New Shorting Rules Will Affect Hedge Funds
New short selling rules are coming into effect both here in the US as well as abroad. They are squarely aimed at “speculators” and are in response to the myriad of crises that have affected markets in the last two years. More recently, the crisis in Greece is currently driving new proposals and bad publicity in the EU around short selling practices. While hedge funds are not the stated “targets” of these new rules, clearly many funds’ investment practices will be affected.
The SEC has now implemented the “alternate uptick rule” which puts in place a circuit breaker when there is excessive downward pressure on a stock. The aim is to reduce volatility and restore investor confidence. Any time a stock has dropped 10% in one day, the circuit breaker would immediately take effect and no shorting would be allowed unless the price is above the current national best bid. The SEC, while cognizant of the benefits of shorting in providing liquidity and pricing efficiency to the markets, believes that excessive downward price pressure is a destabilizing factor and erodes investor confidence. By in effect allowing long sellers to stand in front of the line ahead of short sellers, the SEC is responding to calls for short selling restrictions from investors and issuers alike which were heard loud and clear during the market crises of 2008-2009.
In the EU, the Committee of European Securities Regulators (CESR) has recommended that short sellers be required to report when they are short 0.2% or more to shares listed in the European Economic Area and when they change those positions by 0.1% or more. While there is some on-going debate about how public this reporting should be, we have already seen partial implementation of the rule in Germany and a similar rule already in place in the UK. Look for EU-wide adoption sometime in 2010, as well as additional regulations related to speculation in the CDS markets. Note that Hong Kong already has a rule in place requiring private disclosure to the regulator.
A more detailed description of the new US “alternative uptick” short-selling rule can be found on the SEC’s website at http://www.sec.gov/news/press/2010/2010-26.htm.
Hedge Funds and Client Info Protection: Massachusetts Stepping Up
Hedge funds with Massachusetts clients: take note! A new law is going into effect on March 1, 2010 which affects the way you secure your information.
Under the new law, entitled “STANDARDS FOR THE PROTECTION OF PERSONAL INFORMATION OF RESIDENTS OF THE COMMONWEALTH “, hedge funds will need to have written, comprehensive information security programs if they have “personal information” about a Massachusetts resident. Such personal information includes having: a social security number, drivers license or other government issued ID, financial account number or credit card number. Hedge funds are likely to have some or all of this information through the subscription process.
The law further calls for:
-Encryption of data over public networks
-Encryption of laptop and portable devices
-Having a designated employee in charge of data security
-Training employees on data security
-Developing security policies and overseeing their enforcement, including disciplining employees for infractions
-Selecting appropriate service providers (such as administrators) who can meet the requirements of the law, and so state in a written contract
- Taking steps to prevent physical access to data
-Annual review of program.
The above is a summary of the law. There are also specific requirements regarding computer systems.
We recommend a review of the law in light of your current program, particularly with regard to your administrator. The law can be found at http://www.mass.gov/Eoca/docs/idtheft/201CMR1700reg.pdf.
New SEC Custody Rule has Little Impact on Hedge Funds
In an effort to beef up surveillance of financial firms that hold custody of client assets, the SEC passed a final rule at the end of 2009 which amended the existing Custody Rule (Rule 206(4)-2 under the Investment Advisers Act of 1940). When the amendment was put out for public comment, the additional rules were written so as to be applicable to hedge funds. However, after over a thousand comment letters were received, the final rule was passed with a provision to except out most hedge funds.
In summary, the new amendments provide that a registered adviser having custody of client funds or securities be required to undergo an annual surprise examination by an independent public accountant to verify client assets; to have the qualified custodian send account statements directly to the clients; and unless client assets are maintained by an independent custodian (i.e., a custodian that is not the adviser itself or a related person), to obtain a report of internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board (”PCAOB”).
Most hedge funds are exempt from these requirements as “pooled investment vehicles” that only meet the technical definition of “custody” because they can withdraw fees directly from client accounts. The Custody Rule calls for such pooled investment vehicles to be exempt from all requirements noted above if they obtain an annual audit from a PCAOB auditor within 120 days of their fiscal year end (180 days in the case of fund of funds) and distribute this audit to clients within that time frame. Assets still must be maintained at a qualified custodian. If the hedge fund does not meet these requirements, the adviser must indeed obtain an annual surprise examination and must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement of the pooled investment vehicle to its investors. The only portion of the new rules that do apply to hedge funds is the requirement to obtain the internal control report if the assets are held with an affiliated custodian.
The amendments to the Custody Rule are highly complex and the SEC’s release about them runs over 120 pages. The release can be viewed at http://sec.gov/rules/final/2009/ia-2968.pdf. We expect that this blog post will be used as a summary only and look forward to answering any questions from clients.
Hedge Fund Compliance 2009: The Year in Review
For hedge funds, 2009 was certainly the year of anticipation. Anticipated new rules dominated the headlines and planning meetings. And it seemed like almost weekly, there were new scandals and additional revelations about the Madoff case that left everyone talking over the water cooler, trying to predict what the next shoe to drop would be.
Will registration requirements pass, and what will the size threshold and reporting requirements be? And that custody rule that drew so many comments throughout the year– will that be passed in 2010? 2009 saw the specter of anti-money laundering requirements for hedge funds, as well as the Form SH that was in effect for months before being dropped. The development of new EU requirements continued throughout the year and will do so into 2010 as those have yet to be finalized. The effect of the EU requirements on US fund advisers should not be under-estimated and is a topic that is being closely watched.
The year also saw tremendous developments in the litigation area and the bolstering of prosecutorial muscle. Starting the year with the Madoff scandal in full bloom, and moving into numerous new Ponzi schemes being uncovered, the year wound up with the Galleon insider trading case which featured the first use of wiretaps in such a case. Increasing integration of governmental arms at multiple levels, from the SEC to the States and other federal agencies, including prosecutors’ offices was a key advance in 2009.
So what should an average hedge fund adviser do to get ready for 2010? Easy… fasten your seatbelt, and either get, or stick with, a full-blown compliance program. Wishing you all the best for the new year!
Scorecard on Hedge Fund Registration Legislation
We’re not sure what inning it is, but the hits are coming in fast and furious when it comes to bill proposals for hedge fund registration. Just today, Chris Dodd released the discussion draft of the “Restoring American Financial Stability Act of 2009’’, which contains within it the ‘‘Private Fund Investment Advisers Registration Act of 2009’’. This follows the bipartisan bill actually passed by the House Financial Services Committee at the end of October entitled the “Private Fund Investment Advisers Registration Act”.
Some of the significant highlights, and key differences, are listed below. Note that there are other provisions of both bills that not addressed here.
1. Everyone registers? The Dodd proposal has a threshold of $100m assets under management, the House FSC bill an exemption for “small” funds under $150m. The Dodd proposal exempts both venture capital and private equity funds, the FSC bill only venture capital funds. Both contain similar language for capturing certain offshore advisers, however the Dodd proposal is broader in that it includes any offshore adviser with 10% or more of its securities owned by US persons. This 10% requirement does not appear in the FSC bill.
2. Reporting Requirements. Both bills contain similar requirements for funds to regularly report in certain basic information to the SEC, including information about the amount of assets under management; the use of leverage; counterparty credit risk exposures; trading and investment positions; and trading practices.
3. Update of Investor Qualifications. The Dodd bill contains provisions to continually update the “accredited investor” qualification standard to keep pace with inflation.
4. Further Study. The Dodd bill provides for the Comptroller to do a further study regarding the feasibility of a hedge fund “self-regulatory” agency, the state of “short-selling” in the market, and the appropriate level for the accredited investor standard.
5. Independent Custodian Requirement. The Dodd bill calls for an independent custodian to be used by hedge funds to hold client assets.
In addition, the Dodd proposal creates an entirely new agency, the “Agency for Financial Stability”, which would be charged with identifying and removing systemic risks from the system, including presumably, those presented by hedge funds (the House bill vests this responsibility with Federal Reserve). Like the House bill, the Dodd bill also calls for the creation of a consumer protection agency which would have oversight over financial products, also presumably including hedge funds.
We can’t really call a “winner” at this point, however we do see that all involved are extremely motivated to pass a piece of legislation in the near future. The Dodd bill can be viewed at http://banking.senate.gov/public/_files/AYO09D44_xml.pdf. The Kanjorski bill can be viewed at: http://www.govtrack.us/congress/billtext.xpd?bill=h111-3818
Hedge Fund Insider Trading Probe Expands
With the arrest of 13 additional individuals and entities in the Galleon case, we urgently see the need for hedge fund compliance to beef up in two areas:
OPERATIONAL RISK CONTOLS- Hedge Funds need to understand and monitor where and how the information being traded on is generated.
TRAINING - Employees need to understand precisely what “insider trading” is, how it is uncovered by authorities and what their internal processes related to it are.
The SEC’s investigation of this case goes back to 2007 (well before Madoff), and it has been ground-breaking in numerous ways, including in the use of wiretapping.
In addition— related to the “beefing up” of the SEC– hedge funds should note that the new associate regional director for examinations for the New York office is Norm Champ, the former General Counsel for hedge fund group Chilton. See http://www.sec.gov/news/press/2009/2009-231.htm to view the SEC’s press release regarding this appointment.
“Trust and Delegation” Paper Highlight Problems with Current Hedge Fund Due Diligence Processes
A stunning study released by NYU’s Stern School of Business entitled “Trust and Delegation” finds significant problems with the due diligence reports which are currently heavily relied on by the industry in selecting managers for investment. The authors of the study reviewed a sample of due diligence reports collected from hedge fund managers by a major professional hedge fund due diligence firm, and found an abundance of misrepresentations being made. In particular, 21% of managers misrepresented their past legal and regulatory problems, and 28% had incorrect or unverifiable representations about other topics. In addition, the paper highlights the fact that due diligence reports are typically issued by managers 3 months after historic high performance levels, and at the point of highest cash flow into the fund, thereby indicating that investors, despite conventional wisdom to the contrary, are indeed chasing returns.
“Due Diligence” is one of those terms that can mean different things to different people Is meeting a potential manager for lunch and feeling that you “trust” him doing adequate “due diligence”? Most sophisticated investors would say “no” to that one, but most probably would have said “yes” to reliance on a professional due diligence provider. Apparently, however, there are significant problems with that as well.
Regulatory requirements could conceivably reduce the level of misrepresentations and we continue to monitor developments in that area. The paper itself can be viewed at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1456414#.
Coordination the Name of the Game in Hedge Fund Regulation Proposals
The whole fabric of the regulations which will impact US hedge fund advisers is going to be made up of finely woven threads of regulations which will be issued by various governmental entities. Threads will be contributed by multiple federal, state and even foreign regulatory bodies.
Much press has been given to the proposed federal framework of regulation. The “systemic risk” regulator (overseeing large, leveraged and interconnected firms) and the “Consumer Financial Protection Agency” (to provide “risk-based oversight”) have been well documented. Registration of hedge fund advisers and increased reporting is a component of all proposals, and this function will presumably continue to reside with the SEC. Indeed, the SEC is internally reorganizing and has just recently announced a newly-established Division of Risk, Strategy, and Financial Innovation. This will be an interdisciplinary division, utilizing oversight techniques in the areas of economics, finance and law. In addition, the “pay-to-play” prohibitions contained in a recent proposed SEC rule will have an impact on how some of the hedge fund industry’s fund-raising is done.
On the state level, it appears that the game plan is to have the states more effectively pick up the regulatory slack. In remarks to the North American Securities Administrators Association (NASAA), President Denise Voight Crawford indicated on September 15 that the definition of the boundaries between state and federal regulation are currently being discussed. One of the items on the table is whether the threshold for state investment adviser registration (as opposed to federal) will be moved up to $100m from $25m, thereby widening the universe of advisers that come under state, rather than federal, regulation. The text of Ms. Voight’s speech can be found at http://www.nasaa.org/NASAA_Newsroom/Speeches/11220.cfm
Regulatory developments are moving swiftly in the international arena as well. With the G20 group now firmly entrenched as the operative group (as opposed to the G8), we expect to see coordinated regulations emerge. (See prior post on the EU proposals regarding hedge funds.) In addition, there is increasing pressure on offshore jurisdictions to push for more transparency from hedge funds. For example, the Cayman Islands has recently enacted a system for providing better information to regulators. And now there is a proposed plan which would allow the Cayman Islands Monetary Authority (CIMA) to make available to the public some of this data.
On a separate note, both the Obama regulatory overhaul proposal and Ms. Crawford’s speech at the NASAA called for an end to mandatory, industry-run arbitration (ie., FINRA) for retail and investment advisory cases. The Obama proposal wants to “study” the issue further. While this may not perhaps have a direct impact on hedge fund industry, there may be some indirect consequences lurking here which would need to be fully studied.
While this post is a summary of the different threads we see in various proposals, the final piece is yet to emerge. We will continue to keep you updated.
Will EU Reform Proposals Foreshadow New US Regulations for Hedge Funds?
There’s a battle going on in Europe over proposed regulatory reforms directed at alternative investments. The EU is two steps ahead of Washington in the financial overhaul process, having released a draft Directive in April, 2009. Sides have been drawn, with some calling the provisions too lenient, and others believing that there are significant downsides to the proposal. With another EU Commission meeting scheduled for October, Washington is surely watching how this fight will turn out.
The Directive contains some very specific proposals which impact all EU alternative products, including hedge funds, real estate funds and venture capital funds. There are also direct impacts on non-EU managers and funds. Some of the key provisions include:
*Alternative Investment Fund Managers will need to be authorized by the EU home regulator in order to manage or market an Alternative Investment Fund in the EU; authorized Managers can market their funds throughout the EU via a “passport“; non-EU Managers may be able to if their home jurisdictions meet certain standards related to monitoring of systemic risk and prudent regulation. Authorization is dependent on demonstration of appropriate risk and liquidity management procedures, as well as adequate capitalization. Notification of changes to the Manager’s infrastructure will need to be approved by the regulator.
*Non-EU Alternative Investment Funds can be marketed in the EU by an authorized EU manager to “professional investors”, if the domicile country has signed an effective bilateral tax information agreement.
*Valuation/Custody: an independent valuer and an EU-authorized custodian must be appointed for each fund.
*Disclosure: Certain periodic disclosures are required to both investors and regulators, such a fees, identity of service providers, preferential treatment, valuation procedures, risk profile. Regulators will be required to receive aggregated info on the instruments traded by the fund, the markets traded in, the fund’s principal exposures.
*Side Letters: terms and identity of investors benefiting from the side letter must be disclosed to other investors
* Leverage: Additional disclosure for funds with a debt to equity ratio of greater than 1:1 in two of the past four quarters; additional mesaures may be passed imposing an actual limit on leverage for particular types of Alternative Investment Funds.
The EU proposals are important in the US for two reasons. First, the provisions on disclosure, reporting, registration (authorisation) and leverage, may be looked to in formulating the US legislation. In some cases, these provisions are already encapsulated in the proposals we have seen from Congress. Second, the impact on US-based fund managers should not be underestimated. The current proposal will introduce signficant barriers to marketing in the EU of alternative funds run by non-EU managers or with non-EU domiciles. If passed as currently drafted, these provisions will, at the very least, pose new compliance and reporting hurdles for US managers seeking to market in the important EU market.
The lobbying in Europe over the Directive is reported to be intense now. The entire legislative process in anticipated to be finalized at the end of next year. The full text of the proposal can be found at: http://ec.europa.eu/internal_market/investment/alternative_investments_en.htm
Hedge Fund Bonus Season: Compliance and Regulatory Developments
As the end of the year comes closer, bonuses are increasingly on the minds of Wall Streeters, and in particular, hedge fund employees. With some high water marks not yet recovered from 2008 levels, and the markets still not favorable for many strategies, dividing up the hedge fund bonus pool (if any) for 2009 will surely be a challenging task. And, lurking in the background of this bleak scenario is the threat of government regulation: it seems incredible, but is that a real possibility for hedge funds?
From a compliance point of view, the key to a successful bonus process is twofold: documentation and process. It is important to focus on these two elements: documenting all bonus-related decisions, and subjecting all employees to the same process related to the distribution of the bonus. So, in advance of year-end, it may be helpful to focus on whether your hedge fund organization has these two components in place.
From a regulatory point of view, certainly bank bonuses are in the cross-hairs of legislators. This is particularly so in Europe, where the regulatory process seems to have moved ahead of the US. In the US, the Treasury proposals to over-haul the financial regulatory system may in fact impact certain hedge funds if those funds wind up being characterized as “Tier I” or institutions that pose “systemic risk”. With Obama having a fall timetable in mind for passage of the over-haul, the details will certainly soon emerge.
