Is Your Hedge Fund Style “Drifting”? Quick, Catch It!
Hedge fund style “drift” is said to occur when a hedge fund manager strays from their stated investment strategy. The term used to be an esoteric one, used only by professional hedge fund analysts. However, “drifting” is a problem that is lately coming into view more by regulators and in litigation by disgruntled investors.
Managers that are asked about drifting will usually confidently pull out their offering memo and point to an “investment strategy” section which indicates in extensive legalese that the fund can invest in basically every known security instrument known to the financial world. This language of over-inclusiveness precludes any claim of drifting they will say. ”We are allowed to invest in absolutely everything, so how could we possibly be ‘drifting’? ” That’s how the conventional thinking now goes, but in recent cases and with changes to the advertising landscape yet to come, we believe the reliance on just the offering memo laundry-list language is coming to an end.
In terms of the regulators, in a recent action (SEC v Rooney and Solaris Mgmt), the SEC charged an investment manager with misuse of fund assets for his own benefit. Not a novel situation, but what was different was that the basis for the fraud action rested on the charge that the manager changed the fund’s strategy without disclosure to fund investors. We expect to see more of these types of cases in the future as the SEC gears up to analyze vast quantities of data being mined out of the revised Form ADV and the upcoming Form PF. The Form PF even asks for fairly specific identification of the fund’s strategy (i.e., equity- market neutral, equity- long/short). The SEC has added a Division of Risk, Strategy, and Financial Innovation and within that, Offices of Quantitative Research as well as Risk Assessment and Interactive Data. If style drift is to form the basis of an SEC action in the future, these offices will drive those cases by developing the supporting data for such a claim.
Recent investor litigation has also focused on the issue of style drift. In a recent class action suit filed in early 2012 (Schadv Harbinger Capital Partners LLC), the main claim relates to deviation from
the fund’s stated strategy. Additionally, with marketing materials for hedge funds becoming more sophisticated and widely used (particularly in light of the loosening of advertising restrictions upcoming under the JOBS Act), we expect to see more cases pointing to the stated investment style in the marketing materials, rather than sole reliance on the offering memorandum. For example, if the offering memo states that the fund can invest in absolutely anything, but the marketing materials state that the fund is an emerging markets fund focused on China, a successful claim of style drift might be possible when the manager puts the fund’s portfolio heavily into Iceland.
The case law is evolving in this area, and we will continue to monitor going forward. In the meantime, both investors and managers need to understand the issue and assess their relative positions carefully.
In Controversial Self-Regulatory Organization Proposed Bill, Hedge Funds Are to be Exempt
Congressional Bill HR4624, the “Investment Adviser Oversight Act of 2012” has been introduced into Congress, with a hearing scheduled to be held tomorrow, June 6, 2012. The co-sponsors of the Bill are Finance Committee Chairman Spencer Bachus (R-AL) and Carolyn McCarthy (D-NY).
The idea behind the Bill is that the SEC is spread too thin in terms of staffing and funding resources and so it can not effectively supervise its registered investment advisers. The Dodd-Frank law in fact mandated a study to review and analyze the need for the SEC to have enhanced examination and enforcement resources for investment advisers. This study was completed in January 2011, and indicated, not surprisingly, that resources to meet the pending demand caused by the registration requirement of Dodd-Frank were indeed scarce.
The Bachus-McCarthy proposal in HR4624 is to have FINRA, a non-governmental self-regulatory organization (SRO) now regulating only broker-dealers, also regulate a portion of the registered investment adviser universe. An oft-quoted statistic supporting this proposal is that the SEC examined only 8% of the approximately 12,000 register advisers last year, while FINRA examined 58% of brokers, hence the conclusion that the public would be better served by having FINRA as the regulator of investment advisers.
Whatever your opinion of having FINRA as the SRO — and there are strong opinions on either side of that argument–a careful read of the Bill brings to light the fact that a large portion of the registered investment adviser universe is in any event to be exempted from the proposed FINRA regulation: most prominently hedge funds and mutual fund advisers.
The hedge fund exclusion is puzzling. The sheer volume of hedge fund investment adviser registration since Dodd-Frank is huge. According to the SEC’s latest statistics, as described in a speech by Norm Champ, Deputy Director, Office of Compliance Inspections and Examinations at the SEC on May 11, 2012:
“As of early April, there were approximately 4,000 investment advisers that manage one or more private funds registered with the Commission, of which 34% (more than 1,350) registered since the effective date of the Dodd-Frank Act, July 21, 2011. We estimate that this represents a 52% increase in registered private fund advisers; 32% of all advisers currently registered with the Commission report that they advise at least one private fund…. Registered private fund advisers report on Form ADV that they advise approximately 30,000 private funds with total assets of $8 trillion, which is 16% of total assets managed by all registered advisers.”
If this portion of the registered investment adviser world is left with the SEC (along with the mutual fund world), we hope there will be a rigorous analysis of exactly which categories of investment advisers would actually be moved to FINRA supervision and what portion the SEC would be left with…. and whether this move would actually help the SEC alleviate its documented lack of resources (thereby helping the investing public, which presumably is the goal).
HR4624 can be viewed at http://www.opencongress.org/bill/112-h4624/text
The SEC study referred to above can be viewed at http://www.sec.gov/news/studies/2011/914studyfinal.pdf.
Regulatory Focus on Hedge Funds Continues
The regulatory focus on hedge funds continued during the first quarter of 2012, as new iniatives continued to roll out, and milestones in the implementation of rules put on the books last year were hit.
For “large” hedge funds, we see the summer deadline for filing the Form PF looming large. Required by the Dodd-Frank Act, the Form PF asks for a vast amount of information on hedge fund positions, exposure and risk. While the information will only be available to the government for “risk oversight” purposes, large filers are not only preparing the form itself right now, they are analyzing how to respond to the inevitable requests from investors for the information they provided on the form. While smaller hedge funds have a first filing date in early 2013, they will face similar questions from investors (but a smaller form requiring less information).
On another front, the implementation of the Large Trader ID rules have now come into effect. “Large Traders”, which include many hedge funds, have received their ID numbers from the SEC and have presumably distributed them to their broker-dealers. The broker-dealers are the ones doing most of the work in this regime. The B-D’s will maintain records, report to the SEC and possibly monitor certain Large Traders, all in the hopes of preventing another “flash crash” or other such calamaty or wrong-doing. Hedge funds have to keep their list of broker-dealers current with the SEC by filing quarterly updates — not too onerous a job, but this does require some attention.
During the first quarter, the CFTC jumped into the regulatory act by eliminating an exemption from registration under which many hedge funds operate. This action will result in these exempt fund advisers having to register with the CFTC by the end of the year (in addition to the SEC or state registration that they have already done earlier this year). Along with increased oversight by the CFTC, additional disclosures will be required to investors, and employees with significant trading and marketing roles will have to become registered and pass the Series 3 exam. In April, a lawsuit challenging this new requirement was filed by the Investment Company Institute. In response, Barney Frank stated “It’s just incredible to me….It’s just mindless yearning for the old ways.” The lawsuit’s outcome is uncertain at this time.
Perhaps the biggest development of the quarter was one that received the least press: the SEC entered into comprehensive arrangements with both the Cayman Islands Monetary Authority (CIMA) and the European Securities and Markets Authority (ESMA) as part of long-term strategy to improve the oversight of regulated entities, including hedge funds, that operate across national borders. This follows on to similar “memoranda of understanding” (“MOU’s”) entered into with Quebec and Ontario. This brings the total number of MOU’s that the SEC has entered into to EIGHTY (80). These arrangements detail procedures and mechanisms by which the SEC and its counterparts can collect and share investigatory information where there are suspicions of a violation of either jurisdiction’s securities laws, and after a potential problem has arisen. As enforcement and supervisory tools, they are the key elements to success for a regulator, due to the global operational presence of most hedge funds. This is particularly true as it relates to the SEC and CIMA, which provides a home to many of the world’s hedge funds. CIMA’s chairman, Mr. George McCarthy, OBE, JP stated, ”This MOU with the SEC is particularly important as Cayman is a major domicile for hedge funds and securities in which US institutions and persons of high net worth invest. It will enable more effective supervision on both sides.”
On the flip side of all these new regulatory developments, there was actually a lessening of regulation as the SEC loosened marketing restrictions on hedge funds in the JOBS Act, allowing for lighter restrictions on public statements and disclosure by hedge funds. While the specific rules are yet to be released by the SEC, any move forward in this area is welcome. (See my blog post on 5/26/11 entitled “Hedge Funds and Advertising: “No Advertising Rules More Confusing Than Ever”.)
We will continue to advise of new developments in this area.
Insider Trading at Hedge Funds: A Risk Area that is Difficult to Address
Insider trading is an area of risk that hedge fund management finds very difficult to identify and prevent. While the problem has become increasingly prevalent, the tools to be able to assist hedge fund managers have not expanded proportionately. A break-down in personal trust in the industry as a whole may be to blame.
The problem in the area of insider trading at hedge funds is well-known. Recent high profile hedge fund cases are in the press day after day: the Galleon case, the expert network cases, followed by the Diamondback/Level Global/SAC case of last week. Assuming the problem doesn’t originate from top management, what tools do hedge funds have to combat insider trading by their employees? And, more importantly, are they effective?
To identify and prevent insider trading, hedge funds typically use a variety of methods, including reviewing personal account trading and preclearance of personal account trades, monitoring trading vs. major company events, reviewing communications, requiring conflicts of interest disclosure from employees, and using restricted lists in conjunction with limiting access to non-public information. If you analyze each of these methods closely, they ultimately primarily depend on full disclosure from the employee. While these sorts of tools have their place, ultimately the problem here is that if an employee is a “bad apple” and is ready, willing and able to engage in insider trading, what can a manager really do short of trailing him/her 24/7?
We link the increasing insider trading problem at hedge funds to the expansion of the industry and the seeming “retailization” of these investments. If you consider the original concept of hedge funds, which was a small pooled investment vehicle offered to investors with whom the manager had a real relationship, it is hard to imagine how a manager would have engaged in insider trading because of the personal nature of the investment and the personal scrutiny he was under from investors. Similarly, the organizations were small, so that the employees were under the same sort of scrutiny by the manager. It was really a matter of personal trust– by the manager in his few employees, and by the few investors in the manager. Where this connection has now been diluted, the insider trading problem has expanded.
Go to: http://sec.gov/news/press/2012/2012-16.htm to view the SEC’s release on the Diamondback Capital settlement of insider trading charges.
Perils of Side Letters for Hedge Fund Managers and Investors
Most investors contemplating investing in a hedge fund believe they are presented with a set of fixed terms for their investment. These terms are outlined in the private offering memorandum and appear to apply across the board to all investors. However, careful readers of the offering memo as well as the publicly available registration form (ADV) can ferret out what is often true — that some investors may be subject to more favorable terms. These terms are agreed upon in a “side letter” prior to investment and are usually granted to large or important investors, such as seed investors.
Once thought to be innocuous, if not actually beneficial to a hedge fund, side letters are turning out to be the bain of many managers’ operations. Raising issues ranging from the mundane (housekeeping) to headline-making (SEC regulatory actions), many managers are now thinking twice before granting special terms in a side letter.
Some of the more common issues with side letter usage include:
1. Inadequate disclosure of preferential treatment - This is the area in which regulators may get involved. The most recent example of this is the possible pending SEC case against Philip Falcone’s Harbinger Capital Partners ( http://online.wsj.com/article/SB10001424052970203413304577088440283592970.html) which appears to revolve around the granting of preferential redemption rights to certain investors under the terms of a side letter. Managers granting better treatment to side letter investors must, at a minimum, make adequate disclosure of these terms to all investors, particularly in certain sensitive areas like liquidity, information sharing and fees.
2. “Most Favored Nation” Provisions – This is not a reference to an international treaty of some sort… this is a very common side letter provision which allows an existing investor with an “MFN” clause to tag along with newer investors (usually investing less money than they did) who managed to negotiate a better side term than they did. As a simple example, the MFN clause might work like this: if Investor A invested $200 million in 2008 and signed a side letter with an MFN clause, and then Investor B invested $100m in 2011 and got better fee terms than Investor A has, Investor A would get the benefit of those better Investor B fee terms. Once thought to make perfect sense and to be somewhat innocuous, the MFN provisions can tend to pile up on managers. When faced with a situation where the manager thought just one investor would be invoking their side letter provision, all of a sudden there can be multiple parties invoking the same provision.
3. Housekeeping Issues - Side letters can impose obligations on a manager, for example, to provide certain information about the fund to the side letter investor by a certain date each year. These obligations need to be tracked by the manager to insure that they are fulfilled. In addition, some side letters appear to actually restate provisions of the offering documents. However, these restatements need to be carefully evaluated to determine whether there is in fact any deviation from the original terms.
In conclusion, hedge fund managers and investors alike both need to think carefully about side letters: careful drafting by both parties, followed by proper disclosure and housekeeping by the manager are imperatives.
State Investment Adviser Exams Reveal Significant Deficiencies
The results of coordinated state examinations of investment advisers in the first half of 2011 by the North American Securities Administrators Association (NASAA) reveal significant deficiencies in a broad range of areas. As investment advisers gear up nationally to register either with their state or the SEC in 2012, these results are important road maps of common pitfalls which investment advisers will need to address in their compliance programs going forward. Additionally, investors performing due diligence on advisers certainly should take note of these findings.
The NASAA report looked at 825 state-level adviser exams. While the NASAA has published a summary of findings (referenced below), we would like to highlight several significant areas:
1. Over half the exams had a deficiency in the “registration” category, meaning that their registration paperwork was not done correctly or was inconsistent. The registration process itself is complicated, and is getting more complicated as regulators add questions and requirements. A large number of deficiencies in this category is an indication that more care needs to be taken in completing the registration documents.
2. About a third of the advisers had deficiencies in the “supervisory” category, meaning that they had inadequate business continuity procedures or even no compliance procedures at all. While this can be a somewhat tricky area on the state level because some states may not technically require written procedures, the “best practice” clearly is to have written procedures.
3. About 20% of the advisers had deficiencies in the “financials” category, with violations such as inaccurate financials, non-GAAP financials, commingled accounts or poor financial condition. This is clearly an area for investors to watch out for.
4. Almost 20% of the advisers had deficiencies in the ”fees” category, with violations such as inaccurate calculation of fees, billing errors, and inconsistencies between contracts/disclosure documents and amounts billed. While some of these deficiencies may be inadvertent or the result of failure to keep up with paperwork, advisers must be vigilant to maintain accurate billing.
The NASAA noted that “other areas in which investment advisers faced compliance challenges included privacy, fees, custody, investment activities, and solicitors. Among hedge fund advisers, the top deficiencies included valuation of holdings, cross trading, preferential treatment, registration-exemption issues, non-accredited investors issues and non-disclosed conflicts of interest…”
The link to the NASAA report and related documents can be found at http://www.nasaa.org/6156/coordinated-state-exams-identify-top-investment-adviser-deficiencies/
Hedge Fund Boards of Directors Play Vital Role
The role of directors on offshore hedge funds has often been, at best, a limited oversight role, with perfunctory annual meetings and limited interchange with the fund itself during the year.* This has been changing — slowly— as compliance moves to the top of the list of concerns for investors and managers alike. In addition, directors themselves are realizing that the status quo is no longer tenable.
Recent litigation has ensared directors, pushing them into playing a more active role. For example, in a recent Cayman Islands Grand Court decision in the Weavering fund fraud case**, two “independent” directors were ordered to pay $111 million for willful neglect and failing to carry out their duties. Even those these two directors may not have even been “independent” in a technical sense, the judgement was based on the fact that they “did nothing and carried on doing nothing for almost six years”, as the justice in the case noted.
What should managers and investors be looking for in a board of directors? Here are some areas to focus on:
-Is the board receiving relevant information on a timely basis? That is, do they have the information that they will need to perform their oversight role?
-Are the board meetings substantive, with a full agenda and detailed minutes? This indicates a board that is engaged, as opposed to playing a perfunctory role.
-Is the director a person or a company? While this type of set-up is becoming less common, it is still found occassionally and can be a red flag for a disengaged board.
-Is the board viewed as an integral part of a fund’s operations? Is the board utilized as a resource, and do the directors have the necessary experience and knowledge to be a resource? When a problem arises, the board can play an important role in providing guidance and decision-making.
-Are board fees significantly lower than industry standards? While it is important to keep operating expenses down, excessively low board fees may indicate a lack of engagement by the board members.
While no two boards will have completely similar procedures and levels of involvement, as the role of hedge fund boards move closer to the standard set by independent fund boards in the US, hedge fund advisers will need to add this area to their list of compliance and management concerns. Having the board act as a rubber-stamp is no longer an option.
* Hedge funds advised by US-based investment advisers will generally only have a board of directors if they are domiciled outside the US. That is, it is rare to see a board of directors on a US fund; but a non-US fund (i.e., Cayman Islands) will always have a board of directors.
**Weavering Macro Fixed Income Fund Limited v. Stefan Peterson and Hans Ekstrom, August 2011.
New Rules for Hedge Fund Adviser Registration Adopted — States to Assume More Responsibility
This past week, the SEC finalized rules requiring registration of most hedge fund investment advisers with either their state or the SEC. As mandated by the Dodd-Frank Act, a gaping regulatory hole has now been filled.
Whereas under prior rules, most hedge fund advisers could avoid registration, all but the very smallest advisers will now be subject to regulatory scrutiny. The new registration regime calls for hedge funds to establish a basic compliance program, make more public disclosure of critical items of importance to investors (such as conflicts of interest, key service providers, custody matters), as well as being subjected to the possibility of examination by regulators.
The attempt to require registration of hedge fund advisers failed before, when in 2006 the DC Circuit Court overturned a similar registration requirement in a case brought by hedge fund adviser, Phil Goldstein. Rescinded basically on a technicality, the decision allowed the majority of hedge fund advisers to avoid registration for the ensuing 5 years, until the passage of the Dodd-Frank Act. The new requirement, which goes into effect in March, 2012, closes this gap. There has been little on-the-record resistance to the new requirements by hedge funds.
In crafting the new rules, the federal government believes it has left a substantial portion of this registration burden to the states, as it has effectively raised the “assets under management” minimum for registration with the SEC (to over $100m in most cases), and left the smaller (over $25m, but under $100m) to the states. The SEC believes that as a result of the new rules, about 3,200 of its current 11,500 registered advisers will switch from registration with the SEC to registration with the states. What is left unknown is whether 3,200 or more new registrants will take their place, and, perhaps more importantly, whether the SEC actually has the muscle to oversee and examine these charges. Also left unknown is the extent to which the states themselves can handle an influx of registrants.
With the March 2012 deadline in sight, hedge fund advisers must now begin the paperwork process in earnest, and regulators are simultaneously gearing up their programs and personnel. In the meantime, as registrations begin to trickle in, savvy investors can access the information that the SEC has already gathered through its Investment Adviser Public Disclosure search engine, located at http://www.adviserinfo.sec.gov/(S(ftfawpf0g2kg30ld33pph0xz))/IAPD/Content/IapdMain/iapd_SiteMap.aspx . The website displays information on both state and SEC registered investment advisers.
New Whistleblower Rules Create Challenges and Opportunities for Hedge Funds
As part of the Dodd-Frank Act, the SEC has just adopted a rich bounty program which gives some serious incentives to whistleblowers to report first to the SEC (and to internal compliance later). The consequences for hedge funds in particular could be onerous.
The new whistleblower program makes it easier and more lucrative than ever to report a suspicion of wrong-doing to the SEC (first-hand knowledge isn’t even required). There’s a new office at the SEC to report to (the “Office of the Whistleblower”), and whistleblowers can even do so anonymously and online through the “Tips, Complaints and Referrals Questionnaire”. There could be a big reward too: if a person provides information that leads to a successful enforcement action in which the SEC recovers a total of at least $1 million in monetary sanctions, they could receive an award of between 10% -30% of the amount recovered. The program is topped off by strong anti-retaliatory provisions against the reporting employee. What a terrific opportunity for employees, where a big payday could be just an online form away!
For hedge funds, who run lean, this presents a particular challenge, putting even more pressure on a chief compliance officer who may already be filling multiple roles, ie, Chief Financial Officer/Chief Compliance Officer. The perverse outcome of this new program is that with no incentive to come to the CCO first if a violation is suspected, the CCO is essentially pitted against the employees, rather than working together to run a clean operation. In addition, the aftermath of a whistleblower filing will likely be costly and time-consuming investigations, which a light-infrastructure hedge fund is ill-equipped to handle.
The expectation by the SEC is that they will receive 30,000 tips a year through this program. That’s a large number, and implies that these tips would not all be related to major, serious infractions. The lesser ones might have been cleaned up by internal compliance before a tip was even necessary, but unfortunately, they may not get the chance.
The Office of the Whistleblower website is located at: http://sec.gov/complaint/info_whistleblowers.shtml
Hedge Funds and Advertising: “No advertising” rules more confusing than ever
In the category of “Laws that Haven’t Caught Up with the 21st Century”, the internet aspects of the rules that prohibit hedge fund advisers from “advertising” may come in first place. The SEC rules only allow hedge funds to be offered on a “private placement” basis. This means no general solicitations are allowed. While this is understandable in regard to some venues (think giant billboard in Times Square), when it comes to the internet, these rules may leave you scratching your head.
Consider this anomalous situation:
Beginning with new rules that came into effect in 2011, registered hedge fund advisers now post their ADV Part 2a (“brochure”) on the SEC website. This brochure contains a tremendous amount of information about an adviser’s strategy, fee structure,conflicts of interest and general fund structure. In conjunction with the ADV Part 1 (which has always been a publicly available document and contains more general information about an adviser), a complete picture of the adviser and the funds they manage emerges. This is the very information that most hedge funds now lock down on password-protected websites based on past regulatory interpretations of the private placement rules!
In issuing the new rules, the SEC recognized this issue and stated that the posting of the new ADV Part 2a on its website would not jeopardize the private offering status because there would be no performance information, financial statements or subscription instructions included in the new document.
However, what we see emerging is a new arm of what could be called “shopping information aggregators” taking information from the SEC website and offering it in database format for those “shopping” for hedge fund advisers. So, while we don’t see any of info the SEC seems concerned about, we see a form of advertising that is potentially even more powerful than a general solicitaion. By organizing massive amounts of information and putting it out there for the world to see, we see the ultimate hedge fund search engine emerge. Want to buy a toaster? Here is some basic info on toasters. Want a hedge fund investment adviser? Here is info on every single one of them (that have registered), complete with Google map on where to find them. The irony of this is that the investment adviser itself has no input into these databases, so, in effect, the “advertising” (if it is that) is being done for them.
We are hopeful that the SEC will clarify this confusing issue in the near future.