Sponsors with funds located in the BVI should be aware that at the beginning of next year there will be a new regulatory regime.  Starting on January 1, 2011, all funds must comply with the requirements of the Securities and Investment Business Act, 2010 (“SIBA”) instead of the current Mutual Funds Act, 1996 (“MFA”).

The new laws are much stricter than the previous laws and continue the push by the BVI Financial Services Commission (FSC) to maintain greater oversight of funds located in the BVI.  Managers with BVI funds should pay careful attention to the new laws and make revisions to their documents or operations accordingly.

Below is an overview of the major new requirements under the SIBA:

• Disclaimer on Offering Documents – in the event a fund offers interests or shares on or after December 31, 2010, the fund offering documents must be amended to include the prescribed investment warning under the new law.  The subscription agreements must also include an acknowledgement from any new investor that it has received, understood and accepted the investment warning.
  • Note: these documents must be filed with the Financial Services Commission (“Commission”) within 14 days of their issue.
• 2 Directors – all private funds must at all times have at least 2 directors (at least 1 of which is an individual).
  • Note: a change of the board (and auditor) must be filed with the Commission within 14 days.
• Manager, Administrator, and Custodian – all private funds must have a manager, an administrator, and a custodian which is independent from the manager and administrator.
  • Note:  funds may apply to the Commission from an exemption from the requirement to have a custodian or a manager.
• Notices
  • Appointing a new custodian, administrator, prime broker, or manager must be reported to the Commission at least 7 days prior to the appointment.
  • Audited accounts must be filed within 6 months of the financial year end.
  • 14 days notice to the Commission is also required for change in place of business and amendments of constitutional or offering documents.
  • Annual returns must be filed by June 30 of each year.

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Other related articles include:

• Offshore Hedge Funds Overview
• Offshore Hedge Fund Timeline
• Important Hedge Fund Articles

Bart Mallon, Esq. is a hedge fund attorney and works with a variety of domestic and offshore hedge fund manager.  He can be reached directly at 415-868-5345.

Why QEP Definition is Important for CPOs

The definition of QEP is important for commodity pool operators (CPOs) in a couple of situations.  The first is the 4.13(a)(4) exemption from the registration provisions for a CPO that provides advice to a commodity pool with only QEPs.  The second situation where a CPO will need to make sure the investors are QEPs is if they want to take advantage of the Rule 4.7 exemption.  The Rule 4.7 exemption allows CPOs to follow less-strict reporting requirements with regard to the commodity pool they manage.  These two exemptions essentially provide for reduced regulatory oversight of a CPO who provides advisory services to these class of investors.

Definition of QEP

A qualified eligible person is an investor who fits into one of two distinct groups: (1) investors who do not need to meet the portfolio requirement and (2) investors who need to meet the portfolio requirement.

1.  Investors who do not need to meet the portfolio requirement:

The following are considered to be QEPs regardless of whether or not they meet the portfolio requirement:

• registered futures commission merchants
• registered broker or dealers
• registered commodity pool operators (under certain conditions, see rule for more details)
• registered commodity trading advisors (under certain conditions, see rule for more details)
• state or SEC registered investment advisers (under certain conditions, see rule for more details)
• qualified purchasers
• knowledgeable employee of the CPOs
• certain persons related to advisers to exempt from registration as a CPO or CTA
• trusts (under certain conditions, see rule for more details)
• 501(c)(3) organizations (under certain conditions, see rule for more details)
• non-United States persons
• certain entities in which all of the owners/participants are QEPs

2.  Investors who need to meet the portfolio requirement:

The following will be considered to be QEPs only if they meet the portfolio requirement described below:

• investment companies registered under the Investment Company Act (i.e. mutual funds)
• certain business development companies (defined under both the Investment Company Act and Investment Advisers Act)
• banks, savings and loan associations, and other like institutions acting for their own accounts or for the account of a QEP
• insurance companies acting for their own account or for the account of a qualified eligible person
• plans established and maintained by various governments and related bodies for the benefit of their employees, if such plan has total assets in excess of $5,000,000
• employee benefit plans within the meaning of the ERISA (under certain conditions, see rule for more details)
• 501(c)(3) organizations with total assets in excess of $5,000,000
• corporations, business trusts, partnerships, LLCs or similar business ventures with total assets in excess of $5,000,000 and not formed for the specific purpose of participating in the exempt investment program
• a natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of either his purchase in the exempt pool or his opening of an exempt account exceeds $1,000,000 [HFLB note: this is one part of the accredited investor definition]
• a natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year [HFLB note: this is one part of the accredited investor definition]
• pools, trusts, insurance company separate accounts or bank collective trusts, with total assets in excess of $5,000,000 (under certain conditions, see below)
• other entities authorized by law to engage in such transactions (under certain conditions, see rule for more details)

3.  Portfolio Requirement

If an investor is one of the entities described in (2) above, it will also need to meet the portfolio requirement.  The portfolio requirement can be met in one of three ways:

• Owns securities and other investments with an aggregate market value of at least $2MM;
• Has had on deposit with a FCM at least $200K in exchange-specified initial margin and option premiums for commodity interest transactions in the 6 months prior to the investment; or
• Has a combination of the two above.  For example, has $1MM in securities/investments and $100K in exchange-specified initial margin in the 6 months prior to the investment

The above definitions have been shortened for the purpose of providing a general overview.  When determining whether an investor meets the qualified eligible person definition the CPO should take special care to make sure that the investor meets the full definition which can be found here.  Generally the investor will make these representations in the subscription documents which are drafted by the hedge fund attorney.

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Other related Hedge Fund Law Blog articles include:

• CPO Reporting Requirements
• How to register as a CPO or CTA
• Series 3 Exam
• Forex Registration

Bart Mallon, Esq. runs the Hedge Fund Law Blog.  He can be reached directly at 415-868-5345.

Recently there have been a number of groups springing up to provide a secondary hedge fund market.  While such platforms provide investors with a potential avenue to get out of their illiquid investment (the investment in the fund may be illiquid for a number of reasons including the imposition of a gate provision), they pose problems for the hedge fund manager who will have to deal with the mechanical issues involved in a transfer of the fund interests.  Additionally, as noted in the article below, the manager may have to worry about the PTP issues involved with such potential transfer.

The following article was written by Doug Cornelius of the Compliance Building blog and is reprinted with permission.  All links in the article are from the original.

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Classification of Private Funds as Publicly Traded Partnerships

Due to the increasing incidence of fund investors who want to transfer their investment fund interests, private investment funds face a risk of being classified as publicly traded partnerships. That would mean the fund would become taxable as a corporation.

A bad result.

Under Internal Revenue Code § 7704, a partnership will be classified as a publicly traded partnership if (1) the fund interests are traded on an established securities market or (2) the fund interests are readily tradable on a secondary market or its substantial equivalent.

The big problem is determining when you have a “substantial equivalent” of a secondary market. Under the regulations, the IRS uses a facts and circumstances test to determine if “partners are readily able to buy, sell, or exchange their partnership interests in a manner that is comparable, economically, to trading on an established securities market.” You hate to get into a facts and circumstances discussion with the IRS.

Fortunately there are some safeguards in the implementing regulations at 26 C.F.R. § 1.7704-1.

Involvement of the Partnership

For purposes of section 7704(b), interests in a partnership are not readily tradable on a secondary market or the substantial equivalent unless (1) The partnership participates in the establishment of the market or (2) The partnership recognizes any transfers made on the market by (i) redeeming the transferor partner or (ii) admitting the transferee as a partner.

Since most fund partnerships require the general partner to approve the the transferee and then admit the transferee, they are unlikely to be able to take advantage of this safe harbor.

De Minimis Trading Safeharbor

The focus of a fund should be on the 2% de minimis safe harbor. 26 C.F.R. § 1.7704-1(j) provides for interests in a partnership to be deemed not readily tradable on a secondary market or the substantial equivalent thereof if the sum of the percentage interests in partnership capital or profits transferred during the taxable year of the partnership does not exceed 2 percent of the total interests in partnership capital or profits.

You want avoid having more than 2 percent of the partnership interests changing hands each tax year.

If you get close to that number there are several transfers that are disregarded transfers for this safeharbor, including:

• block transfers by a single partner of more than 2% of the total interests
• intrafamily transfers
• transfers at death
• distributions from a qualified retirement plan
• Transfers by one or more partners of interests representing  50 percent or more of the total interests in partnership

Private Placement Safeharbor

The regulations deem a transfer to not be a trade if it was a private placement. But the regulations have their own definition of a private placement: (1) the issuance of the partnership interests had to be exempt from registration under the Securities Act of 1933,  and (2) the partnership does not have more than 100 partners at any time during the tax year of the partnership. 26 C.F.R. § 1.7704-1(h)

The first prong should be straight-forward for most private funds. The trickier part is the second prong. In some circumstances the IRS can look through the holder of a partnership interest to its beneficial owners and expand the number of partners to include the beneficial holders of that interest.

Passive Income Safeharbor

If a fund is determined to be a Publicly Traded Partnership, it will nonetheless not be taxed as a corporation if 90% or more of the fund’s gross income is passive-type income. [26 U.S.C. § 7704(c)] Passive-type income generally includes dividends, real property rents, gains from the sale of real property, income from mining and oil and gas properties, gains from the sale of capital assets held to produce income, and gains from commodities (not held primarily for sale in the ordinary course of business), futures, forwards, or options with respect to commodities. The income test is on a taxable year basis and must be have been met each prior year.

References:

• 26 U.S.C. § 7704 : Certain publicly traded partnerships treated as corporations
• 26 C.F.R. § 1.7704-1
• Risk of Possible Classification of Funds as Publicly Traded Partnerships by Paul Weiss

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Please also see the post on hedge fund compliance and twitter which includes another reprint of a Compliance Building article.

Other related hedge fund law articles include:

• What are Hedge Fund Investors Looking For?
• How to Invest in a Hedge Fund
• Regulation D Overview
• Hedge Fund Due Diligence

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog.  He can be reached directly at 415-868-5345.

We’ve published a number of thoughtful pieces on this blog from Chris Addy, president and CEO of Castle Hall Alternatives (see, for example, article on Hedge Fund Operational Issues and Failures).  Today we are publishing a piece by Chris which discusses hard to value hedge fund assets (so called Level III assets).  In certain situations hedge fund audit firms will be engaged to perform an “Agreed Upon Procedures” review of the pricing of these assets.  As discussed in the article below, agreed upon procedures engagements do not provide hedge fund investors with a great deal of comfort with regard to the pricing of these assets.  It is unclear whether in the future investors will push back with regard to such engagements and require more robust pricing audits.  The problem with more robust procedures, obviously, is increased cost (because of increased liability for the audit firms).

Managers who are engaging audit firms pursuant to agreed upon procedures should be aware that they may face tougher questions from investors going forward.

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Agreed Upon Procedures

A number of our recent posts have focused on the challenges of the hedge fund administrator‘s role in relation to security valuation.  We will, of course, return to this topic – but, in the meantime, wanted to focus on some of the alternatives to administrator pricing.

One of the more common comments from today’s administrators is that, while an admin may be able to price Level I and Level II securities, they do not necessarily have information to price Level III instruments.  (To recap, the US accounting standard FAS 157 divides portfolios into three levels, being Level I, liquid instruments readily priced from a pricing feed (typically exchange traded); Level II, instruments priced using inputs from “comparable” securities (essentially mark to model, albeit with mainstream models); and Level III, everything else.)

This leaves investors with a challenge – if administrators cannot price Level III instruments, who can? Moreover, to repeat one of our frequent comments, it is self evident that if a hedge fund manager wishes to deliberately mismark securities, they would most likely misprice a Level III instrument.  It is, of course, very hard to fake the price of IBM common stock, but much easier to mismark emerging market private loans.

Two of the most common tools available to hedge fund managers looking for third party oversight over pricing for Level III instruments – assuming the administrator has washed their hands of the problem – are third party pricing agents and auditor agreed upon procedures, or “AUP”.  We will return to the strengths and weaknesses of third party pricing agents in a subsequent post, but wanted to focus this discussion on AUP.

In an Agreed Upon Procedures engagement, the auditor completes specific procedures which have been dictated by the client.  The procedures are specified and the auditor then prepares a report outlining the findings of that specific work.

We have two comments here: the first is to take a high level view as to the adequacy of these procedures, and the second is to dig a little more deeply into the actual audit guidance that covers this type of work.

Our first comment is, unfortunately, an Emporer Has No Clothes observation.  The significant majority of hedge fund AUP engagements we have seen require the auditor to test a fund’s pricing on a quarterly basis.  This usually involves (i) obtaining a portfolio list from the investment manager and (ii) testing the pricing support for those positions.

There are, however, generally two snags.  Firstly, many AUP only test a sample of prices, not the whole portfolio.  Sample testing clearly provides much less assurance than a price review of all positions: the administrator, for example, is usually expected to price the entire book (would any investor accept a NAV which has been priced on a “sample” basis???)

The bigger problem, however, is the type of testing completed by the auditor.  In way, way too many cases, the auditor tests security prices back to the manager’s own pricing support and makes no attempt to obtain independent pricing information.

This type of work is, clearly, somewhere between minimal and absolutely no value for investors.  If the auditor receives a spreadsheet from the manager showing the matrix of broker quotes received, how does the auditor know that the manager has not adjusted that spreadsheet to exclude quotes which were uncomfortably low?  Even more importantly, if all the auditor does is to check prices back to pieces of paper in the manager’s own pricing file, how does the auditor know that those pieces of paper are genuine?  As we have said before, and will keep on saying, it only costs $500 to buy a copy of Adobe Photoshop if you are of a mind to alter documentation.

When discussing this type of work, the manager typically notes that, if the auditor was to complete a full, independent pricing review, it would be too costly and too time consuming to be practical on a quarterly basis.  A full, GAAP audit review is, of course, performed at year end – this does include independent pricing (although – investor fyi – auditors will still only sample test many portfolios.)

While these are fair points, it remains the case that this type of AUP provides minimal protection against pricing fraud.  In the meantime, the manager gets the marketing benefit of being able to claim enhanced scrutiny and oversight from a Big 4 firm each quarter.

Which leads to our second point.  Why would an auditor accept to complete agreed upon procedures when any reasonable accountant would rapidly conclude that the typical scope of these AUP provide pretty much nil controls assurance?  Why does the auditor not insist that, if their name is to be associated to this work, then the procedures must be meaningful and sufficient to meet an actual control standard?

To this point, the actual audit standard applicable to AUP is available here.  The standard states:

An agreed-upon procedures engagement is one in which a practitioner is engaged by a client to issue a report of findings based on specific procedures performed on subject matter. The client engages the practitioner to assist specified parties in evaluating subject matter or an assertion as a result of a need or needs of the specified parties. Because the specified parties require that findings be independently derived, the services of a practitioner are obtained to perform procedures and report his or her findings. The specified parties and the practitioner agree upon the procedures to be performed by the practitioner that the specified parties believe are appropriate. Because the needs of the specified parties may vary widely, the nature, timing, and extent of the agreed upon procedures may vary as well; consequently, the specified parties assume responsibility for the sufficiency of the procedures since they best understand their own needs. In an engagement performed under this section, the practitioner does not perform an examination or a review, as discussed in section 101, and does not provide an opinion or negative assurance. Instead, the practitioner’s report on agreed-upon procedures should be in the form of procedures and findings.

In practice, this all gets horribly circular.  Per the standard, a client requests an auditor to complete AUP to assist “specified parties” to “evaluate subject matter or an assertion”.  In our case, the assertion would be “are hard to value securities valued correctly at quarter end.”

However, the specified party is usually the manager itself, making the client and specified party the same person.  The particular trick applied, in many cases, is for the auditor to seek to prevent the investor from actually seeing the AUP in the first place!  However, if the investor is to have access to the AUP, the auditor universally requires the investor to sign a Catch 22 document which requires the investor to acknowledge that the AUP are “sufficient for their needs”.  So, even if the investor believes that the AUP are not “sufficient for their needs” – which is hardly a long stretch – the investor has to sign that the procedures are sufficient if they are to even see the auditor’s work.  With this magic piece of paper, the auditor has met its requirements and can sleep easy.  Meanwhile, the auditor will send a bill to – guess who – the fund, meaning that investors have, once more, had to foot the bill.

As always, Caveat Emptor.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

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Related hedge fund law articles:

• Hedge Fund Due Diligence
• Hedge Fund Auditor
• Hedge Fund Investors Overview
• Hedge Fund Law Firm
• Hedge Fund Fee Discussion
• ERISA versus Hedge Funds

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs Hedge Fund Law Blog and can be reached directly at 415-868-5345.

While hedge funds have reluctantly resigned to the likely fate of SEC registration (see MFA Supports Registration), the venture capital community has been fighting hard to remain unregistered.  On this front, the VC community enjoyed a victory last week as Congressman Paul E. Kanjorski (D-PA) proposed an amendment to the Obama administration’s Private Fund Investment Advisers Registration Act of 2009 (“PFIARA”).  The new proposed bill provides an exemption from registration for certain managers to “venture capital funds” as that term will be defined by the SEC.  The following section provides the full wording of the new exemption and I end this posts with some of my thoughts on this exemption.

Venture Capital Fund Registration Exemption

The following section has replaced the previous section 6 (which now becomes section 7).  Besides this change the PFIARA remains the same.

SEC. 6. EXEMPTION OF AND REPORTING BY VENTURE CAPITAL FUND ADVISERS.

Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3) is amended by adding at the end the following new subsection:

‘‘(l) EXEMPTION OF AND REPORTING BY VENTURE  CAPITAL FUND ADVISERS.—The Commission shall identify and define the term ‘venture capital fund’ and shall provide an adviser to such a fund an exemption from the registration requirements under this section. The Commission shall require such advisers to maintain such records and provide to the Commission such annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors.’’.

Discussion of the Exemption

From a political perspective, I am actually pretty surprised that this was added to the bill.  First, I find it interesting that a bill named the “Private Fund” registration act (not “Hedge Fund” registration act) would then exempt certain private funds.  Second, it is curious that the drafter left it to the SEC to create a definition of “venture capital fund” – it will be interesting to see how the SEC interprets this Congressional mandate.  Finally, it is also curious that VC funds are specifically exempted and potentially not private equity funds.  Generally VC funds are regarded as a type of private equity fund – presumably the SEC could fix this by creating a very broad definition for “venture capital funds” which would also include private equity.  Unfortunately this puts the SEC in a difficult position as they will now have to deal with the politics of creating definitions.

We will keep you up to date on this and other bills. Please also remember that this current version of the bill is subject to future change.

For the full proposed bill, please see: Hedge Fund Registration Bill – No VC Registration

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10/1/09: Kanjorski Releases Financial Reform Drafts on Investor Protection, Private Advisor Registration

Capital Markets Chairman Addresses Key Pieces of Financial Regulatory Reform Through Comprehensive Bills and Administration Input

WASHINGTON – Congressman Paul E. Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, today released discussion drafts of three pieces of legislation aimed at tackling key parts of reforming the regulatory structure of the U.S. financial services industry.  The draft bills include the Investor Protection Act, the Private Fund Investment Advisers Registration Act, and the Federal Insurance Office Act.

Chairman Kanjorski introduced bipartisan legislation earlier this year and in the last Congress to create a federal insurance office, which was backed by the Obama Administration and included in its proposals for financial services regulatory reform.  Congresswoman Judy Biggert (R-IL), Ranking Member of the House Financial Services Subcommittee on Oversight and Investigations, joined as an original co-sponsor of the 2009 bill when it was first introduced.  Chairman Kanjorski also worked to revise and significantly enhance the Investor Protection Act and the Private Fund Investment Advisers Registration Act proposed by the Obama Administration this summer.

“Today, we take another step forward in overhauling the regulatory structure of the financial services industry,” said Chairman Kanjorski.  “With these three bills we will address many of the shortcomings and loopholes laid bare by the current financial crisis.  The Investor Protection Act will better protect investors and increase the funding and enforcement powers of the U.S. Securities and Exchange Commission.  We must ensure that investor confidence continues to increase for the betterment of our financial system.

“Additionally, we need to ensure that everyone who swims in our capital markets has an annual pool pass.  The Private Fund Investment Advisers Registration Act will force many more financial providers to register with the SEC.  Many financial firms skirt government oversight and get away like bandits, but now the advisers to hedge funds, private equity firms, and other private pools of capital would become subject to more scrutiny by the SEC.

“Finally, bipartisan legislation which I first introduced in the last Congress to create a federal insurance office to fill a gap in the federal government’s knowledge base on financial activities.  For several years, including in this Congress, I have worked to advance bipartisan legislation to address this issue, and I am pleased that the Administration also understands the need for this office and welcome the refinements they suggested to my bill.”

Summaries of the three legislative discussion drafts follow:

…

Private Fund Investment Advisers Registration Act

Everyone Registers. Sunlight is the best disinfectant. By mandating the registration of private advisers to hedge funds and other private pools of capital, regulators will better understand exactly how those entities operate and whether their actions pose a threat to the financial system as a whole.

Better Regulatory Information. New recordkeeping and disclosure requirements for private advisers will give regulators the information needed to evaluate both individual firms and entire market segments that have until this time largely escaped any meaningful regulation, without posing undue burdens on those industries.

Level the Playing Field. The advisers to hedge funds, private equity firms, single-family offices, and other private pools of capital will have to obey some basic ground rules in order to continue to play in our capital markets. Regulators will have authority to examine the records of these previously secretive investment advisers.

http://kanjorski.house.gov/index.php?option=com_content&task=view&id=1627&Itemid=1

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THE NATIONAL VENTURE CAPITAL ASSOCIATION APPLAUDS VENTURE CAPITAL EXEMPTION LANGUAGE IN DRAFT OF PRIVATE FUND INVESTMENT ADVISERS REGISTRATION ACT

Washington D.C., October 1, 2009 –

The following statement is attributed to Mark G. Heesen, president of the National Venture Capital Association:

“The National Venture Capital Association (NVCA) applauds the Private Fund Investment Advisers Registration Act proposal announced today by Representative Paul Kanjorski (DPA), Chairman of the House Financial Services Capital Markets Subcommittee. We are extremely appreciative of the work done in drafting this legislation by the Subcommittee and Members of the full Committee under the leadership of Chairman Barney Frank (DMA). This proposal recognizes that venture capital firms do not pose systemic financial risk and that requiring them to register under the Advisers Act would place an undue burden on the venture industry and the entrepreneurial community. The venture capital industry supports a level of transparency which gives policy makers ongoing comfort in assessing risk. The NVCA is committed to working with Congress, the SEC and the Administration on the most effective implementation of this proposal.

We look forward to sharing specific thoughts with Members of the Committee on Tuesday, October 6 when NVCA Chairman Terry McGuire is scheduled to testify at the hearing, “Capital Markets Regulatory Reform: Strengthening Investor Protection, Enhancing Oversight of Private Pools of Capital, and Creating a National Insurance Office.” The National Venture Capital Association (NVCA) represents more than 400 venture capital firms in the United States. NVCA’s mission is to foster greater understanding of the importance of venture capital to the U.S. economy and support entrepreneurial activity and innovation. According to a 2009 Global Insight study, venture-backed companies accounted for 12.1 million jobs and $2.9 trillion in revenue in the United States in 2006.

The NVCA represents the public policy interests of the venture capital community, strives to maintain high professional standards, provides reliable industry data, sponsors professional development, and facilitates interaction among its members. For more information about the NVCA, please visit www.nvca.org.

http://www.house.gov/apps/list/press/financialsvcs_dem/discussion_draft_of_the_private_fund_investment_advisors_registration_act.pdf

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Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  Cole-Frieman & Mallon LLP helps hedge fund managers to register as investment advisors with the SEC or the state securities divisions.  If you are a hedge fund manager who is looking to start a hedge fund or register as an investment advisor, please contact us or call Mr. Mallon directly at 415-296-8510.  Other related hedge fund law articles include:

• How to register as an Investment Advisor
• Hedge Fund Attorney
• New Hedge Fund Regulation
• Private Equity Funds

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.

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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

Introduction

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.

http://www.njconsumeraffairs.gov/bos/bosregs.htm

Indiana

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.

Michigan

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.

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

• Hedge Fund Performance Fees
• Hedge Fund Performance Fee – State Law Issues
• State Registered Hedge Fund Managers
• Overview of Hedge Fund Investment Advisors

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.

The new investment banking exam, the Series 79, will be available for those first new test takers on November 2, 2009 at any of the FINRA testing centers (Pearson and Prometric).  In addition to the test date announcement, FINRA also published a Series 79 Content Outline which seems to be very comprehensive.  We have provided an overview of the exam below and will continue to bring you updated information on this exam.

Also, please note that right now we do not know of any groups who have completed a Series 79 exam study guide, but we have had informal conversations with representatives from both STC and Kaplan – these representatives have stated that they are currently working on developing such a study guide which should be available soon.  We will let you know when these study materials become available.

Series 79 Overview

According to FINRA, the following are the key stats for the Series 79 exam:

• Questions:  175 multiple choice questions (plus 10 pre-test, non-graded questions)
• Time:  5 hours testing time
• Eligibility:  FINRA member firm must sponsor the candidate
• Application:   Submission of Form U-4 through Web CRD
• Purpose:  This examination qualifies an individual to advise on or facilitate debt or equity offerings through a private placement or public offering or to advise or facilitate mergers or acquisitions, tender offers, financial restructurings, asset sales, divestitures or other corporate reorganizations or business combination transactions.

FINRA’s Stated Exam Purpose

The Series 79 Examination is designed to assess the competency of entry-level investment bankers. As a qualification examination, it is intended to safeguard the investing public by seeking to measure the degree to which each candidate possesses the knowledge, skills and abilities needed to perform the major functions of an entry-level investment banker. Candidates should note that the duties and functions of the investment banker must be performed in accordance with just and equitable principles of trade, federal and state laws, and industry regulations. Furthermore, it is the responsibility of the candidate to be aware of changes in current legislation, regulation and policy. A registrant who violates industry regulations is subject to disciplinary action, including censures, fines, suspension, and permanent loss of registration.

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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:

• Series 79 Exam Approved
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• Form U4 Information
• Hedge Fund

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about the Series 79 or investment banking activities, please call Mr. Mallon directly at 415-296-8510.

There are two main jurisdictions to establish an offshore hedge fund (either as a single hedge fund or as part of a master-feeder structure).  The two jurisdictions are the BVI and the Cayman Islands.  This article will discuss some of the features of Cayman Island based hedge fund structures.

Why the Cayman Islands?

Cayman has been the leading jurisdiction for fund formation with an estimated 80% of the world’s hedge funds domiciled there.  As of December 2008, Cayman had over 10,000 hedge funds registered with the local regulatory authority: The Cayman Islands Monetary Authority (“CIMA”).

First and foremost: establishing a fund in the Cayman Islands is easy and efficient, offering managers many competitive advantages over other jurisdictions including:

• Non-public funds can be registered in as little as 3-5 days with CIMA and the vehicle of choice for the fund can be registered within 1 day prior to filing, if necessary;
• Flexible statutory regimes, with an absence of exchange control provisions, that are well-established and relatively low-cost;
• There are no restrictions on: (i) investment policy (ii) issue of equity interests (iii) prime brokers or (iv) custodians;
• The regulatory and legislative environment is continuously evolving to strengthen the jurisdiction’s appeal for hedge funds in response to ever changing market conditions;
• Cayman is a tax neutral jurisdiction – there are no capital gains, income, profits, withholding or inheritance taxes attaching to investment funds established there, nor to investors in such investment funds;
• Cayman is a British Overseas Territory and as such maintains all of the security and stability associated with the British flag.  The UK remains responsible for the islands’ external affairs, defence and their legal system; and
• The quality and expertise of the Cayman Islands local services, infrastructure and legal system is well above par.

Does Every Hedge Fund Have to be Registered with CIMA?

While most funds (90%) will be required by Cayman Islands law to register with CIMA, there are some funds that will not: those funds where the equity interests are not held by more than 15 investors who collectively have the power to appoint or remove the “operator” of the fund i.e. the director, trustee, or general partner, depending on the fund’s choice of vehicle.  For example, a private fund or closely held funds such as partners’ funds or those in incubation “testing the waters” before launching into the registered world.  These funds need not make filings or pay fees to CIMA.

All other funds must register with CIMA, pay annual fees and undergo annual auditing.

What are the CIMA Hedge Fund Registration Requirements?

1.  Incorporation/Formation of the fund vehicle.  The fund must be in the form of one of three vehicles: i) a Cayman Islands Exempted Company (most common); ii) a Unit Trust; or iii) an Exempted Limited Partnership.  (The latter is popular with US investors as the Cayman Islands Exempted Limited Partnership Law follows the equivalent legislation in Delaware.)  There must be a minimum of two (2) directors appointed to the fund – corporate or individuals.  The directors need not be local.

2.  Preparation of the fund’s Offering Document.

3.  Preparation of the fund’s constitutional documents (i.e. Memorandum and Articles of Association) to reflect the terms of the Offering Document.  This is usually done by way of amending and restating the constitutional documents after the vehicle for the fund has been properly formed (see 1 above).

4.  Preparation of the service agreements i.e. administration agreement/investment management agreement/advisory agreement etc.

5.  Preparation of the form of subscription agreement to be executed by the investors of the fund.

6.  Resolutions must be passed approving: the Offering Document, service agreements and the issue of equity interests by the fund.

7.  All of the following documents must then be submitted to CIMA:

i)    A certified copy of the fund’s certificate of incorporation (or otherwise, depending on the vehicle used);
ii)    Fund’s Offering Document;
iii)    Application Form (“Form MF1”);
iv)    Auditor’s letter of consent; (A local auditor must be appointed.  Such auditor must also sign off on the fund’s audited financial statements which are to be submitted annually to CIMA.)
v)    Administrator’s letter of consent (no requirement for local administrator);
vi)    Registration fee (approximately US$3,000 (subject to change))

What Are the Costs for CIMA Registered Funds?

The total approximate costs of setting up a Cayman Islands Hedge Fund will include: the incorporation/formation costs of the vehicle required plus the ongoing annual fee (for exempted companies); the annual administrator’s fee; the annual auditor’s fee; the initial registration fee of the fund with CIMA and an annual fee to maintain the fund’s registration, and any legal fees associated therewith.

Quotes for incorporation etc. and estimates for services may be obtained from service providers and legal counsel directly, as these will likely vary.  Legal counsel may provide recommendations for service providers upon request.

Article Written by Michelle Richie

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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:

• Offshore Hedge Fund – Side by Side Structure
• offshore hedge fund structural considerations
• Offshore Hedge Fund Timeline
• BVI Offshore Hedge Funds
• Segregated Porfolio Companies for Offshore Hedge Funds
• Master Feeder Organizational Chart
• Hedge Fund UBTI
  

Bart Mallon, Esq. has written most all of the articles which appear on the Hedge Fund Law Blog.  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, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.

The Margin Lock-up Returns to Prime Brokerage
By Karl Cole-Frieman, www.colefrieman.com

In 2009, the problems affecting major banks have also impacted their prime brokerage units, and accordingly there is less appetite to extend credit to hedge funds.   As the banking industry recovers, however, credit terms are beginning to loosen up again.  As a result, we are beginning to see the return of the margin lock-up for larger prime brokerage clients, who may in fact be in a stronger bargaining position for such agreements than they were a year ago.

What is a Margin Lock-up or Term Commitment?

In the most basic terms, a “margin lock-up” or a “term commitment” is a credit facility extended by a prime broker to a hedge fund or other institutional client.  The terms are used interchangeably in the industry.  Margin lock-ups prevent the prime broker from changing margin rates, collateral requirements, and often from declining to clear the hedge fund’s trades during the term of the lock-up.  For large managers, they are often 90 days, but can range from 30 days to 120 days, and perhaps even longer for the largest hedge fund managers.  Practically speaking, the way the arrangement works is that if a prime broker wants to make a change covered by the margin lock-up, they will provide the manager with the requisite notice before doing so.

Margin Lock-ups and Prime Brokerage Agreements

A margin lock-up is negotiated separately from a prime brokerage agreement, but ideally the two agreements are negotiated at the same time.  Our experience has been that it is significantly more difficult to negotiate a margin lock-up after the prime brokerage relationship has been established, and that a fund’s greatest negotiating leverage is before signing the prime brokerage agreement.

Negotiating a Margin Lock-up

There are two significant points to negotiate in a margin lock-up: (1) the scope of the commitment (and exclusions), and (2) the termination events.  For the scope of the commitment, it is essential that the commitment includes clearing trades.  Remember that a prime brokerage arrangement is a demand facility, and the prime broker can normally decide to stop clearing a hedge fund’s trades at any time and for any reason.  This is potentially highly disruptive, and could result in significant losses for a fund.  If clearing trades are covered by the margin lock-up, the prime broker will have to provide the requisite notice, which will allow time to make alternative arrangements with other counterparties.

Termination Events and Margin Lock-ups

Termination events can be very contentious in a margin lock-up negotiation.  The termination events in a margin lock-up give the prime broker the right to terminate the margin lock-up if a certain event occurs.  The prime brokers will want to negotiate off of their templates, which will initially have so many termination events it would make the margin lock-up worthless.  Managers should be wary of a completely subjective termination event, and such provisions should be negotiated out of the agreement.  For example, some prime brokers will try to insist on including a provision that it will be a termination event if the prime broker determines that it would cause the prime broker reputational risk to continue to do business with the fund.   More typical termination events include NAV triggers and key person provisions.

Bilateral Termination Events are a Secondary Consideration

Some hedge fund lawyers advocate that the termination events in a margin lock-up should not be completely unilateral, meaning, for example, that the credit rating of the prime broker should be a termination event.  We view this as a secondary consideration, and not a point to get bogged down on in the negotiation.  If a manager is concerned about the credit rating of the prime broker, they can simply move their balances.  They don’t need to terminate the lock-up – leave it in place in case the fund restores balances with that prime broker.

To find out more about margin lock-ups and other topics relating to prime brokerage or custody, please contact Karl Cole-Frieman of Cole-Frieman & Mallon LLP (www.colefrieman.com) at 415-352-2300 or karl@colefrieman.com.

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If you are thinking of starting a hedge fund, please contact Mr. Bart Mallon, Esq. at 415-296-8510.  Other related hedge fund law and start up articles include:

• Start Up Hedge Fund Articles
• Hedge Funds and Rehypothication
• Side Letters
• Hedge Fund Soft Dollars
• Hedge Fund Managers
• Mini-Prime Brokers
• Hedge Fund Law Firm
  

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And the auditors work for….

Audit opinions of a hedge fund’s financial statements are unlikely to make the New York Times bestseller list.  As a result, we can certainly understand if the auditor’s fine print is not exactly top of the list for investor attention.  However, not all audit opinions are the same and, over time, it seems that different audit firms are quietly introducing different standards of care and attention – and, of course, liability, which is always the 800 pound gorilla.

The issue is the addressee of the audit report – or, put more simply, who the auditor works for.  In a public company, the auditors report to both the shareholders and the Board of Directors.  A quick web search gives us a couple of examples – GE and Goldman Sachs (don’t laugh at the Level III assets, by the way).

In a hedge fund, however, sometimes the audit report mentions the shareholders, but sometimes it does not.  What seems to be a fine difference is actually very profound – exactly why would a hedge fund auditor report only to the Board of Directors and deliberately fail to address their report to the shareholders?  Adding insult to injury, of course, is the reality that the average Board of Caymanian rent-a-directors hardly acts with the same vigor and intervention as the non execs on the boards of GE and Goldman.

In our experience, certain audit firms appear to have taken a deliberate decision to direct their audit opinions, wherever possible, only to the directors.  This is a difference which applies across both US GAAP reports as well as audits completed under International Financial Reporting Standards.  Check 10 audit reports from different firms, and see what we mean.

The underlying issue – of course – is the lack of investor control.  Investors, if asked, would very likely have an opinion on this issue: but, needless to say, they are not asked.  Audit engagement letters are signed under cloak and dagger secrecy (usually because they include ever more expansive terms seeking to limit auditor liability under Caymanian law).  Thereafter, as investors and due diligence practitioners know to their ongoing annoyance, it proves incredibly difficult and pointlessly time consuming to get some auditors even to confirm that they are the auditor of record for the hedge fund in question.

In the short term, one answer would be for offshore jurisdictions such as the Cayman Islands to mandate that all audit reports filed for Caymanian hedge funds be addressed to the shareholders rather than just the Board.  If it’s good enough for GE, it should be good enough for any hedge fund.

In the bigger picture, however, this is just one question within the broad construct of Hedge Funds 2.0 post Madoff.  Unfortunately, it is only investor pressure which can enforce any change so that service providers – auditors, administrators, lawyers et al – take responsibility and recognize that their primary duty of care is to the investors that pay them.  Without that pressure, hedge funds will continue to be the asset class where everyone wants to get paid, but no-one wants to take responsibility.

www.castlehallalternatives.com
Hedge Fund Operational Due Diligence

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Other related hedge fund law and start up articles include:

• Start Up Hedge Fund Articles
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