The SEC is finalizing the Dodd-Frank Rules

On Wednesday, June 22 the SEC approved two sets of rules to implement amendments to the  Dodd-Frank Wall Street Reform and Consumer Protection Act.  One set of rules requires advisers to hedge funds and other private funds to register with the SEC, establishes new exemptions from SEC registration and reporting requirements for certain advisers and transfers regulatory responsibility for certain advisers between the SEC to the state level. The other rule defines “family offices” that are to be excluded from the Investment Advisers Act.

The rules implementing the amendments to the Investment Advisers Act include a transitional exemption period so that private advisers, including hedge fund and private equity fund advisers, newly required to register do not have to do so until March 30, 2012. The rules regarding exemptions for venture capital fund and certain private fund advisers are effective July 21, 2011. Family offices that do not meet the terms of the exclusion under the new rule must register with the SEC or applicable state securities authorities by March 30, 2012.

During the public comment period, the SEC received 70 comment letters on their proposed rules.  Note at this post writing I will address on the definition of the “Mid-Sized Advisor”.  Over the next few posts I will abstract the remainder of the rule changes. 

The Mid-sized Advisor

The SEC added a new category for the advisor called “Mid-Sized Advisers”.  In effect, the Mid-sized advisor would be considered those funds with assets under management of between, $25 million to $100 million.  These Mid- Sized Advisors would no longer register with the Commission but instead be under the auspice of state regulators.   Those who already registered with the SEC will have to withdraw their registration.  The only exemption from state registration (therefore still be under SEC) is where a state would not perform an examination of the Funds. 

Note: advisers with their principal office and place of business in Minnesota, New York and Wyoming with between $25 million and $100 million in AUM won’t have to switch to state regulation and instead must register with the SEC. New York did not provide confirmation that it conducts exams of advisory firms when surveyed by the SEC; Minnesota reported it doesn’t conduct exams; and Wyoming doesn’t have an investment adviser law.

The SEC stated  that this amendment  will force about 3,200 of the current 11,500 registered advisers to switch from registration with the SEC to registration with the states.

I am attaching a link to the 238 page report on the amendments to Dodd Frank http://www.sec.gov/rules/final/2011/ia-3221.pdf 

and the 52 page report on 

http://www.sec.gov/rules/final/2011/ia-3220.pdf 

on the definition of a “Family Office”

SEC Announces Steps to Address One-Year Effective Date of Title VII of Dodd-Frank Act

Relief is on the way for SWAPS

On June 10, 2011 the SEC indicated they will take a series of actions in the coming weeks to clarify the requirements that will apply to security-based swap transactions as of July 16 (the effective date of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act) and to provide appropriate temporary relief.

Title VII is the portion of the Dodd-Frank Act that establishes a comprehensive framework for regulating over-the-counter derivatives. In particular, it authorizes the SEC to regulate “security-based swaps” while also authorizing the CFTC to regulate other swaps.

The portion of Title VII referred to as Subsection B, which deals with the new regulatory regime for security-based swaps, will take effect on July 16 (360 days after the date of the Dodd-Frank Act’s enactment).

The SEC will:

1. "Provide guidance regarding which provisions of Subtitle B of Title VII will become operable as of July 16, and, where appropriate, provide temporary relief from several of these provisions.
2. Provide guidance regarding  and where appropriate, temporary relief from – the various pre-Dodd-Frank provisions of the Exchange Act that would otherwise apply to security-based swaps on July 16. Under Dodd-Frank, security-based swaps would be included in the definition of “security” under the Exchange Act. While such swaps will be subject to provisions addressing fraud and manipulation, the Commission intends to provide temporary relief from certain other provisions of the Exchange Act so that the industry will have time to seek, and the Commission can consider, what if any further guidance or action is required.
3. Take other actions such as extending existing temporary rules under the Securities Act, the Exchange Act, and the Trust Indenture Act, and extending existing temporary relief from exchange registration under the Exchange Act. This will help to continue facilitating the clearing of certain credit default swaps by clearing agencies functioning as central counterparties."

Speech by SEC Commissioner: Remarks at the Symposium on “Hedge Fund Regulation and Current Developments”

Troy A Paredes

On June 8, 2011 a commissioner of the SEC, Troy A. Paredes addressed the Center for Law, Economics & Finance (C-LEAF), in New York.  For reference sake, Mr. Paredes was appointed a Commissioner by George W. Bush in 2008.  I have highlighted a few key sections of his speech that I feel is somewhat news breaking.     

Short Sales and Public Comments

“Because short selling was such a focal point during the peak of the financial crisis in 2008, I should also note that Dodd-Frank calls upon the Commission to conduct two studies of short sale disclosure that hedge funds undoubtedly have an interest in. 

Dodd-Frank requires the SEC to study the effects of requiring the reporting of short sale positions in real time, either publicly or confidentially to the SEC. Second, the statute requires the agency to study the prospect of a pilot program that would require that trades be marked as “long,” “short,” “market maker short,” “buy,” or “buy-to-cover” in real time on the Consolidated Tape. The Commission has issued a request for comment to receive input on these studies."

Can we really define Systemic Risk?

“Title I — including which nonbank financial companies will be designated as “systemically important” (that is, as “SIFIs”) and thus subject to heightened prudential supervision and more intrusive government dictates — is still uncertain.

Personally, I am concerned about the ability of even a conscientious and well-intentioned systemic risk regulator to accurately identify when a firm is “systemically important” and to properly calibrate the source of future danger to the financial system.

And questions persist, at least to my mind, as to what the limits are on the government’s authority to regulate under the Financial Stability Act once SIFIs are designated".

Too much information might compromise a hedge fund’s competitive edge

When regulating, we need to account for the risk that these economy-wide benefits could be sacrificed if the regulatory regime unduly burdens and constricts the activities of hedge funds. It would be concerning, for example, if hedge funds were required to make public disclosures that compromise their proprietary investment strategies or if the regulation of our equity markets changed so that it became more costly to provide liquidity.

Let’s not rush into anything

"I also want to emphasize my view that, in advancing the numerous Dodd-Frank rule makings that the SEC is charged with, the agency cannot rush. The scope and complexity of the rulemaking is daunting and unprecedented. Trying to adopt too many rules and regulations too quickly is fraught with risk. Nor should we rush the implementation of the new rules and regulations, whatever their substance may be when enacted. Market participants, including hedge funds, will need to evaluate their business and investment options in light of the new regulation; structure their operations and activities accordingly; and develop and implement the systems, procedures, policies, and controls they will need to comply with the new regulatory regime.

This will take time. Thus, we need to be realistic about how quickly after being adopted the new rules and regulations should become effective in order to ensure that the transition to the new regulatory environment is orderly and workable in practice."

Another instance why we need regulations Bernie Madoff

The Securities and Exchange Commission charged Eric Lipkin, a longtime employee of Bernard  Madoff  with assisting Madoff’s firm deceive and defraud investors and regulators about the massive Ponzi scheme.

“Eric Lipkin helped create the detailed and entirely phony trading and business records that contributed to the success of Madoff’s fraud,” said George S. Canellos, Director of the SEC's New York Regional Office. “The SEC is committed to holding accountable those who helped to perpetrate and conceal Madoff’s scheme.”

Lipkin, 37, pleaded guilty on June 6^th 2011 to six criminal counts, including conspiracy, falsifying records and bank fraud. Lipkin agreed to cooperate with the government in its investigation of the fraud at Bernard L. Madoff Investment Securities LLC.

“I’d like to first apologize to my family, my friends and all the victims in the case,” Lipkin told U.S. District Judge Laura Taylor Swain.

Guide to Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Infrastructures

OPERATIONS SECTION

I abstracted the operations section of the Guide to Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Infrastructures.  This is a long post but this should be required reading for investors and hedge funds. 


Organization and Control Environment
 

The firm should have a clear corporate organization chart presenting; parent companies, subsidiaries and other affiliated entities.

The firm should be structured to allow for adequate oversight of the primary functions within the firm. Investors will want to see a clear organization chart showing, at a minimum, reporting lines, team numbers, and the names of key professionals in order to understand how the team is organized by function.

The back office should have a strong voice in the firm, with a high level of authority and influence in the organization. There should be a senior chief operating officer (“COO” hereafter)/chief financial officer (“CFO” hereafter) independent of the investment process, with authority over operational processes.

The organization should demonstrate clear segregation of duties and levels of staffing given the complexity of strategy and risks.

The firm should re-evaluate resources as it grows or changes. Managers should explain where employees are located, how personnel in different locations interact and how their knowledge base is kept up to date.

Turnover is a reality, and often healthy, but should be manageable. Investors will expect to be notified of key hires and departures as well as want to understand the reasons behind recent turnover.

Internal organizational procedures, controls and systems should be documented,

Conflicts

Investors will want to see a documented conflicts policy, together with an understanding of what steps have been taken to identify and resolve conflicts, and the existence of a conflicts or compliance committee to manage conflicts and develop a framework for disclosure of conflicts

While managers will produce standard documentation that complies with legal and regulatory obligations, investors will expect substantially more disclosure in the form of due diligence questionnaires, historic reports and sample documentation such as operations manuals, valuation policies and samples of board meeting minutes (redacted if necessary).

Compliance

Investors expect to see a strong compliance culture at a firm starting at the top and a robust compliance

Where managers are preparing to become registered for the first time, a proper gap analysis and implementation plan should be in place. Investors will want to understand, in outline, the results of regulatory visits and may ask to see copies of key reports. Even if a firm is unregistered with a regulatory body, it still should operate to the same standards as if it was registered.

Investors will want to review the compliance manual that documents the procedures and controls.  The compliance manual should be updated regularly as a “live document”, is tailored to the business and that the policies in key areas are appropriate. When new policies are implemented, the manual should be updated accordingly with a copy given to every member of staff.

In addition investor Expectations and Preferences

• Annual declarations from employees to confirm they have read and complied with firm policies and procedures.

• Appropriate level of compliance oversight into issues such as personal account dealing, AML, KYC and employee gift reporting, as well as investment strategy issues.

• Written code of workplace ethics with adequate training.

• If preferential side letter terms to selected investors exist (e.g., fees, liquidity, transparency) those terms should be approved by fund board of directors and disclosed to all potential and existing investors of the fund.

Trade Processes

Managers should ensure that the infrastructure is appropriately tailored to the business, and they should assess the market, frequently, for new products or enhancements. The suite of portfolio systems should allow, where appropriate, for a high degree of automation and straight-through processing for reliable books and records.

There should be a centralized location for all portfolio data (data warehouse), with an extensive security master file and real-time reporting through direct market feeds. Managers should have systems that maintain comprehensive trading data (i.e., corporate actions, realized/unrealized gains, commissions, etc.) and a complete general ledger with partnership accounting; updated for current accounting requirements.

Timely reconciliation and resolution of reconciling items is an essential requirement to promptly identify duplicate, missing or incorrect transactions.

Investors expect hedge funds to be independently audited by a specialist audit firm with a recognized record for auditing hedge funds. Likewise, investors expect for the hedge fund to have an independent third party fund administrator

Investors expect the hedge fund manager to undertake a thorough due diligence process when recommending a service provider to ensure that they have the essential level of experience and expertise to carry out their roles to the required level.

Valuation

The process of valuing the hedge fund’s investments is at the forefront of every hedge fund operational due diligence review. Pricing is probably one of the most sensitive and important areas in hedge fund controls. There is room for manipulation, fraud, or even simple errors in valuing assets, with valuations artificially boosting fund performance or smoothing “mark to market” returns.

1. Separation from the front office: While the front office may be instrumental in the valuation of some assets, final authority should reside with the back office.

2. External oversight: External to the manager’s organization

The manager’s valuation committee should consist of senior management, with the majority represented by members who are independent of the investment team. Given that the pricing policy within the fund offering documents is generally vague, there should be a detailed documented pricing policy that describes the material aspects of the valuation process and valuation procedures and controls for each asset type.

The treatment of side pockets is often a source of contention, and there are some best practices that all funds should follow:

1. The fund should have clear documentation that defines a side pocket.

2. The fund should provide investors with a description of assets which have been side pocketed and pricing at the point of side pocketing.

3. Where possible, multiple price sources should be used to verify the valuation of each position in a fund’s portfolio.

Administrator

A good administration relationship can provide important third party oversight, but the administrator must have the appropriate capabilities and the fund manager should have the proper controls in place to monitor the quality of the administrator’s work. Roles and responsibilities should be defined in a clearly written SLA, and the manager should have a formal process to allow for a regular evaluation of their administrator’s performance.

Fund–specific monthly report independent of the manager which details the pricing sources used (including the reliance on manager prices quantified as a percentage of NAV) and fund counterparties for both liquid and illiquid portions of the fund portfolio and fund counterparties.

Business Continuity/Disaster Recovery

Business continuity planning (“BCP” hereafter) refers to a hedge fund manager’s ability to continue operating in the event of a disruption to its business. Disaster recovery (“DR” hereafter) relates to a hedge fund manager’s ability to restore itself back from a disaster event to the point where it was before the disaster occurred. BCP and DR planning spans all areas of the hedge fund organization.

All firms need to implement best practice procedures and infrastructure in order to protect the business in the event of natural disaster, terrorism, pandemics and other disruptions, although the BCP and DR plans should be bespoke in that they consider the risks of the manager’s strategy.

Investor Expectations and Preferences

• Well documented BCP and DR.

• Dedicated DR/BCP crisis team for oversight of key issues.

• Plan is managed by senior management (COO, CFO).

• Proprietary data appropriately backed up and housed at an offsite venue.

• Appropriate level of documentation on the firm’s recovery plan, with step by step guide to facilitate   best return to operations.

• BCP/DR plan is regularly stress tested.

• Key person(s) risk of the firm is considered, with appropriate policies in place

Guide to Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Infrastructures

Governance:

This is my 2^nd post in a series, abstracting the white paper issued by the Alternative investment management association “AIMA”.  This document reflects the views of investors and is written to educate the AIMA’s constituents (investors).  The section on governance is is authored by Luke Dixon of Universities Superannuation Scheme.

“Their is a growing importance of good fund governance and by association, high quality independent "directors".  Conflicts of interest frequently exist between the hedge fund’s board of directors (if they are any), investment managers and the fund’s advisors.” These conflicts can often lead to decisions being taken in the interests of the hedge fund’s investment manager rather than in the interests of the fund and its shareholders as a whole.  The threat is this governance is contrary to the fiduciary obligations of the fund’s directors. 

Investors recommend that governance structures and oversight responsibilities should be in place to protect them, and want all oversight responsibilities to be undertaken by responsible, knowledgeable and independent fiduciaries. Despite the private nature of hedge fund investments, the trajectory of their governance is towards the public market model of strong, independent boards and democratically empowered investors.

The section continues to outline what investors would consider an ideal governance platform. 

Investor shares should provide relevant voting rights.  As an example the voting rights might include

"the appointment and removal of the investment manager; the election of directors; approval of directors’ fees; In addition, these fund shareholders should be able to nominate directors; file a resolution at general meetings; convene an extraordinary general meeting; while the fund’s registrar should facilitate investor communications, solicitations and proxies, in this respect."

•   Service providers periodically report directly to the board. 

•   Information prepared by service providers should be delivered directly by them to the  board. This reporting distinction explicitly recognizes that the service providers are contracted by the fund rather than by the investment manager.

•   The” board” should have much more of a say in the valuation of securities. Security pricing should not be left to the discretion of the investment manager.

•  The board should be empowered to monitor and replace the fund’s service providers, including the investment manager. 

The hedge fund’s Offering Memorandum should be sufficiently precise when describing the fund’s investment strategy and appropriate investment restrictions, to serve as a guide for director and investor oversight.

Investors would also like to see that decisions to invoke fund gating mechanisms and side pockets, or to suspend fund redemptions and net asset value (“NAV” hereafter) calculations, to be also the responsibility of the board of directors


How much of this idealistic view of what investors want will become reality is yet to be seen. However, it is very clear that hedge funds are moving from a private organization structure to a more transparent model.