Tag Archives: State hedge fund laws

Wall Street Reform Bill Issues – Performance of State Securities Regulators

As we move closer to the signing of the Dodd-Frank Wall Street Reform and Consumer Protection Act, more groups are highlighting the fact that state securities divisions are going to be affected by the act.  After pressure from NASAA, the association of state securities regulators, Congress has provided that state regulators will be required to provide oversight of investment advisers with up to $100 million of AUM – a significant increase from the current level of $30 million of AUM.  Of course this will increase the number of advisers that the states oversee and will make the job of the securities divisions much more difficult.  We have consistently stated that we do not think the states, collectively, are going to be capable to provide proper oversight with the increase in responsibility – mostly because of budget issues.  We have been surveying the states to see which divisions have budget issues and will be reporting on that shortly.  Until then we will examine one securities division which has faced scrutiny from members of the investment community and the state legislature.

Overview of Utah Division of Securities Audit

Over the years there has been a number of complaints about the manner in which the Utah Division of Securities conducts business – a simple Google search will reveal a number of interesting stories.  After repeated complaints the state legislature decided to audit the division and released a report in July of 2008 entitled A Performance Audit of the Division of Securities.

The results are nothing less than shocking.

Faith in government agencies is based on the belief that they will act fairly and effectively.  The report shows capricious behavior and essentially a belief that members of the investment management community are ‘guilty’ until proven ‘innocent’.  Special attention should be paid to the fact that the state securities divisions do have power to make life miserable for a business owner, even if that business owner has not acted wrongly.  Redress is difficult and “the Division Always Wins” (see below).  It is in with this understanding that we question whether the states will be in the best position to oversee the investment management industry.

Below are a number of direct quotes from the audit – many should make any ready angry and sick.  [Please note that we are not saying that all securities divisions have these problems.  Additionally, we have not conducted any follow up with Utah so we do not express any opinion on the current state of the division.]


Reason for audit:

The credibility of the Division of Securities has been challenged by those investigated by the division. Their concerns are with procedural errors, an alleged overzealous pursuit of securities violations, and the perception that those investigated do not receive fair treatment.

While the division protects securities investors, it is alleged the division has abused its power and damaged reputations. The division has significant authority but its credibility depends on using that authority judiciously.

Page i

Ad Hoc Manner of Conducting Investigations:

There does not appear to be a consistent relationship between the number of complaints, number of cases opened, and the number of actions filed. This is because cases can be opened without a resulting action, there can be multiple actions on one case, or the action may not be filed until the following year. In addition, our evaluation leads us to believe the information is not reliable.

Page 3

Reason for Division Audit

Legislators requested this audit based on concerns about how the division managed three cases. We reviewed the division’s administrative process followed in these cases and a number of others brought to our attention. We did not address the legal issues of any of the cases. Our work has been complicated by the desire of many interviewees to keep their names confidential. They fear reprisal for criticizing the division’s actions.

Page 9

Lack of Policies & Procedures Equals Inconsistent Decisions

The division has not been operating under set, written policies and procedures. As a result, division decisions for actions against the regulated industry and the treatment of its employees rest solely with department and division management. Frequent management changes have brought changes in management philosophy and an increased likelihood for inconsistent decisions.

Page 9

Years of No Policies & Procedures

During the course of this audit, we were told that the division did have policies and procedures a number of years ago. However, there have been no written policies and procedures in place, or operational procedures followed, for at least the last four years under the direction of three division directors.  Shortly before this audit’s completion, division staff found a discarded copy of a 1993 policies and procedures manual. It is disconcerting that the division has faced procedural control difficulties for a number of years, yet no one in either departmental or divisional leadership noted the lack of policies and procedures.

Page 9 and 10


Complaints surfaced that those charged with securities violations could not get a fair hearing.

Page 10

Division Bias Ignored

In several cases, it was questionable if the former director had maintained an independent and unbiased perspective. For example, the former director did not recuse himself from serving as the presiding officer after helping to draft the pleadings for the case. It was apparent he was no longer impartial. Even the perception that the presiding officer is biased is concerning as it can give the appearance of unfair treatment.

Page 10

Intimidation…and…the Division always wins…

Those accused of securities violations told us they felt intimidated into settling, given that the division’s former director would likely serve as the presiding officer. One business owner perceived the system as “a stacked deck” because the investigator, jury, and judge are all in the same office. He informed us that during an investigation, a division employee boasted that the division always wins.

Page 11

State Lawyer Effectively Pushed Out

poor communication between the former director and an attorney resulted in the exclusion of the attorney from a decision on how a case would be handled, even though the attorney had been involved in the case for a number of months. The attorney was frustrated and raised concerns when the former director drafted and sent out documents over the attorney’s name, thus implying the AG gave his approval, even though the attorney was not aware a decision had been made and had not reviewed the final document. He learned about the legal action when defendants contacted him because they assumed he represented the division. The former director contends that the attorney was familiar with the document.

Pages 12-13

Questionable Actions

During the audit, many individuals associated with various cases contacted us with complaints about the division. Our review of case files resulted in a number of questionable actions including: inappropriate publicity, emphasis on punishment rather than compliance, the use of intimidation tactics, violating terms of settlement agreements, failure to notify those being investigated, and inconsistent case management.

Page 15

Fear of Retaliation!!??

To evaluate these complaints, we reviewed case files, listened to tapes of hearings, and interviewed staff and attorneys involved with the cases. Many of those who talked with us requested confidentiality because they feared retaliatory action by the division if they were identified.

Page 15

Inconsistent Procedures…

questionable actions often can be attributed to the divisions lack of clearly defined procedures. A discarded policy manual states that “the manual will be reviewed and updated on a yearly basis to reflect current or additional practices.” Not complying with this requirement has resulted in division policies and procedures that are inconsistently applied.

Page 15

Emphasis on Punishment Rather than Compliance

The division appears to emphasize punishment of offenders rather than compliance with securities laws. A number of those involved in the division’s actions believe the division has overzealously pursued securities violations. They criticize that charges are brought one after another, cases are drawn out over long periods of time, and decisions on who to investigate can be arbitrary.

Page 17

Threats and Coercion

The division’s use of intimidation to obtain information has been cited by both those being investigated and others involved with the division. In one case, the accused stated that an investigator attempted to coerce cooperation by intimidating and threatening that the person would be arrested. In another case, investigators seized personal information by copying all information from the business owner’s computer without distinguishing business and personal information. The owner said that he complied with the investigator’s demands only because they threatened to immediately close him down if he refused.

Page 18-19

Does not Honor Settlement Agreements

The division has, at times, violated the terms of its settlement agreements. In one case, the division agreed to not publicize the action or commence further administrative actions and then violated both terms of the agreement. The person accused told us he felt compelled to plead guilty to a lesser criminal charge rather than place his business in jeopardy defending a greater charge. The division agreed to not seek additional charges but nevertheless pursued an administrative action. The respondent then signed the settlement agreement after the division agreed to not publicize it. However, the day the settlement was signed, the division publicized the information on its web page and also published the information in its newsletter the following month.

Page 19-20

Surprised Charges Filed…Harming Innocent Business

According to the business owner, he learned about the investigation only after it was completed and charges were filed. Before he had an opportunity to respond, the media called to ask about the division revoking his license and issuing fraud charges. The media release was damaging to the business and the resulting retraction and apology was damaging to the division.

Page 21

Fines Arbitrary!!??

The division has been criticized for not identifying how fines are set. Board minutes disclosed the former director explained that fines are set to “make it hurt,” which is troublesome to those in the securities industry. The former director explained to us that fines are set based on an evaluation of the seriousness, nature, circumstances, and persistence of the conduct which is consistent with the Financial Industry Regulatory Authority (FINRA) guidelines. However, because the division does not have written guidelines or procedures identifying the process used to set fines, they appear to be set arbitrarily, based solely at the discretion of the division.

Page 22

Staff Demoralized, Scared of Reprisal

Personnel conflicts within the Division of Securities (division) have resulted in management turnover and a demoralized staff. Both the department executive director and the division’s former director have been open about their beliefs that specific employees have seemed reluctant to accept change and may be subverting management authority. A number of division staff feel their jobs are threatened or other forms of management reprisal may occur should they offend management in some way. The escalating conflicts have resulted in reprimands, restructuring, and ultimately, the resignation of the director, and the threat of legal action by several employees.

Page 25

Division Blatantly Breaks Laws at Director’s Direction

After being hired in October 2005, a number of the former director’s actions have been questionable. He was reprimanded and received a one-day suspension without pay for instructing staff to hold fine payment checks without processing them within the three-day time period required by statute (Utah Code 51-4-1). Delaying the deposit would allow the division to retain funds in the division rather than transfer them to the state general fund. By statute, if a balance in the division’s education fund exceeds $100,000 at the close of a fiscal year, the excess must be transferred to the General Fund (Utah Code 61-1-18.7(6)).

Staff related other instances in which they feel the former director gave them inappropriate directions. For example, staff provided information showing the director:

  • directed staff to sign pleadings that the former director had either drafted or modified, possibly to prevent his name, as the presiding officer, from appearing on documents. Administrative rules state “the signature shall be deemed to be a certification that the signer has read the pleading and that, to the best of his knowledge and belief, there is good ground to support it.”
  • directed staff to provide protected information to an influential person which violates Utah securities law prohibiting employees from disclosing non-public information filed with or obtained by the division (Utah Code 61-1-18.3).
  • used coercive settlement tactics by instructing staff to keep unwarranted allegations in the pleadings to serve as a bargaining chip for the negotiations. The respondent agreed to the settlement after the allegations were removed.
Page 30-31

We hope that this provides another look at the issue of having the states responsible for investment advisers with a wide ranging practice which may involve investors from many states.


Other related hedge fund law articles:

Cole-Frieman & Mallon LLP provides comprehensive formation and hedge fund start up support.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Investment Advisory Fees | Hedge Fund Performance Fees and Management Fees

Review of State Investment Advisory Fee Rules

One of the things I have tried to emphasize within this blog is that there is no “one size fits all” legal solution to hedge fund formation.  Each client/manager has a unique set of circumstances and will be subject to a potentially different sets of laws or regulations depending on those circumstances.  This is especially true with regard to those managers who must register in a state that requires hedge fund manager registration.  Because no two sets of state laws and regulations are the same, the manager must make sure that he understands the rules which are specific to his state.

High Asset Management Fees and Disclosure

One issue which comes up every now and again is whether or not disclosure will be required when the manager charges an annual asset management fee in excess of 3% of AUM.  Generally regulators will require that certain disclosures be made to investors through the manager’s disclosure documents (generally in both the Form ADV and the hedge fund offering documents).  Sometimes the regulator will require such disclosures based on a general provision (see CO IA fee rule discussion below) or on more explicit provisions (see 116.13(a) of the Texas Administrative Code).  In either case managers will generally be required to make a prominent disclosure to investors that a 3% (or higher) annual asset management fee is in excess of industry norms and that similar advisory services may be obtained for less (whether or not this is true).  While such a disclosure would, in most instances, be a best practice, managers should be aware that it may also be required if they are registered with a particular state.

State Performance Fee Rules

Like management fee disclosures, the rules for performance fees may differ based on the state of registration.  For example, here are how four different states deal with performance fee issue:

Texas – Like most states, Texas allows state-registered investment advisers to charge performance fees only to those investors in a fund which are “qualified clients” as defined in Rule 205-3 of the Investment Advisers Act. This means that a hedge fund manager can only charge performance fees to investors in the fund which have a $1.5 million net worth or who have $750,000 of AUM with the manager (can be in the fund and through other accounts).  See generally  116.13(b) of the Texas Administrative Code reprinted below.

New Jersey – Many states adopted laws and regulations based on the 1956 version of the Uniform Securities Act and have yet to make the most recent update to their laws and regulations (generally those found in the 2002 version of the Uniform Securities Act).  Under the New Jersey laws a manager can charge performance fees to those clients with a $1 million net worth.

Indiana – similar to New Jersey, Indiana has laws which allow a manager to charge performance fees to those investors with a $1 million  net worth.  Additionally, Indiana allows a manager to charge performance fees or to those investors who have $500,000 of AUM with the manager (can be in the hedge fund and through other separately managed accounts).  Indiana also has an interesting provision which specifies the manner in which the performance fee may be calculated – it requires that the fee be charged on a period of no less than one year.  This rule is based on an earlier version of SEC Rule 205-3.  What this means, essentially, is that managers who are registered in Indiana cannot charge quarterly performance fees, but must charge their performance fees only on an annual basis (or longer).

Michigan – Unlike any other state, Michigan actually forbids all performance fees for Michigan-registered investment advisors.  The present statute is probably an unintended consequence of some sloppy drafting.  Nonetheless, it is a regulation on the books.  Hedge Fund Managers registered with Michigan, however, should see the bright spot – Michigan is in the process of updating its securities laws and regulations.  This means that sometime in late 2009 or early 2010 it should be legal for investment advisors in Michigan to charge their clients a performance fee under certain circumstances (likely to mirror the SEC rules).

New York – Sometimes, states will have some wacky rules.  In the case of New York, there are no rules regarding performance fees.

Other Issues

With regard to performance fees, the other issue which should be discussed with your hedge fund lawyer is whether or not the state “looks through” to the underlying investor to determine “qualified client” status.  Generally most states will follow the SEC rule on this issue and look through the fund to the underlying investors to make this determination.

While these cases are just a couple of examples of the disparate treatment of similarly situated managers, they serve as a reminder that investment advisor (and securities) laws may differ wildly from jurisdiction to jurisdiction.  Managers should be aware of the possibility of completely different laws and should be ready to discuss the issue with legal counsel.

The various rules discussed above have been reprinted below.


Texas Rule

The full text of the Texas IA fee rules can be found here and are copied below.

§116.13.Advisory Fee Requirements.

(a) Any registered investment adviser who wishes to charge 3.0% or greater of the assets under management must disclose that such fee is in excess of the industry norm and that similar advisory services can be obtained for less.

(b) Any registered investment adviser who wishes to charge a fee based on a share of the capital gains or the capital appreciation of the funds or any portion of the funds of a client must comply with SEC Rule 205-3 (17 Code of Federal Regulations §275.205-3), which prohibits the use of such fee unless the client is a “qualified client.” In general, a qualified client may include:

(1) a natural person or company who at the time of entering into such agreement has at least $750,000 under the management of the investment adviser;

(2) a natural person or company who the adviser reasonably believes at the time of entering into the contract:  (A) has a net worth of jointly with his or her spouse of more than $1,500,000; or (B) is a qualified purchaser as defined in the Investment Company Act of 1940, §2(a)(51)(A) (15 U.S.C. 80a-2(51)(A)); or

(3) a natural person who at the time of entering into the contract is: (A) An executive officer, director, trustee, general partner, or person serving in 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 function or duties for or on behalf of another company for at least 12 months.

CO Rule

The full text of the Colorado laws and regulations can be found here.  The fee discussion is reprinted below.

51-4.8(IA) Dishonest and Unethical Conduct


A person who is an investment adviser or an investment adviser representative is a fiduciary and has a duty to act primarily for the benefit of its clients. While the extent and nature of this duty varies according to the nature of the relationship between an investment adviser and its clients and the circumstances of each case, an investment adviser or investment adviser representative shall not engage in dishonest or unethical conduct including the following:

J. Charging a client an advisory fee that is unreasonable in light of the type of services to be provided, the experience of the adviser, the sophistication and bargaining power of the client, and whether the adviser has disclosed that lower fees for comparable services may be available from other sources.

New Jersey

The full text of the New Jersey performance fee rules can be found here and are copied below.

13:47A-2.10 Performance fee compensation

(b) The client entering into the contract subject to this regulation must be a natural person or a company as defined in Rule 205-3, who the registered investment advisor (and any person acting on the investment advisor’s behalf) entering into the contract reasonably believes, immediately prior to entering into the contract, is a natural person or a company as defined in Rule 205-3, whose net worth at the time the contract is entered into exceeds $1,000,000. The net worth of a natural person shall be as defined by Rule 205-3 of the Investment Advisors Act of 1940.



The Indiana rule can be found here and is reprinted below.

(f) The client entering into the contract must be either of the following:

(1) A natural person or a company who immediately after entering into the contract has at least five hundred thousand dollars ($500,000) under the management of the investment adviser.

(2) A person who the investment adviser and its investment adviser representatives reasonably believe, immediately before entering into the contract, is a natural person or a company whose net worth, at the time the contract is entered into, exceeds one million dollars ($1,000,000). The net worth of a natural person may include assets held jointly with that person’s spouse.


The current law (until October 1, 2009) can be found here and is copied below.

451.502 Investment adviser; unlawful practices.

(b) It is unlawful for any investment adviser to enter into, extend, or renew any investment advisory contract unless it provides in writing all of the following:

(1) That the investment adviser shall not be compensated on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client.

New York

No laws regarding performance fees for state registered investment advisers.


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, Cole-Frieman & Mallon LLP, is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.

Hedge Fund Law – State Law Issues

Dealing with Ambiguous State Securities Laws

An issue which often arises during the planning phase of the hedge fund formation process is whether certain state securities or investment advisory laws or regulations apply to a certain fact situation.  Many times these issues arise in the context of investment advisor registration (especially with regard to “custody” and net worth requirements), but they can also apply to less common issues (such as spot forex registration and matters involving commodities and futures licensing).  The problem is not only that the laws and regulations may not apply to a specific situation (many state laws are based on a model code which was written over 50 years ago), but also that there are no judicial or administrative actions which can provide valuable insight into how the state or the enforcement division would view a similar situation.

Unfortunately it can be very hard to receive clarification on these laws and regulations  and sometimes reaching out to state regulators can be an exercise in futility.  In a recent call with the California Department of Corporations (which is in charge of, among other things, administering the state securities laws) I was practically scolded by the staff attorney for first reaching out to the state to determine if they had any informal thoughts on my question.  In situations where we cannot receive informal guidance from a state, the client may choose to request a no-action letter from the state with regard to their situation.

Requesting a No-Action Letter or Interpretive Opinion

NASAA, the North American Securities Administrators Association, has provided this description of no-action letters and interpretive opinions:

Many state securities regulators have the authority issue “no-action letters” in which staff confirms that a transaction carried out under a set of assumed facts will not result in a recommendation for enforcement action.  Some states also issue “interpretive opinions” in which staff provides guidance by indicating how a provision of law applies to a situation presented.

Generally states will allow groups to submit either request.  The request letter will include a restatement of the applicable facts and laws and an argument as to why the requested relief or opinion should be granted.  The attorney will draft this letter on behalf of the manager.  The manager will also need to pay a fee to the state, usually $100-$300 to receive an answer to the request letter.  There is no guarantee that the state will agree with manager and grant any relief.  It will usually take a minimum of 30 days to receive an answer from the state.

Unfortunately the process is both expensive and time consuming.

Fixing the Problem

There are many problems with the federalism system with regard to securities regulation.  One of the biggest issues is the lack of uniformity between the state laws and the disparity between states with regard to enforcement.  I posted an article yesterday about what NASAA is doing this area.  I commend NASAA for taking this step forward – it will be a big improvement over the current system and hopefully will lead to more uniform laws (and application of those laws) throughout the states.  However, this is not a panacea and we are unlikely to see truly fair and efficient enforcement of laws unless there is a wholesale scrapping of the current system and unfortunately even then we are still left with federalism which provides state securities commissions with powers that most do not understand how to deal with.

Ultimately this increases costs to the managers and ultimately investors.

Alabama Hedge Fund Law – Regulation D Filings

In our continuing effort to expand our hedge fund law resources on this blog, we will be posting statutes and other legal resources from each of the states.  Because each state has different laws and enforces those laws differently, hedge fund lawyers often discuss state specific hedge fund issues with the securities division prior to providing advice to clients.  The post below provides information on Alabama’s regulation D requirements.  Please contact us if you would like to establish an Alabama hedge fund or have questions on Alabama investment advisory issues. Continue reading