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RECENT ALERTS: FUNDS
HEDGE FUND INVESTORS FORCE FUND INTO BANKRUPTCY TO OBTAIN
Investors in a hedge fund they claim is in liquidation filed an involuntary bankruptcy petition in order to compel
the fund’s manager to deliver financial information. As shareholders who have made unpaid redemption
requests, the petitioners claim to be unsecured creditors entitled to relief under the bankruptcy laws. According
to their motion, the investors have claimed that the fund manager has stonewalled investors when confronted
with demands for payment, accounting, and related information. The petitioning investors have requested
information about the assets and related valuations, financial statements, related-party transactions, leverage
transactions, asset dispositions, and use of funds.
Our take: The investors are using the Bayou strategy by claiming to be unsecured creditors and using the
bankruptcy courts to compel the delivery of information and priority payment of claims. In this case, the fund
manager rejects the notion that the fund is in liquidation and that a bankruptcy proceeding is appropriate. We
expect more use of the bankruptcy courts to sort out these types of disputes.
SEC CHARGES OUTSIDE COUNSEL WITH AIDING AND ABETTING SECURITIES FRAUD
The SEC has filed a civil complaint against an issuer’s longtime outside counsel for aiding and abetting the
issuer’s violations of the securities laws. The issuer’s disclosure documents for its debt offering and its IPO
failed to disclose material information about related party transactions. The SEC has charged that the lawyer
assisted the issuer with executing the transactions, knew the details, but failed to recommend appropriate
disclosure of the transactions in the applicable disclosure documents. Per the SEC, the lawyer “knowingly or
recklessly provided substantial assistance” to his client’s securities laws violations. Criminal charges have also
been filed by the U.S. Attorney’s Office for the Southern District of New York.
Our take: This case increases the due diligence required of lawyers working on disclosure documents. It also
raises the uncomfortable question of the actions a lawyer should take if a client ignores disclosure advice. This
case could have a significant chilling affect on a lawyer’s willingness to represent clients engaged in questionable
BOND FUND MANAGER SUED FOR MATERIALLY MISLEADING SALES MATERIALS AND
DISCLOSURE DOCUMENTS (12/13/07)
A lawsuit recently filed in federal court in Tennessee seeks damages, rescission, and class action status in
connection with significant losses in two bond funds that had concentrated positions in high yield securities that
declined in price, resulting in significant losses to the funds. The plaintiffs allege that sales materials and
disclosure documents were materially misleading by failing to disclose the funds’ exposure to illiquid securities
and to include material information relating to the funds’ NAV calculations and financial statements.
Defendants include the funds’ investment manager, directors, officers, and auditors. Relief is claimed under
Section 34(b) of the Investment Company Act and several provisions of the Securities Act of 1933.
Our take: Plaintiffs appear to rely heavily on sales materials and disclosure documents that used phrases such as
“potential for lower NAV volatility,” “conservative credit posture,” and “diversified portfolio.” This could be a
FBI AGENT POSES AS HEDGE FUND MANAGER TO UNCOVER KICKBACK SCHEME
As the result of a sting operation conducted by the FBI and the SEC, the SEC charged five defendants for
paying kickbacks to a purported hedge fund manager to purchase penny stocks that the defendants were
promoting. Unfortunately for the defendants, the hedge fund manager was really an undercover FBI agent. The
hedge fund manager told the defendants to pay a phony consulting fee to a phony consulting company
controlled by the hedge fund manager. The stock purchase transactions had a material affect on the stock
trading. In addition to the SEC complaints for violations of various securities laws, the U.S. Attorney’s Office
announced criminal indictments.
Our take: This type of sting operation should significantly deter potential wrongdoers tempted to engage in
unlawful activity on the theory that enforcement risk is low. Believe that the SEC and the FBI will use similar
sting operations to discover potential illegal activity by other securities professionals including fund managers,
advisors, and brokers.
DONOHUE PRIORITIZES 12B-1 AND RECORDKEEPING REFORM FOR 2008 (12/7/07)
In a recent speech, Andrew Donohue, Director of the SEC’s Division of Investment Management, stated that
the Division would prioritize Rule 12b-1 and recordkeeping reform in 2008. Most significantly, Mr. Donohue
stated that a 75 basis point 12b-1 fee should be called a “sales load” and described as such in both the
prospectus and the sale confirm. He also expressed a need to re-work the recordkeeping rules for advisors and
funds to make use of developing technologies.
Our take: We still maintain that Rule 12b-1 “reform” is a solution in search of a problem. Now, the SEC seems
more focused on the labeling of 12b-1 fees rather than the uses for 12b-1 fees, about which Chairman Cox had
expressed so much concern. We are also not sure what Mr. Donohue means by use of “developing
technologies.” The recordkeeping rule already allows for electronic retention.
SEC PUNISHES HEDGE FUND MANAGER FOR PPM DISCLOSURE (12/5/07)
The SEC sanctioned and fined a hedge fund manager for causing its funds to engage in principal transactions
and investments that were inconsistent with the funds’ private offering documents. Despite PPM disclosure
that the fund did not intend to engage in any transaction with the General Partner or a person under common
control, the fund made loans to affiliated funds and paid undisclosed management fees to related entities. One
fund invested in a fund managed by the same entity even though the PPM stated that the fund would only invest
with unaffiliated managers. Additionally, one of the funds invested in commercial receivables when the PPM
stated that the fund would invest in healthcare receivables. The SEC stated that the manager and its founding
principal violated Section 17(a)(2) of the 1933 Act.
Our take: It is notable that the SEC brought this case as a 17(a)(2) violation rather than a substantive violation
of the Advisers Act. Unregistered hedge fund advisers should note that the SEC can allege a 17(a)(2) violation
even though a hedge fund adviser is not registered under the Advisers Act. The SEC has consistently come
down hard on undisclosed conflicts of interest that enrich the fund manager.
SEC PUBLISHES PROTOTYPE SUMMARY PROSPECTUS FOR FUNDS (11/30/07)
The SEC has published a prototype “summary prospectus” for review and comment in connection with its
recent proposal to revamp mutual fund disclosure. The prototype includes basic information about investment
objectives, costs, investment strategies and risks, portfolio holdings, the investment adviser, purchase/sale/tax
information, and broker compensation. The SEC also seeks comments on the interrelationship between the
summary prospectus and the full prospectus and SAI and how each should be delivered to shareholders.
Our take: Not all mutual funds are created equally. Will the SEC allow deviation from the prototype? Will it
require deviation to include other “material” information? Regardless, fund sponsors should begin the process
of reworking their fund disclosures.
DONOHUE URGES FUND DIRECTORS TO ASSESS VALUATIONS (11/29/07)
In his recent speech to the Investment Company Directors Conference, Andrew Donohue, Director of the
SEC’s Division of Investment Management, stressed the responsibility of the directors with respect to fair
valuation of fund securities. Mr. Donohue digressed from his prepared remarks to state that a “key area where
fund directors add value for shareholders is the fair valuation of portfolio securities.” He directed the directors
to ensure the liquidity of securities held in open-end funds. Mr. Donohue also indicated that the Staff would
soon provide recommendations on Rule 12b-1 reform and soft dollars. With respect to soft dollars, Mr.
Donohue lauded technological efforts to unbundle research and other soft dollar benefits from the underlying
Our take: We are unsure how much responsibility independent directors should have for fair valuation of
securities. While they certainly must review a fund’s policies and procedures to ensure compliance with
applicable law and guidance and review the implementation of those policies and procedures, is Mr. Donohue
suggesting that independent directors have strict liability for a valuation failure that results in harm to
MASSACHUSETTS SUES HEDGE FUND SPONSOR FOR FAILING TO OBTAIN APPROVAL
OF PRINCIPAL TRADES (11/20/07)
The Massachusetts Securities Division has filed an Administrative Complaint against a large hedge fund sponsor
that failed to obtain proper approvals for its funds’ principal trades with affiliated entities, ultimately resulting in
collapse of the funds. In the offering documents, the funds undertook to seek independent director approval
for affiliated trades as a method to comply with the Advisers Act requirement for pre-approval of principal
transactions. Management delegated the responsibility to obtain the approvals to untrained junior personnel.
As a result, a majority of principal trades were never properly approved either because the trades were submitted
after the trades were executed or the approval request did not contain sufficient information. After several
efforts to correct the failure to comply with the offering documents and its own procedures, the Compliance
Department imposed a moratorium on principal trades. The resulting lack of liquidity ultimately bankrupted the
funds. The Securities Division has alleged that the offering documents were misleading and that the sponsor’s
failure to comply with the Advisers Act served as a device to defraud investors.
Our take: Obtaining approval of principal transactions was fundamental to the fund’s investment strategy and
its risk-management controls. Delegating responsibility to untrained junior staff and ignoring Compliance’s
efforts to remedy the violations led to the funds’ collapse. Failure to prevent/mitigate conflicts of interest is the
leading cause of enforcement and other legal actions.
SEC VOTES TO REVAMP PROSPECTUS DISCLOSURE AND DELIVERY (11/16/07)
The SEC has voted to propose rules that would require a complete re-working of the mutual fund disclosure
regime. The proposal (which has not yet been released) will require standardized summary information (similar
to the current risk/return summary) at the front of every prospectus to include information about investment
objectives/strategies, risks, costs, top 10 holdings, investment adviser and portfolio manager, and financial
intermediary compensation. The proposal would also allow firms to deliver a summary prospectus including
this information so long as investors can access full prospectus information via tagged web links. Fund firms
would also be required to deliver paper documents to those requesting them. Commissioner Paul Atkins, in a
related speech, alluded to a requirement that fund firms would be required to update key information quarterly.
Our take: Since the SEC has stated that the prospectus contains too much incomprehensible information, why
doesn’t it just re-write N-1A to reduce the amount of disclosure required to be delivered to shareholders
whether electronically or hard copy? Then, fund firms would be less concerned about securities law liability for
failing to deliver a full disclosure package.
SEC’S GOHLKE OFFERS ADVICE TO DIRECTORS ABOUT OVERSIGHT OF DERIVATIVES
AND VALUATION (11/14/07)
In a recent speech to the Mutual Fund Directors Forum, Gene Gohlke, Associate Director of the SEC’s OCIE,
offered 12 areas of focus for a director whose fund invests in derivatives. Most significantly, Mr. Gohlke laid
out a detailed fair valuation methodology (which could be applied to any fair valuation decision). Among the
other most significant areas of focus include: (a) whether the adviser has the intellectual and financial resources
to capably invest in derivatives; (b) whether proper risk disclosure is made in the offering documents; (c)
whether the fund has available liquidity in the event of a negative event; and (d) whether the compliance policies
and procedures are effective to manage risks. In a footnote, Mr. Gohlke noted that although fund directors are
not specifically required to perform these functions, “in my opinion, they would fall within the oversight
function” of the Board.
Our take: Mr. Gohlke’s fair valuation methodology provides insight on the SEC’s standards for measuring a
firm’s fair valuation procedures. The speech is also a warning shot to funds investing in hard-to-value securities
such as derivatives.
ICI/IDC RELEASES FUND GOVERNANCE BEST PRACTICE DATA (11/12/07)
The Investment Company Institute and the Independent Directors Council have published a Study reporting on
mutual fund governance practices. The research follows up on the ICI’s 1999 Report on Fund Director Best
Practices. The Report indicates that most (in some cases, overwhelming majorities) fund boards: (a) are
comprised of at least 75% independent directors; (b) are led by independent directors; (c) have separate legal
counsel for independent directors; and (d) have an audit committee financial expert. Interestingly, only 23% of
fund complexes have a formal policy requiring directors to own shares of the funds overseen. The Study
indicates rising adoption of the 1999 Best Practice recommendations.
Our take: Following the Best Practices should help defend regulatory actions as well as civil suits. Nevertheless,
many industry participants have questioned whether increased Board member independence truly protects
shareholders. Instead of a reliance solely on independence, funds should also review the effectiveness of the
Board and the quality of the Board members.
SEC TO CONSIDER OVERHAUL OF MUTUAL FUND DISCLOSURE (11/9/07)
At its Open Meeting next Thursday (November 15), the SEC will consider revamping mutual fund disclosure to
require the delivery of a summary/profile prospectus together with enhanced Internet availability of longer-form
prospectuses and SAIs. Presumably, the SEC will also require XBRL tagging of the electronic documents. For
those interested in attending, the meeting will occur at 10:00 AM.
Our take: Open meetings very often result in rule-making. A complete re-working of Form N-1A would be a
significant undertaking for most mutual fund firms.
SEC ALLOWS AFFILIATE TO ISSUE L/C TO PROTECT MONEY MARKET FUNDS (11/2/07)
The SEC recently granted No-Action Relief to allow an affiliate of an adviser to issue a Letter of Credit to
protect money market funds from losses on sub-prime paper. The money market funds held medium term
notes issued by an asset-backed SPV that was downgraded by the rating agencies. As a result of the downgrade,
the securities were no longer “Eligible Securities” under Rule 2a-7 of the Investment Company Act, even though
the issuer had not missed any principal or interest payments. The Adviser convinced the Board that it was
better to hold the securities than liquidate the positions. To protect the Fund, the Adviser obtained a standby
Letter of Credit from its bank parent to guarantee any non-payment of principal or interest by the issuer.
Without no-action relief, the L/C would violate the affiliate transaction and joint transaction prohibitions under
the Investment Company Act.
Our take: Correct move by the Adviser; correct decision by the SEC. Why create more havoc by liquidating the
paper when payments are still being made? The standby L/C protects against breaking the $1.00 NAV, and
does not unduly benefit the Adviser or its affiliates. We may see more of this as more paper gets downgraded.
PORTFOLIO MANAGER BARRED FROM INDUSTRY AND FINED $175,000 FOR
CONCEALING PERSONAL TRADING (10/26/07)
A mutual fund portfolio manager was barred from the industry and ordered to pay $175,000 in fines, interest
and disgorgement for concealing personal trading. The portfolio manager executed and concealed over 3,500
short-term trades over an 8-year period in publicly traded securities, many of which were owned, or about to be
purchased by, mutual funds he managed. In addition to violating the Investment Company Act, the manager
violated his employer’s personal trading policy which required pre-clearance, prohibited frequent trading,
required a holding period for purchases, and mandated reporting and certification. The firm also conducted
training attended by the portfolio manager.
Our take: Show this case to your portfolio managers who do not take the Code of Ethics seriously. Also,
compliance officers should take comfort that, if they have good procedures and follow them, the SEC may not
impose liability on the firm even if one bad actor slips through the cracks due to his fraud.
DONOHUE LAYS OUT CLOSED END FUND CONCERNS (10/12/07)
In a recent speech, Andrew Donohue, Director of the SEC Division of Investment Management, laid out his
regulatory concerns about closed end funds: valuation, distributions, and disclosure. As many closed end funds
are designed to invest in less liquid securities, Donohue explained the importance of fair valuing securities to
ensure efficient market pricing of fund shares, calculating fees, delivering accurate client statements, and
complying with the Investment Company Act. Donohue also reiterated the importance of properly classifying
distributions (and informing shareholders) as income or a return of capital. He also stated that the fund
directors have an obligation to monitor managed distribution plans to make sure they are sustainable and not
misleading. Finally, he expressed a desire to streamline the disclosure regime, which currently relies on annual
and semi-annual reports. Donahue said the industry should consider leveraging the XBRL initiative and the 2-
page profile concept.
Our take: Expect more scrutiny of closed end funds. The SEC tends to view closed end funds that invest in
“exotic” and illiquid instruments as close cousins of those risky hedge funds that the courts won’t let them
MANAGER-OF-MANAGERS SEEKS RELIEF TO PAY PERFORMANCE FEE TO FUND SUB-
ADVISER BASED ON GROSS PERFORMANCE (10/8/07)
A manager-of-managers fund sponsor is seeking exemptive relief to pay a performance-based fee to a sub-
adviser solely on the basis of gross performance. The performance fee would only be paid to the extent that the
sub-adviser exceeded a hurdle rate based on an applicable index plus an amount equal to the sub-adviser’s base
fee. The hurdle amount is designed to serve as a proxy for the performance drag that would otherwise occur by
deducting the base fee on an ongoing basis. The performance fee would be paid quarterly on a rolling basis with
a negative performance recoupment feature. Relief is sought under Section 205(b) and Rule 205-1 of the
Advisers Act. The performance fee was approved by shareholders, and the sub-adviser is not affiliated with the
manager-of-managers or the fund.
Our take: Many registered funds have moved to performance-based fee structures to compete with their hedge
fund competitors. This type of exemptive relief provides some needed flexibility.
HEDGE FUND MANAGER BANNED FOR USING OTHER FUND’S ASSETS TO PAY
A hedge fund manager was barred from the industry and fined for using money from one fund to pay the
redemption request on another fund as well as misrepresenting his educational credentials. The fund manager
could not satisfy the redemption request directly because the fund’s assets were locked up in a derivative
transaction. The fund manager used assets from another fund to satisfy the redemption request. Interestingly,
the derivative successfully unwound and the fund manager returned the money without harm to any investor.
The fund manager also misrepresented that he attained an MBA degree.
Our take: If a fund manager misuses funds or makes misrepresentations to investors, the fund manager will not
escape SEC action on the basis that no investor was harmed. This may mitigate the penalty, but you still need to
comply with the law.
CLOSED-END FUNDS FINED $1.7 MILLION FOR FAILING TO DISCLOSE SOURCE OF
Four closed-end fund managers were fined a total of $1.7 Million (3 for $450,000 and 1 for $350,000) for
violating Section 19(a) and Rule 19a-1 of the Investment Company Act by failing to provide shareholders with
contemporaneous written statements identifying that distributions came from capital gains rather than net
income. The funds had policies to make distributions either monthly or quarterly. The SEC noted that merely
providing the information in the Form 1099-DIV was not sufficient because it was not provided
contemporaneously with the distribution. Two of the fund manages were also sanctioned because the
Management Discussion of Fund Performance in the annual reports did not sufficiently disclose the source of
Our take: These are essentially disclosure actions. The disclosure regime for closed end funds relies on annual
reports and distribution notices to ensure current disclosure. The SEC will take action against closed-end funds
(especially those whose distribution policies resemble open end funds) that fail to fully inform shareholders
about financial matters. And, as the SEC said, the 1099s aren’t enough.
FUND/SERV ABUSED IN SCHEME TO LATE-TRADE FUNDS FOR HEDGE CLIENTS
The SEC settled an enforcement action against four individuals that set up entities that registered with the
NSCC for the sole purpose of late trading mutual funds for the benefit of hedge fund clients. The Respondents
made false misrepresentations to the NSCC that two entities under their control were third-party administrators
for retirement plans. By registering with the NSCC, the entities could use Fund/SERV to place mutual fund
trades as late as 3:00 AM. The Respondents used several registered investment advisers to take late trades made
by hedge fund clients and used the NSCC members to make late “as-of” trades. The Respondents’ RIA firms
charged the hedge fund clients 250 basis points for the late trading service.
Our take: While it is very difficult to stop fraud, the NSCC has to do a better job conducting due diligence to
prevent wrongdoers from abusing Fund/SERV. Otherwise, the SEC can use this case as an example of why the
markets need a hard 4:00 close.
CLOSED END FUND SEEKS RELIEF TO CREATE “C” SHARES (8/27/07)
A closed end interval fund is seeking exemptive relief to offer Class C shares with a CDSC of 1% on
redemptions occurring within one year. The applicant is requesting relief under sections 18(c) and 18(i) to offer
multiple classes and 23(c) to impose the CDSC.
Our take: The SEC is already concerned about valuation and discounts on closed end funds. The closed end
structure itself is a structural impediment to rapid redemptions. It will be noteworthy to see whether the SEC is
willing to allow a closed end structure to resemble a classic open-end structure without daily liquidity and
SEC SUES CASH MANAGER FOR COMMINGLING AND LEVERAGING CLIENT ASSETS
The SEC charged an investment manager that managed cash for hedge funds and other clients with fraud and
several violations of the Advisers Act for commingling client assets and leveraging them. The Defendant did
not segregate client assets, commingled them together and with Defendant’s assets, and pledged client assets as
collateral for borrowing. When the credit markets deteriorated and the Defendant was forced to sell securities
to satisfy lenders, the Defendant could not meet redemption requests. The leveraging and commingling were
not disclosed in the firm’s client agreements, account statements, or ADV Part II. The SEC charged the firm
with violations of the anti-fraud, custody, and books and records rules.
Our take: Without sounding like we’re blaming the victim here, it seems negligent (at best) that the firm’s clients
never did sufficient due diligence to learn that assets were leveraged and not segregated, especially where they
were using the firm as a cash manager.
INVESTMENT MANAGER FINED FOR NOT FILING 13Fs (8/16/07)
The SEC fined a hedge fund manager $100,000 for failing to make its required 13F filings. Section 13(f) and
Rule 13f-1 require institutional investment managers with more than $100 million in exchange-traded securities
under management to file quarterly 13F holdings reports. The hedge fund manager failed to make any filings
over a 4-year period. The SEC’s inspection staff discovered the violations. The SEC stated that the violations
were willful because the hedge fund manager’s compliance manual included the filing requirement and the firm
had received law firm and audit firm memos about the filing requirement.
Our take: File your 13Fs. Also, investment managers should take note that failure to comply with your own
compliance manual, whether or not you intended to violate the law, could result in SEC fines for willful
FUND MANAGER FINED $6 MILLION FOR FAILING TO DISCLOSE LARGE INVESTMENT
The Southern District of New York entered a final judgment by consent against a hedge fund manager and
ordered him to pay over $6 Million in disgorgement and interest in connection with materially defrauding
investors by failing to disclose an overly concentrated position. At one point, more than 60% of the fund’s
assets were invested in the stock of EndWave Communications, and the fund held more than 40% of
EndWave’s stock. The fund’s offering materials and marketing documents indicated that the fund would be
diversified and not invest more than 10% in any one stock. The fund’s advisor amassed the large position
partially as a result of a significant run-up in the stock’s price. The fund also failed to engage a third party
auditor in contrast to the statements made in the offering memorandum. The SEC claimed violations of 10b-5,
17(a) of the Exchange Act, and Sections 206(1) and 206(2) of the Advisers Act. The SEC also claimed
violations of Sections 13 and 16 of the Exchange Act for failing to file the necessary holdings reports when a
manager amasses more than 5% and 10% of a company’s outstanding securities.
Our take: This case is an example of the SEC using its authority under the anti-fraud rules to pursue a hedge
fund manager that was not a registered investment adviser. Also, the case is notable in that the SEC reminds
fund managers of their obligations under Section 13 and 16 to file holdings reports.
FINRA EXEMPTS ISSUER-DIRECTED SECURITIES FROM NEW ISSUES RULE (8/10/07)
FINRA (fka NASD) has amended the New Issue Rule (2790) so that the prohibitions on the purchase and sale
of new issues for the benefit of restricted persons (broker-dealers, portfolio managers) will not apply to
securities directed by the issuer. The exemption applies so long as a broker-dealer does not act as an
underwriter and does not influence the issuer’s allocation decisions. The Regulatory Notice indicates that an
issuer could still retain a broker-dealer to provide advisory services in connection with the offering.
Our take: FINRA may have opened a bigger loophole that it intended. Small issuers rely heavily on the
“restricted person” community to buy its shares. Now, such issuers may consider retaining a broker-dealer
adviser for a fee, rather than a percentage of the offering, and avoid the strictures of 2790.
SEC ADOPTS BROAD ANTI-FRAUD RULE FOR FUND ADVISERS (8/9/07)
The SEC has adopted new Rule 206(4)-8 under the Investment Advisers Act, making it unlawful to make a false
or misleading statement to investors or prospective investors in funds or otherwise defrauding investors. The
Rule applies (a) to registered and unregistered advisors; (b) with respect to investors or prospects; (c) to
registered mutual funds and unregistered funds including hedge funds and private equity funds; (d) with respect
to offering documents, RFPs, solicitations, and personal meetings; (e) statements regarding investment
strategies, an adviser’s experience/credentials, fund risks, performance, valuation, and allocation practices; and
(f) to conduct that is merely negligent, rather than intentional. The Rule provides that the SEC can bring civil
and administrative enforcement action.
Our take: The SEC did not back off at all from the proposing release. In fact, the new rule appears as broad as
possible to allow the SEC maximum jurisdiction up to the Goldstein case. As a practical matter, this broad anti-
fraud authority allows the SEC to regulate the conduct of all unregistered advisers to pooled investment
SEC PROPOSED RELAXING REGULATION D BUT NOT FOR PRIVATE FUNDS (8/8/07)
The SEC recently proposed amendments to Regulation D that would add a new category of “large accredited
investors” and use an investments owned test to the definition of accredited investor. The proposed rule would
not apply to investors in private funds (3(c)(1) or 3(c)(7)); instead, the SEC will continue to seek comments on
its December 2006 proposal requiring investors in such funds to be “accredited natural persons” (person who
owns at least $2.5 million in investments exclusive of real estate). New Rule 507 would allow unlimited
purchases by entities with $10 Million in investments and individuals with either $2.5 Million in investments or
an annual income of $400,000. The Rule would also allow for limited advertising via written tombstones
containing basic information about the offering. The proposal also provides for an alternative qualification for
accredited investor: somebody with $750,000 in investments exclusive of real estate.
Our take: We don’t understand why the SEC would make it easier to sell non-fund Regulation D offerings and
harder to sell fund offerings. Despite the enforcement history, the SEC continues to have an anti-hedge bias.
One interesting twist for fund companies: if a fund registers under the 1940 Act but not under the 1933 Act, the
fund could take advantage of the newly liberalized Regulation D without worrying about the “accredited natural
INSURANCE COMPANY TO PAY OVER $100 MILLION TO SETTLE VARIABLE ANNUITY
MARKET TIMING CHARGES (7/23/07)
A large insurance company agreed to pay $84 Million in restitution and over $20 Million in fines to New York
State to settle charges in connection with market timing its variable annuities. The New York State Attorney
General charged that the company failed to police hedge funds that market timed its variable annuities. New
York State also charged that the insurance company invested in a hedge fund that market timed its variable
Our take: The market timing prosecutions continue. This time, the action focuses on variable annuities, which
are designed for long-term retirement saving for individual investors, not for short-term trading by hedge funds.
SEC VOTES TO ADOPT ANTI-FRAUD RULE FOR HEDGE FUND ADVISERS (7/12/07)
The SEC voted unanimously to apply the Investment Advisers Act’s antifraud prohibition to hedge fund and
private equity advisers. The new rule, which is not yet published, will prohibit investment advisers to pooled
investment vehicles, including private funds formed under 3(c)(1) or 3(c)(7), from making false or misleading
statements to, or otherwise defraud, investors or prospective fund investors. The new rule will also apply to
investment company advisers. The SEC has not yet decided whether to raise the qualification standards for
investors in private funds, but action is expected soon.
Our take: Applying a broad anti-fraud rule to hedge and private equity advisers essentially brings them under
the Advisers Act. As nearly every enforcement action brought against a registered investment adviser includes
an anti-fraud claim, an unregistered private fund adviser will need to comply with most of the Act’s provisions in
order to avoid enforcement under the new rule.
NFA MEMBER FINED FOR VIOLATING ADVERTISING, NET CAPITAL, AML, AND BCP/DR
The National Futures Association (NFA) recently fined an Introducing Broker and a Futures Commission
Merchant and Forex Dealer Member, each with the same principal, for using deceptive and misleading
promotional material in connection with foreign currency futures and options, failure to establish adequate anti-
money laundering and disaster recovery programs, failure to meet net capital requirements and failure to
maintain accurate books and records. The promotional materials included profit claims without supporting
documentation or statements of risk. The AML program did not include annual audits. The BCP and DR plans
did not adequately address offsite storage or the impact of business interruption of carrying brokers. The firm
also mis-classified an unsecured receivable from an affiliate as a current asset in calculating its net capital. The
NFA fined the combined firms $75,000.
Our take: This action is a reminder that NFA members are subject to similar regulatory requirements as
registered investment advisers and broker-dealers. This is significant for unregistered hedge fund managers who
trade in the derivative markets.
SUPREME COURT RAISES PLEADING STANDARD FOR SHAREHOLDER SUITS (7/5/07)
In a recent opinion, the Supreme Court made it more difficult for plaintiffs to prove securities fraud. The Court
stated that a plaintiff’s pleadings must include facts that give rise to an inference of an intent to defraud (aka
scienter) that is cogent and as compelling as any other non-fraudulent explanation. The opinion clarifies a
provision of the Private Securities Litigation Reform Act of 1995 and resolves a split among the lower courts.
Justice Ginsburg’s opinion further elaborates that the trial judge must "consider the complaint in its entirety,"
and "whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter”. The judge
must also consider "plausible opposing inferences”, i.e., whether the reason for the action taken was plausible or
sinister in motive. The Court rejected an even stricter formulation requiring that the plaintiff’s inference be the
most plausible of competing inferences. The Court also rejected a more pro-plaintiff formulation that allowed a
case to continue if a reasonable person could infer fraudulent intent if the facts as pleaded were true.
Our take: Although many have reported that the opinion shows the pro-business tilt of the new Court, we
wonder whether the standard provides enough clarity to reduce suits.
MASSACHUSETTS TAKES ACTION AGAINST PRIME BROKER’S HEDGE FUND HOTEL
The Enforcement Division of the Massachusetts Securities Division has filed an administrative complaint
against a large prime broker, claiming its operation of a “hedge fund hotel” violated NASD rules and
Massachusetts law. According to the Complaint, the prime broker offered below market rent, information
technology services, capital introduction services, personal loans with below market interest rates, and sports
tickets to hedge fund managers in exchange for stated levels of brokerage or other revenue. The MSD cited
violations of NASD Conduct Rule 3060, which prohibits the giving of anything of value in excess of $100.
Massachusetts law allows the MSD to take action against brokers that violate NASD Rules.
Our take: This is a conflict of interest case. In the complaint, the MSD seemed most concerned about the hedge
funds’ failure to disclose the soft compensation they received. It is unclear whether the funds actually paid
UK HEDGE FUND SPONSOR TO PAY $3.2 MILLION FOR VIOLATING SHORT SALE RULES
A London-based hedge fund firm agreed to pay more than $3.2 Million in fines, disgorgement, and interest for
violating Rule 105 of Regulation M by covering short sales by purchasing securities in a public offering within 5
days. The firm violated Rule 105 on 16 occasions in 14 public offerings over the course of 3 years. In its press
release, the SEC’s Associate Director of Enforcement stated “Foreign-based hedge funds that trade on the U.S.
markets cannot turn a blind eye to compliance with the U.S. federal securities laws.”
Our take: The SEC has stepped up its Rule 105 enforcement efforts and is generally concerned that short sellers
may be manipulating the market. At the same time, Chairman Cox has questioned whether the U.S. over-
regulates to the detriment of U.S. capital markets as compared to non-U.S. markets. We wonder how the SEC
will reconcile its enforcement agenda with its competitiveness agenda.
MUTUAL FUND SPONSOR ORDERED TO PAY $21 MILLION FOR REVENUE SHARING
The SEC ordered a mutual fund sponsor to pay approximately $21 Million in disgorgement, interest, and
penalties in connection with the use of fund brokerage to pay for revenue sharing arrangements with selling
broker-dealers. The SEC indicated that the funds’ distributor had obligations to pay third party broker-dealers
certain marketing fees to obtain access to brokers and ensure product placement. To meet these obligations, the
distributor’s affiliated advisor directed fund brokerage commissions. The SEC indicated that the advisor failed
to inform the Board of the conflict of interest inherent in using fund assets to offset an affiliate’s obligations.
The SEC also stated that although the SAI stated that sales of shares would be a consideration in selecting
brokers, it did not specifically state that the advisor would direct brokerage “in consideration of fund sales.”
The SEC also charged a violation of Section 17(d)’s joint transaction prohibition.
Our take: The SEC does not like revenue sharing or directed brokerage. We wonder whether any amount of
disclosure to the Board or in the SAI would be sufficient to protect a mutual fund manager from regulatory
SEC VOTES TO TIGHTEN RULE 105 RE SHORT SALE COVERING (6/22/07)
The SEC voted to amend Rule 105 of Regulation M to prohibit short sellers from purchasing shares in an
offering after a short sale in securities. Previously, the Rule only prohibited covering the short sale by
purchasing shares in the offering. The SEC indicated the change was precipitated by persistent non-compliance
with the prior rule. The Rule will contain certain exceptions for investment companies and other entities that
make separate trading and investment decisions. The full text of the Rule has not yet been released.
Our take: The change in Rule 105 is intended to prevent the abuses rampant in the PIPE market. On the hope
that bad facts won’t make bad law, we are concerned about the implications to legitimate short sellers.
SCHAPIRO ANNOUNCES NAME AND PURPOSE OF NEW REGULATOR (6/21/07)
In a recent speech, Mary Schapiro, NASD Chairman and CEO, described the objectives of the new combined
regulator and announced its new name: the Securities Industry Regulatory Authority. The new SIRA will move
toward a more “principles-based approach” to regulation and away from a complete reliance on rule-making. It
will also avoid “one size fits all” rulemaking and move toward more “tiered regulation” based on firm size and
business model. The new SIRA will also offer guidance to help the industry and not just regulate by rule and
enforcement action. It will also offer investor education.
Our take: We don’t really understand the implications of “principles-based” regulation. Even Ms. Schapiro,
who used the UK’s FSA as a model, noted that, although the FSA had 11 core principles, it also had more than
8,000 pages of rules. We also fear that principles-based regulation puts more pressure on compliance officers to
defend their positions against aggressive sales tactics that are not specifically prohibited.
IDC TASK FORCE RECOMMENDS BOARD OVERSIGHT OF FUND SERVICE PROVIDERS
A Task Force of the Independent Directors Council of the ICI issued its report titled “Board Oversight of
Certain Service Providers.” In the Report, the Task Force highlights Board considerations when evaluating
administrators, custodians, fund accounting agents, transfer agents and securities lending agents. The Report
indicates that Boards should review applicable agreements, qualifications and capabilities, fees, and potential
conflicts of interest. The Report specifically recommends a higher standard of review when the service provider
is an affiliate of the sponsor. Moreover, the Report recommends a specific review of any financial benefits
flowing back to the sponsor through unaffiliated service providers through any type of revenue sharing or
Our take: Previous actions against fund administrators have raised the bar for a Board’s standard of review.
The Task Force’s recommendations remind us of the type of review conducted in connection with a 15(c)
review of an advisory contract.
FUND PORTFOLIO MANAGERS TO PAY HEFTY FINES FOR MARKET TIMING FUNDS
Two former mutual fund portfolio managers consented to a final judgment requiring them to pay approximately
$1 Million and $500,000, respectively, in connection with market timing mutual funds for which they acted as
portfolio managers. They were also barred from the business for a year. The defendants used their deferred
compensation and retirement accounts to conceal fund trading that took advantage of price arbitrage
opportunities on securities held by several international funds.
Our take: Compliance officers must monitor all personal accounts when enforcing the Code of Ethics. Clever
wrongdoers will always try to find a way to game the system.
NFA REMINDS CPOS AND CTAS TO DISCLOSE CONFLICTS OF INTEREST (5/31/07)
The NFA recently sent a Notice to Members reminding them of their obligation to deliver a disclosure
document including all material information including information related to conflicts of interest. The NFA
noted that the CFTC staff has expressed some concern that CPO and CTA Disclosure Documents do not
properly disclose conflicts of interests. By way of example (and not to be exclusive), the NFA reminds CPOs
and CTAs to disclose affiliate relationships with an introducing broker or futures commission merchant, shared
principals, any compensation received by a CPO from a CTA, and loans between CPOs and affiliated persons.
Our take: Institutional money managers and hedge fund sponsors that are CTAs or CPOs must be mindful of
their disclosure obligations especially when conflicts are involved. When the NFA sends out a “reminder,” it is
an indication that enforcement actions will follow.
SEC TO CONSIDER 12B-1 RESCISSION AT JUNE 19 ROUNDTABLE (5/30/07)
The SEC announced that it will host a roundtable on June 19 to review Rule 12b-1. Most significantly, the
roundtable will address “options for reform or rescission of Rule 12b-1.” The roundtable will also address the
Rule’s history and intended purpose, the use of 12b-1 fees for fund distribution, and the Rule’s costs and
benefits. Participants and a final agenda have not yet been published. The SEC will provide a list of specific
issues on which it would like public feedback. Rule 12b-1 permits funds to use assets to finance distribution.
Our take: Chairman Cox had previously questioned the use of Rule 12b-1. This may be the first step toward its
elimination. We only hope that the SEC thinks through the implications to the industry and to shareholders. As
we have often said, nobody will sell funds without getting paid. Without 12b-1 fees, either the fund companies
or the shareholders will have to come directly out of pocket.
SEC STAFF OFFERS FUND-OF-FUNDS EXPENSE DISCLOSURE GUIDANCE (5/24/07)
As a follow-up to its June 2006 Fund-of-Funds Release, the Division of Investment Management staff has
provided guidance concerning disclosure of acquired fund expenses in the Acquired Fund Fees and Expenses
item of the acquiring fund’s fee table. Most significantly, the SEC clarified that (i) the expenses of structured
finance vehicles do not need to be included in the expense table; (ii) the expense table need not include expenses
incurred by the acquired fund in the investment in underlying funds; (iii) the appropriate expense ratio to use is
contained in the acquired fund’s most recent annual or semi-annual report; and (iv) the expense table need not
include fees and expenses associated with investing cash collateral received in connection with loans of portfolio
securities in a money market fund or other cash sweep vehicle.
Our take: The SEC needed to clarify several of these open issues raised by the 2006 Release. In particular, the
excepting out of structured finance vehicles is a welcome clarification. We expect the staff to continue to offer
disclosure guidance for fund-of-funds.
FED REPORT SAYS THAT ECONOMIC DATA DO NOT PORTEND IMMINENT FINANCIAL
CONTAGION FROM HEDGE FUNDS (5/7/07)
A recent report of the Federal Reserve Bank of New York titled “Measuring Risk in the Hedge Fund Sector”
concludes that the financial market risk from a hedge fund crisis has increased but is not at “particularly high
levels by historical standards.” The Report argues that covariance (the extent to which hedge fund returns move
together) is a more relevant risk measurement than comovement (covariance/return variability). The Report
notes that today’s high level of correlations is the result of an “unusually low level of return volatility” while a
high level of correlations prior to the Long-Term Capital Management crisis was associated with high
Our take: This Report is an example of how different sources can interpret data. Although the Report on its
face appears to suggest that a systemic hedge fund contagion is much less likely today than in 1998, other news
outlets used the data to argue that risk has significantly increased. See, for example the attached link to a Reuters
article with the headline: “Hedge funds may pose huge market risk: Fed; Could be largest risk since Long-Term
Capital Management crisis in 1998 says New York Federal Reserve.”
NFA FINES CPO FOR FAILING TO MAKE ANNUAL FILINGS (4/23/07)
The National Futures Association fined a Commodity Pool Operator $35,000 for failing to file annual reports.
The NFA claimed a violation of Rule 2-13 following the firm’s failure to file the annual reports even after
receiving extensions. The action involved 10 pools in 2005 and 3 in 2004.
Our take: The NFA wants CPOs to take their filing requirements seriously. Also, don’t ask for an extension
and then ignore the deadline.
SEC TAKES ACTION AGAINST MUTUAL FUND PORTFOLIO MANAGER FOR PERSONAL
The SEC instituted an enforcement action against a mutual fund portfolio manager who traded for his own
account without pre-clearing or disclosing the trades. The portfolio manager made approximately 3500 trades
(mostly short-swing) in public company stocks during a 5-year period. The portfolio manager falsified holdings
reports and failed to pre-clear trades. Engaging in a pattern of short-term trading, he never abided by his
employer’s 60-day holding period requirement. The SEC indicated that he violated Section 17(j) and Rule 17j-1
as well as the investment advisor’s Code of Ethics.
Our take: It is significant that the SEC has not pursued action against the investment advisor. The SEC
indicated that the advisor had a valid Code of Ethics prohibiting the alleged activities and conducted training
attended by the portfolio manager. We believe that this action offers a roadmap for an investment advisor to
defend itself against the actions of a rogue portfolio manager. Also significant is that the SEC never alleged any
harm to the fund or the shareholders. The portfolio manager profited and violated the law, which was enough
for the SEC to refer the matter to enforcement.
IOSCO ISSUES HEDGE FUND VALUATION REPORT (4/5/07)
The Technical Committee of the International Organization of Securities Commissions has issued “Principles
for the Valuation of Hedge Fund Portfolios.” IOSCO intended the Report as a “practical tool” for valuation of
securities. The Report offers 9 principles including documented polices and procedures, consistency in
valuation, independent review, due diligence on third party pricing vendors, and transparency.
Our take: Valuation has become the most significant compliance issue facing the investment management
industry. Hopefully, the IOSCO Report will be the first step in more specific industry guidance. The SEC
needs to reconcile all the guidance currently offered by industry sources including ICI, FASB, IOSCO, etc.
NFA AMENDS MARKETING GUIDELINES FOR FOREX TRANSACTIONS (3/26/07)
The NFA adopted additional guidelines with respect to marketing of Forex transactions. The amendments to
the applicable NFA Interpretive Notice apply to both on-exchange and off-exchange transactions. The NFA
clarified that any testimonials must be representative, state that past results are no guarantee of future success,
and identify that the testimonial was provided in return for compensation. Also, statements of opinion must be
clearly identified. Additionally, certain radio and television advertisements with respect to off-exchange trading
must be submitted to NFA for review and prior approval. The amendments also prohibit “no slippage” or
“guarantee fill” claims unless all orders are executed at the price quoted on the platform when the order was
placed and there is no ability to change prices.
Our take: The NFA continues to expand its supervision of its members’ sales practices, thereby taking a more
primary role it the registration of hedge funds that deal in commodities.
SEC ALLOWS PRIVATE FUND SALES TO 501(C)(3) CORPORATIONS (3/21/07)
In a recent No-Action Letter, the SEC indicated that a 501(c)(3) charitable corporation could be considered a
“qualified purchaser” for purposes of satisfying Section 3(c)(7) of the Investment Company Act, even if the
charitable corporation did not own and invest at least $25 million in investments. The charitable corporation
must own at least $5 million in investments and must be created through contributions by related persons.
Alternatively, each person authorized to make investment decisions and each person who contributes assets
must be a qualified purchaser. In either case, the 501(c)(3) cannot be formed for the specific purpose of
acquiring an interest in the private fund relying on Section 3(c)(7).
Our take: This No-Action Letter should help private funds selling to the 501(c)(3) space.
SEC SETTLES ACTION AGAINST FORMERLY REGISTERED HEDGE FUND MANAGER
The SEC accepted the settlement of an enforcement action against a hedge fund manager that was no longer
registered under the Advisors Act. The SEC brought the action under Rule 105 of Regulation M, which
prohibits short sales covered by purchases of public offerings in the same securities. The manager had sold
short certain securities for its Cayman-based fund-of-funds and then covered the short sales with securities
purchased from the public offering within 5 days of the short sale. The SEC brought the action under both the
Exchange Act and the Advisors Act. The SEC noted that the fund manager had been registered under the
Advisors Act when the violation took place but had terminated its registration following rescission of the
Our take: The SEC is asserting aggressive jurisdiction, pursuing a manager that was no longer registered. The
lesson from this case is that even if you were only registered as a result of a law that the courts struck down and
you terminated your registration, you still risk SEC action with respect to activities that occurred while
INVESTMENT COMPANY SEEKS TO CREATE INNOVATIVE FUND-OF-FUNDS
An investment company is seeking exemptive relief to create a fund-of-funds structure that includes underlying,
affiliated ETFs. Section 12 of the 1940 Act generally prohibits fund-of-funds structures except if all underlying
funds are unaffiliated (aka the 3, 5, 10 rule) or all the funds are part of the same group of investment companies.
This most recent request would not fall into either category. The applicant has assured the SEC that the
independent directors will ensure no double dipping of advisory fees, proxy voting will follow the other
shareholders, and that the underlying funds will not also be fund-of-funds.
Our take: The hedge fund world has used the affiliated/unaffiliated fund-of-funds structure to further asset
allocation, enhance diversification, and avoid market correlation. The mutual fund industry is trying to follow
suit. It will be interesting to see if the SEC adds any additional conditions.
COURT DISMISSES SEC CHARGES AGAINST FUND EXECS (3/8/07)
A federal judge dismissed the SEC’s case against two fund executives who were charged with aiding and abetting
violations of the Advisers Act by concealing material information from a fund’s board. The action involved an
affiliate of an adviser that collected a portion of the fund’s transfer agency fees while sub-contracting transfer
agency services to a third party. The SEC alleged that the execs misled the Board by concealing a side letter
between the adviser and the sub-transfer agent concerning revenue guarantees unrelated to the funds and
understating its profitability on the transfer agency relationship. The court dismissed the case primarily on
procedural grounds but rejected disgorgement because the SEC failed to link the executives’ compensation to
the alleged misconduct.
Our take: The courts (see the Putnam/Lasser case) have not looked favorably on the SEC trying to prosecute
corporate executives for misconduct of their employers, especially when the only compensation received was
salary and bonus un-linked to any particular transaction.
DONOHUE CALLS FOR FUND DISCLOSURE OVERHAUL (3/7/07)
The SEC Director of the Division of Investment Management, Andrew J. Donohue, called for sweeping reform
of the mutual fund disclosure regime. In a speech at the Mutual Fund Directors Forum Institute, Mr. Donohue
called for a two-page document to be delivered to investors either electronically or in paper form with a more
substantial disclosure document available on the internet. The two-pager would include fees/expenses, risks,
investment objectives/strategies, and performance. Mr. Donohue indicated that a new disclosure regime is
closely linked to the SEC’s XBRL initiative, which would allow easier access to more information. He also noted
that the SEC is examining the delivery of shareholder reports.
Our take: Simple and effective disclosure is a worthy goal. However, the prospectus is as much about shielding
an issuer from liability as it is about informing investors. To accomplish effective disclosure reform, the SEC
must limit private rights of action and offer a disclosure safe harbor.
SEC ANNOUNCES CCOUTREACH SCHEDULE (3/6/07)
The SEC announced its 2007 CCOutreach program schedule. The CCOutreach program was designed to
enhance communication with fund and adviser CCOs in the wake of the mutual fund and adviser compliance
rules (38a-1 and 206(4)-7). This year’s topics include the examination process, books and records, brokerage,
Our take: These seminars, while short on specific guidance, give CCOs a sense of the SEC’s temperature and
FEDERAL COURT REJECTS FEE CLAIM AGAINST FUND ADVISER (3/5/07)
The US District Court for the Northern District of Illinois granted summary judgment (opinion attached) to a
mutual fund adviser accused of breaching its fiduciary duty by taking excessive fees (§36(b) of the 1940 Act).
The court applied the traditional Gartenberg factors including fee comparisons, the nature/quality of services
provided, fund performance and economies of scale. The court explained that “fiduciary duty” under the 1940
Act is “significantly more circumscribed than the duty that a common-law fiduciary would owe to a beneficiary”
and that the appropriate question is whether the fees were “so disproportionately large that they could not have
been the result of arm’s-length bargaining.”
Our take: Don’t rely too heavily on this opinion. First, the court applied a very narrow standard of fiduciary
duty. Second, although the court cited the independence of the Board members, the plaintiffs alleged several
connections with fund management. Outside of the Seventh Circuit, this case may not have been dismissed on
summary judgment. We believe this case serves as further justification for Board independence, at least as
protection against a §36(b) suit.
REDEMPTION PROCEEDS SUBJECT TO ONE-YEAR CLAWBACK FOLLOWING FUND
A federal judge ruled that investors in a failed hedge fund now in bankruptcy could sue redeemed investors
through the bankruptcy estate to recover money redeemed within one year prior to the bankruptcy, according to
The Wall Street Journal. The judge in the Bayou case ruled that all such redemptions could be a “fraudulent
conveyance” presumably under Section 548 of the Bankruptcy Code (link attached). The judge ruled that the
bankruptcy estate could claw back the entire amount of the redemption, not just the profits.
Our take: This ruling raises the stakes when investing in riskier funds. Redemption proceeds could be subject to
refund for up to one year following redemption. This would also stop the game of musical chairs that occurs
when funds start to falter.
PRESIDENT’S WORKING GROUP RETREATS FROM FURTHER HEDGE FUND
The President’s Working Group on Financial Markets issued its “Principles and Guidelines Regarding Private
Pools of Capital” recommending that markets themselves, rather than additional regulation, monitor hedge
funds. The Report calls upon investors, creditors, counterparties, pool managers, and fiduciaries to limit risk
and protect investors. The Report urges fund managers to provide investors with sufficient information and
implement appropriate risk management systems. Nevertheless, according to The Wall Street Journal, the
Group supported the SEC’s efforts to further limit access to unregistered funds to those with $2.5 Million in
assets. The President’s Working Group is chaired by Treasury Secretary Paulson and is composed of the
chairmen of the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures
Our take: Now, what? The President’s Working Group says “no more regulation.” Connecticut wants more
regulation (see link below). Canada (and much of Europe) is requiring hedge funds to register (see link below).
We believe that the Report and resulting blowback will almost guarantee that the SEC raises the investor
suitability standards as a minimum compromise.
SEC ALLOWS ADVISERS TO LIMIT LIABILITY (2/22/07)
In a recent no-action letter, the SEC tacitly approved the use of investment adviser agreement “hedge” clauses
i.e. language that indemnifies and holds the adviser harmless from any liability other than that arising from its
gross negligence or willful misfeasance. Although the SEC did not specifically approve the hedge language used
by the requesting party, it noted that hedge clauses are not a per se violation of the Advisers Act’s anti-fraud
rules. The SEC explained that an adviser had to conduct a facts and circumstances test based on the specific
language of the clause, the explanation to the client, and the disclosure about a client’s legal rights.
Our take: This is good news. Advisers should consider the use of liability-limiting language in their agreements.
We would recommend that advisers separate and highlight the language and related disclosure through use of a
separate writing or at least by specifically highlighting the language in bold, caps, etc.
ENFORCEMENT ACTION AGAINST HEDGE FUND ADVISER UNDER ADVISERS ACT
A Federal judge issued an injunction against a hedge fund advisor in connection with misleading investors about
assets under management and account values. Following significant trading losses, the adviser fabricated
account statements and continued to deliver offering documents that misstated the funds’ assets. In its
complaint, the SEC, in addition to alleging the more oft-cited violations of the Exchange Act, also cited the
adviser, which was registered in several states, for violating the Advisers Act’s anti-fraud rules in connection with
filing misleading ADVs.
Our take: The specific reference to the Advisers Act and the misleading ADV is significant. Rarely has the SEC
sought enforcement relief under the Advisers Act’s anti-fraud rules. Recently, the SEC proposed applying the
Act’s anti-fraud rules to hedge fund advisers that are not registered. Look for the SEC to use this type of
enforcement case as justification for its proposal.
NFA ISSUES ANNUAL REGULATORY REQUIREMENTS (2/13/07)
The NFA sent out notices outlining the annual regulatory requirements for independent introducing brokers,
guaranteed introducing brokers, commodity trading advisors, commodity pool operators, and futures
Our take: This is great guidance from one of the most informative SROs. If you are a compliance do-it-your-
selfer, put this in your file.
CONNECTICUT PURSUES HEDGE FUND REGULATION (2/12/07)
A Connecticut newspaper has reported that the Connecticut General Assembly has introduced legislation to
regulate hedge fund disclosure and conflicts of interests. The legislation is still being written, but a February 20
hearing is scheduled. The Connecticut Attorney General supports increased hedge fund regulation, although he,
along with the bill’s sponsor, supports federal legislation.
Our take: Connecticut is putting pressure on the SEC to take action. The Connecticut legislation appears
broader in scope than the recent SEC proposal raising investor accreditation standards.
MASSACHUSETTS TAKES ACTION AGAINST ACTIVIST HEDGE FUND (2/12/07)
The Massachusetts Securities Division has filed a complaint against a prominent hedge fund alleging that its
marketing activities through its website resulted in the public offering of unregistered securities. Massachusetts
alleged that through an unrestricted web site, prospective investors had access to general advertising and offering
materials. The web site did not pre-qualify potential investors based on location or accreditation. Massachusetts
alleged that the fund did not comply with the SEC’s guidance with respect to private offerings of securities over
Our take: If the facts are as alleged, the hedge fund pushed the envelope too far with its website. Nevertheless,
the fact that the fund engaged in activist arbitrage may have also raised the ire of the Securities Division. A
broader solicitation would certainly help execute an arbitrage strategy.
DOL ALLOWS INVESTMENT ADVICE WITHIN QPAM EXEMPTION (2/7/07)
The DoL has offered guidance allowing third parties to provide investment advice to self-directed plans without
running afoul of the QPAM exemption. The DoL implied that services “limited to advising participants with
respect to allocation of investments” do not result in the advice provider exercising authority and control of the
investments. Such authority and control would prevent the fund from which the assets were invested to rely on
the QPAM (qualified professional asset manager) exemption with respect to transactions with any affiliate of the
Our take: Be careful relying on this Advisory Opinion. It assumes that the advice provider has not effectively
exercised control. In the real world, where a fund investment has gone bad, an aggressive plaintiff’s lawyer (or
the DoL) may be able to show otherwise.
CFTC DELIVERS LETTER RE ANNUAL REPORTING REQUIREMENTS FOR CPOS (2/6/06)
The CFTC sent out the attached letter describing the annual reporting requirements for Commodity Pool
Operators. The letter includes all due dates, required filings, accounting issues, and contact information.
Our take: Put this document in the reference file. It’s a good piece.
SEC BANS HEDGE FUND MANAGER IN CONNECTION WITH VALUATION (2/6/06)
The SEC banned a hedge fund manager from associating with an investment adviser in connection with
delivering incorrect valuations to the fund administrator, thereby misleading investors about the fund’s
performance. The SEC applied the “Steadman” factors: egregiousness of the conduct, whether the infraction
was isolated or recurrent, the degree of scienter (intent), the sincerity of the assurance against future violations,
recognition of the conduct’s wrongfulness, and the likelihood for future violations. Interestingly, the SEC
seemed to exonerate the fund’s administrator and prime broker.
Our take: The Administrative Law Judge stated that he did not believe that the respondent/defendant would
not violate securities laws in the future because he “continues to blame everyone but himself, including the
SEC.” In our experience, the SEC tends not to seek industry bans where the advisor takes responsibility and
action to fix the problem.
VIOLATION OF PRIVATE OFFERING COULD REQUIRE BROKER-DEALER
The SEC has issued an order instituting administrative proceedings against a hedge fund manager that operated
a fraudulent investment program and Ponzi scheme. The Division of Enforcement has alleged that the firm
engaged in a public offering of an unregistered hedge fund by sales agents and relationship managers who
solicited investors, a public web site, and a mass mailing to prospective investors. The fund never made money
and only returned money to investors by soliciting money from other investors. Moreover, the advisor's
registration with California had been revoked.
Our take: Based on the facts as alleged by the SEC, the advisor's actions appear pretty egregious. Most
significantly, the case is a model for how not to engage in a private offering. Also, the SEC alleged that the sales
activity required registration as a broker-dealer. Hedge fund managers should take note that if you violate
Regulation D (private offering), you may also violate the issuer exemption (Rule 3a4-1), which allows hedge fund
sponsors to sell shares of the sponsored fund without registering as a broker-dealer.
DEFRAUDED HEDGE FUND MANAGER FAILED TO CONDUCT DUE DILIGENCE (2/1/07)
A defrauded hedge fund manager was ordered to pay a $200,000 penalty plus disgorgement in connection with a
fraudulent "prime bank" scheme in which the fund invested. Although it appears that the manager was more
the victim than the perpetrator, the SEC cited the manager for failing to properly investigate the investment or
its sponsors, resulting in a breach of fiduciary duty and misleading disclosure documents.
Cipperman's take: Just because you think you're doing the right thing, doesn't mean you are. In this action, the
hedge fund manager thought she was hiring a legitimate trading firm and ultimately cooperated with the SEC
and the US Attorney's Office in its investigations of the prime bank scheme. In fact, it appears most of the
money was returned to investors. Nevertheless, investors lost money and, as a fiduciary, the fund manager is
SEC CITES SECURITIES LENDING DEFICIENCIES (1/29/07)
The Wall Street Journal is reporting that the SEC has sent deficiency letters to several fund companies in
connection with securities lending programs. The SEC raised issues where an affiliate of the fund's investment
adviser served as lending agent. The Journal quoted Gene Gohlke who questioned the integrity of the bidding
process for lending agents that result in selection of the adviser's affiliate. He noted that "directors...were not
adequately overseeing the securities lending of the funds."
CANADIAN REGULATORS PROPOSE HEDGE FUND REGISTRATION (1/16/07)
The Canadian Securities Administrators (an affiliation of provincial securities regulators) has proposed the
registration of hedge fund managers and hedge funds. The registration would focus on resources, conflicts of
interest, capital and insurance, and proficiency and integrity. As the regulators increasingly cooperate across
borders, the SEC will likely use the Canadian experiment to determine its own regulatory course.
NFA PERMANENTLY BARS FIRM AND PRINCIPALS FROM MEMBERSHIP (1/12/07)
The National Futures Association permanently barred a firm and its principals from membership for high
pressure and misleading sales tactics, failure to keep proper records, and failure to maintain an adequate anti-
money laundering program. (See attached link to complaint.) The action is notable because the NFA does not
often pursue a regulatory action against its members, suggesting a heightened compliance effort by the NFA.
Also, the permanent bar from the NFA essentially puts the firm out of business.
INTERAGENCY STATEMENT ON COMPLEX STRUCTURED FINANCE TRANSACTIONS
The Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office
of the Comptroller of the Currency, the Office of Thrift Supervision and the Securities and Exchange
Commission issued a final statement on complex structured finance transactions (see attached link). The
statement describes the internal controls and risk management procedures for identifying, managing, and
addressing the "heightened legal and reputational risks" from structured finance transactions. The statement is
supervisory guidance for banks but is only a policy statement for advisors and broker-dealers.
SEC PROPOSED NEW HEDGE FUND RULES (12/28/06)
The SEC proposed new rules that affect hedge funds (see attached link). Proposed Rule 206(4)-8 under the
Investment Advisers Act prohibits false or misleading statements made to current or prospective investors in
3(c)(1) or 3(c)(7) funds. The Rule would apply whether the adviser to the fund was registered or unregistered
under the Advisers Act. The Rule would apply to hedge funds, private equity funds, and registered mutual
funds. The rule would apply to any statement made to an investor or potential investor including offering
documents, sales materials, account statements or requests for proposal. The SEC specifically identified
information concerning investment strategies, adviser credentials, risks, performance, valuation, and operations.
The SEC could bring enforcement actions under the Rule, but there would not be a private right of action.
The SEC also proposed Rules 509 and 216 under the Securities Act that would create a new "accredited natural
person" definition. To accept investments from a natural person, a 3(c)(1) fund would require such person to
meet the definition of accredited investor ($1,000,000 net worth or $200,000 in income) and ensure that such
person owns at least $2.5 million in investments exclusive of real estate. The SEC proposed to index for
inflation the $2.5 Million threshold. The SEC made clear its intent to maintain at less than 2% the number of
households that would qualify. The Rules would not apply to 3(c)(7) funds or venture capital funds.
Comments are due by March 9, 2007.
Comments are expected. The SEC is engaging in regulatory gymnastics in order to limit hedge fund sales. Even
the SEC acknowledges that it has never applied Section 206 to advisers not registered under the Advisers Act.
Additionally, the SEC fails to connect investment sophistication with the amount of such person's investment
portfolio. Is the SEC really protecting investors or is it really banning hedge fund sales except to rich people
who can better afford to lose money? Also, why is there is an exception for venture capital funds? Perhaps, the
SEC should have considered enhancing the disclosure regime (as it traditionally has done) rather than change the
investor eligibility criteria.
The proposed rules again highlight the SEC's fear of hedge funds. The SEC notes that "private pools have
become increasingly complex and involve risks not generally associated with many other issuers of securities."
The SEC cites complex investment strategies, minimal information, undisclosed conflicts of interest, complex
fee structures, and higher risks.
HEDGE FUND MANAGER SANCTIONED IN PIPE DEAL (12/21/06)
The SEC sanctioned a hedge fund and its investment adviser by engaging in naked short sales in connection
with a PIPE offering. In In re Spinner Asset Management, the SEC found that a hedge fund portfolio manager
conspired to avoid the short sale rules by using a Canadian broker-dealer to pre-arrange purchases of the PIPE
securities, rather than the issuer's publicly offered securities, to cover short positions. See attached link.
Combined with recent actions in connection with the Compudyne PIPE offering, the case highlights the
regulators' dislike of the PIPE structure, especially when hedge fund managers attempt to avoid the naked short
ACTION AGAINST AUDIT FIRM FOR SECURITIES VALUATION (12/19/06)
The SEC recently sanctioned the concurring partner at a mutual fund's outside auditor because he knew that
certain securities in a money market fund had maturity dates in excess of 397 days but failed to inform the
engagement partner. The SEC stated that his failure resulted in misrepresented financial statements. Moreover,
the SEC stated that the partner unlawfully permitted his firm to issue an unqualified opinion. See link below.
The action raises the standard of care for audit firms because it holds them accountable for the valuation of
securities, rather than simply relying on management's opinion. Although this case was fairly easy for the SEC
because it arose in the 2a-7 context, it could have broader implications with respect to financial statements for all
types of funds, especially those with hard to value securities.
HEDGE FUND RULE REDUX (12/14/06)
The SEC voted to propose rules that would apply the anti-fraud rules of the Advisers Act to hedge funds
whether or not the adviser/manager is a registered investment adviser. The SEC also voted to propose raising
the accredited investor definition to require investors in hedge funds to own at least $2.5 Million in investments.
See attached link.
The proposed rules are a response to the court-imposed rescission of the rule that required hedge fund advisers
Applying the anti-fraud rules would give the SEC enforcement power with respect to the offering of hedge fund
securities. It could also potentially result in private rights of action.
Raising the accredited investor standard will make it more difficult to raise assets from the high net worth
What are the chances that these proposals become rules? Pretty good. The SEC wants to regulate hedge funds,
and they may have found a back door way.