interest, civil penalties, and any equitable and ancillary relief deemed necessary by the court.

SEC Obtains Asset Freeze After Uncovering Cherry-picking Scheme. On June 17, 2021, the SEC announced that it obtained an asset freeze and filed fraud charges in connection to a cherry-picking scheme where a Miami-based investment professional and two investment firms allegedly funneled trading profits to preferred accounts. The complaint alleges defendants engaged in a long-running fraudulent trade allocation scheme. Approximately $4.6 million in profitable trades were allocated to accounts held by relatives of the defendants while several other investment advisory clients bore first day losses totaling more than $5.5 million. This investigation originated in the Market Abuse Unit’s Analysis and Detection Center, which uses data analysis to detect suspicious activity such as impossibly successful trading. The SEC is currently seeking permanent injunctions, disgorgement, prejudgment interest, and civil penalties. It also intends to recover any unlawful gains and prejudgment interest from the preferred accounts.

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Digital Asset Matters

Update on BitMEX Lawsuit. On October 1, 2020, the Department of Justice filed a criminal complaint against specific individuals associated with BitMex for violating and conspiring to violate the Bank Secrecy Act. The CFTC also filed a civil complaint against BitMEX, alleging failure to register with the CFTC and violation of various laws and regulations under the Commodity Exchange Act. Both actions are pending in the U.S. District Court for the Southern District of New York. On February 10, 2021, the Department of Justice intervened in the CFTC case and sought a stay of discovery pending the criminal case’s resolution. On February 11, the CFTC submitted a letter not to oppose the DOJ’s stay. On March 24, United States District Judge Mary Kay Vyskocil granted the motion to permit the DOJ to intervene in the CFTC case for the purpose of seeking a stay of discovery, further noting that the DOJ is permitted to file a motion to stay discovery after the defendants have responded to the complaint. Both cases remain pending. These two lawsuits signal that the DOJ and the CFTC has and will continue to monitor the digital asset market. 

SEC Files Action Against Ripple for Unregistered Securities Offering. In December 2020, the SEC filed an action against Ripple Labs Inc. (“Ripple”) and two of its executives in the U.S. District Court for the Southern District of New York, alleging that they raised over $1.3 billion through an unregistered, ongoing digital asset securities offering. The SEC’s case rests on the proposition that XRP is a security because investors who purchased XRP anticipated that profits would be dependent upon Ripple’s efforts to manage and develop the market for XRP. The case remains pending. The outcome of this lawsuit, although uncertain at this point, may have significant impact on the future regulation on cryptocurrencies and blockchain technologies.

South Korea to Introduce 20% Tax on Crypto Trading Profits. South Korea will implement a 20% capital gains tax on Bitcoin (BTC) and cryptocurrency profits starting January 1, 2022. The tax is expected to be triggered when profits exceed 2.5 million Won, with gain made up to this point being tax-exempt.

Yield Farming Strategies. As decentralized finance (“DeFi”) applications continue to develop, the interest in yield farming has grown exponentially. At a high level, the goal of yield farming is to maximize returns by leveraging various DeFi protocols, and this can be done in a few different ways. To employ a yield farming strategy, a liquidity provider essentially locks its digital assets in a liquidity pool (where users can lend, borrow, or exchange tokens), thus providing liquidity to that pool. In return, the liquidity provider receives an annual percentage return. Liquidity mining, a type of yield farming, provides liquidity providers with reward tokens on top of that annual return. Liquidity providers can then deposit reward tokens into other liquidity pools to earn more rewards and repeat this process countless times. To increase the potential return of an investment, yield farmers can also deposit tokens as collateral to a liquidity pool, then use the borrowed tokens as further collateral to then borrow more tokens, and so on. It is important to note that if a position becomes undercollateralized, there is a risk that the DeFi protocol may liquidate the collateral which could result in a total loss to the liquidity provider. While the potential of impressive returns is enticing, those interested in yield farming strategies should consider the many risks inherent in such strategies, including impermanent loss, price slippage, smart contract code bugs leading to hacks or fraud, “rug pulling” scams, as well as the risk of under collateralization, which can incidentally result from price movements of the borrowed token.

El Salvador Adopts Bitcoin Legal Tender. On June 8, 2021, the Salvadorian Congress approved new legislation, making it the first country to adopt Bitcoin as legal tender. “The purpose of this law is to regulate Bitcoin as unrestricted legal tender with liberating power, unlimited in any transaction, and to any title that public or private natural or legal person require carrying out,” the law reads. Under the new law, prices can be displayed in Bitcoin, taxes can be paid in Bitcoin, and transactions conducted using the digital currency will not be subject to a capital gains tax. The exchange rate with the U.S. Dollar (El Salvador’s current official currency) will be established by the market. The law also adds that the Salvadorian government will implement trainings and other mechanisms to ensure that its citizens can access Bitcoin transactions.

DeFi “Raises Challenges” for Investors, Regulators, SEC’s Gensler Says. In a written testimony before the House Appropriations Committee, SEC Chairman Gary Gensler discussed the challenges posed by decentralized finance. Examples of the challenges of DeFi given include market volatility and novel product offerings. Gensler’s concerns surrounding DeFi did not come as a surprise. In January, SEC Commissioner Hester Peirce offered the following quote: “It’s going to be challenging to us because most of the way we regulate is through intermediaries and when you really build something that’s decentralized, there’s no intermediary…. It’s great for resilience of a system but it’s much harder for us when we’re trying to go in and regulate to figure out how to do that”. Gensler has also previously suggested establishing a dedicated market regulator for cryptocurrency in order to provide protection against market manipulation and fraud. As DeFi continues to grow, it will be interesting to watch regulator’s approach to DeFi as it may have a large impact on the emerging space. 

SEC Petitioned on NFTs as NFT Platform is Sued in Class Action. On April 12, 2021, a broker-dealer registered with the SEC and FINRA issued a petition to the SEC, calling for a concept release of regulations for nonfungible tokens (NFTs) and rules addressing when NFTs are considered securities. The petitioner notes that the existing definition of a security does not explicitly include NFTs, but NFTs that promise a “return on investment from the efforts of others”, could be deemed a security under the Howey test. The petitioner further clarifies that if an NFT “relates to an existing asset and is marketed as a collectible with a public assurance of authenticity on the blockchain, it should not be deemed a security.” To date, the SEC has not issued interpretive guidance on NFTs and has not initiated any enforcement actions against an NFT creator or NFT trading platform.

This petition arrives as Dapper Labs, the creator of the popular NFT marketplace NBA Top Shot, faces a class action lawsuit. The plaintiffs assert that NBA Top Shot’s “moments”, NFTs sold as collectable video highlights, are securities. These allegations center on the argument that moments increase in value as NBA Top Shot rises in popularity, therefore satisfying the Howey Test. The complaint also alleges that Dapper Labs has controlled the marketplace in way that prevents users from “cashing out” their purchases, keeping their value artificially high. It will be interesting to see how these issues are resolved by the SEC and the courts, as if NFTs are determined to be a security either by the SEC or the courts, NFT marketplaces and issuers may be forced to register with the SEC.

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CFTC Matters

Changes for Form CPO-PQR. Beginning with the March 31, 2021 reporting date, a revised and streamlined Form CPO-PQR will be used based on recent CFTC amendments. The revised Form CPO-PQR has been reduced to one schedule (Schedule A), and all reporting commodity pool operators (“CPOs”) will file the revised Form CPO-PQR every quarter, regardless of size. Technical updates have also been made, which make the form easier to fill out. 

Default Judgment Entered Against Operator of Cryptocurrency Pool. On March 29, 2021, the U.S. District Court for the District of Nevada entered a default judgement against an Australian national and his Nevada corporation in connection with a cryptocurrency fraud and misappropriation scheme. The court concluded that the defendants made false claims about the individual’s trading acumen and baselessly guaranteed high rates of return in soliciting investors into a pool operated by the Nevada corporation. The pool engaged in off-exchange binary options trading on forex and cryptocurrency pairs; however, the defendants also stole participants’ funds and comingled assets in the individual’s personal cryptocurrency wallet. Additionally, the defendants effected a Ponzi scheme by paying investor redemptions with funds from other investors. Although the default judgment orders the defendants to pay restitution, disgorgement of profits and penalties totaling more than $32 million, the CFTC cautions investors that such order does not guarantee participants a full recovery.

CFTC Establishes Climate Risk Unit. In March, Acting CFTC Chairman Rostin Behnam announced the establishment of the Climate Risk Unit (“CRU”), which will assess the efficacy of derivatives products in addressing climate and weather-related risks in the financial system. Also, in an effort to reduce carbon emissions world-wide, the CRU will represent the CFTC in industry discussions in furtherance of this mission. The CRU also intends to, inter alia, facilitate dialogue regarding emerging climate risks, develop new products to help transition to a “net-zero” economy, support development of climate-related market risk data, and evaluate the utility of other tools (e.g., regulatory sandboxes) in accelerating such products and services.

NFA’s New Notice Requirements for CPOs Became Effective as of June 30, 2021. The NFA’s newly adopted Compliance Rule 2-50 requires CPOs to notify the NFA upon the occurrence of certain events such as a commodity pool’s ability to fulfill its obligations to investors or a potential unplanned liquidation of the pool. CPOs are now required to notify the NFA if they: (1) operate a pool that cannot meet a margin call, (2) operate a pool that cannot satisfy redemption requests in accordance with their subscription agreements, (3) operate a pool that has stopped redemptions unrelated to existing lockups or gates, and pre-planned cessation of operations or (4) receive notice from a swap counterparty that a pool operated by the CPO is in default. This rule applies to all pools operated by a CPO, including pools that meet the “de minimis” threshold pursuant to CFTC Regulation 4.13(a)(3). Generally, notice of a specified event must occur no later than 5:00 pm CT of the next business day; provided that, Interpretive Notice 9080 gives examples of when notice is not required (e.g., if a CPO reasonably expects to meet the margin call within the time prescribed by its FCM).

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Other Matters

Corporate Transparency Act Requires Disclosure of Ownership Information of Certain Entities. Overriding President Trump’s veto, Congress enacted the National Defense Authorization Act for Fiscal Year 2021 on January 1, 2021, which, among other things, includes the Corporate Transparency Act (the “CT Act”) requiring certain ‘reporting companies’ to report their beneficial ownership information to the Financial Crimes Enforcement Network (“FinCEN”). Today, the CT Act excludes from the definition of ‘reporting companies’ registered investment advisers, venture capital fund advisers that file Form ADV, and private investment funds advised by investment advisers and identified by name on such advisers Form ADV. However, investment advisers relying on the private fund exemption are not exempt from the CT Act and, absent changes in the regulations adopted by the U.S. Treasury, will be required to report their beneficial ownership information to FinCEN. The CT Act goes into effect on the date regulations are issued by the U.S. Treasury, which shall occur no later than January 1, 2022. FinCEN is currently soliciting public comment on questions about the new reporting requirements.

Executive Orders Prohibit the Purchase of Publicly Traded Communist Chinese Military Company Securities by U.S. Persons. President Trump signed Executive Order 13959 on November 12, 2020, and subsequently amended it with Executive Order 13974 on January 13, 2021, to prohibit the purchase of publicly traded Communist Chinese Military Company (“CCMC”) securities, including securities that are derivative of or designed to provide investment exposure to such CCMC securities. The orders prohibit the purchase by U.S. persons of any such securities beginning 60 days after an entity is designated as a CCMC, and require U.S. persons to divest from those securities within one year of such designation. Therefore, for the CCMCs initially designated on November 12, purchase of such securities was prohibited beginning January 11, 2021, and all U.S. persons must divest by November 11, 2021. While the Office of Foreign Asset Control has issued an FAQ clarifying the orders, neither the orders nor the FAQ provide clarity on whether U.S. persons must divest from foreign private funds that hold CCMC securities, and it remains to be seen if the new administration will seek to amend the order before divestment is required. A list of entities designated CCMCs as of June 16, 2021 can be found here.

New York Eliminates Pre-Offer Filing Requirements for Rule 506 Offerings under Regulation D. The New York Attorney General announced on December 1, 2020, an amendment to New York’s antiquated and controversial securities regulations applicable to offerings made under Rule 506 of Regulation D. The old rule required issuers to file a Form 99 prior to any sale or offering of such “covered securities” in the state. Beginning on December 2, 2020, the updated rule eliminated the Form 99 requirement and provided that notice filings shall be made within 15 days following the date of the first sale of applicable securities via the North American Association of Securities Administrators electronic filing depository system. The filing fee continues to be based on the offering amount and is unchanged from the fees required prior to the adoption of the new rule.  

Registration of New York IARs. Starting February 1, 2021, IARs who engage in business within or from New York and principals or supervisors of New York-state registered investment advisers must register with the New York Investor Protection Bureau (the “NYIPB”) by filing a Form U4 or updating an existing Form U4, and must also meet certain exam requirements. IARs with a place of business in New York that represent SEC-registered investment advisers that notice-file in New York must also register with the NYIPB. The new regulations grant IARs operating in New York prior to February 1, 2021, a grace period to submit their Form U4 until August 31, 2021, and such IARs may continue such service without an approval until December 2, 2021.

Employers can Inquire about the Vaccination Status of Employees. On May 28, 2021, the U.S. Equal Employment Opportunity Commission (“EEOC”) updated its guidelines on the COVID-19 vaccine and Americans with Disabilities Act (“ADA”) compliance. The guidelines reaffirmed the EEOC’s previous position that employers can ask their employees whether or not they have received the COVID-19 vaccine but added that any vaccination status documentation must be kept confidential and stored separately from the employee’s personnel file. It is recommended for employers to only ask for the bare minimum, such as a vaccination card or survey response, to prevent employees from providing additional medical information and implicating the ADA. Additionally, employers can “encourage” employee vaccinations by providing information on approved vaccines, addressing common questions and concerns, or by offering incentives to employees who receive the vaccine. As of the date of publication, there are no examples of states passing laws conflicting with EEOC guidance, but this may change as companies continue to return to the office.

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Compliance Calendar

Please consult our Compliance Calendar for key dates as you plan your regulatory compliance timeline for the coming months and contact us with any questions for assistance with any of the above topics.

We wish you and yours a safe and healthy summer.

Sincerely, Karl Cole-Frieman, Bart Mallon, Lilly Palmer, David Rothschild, & Scott Kitchens

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Cole-Frieman & Mallon LLP is one of the top investment management law firms in the United States, known for providing top-tier, innovative, and collaborative legal solutions for complex financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP services both start-up investment managers and multi-billion-dollar firms. The Firm provides a full suite of legal services to the investment management community, including hedge fund, private equity fund, venture capital fund, mutual fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters. The Firm also publishes the prominent Hedge Fund Law Blog, which focuses on legal issues that impact the hedge fund community. For more information, please add us on LinkedIn and visit us at colefrieman.com.   

New Hedge Fund Laws Proposed in Connecticut

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State to Increase Regulation of Hedge Funds

(www.hedgefundlawblog.com)  Connecticut, home of many of the biggest hedge funds in the world, may begin regulating hedge funds in a heavy handed manner.  Recently state lawmakers have introduced three bills (Raised Bill No. 953, Raised Bill No. 6477 and Raised Bill No. 6480) which would greatly increase oversight of hedge funds which have a presence in Connecticut.   This article provides an overview of the three raised bills and provides reprints the actual text of these bills.

Raised Bill No. 953

The largest of the three bills, No. 953 has the following central features:

  • Definitions certain terms (including the term “Hedge Fund”) which are used throughout the bill.
  • Provides that, starting in 2011, hedge funds may not have individual investors  who do not have $2.5 million in “investment assets” (different than net worth)
  • Provides that, starting in 2011, hedge funds may not have institutional investors who do not have $5 million in “investment assets”
  • Provides that funds must disclose certain conflicts of interest of the manager
  • Provides that funds must disclose the existence of side letters
  • Requires an annual audit (beginning in 2010)

The above provisions would apply to those funds which have an office in Connecticut where employees regularly conduct business on behalf of the fund.   It is currently unclear whether there will be any sort of grandfathering provisions for those funds which currently have investors who do  not meet the “investment assets” threshold.   Another interesting part of the bill is that it defines a hedge fund with reference to Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act.  The recently proposed Hedge Fund Transparency Act would actually eliminate these sections and add new Section 6(a)(6) and Section 6(a)(7).

Raised Bill No. 6477

The next bill is No. 6477 which would require hedge funds to be regulated by the Connecticut Banking Commission.  The bill requires hedge funds to purchase a $500 license issued by the Connecticut Banking Commissioner prior to conducting business in Connecticut.  The license would need to be purchased each year.  The bill also provides the Banking Commission with authority to adopt regulations.

This bill is interesting because it is fundamentally different from most hedge fund regulations which seek to regulate the management company through investment advisor registration.  This bill regulates the fund entity (as opposed to the management company) and does so through the power of the state to regulate banking.   Right now it looks like this bill will apply to all hedge funds, even those who do not utilize leverage.  It is not currently clear why or how the Banking Commission has jurisdiction non-banking private pools of capital, especially for those funds which do not utilize any sort of leverage.

It is also interesting to note that No. 6477 would apply regardless of the registration status of the fund’s management company.  This means that a fund could be subject to SEC oversight and may also be subject to direct oversight by the Connecticut Department of Banking (“DOB”), which means the DOB could presumably conduct audits of the fund.  Of course, this could potentially greatly increase operational costs for hedge funds with an office in Connecticut.

Raised Bill No. 6480

The final bill is No. 6480 which would require Connecticut based hedge funds with Connecticut pension fund investors to disclose detailed portfolio information to such pension funds upon request.  It goes without saying that this bill is likely to receive a considerable amount of scrutiny from the Connecticut hedge fund community.

Conclusion

The hedge fund industry continues to be a major focus of both state and federal lawmakers who are anxious to start regulating these vehicles.  Unfortunately we are witnessing a patchwork approach to regulation where there is little communication between the states and the federal lawmakers.  If other states follow Connecticut’s lead then we face the potential situation where funds in each state will need to follow state specific laws enacted by quick-to-legislate, out-of-touch lawmakers.   Efficiency in the securities markets is undercut by overlapping and unnecessary regulations – both managers and investors would be better served by a comprehensive effort to revise the securities laws at the federal and state levels.

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Raised Bill No. 953
January Session, 2009

Referred to Committee on Banks
Introduced by: (BA)

AN ACT CONCERNING HEDGE FUNDS.

Be it enacted by the Senate and House of Representatives in General Assembly convened:

Section 1. (NEW) (Effective October 1, 2009) (a) As used in this section:

(1) “Hedge fund” means any investment company, as defined in Section 3(a)(1) of the Investment Company Act of 1940, located in this state (A) that claims an exemption under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940; (B) whose offering of securities is exempt under the private offering safe harbor criteria in Rule 506 of Regulation D of the Securities Act; and (C) that meets any other criteria as may be established by the Banking Commissioner in regulations adopted under subsection (f) of this section. A hedge fund is located in this state if such fund has an office in Connecticut where employees regularly conduct business on behalf of the hedge fund;

(2) “Institutional investor” means an investor other than an individual investor including, but not limited to, a bank, savings and loan association, registered broker, dealer, investment company, licensed small business investment company, corporation or any other legal entity;

(3) “Investment assets” includes any security, real estate held for investment purposes, bank deposits, cash and cash equivalents, commodity interests held for investment purposes and such other forms of investment assets as may be established by the Banking Commissioner in regulations adopted under subsection (f) of this section;

(4) “Investor” means any holder of record of a class of equity security in a hedge fund;

(5) “Major litigation” means any legal proceeding in which the hedge fund is a party which if decided adversely against the hedge fund would require such fund to make material future expenditures or have a material adverse impact on the hedge fund’s financial position;

(6) “Manager” means an individual located in this state who has direct and personal responsibility for the operation and management of a hedge fund; and

(7) “Material” means, with respect to future expenditures or adverse impact on the hedge fund’s financial position, more than one per cent of the assets of the hedge fund.

(b) On or after January 1, 2011, no hedge fund shall consist of individual investors who, individually or jointly with a spouse, have less than two million five hundred thousand dollars in investment assets or institutional investors that have less than five million dollars in assets.

(c) The manager shall disclose to each investor or prospective investor in a hedge fund, not later than thirty days before any investment in the hedge fund, any financial or other interests the manager may have that conflict with or are likely to impair, the manager’s duties and responsibilities to the fund or its investors.

(d) The manager shall disclose, in writing, to each investor in a hedge fund (1) any material change in the investment strategy and philosophy of the fund and the departure of any individual employed by such fund who exercises significant control over the investment strategy or operation of the fund, (2) the existence of any side letters provided to investors in the fund, and (3) any major litigation involving the fund or governmental investigation of the fund.

(e) On January 1, 2010, and annually thereafter, the manager shall disclose, in writing, to each investor in a hedge fund (1) the fee schedule to be paid by the hedge fund including, but not limited to, management fees, brokerage fees and trading fees, and (2) a financial statement indicating the investor’s capital balance that has been audited by an independent auditing firm.

(f) The Banking Commissioner may adopt regulations, in accordance with chapter 54 of the general statutes, to implement the provisions of this section.\

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Raised Bill No. 6477
January Session, 2009

Referred to Committee on Banks
Introduced by: (BA)

AN ACT CONCERNING THE LICENSING OF HEDGE FUNDS AND PRIVATE CAPITAL FUNDS.

Be it enacted by the Senate and House of Representatives in General Assembly convened:

Section 1. (NEW) (Effective October 1, 2009) (a) No person shall establish or conduct business in this state as a hedge fund or private capital fund without a license issued by the Banking Commissioner. Applicants for such license shall apply to the Department of Banking on forms prescribed by the commissioner. Each application shall be accompanied by a fee of five hundred dollars. Such license shall be valid for one year and may be renewed upon payment of a fee of five hundred dollars and in accordance with the regulations adopted pursuant to subsection (b) of this section.

(b) The Banking Commissioner shall adopt regulations in accordance with the provisions of chapter 54 of the general statutes for purposes of this section.

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Raised Bill No. 6480
January Session, 2009

Referred to Committee on Banks
Introduced by: (BA)

AN ACT REQUIRING THE DISCLOSURE OF FINANCIAL INFORMATION TO PROSPECTIVE INVESTORS IN HEDGE FUNDS AND PRIVATE CAPITAL FUNDS.

Be it enacted by the Senate and House of Representatives in General Assembly convened:

Section 1. (NEW) (Effective October 1, 2009) Any hedge fund or private capital fund that is (1) domiciled in the state, and (2) receiving money from pension funds domiciled in the state shall disclose to each prospective pension investor in such funds, upon request, financial information including, but not limited to, detailed portfolio information relative to the assets and liabilities of such funds.

Another Ponzi Scheme

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Broken Record

I’ve said it all before.  The following press release can be found here.  Please see the following articles on hedge fund and investment advisor fraud.

Continue reading →

Hedge Fund Law – Summary of Hedge Fund Laws and Regulations

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he following is a summary of the major laws which affect the hedge fund industry.  If you have any questions on how these laws impact hedge funds in general or your specific situation, please contact us.

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Securities Act of 1933 – the 1933 Act was enacted on May 27, 1933 as a reaction to the market crash of 1929. The overarching purpose of the act was to require that all “securities” be registered with the government (at the time the FTC). The Act provides some exemptions from this general requirement; for hedge fund managers, the most important exemption from registration is found in Section 4(2) which provides that securities will not need to be registered is they are sold in a transaction which does not involving any public offering. Continue reading →

SEC Wins another Hedge Fund Fraud Case – Provides Insight to Hedge Fund Managers

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Hedge fund fraud cases are important because they give some definition and life to the various investment advisor and hedge fund laws.  Much of the advice that hedge fund lawyers give to their clients is based on reasonableness and best guesses on how the securities laws will be implemented in the hedge fund context.  For many hedge fund issues there are not clear cut cases which give color to the securities laws.  One of my colleagues refers to this as the “square peg – round hole” dilemma by which he means it is hard to apply the archaic securities laws with the current state of the hedge fund and investment management industry.

When the SEC does bring cases, as practitioners we get to see how the SEC views the securities rules and how we should be advising clients. While many of the fraud cases represent completely unbelievable actions by unscrupulous people, there are still lessons which well-intentioned managers can learn from.

Specifically this case gives us an opportunity to examine five separate areas which invesment managers should be aware of:

1.    Make sure all statements in the hedge fund offering documents and collateral marketing materials is are accurate.

In this case the hedge fund offering documents contained many material misstatements including materially false and misleading statements in offering materials and newsletters about, among other things, the Funds’ holdings, performances, values and management backgrounds.  For example the complaint alledges:

Specifically, both PPMs represented that most investments made by Partners and Offshore would trade on “listed exchanges.” In truth, a majority of those funds’ investments were and are on unlisted exchanges such as the OTCBB or pink sheets. Furthermore, the Partners’ PPM stated that investors would receive yearly audited financials upon request. Partners has not obtained audited financials since the year ended 2000 and repeatedly refused at least one investor’s requests for audited financials for the year ended 2001.

2.    Make sure all appropriate disclosure relating to personnel are made.

Hedge fund attorneys will usually spend time with the manager discussing the employees of the management company and their backgrounds.  During this time the attorney will ask the manager, among other questions, whether any person who is part of the management company has been involved in any securities related offense.  In this case there were two specific items which the manager should have disclosed in the offering documents and other collateral material:

Failed to disclose that a “consultant” to the management company was enjoined, fined and also barred from serving as an officer or director of a public company for five years for his fraudulent conduct involving, among other things, misallocating to himself securities while serving as CFO and later president of a publicly traded company.

Failed to discloase a member of the fund’s board of directors was barred from associating with any broker or dealer for 9 years.

3.    Take care when going outside stated valuation policies.

Many hedge fund documents have stated valuation policies but then allow the manager to modify the valuation, in the manager’s discretion, to better reflect the true value of the securities.  However, when a manager uses this discretion, the manager should have a basis for the valuation.  Such valuation should not be based on an artificially inflated value of the asset.  To be safe managers should probably have some internal valuation policies which should be in line with generally accepted valuation standards for such assets.  I found the following paragraph from the SEC’s complaint particularly interesting (emphasis added):

II. Bogus Valuations

34. In order to obtain at least year end 2001 audited financials for Offshore, Lancer Management provided Offshore’s auditor with appraisals valuing certain of that fund’s holdings. These appraisals mirrored or closely approximated the values assigned to Offshore’s holdings by Defendants based on the manipulated closing prices at month end. These valuation reports were, however, fatally flawed and did not reflect the true values of Offshore’s holdings under the generally accepted Uniform Standards of Professional Appraisal Practice or American Society of Appraisers Business Valuation Standards. For example, the valuations were improperly based on unreliable market prices of thinly traded securities; unjustified prices of private transactions in thinly traded securities; unfounded, baseless and unrealistic projections; hypotheticals; and/or an averaging of various factors. Indeed, under accepted standards of valuing businesses, certain of the Funds’ holdings were and/or are essentially worthless.

4.    Do not engage in market manipulation.

Many of the securities in which this hedge fund invested were traded on the OTCBB.  The fund engaged in trading in these securities near valuation periods in order to artificially inflate the price of these very thinly traded securities.  Additionally, the complaint alleges many incidents of “marking the close.”  This goes without saying but a hedge fund manager should not engage in market manipulation.

5.    Always produce accurate portfolio statements.  Do not overstate earnings.  Always make sure that statements to investors are accurate.

Enough said.

While many of the examples above are so egregious they probably do not need to be listed on a “do not” list, you should make sure you do not engage in any of these activities. Additionally, if you do make some error or mistake (for example, if a valuation turns out to be incorrect or inaccurate), immediately contact your attorney to create a plan to inform investors about the incorrect or inaccurate statements.  A mistake can generally be cured, all out fraud cannot.

I have posted a full text version of the SEC’s case, SEC v. Lauer.  I have included the statement by the SEC below which can be found here.

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SEC Wins Major Hedge Fund Fraud Case Against Michael Lauer, Head of Lancer Management Group

FOR IMMEDIATE RELEASE
2008-225

Washington, D.C., Sept. 24, 2008—The Securities and Exchange Commission announced that a district court judge today granted its motion for summary judgment against the architect of a massive billion-dollar hedge fund fraud.

Michael Lauer of Greenwich, Conn., was found liable for violating the anti-fraud provisions of the federal securities laws. In a 67-page order, The Honorable Kenneth A. Marra, U.S. District Judge for the Southern District of Florida, found that Lauer’s fraud as head of two Connecticut-based companies – Lancer Management Group and Lancer Management Group II – that managed investors’ money and acted as hedge fund advisers was “egregious, pervasive, premeditated and resulted in the loss of hundreds of millions of dollars in investors’ funds.”

Linda Chatman Thomsen, Director of the SEC’s Division of Enforcement, said, “This case highlights the SEC’s ongoing efforts to combat hedge fund fraud and our dedicated work on behalf of investors to ensure that hedge fund managers are held accountable for any unlawful conduct.”
David Nelson, Director of the SEC’s Miami Regional Office, added, “We are particularly gratified at this decision, which resulted from several years of hard work to protect investors, starting when we successfully halted the fraud while it was still ongoing.”

Lauer raised more than $1.1 billion from investors and his fraudulent actions caused investor losses of approximately $500 million. The SEC initially won emergency temporary restraining orders and asset freezes against Lauer and his companies, which were placed under the control of a Court-appointed receiver after the SEC filed its enforcement action in 2003.

During the protracted litigation, the SEC successfully stopped Lauer from diverting or hiding millions of dollars of assets from the Court’s asset freeze.

The summary judgment order found that Lauer:

  • Materially overstated the hedge funds’ valuations for the years 1999 to 2002.
  • Manipulated the prices of seven securities that were a material portion of the funds’ portfolios from November 1999 through at least April 2003.
  • Failed to provide any basis to substantiate or explain the exorbitant valuations of the shell corporations that saturated the funds’ portfolios.
  • Hid or lied to investors about the Funds’ actual holdings by providing them with fake portfolio statements.
  • Falsely represented the funds’ holdings in newsletters.

The judge’s order entered a permanent injunction against Lauer against future violations of Sections 17(a)(1)-(3) of the Securities Act of 1933 (Securities Act), Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 (Exchange Act), and Sections 206(1) and (2) of the Investment Advisers Act of 1940 (Advisers Act). The order reserved ruling on the SEC’s claim for disgorgement with prejudgment interest against Lauer, and on the amount of a financial penalty Lauer must pay. The SEC is seeking a financial penalty and disgorgement of the more than $50 million Lauer received in ill-gotten gains from his fraudulent scheme.