The article was originally published as part of the Marcum Private Investment Forum newsletter and can be found here.  Please feel free to contact us if you have any questions or comments on the article.

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MF Global Bankruptcy to Shape Managed Futures Regulation in 2012

By Bart Mallon, Esq. Partner, Cole-Frieman & Mallon LLP

It was a combination of the Lehman bankruptcy and the Madoff fraud that led an angry and embarrassed Congress to publicly castigate the SEC for not properly doing its job. What came to bear was the passage of the Dodd-Frank Act which ushered in new laws for the SEC and the CFTC to implement in short order and with limited budgets. The CFTC is in the middle of a similar event which saw the 8th largest bankruptcy in U.S. history as MF Global (MFG) declared bankruptcy on October 31, 2011. The biggest revelation, however, might have been that $1.2 billion of customer money was missing. The fact that there was the potential for a “shortfall” in a managed futures account was shocking – the industry that had prided itself so much on the sacrosanct customer account was now trying to make sense of how something like this happened.

While the various investigators, including the FBI, are trying to figure out where the money is and what transactions are valid, Congress and others are debating the future of regulation for the industry. The Commodity Futures Trading Commission (CFTC), the governmental agency which oversees the managed futures industry, is dealing with not only the MFG bankruptcy but a whole host of other issues. The MFG bankruptcy has brought to light issues with the regulation of the managed futures industry – (1) the practice of utilizing self regulatory organizations (SROs) to oversee important entities within the industry, (2) no “insurance” for margin in managed futures customer accounts and (3) lack of proper funding for the CFTC. Ultimately these issues will need to be addressed and will shape how the industry is regulated moving forward.

Self-Regulation – Is the Fox Watching the Henhouse?

Prior to MFG bankruptcy, the managed futures industry prided itself on the fact that “not a single cent” was ever lost in a customer account due to theft from a futures commission merchant (FCM). Perhaps because of this, the industry seemed unconcerned about the hodge-podge of government agency oversight combined with self-regulation over the managed futures participants. The central SRO for MFG was the CME Group, the world’s largest futures exchange which includes the CME, CBOT, NYMEX and COMEX exchanges. The CME Group is a publicly traded company subject to oversight by the CFTC with respect to its own operations and is also subject to oversight of its supervision of MFG.

MFG ran most of its clearing business through the CME. This means that while the CME derived substantial revenue from MFG, it also was in charge of overseeing MFG to make sure the laws and regulations under the Commodities Exchange Act (CEA) were being followed. While it seems like this will be a conflict of interest on its face, this is how the futures industry works. The argument for having the CME Group act as the SRO to MFG is that as the central exchange, it was in the best position to regulate MFG. The futures industry is an altogether different beast from the securities industry and the CME Group, because of its understanding of the relationships between the firms, was in the best position to oversee MF Global and make sure the firm was complying with all of the requirements of the Commodities Exchange Act. The CME Group is now being investigated – what did it know about MFG’s shortfall and when?

It is easy to paint MFG as simply the bad actor by hiding transactions from the CME Group. But we will learn more as the investigation moves on and if we find that the CME Group was deficient in its oversight of MFG, the SRO model (especially in instances where there is potential conflicts of interest) will need to be reexamined. If it is discovered that there were deficiencies with the SRO oversight of MFG, this will likely create liabilities for the CME Group and may change which SROs can oversee which organizations.

No Insurance for Futures Accounts

The second issue which the MFG bankruptcy highlighted is that there is no insurance for managed futures accounts. In the segregated account structure, the margin required for each futures contract is supposed to be kept in the customer’s name. With respect to the MFG bankruptcy, the $1.2 billion in missing customer assets meant that when customer accounts were transferred from MFG to the various other FCMs only a certain percentage of the margin was transferred to the new FCM, initiating additional margin calls at the new FCM. Many investors were not able to meet the additional margin calls at the new FCM and thus their positions were liquidated. Forced liquidations left a number of investors either unhedged or worse. Small farmers that held accounts at MFG for hedging their crops were especially hard hit.

On the securities side there is the Securities Investor Protection Corporation (SIPC) which provides insurance coverage of up to $500,000 of securities and up to $250,000 in cash in the event that a broker-dealer fails. During the Lehman bankruptcy and Madoff fraud investigation, the SIPC was available to assuage the fears of smaller investors by acting as a backstop to potential losses. Indeed, the SIPC was formed for events just like Lehman. There is no similar insurance program for the margin held in segregated accounts at FCMs.

There have been calls for creating an insurance-like mechanism for futures accounts. The benefits are clear – a guarantee of customer accounts will protect the smaller investors like the farmers and other smaller hedgers. However, there are cost issues to consider and the creation of an SIPC-like mechanism for the managed futures industry needs to be initiated at the Congressional level. The managed futures industry will likely push back any such proposal because of the significant costs involved with implementing such a structure. Timing may also be an issue – the CFTC faces a funding shortfall in addition to Dodd-Frank mandates and other proposed rulemaking functions.

CFTC Funding Issues Present Big Problems for Industry

The CFTC lacks proper funding to adequately protect investors and maintain the integrity of the managed futures industry. The Congressional appropriations process is obviously a political game at which both the SEC and CFTC have failed. The two federal agencies charged with maintaining the integrity of the investment universe are woefully underfunded given their mandates. It is this underfunding that is perhaps the biggest issue for the integrity of the managed futures industry which is why the CFTC needs more money from Congress. More money also helps the CFTC to properly implement parts of the Dodd-Frank Act as well as other adopted and/or proposed regulations.

Dodd-Frank & Swaps Clearing

One of the central pieces of the Dodd-Frank Act is the requirement that swaps be traded and cleared on exchanges. The multi-trillion dollar industry has been unregulated – making counterparties liable to one another and subject to counterparty risk. The intermediation of a clearing house not only creates logistical issues (who, how, when, at what price) but also requires complex, detailed regulations. The CFTC, in conjunction with the SEC with respect to certain matters, was tasked with creating these regulations from scratch. This will be the largest undertaking for the CFTC in 2012 and will likely consume more resources than the MFG investigation.

Other Regulatory Proposals

In addition to the swaps regulations, there are a number of other important regulatory proposals which, if implemented, drastically changes how the managed futures industry operates.

Repeal of Regulation 4.5 –

CFTC Regulation 4.5 essentially exempts certain mutual funds that invest in managed futures from the commodity pool operator (CPO) registration provisions. This means that mutual funds that are essentially publicly traded commodity pools are only regulated by the SEC, who has no experience dealing with the ultimate underlying investments.

In January of 2011 the CFTC proposed repealing Regulation 4.5. If this proposal is adopted as written, managers to managed futures mutual funds need to register as CPOs with CFTC (and become members of the NFA, subject to NFA oversight). This requirement increases the cost burden for these mutual funds and subjects them to great regulatory oversight.

Repeal of Regulation 4.13(a)(4) and 4.13(a)(3) –

Regulation 4.13(a)(4) provides an exemption from CPO registration to those managers who provide advice to a fund (commodity pool) which only has investors who are qualified eligible persons (QEPs). In general, QEPs are investors who meet a higher net worth requirement than accredited investors.

The CFTC also proposed the repeal of Regulation 4.13(a)(3) which provides a “de minimis” exemption from CPO registration to those commodity pool (i.e. hedge fund) managers who only trade a small amount of futures in addition to securities. If 4.13(a)(3) was repealed, all fund managers who trade any amount of futures will be required to become registered as a CPO. It seems that right now this proposal will likely fail, leaving hedge fund managers with the possibility of escaping CPO registration.

Proposed with the Regulation 4.5 repeal, the Regulation 4.13(a)(4) and (a)(3) repeal requires a large number of managers who are not currently registered with the CFTC to register and become NFA members. Again, this will increase the number of firms subject to NFA (and ultimately CFTC) oversight.

Position Limits -

Dodd-Frank Act mandated for the CFTC to impose position limits across different markets, including traditional futures markets, option on futures or commodities traded on a regulated exchange, and trading in swaps. These position limits will not apply to bona fide hedging transactions and counterparties to a bona fide hedge may also be eligible for an exemption. In general, position limits set at 25% of estimated physical deliverable supply for spot-month positions and, with respect to non spot-months, at 10% of open interest (based on futures open interest, cleared swap open interest, and uncleared swaps open interest) in the first 25,000 contracts and 2.5% above that level. There will also be additional reporting requirements for traders exceeding a non-spot-month position visibility level in energy and metal contracts. The industry is vehemently fighting this proposal.

Other Proposals –

in addition to these proposals, the CFTC has other standard enforcement and regulatory issues that have become focus areas. These include high frequency trading and co-location.

It seems clear that given the Dodd-Frank Act’s inclination toward more oversight and regulation of the investment management industry, as well as the recent regulatory fumbles involving MFG, some of these proposals are likely to be adopted. Therefore, managers are going to be required to register as CPOs and the NFA will be the watchdog. But, the NFA, like the CFTC, is a resource limited organization and the ability to effectively monitor member firms will depend on the NFA’s ability to scale to meet the regulatory requirements.

Conclusion

Over the next several months and potentially years the MFG bankruptcy will be sorted out, and hopefully investors will be made whole. During the process of rebuilding the industry to handle the managed futures markets in a time of significant growth in trading and technology, the focus should be on doing whatever is necessary to bring confidence back into the managed futures markets. This will include examining the role of the SRO industry moving forward, examining an insurance SIPC-like program for futures customers and providing more resources for the CFTC. Moving forward it will be Congress who will need to show leadership and provide the CFTC with the funding it will need and the appropriate legislative tools to make sure the industry becomes safer. Hopefully, that will be the good which arises from the unfortunate events that led to the MFG bankruptcy.

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Bart Mallon is a Partner at Cole-Frieman & Mallon LLP where his practice focuses on the investment management industry, specifically working with hedge fund managers and groups in the managed futures industry. Mr. Mallon also founded and runs the widely-read Hedge Fund Law Blog.

Managers registered with the CFTC as either CTAs or CPOs are required to file a disclosure document with the NFA for review by the NFA prior to using the documents to solicit clients/investors.  The disclosure documents are required to conform with certain NFA rules.  The NFA previously provided guidance to CPOs with respect to disclosures regarding the MF Global bankruptcy.  Specifically, the NFA provides guidance with respect to the manner in which CTAs provide trading program performance information in their disclosure documents.  The NFA’s guidance provides CTAs with a reasonable way to deal with describing performance if assets were held at MF Global and then transferred after the bankruptcy.

CTAs should remember that disclosure documents must be update (and reviewed by the NFA) every nine months.  If you are a CTA that needs help updating your disclosure documents, please contact us.

The full NFA release is reprinted in full below.

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Notice to Members I-12-04
January 27, 2012

Frequently Asked Questions – Trading Program Performance Calculations and Presentation by CTAs with Client Assets held at MF Global, Inc.

As a result of the October 31, 2011 bankruptcy proceeding involving MF Global, Inc. (MFG), NFA has received a number of questions from CTAs regarding how to calculate and present performance information for Trading Programs with client managed accounts that were affected by the MFG bankruptcy proceeding. NFA is issuing this notice to address those frequently asked questions.

1. All of my managed client accounts were held at MFG. The open positions in those accounts were subsequently transferred to another FCM. After the transfer, I continued to trade the accounts according to the trading program. How do I reflect the performance results?

Results should be based upon the assets under the CTA’s control. Any customer assets that were not included in the transfer may not be included in assets under management for purposes of calculating the trading program’s rate of return. The trading program’s capsule performance must include appropriate footnote disclosure (See question 5 below).

2. All of my managed client accounts were held at MFG. The open positions in those accounts were subsequently transferred to another FCM. After the transfer, all positions in those accounts were liquidated, and I did not resume trading these accounts in accordance with the trading program. How do I reflect the performance results after the transfer?

For November 2011, the performance capsule for that trading program should reflect NT to indicate that the program did not trade during the month. The trading program’s performance capsule must include appropriate footnote disclosure (See question 5 below).

3. My managed client accounts that were held at MFG and the open positions in those accounts were subsequently transferred to another FCM. After the transfer, I was able to continue trading those accounts. I have notional funding agreements with those accounts. Should I continue to include the amount of notional funds under the agreement in assets under management for purposes of calculating rate of return?

If you are trading the managed client accounts pursuant to an active notional funding agreement, you should continue to calculate rates of return using nominal account size as the denominator.

4. I have some managed client accounts held at MFG (with open positions that were subsequently transferred) and other managed client accounts held at other FCMs that are trading the same program. Since I did not have full control over the assets held at MFG, the rates of return for those accounts are materially different than the rates of return for accounts held at an FCM other than MFG. How do I reflect the performance results of the program?

For the month of November 2011, you should exclude the accounts that were held at MFG from the performance capsule. You do not have to prepare a separate capsule for these accounts. However, the trading program’s performance capsule must include appropriate footnote disclosure (See question 5 below), including the range of the rates of return for those accounts.

5. What information should I include in the footnote disclosure?

At a minimum, the footnote disclosure should:

• Explain that as a result of the MFG bankruptcy proceeding, certain client managed accounts were not fully under the control of the CTA and therefore were excluded in whole or in part from the monthly performance calculation;
• Indicate the number of client accounts excluded;
• Indicate the amount of assets that were excluded;
• Indicate the percentage that the excluded assets represent of total assets under management for that program as of October 31, 2011.

6. Do I need to amend my disclosure document to reflect this information?

CTAs that plan to solicit new clients must ensure that all material information in their disclosure documents has been updated including, but not limited to, changes to assets under management, past performance results, and the firm’s carrying broker relationships. As a reminder, all amended disclosure documents must be submitted to NFA for review prior to use.

Any questions regarding these disclosure issues should be directed to:

Susan Koprowski, Manager, at (312) 781-1288 or at skoprowski@nfa.futures.org
Kaitlan Chi, Manager, at (312) 781-1219 or kchi@nfa.futures.org
Mary McHenry, Senior Manager, at (312) 781-1420 or at mmchenry@nfa.futures.org

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Cole-Frieman & Mallon LLP works with CTA and CPOs and provides managed futures legal and compliance services.  Bart Mallon can be reached directly at 415-868-5345.

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Investment Adviser Registration Presentation for Fund Managers Released by Cole-Frieman & Mallon LLP

March 30, 2012 Deadline for SEC Registration Approaches

SAN FRANCISCO, CA – January 25, 2012 — Cole-Frieman & Mallon LLP, a leading boutique investment management law firm, is proud to announce the release of a presentation designed to help fund managers understand their registration obligations with the U.S. Securities and Exchange Commission. Many hedge fund managers who are not currently registered with the SEC will be required to be registered by March 30, 2012. Because of the application process, managers will need to submit their registration applications to the SEC by February 14, 2012. The presentation is posted on the Hedge Fund Law Blog at www.hedgefundlawblog.com/iaregistration2012.

The presentation, which includes a voice-over discussion, provides both hedge fund and private equity fund managers with a high level overview of the registration process and important compliance issues. “Most private fund managers have a general idea that they need to register with the SEC but many have delayed beginning the process,” said Bart Mallon, a partner with Cole-Frieman & Mallon LLP. “We developed this presentation to remind managers of the requirements but to also provide them with accurate information about what it means to go through the registration process and become registered with the SEC.”

In addition to information on the investment adviser registration process, the presentation also details compliance obligations of registered managers. “Fund managers tend to underestimate the importance of a proper SEC compliance program,” said Niel Armstrong, president of Gordian Compliance Solutions, a compliance consulting firm that offers fund managers outsourced SEC compliance solutions. “Implementing a robust compliance program that is tailored to a fund manager’s specific organizational structure is important from a regulatory perspective, and many managers also find a business benefit when they employ compliance best-practices.”

Cole-Frieman & Mallon partner Aisha Hunt added “Fund managers generally have business specific needs that should be addressed during the SEC registration process. The presentation and supplementary information on the Hedge Fund Law Blog will provide those managers with the resources they need to understand the relevant business and compliance issues and begin the registration process.”

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About Cole-Frieman & Mallon LLP

Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP has an international practice that services both start-up investment managers, as well as 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, and 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 (http://www.hedgefundlawblog.com), which focuses on legal issues that impact the hedge fund community. For more information please visit us at: www.colefrieman.com.

Background on CFTC Rule 4.5

As previously discussed in an earlier article on CFTC Rule 4.5, the issue of requiring mutual funds to register with the CFTC has been on the Commission’s radar for a long time.  In part because of pressure from the NFA, the CFTC proposed changes to Rule 4.5 in February of 2011 which would require CPO registration for most managers to managed futures mutual funds. While the current rule exempts managers from the registration requirements, prior to 2003 mutual fund managers were required to register as CPOs unless they:

1. restricted their commodities and futures marketing activity,
2. limited commodity futures or options activity to bona fide hedging transactions, and
3. limited the aggregate futures margins and/or options premiums for non-hedging positions to 5% of the liquidating value of the entity’s portfolio (after taking into account unrealized profits and losses).

When the CFTC amended Rule 4.5 in 2003, it eliminated the trading and marketing restrictions and as a result managed futures mutual funds currently market participation in their funds as managed futures funds and have more than 5% direct exposure to managed futures for speculative purposes.  The February proposal seeks to reinstate the pre-2003 language in Rule 4.5.

Wholly-Owned Subsidiaries

It is important to note that the 5% limit in the proposed Rule 4.5 would apply to the entity filing for the Rule 4.5 exemption, not subsidiaries. Managed futures mutual funds are currently structured so that the managed futures investments are made through wholly-owned subsidiaries.  Wholly-owned subsidiaries would not qualify for the 4.5 exemption unless each subsidiary independently met all the requirements set forth in the proposed amendment. Therefore, mutual funds (i) with an investment objective to provide exposure to physical commodities as an asset class and (ii) that do so by investing in commodity futures, options, and swaps via wholly-owned subsidiaries, must make sure that those subsidiaries qualify for Rule 4.5 as well.

Conclusion

If the CFTC approves the proposed regulation, it would subject many mutual funds to CFTC registration and oversight by the NFA.

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Cole-Frieman & Mallon LLP provides advice to managers in the managed futures industry.  The firm also has a robust alternative mutual fund practice led by Aisha Hunt.  Bart Mallon can be reached directly at 415-868-5345.  Aisha Hunt can be reached directly at 415-762-2854.

This is the second biggest event of the year for the hedge fund industry in San Francisco.  Ticket information is below and we all look forward to seeing you there.

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California Hedge Funds to Support Child Abuse Prevention at 2nd Annual West Coast Committee of Hope Poker Tournament

Charity Poker Event Will Be Held Wednesday, January 25th at The City Club of San Francisco

NEW YORK – January 12, 2012 – Hedge Funds Care, a financial services industry-supported charity dedicated to preventing and treating child abuse, today announced that it would be holding the 2nd Annual West Coast Committee of Hope Poker tournament. Proceeds from the event will go to support child abuse prevention and treatment programs in the San Francisco Bay area. The event, sponsored by Battea Class Action Services and Ernst and Young, will be held on January 25th at 4:30pm PST at The City Club of San Francisco (155 Sansome Street, San Francisco, CA). Hedge fund industry participants who attend will enjoy an open bar, hors d’oeuvres and networking.

“This event has really grown in size and reputation over the last year and we expect to easily surpass last year’s fundraising achievements,” said Alicia Gavello, Fund Accountant at Partner Fund Management and the chair for this year’s benefit. “Programs that help treat child abuse are still badly underfunded and this is the California hedge fund industry’s chance to stand up and make a difference,” she added.

Since their inception, the West Coast Committee of Hope and Committee of Hearts have raised a combined $6.1 million and distributed 150 grants to Californian child abuse and prevention programs. A limited number of tickets and sponsorships are still available. For more information, please click here:
http://www.hedgefundscare.org/event.asp?eventID=61

About Hedge Funds Care

Hedge Funds Care is an international charity supported largely by the alternative investment industry. Its sole mission is to support efforts to prevent and treat child abuse. Hedge Funds Care raises money, primarily through events, and awards grants in 12 major cities in the United States, Canada, the Cayman Islands, and the United Kingdom. Approximately 30 events are held annually. Hedge Funds Care’s grantees service children of all ages and span the entire spectrum from preventive and educational services for at-risk families to forensic interviews and treatment of children who have already experienced abuse. It generally funds small, community-based organizations, where small grants can have a profound impact. Since inception, Hedge Funds Care has awarded more than 660 grants totaling almost $24 million. Hedge Funds Care is largely a volunteer-driven organization, with professionals from the hedge fund industry serving on the Board and on local committees that plan events and evaluate grant proposals. The organization has a small staff based in New York City.

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Hedge Funds Care – West Coast Events

Dan Butchko

Hedge Funds Care

212-991-9600 ext. 336

DButchko@HedgeFundsCare.org

70 West 36th Street, Suite 1404    - New York, NY 10018 - tel. 212.991.9600 fax. 646.214.1079 - HedgeFundsCare.org

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Cole-Frieman & Mallon LLP provides hedge fund start-up and other legal services to hedge fund managers.  Bart Mallon can be reached directly at 415-868-5345.

As a general proposition, managers who are located in California must register as an investment adviser if they are providing investment advice for compensation.  There are exemptions from the registration requirement which we have detailed previously.  Because of the changes in the statutes and regulations at the Federal level, the states are changing their laws with respect to adviser registration.  Some states, such as California (see post), have adopted interim orders for certain advisers to address gaps in the Federal and state laws until state laws or appropriate regulations can be adopted.  California is proposing to adopt laws which would exempt many hedge fund managers from registration with the California Securities Regulation Division.

The proposed regulations if adopted would likely go into effect sometime in the first half of 2012.  The California Department of Corporations has requested comments on the proposal which may be submitted by February 20, 2012.  We have summarized the proposed exemption below and for more information, please see the following releases:

• Proposed Amendment to Section 260.204.9
• CA Notice of Proposed Private Fund Exemption
• CA Statement re: Private Fund Exemption

California Private Adviser Exemption Overview

If the proposed rule is approved, a manager would be exempt from registration as an investment adviser with the state of California if the manager meets the following requirements:

• manager provides advice only to one or more “qualifying private funds” (includes Section 3(c)(1) funds and Section 3(c)(7) funds)
• manager may not have not violated securities laws;
• manager must file periodic reports with the Department of Corporations (an abbreviated version of the Form ADV);
• manager must pay the existing investment adviser registration and renewal fees ($125); and
• manager must comply with additional safeguards when advising funds organized under Section 3(c)(1) (other than venture capital companies). This includes:
• only accredited investors may invest in the private fund;
• the firm shall provided certain written disclosures about the services it provides, its duties, and other material information;
• the firm shall obtain an annual audit of each fund and deliver them to each investor; and
• performance fees can only be charged to qualified clients.

Firms may register with the SEC once they reach $100M in AUM. Therefore, the firm may rely on the California private adviser exemption and then, absent an exemption from SEC registration, register with the SEC at that point. Section 203(m) of the Adviser’s Act of 1940 (as amended by Dodd-Frank) provides such an exemption from such registration if the firm only manages private funds and has less than $150M AUM (the firm would be an exempt reporting adviser and would have to file the abbreviated Form ADV with the SEC).

Funds with Non-Accredited Investors

The proposed rule does have a grandfathering provision that will make the California private adviser exemption available to a firm that currently manages any Section 3(c)(1) fund that has non-accredited investors if the following requirements are met:

• the fund existed prior to the effective date of the California private adviser exemption;
• as of the effective date of the Private Adviser Exemption, the fund no longer accepts accredited investors;
• the firm provides certain written disclosures about the services it provides, its duties, and other material information; and
• as of the effective date of the Private Adviser Exemption, the firm delivers audited financials to the investors.

Currently, the proposed rule does not have an anticipated effective date. If approved, managers of funds with non-accredited investors may still qualify for the Private Adviser Exemption.

Conclusion

The California private adviser exemption will change the entire registration regime in California. Firms that solely manage qualifying funds and meet the requirements discussed above will not have to register with the DOC and those that are currently registered may withdraw their registration. So, hedge fund managers in California with under $100M in AUM generally will not be registered with any regulatory agency. Do keep in mind that if a manager manages even a single separate account, in addition to the qualifying funds, it will not be eligible for the private adviser exemption.

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Cole-Frieman & Mallon LLP provides investment adviser registration and compliance services to hedge fund managers.  Bart Mallon can be reached directly at 415-868-5345.

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January 10 – 11

• Sponsor: HFBOA
• Event: Optimizing Hedge Fund Business Operations
• Location: New York, NY

January 10 – 12

• Sponsor: Opal Financial Group
• Event: Public Funds Summit
• Location: Scottsdale, AZ

January 17

• Sponsor: Infovest 21
• Event: Morning Investor Seminar/Breakfast
• Location: New York, NY

January 17

• Sponsor: Infovest 21
• Event: Afternoon Seminar
• Location: New York, NY

January 17

• Sponsor: Infovest 21
• Event: Afternoon Seminar: Impact of Regulation on Client Reporting and Due Diligence
• Location: New York, NY

January 17

• Sponsor: FMW
• Event: Intensive Introduction to the Securities Industry 
• Location: New York, NY

January 18 – 20

• Sponsor: TMA
• Event: Distressed Investing Conference 
• Location: Las Vegas, NV

January 18 – 20

• Sponsor: Infocast
• Event: Projects & Money 2012
• Location: New Orleans, LA

January 19

• Sponsor: FRA
• Event: Hedge Fund Tax 101
• Location: New York, NY

January 20

• Sponsor: FRA
• Event: K-1 Boot Camp 
• Location: New York, NY

January 23 – 24

• Sponsor: Deal Flow Media
• Event: Activist Investor Conference 2012
• Location: New York, NY

January 23 – 25

• Sponsor: IIR
• Event: GAIM USA 2012
• Location: Boca Raton, FL

January 24

• Sponsor: FMW
• Event: Risk Management for Non-Quants
• Location: New York, NY

January 25 – 26

• Sponsor: Opal Financial Group
• Event: Energy Investment Forum
• Location: Austin, TX

January 25

• Sponsor: Hedge Funds Care
• Event: 2nd Annual West Coast Committee of Hope Poker Tournament
• Location: San Francisco, CA

January 26

• Sponsor: Hedge Funds Care
• Event: 2012 AlphaMetrix Summit Cee Lo Green Concert to benefit HFC
• Location: Miami, FL

January 29 – 31

• Sponsor: MFA
• Event: Network 2012
• Location: Palm Beach, FL

January 29

• Sponsor: Hedge Funds Care
• Event: MFA Charity Golf Tournament & Networking Event to benefit HFC
• Location: Palm Beach, FL

January 31

• Sponsor: HFA
• Event: Effective Hedge Fund Strategies
• Location: Aventura, FL

January 31

• Sponsor: PLI
• Event: Hedge Fund Registration & Compliance 2012
• Location: New York, NY

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Cole-Frieman & Mallon LLP provides legal services for hedge fund managers and other groups within the investment management industry. Bart Mallon can be reached directly at 415-868-5345.

Clients, Friends, Associates:

Although we are late in publishing this year-end planning memo, we believe it may still be helpful for managers on this last day of 2011 and into the new year.  In addition to all of the administrative details involved in closing out the year, the regulatory landscape has shifted dramatically over the past year. As a result, year-end processes and 2012 planning are particularly important, especially for General Counsels, Chief Compliance Officers (CCOs) and key operational and financial personnel. We have updated our own year-end checklist to help managers stay on top of these priorities.

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Regulatory Compliance:

New Issue Status. On an annual basis, a manager needs to confirm or reconfirm the eligibility of investors that participate in initial public offerings or new issues. Most managers reconfirm this via negative consent, i.e., investors are informed of their status as on file with the manager and asked to inform the manager of any changes. No response operates as consent to the current status.

In addition, this is a good time to review your offering documents to confirm that they include FINRA’s anti-spinning rule (Rule 5131), as well as the SEC’s current thresholds for accredited investor and qualified client status, which became effective this year.

ERISA Status. Given the significant problems that can occur from not properly tracking ERISA investors, we recommend that managers also confirm or reconfirm on an annual basis the ERISA status of its investors. This is particularly important for managers that track the underlying percentage or ERISA funds for each investor. This reconfirmation can also be obtained through a negative consent.  [For more information, please see our post on ERISA issues for hedge funds.]

Annual Privacy Policy Notice. On an annual basis, a registered investment adviser must also provide its investors with a copy of its privacy policy, even if there are no changes to the policy.

Annual Compliance Review. On an annual basis, the CCO of a registered investment adviser must conduct an annual review of a manager’s compliance policies and procedures. This annual compliance review should be in writing and presented to senior management. We recommend that you discuss the annual review with your outside counsel, who can provide guidance about the review as well as a template for the review. Managers should be careful that sensitive conversations regarding the annual review are protected by attorney-client privilege. CCOs may also want to consider additions to the compliance program, including implementation of policies relating to use of social media, a hot topic for both managers and regulators in 2011.

Managers who are not registered may still wish to review their procedures and/or implement a compliance program as a best practice.

Trade Errors. Managers should make sure that all trade errors are addressed by the end of the year, pursuant to the manager’s polices regarding trade errors. Documentation of trade errors should be finalized, and if the manager is required to reimburse the funds, it should do so by year-end.

Soft Dollars. Managers that participate in soft dollar programs should make sure that they have addressed any commission balances by the end of the year.

Custody Rule Annual Audit. SEC-registered advisers must (i) maintain client funds and securities with a qualified custodian in a separate account for each client under that client’s name, or in an account that contains only client funds and securities with the adviser listed as agent or trustee for the clients; (ii) have a reasonable basis, formed after “due inquiry,” for believing that the qualified custodian holding client funds or securities sends an account statement to each advisory client at least quarterly; (iii) notify clients upon opening any new custodial account on behalf of the client (or changes to any such account) and include a legend in such notice urging the clients to compare custodial account statements with any statements received from the adviser (if the adviser elects to send any such statements directly); and (iv) undergo an annual surprise examination conducted by an independent public accountant.

Advisers to pooled investment vehicles may avoid both the quarterly statements and surprise examination requirements by having audited financial statements prepared in accordance with GAAP by an independent public accountant registered with the Public Company Accounting Oversight Board. Statements must be sent to the fund or, in certain cases, investors the fund within 120 days after the fund’s fiscal year end. Managers should review their custody procedures to ensure compliance with the rule. Requirements for state-registrants may differ, and we encourage you to contact us if you have any questions or concerns about your custody arrangements.

Please see our post on the SEC Custody Rule for more information.

Schedule 13G/D and Section 16 Filings. A manager whose managed funds are beneficial owners of 5% or more of a registered voting equity security must report these positions on Schedule 13G. Schedule 13G filings are updated annually within 45 days of the end of the year. For managers who are also filing Schedule 13D and/or Section 16 filings, this is an opportune time to review your filings to confirm compliance and anticipate needs for Q1.

Form 13F. A manager must also file a Form 13F if it exercises investment discretion with respect to $100 million or more in certain securities within 45 days after the end of the year in which the manager reaches the $100 million filing threshold. The SEC lists the securities subject to 13F reporting on its website.

Form 13H. Managers who meet the SEC’s new large trader thresholds (in general, managers whose transactions in exchange-listed securities equal or exceed two million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month) were required to file an initial Form 13H with the SEC on December 1, 2011. Large traders will need to file amended 13Hs on an annual basis. In addition, changes to the information on 13H will require interim amendments following the calendar quarter in which the change occurred.

Blue Sky Filings. On an annual basis, a manager should review its blue sky filings for each state to make sure it has met any renewal requirements. States are increasingly imposing late fees or rejecting late filings altogether. Accordingly, it is critical to stay on top of filing deadlines, for both new investors and any renewals.

SEC Form D. Form D filings for most funds need to be amended on an annual basis, on or before the anniversary of the initial SEC Form D filing. Copies of Form D can be obtained by potential investors via the SEC’s website.

IARD Annual Fees. Preliminary annual renewal fees for state registered and SEC registered investment advisors were due by December 12, 2011. In the event a manager has not submitted these fees, the manager should submit these fees immediately through the IARD system. The manager will likely be subject to additional late filing fees and these must be paid through the IARD by February 3, 2012.

Pay-to-Play Rules. In 2010, the SEC’s adopted Rule 206(4)-5, which disqualified investment advisers, their key personnel and placement agents acting on their behalf from seeking to be engaged by a governmental client if they have made political contributions. State and local governments are following suit, including California, which requires such persons to register with the state as lobbyists, and mandates lobbyist registration in California’s cities and counties as well. This is an important issue for any manager seeking investments by government pension plans.

Registered Commodity Pool Operators and Commodity Trading Advisers. Registered CPOs and CTAs must prepare and file Annual Questionnaires and Annual Registration Updates with the NFA. Registered CPOs must also prepare and file an annual report for each commodity pool. Unless its funds qualify for an exemption, registered CPOs and CTAs must update their disclosure documents periodically, as they may not use any document dated more than 9 months prior to the date of its intended use. Disclosure documents that are materially inaccurate or incomplete must be promptly corrected and the correction must be promptly distributed to pool participants.

Fund Accounting and Financial Matters:

Wash Sales. Managers should carefully manage wash sales for year end. Failure to do so could result in embarrassing book/tax differences for investors. Certain dealers can provide managers with swap strategies to manage wash sales, including Basket Total Return Swaps and Split Strike Forward Conversions. These strategies should be considered carefully to make sure they are consistent with the investment objectives of the fund.

Financial Accounting Standards Board Interpretation No. 48 (“FIN48″). Under FIN48, which became effective in 2009, managers must implement procedures to assess material tax positions, and potentially accrue liabilities. Managers should begin preparing to implement FIN48 as soon as possible, and should discuss with their auditors whether FIN48 will apply to them. Funds with exposure to certain countries, including Spain and Australia, should make sure they are aware of the implications of FIN48.

Redemption Management. Managers with significant redemptions at the end of the year should carefully manage the unwinding of positions so as to minimize transaction costs in the current year (that could impact performance), and prevent transaction costs from impacting remaining investors in the next year. When closing funds or managed accounts, managers shall pay careful attention to the liquidation procedures in the managed account agreement and the fund constituent documents. Offshore funds may involve unusual or lengthy dissolution procedures. Please contact us to help you evaluate and manage any fund dissolutions you are considering.

NAV Triggers and Waivers. If redemptions, performance or a combination of these are expected cause a termination event (NAV declines are typical inclusions in these provisions) in a fund’s ISDA or other counterparty agreement, managers should seek waivers of those events before the end of the year. We recommend starting this process early as credit officers at many banks may become unavailable during the holiday season.

Fund Expenses. Managers should make sure that all fund expenses for a particular year are paid for in that year, and do not roll over into the next year. In particular, managers should contact their outside legal counsel to obtain accurate and up to date information about legal expenses. Outside counsel and other vendors should be given a deadline so that checks do not need to be processed on New Year’s Eve.

Management Company Issues:

Management Company Expenses. Similarly, managers who distribute profits on an annual basis should attempt to pay management company expenses in the year they are incurred. If ownership or profit percentages are adjusted at the end of the year, a failure to manage expenses could significantly impact the economics of the partnership or the management company.

Employee Reviews. An effective annual review process is important to reduce employment related litigation and protect the management company in the event of such litigation. Moreover, it is an opportunity to provide context for bonuses, compensation adjustments, employee goals and other employee-facing matters at the firm. It is not too late to put an annual review process in place for 2011.

Compensation Planning. In the hedge fund industry, and the financial services industry in general, the end of the year is the appropriate time to make adjustments to the compensation program. Since much of a manager’s revenue is tied to annual income from incentive fees, any changes to the management company structure, affiliated partnerships, or any shadow equity program should begin on the first of the year.

Insurance. If a manager carries D&O Insurance or other liability insurance, the policy should be reviewed on an annual basis to make sure that the manager has provided notice to the carrier of all claims and all potential claims.

Future Regulatory Change:

Form ADV. Current registrants must file an annual amendment to Form ADV within 90 days of the end of its fiscal year. For SEC registrants, an updated Part 1A will be due on March 30, 2012, regardless of your FYE, to indicate your AUM for purposes of eligibility to remain registered with the SEC.

Annual amendments for SEC registrants will include Parts 1A and 2A (the firm brochure). For most state registrants, this will include all parts of the ADV as well as U4s for its investment adviser representatives. For managers who have not yet filed using the revised ADV Part 2 (for example, those who filed at the end of 2010, but were not approved until after January 1, 2011), you should anticipate additional time translating your old Part II and Schedule F information into the narrative format of Part 2A and B.

Additionally, on an annual basis, registered investment advisers must provide a copy of the updated Form ADV 2A brochure and Part 2B brochure supplement to clients (or a summary of changes, with an offer to provide the complete brochure).

For managers who are required to register with the SEC, the deadline to be registered is March 30, 2012. We recommend filing the ADV by at least February 14, 2012 to ensure meeting this deadline.

Managers who will no longer meet the AUM threshold to maintain registration with the SEC will have until June 28, 2012 to transition to state registration.

Form PF. Managers to private funds who are either registered with the SEC, or required to be registered with the SEC, will begin filing Form PF in 2012. Most private fund advisers will be required to begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, to end on or after December 15, 2012. Those with $5 billion or more in private fund assets must begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, to end on or after June 15, 2012.

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For assistance with any compliance, registration, or planning issues with respect to any of the above topics, please contact Karl Cole-Frieman at 415-352-2300, Bart Mallon at 415-868-5345 or Aisha Hunt at 415-762-2854.

Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for financial services matters.

Cole-Frieman & Mallon LLP
150 Spear Street, Suite 825
San Francisco, CA 94105
t. 415-352-2300
f. 646-619-4800
www.colefrieman.com

This Cole-Frieman & Mallon LLP Announcement is published as a source of information only for clients and friends of the firm, and should not be construed as legal advice or opinion on any specific facts or circumstances. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Circular 230 Disclosure: Pursuant to regulations governing practice before the Internal Revenue Service, any tax advice contained herein is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Cole-Frieman & Mallon LLP is a California limited liability partnership.

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December 1

• Sponsor: Bloomberg LINK
• Event: Bloomberg Hedge Funds Summit
• Location: New York, NY

December 1

• Sponsor: Infovest 21
• Event: Investor Morning Seminar/Breakfast
• Location: New York, NY

December 4-6

• Sponsor: Opal
• Event: Alternative Investing Summit
• Location: Laguna Niguel, CA

December 5

• Sponsor: CHFA
• Event: California Hedge Fund Association—Winter Networking Reception
• Location: Laguna Beach, CA

December 5

• Sponsor: Financial Research Associates, LLC
• Event: Hedge Fund Financial Reporting Master Class
• Location: New York, NY