Hedge Fund Regulation & Compliance

SEI Checklist of HF Pre-SEC Registration Issues

2005-09-18T16:40:00.000-07:00

SEC Registration Has Broad Business Implications for Hedge Funds, States SEI Investments

SEI Identifies Top 10 Issues to Resolve Before Registering

OAKS, Pa., Sept. 14 /PRNewswire-FirstCall/ -- Hedge funds planning to register with the SEC must be proactive in crafting policy frameworks to fit new regulatory demands or risk damage to their reputation and lost business opportunities, according to SEI Investments (Nasdaq: SEIC), a leading global provider of asset management services and investment technology solutions. The advice, along with 10 critical issues for hedge fund managers to address in those policies, came from regulatory experts at a recent web seminar hosted by the SEI Knowledge Partnership.

The session provided SEI's hedge fund clients a roadmap leading up to the February 1, 2006 deadline for SEC registration. Nearly all hedge fund advisers will be subject to the registration requirement adopted by the SEC earlier this year. Panelists outlined a series of recommendations which are detailed in an SEI white paper, entitled "Countdown to Hedge Fund Adviser Registration: Essential Steps to Take Now."

"It would be a mistake to think of registration as merely an exercise in completing paperwork. It is about getting your business ready to operate in a regulated environment - and many aspects of that will be new to previously unregistered advisers," said Jim Volk, Chief Accounting Officer and Chief Compliance Officer for SEI's Investment Manager Services business.

Volk cited conflicts of interest, a code of ethics requirement, record- keeping obligations and e-mail retention among areas in which hedge funds will need to focus on changing practices.

Paul Schaeffer, Director of the SEI Knowledge Partnership, observed that new disclosure and code of ethics requirements will require that hedge fund partners and employees disclose their personal holdings and trades. "This introduces a level of scrutiny hedge fund advisors are not accustomed to," said Schaeffer. "In the bigger picture, it will mean hedge funds have to undergo a major cultural shift that could affect many aspects of their operations."

The seminar panelists identified ten key issues hedge funds must address in their policies and procedures:

1. Conflicts of interest. Conflicts include those implicated by an
adviser's brokerage practices, especially concerning the use of soft
dollars. "It's critical that your soft dollar agents be consistent
with your obligation to pursue 'best execution,'" said Phil
Masterson, an SEI in-house attorney, who observed that a pending rule
is likely to limit the use of soft dollars to research reflecting
unique intellectual content.

2. Trade allocation practices, which must be "fair and equitable" to
each client over time. Consistency is important and exceptions, in
the rare instances that they occur, should be documented and
disclosed.

3. Handling of trading errors. There are several things managers should
avoid, including using soft dollars to compensate a broker for
absorbing a loss and reallocating erroneous trades among clients.

4. "Side letter" provisions providing preferential treatment for some
clients -- especially those concerning liquidity and transparency.
Consider alternative ways of handling preferential terms and make
sure to add disclosures where appropriate.

5. Third-party marketing. To avoid the risk of lawsuits, hedge funds
should only pay for capital introductions made by a broker-dealer
registered in the state where the introduction was made, said Steven
B. Nadel, a Partner at the law firm of Seward & Kissel, LLP.

6. Personal trading by adviser personnel. A code of ethics should be
written to address issues concerning short selling, accepting gifts
and trading restricted stock, and cover employees and their families
as well.

7. Valuation practices, which can raise conflicts of interest. The SEC
has become very aware of this issue and registered advisors will need
to quickly develop protocols for every possible scenario that might
occur.

8. Adviser performance advertising, which cannot include testimonials,
"cherry-picking," or any false or misleading statements.

9. Proxy voting procedures. Disclosure and documentation are key here.

10. E-mail retention, which raises questions such as the scope of e-mails
the SEC can examine and whether hedge funds should conduct monitoring
and surveillance of their e-mail. "Internal training programs on the
use of e-mail is absolutely critical, so that employees consider in
advance what gets put into e-mail," said Schaeffer.

Still, panelists suggested hedge fund managers have no reason to avoid registering. "If you're going after institutional money, clients will expect you to be registered. And even if you're exempt for some reason like having a two-year lockup, they will still expect to see policies that satisfactorily address every significant issue," said Nadel. He said being registered would also permit hedge funds to raise more ERISA money than is currently allowed.

The SEI Web seminar was the eighth in a compliance series held by the SEI Knowledge Partnership in collaboration with SEI's ComplianceAdvantage program. In addition, this is the sixth white paper on regulatory challenges published by the Knowledge Partnership. The white paper is available by e-mailing SEIKnowledgePartnership@seic.com.

About The SEI Knowledge Partnership

The SEI Knowledge Partnership provides SEI's investment manager clients with actionable business intelligence on issues in the areas of compliance; business operations and outsourcing; marketing, sales, distribution, and client service; and business strategy. Through ComplianceAdvantage, SEI offers comprehensive compliance services, guidance, and one-on-one support. Both programs are initiatives of the Investment Manager Services unit of SEI Investments, which provides integrated operating solutions to traditional and alternative investment management organizations.

About SEI

SEI Investments (Nasdaq: SEIC) is a leading global provider of asset management services and investment technology solutions. The company's innovative solutions help corporations, financial institutions, financial advisors, and affluent families create and manage wealth. As of the period ending June 30, 2005, through our subsidiaries and partnerships in which we have a significant interest, SEI administers $312.0 billion in mutual fund and pooled assets, manages $130.7 billion in assets, and operates 22 offices in 12 countries. For more information, visit http://www.seic.com.

Company Contact Media Contact
Dana Grosser Jason Rocker
SEI Investments Braithwaite Communications
610-676-2459 215-564-3200 x 10
dgrosser@seic.com jrocker@braithwaitepr.com

SOURCE SEI Investments
-0- 09/14/2005
/CONTACT: Company Contact: Dana Grosser, SEI Investments,
+1-610-676-2459, dgrosser@seic.com; or Media Contact: Jason Rocker,
Braithwaite Communications, +1-215-564-3200 x 10, jrocker@braithwaitepr.com/
/Web site: http://www.seic.com /
(SEIC)

CO: SEI Investments
ST: Pennsylvania
IN: FIN MFD
SU: SVY

PD
-- PHW020 --
2092 09/14/2005 10:52 EDT http://www.prnewswire.com

More on NASD Attack on Retail HF Sales

2005-08-27T19:44:00.000-07:00

August 25: Operational Risk - NASD Investigates Hedge Fund Sales Practices
--------------------------------------------------------------------------------
Location: New York
Author: Ellen J. Silverman
Date: Thursday, August 25, 2005
--------------------------------------------------------------------------------

A top NASD official said on Wednesday that they have launched an investigation into brokers selling hedge funds to individual investors without alerting them to the potential risks.

Hedge funds have long been viewed as the domain of wealthy “accredited” investors and institutions with a bigger appetite for risk. But they’ve come downstream in recent years, as a slew of new products have flooded the marketplace. “The marketing and sales of hedge funds to individual investors has been an ongoing focus of the NASD,” said Barry Goldsmith, executive vice president of enforcement at the NASD, in a prepared statement. “We are continuing to look at issues in this but cannot comment on any specifics.”

Goldsmith’s remarks came in response to a Bloomberg wire report that the broker watchdog sent letters of inquiry to at least 10 brokerage houses, including Citigroup, Merrill Lynch and UBS . The NASD reportedly asked the firms what type of cautionary disclosures were made to investors when selling hedge funds that carried minimums of $50,000 or less. The firms were also asked if they paid brokers sales incentives to pitch certain hedged vehicles. The NASD reportedly said that the investigation should not be interpreted as a sign that examiners have concluded that the targeted firms violated securities laws.

This isn’t the first time hedge fund sales practices have drawn attention from regulators. In October 2004, the NASD slapped Citigroup’s brokerage unit with a $250,000 fine for distributing hedge fund sales literature that didn’t adequately explain risks or disclose performance properly. In April of that year, Altegris Investments was penalized $175,000 for similar practices. In that case, the NASD censured and fined the company’s chief compliance officer $20,000 for failing to adequately supervise the firm’s advertising practices.
--------------------------------------------------------------------------------

Article Printed From RiskCenter.com

NASD Targeting Big Wirehouse Retail HF Sales

2005-08-18T09:25:00.000-07:00

NASD probing broker hedge-fund sales
Regulator focusing on sales to individual investors
By Alistair Barr, MarketWatch
Last Update: 12:29 PM ET Aug. 17, 2005

SAN FRANCISCO (MarketWatch) -- The National Association of Securities Dealers said Wednesday that it's investigating brokers' sales of hedge funds to individual investors.

"The marketing and sales of hedge funds to individual investors has been an on-going focus of NASD," said Barry Goldsmith, executive vice president of enforcement at the NASD, in a statement. "We are continuing to look at issues in this area but cannot comment on any of the specifics."

Goldsmith's remarks came after the Bloomberg wire service reported that the regulator sent letters in June to about 10 brokerage firms including Citigroup Inc. (C: news, chart, profile) , Merrill Lynch & Co. (MER: news, chart, profile) and UBS AG (UBS: news, chart, profile) inquiring about sales practices.

The NASD asked the firms what warnings they gave investors when selling hedge-fund products with minimum investments of $50,000 or less and whether they paid brokers sales incentives, Bloomberg reported.

The NASD said in its letter that the probe should not be construed as a sign that investigators have concluded that the firms violated rules or securities laws, the report added, citing a copy of the June 22 letter.

NASD spokesman Tom Holloman declined to comment on the letter or on which companies are being investigated.

Hedge funds have traditionally been been sold to wealthy individuals and institutions and sported minimum investment levels of $1 million or more. But new products have been developed in recent years with greatly reduced thresholds.

Merrill introduced a registered fund of hedge funds called Multi-Strategy Hedge Opportunities in late 2004 that invests in a range of underlying managers and has an investment minimum of $25,000. See full story.

NASD investigators are looking for evidence that the firms tried to sway nonprofessional customers to make unsuitably risky or expensive investments, Bloomberg said.

The NASD has cracked down on firms over hedge-fund sales practices in the past.

In October 2004, the agency fined Citigroup's brokerage unit $250,000 for distributing hedge-fund literature that didn't adequately explain risks or disclose performance properly. See full story.

Earlier that year, the NASD levied a $100,000 penalty against Turner Investments Distributors and charged Altegris Investments $175,000 for similar practices.

Alistair Barr is a reporter for MarketWatch in San Francisco.

HF Group Fights Back at SEC

2005-07-30T18:27:00.000-07:00

Hey, SEC Targets: Need a Hedge Fund Handout?
FORTUNE
Tuesday, May 31, 2005
By Barney Gimbel

If the SEC has broken down your door, seized your files, and frozen your bank accounts, help may be on the way—courtesy of hedge fund magnate Kevin Kelly. It all started in early February, when Kelly and his two former partners at Northshore Asset Management, a hedge fund in Chicago, were indicted for allegedly putting $37 million of investor money into shaky companies they had a stake in. Since then Kelly's bank accounts have been locked up, his company broken up, and his name splashed across the papers. All for what he says are bogus charges. "The way the SEC goes after people would scare most Americans," Kelly says. "They're thuggish. And the only way to keep the SEC in check is to have the money to fight back." (The SEC declined to comment.) Given that his own cash was not at his disposal, he, along with his lawyer and a close friend, recently set up the Alternative Investment Alliance, a 501(c)3 nonprofit foundation with the sole purpose of helping fellow accused fraudsters battle the SEC. Kelly claims fellow hedge fund types and a large investment bank plan to donate generously, and the group has even scheduled a celebrity golf fundraiser in Chicago later this summer (no celebs are confirmed as yet). While the foundation's first move will be to pay for Kelly and his partners' defense, they will consider bankrolling anyone indicted by the SEC. Given how fast that group is growing, they'd better hope for lots of celebrity golfers.

Spanish Hedge Fund Law Changes

2005-07-30T15:12:00.000-07:00

Saturday, 30th July 2005

Spanish Hedge Funds move closer to a reality

Friday, 29th July 2005 07:00 GMT

Jesús Mardomingo Cozas and Jorge Canta from the Banking Law and Financial Institutions Group at Cuatrecasas, Madrid, outline the changes in Spain.

Act 35/2003 on Collective Investment Institutions (“Act 35/2003”), implementing UCITS III, introduced a new scenario for the Spanish collective investment institutions (“CII”).

In order to develop this Act further, on October 13 2004, the Ministry of Finance published the first Draft Regulation on CII, which included one of the most eagerly-awaited developments: the regulation of hedge funds. However, it established requirements such as the calculation of daily NAV and the impossibility to invest in offshore hedge funds, which rendered the Spanish hedge funds market uncompetitive, since it was too restrictive.

On July 18 2005, a new Draft Regulation on CII (the “Draft”) was published. This incorporates some of the industry’s demands and establishes a less restrictive regulatory framework by, for example, eliminating the requirement for daily NAV and requiring the funds to provide it quarterly.

This Draft will now have to be discussed by the Council of Ministers before its final enactment (expected in October); however, the final wording of the Regulation is expected to be very similar to this Draft since, as we mentioned, all the comments made by the sector and the regulatory bodies have already been discussed and, in some cases, incorporated.

Both alternative investment funds (Free investment Collective Investment Institutions -i.e., single manager funds) and funds of alternative investment funds (Funds of Free investment Collective Investment Institutions - i.e., multi-manager funds) are provide for.

The principal characteristics of single manager funds and multi-manager funds are the following:

Single funds - Free investment Collective Investment Institutions

Whereas (in the first Draft) only institutional investors could acquire single manager funds, the new Draft establishes only a requirement of a minimum investment of EUR 50,000.
Marketing activities can only be carried out when addressed to qualified investors (the earlier version of the Draft established that no marketing activities could be carried out).
Minimum number of unit- or shareholders of 25.
Possibility of subscription and reimbursement in kind.
The NAV must be calculated quarterly. However, if it is required by the type of investments, it can be calculated half-yearly.
The subscriptions and reimbursements shall be carried out with the same recurrence.
There is no restriction on investment in any kind of assets, including credit derivatives, irrespective of which are the underlying assets. The only requirement is for the investment policy to follow principles of liquidity, diversification and transparency.
There is no restriction for derivative leverage.
Rules on maximum fee limits stated in Spanish legislation for CII are not applicable.
Possibility of indebtedness up to 5 times the value of the assets of the single manager fund.
Possibility of pledging the assets of the fund.
The risk management system shall include the performance of regular simulations in order to evaluate the effects of adverse market developments on the ability of the fund to fulfil its commitments.
Before acquisition of share/units of this type of CII, the investor shall declare in writing that he is aware of the inherent risks of this type of investment.
The Free investment Collective Investment Institutions have to be registered in a special registry at the Spanish supervisor (CNMV).
Funds of funds – Funds of Free investment CII

No limits on investors to whom product can be sold.
Minimum investment of 60% of the assets of the multi-manager fund in other Spanish Free investment CII or other similar foreign funds domiciled in OECD countries or funds whose management has been entrusted to a management company subject to supervision in an OECD country.
Maximum investment of 10% of the assets of the multi-manager fund in a single CII.
The NAV must be calculated quarterly. However, if required by the type of investments, it can be calculated half-yearly. The subscriptions and reimbursements shall be carried out with the same recurrence.
Legislation on maximum fee limits provided by Spanish legislation for CII is not applicable.
The Fund of Free investment CII has to be registered in a special registry at the Spanish supervisor (CNMV).
Before the acquisition of share/units of this type of CII, the investor shall declare in writing that he is aware of the inherent risks of this type of investment.
The Prospectus, Simplified Prospectus and all marketing material shall include information about the special risks that implies the investment in this type of CII.
According to the above, it seems that - finally - Spain should have a flexible regulatory framework for the launch of Hedge Funds. However, there are still some issues that need further clarification:
(i) the scope of the prime brokerage agreements that can be entered into by Spanish Hedge Funds,
(ii) whether the Spanish Multi-manager Funds can invest in Funds of Funds,
(iii) the actual meaning of “management company located in OECD” for the purposes of eligibilty for investment by Spanish Multi-manager Funds, and
(iv) which requirements would be imposed on the Spanish management companies that intend to manage alternative investment products.

© Copyright Hedgeweek 2005

UK FSA Concerns on "Megamanagers"

2005-06-24T16:35:00.000-07:00

U.K. Markets Regulator
Warns of Hedge-Fund Dangers

By DAVID REILLY
Staff Reporter of THE WALL STREET JOURNAL
June 24, 2005; Page C1

The United Kingdom's financial-markets watchdog warned that "some hedge funds are testing the boundaries of acceptable practice concerning insider trading and market manipulation."

As a result, the Financial Services Authority plans to take a more proactive stance toward hedge funds, in particular the so-called megamanagers who run billions of dollars in investments, the agency said in two papers released yesterday. The U.K.'s regulatory approach to the industry is particularly important as London is home to the vast majority of European hedge funds, lightly regulated investment pools open to institutional and wealthy individual investors. The papers will spark a debate in Europe's most important market as to whether there is a need for more stringent regulation. The FSA added that it was also concerned that the hefty fees hedge funds pay to investment banks could induce others "to commit market abuse."

The moves come as regulators around the world, including the Securities and Exchange Commission, are looking to step up their oversight of the funds, which now manage more than $1 trillion globally. In Europe, German Chancellor Gerhard Schroeder plans to call for global regulation of hedge funds at next month's U.K. summit of the leaders of the world's eight leading nations. (See related article1.)

In the two discussion papers that examine hedge funds and their impact on U.K. financial markets, the FSA didn't go so far as to propose new rules for hedge funds. The agency also noted that hedge funds play an important role in providing liquidity to markets and are an important part of the financial landscape. Hedge funds, for example, now account for between 30% and 40% of trading on the London Stock Exchange, Europe's biggest stock market, according to recent remarks by LSE Chief Executive Clara Furse.

But the FSA said that given potential risks posed by hedge funds, it plans to create a new unit that will focus specifically on them, while also undertaking "increased proactive surveillance" of both hedge funds and the banks that help them manage trading activities.

Some see tighter regulation ahead. "There's undoubtedly a risk that the ultimate effect will be a more intrusive regime for hedge-fund managers," said Peter Astleford, partner and co-head of the financial-services group at law firm Dechert LLP in London.

Although the FSA flagged potential abuses by hedge funds and investment banks, it didn't provide any direct evidence of wrongdoing or cite any firms. The agency currently is investigating trades at several hedge funds over potential abuses stemming from so-called premarketing by investment banks of sales of large blocks of stock or convertible bonds. It has yet to take any enforcement action on the issue.

Nor did the agency find that hedge funds pose an inherent, systemic risk to financial markets. It said there are risks from a potential blow-up of one large hedge fund, or from "a cluster of medium-sized hedge funds with significant and concentrated exposures." However, "the probability of an event on a scale that could significantly affect U.K. financial stability is relatively low," the agency said.

Write to David Reilly at david.reilly@wsj.com2

URL for this article:
http://online.wsj.com/article/0,,SB111956208657468015,00.html

Hyperlinks in this Article:
(1) http://online.wsj.com/article/0,,SB111957166538168279,00.html
(2) mailto:david.reilly@wsj.com

HF Insider Trading Through Lender Info?

2005-06-23T14:44:00.000-07:00

The New Insider Trading?
Carolyn Sargent
June 20, 2005

Insider trading" may conjure up visions of Martha Stewart selling shares of ImClone Systems Inc. after being tipped by the company founder, but today it's not the stock market that's under the most intense scrutiny for potential abuse of material nonpublic information. Even greater opportunity for misdeeds may lie in the more arcane world of bank, bond and credit derivative capital markets.

That hasn't always been the case. But the rapid evolution of the leveraged loan business, which originates and trades speculative-grade bank loans, has profoundly altered the credit landscape. In the past three years or so, the secondary loan market has grown from a fiefdom controlled by tightly regulated commercial banks and insurance companies to a fast-moving, highly liquid market played aggressively by hedge funds and Wall Street's proprietary trading desks. And this full-throated participation by new, lightly regulated investors in an instrument that increasingly trades like a security is raising serious questions about standards of trading conduct.

"So far, nothing terrible has happened. There have been no big blowouts. Now everyone is just hoping that something terrible doesn't happen before the industry figures it out on its own, so the regulators don't end up coming in," says Marc Baum, the founder of Solel Group, a consulting firm that counsels hedge funds on legal compliance and regulatory issues.

The crux of the issue is this: Companies have a much closer relationship to their lenders than to investors in their public securities, and they give those lenders private information that public investors never see. Called syndicate-level information, it might include a whole bunch of items that aren't "material" to a company's financial position-like quarterly compliance certificates. But it can also include material information, such as updated projections of revenues and earnings, or plans for an acquisition or divestiture. In the hands of a reasonable investor, such info would likely cause a change in the price of a public security.

Lenders of all stripes-commercial banks, insurance companies, mutual funds and hedge funds-have an obligation to keep all syndicate information confidential. But investors in syndicated loans are often also traders, and many trade bank loans next to high-yield bonds and credit derivatives. Some, especially hedge funds, use the same professional to trade all the financial instruments across a company's capital structure. Keeping private information private under such porous circumstances obviously is a challenge.

"Is private information being used to trade public securities? Or are these investors really on the up-and-up?" one hedge fund manager asks. "The rumors and innuendos are definitely out there. And that is the key issue. Until you can get some resolution, or a slightly thicker Chinese wall, there will continue to be speculation."

Finger pointing

Both investors and universal banks have ample opportunity to trade on material inside information. "If you talk to the commercial bank people, they'll point to the hedge funds and say they don't have good Chinese walls, that they're getting private information from the other side. And hedge funds say the trading desks at the commercial banks aren't very good at keeping information separate," says a market source who declined to be identified. "So there's a lot of finger pointing out there, and as a result increasing concern."

Often fingered first are hedge funds, who became major players in the leveraged loan market in the recent economic downturn, when many credits deteriorated and couldn't be held any longer by traditional pools of capital-those held by commercial banks and insurance companies. Because hedge funds are only lightly regulated, and because so many of them are start-ups with small staffs, many have not established rigid internal control and compliance functions like the universal banks, which are regulated by a host of entities, from the Federal Reserve Board to the Securities and Exchange Commission and even state regulators. "Hedge funds are frequently just eight people sitting in a room. They're just not staffed at the same size [as more established, regulated entities]. What that means is that historically, they just haven't thought through the issues," Solel's Baum says.

Worse, it is often a single trader at a hedge fund who deals in all of a company's debt instruments. "You can't put a Chinese wall through someone's head," says Michael Kaplan, a partner in the corporate practice at law firm Davis Polk & Wardwell.

Buyside sources say a trader could use the material nonpublic information received through a loan participation to trade the company's bonds, convertibles or even stocks. A trader could also use that knowledge to write credit protection in the credit default swaps market.

Traders can gain access to this information easily, and with just a small capital commitment. "A hedge fund might get into the loan business by buying very small amounts of loan syndications of various borrowers. And in so doing, the fund gets access to any information a bank would have access to: financial statements, growth projections and any renegotiations of covenants, or new covenants, or an update on the state of some type of negotiation" such as an acquisition, says one credit investor. "The temptation is great, and there is no barrier to entry."

Chris Dialynas is a managing director and portfolio manager at Pacific Investment Management Co., one of the world's top bond investors. He has written about the possible misuse of private information in the credit markets. Indeed, research that Dialynas authored in October 2002 "was directly responsible for the Joint Market Practices Forum," a consortium of industry associations that a year later introduced guidelines for the handling of material nonpublic information by broker/dealers, says Marjorie Gross, regulatory counsel for the Bond Market Association.

Dialynas believes that "the probability of acting on the temptation increases as the reward to people who might do the misdeeds increases." A large part of a hedge fund manager's compensation is based on a percentage of performance, he notes, "and that would give them a greater incentive to cross the barrier." The same principle would apply to a trader making bets for the proprietary account of a universal bank.

Such behavior would be less likely to occur at traditional investment managers, Dialynas argues. That's because most asset managers have a longer-term horizon, they don't get compensated strictly on performance, and generally they have more franchise risk, he says.

The information divide

That's not to say traditional credit investors don't have to cross this potential minefield, too. 40/86 Advisors, a Carmel, Ind., asset manager, invests in bank loans, high-yield bonds and collateralized bond obligations, or pools of corporate credit that have been repackaged into new securities bearing various levels of risk.

40/86 employs separate portfolio managers to run its bank loan and high-yield bond investments, but its managers share the same headquarters. To avoid the possibility of mishandling private, material information, 40/86-like a growing number of loan investors-chooses not to receive private, syndicate information in most cases. "We have a policy of remaining public, and if and when we make the decision to become private on a name, the name is identified and tracked on a restricted list. My concern is that these policies and procedures may not be in place universally to avoid the misuse of material nonpublic information," says Amy Gibson, vp in charge of 40/86's high-yield group.

An investor who chooses to be a "private" lender may receive material nonpublic information about the borrower. Antifraud provisions of the securities laws prohibit any investor from using private, price-sensitive information to trade the public securities.

But just because an investor refuses to receive syndicate information doesn't mean it isn't readily available, should he have a change of heart. "It's a little bit too much on the honor system right now," said one portfolio manager who declined to be identified. "Even though we are public right now, we could go out and ask for private information-and get it."

Self-policing, then, does not seem to be the answer, in part because private information can be so tantalizing. One hedge fund manager who focuses solely on credit opportunities says that he, too, refuses to receive private loan information-except in rare instances when a company has no outstanding public securities, and the only way to participate in a loan is to receive syndicate information. "When you participate in those deals, you get a glimpse of what other [investors] might be seeing about public companies, and it piques your curiosity, particularly on a complicated deal."

Given that insight, he says, he sometimes has to walk away from a deal if he thinks the playing field isn't level: in short, if he faces an information disadvantage that prevents him from making an effective judgment about the investment.

At least one big loan information provider has recognized the problem-and come up with a solution. IntraLinks Inc. makes information about many large U.S. bank loans available through an Internet-based document distribution system. Historically, investors agree, it has been very easy for so-called public loan investors to receive private information via IntraLinks simply by clicking on the icon for a folder that contained private documents. "The information is all on IntraLinks, and in theory it has been very easy to press the wrong button" to receive private information, says a loan investor.

But in late March, IntraLinks launched a redesign of the system's architecture to try to prevent investors from being accidentally exposed to private, material information. Now, lenders are required to self-declare as public or private investors before they gain access to any loan documents. Fund managers who identify themselves as public have access only to loan documents that the agent bank deems appropriate for public investors. The same goes for the correspondence they receive from the agent bank.

"This system allows syndicating agents to feel better about how they disclose information to their investors. And from an investor's standpoint, it provides them with greater safeguards to ensure they don't get accidentally tainted," says Andy Fieweger, IntraLinks' product marketing manager for debt capital markets.

The IntraLinks innovation does help agent banks and investors manage their information flow, but it isn't fool-proof-nor was it expected to be.

For one, as an increasing number of lenders have chosen to be public, agent banks and borrowers have found it difficult in some cases to secure the requisite number of approvals on credit amendments, according to market sources.

A good many credit amendments require approval from a simple majority, or 51%, of a company's lenders. But those that involve serious changes to a loan's terms-such as one that would decrease pricing-require approval from all investors. "If the company has designated the amendment as private, and the bulk of its lenders have designated themselves as public, then you have a quandary because there aren't enough lenders to vote" on the amendment, says Gibson of 40/86.

When that is the case, banks end up calling investors individually to solicit votes-an interaction that the buyside says can cause confusion. In April, Six Flags Inc. was looking for approval of an amendment to its $1 billion credit facility that would expand its letter of credit capacity and permit a separate financing for its Montreal facility, allowing the company to have Canadian dollar-denominated debt. The company designated the amendment as private and posted it as such on IntraLinks, says James Dannhauser, Six Flags's chief financial officer.

Looking for approval from the majority of the Six Flag lenders, agent bank Lehman Brothers wound up calling investors to solicit votes, a practice market participants say is not uncommon. One "public" lender was told that while the amendment was marked private, it didn't contain any material information, and thus it was okay to receive. The lender found that advice confusing. "If it didn't contain material information in the first place, why not make it public?" the lender asks.

Traditionally, banks have used standard language regarding confidentiality agreements when they launch a syndicated loan deal on IntraLinks. But banks are starting to customize that confidentiality language. Bank of America, for example, is implementing changes to include the requirement that lenders designate a recipient either inside or outside the firm-an attorney, for instance-to receive private information from the borrower or agent, which would ensure that the bank doesn't have trouble getting approvals in the future. "We felt we needed to explicitly require each lender to declare that they would have the ability to receive all communications from the borrowers," says Alex Spiro, associate general counsel.

IntraLinks is also testing a feature with a handful of buyside firms that would provide greater visibility to compliance officers and counsel on activities within their firm. "We have seen a growth in the number of investment firms wanting the ability to monitor activity with regard to what specific individuals are looking at what documents," says IntraLinks' Fieweger. For those clients, IntraLinks is now providing daily reports on activity across the firm's user base. It is planning to offer this service to a much wider audience, perhaps as early as this year.

Definitions misunderstood

To further complicate matters, many investors get confused about the definition of materiality, and exactly what "public" information means.

While well defined in securities laws, in practice the interpretation of materiality is always subjective. "One never knows whether something is really material until it is challenged or disputed," says one credit investor. "What might affect the value of a security in one situation might not affect it in another. If I saw a company's projections a year ago, am I still private, or has that point passed?"

The securities laws define public information as that which is widely disseminated. But what constitutes widely disseminated? Consider the information coming out of a bank meeting, in which commercial bankers meet with investors to share information about a borrower. These days, it is standard practice to ask public investors to leave midway through the meeting so that syndicate-level information can be provided to private investors.

"Clearly, a lot of things happen after a bank meeting ends. Calls get made, and loans start to move in the market," Baum says. "Based on which direction trades are taking, it becomes rather obvious to public investors what is happening. That raises the question as to whether that information is then really public."

The permeability of some information walls is underscored by the fact that more companies are choosing not to provide as much information to private investors as they have in the past. Notes Gibson of 40/86: "Too often the information in a private' lender call got out on the press wires within 20 minutes. So companies are now erring on the side of not sharing as much information, even though it is supposedly to private lenders." Some companies are also further stratifying information disclosure, choosing to share the most private information with only the managing-agent level of banks, market insiders say.

The tension is that "everybody wants to be on the safe side," Gibson says. "Our policies prohibit me from acquiring or accessing certain information, so, if I am not sure, I am not going to open an e-mail, and if a company is not sure, it will mark that correspondence private. Each party is asking the other to make the determination, which in some cases is forcing everybody into inaction."

Six Flags' Dannhauser concurs. "We mark everything private because we'd be stupid not to," he says.

Street questions, too

Investors aren't the only market participants under fire. "To the extent that a bank participates in the CDS market and is an underwriter or lender to that same name, it presents a natural conflict and a potential regulatory concern," says Pimco's Dialynas.

"We are not aware of any specific situations of abuse, but it is certainly a question that people ask," Gibson says. And, says a hedge fund manager: "Many investors have lingering questions with regard to banks' behavior."

In October 2003, a consortium of industry associations led by the BMA put out a statement of principles and recommendations regarding the handling of material nonpublic information for the U.S. market. Among others, those best practices include establishing written and formalized policies and procedures, an independent compliance function, the physical and functional separation of departments, procedures for communications across Chinese Walls and for restricted lists, watch lists and trading reviews.

In part due to those best practices, investors say they have more confidence now that broker/dealers have adequate safeguards to prohibit the transfer of material nonpublic information from their lending business units to the desks that trade bank debt, bonds and credit derivatives. By and large, banks are also perceived to have walled off from lending their credit portfolio management activities, or those operations undertaken to offset risk in their loan portfolios.

But no single model is evolving. When the BMA guidelines came out, Gross says, "firms were debating whether their loan traders and credit portfolio managers should be on the public side or the private side of the wall."

Earlier this year, JPMorgan Chase moved its bank-debt trading operations to the public side of the house, an effort that could avoid the perception of wrongdoing. But the fact that Citigroup, an archrival in both loan origination and debt underwriting, has chosen to keep trading bank debt on the private side simply underscores how fluid best practices may be.

Gross says a universal bank "can be in compliance either way, but it needs policies and procedures for making sure it is not misusing material nonpublic information, as outlined in the 2003 paper."

That said, a proprietary trader working for a broker/dealer could very easily find himself in rough seas. For example, says one market participant, that trader might consistently work with a certain hedge fund, and might have a strong suspicion-from seeing the fund's participations in lending syndicates and subsequent trades-that the fund is acting on material nonpublic information. "The second the fund puts on a series of trades-say, buying a small piece of a loan and then buying protection on it-it has transferred that information" to the trader, says one market participant. The trader who then puts on the same trades as the hedge fund could be viewed as having violated antifraud provisions of the securities laws, lawyers say.

Warnings in Europe

The potential for mishandling private, price-sensitive information is also getting attention in Europe. In late April, European banking groups warned members dealing in credit derivatives to maintain strong Chinese walls between their lending and trading departments or potentially face insider dealing charges. In May, those banking groups-including the International Swaps and Derivatives Association, the Loan Market Association and the BMA-published a manual of best practices similar to those introduced in the U.S. 20 months ago.

As in the U.S., there haven't been any public cases of insider dealing in credit derivatives brought against European banks thus far, but the measure may not be totally pre-emptive. A report published earlier this month by two researchers at the London Business School concluded that over the past four years, price movements in the CDS market indicate that some banks could be misusing private information to take trading positions.

Richard Metcalfe, senior policy director and co-head of ISDA's European office, says the paper's particular emphasis is on credit portfolio management, "because that is where the nub of the issue is. Questions are being raised about whether banks in the lending business could gain some advantage that would ultimately aid their credit portfolio management activities."

The guidelines were triggered in part by the European Union's Market Abuse Directive, which goes into effect on July 1. The paper tightens the definition of insider trading in many European countries and explicitly brings credit derivatives into the regulatory regime. As it stands, insider trading laws in some EU member states do not extend to securities not traded on public exchanges, such as credit derivatives, Metcalfe says.

Ahead of the curve'

In 2004, the Securities and Exchange Commission is said to have conducted a sweep of the major universal banks, including Citigroup, JPMorgan Chase, UBS and Credit Suisse First Boston, with the aim of examining the way leveraged loans are traded. The questions raised in that sweep have subsequently shown up in routine examinations of other broker/dealers, sources say. The agency's continuing interest in this topic has spurred the loan industry to be very proactive in formulating appropriate internal policies and procedures to prevent misuse of private, price-sensitive information.

A spokesman for the SEC, following its customary practice, declined to confirm or deny any investigative actions.

The BMA guidelines, aimed at the broker/dealer community, are seen by some as a good start. Those recommendations suggest that Chinese walls should exist between the people who are privvy to inside information through the bank loan market and those who are trading the securities and credit derivatives, and that those policies should be very rigid. Gross, the BMA's regulatory counsel, notes that the October 2003 forum paper-formally released by the Joint Market Practices Forum-"had nothing to do with pressure from regulators and everything to do with staying ahead of the curve with regard to all the legal and reputational issues that arise when a bank hedges its credit exposure to a company that gives it nonpublic credit information, by trading securities and security-based derivatives of the same company."

Pimco's Dialynas is impressed with parts of the proposal. But he and others have criticized the BMA guidelines because they don't include a mechanism to ensure that the recommendations are being implemented. "That begs the question whether there was anything significant to come out of [the guidelines] in a real sense. The recommendation was quite good, but again, if there is no policing mechanism, and penalties are not well stipulated, then there is always the temptation to cheat."

As a trade association, the BMA does not see itself as having a regulatory role. "The law provides penalties for misuse of material nonpublic information," says Gross. "We don't need to."

Meanwhile, the Loan Syndications and Trading Association is in the midst of a confidential process to "determine what guidelines, if any, should be developed in the broader loan capital markets," according to spokesman Jon Teall. Because the association takes in all participants in the loan market, it has a tough, and possibly long, road ahead to build consensus among players with a disparity of interests.

Materials handed out in an April LSTA seminar on the subject outlined an ambitious goal: "to establish general standards of trading conduct that are applicable to all market participants in connection with all loan market activities."

Are loans securities?

Heightened regulatory oversight of hedge funds could put the brakes on some dodgy trading practices. In February 2006, the investment advisers to most hedge funds must register with the SEC. As such, at least in theory, the funds will be subject to a physical walkthrough once a year by an agency examiner. Among other things, says Baum, "that means the SEC will look through a fund's records to figure out whether the fund has given the best execution to its accounts. And it will look at basic documentation, to make sure they're trading properly."

And then there's the possibility that loans traded in the secondary market will be deemed securities, which would cut off the flow of private information to lenders. It's a possibility former SEC Chairman Harvey Pitt believes is sufficiently real-and told LSTA members as much at its annual conference in late October.

The Supreme Court has ruled that traditional commercial loans are not securities. But that decision was premised on a number of assumptions, one of which was that there was an alternative regulatory apparatus-the Fed and the OCC-to oversee commercial banks, which at that time held the loans, securities lawyers said.

Today, "the real question is, Are these loans really loans, or are they securities?'" says one securities lawyer. The types of loans that hedge funds and mutual funds buy-called B-term loans-are structured more like a bond than a loan, with a bullet maturity and minimal amortization schedule, of, say, 1% a year.

"When you look at a term loan B, you don't have the alternative regulatory scheme that you have with commercial bank loans, because you don't have commercial lenders, you have hedge funds, which are all lightly regulated," the lawyer explains. "So now you have a whole bunch of people who are basically high-yield bond buyers who are buying loans and high-yield bonds and effectively viewing them as fungible. Clearly, the question arises as to whether they really may be securities."

And that's an outcome, however unlikely, that the leveraged loan market will fight at any cost.

(c) 2005 Investment Dealers' Digest Magazine and SourceMedia, Inc. All Rights Reserved.

http://www.iddmagazine.com http://www.sourcemedia.com

UK FSA On Individuals in HFs

2005-06-17T09:02:00.000-07:00

FSA is not poised to support retail hedge funds
Thu Jun 16, 2005 4:41 PM BST

By Tom Burroughes

LONDON (Reuters) - Britain's Financial Services Authority is not poised to support freeing up direct mass market sales of hedge funds as some recent media reports have suggested, a senior FSA official said on Thursday.

The regulator is due to publish discussion papers next week about issues affecting the $1.0 trillion sector (550 billion pound), hoping to shape debate about these fast-growing funds, Dan Waters, sector leader for asset management at the FSA, told an Investment Management Association conference.

He said the FSA was not about to urge a change in the law allowing direct investment in hedge funds by the public.

"The first thing to do is correct the impression that the FSA has decided to open the door to retail investment in hedge funds," Waters said. He did not elaborate on which reports had suggested such a change was on the cards.

Present rules restrict hedge funds to institutions or wealthy individuals able to invest a minimum sum, typically of one million pounds.

Last September the FSA said it was considering hedge fund regulations following steps to free up laws in some other European nations,

Hedge funds have grown rapidly as investors have been attracted by these portfolios' ability to make returns regardless of market movements due to techniques such as short-selling. However, the sector has suffered weak returns in recent months.

The FSA is also carrying out a survey of prime brokers to understand their financial exposure to hedge funds, and also assess the impact of the industry on market stability.

Activities of hedge funds have become a political hot potato in countries like Germany, where there have been calls for tighter controls on these traditionally secretive institutions.
--------------------------------------------------------------------------------

European Savings Directive HF Impact

2005-06-15T09:05:00.000-07:00

Handbook flags directive’s impact on hedge funds

IPE.com 15/Jun/05: IRELAND – The European savings directive on the funds industry will have an impact on Hedge funds and hedge fund of funds, according to a handbook from Dublin- and London-based funds consultancy Carne Global Financial Services.

The directive is due to come into force on 1 July 2005.

“Many hedge managers have taken a view that the directive does not affect any hedge funds,” said Carne CEO John Donohoe. “This is not true.”

The handbook notes that, depending on their domicile, hedge funds may be directly or indirectly affected by the directive.

Hedge funds domiciled outside specified territories, for example Bermuda and the Bahamas, do not appear to benefit from the directive’s exemption of UCITS-type funds. Consequently, if they are held by EU-taxable individuals and involve a cross-border payment, for example a redemption payment by a paying agent within the specified areas, such a payment could fall within the reporting or withholding tax requirements if the fund breaches the various asset tests. “

It also lists other complications for hedge funds, including:
Hedge fund of funds may require asset tests from the underlying hedge funds regardless of the underlying funds’ domicile, so hedge funds domiciled in the Cayman Isles or Dublin may need to supply asset tests even though they may be outside the scope of the directive;
Asset tests may be very complex especially where leverage or derivatives are used;
Long/short funds can hold considerable cash, thereby affecting asset test;
Many hedge funds are administered in Dublin or Luxembourg resulting in the paying agent being based within the EU.

“It is imperative that managers understand their ultimate investor base and be able to look through nominee accounts where possible to determine any impacts,” said Donohoe. “Where a fund may be directly or indirectly impacted the manager should determine the need for investor communication and ensure full compliance with the directive.”

Copies of the handbook are available from John Donohoe at john.donohoe@carnegroup.com or on +353 1 489 6800.

Greenspan on HF Regulation

2005-06-09T18:17:00.000-07:00

American Banker: The Financial Services Daily
Greenspan: Giving Hedge Funds New Rules Won't Work
From:
Friday, May 06, 2005
By Barbara A. Rehm and Rob Blackwell

CHICAGO -- Federal Reserve Board Chairman Alan Greenspan warned bankers Thursday to demand more of their hedge fund customers, while U.S. Bancorp chairman Jerry Grundhofer warned against following nonbanks down a slippery slope to a pile of problem credits.

Mr. Grundhofer said competition for commercial credits is fierce, with hedge funds and other nonbank lenders making pricing irrational.

"There is margin compression everywhere," he said in a luncheon speech at the Federal Reserve Bank of Chicago's annual Conference on Bank Structure and Competition.

U.S. Bancorp accepts that and attempts to make up for lower rates with higher volume, he said, but that's "a tough call, a tough line to walk." U.S. Bancorp is trying not to "reach too far for marginal credit." But some nonbank rivals, including hedge funds, are not as disciplined, he said.

"Overall credit standards have deteriorated. Certainly pricing has, and we're starting to see problems with structure as well," he said in an interview after his speech. "They may be the smartest underwriters on Earth," he said of hedge funds. "We'll see who's right and who is wrong."

U.S. Bancorp is "trying to be aggressive on pricing, and get new business, but not fool around with" changes in loan terms and conditions, he said.

Mr. Greenspan said that banks had made "considerable progress" in strengthening oversight of their relationships with hedge funds since the fall of Long-Term Capital Management in 1998.

But he said a recent central bank study of banks' management of hedge fund credit risk found several "weaknesses."

"Competitive pressures may be eroding the protection that banks achieve through collateral requirements by reducing the initial margins that they obtain from hedge funds," Mr. Greenspan said. "The review suggests that banks and their supervisors need to be alert to the possibility that further slippage of credit terms could result in material increases in credit risk to banks, a material loss of market discipline on hedge funds, and a material increase in the potential for hedge fund leverage to adversely affect market dynamics."

Mr. Greenspan urged bankers to persuade hedge fund managers to provide more information about their portfolios, including "forward-looking measures of the risks that the funds are assuming."

"Most banks' policies," he said, "could be improved by the establishment of clearer and firmer links between credit terms and transparency."

Mr. Greenspan also urged bankers to aggregate stress-test results across hedge fund counterparties "to assess concentrations of exposures in volatile and illiquid markets."

However, Mr. Greenspan said he opposes ramping up regulation of hedge funds. Any additional disclosure requirements would be fruitless. "Most of the data would tell you their strategy of last night. This morning they would have a new one. It's their very nature to be innovative and ever-changing," he said during a question-and-answer session.

Speaking on other risks to the financial system, Mr. Greenspan said concerns that credit derivatives have transferred too much risk outside the banking system appear to be overblown.

There were $4.5 trillion of the derivatives as of June, and some experts have become concerned that losses to nonbank risk-takers could force them to liquidate their positions if credit spreads widen appreciably.

But Mr. Greenspan cited a study conducted last year by the Joint Forum that said the notional values of derivatives had "significantly overstated the amount of credit risk that had been transferred outside the banking system."

Mr. Greenspan also reiterated his position that the mortgage portfolios of Fannie Mae and Freddie Mac should be reduced.

But instead of recommending specific caps, as he has done in the past, Mr. Greenspan said he agreed with Treasury Secretary John Snow's recommendation that a proposed new regulator for the GSEs have power over the portfolios and get specific guidance from Congress on how to treat them.

"Specifically, the GSE should hold only the minimum level of assets needed to accomplish the primary missions mandated by their charter," Mr. Greenspan said.

Goldman Sachs Conflicts w/HFs and Clients

2005-06-07T08:29:00.000-07:00

Sensitive Boundaries
Goldman Faces New Tensions
In Trading, Serving Hedge Funds

Salesmen Both Advised Clients
Of Firm and Influenced
Its Own Bets on Market
Word of a Stock Sale Leaks
By ANITA RAGHAVAN
Staff Reporter of THE WALL STREET JOURNAL
June 6, 2005; Page A1

LONDON -- One day two years ago, as Goldman Sachs Group was readying a sale of millions of shares held by German industrial giant Siemens AG's pension arm, the stock started falling, suggesting that word of the deal had leaked. Early word of it would have given an investor valuable information that the stock was about to face downward pressure.

When Goldman investigated, it found that a managing director in its London office had tipped off an important hedge-fund client of the firm. While it didn't appear the tip had caused the stock's fall, Goldman fired the managing director.

The incident opened a window on new tensions inside investment banks as their business models shift. When stock markets are flush, as in the 1990s, big securities firms like Goldman rake in cash by underwriting numerous new stock offerings for corporate clients and collecting commissions from stock investors. The bursting of the stock-market bubble in 2000 hurt both of those traditional mainstays. Goldman and its rivals have since looked increasingly to other activities that could still offer rich profits.

One of these is playing the markets with their own money, known as proprietary trading. Another is serving the one set of clients that still provides lush trading commissions: hedge funds, or lightly regulated investment pools for institutions and the rich. In the increasing focus on these lines, new possibilities for conflicts of interest arise. The tensions are well illustrated at Goldman's stock-trading operation in London, which has been aggressive in pursuit of these activities.

Goldman hasn't drawn any regulatory flak for its practices here. But in some cases it has faced questions about its practices from within its own ranks. It also has discontinued some of them. Goldman says employee concerns weren't the reason, while adding that it always investigates such concerns.

A look at the London stock operation shows how the big securities firm has periodically reassessed its practices as it seeks to find the proper boundaries. "Changing market dynamics bring new challenges," says a Goldman spokesman, "and we are particularly mindful of the way in which we conduct business."

In 2002, the London office set up a small group of stock traders, taking proprietary positions, who sat near the salesmen and traders who handled transactions for clients. Many securities firms physically isolate their proprietary traders, to make sure they don't overhear clients' orders and take unfair advantage of the information.

Goldman, for a time, also gave this set of traders access to a computer system that showed client buy orders and sell orders. (Client names were usually omitted.) No rules bar such access. But some former Goldman traders and salesmen say this practice posed a risk that the traders would be tempted to jump in with their own orders ahead of clients. That could put the investment bank in the position of profiting from trades that in turn drive up the cost paid by clients.

"It's only logical that banks would use information they glean from clients such as trading intentions...to support their own proprietary-trading activities," says Richard Kramer, a former top-ranked Goldman analyst now at Arete Research in London. Indeed, he says, "we think proprietary trading could be the next scandal" in financial services.

In another move, Goldman allowed stock salesmen who gave investment ideas to an important hedge-fund client to contribute some of the same ideas to Goldman traders taking proprietary positions. Here, one concern was that Goldman and the hedge fund could benefit at the expense of less-favored clients who might be pitched these same ideas later.

In later discontinuing these practices, Goldman says it found no evidence its traders had acted improperly. It also said its reason for putting traders who took proprietary positions adjacent to salesmen wasn't to overhear client orders.

For hedge funds, Goldman and other major securities firms offer a wide array of services: executing hedge funds' many trades; lending them money; lending them shares to "short" when they want to bet on a stock to fall; sometimes investing in the funds; and providing them with research and investment ideas for sometimes-complex trades.

Wall Street and hedge funds "are feeding off each other -- the broker-dealer needs the order flow from the hedge fund and the hedge fund needs the information," says Matthew Nestor, a former Massachusetts securities regulator. Goldman got more than a third of its stock revenue last year by doing business with hedge funds, according to a Merrill Lynch & Co. analyst's estimate. Goldman has no comment on that.

At the forefront in nurturing Goldman's ties to hedge funds in London is Phillip Hylander, chief of its European stock-products group and head trader in Europe.

Until Mr. Hylander arrived at the London office in 2002, its top traders -- the people who actually execute trades -- shied away from speaking to clients during market hours. Client interaction was left to stock salespeople.

Direct trader-client contact is risky, says Gary Williams, who was Goldman's European stock-trading chief until the end of 2001. The reason is that each side often has information the other would like to know, but some of this may be confidential, such as how a competitor's deal is faring or insight into the placing of a block of stock. "Head traders are privy to information that neither clients nor those speaking to clients should know," Mr. Williams says.

But one of Mr. Hylander's strengths when Goldman hired him as a trading executive was his close relationships with hedge funds. Colleagues say they often heard him on the trading floor chatting with clients, using his cellphone. And after the botched 2003 stock sale for Siemens, Goldman investigated whether Mr. Hylander might have used his cellphone to tip a client to the impending sale. It concluded he hadn't.

Goldman says it's no longer out of the ordinary for traders, at Goldman or elsewhere, to talk to investment clients. "Our clients want to talk to traders to get a sense of the market," says J. Michael Evans, co-head of Goldman's global securities division. Mr. Hylander, for his part, says he talks to clients because "they demand it. It would be a mark against you if you didn't."

Mr. Hylander, 36 years old, was behind some of the proprietary-trading initiatives, such as setting up a small group of traders who sat on the mammoth stock-trading floor and made bets with the firm's own money. He encouraged stock salesmen to tell the proprietary traders if they had gleaned "useful information" from dealing with clients, according to three people familiar with the situation.

Asked about this, Mr. Hylander said, "There is a very pure reason for people to talk to each other, and that was the context for this remark." A Goldman spokesman, Lucas van Praag, elaborated, saying, "An important component of every broking business is open debate about investment ideas...internally with colleagues and externally with clients.... Needless to say, this sharing of information does not include anything price-sensitive or otherwise inappropriate."

This group of traders was known as the Risk Unit. Mr. Hylander says it had been set up not just to do proprietary trading but primarily to "manage franchise risk," and for that reason it needed access to client orders.

Still, the firm took away the Risk Unit's access to client orders in October 2003, a year after giving it access. Goldman did so to "avoid any perception of impropriety," its spokesman says. Several months later, in 2004, it closed the Risk Unit altogether. Mr. Evans says this was because "it wasn't making money."

Mr. Hylander also gave salesmen -- the people who pitch investment ideas to clients -- a say in investing a small amount of Goldman's own money. They could contribute ideas to proprietary-trading portfolios that bore their initials.

'I Just Tipped It'

One of Mr. Hylander's client relationships was with a London hedge fund called Marshall Wace Asset Management. Colleagues tell of hearing him chatting on the trading floor with a founder of the fund, Ian Wace. Mr. Hylander and Mr. Wace, through spokesmen, describe their conversations as infrequent.

Mr. Hylander set up one proprietary portfolio that traded in some of the stocks Goldman salesmen had recommended to Marshall Wace. The portfolio was called MW TIPS. After making a recommendation to the fund, a Goldman salesman would sometimes tell a proprietary trader what the recommendation was, saying, "I just tipped it," according to people familiar with the situation.

An arrangement like this can disadvantage other investors, says John Wheeler, head trader at the American Century mutual-fund family. "Any time someone you rely on to provide investment advice contributes to [proprietary] investments in similar securities, there is an inherent conflict," he says. One risk is that the firm would later promote the same stocks to less-favored clients -- whose subsequent buying would boost the value of holdings for the securities firm or its favored hedge-fund client.

Mr. van Praag, the Goldman spokesman, says the firm didn't "sequence our sales ideas" to favor any one client, such as Marshall Wace. He says Goldman required traders who'd been told of a recommendation to Marshall Wace to wait 30 minutes before making a trade for Goldman's account in the same security. One reason was to give clients time to act on the trading idea first.

He adds that there was no direct correlation, in either timing or the direction of trades, between ideas recommended to Marshall Wace and trades made in the MW TIPS proprietary portfolio. Indeed, the Goldman spokesman says in an email, at times a Goldman "salesman might have suggested MW buy the stock [and] our traders might have shorted it."

A spokesman for Marshall Wace says it "does not and cannot prevent or monitor securities firms trading on their own ideas."

One Goldman trader, Boris Pilichowski, complained of being uncomfortable trading for the MW TIPS account, say people familiar with the matter. Besides sharing the concern Mr. Wheeler describes, Mr. Pilichowski had an additional one: That some trades might be based on information about other clients' intentions. He suggested that ideas from salesmen be sent to traders electronically, creating a record of where they originated and forcing salesmen to be sensitive to any possible impropriety.

Mr. Hylander raised the trader's concerns with compliance officials. Goldman says it looked into them and found no evidence of any abuses. It also says it assured Mr. Pilichowski, who moved to Morgan Stanley this year, that he had total discretion about whether to do trades proposed by the stock salesmen.

Goldman didn't adopt his suggestion about sending ideas electronically. It disbanded the MW TIPS account in May 2004. One reason was a new United Kingdom rule that said ideas from salesmen could potentially be viewed as research, which securities firms generally can't trade on until it's published.

Another Goldman trader raised concerns about how the firm behaved when approached by an institutional client that wanted to buy or sell a basket of stocks. Such a client will often ask firms to bid to handle the deal, without naming the stocks or saying whether it wants to buy or sell. But securities firms can often guess, based on their knowledge of the client and on questions the client asks about a particular sector. The securities firms then sometimes quickly start loading up on -- or dumping -- the stock. The practice is known as "pre-hedging."

Goldman sometimes pre-hedges. It says it doesn't do so if clients object.

Last year, according to people familiar with the situation, Goldman trader Geoffroy Houlot told Mr. Hylander he thought pre-hedging hurt clients, because it could move stocks' prices before clients' trades took place. Goldman says Mr. Hylander raised Mr. Houlot's concerns with the compliance department, which found no impropriety. Mr. Houlot left to rejoin his old firm, Morgan Stanley, last year.

Following questions this year from The Wall Street Journal, Goldman retained a law firm to review activities of its London stock group. The law firm, Freshfields Bruckhaus Deringer, declines to comment.

Sale for Siemens

The loudest internal complaints concerned the stock sale for Siemens on March 18, 2003. Siemens had decided to sell 36 million shares its pension arm held in a firm called Infineon Technologies. Goldman's role was to buy the Infineon stock from Siemens in a block, unloading it to other investors later.

That morning, the two sides discussed a possible price in a moving market. But shortly before 3 p.m., with the sale approaching, Infineon shares started to slide. On the Deutsche Börse's electronic Xetra exchange, they traded around €7.55 at 2:52 p.m. By 3:39 p.m., when the sale was announced, they were down 5% to €7.15. The result: Siemens got several million dollars less than it had expected. Goldman itself lost millions of dollars, because after it had become the owner of the shares, they continued to decline.

Goldman later said in a regulatory filing that a managing director of the firm named Andrea Casati had alerted a client about the imminent offering. "We reviewed people's taped lines and discovered that he had shared this information with a client just before the trade was launched," says Goldman's Mr. Evans.

Yet he adds that the "conversation didn't seem to have had any effect on the price" of Infineon's stock. That left the cause of the drop still unknown. Goldman told regulators that the tip occurred less than two minutes before the Infineon sale, and that the client said it hadn't acted on the tip. The client, hedge fund GLG Partners, declines to comment.

Goldman discharged Mr. Casati, a top-producing stock salesman, for violating policy. It reported the matter to the U.K.'s Financial Services Authority and other regulators. Mr. Casati, now at UBS AG, declined several requests for comment on Goldman's account.

Cellphone Logs

Goldman says it investigated all involved in the trade, including Mr. Hylander, the top trader who often used a cellphone on the floor. A Goldman executive says there was "whispering, rumors of people pointing fingers at a number of people, including Phil, over this trade." The executive says the firm sifted through cellphone logs and other records and found "absolutely nothing" to suggest Mr. Hylander behaved improperly.

Mr. Hylander says that on the day of the Siemens deal he used his cellphone to talk to his senior management, not to clients. He and a Goldman spokesman say Mr. Hylander, far from tipping off an outsider who could profit from knowledge of the sale, urged that the sale be aborted when Infineon shares started falling.

The internal inquiry couldn't delve into stock-exchange records that would have pointed to who was selling Infineon shares at the time in question. Only regulators have access to such records.

One Goldman executive questioned whether the firm really did a thorough probe. Christian Meissner, concerned about Siemens's unhappiness with the stock sale, pushed for a fuller inquiry, says someone familiar with the matter. This person says Mr. Meissner -- then co-head of European stock capital markets for Goldman and now working at Lehman Brothers -- pressed Goldman's compliance department to examine cellphone records more carefully. The person says Goldman lawyers rebuffed Mr. Meissner and told him to let the matter go.

A Goldman executive acknowledges telling people inside the firm to "let it go," adding that "there was a lot of whispering and gossiping that I thought was destabilizing." The executive says the firm did a complete investigation, including a full look at mobile-phone records.

Actually, Goldman had a policy barring traders from using mobile phones to talk business with clients. Many firms encourage use of land lines, since their calls can be taped. After its inquiry, Goldman reiterated its policy against using mobile phones on the trading floor to talk business with clients. Later, it barred all use of mobile phones on the trading floor.

Mr. Hylander says he has a duty to lead by example, and is following the newest mobile-phone policy. Without that ban, he says, "we were putting ourselves in a place that we didn't want to be."

Write to Anita Raghavan at anita.raghavan@wsj.com1

URL for this article:
http://online.wsj.com/article/0,,SB111800860909751205,00.html

Hyperlinks in this Article:
(1) mailto:anita.raghavan@wsj.com

Greenspan Speech on HF Risks

2005-06-07T08:05:00.000-07:00

washingtonpost.com
Greenspan Sees Threat in Free-Trade Curbs
Fed Chief Also Warns of Possible Losses From Risky Trading Strategies

By Nell Henderson
Washington Post Staff Writer
Tuesday, June 7, 2005; D06

Federal Reserve Chairman Alan Greenspan said yesterday that recent efforts to restrict international trade and hinder free markets represent a "truly worrisome" threat to global prosperity.

He also warned that many hedge funds -- highly leveraged private investment firms -- are pursuing high-risk and complex trading strategies that could result in significant losses. He added that he did not believe those losses would be significant enough to pose a threat to broader financial stability.

Speaking via satellite to a bankers' conference in Beijing, Greenspan did not mention specifics. But his remarks come at a time of increasing tension between the United States and China over textile trade and China's unwillingness to let its currency's value fluctuate.

Greenspan warned that he and other economic policymakers cannot always foresee and prevent financial crises. The best insurance against such events is to promote financial "flexibility and resilience," he said.

Financial "flexibility" is Greenspan's shorthand for policies that allow free markets to drive the movement of prices, interest rates, currency values, labor and investment. Such policies have made the U.S. economy highly resilient, as was clear by the way it was able to absorb the shocks of the Sept. 11, 2001, terrorist attacks, he said.

Greenspan did not comment otherwise on the health of the U.S. economy or the likely path of the Fed's interest rate policy in coming months.

But he did express concern that the U.S. and global economies could be hurt by the movement away from financial flexibility. "The recent emergence of protectionism and continued structural rigidities in many parts of the world are truly worrisome," he said.

The Bush administration and the European Union, responding to a surge in Chinese textile exports, recently imposed new limits. Beijing responded by lifting textile export tariffs that it had earlier imposed on United States- and Europe-bound goods as a goodwill gesture.

Meanwhile, the U.S. and some European governments are taking an ongoing dispute over aircraft manufacturer subsidies to the World Trade Organization. And President Bush faces an uphill battle to win congressional ratification of his proposed free-trade agreement with Central America.

Greenspan didn't spell out what he meant by "structural rigidities," but many economists would point to China's currency peg as one obvious candidate. China maintains the value of its currency, the yuan, at 8.28 per dollar, a rate many U.S. manufacturers complain is too low, unfairly boosting Chinese exports in global markets.

The Bush administration has urged China to relax its peg, stepping up the pressure recently by threatening to brand Beijing a currency "manipulator" in the future if it does not do so.

Greenspan, responding to a question after his prepared remarks, said it would be "to the advantage of the Chinese to allow a little more flexibility in its exchange rate" and added, "I'm sure it's something they will take on reasonably soon."

He also indicated he hasn't found a convincing explanation for why long-term interest rates are so low globally. The Fed has raised short-term U.S. rates steadily for nearly a year, and long-term rates typically follow. This time they have fallen, a situation he said "is clearly without recent precedent."

"Yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than Treasurys over the same period," he added.

Greenspan said this phenomenon has caused increasing numbers of investors -- often operating through hedge funds -- to take greater risks in their "search for yield," or efforts to make a bigger profit, he suggested.

"But continuing efforts to seek above-average returns could create risks for which compensation is inadequate," he said. Put more bluntly, "the hedge fund industry could temporarily shrink, and many wealthy fund managers and investors could become less wealthy."

But, he added, if banks and the others who lend money to hedge funds are managing their credit risks effectively, "this necessary adjustment should not pose a threat to financial stability."

Research Transparency/Soft Dollar Issues

2005-05-23T07:47:00.000-07:00

Broker Research: What's It Worth?

Apr 26, 2005
URL: http://www.wallstreetandtech.com/showArticle.jhtml?articleID=161600239

With the Securities and Exchange Commission expected to rule on the use of soft dollars in June, the securities industry is hoping that the SEC will clear up the uncertainties surrounding the controversial practice and determine once and for all who is responsible for placing a value on proprietary research. In anticipation of the ruling - which, at a minimum, likely will result in more transparency into how buy-side firms are spending investors' money - buy-side firms are beefing up their internal controls to track their commission payments for executions versus third-party research.

The challenge, however, is figuring out how much the sell side's research actually is worth. But the SEC may go a step further than just requiring increased transparency into brokerage commissions and force brokerage firms to "unbundle," or break out, the prices they charge for executions, proprietary research and capital commitment individually.

Generally, soft dollars refer to the portion of a brokerage commission paid by money managers that is used to cover third-party research services, such as market data and investment analysis tools. Under section 28 (e) of the Securities and Exchange Act of 1934, known as the safe harbor rule, a manager can "pay up" for a trade - pay more than the lowest price to buy or sell a stock - if the manager believes the research will add value to the investment process. Asset managers must be in compliance with the safe harbor rule to justify soft-dollar transactions.

Today, bulge-bracket firms charge a bundled commission - four, five or six cents a share, for example - that covers the cost of both the execution and proprietary research. If the SEC rules for greater transparency, the buy side will have to come up with a process to value the sell side's research. However, if unbundling is mandated, the burden will shift to the sell side, as it will be required to put a price tag on its proprietary research (which includes research reports, analyst calls and conferences to which brokers have access) before charging its buy-side counterparts. According to industry sources, a mandate to unbundle commissions could reshape the brokerage and money management landscapes.

Prepping for Transparency

Although the outcome of the ruling still is in doubt, most believe the SEC will rule in favor of soft-dollar transparency. As a result, the buy side is scrambling to get technology and processes in place to ensure that it can track trading commissions and come up with a process to value research.

Currently, to calculate their commission budgets, buy-side firms typically conduct what's known as a "broker vote," an internal process in which all of a firm's portfolio managers, analysts and traders qualitatively assess the value of the various services provided by different brokers and decide which firms' services they want to buy. Asset managers may develop their own voting system based on internally developed qualitative factors, using points or a ratings system.

For example, Darren Bodenhamer, head trader at JMP Asset Management, a San Francisco-based hedge fund, relates, "We have a quarterly voting process in which we quantify the value of research and execution from each broker. We're all involved in the process."

To augment the process, buy-side firms are ramping up their systems to help them track executions and value the research and other services they receive from brokers. Bodenhamer notes that his firm purchased Traders Console, an order management system developed by Boston-based Eze Castle Software, to track its commission payments to brokers. The system allows the hedge fund to break out commissions by using labels such as "r" for research, "e" for execution and others, he explains.

Another buy-side firm enhancing its technology in preparation for the SEC's ruling is The Boston Company Asset Management. To make its commission budgeting and allocation process more rigorous, the asset manager implemented Eze Castle's Commission Optimizer. The firm now is in the early stages of tracking and evaluating what it consumes from sell-side research.

"With the regulatory environment moving toward increased disclosure on third-party soft dollars and toward an unbundled structure on proprietary research, we needed to go beyond having an anecdotal, subjective assessment twice a year that didn't integrate the actual interactions we were having with our brokers and their actual inputs we were using from brokers as part of proprietary research," says David Brooks, head trader at The Boston Company Asset Management.

Now, the investment firm uses the commission management system to track all of its interactions with brokers more dynamically, notes Brooks. "We're trying to get a much better handle on what we're consuming and what is the value of what we're consuming," he says. To track the interactions that portfolio managers are having with brokers on a daily basis, assistants enter the data into Commission Optimizer. When a broker introduces the investment firm to a company's management, or a sell-side analyst stops by the firm, or the broker sponsors a conference, or the firm takes away ideas from a conference call, the information is logged into the system. The firm is not yet tracking written research, however, "because the volume of product is too immense to track," says Brooks.

Scrutiny from All Sides

Aside from regulatory pressures, buy-side firms are facing scrutiny from pension fund clients, independent boards of directors and trustees about why they are paying commissions to various brokers and whether they are getting value from the research, according to Donna Anderson, director of research at AIM Investments, a Houston-based mutual fund manager with about $141 billion in assets. "We're not necessarily setting a price on research - we're trying to quantify the value we get from research and we're trying to send it to our internal management and to our own internal board of trustees," she says, adding that "When it comes to firms that have a bundled execution and research product, we need a way to rate the information we're getting as well as the executions we're getting."

As a result, less than a year ago, AIM purchased a system called ResearchTrak from Cogent Consulting to help the firm understand its total commission picture. Prior to implementing the system, under pressure from the mutual fund company's board of trustees, AIM had revamped its voting structure for the purpose of more clearly differentiating its brokers, Anderson relates.

AIM is using its Web-based system to track proprietary research services down to the individual resource level, with the hope of placing a value on brokers and their research. A resource can be a specific analyst, a conference or set of conferences, a specific quantitative tool or a data set, Anderson says. The software provides a detailed menu of resources provided by every brokerage firm. The fund management firm populates the system with the names of all the analysts at every brokerage from a database provided by Starmine - a San Francisco-based company that measures the performance of sell-side analysts - and conducts a vote twice a year. The head of research administers the vote, which includes all the portfolio managers and analysts; the trading group conducts a separate vote on the execution and sales trading relationship.

How Much Is That Research in the Window?

By using the technology to create a more detailed voting process, AIM has been able to place a value of sorts on its brokers and thus on its research. ResearchTrak has allowed AIM to create a scorecard with which to identify brokers' strengths and weakness. The firm communicates to its brokers how individual analysts rank by sector or company versus their peers. This type of feedback is appreciated by brokers and helps asset managers work in partnership with Wall Street firms as it gives the brokers specific tips on how to improve their rankings to compete for more commission dollars.

Money managers use the voting process to set commission targets for each broker, and they may put brokers in different tiers. If the OMS system is feeding trades into the commission management system, a buy-side firm can see where a broker ranks on a commission basis against the targets and compare the broker's commission ranking to its research ranking, which asset managers base on quality or perceived value. "Clients look very closely at the disconnect there," says Robin Hodgkins, president of Summit, N.J.-based Cogent Consulting. "Better-rated brokers should be getting more of your commissions," he says. "If a broker is providing better service, their commission should be going up, and if they're providing worse service, their commission should go down."

Although several buy-side firms have found technology to help them track commissions, and even place relative values on research - certainly a step in the right direction - the biggest challenge still remains: actually placing a price in dollars and cents on the research. Despite buy-side firms' efforts, pinpointing the value of proprietary research remains a conundrum because the sell side doesn't break out the pricing. "The sell side, up until this point, has not been too helpful in providing guidance on these inputs," points out The Boston Company Asset Management's Brooks.

Using buy-side OMS platforms like Traders Console - such as those from OMS providers Charles River Development, Macgregor, Linedata Services and Latent Zero - to record the commissions on each trade, buy-side firms can tag their trades and broadly classify the different groups into buckets, adds David Quinlan, president of Eze Castle. In addition, commission-tracking systems, such as Eze Castle's Commission Optimizer, Financial Sockets' BrokerVote and Cogent's ResearchTrak, enable the buy side to compare actual trading commissions against their soft-dollar targets.

But, while a firm can record that it completed a four-cent trade with a particular broker, of which one cent was for the execution and the other three cents paid the broker for research-related services, the firm can't break down with any granularity for what services the three cents paid. "What's the research worth? That's the piece that's still missing," Quinlan says.

How Will the SEC Rule?

The consensus among industry sources is that the SEC definitely will call for greater transparency regarding soft-dollar spending. But, buy- and sell-side firms are waiting to see if the SEC will place the onus on the sell side by requiring the brokerage community to unbundle its services and disclose the price of its research versus executions.

David Tittleworth, executive director of the Investment Adviser Association (formerly the Investment Counsel Association of America; ICAA), isn't convinced that the SEC will require unbundling. "I think it's appropriate for the brokers to value [research], but I'm not convinced we've won that battle at the SEC," he says.

According to a Bear Stearns report issued in March, "The SEC's most likely action will be to increase disclosure and transparency - while possibly narrowing the definition of soft dollars." But, the report adds, Bear Stearns analysts "believe the SEC is seriously considering further rules regarding unbundling of commissions - or placing value on proprietary research, execution and capital commitment."

"U.S. brokerage firms are in the midst of creating a menu of services," continue Daniel Goldberg and Andrew Lee, the Bear Stearns analysts who authored the report. For example, rather than charge a bundled rate of five cents per share - which includes research, execution and capital commitment, among other services - the brokers soon could be required to break out that five cents per share into two cents for research, 1.5 cents for execution and 1.5 cents for capital commitment, the report says.

Without unbundled pricing, according to Cogent Consulting's Hodgkins, firms "have no decent way to put a value on the research they're getting." For example, "You can have three calls from an analyst on one day - two can be meaningless but the third call can be priceless. How do you price those calls?" he asks. "That's the dilemma in having an a la carte price list for this kind of very subjective research."

The ramifications of unbundling services are huge for sell-side firms since any movement toward unbundling would shake up their business model. "It wouldn't surprise me - with the devaluation of the business model on the sell side - that brokers have already started understanding what their cost structure is in providing the trading services as opposed to research," says John Feng, a consultant at Greenwich Research. He cautions that unbundling will have unintended consequences, however. "Given the decline in the commission pool, the sell side has been rationalizing research," he says, and its research budget has been shrinking. "Brokerage firms have to be realistic about their business and determine which accounts are profitable to serve."

If regulators were to require brokers to unbundle commissions, it could lead to increased use of low-cost algorithmic trading tools by the buy side, resulting in price wars among brokers, note the Bear Stearns analysts. As unbundling of commissions evolves, sell-side firms would be forced to provide a menu of services reflecting a breakdown in the pricing of executions, research and capital commitment so that asset managers could pick the services they want. This could lead money managers to buy less proprietary research and therefore reduce their commission payments to brokers, which could in turn force brokers to slash their research coverage and impair the quality of available proprietary research.

Balancing Act

From the investment managers' point of view, a balance needs to be struck between ensuring that they get good service - including good research coverage and idea flow - while minimizing costs. "Slashing trading costs without being mindful of other repercussions may not be advisable," Greenwich Research's Feng warns. The resulting decline in broker commissions could lead brokers to cut their research budgets further while focusing their efforts on their most profitable clients. This could lead to an overall drop in the quality of research and services available to the buy side.

Still, industry sources assert that brokers' commissions need to be more transparent. "Investors should have an opportunity to see how their commission dollars are spent between execution and research," says The Boston Company Asset Management's Brooks.

"It's a difficult exercise when you talk about taking what historically had been sort of an all-you-can-eat price and turn it into an a la carte model," admits the head trader. "That's why you are seeing a lot of push-back now from the buy side and sell side. It really is a huge structural change," Brooks continues. "It's not a matter of flipping a switch and having those numbers broken out," he adds. "But I do think it's important to get there."

FSA Proposes Rules on Bundled Services and Soft Dollars

On March 31, the Financial Services Authority - the United Kingdom's financial services regulator - published proposed rules to address the lack of transparency and accountability identified in soft commissions and bundled brokerage arrangements. Industry sources speculate that the SEC will at least partly follow the FSA's example.

The FSA's new rules aim to limit investment managers' use of dealing commissions for the purchase of execution and research services; require investment managers to disclose to customers details of how these commission payments will be spent and what services have been acquired with them; and promote a level playing field in the production of research, whether it is produced within investment banks or by third parties.

Under the proposed rules, the FSA spells out the goods and services that fall under the definition of executions and research and details what can be paid for with commissions versus those services that cannot. While the FSA did not definitively say whether market pricing and information services are permitted or non-permitted services, it offers guidelines that investment managers can use to categorize particular goods and services. The FSA's proposed list of non-permitted goods and services includes computer hardware, seminar fees and travel or entertainment costs.

The FSA also proposes new disclosure requirements stating that investment managers will need to supply descriptions of their policies and procedures in the management of trading commissions paid on behalf of clients.

Investment managers will need to give clients specific information on how commissions paid have been generated and how they have been used, including a split between amounts spent on execution and amounts spent on research. "The FSA is asking investment managers to provide clarity on how they come up with those splits, whether it is an assignment of value or whether it's a discussion they have with brokers in which they mutually arrive at a percentage split," says John Feng, consultant at Greenwich Research.

The FSA's consultation paper and proposed rules are available for comment until May 31. Final rules are expected in July 2005.

To download the FSA paper, go to: www.fsa.gov.uk/pubs/cp/cp05_05.pdf

3 HFs Get SEC Action on Illegal Shorts

2005-05-20T17:16:00.000-07:00

SEC sues and fines 3 hedge funds
Agency claims illegal short sales before share offerings
By Alistair Barr, MarketWatch
Last Update: 11:57 AM ET May 19, 2005

SAN FRANCISCO (MarketWatch) - The Securities and Exchange Commission sued and fined three hedge funds for illegally short-selling shares of several companies before secondary offerings.

Galleon Management LP, Oaktree Capital Management LLC and DB Investment Managers Inc., a unit of Deutsche Bank, were sued for breaking an anti-manipulation rule and agreed to pay a total of almost $2.4 million in disgorged profits, penalties and interest, the SEC said in a statement Thursday.

Deutsche Bank (DB: news, chart, profile) shares declined 2.5% to $77.60 in late morning trading Thursday.
In a short sale traders sell borrowed securities, hoping to buy them back later at a lower price. They then return the securities to the lender at the original price, pocketing the difference.

Short-selling is a legal and important part of securities markets. However, when short sales undermine the integrity of capital-raising efforts such as secondary, or follow-on, share offerings, they can be illegal.

A short sale is illegal when it's covered with securities obtained in a follow-on share sale if the short trade occurred five days before the pricing of that offering, the SEC said.

Enforcing this "is an important way to protect the integrity of the public offering process and to discourage activities that could unfairly influence the market for an offered security," Peter Bresnan, an associate director in the SEC's Division of Enforcement, said.

Shareholders of the company issuing more shares suffer from this type of illegal short-selling because it can artificially depress prices before an offering, Bersnan added.

Companies are also short-changed by the practice because it may cut the valuation of a follow-on offering, ultimately reducing "an issuer's proceeds from the deal by millions of dollars," the SEC said.

Galleon, Oaktree and DB Investment Managers illegally sold stock short before secondary share sales by 22 companies, the SEC alleged.

The three hedge funds made $1,040,882, $169,773 and $15,585 respectively from the trades, the agency added.

Galleon and Oaktree also created "sham" transactions to make it look like they were trading within the rules, the SEC claimed.

The funds built up large short positions within the restricted period, purchased shares in a follow-on offering and then "engaged in further transactions or trading practices" to make it look like the deal complied with the rules, the agency explained.

The three funds didn't admit or deny the allegations.

EU Commission Eyes HF Regulation

2005-05-20T08:49:00.000-07:00

EU Commission eyes hedge fund regulation

IPE.com 20/May/05: EUROPE – The European Commissioner in change of the internal market, Charlie McCreevy, has identified the “patchwork quilt” of hedge fund regulation in Europe as something that needs to be looked at.

McCreevy told an audience in Dublin that there is currently no common regulatory approach to hedge funds within the European Union.

He said: “Many national regulators have however responded individually which in turn has given rise to something of a patchwork quilt of rules across the member states.

“The extent to which this might limit the future efficient development of the alternative investment market is something that needs to be explored.

“We need to see if at EU level we can facilitate the development of this sector in a way that stimulates greater efficiency for operators.”

Speaking at the Annual Global Funds Conference hosted by the Dublin Funds Industry Association and the National Investment Company Service Association, he also expressed concern over investor protection and the possible economic impact of hedge funds.

He said: “Regulators examining these changes in the landscape are focused specifically on the potential implications for unwary investors and for the possible impact of some of the investment and trading strategies in a macroeconomic context.”

But he said the Commission would try to keep a balance. “We don’t want to end up with rules that place excessive restrictions on financial innovation or that smother the market’s ability to efficiently meet real investor needs.”

The London-based Centre for Economics and Business Research yesterday likened investing in hedge funds to betting on horses, according to a Reuters news report.

Another SEC PIPEs Enforcement Case

2005-05-18T16:52:00.000-07:00

--------------------------------------------------------------------------------
Printed from NewYorkBusiness.com

--------------------------------------------------------------------------------

Hedge fund manager fined for insider trading

May 18, 2005

A former hedge fund manager for First New York Securities was ordered to pay $1.45 million to settle fraud and insider trading charges by the National Association of Securities Dealers and the Securities and Exchange Commission related to a private placement transaction.

NASD permanently barred the manager, Hilary Shane, from working with any of its registered firms, while the SEC suspended her for one year from the investment advisory business.

Regulators charged Ms. Shane with insider trading, saying she sold short Compudyne Corp. stock in 2001 before the public announcement of a private investment in public equity, or PIPE, transaction that raised more than $29 million. Regulators said Ms. Shane, who did not admit any wrongdoing, made $1.13 million from the illegal activity.

PIPE shares need to be registered with the SEC before investors can sell them on the open market.

--------------------------------------------------------------------------------

Greenspan on HF Regulation

2005-05-07T11:00:00.000-07:00

Greenspan: Giving Hedge Funds New Rules Won't Work
Friday, May 6, 2005
By Barbara A. Rehm and Rob Blackwell

CHICAGO - Federal Reserve Board Chairman Alan Greenspan warned bankers Thursday to demand more of their hedge fund customers, while U.S. Bancorp chairman Jerry Grundhofer warned against following nonbanks down a slippery slope to a pile of problem credits.

Mr. Grundhofer said competition for commercial credits is fierce, with hedge funds and other nonbank lenders making pricing irrational.

"There is margin compression everywhere," he said in a luncheon speech at the Federal Reserve Bank of Chicago's annual Conference on Bank Structure and Competition.

U.S. Bancorp accepts that and attempts to make up for lower rates with higher volume, he said, but that's "a tough call, a tough line to walk." U.S. Bancorp is trying not to "reach too far for marginal credit." But some nonbank rivals, including hedge funds, are not as disciplined, he said.

"Overall credit standards have deteriorated. Certainly pricing has, and we're starting to see problems with structure as well," he said in an interview after his speech. "They may be the smartest underwriters on Earth," he said of hedge funds. "We'll see who's right and who is wrong."

U.S. Bancorp is "trying to be aggressive on pricing, and get new business, but not fool around with" changes in loan terms and conditions, he said.

Mr. Greenspan said that banks had made "considerable progress" in strengthening oversight of their relationships with hedge funds since the fall of Long-Term Capital Management in 1998.

But he said a recent central bank study of banks' management of hedge fund credit risk found several "weaknesses."

"Competitive pressures may be eroding the protection that banks achieve through collateral requirements by reducing the initial margins that they obtain from hedge funds," Mr. Greenspan said. "The review suggests that banks and their supervisors need to be alert to the possibility that further slippage of credit terms could result in material increases in credit risk to banks, a material loss of market discipline on hedge funds, and a material increase in the potential for hedge fund leverage to adversely affect market dynamics."

Mr. Greenspan urged bankers to persuade hedge fund managers to provide more information about their portfolios, including "forward-looking measures of the risks that the funds are assuming."

"Most banks' policies," he said, "could be improved by the establishment of clearer and firmer links between credit terms and transparency."

Mr. Greenspan also urged bankers to aggregate stress-test results across hedge fund counterparties "to assess concentrations of exposures in volatile and illiquid markets."

However, Mr. Greenspan said he opposes ramping up regulation of hedge funds. Any additional disclosure requirements would be fruitless. "Most of the data would tell you their strategy of last night. This morning they would have a new one. It's their very nature to be innovative and ever-changing," he said during a question-and-answer session.

Speaking on other risks to the financial system, Mr. Greenspan said concerns that credit derivatives have transferred too much risk outside the banking system appear to be overblown.

There were $4.5 trillion of the derivatives as of June, and some experts have become concerned that losses to nonbank risk-takers could force them to liquidate their positions if credit spreads widen appreciably.

But Mr. Greenspan cited a study conducted last year by the Joint Forum that said the notional values of derivatives had "significantly overstated the amount of credit risk that had been transferred outside the banking system."

Mr. Greenspan also reiterated his position that the mortgage portfolios of Fannie Mae and Freddie Mac should be reduced.

But instead of recommending specific caps, as he has done in the past, Mr. Greenspan said he agreed with Treasury Secretary John Snow's recommendation that a proposed new regulator for the GSEs have power over the portfolios and get specific guidance from Congress on how to treat them.

"Specifically, the GSE should hold only the minimum level of assets needed to accomplish the primary missions mandated by their charter," Mr. Greenspan said.

© 2005 American Banker and SourceMedia, Inc. All rights reserved.

Hedge Funds as B-Ds/Compliance Issues

2005-04-22T16:20:00.000-07:00

A Broker-Dealer Morality Tale
John Hintze
April 25, 2005

Citadel Investment Group and Ramius Capital may be using broker-dealer affiliates to build new businesses as part of their natural growth as financial institutions. But broker-dealer affiliates can also be used to obscure business practices, including fraudulent ones, by minimizing the traditional market scrutiny of hedge funds.

To the dismay of investors and Wall Street participants, that is apparently what happened when KL Financial, a Palm Beach-based hedge fund, collapsed in early March, leaving investors with more than $100 million in losses.

KL Financial acquired a broker-dealer in 2001 that reportedly had a pre-existing correspondent clearing relationship with Spear, Leeds & Kellogg Specialists LLC, which was bought by Goldman Sachs and is now part of its execution and clearing operation.

Gary Klein, a former Securities and Exchange Commission enforcement official who is currently representing investors suing KL Financial, says the relationship with Goldman gave the broker-dealer, Shoreland Trading, "immediate credibility" on the Street. As a result, it was probably able to get financing and pursue trades that a prime broker would have frowned at.

Shoreland Trading left Goldman last summer and moved to Penson Financial Services, a clearing firm headquartered in Dallas. Sources familiar with Shoreland's relationship to Penson said the clearing firm provided leverage to Shoreland, as clearing firms typically do, although it was unclear by press time whether Penson suffered losses as a result.

Indeed, it was unclear which firm Shoreland was using to clear through shortly before its collapse. Dan Son, the president of Penson Worldwide, said Shoreland cleared through Penson through late December or very early January. Shoreland then reportedly moved to West Coast clearing firm Wedbush Morgan, although officials there declined to comment.

Sources said Goldman and Penson each viewed Shoreland as a proprietary trading broker-dealer. Both firms also provide prime brokerage services directly to hedge fund managers, and prime brokers typically employ sophisticated risk management models to monitor their customers' trading for undue risk. As a broker-dealer, however, KL Financial's Shoreland Trading used those firms' correspondent clearing functions, and correspondent clearers have long argued that they are simply trade processors and are not responsible for their correspondents' actions.

That argument especially applies to proprietary trading correspondents, which stand to lose only their principals' own capital. For correspondent clearers, proprietary traders are a source of high trading volumes and hence fees, without the requirements to service broker-dealers catering to investors.

Shoreland, however, was not truly a proprietary trader, since it had investors through its hedge fund affiliate that apparently funded its trading. In a fully disclosed clearing relationship, the clearing firm also sends statements to the broker-dealer's customers. In the case of KL Financial, its investors received statements purporting fantastic gains. But those statements came from the hedge fund and clearly had little to do with the financial results provided by the clearing firms. In fact, each clearing firm reportedly ended its relationship with Shoreland based on concerns about Shoreland's financial health and risk.

Even the Pacific Exchange, which Shoreland joined in May 2003, failed to detect the trading activity that ended up costing the hedge fund's investors more than $100 million.

"Any time you have a registered broker-dealer, you think you have additional layers of compliance. You're supposed to be sitting with a [Series 24-licensed principal who is] supervising all this, and the exchange is coming in to look at [the broker-dealer's activities]," said Klein.

Klein noted that exchanges examine registrants at least once a year-which is one reason hedge funds so adamantly opposed registration under the Investment Advisors Act of 1940. Hedge funds will have to register under that statute next February, and while the requirements are far less demanding than registering as a broker-dealer, even hedge funds without broker-dealer affiliates will face annual examinations.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

http://www.thomsonmedia.com http://www.iddmagazine.com

ICI on MF/HF Differences 032005

2005-04-20T19:38:00.000-07:00

The Differences Between Mutual Funds and Hedge Funds
Mutual funds and hedge funds differ in many ways. The areas of greatest difference between the two are: fees; leveraging practices; pricing and liquidity; degree of regulatory oversight; and investor characteristics.

U.S. mutual funds are among the most strictly regulated financial products. They are subject to numerous requirements designed to ensure that they are operated in the best interests of their shareholders. Hedge funds are private investment pools subject to far less regulatory oversight. In 2004, however, the SEC adopted new rules requiring hedge fund advisers to register with the SEC under the Investment Advisers Act of 1940.

Regulatory Requirements
Mutual Funds
Mutual funds are investment companies that must register with the U.S. Securities and Exchange Commission (SEC) and, as such, are subject to rigorous regulatory oversight. Virtually every aspect of a mutual fund's structure and operation is subject to strict regulation under four federal laws: the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisers Act. The SEC is charged with overseeing the mutual fund industry's compliance with these regulations. The Internal Revenue Code sets additional requirements regarding a fund's portfolio diversification and its distribution of earnings, and the National Association of Securities Dealers, Inc. (NASD) oversees most mutual fund advertisements and other sales materials. In addition, mutual funds must have directors who are responsible for extensive oversight of the fund's policies and procedures. For virtually all funds, at least 75 percent of their directors and the chairman of the fund board must be independent of the fund's management.

The Investment Company Act is the cornerstone of mutual fund regulation. It regulates the structure and operation of mutual funds and requires funds to safeguard their portfolio securities, forward price their securities, and keep detailed books and records. In addition, the 1933 Act requires all prospective fund investors to receive a prospectus containing specific information about the fund's management, holdings, fees and expenses, and performance.

Hedge Funds
Hedge funds are private investment pools subject to the terms of an investment agreement entered into by the sponsor of, and investors in, the hedge fund. In response to rapid growth in the hedge fund industry, the SEC ordered a study of the hedge fund market and, in October 2004, adopted a rule requiring advisers to hedge funds - for the first time - to register under the Investment Advisers Act. The new rule will allow the SEC to inspect all hedge fund advisers and to deny the registration of any hedge fund adviser that has been convicted of a felony or has a disciplinary record.

Under the Investment Advisers Act, hedge fund advisers are now subject to many of the same requirements as mutual fund advisers, including registration with the Commission; designation of a Chief Compliance Officer; implementation of policies to prevent the misuse of nonpublic customer information and to ensure that client securities are voted in the best interests of the client; and implementation of a code of ethics. Hedge fund advisers are required to comply with all of these requirements by February 2006.

Fees
Mutual Funds
Federal law imposes a fiduciary duty on a mutual fund's investment adviser regarding the compensation it receives from the fund. In addition, mutual fund sales charges and other distribution fees are subject to specific regulatory limits under NASD rules. Mutual fund fees and expenses are disclosed in detail, as required by law, in a fee table at the front of every prospectus. They are presented in a standardized format, so that an investor can easily understand them and can compare expense ratios among different funds.

Hedge Funds
There are no limits on the fees a hedge fund adviser can charge its investors. Typically, the hedge fund manager charges an asset-based fee and a performance fee. Some have front-end sales charges, as well.

Leveraging Practices
Mutual Funds
The Investment Company Act severely restricts a mutual fund's ability to leverage or borrow against the value of securities in its portfolio. The SEC requires that funds engaging in certain investment techniques, including the use of options, futures, forward contracts and short selling, "cover" their positions. The effect of these constraints has been to strictly limit leveraging by mutual fund portfolio managers.

Hedge Funds
Leveraging and other higher-risk investment strategies are a hallmark of hedge fund management. Hedge funds were originally designed to invest in equity securities and use leverage and short selling to "hedge" the portfolio's exposure to movements of the equity markets. Today, however, advisers to hedge funds utilize a wide variety of investment strategies and techniques. Many are very active traders of securities.

Pricing and Liquidity
Mutual Funds
Mutual funds are required to value their portfolios and price their securities daily based on market quotations that are readily available at market value and others at fair value, as determined in good faith by the board of directors. In addition to providing investors with timely information regarding the value of their investments, daily pricing is designed to ensure that both new investments and redemptions are made at accurate prices. Moreover, mutual funds are required by law to allow shareholders to redeem their shares at any time.

Hedge Funds
There are no specific rules governing hedge fund pricing. Hedge fund investors may be unable to determine the value of their investment at any given time

Investor Characteristics
Mutual Funds
The only qualification for investing in a mutual fund is having the minimum investment to open an account with a fund company, which is typically around $1,000, but can be lower. After the account has been opened, there is generally no minimum additional investment required, and many fund investors contribute relatively small amounts to their mutual funds on a regular basis as part of a long-term investment strategy. More than 92 million Americans own mutual fund shares. The typical fund investor is a middle-income, middle-aged individual.

Hedge Funds
A minimum investment of $1 million or more is often required of hedge fund investors. Under the National Securities Markets Improvement Act of 1996, certain hedge funds can accept investments from any individual who holds at least $5 million in investments. This measure is intended to help limit participation in hedge funds and other types of unregulated pools to highly sophisticated individuals. Hedge funds can also accept other types of investors if they rely on other exemptions under the Investment Company Act or are operated outside the United States.

March 2005

© 1997 - 2005 Investment Company Institute

SEC Mandated Email Archiving for RIA HFs

2005-03-17T05:53:00.000-08:00

R U Compliant?

By Terry Stanton, Managing Editor
Monday, January 24, 2005 3:18:31 PM ET

Under registration, hedge funds will have to archive all electronic communication, including instant messaging

It's the cute little message system that once was mostly the province of keyboard-chattering teenagers and preadolescents. A fast way to share fleeting thoughts and tidbits of information with family, friends and co-workers, it's efficient, it's ephemeral, but now, for hedge funds, it's official—an official medium of business communication, that is.

It's instant messaging, and now that hedge funds face the prospect of mandatory registration with the Securities and Exchange Commission as investment advisers, they need to face the fact that IM-generated communication can be a bona fide business record. And that means they need to ensure that they have a system in place to store instant messages in a way that satisfies the commission's requirement as spelled out in Rule 17a-4 under the Securities Exchange Act of 1934, among other legal mandates that go with registration.

One for the Archives

At many unregistered funds, and probably at some that have signed up with regulators, executives haven't given much thought to whether their procedures for electronic storage—if they have any formal protocol at all—live up to federal standards. What attention they have paid to the issue might deal only with email. With its automatic backup and storage features, email sorts and retains its own record on hard drives and networks. Companies that back up and store the messages on tape may be satisfied that they are in compliance with regulations for the financial industry. Officials at such companies might want to get to know the rules better, including what kinds of searches they might have to conduct in the event of an audit.

At a seminar on the issue of record keeping and instant messaging at the fall meeting of the Futures Industry Association, David Cox, chief technical officer at Calyon Financial Inc., Chicago, told the audience, "Anyone in the room who thinks they're in compliance with the new regulations, think again."

While that discussion focused on how to lasso instant messaging into a proper storage pen, dealing with IM begins with understanding the requirements for retention of any electronic communication. The basic rule is that organizations in financial services, along with other selected industries, must capture and store for auditing purposes all business-related communications conducted by employees and with clients, generally for a minimum of five years.

For email, that means "a usage policy backed up by active processes for monitoring, archiving and storage," says Richard Fleischman, whose New York-based RFA Technology Consulting firm helps financial companies, hedge funds among them, with message-storage compliance issues. "Additionally they require an email forensic solution that can track, report and monitor email usage to avoid costly manual recovery practices," he said, referring to the complex process that may be involved in retrieving specific messages from records that merely have been slapped onto magnetic tape.

A fully compliant solution stores messages on a medium (WORM—or, "write once, read many") whose contents can be read but not written over or deleted and which can be retrieved in targeted searches, such as by individual, time period or trading position for a particular holding.

So far, the hedge fund world has not rushed into strict compliance.

"Virtually none of them archive email properly," says Chris Grandi, managing director of Boston-based Eze Castle Integration Inc., speaking of hedge fund clients with which his Boston-based firm has worked. "They back it up on tape, but then [to retrieve something for an audit] you have to restore it and search and find—which could take 300 hours and thousands of dollars to do. We deem that unacceptable."

The IM Conundrum

While a haphazard approach of back-up-and-hope might let a firm squeak by for email when the examiners come knocking—albeit with great expense and hassle—it won't work with instant messaging.

"In the IM space, there is more entropy than there is movement in the other direction," Jonathan Christensen, vice president of products and chief technology officer for FaceTime, Foster City, Calif., told his audience as a member of that IM seminar panel. In science, entropy refers to the tendency of things to move to a state of disorder, and while Mr. Christensen was describing the persistent lack of standardization and control among IM networks as their use grows, he also was referring to the tendency of information transmitted via IM to vanish into thin air unless deliberate measures are taken to capture it and store it.

While the same storage requirements that cover email apply to instant messages, complying with them is a trickier task technologically and one that eludes many firms that don't act. "The vast majority of IM use is still ‘undiscovered,'" Mr. Christensen said at the seminar. "Unlike email, IM has no backup or archive, no standard addressing method, no monitoring tools. It's very tricky to manage because of nuances as to how it works." And yet, he said, instant messaging is the fastest-growing form of communication, one that is used in 90% of enterprises and that by 2006 will "usurp email as the preferred method."

But tricky to manage is not the same as impossible or even highly difficult or expensive, all three of the IM specialists contacted for this article agree. Their companies each offer technical and administrative solutions for the IM challenge that don't require much in the way of active monitoring or policing and that can be economically feasible even for small shops.

On Site or Off

As with many IT challenges, organizations seeking to implement message archiving can work with suppliers to set up a system in-house or can completely outsource the job, including the physical storage, to a vendor. Many of the technology consultants that work in this field can help with either route.

Generally the in-house solution, involving an on-site server, has relatively high upfront costs—perhaps US$40,000 or more and requires some ongoing monitoring by internal employees with expertise. Shipping the storage job out to an offsite location requires no new onsite hardware and is much less expensive to implement, but may involve a per-user charge and will entail an ongoing service fee. Start-up costs for outsourcing may be as low as US$3,000.

For larger firms, the in-house option and the one-time major investment will even out with the ongoing cost of outsourcing in about 24 months, according to Mr. Fleischman (although periodically the storage medium in the on-site hardware must be replaced). Obviously, the outsourcing approach makes more economic sense for the many smaller firms that manage hedge funds. "Monthly, you're renting space on somebody's servers," he says, "but it's US$500 a month vs. US$40,000."

Money is not the whole issue. "The smaller shops definitely have less time and attention to worry about IT structure," says Mr. Christensen, whose FaceTime firm has an off-site archiving product, RTShield, geared to small- and medium-sized firms but which also counts many of the largest financial institutions among its customers. For many of the big banks, FaceTime's in-house IM Auditor system is the choice.

For the hedge funds served by Eze Castle, "off-site is much more popular," Mr. Grandi says. His firm markets its Integration Email & IM solution, which like many such offerings uses software from other suppliers (iLumin Software Services and IMIlogic) for archiving, indexing and retrieval tasks. As with other outsourced systems, Eze Castle's setup transfers a copy of each email and IM to secure facility. Those messages "sit in suburban Boston, outside any financial district," Mr. Grandi says.

RFA also offers two basic approaches. It can install an on-site server that collects email and instant messages (along with Bloomberg messaging, as most of the providers do), using Zantaz and IMLogic software. If the client firm chooses, RFA will monitor the system from offsite for a fee. RFA's offsite solution is called MessageRite. It provides a scalable messaging infrastructure that archives and indexes, using technology and software from Lightport and Iron Mountain

A number of other vendors offer products and services for message archiving. For example, Smarsh Inc., of Portland, Ore., recently announced the release of its Archive InSite product, which is geared to small- and mid-sized hedge funds.

It's Not Too Late

If you are a hedge fund manager and you haven't given much thought to the IM activity in your office, or to the issue of archiving electronic messages in general in anticipation of the imposition of mandatory SEC registration Feb. 1, 2006, not only do you still have about a year to get a system into place but you are far from alone.

Mr. Grandi says that many fund firms are just at the stage of appointing a chief compliance officer and that many fund executives, while vaguely aware that a record-retention protocol is part of the registration checklist, have not delved into the details. Right now he estimates that about 90% of funds have not achieved full compliance.

He says Eze Castle is starting to see an uptick in inquires about archiving from hedge funds in the wake of the SEC's adoption of the final rule, and he anticipates a large increase in activity over the next six months, a sentiment shared by FaceTime's Mr. Christensen and RFA's Mr. Fleischman, who says, "They're queuing up for the first and second quarter. By summertime, people will have something in place, or a clear plan."

"They are slowly learning," Mr. Grandi says. "They're asking questions. Now that they know there has to be a compliance officer, they're learning about it, but they don't know what it means."

Mr. Christensen observes a similar scene. "There's already some understanding, but maybe some frustration," he says. "They say, ‘We see the regulation, but explain to us what it means, how we can comply in an affordable, simple solution.' Most of these guys want to comply, and it's really been [a matter of] understanding what it means. Hedge funds typically are smaller organizations—kind of lean, mean organizations. Their IT is focused on proprietary algorithms for strategy, not information management."

The typical fund manager has a rather limited understanding of IM and archiving technology, to say the least, says Mr. Grandi. "The majority has no clue. They outsource everything, so they don't know a lot."

That's not to say that hedge fund managers should be signing up for night classes in IT. There's plenty of help from professionals available. Still, a bit of knowledge can be helpful. That a number of technology companies are able to provide compliance systems that are nearly turnkey in implementation and not highly burdensome to maintain is good news for time-stretched and cost-conscious managers, but a bit of time invested up front to understand the devilish ways of instant messaging can help ensure that the solution from the vendor is appropriate and as airtight as possible.

I Want My IM!

The technology vendors say that many of their clients, upon first learning about the rules for record retention and being told what a slippery fish IM is to catch and store, respond by proposing to banish the use of instant messaging from their premises.

The vendors also say it's a bad idea.

"The interesting thing with IM," says Mr. Grandi, "is that they'll say, ‘Well, I'll just tell people to stop using it.'"

Such a tack is ill-advised for two major reasons: the marketplace and human behavior.

Preventing people from using IM in a hedge fund office might solve some headaches for the hedge fund, but it won't change the fact that instant messaging is the primary means of communication for many of the folks with whom hedge funds do business—especially those in the trading community.

"We tell people, you can try to shut it down, but your traders and the people who have contact with Wall Street won't like it," Mr. Grandi says. "IM is prolific" in communication between buy and sell sides, he adds.

In other words, cutting off IM means cutting off an important channel of communication and could have a negative effect on efficiency and performance.

In any event, Mr. Christensen says, seeking to ban IM usage by fiat or trying to restrict usage to one IM network (the big three are AOL, Yahoo! and MSN) for the sake of standardization is an unrealistic strategy. People who use IM will keep using it unless they are physically prevented from doing so by network blocks.

As for confining users to one network, he notes that different IM networks prevail in different industries. Institutional traders on Wall Street use AOL's AIM "almost exclusively," he says, while among energy traders, Yahoo! Messenger is king. "There's cross-talk," he says, noting that many users communicate over more than one service. "Asking them to move" to one approved service, for the sake of simplifying the archiving process, "means they have to give up a piece of their Rolodex—their address network."

Mr. Christensen says that even the AOL and Yahoo! IM providers acknowledged how futile or misguided it is to try to confine users to one service when they abandoned last year their efforts to market an archiving and control product that worked only for traffic on their networks. He advises companies just to accept the fact that people use different networks and to adopt a compliance solution, such as FaceTime's or others, that works for all the known networks. "Most firms with more than 100 people already have all three major networks running. Even in a small shop with 15 people, there's always one or two people using something else."

Everybody Now

Because the SEC does not require that communication of all employees be retained—just that of those interacting with clients and involved in transactions—some companies that adopt archiving systems try to apply them only to selected users.

But the technology people say that savings obtained by excluding some mailboxes from an archiving solution are probably not worth the loss of certainty that everything is being retained. Mr. Christensen says many of the large institutions with which he works archives everything from everybody, for the sake of both simplicity and ultimate security. Mr. Fleischman says he advises all clients to include all employees. In many cases, especially at smaller offices, the extra software cost for universal coverage is negligible.

In setting up a retention system for IM, organizations might also do well to examine their general policies regarding the use of email and instant messaging—or to create and implement policies if they don't have them. As Mr. Fleischman notes in a statement on "messaging compliance" that he wrote, "Each email/IM sent has a potential liability attached. Executive management and corporate officers have a fiduciary duty to act in the best interest of the company and may become personally liable for statutory offenses committed by the firm. With so many people using email/IM so frequently, and having a mistaken impression that this type of communication is private, there is a risk of intellectual property or other confidential information being sent outside of the company's domain."

In short, it makes good business sense to have a policy on electronic messages and to ensure that employees are aware of it. A specific consideration for IM is screen names that people use. Mr. Christensen notes that unlike company email, with IM, users pick their own names, meaning that some guidelines might be in order. Among questions he suggests addressing are, "Are your people choosing risqué names? Is corporate HR policy being violated?"

A sound compliance and retention program also is likely to yield the benefit of increased security in a company's communication system, since the systems installed for archiving can also set up blocks to thwart would-be hackers, spoofers, identity thieves and other miscreants of the web.

No one says SEC registration is going to be a picnic, but by acting soon on email and IM issues, hedge fund managers can reap the satisfaction of both checking a regulatory chore off their list and finding that they have a communication system that is secure, efficient and law-abiding. At that fall seminar, Dale Martin, executive vice president of Cargill Financial Services, Chicago, noted that a properly instituted IM system is both an important security asset and a facilitator of good business practice. He said that excessive use of email by employees, with the constant "cc'ing" and lengthy volleying sessions of replies that flourish almost inevitably was choking work flow. "Email was being used as IM," he said. "Productivity suffered." Setting up a sanctioned, secure IM protocol and encouraging IM use addressed the problem and yielded benefits for the company. "We wanted to push an internal culture so that we had a global sense of community," he said, "so that we could provide outstanding service and so that all internal employees see the same culture."

TStanton@HedgeWorld.com

UK Pension Fund "Guidance" for HF Investing (SundayHerald.com)

2005-03-14T09:15:00.000-08:00

Sunday Herald - 13 March 2005
Pension fund conference to tackle hedge fund fears
By Ian Fraser and Teresa Hunter

--------------------------------------------------------------------------------

HEDGE funds are to come out of the cold and into the investment mainstream at a major conference in Edinburgh this week.
The National Association of Pension Funds, whose members look after more than £600 billion for UK employees and pensioners, is holding its investment conference in the EICC from Wednesday to Friday.

The organisation will launch new guidance to UK occupational pension schemes endorsing the use of hedge funds as an asset class .

A document entitled Hedge Funds And Funds Of Hedge Funds Made Simple: What A Trustee Needs To Know, suggests that is acceptable for pension funds to put up to 10% to15% of total assets in this still controversial asset class.

The guide says hedge-fund investing makes sense as it is a means for pension-fund trustees to even out the risk in their portfolios.

The guide says: “For pension-fund trustees, an important consideration is that many hedge-fund strategies have historically provided [absolute] returns at lower volatility levels than the stock market.

“In general, hedge funds tend to measure and manage risk over much shorter time horizons, and are less tolerant of losses than in traditional asset classes.

“Most hedge funds are conservatively run and place great emphasis on disciplined risk management procedures. It is common for hedge-fund managers to invest a portion of their own capital in their portfolio, which is a strong indication that they do not want to take on any untoward risk.

“A low correlation with other investments [in a pension fund’s portfolio] has the potential to reduce the overall risk in the portfolio.”

But the document does accept that there are “some areas of risk [associated with hedge-fund investment] which are not desirable.” These include a lack of transparency.

Fees can also be very much higher. Typical management fees are 1% to 2% of invested assets, and performance fees are typically about 20% of realised returns.

Last April the Rail Pension Scheme declared it was going to invest more than £700 million in hedge funds, in a move that saw it overtake the BT Pension Scheme as the UK’s largest single investor in this asset class.

Railpen, as the scheme is known, controls £14bn in assets. The trustees were advised by Chris Hitchen, now Railpen’s chief executive, to allocate 5% of their assets to hedge-fund investments. Hitchen is chairing the session on hedge-fund investing at this week’s event.

At the NAPF conference, James Montier, of Dresdner Kleinwort Wasserstein, will propose a motion that, “This house believes that pension funds investing in hedge funds will all end in tears”. The motion is being opposed by Ian Morley of Morley, Day Olympia.

Other speakers include David Hunter, of Glasgow-based Arlington Property Investors and Nicola Horlick of Bramdean Asset Management who was last week rebuffed in her attempts to acquire Deutsche Asset Management’s UK business.

Trustees and fund managers will be urged to look increasingly to commodities, hedge funds and alternative forms of investment, against growing fears that equities will not produce sufficient return over the next decade to meet companies pensions promises.

Hitchen, chairman of the NAPF investment council, said: “Every pension fund needs to earn a certain return to meet their liabilities, which will continue to roll up. The future return from equities may not be enough to keep pace with the growing pension promise.”

This doomsday scenario would have it that despite the recent improvement in the FTSE, a 10-year famine looms. Hitchen said: “If you look at historic patterns, you can see a trend of 15 years of feast, followed by 15 years of famine. That means we still have 10 years to go before feast days return.”

Trustees and investment managers will be coached at the conference in the use of alternatives to equities, particularly hedge funds, commodities and private finance initiatives.

Hitchen, who is also the head of the railways pension fund, concluded: “These are difficult concepts for the average trustee to grasp.

“But in future, they will have to diversify their investment strategy and have a much wider basket.

“In the past, we all thought we knew where the best returns were to be had, and that was stock markets. That is no longer the case.”

--------------------------------------------------------------------------------

SEC Registered Adviser Exams (Albourne Village 3/14/05)

2005-03-14T08:29:00.000-08:00

Compliance Alert: Exam-by-Mail Mini Sweeps and New SEC Exam HotLine

posted by jeffmorton on Friday 11 Mar 2005 13:22 GMT

New SEC Mini-Sweep

It appears as though the SEC is beginning to conduct an "Exam-by-Mail" mini-sweep of advisers in the New York City area. Recently, several of our clients (mainly registered hedge fund managers) received a letter from the SEC via FedEx requesting 22 items to be sent back to the SEC no later than March 28, 2005. The letter indicates that the "staff's examination will focus on Registrant's brokerage arrangements and certain investment transactions made on behalf of Registrant's clients..." You can view the "Exam-by-Mail" request list by clicking on the following link: www.advisercomplianceassociates.com.

New SEC Exam Hotline

Lori Richards, Director of the SEC's Office of Compliance Inspections and Examinations, recently announced the rollout of a new SEC "Exam HotLine." According to Ms. Richards, the purpose of the HotLine is to field calls from members of the investment management industry who have a complaint or a concern about an SEC examination. The HotLine, which will be staffed by senior attorneys in OCIE's Office of Chief Counsel, can be reached by phone at (202) 551-EXAM (3926) or, alternatively, via e-mail at examhotline@sec.gov. For a copy of the speech announcing the creation of the HotLine, please see www.sec.gov.

If you have any questions on the above noted issues or if we can be of any assistance with the development or maintenance of your compliance program, please feel free to give us a call at your convenience.

Regards,

Adviser Compliance Associates, LLC 2120 L Street, NW, Suite 530 Washington, DC 20037 Ph: (202) 955-5800

Use of "Related Performance" Data

2005-03-13T17:51:00.000-08:00

Hedge Fund and Private Equity Fund Use of Related Performance - So That's the Difference!

March 08 2005
San Francisco, CA (www.hedgeco.net) When a hedge fund or private equity fund manager (collectively, "private fund managers") decides to organize a new fund, perhaps the most relevant information that a potential investor could be presented with would be the past performance of the existing funds advised by the private fund manager or a track record of the private fund manager developed at a previous employer. The presentation and use of this type of information is generally referred to as "related performance" and it is a topic of great interest at the National Association of Securities Dealers (the "NASD"). This "great interest" by the NASD affects every private fund manager that expects to generate distribution of its fund through third party marketing agents or capital introduction services of an NASD member broker dealer.
It is the NASD's position that Rule 2210 of the NASD's Rules of Conduct prohibits NASD member brokers from using or distributing sales materials or other communications to the public that present related performance. This prohibition applies not only to information prepared by the member broker, but also to information prepared by a non-member, such as a private fund manager. Accordingly, it is illegal for a broker to present to its clients the marketing materials prepared by a private fund manager if such marketing materials include related performance. The NASD reaffirmed this position in an interpretive letter to the Securities Industry Association dated October 2, 2003.

Most private fund managers are not NASD member brokers in reliance upon the "issuer's exemption" of Rule 3a4-1 under the Securities Exchange Act of 1934, and therefore, are not subject to the NASD prohibition on the use of related performance. As investment advisers to funds, private fund managers are subject to the anti-fraud provisions of the Investment Advisers Act of 1940 (the “Advisers Act”), whether or not they are actually registered with the Securities and Exchange Commission (the "SEC") as investment advisers. The SEC, in a line of no-action letters dating back to 1986, has permitted the use of various types of related performance in communications to clients under very specific conditions and with prominent and adequate disclosure with respect to what the related performance is and is not. If you think life is unfair, you should also know that it is the position of the NASD that member brokers may publish or distribute sales literature for a public commodity pool that presents the same related performance information that appears in the pool's offering document as prescribed by the Commodity Futures Trading Commission.

In a more recent interpretive letter (Davis Polk, December 30, 2003), the NASD attempted to draw a distinction between hedge funds and private equity funds for purposes of permitting the use of related performance. In this letter, the NASD took the position that a member broker may present related performance about a fund that is exempt from registration under Section 3(c)(7) of the Investment Company Act of 1940 (the "1940 Act"). A private fund that relies on Section 3(c)(7) must be completely comprised of "qualified purchasers," which means an individual with $5 million in investments, or an institution with at least $25 million in discretionary assets under management.

Although many private equity funds limit themselves to qualified purchasers, that is not the case for all. It is typical for most hedge funds, and a great number of private equity funds, to rely on the lower "accredited investor" standard of Section 3(c)(1) in order to permit investment by certain "friends and family" types. An "accredited investor" need only have $1 million in net worth and an income of $200,000 in each of the past two years. As a practical matter, this standard will likely increase as a result of the new hedge fund adviser registration rule, Rule 203(b)(3)-2, which effectively prohibits the use of performance fees in a private fund unless all investors meet the definition of "qualified client" in Rule 205-3 under the Advisers Act. Because most private funds impose a performance fee, after February 1, 2006, new private fund investors will likely be limited to those with $750,000 under management with that particular manager, or $1.5 million in net worth.

So where does this leave private fund managers that hope to take advantage of a broker dealer's capital introduction services? Unless the NASD can see its way clear to permit the use of related performance by member brokers for the benefit of their high net worth and sophisticated clients, member brokers will continue to direct clients to the private fund managers to obtain such information and hope that the NASD Enforcement arm does not view this activity as a circumvention of Rule 2210.

Note: White & Case LLP represents hedge fund and private equity fund sponsors and advisers, prime brokers, and administrators through its 38 offices in 25 countries around the world. For further information on the White & Case investment funds practice, contact:

Jay B. Gould, Esq.
White & Case LLP
San Francisco, California 94111
415-544-1112 (O)
310-800-6500 (C)
Jgould@whitecase.com

David A. Goldstein
White & Case LLP
New York, New York 10036
212-819-8757 (O)
917-891-8900 (C)
dgoldstein@whitecase.com

SEC Email Retention Policy

2005-03-03T11:15:00.000-08:00

Financial-Planning.com
You've Got Mail

A new compliance rule raises a host of questions about recordkeeping and e-mail retention.

By Andrew Miller

March 1, 2005- Jo-Ann Gallerstein, a registered investment adviser in Morris County, N.J., has become as meticulous in handling compliance-related issues as she is in constructing clients' financial plans. She is taking no short cuts-investing nights and weekends familiarizing herself with the Securities and Exchange Commission's new and complex compliance regulation.

The rule, which went into effect in February, requires advisers to appoint a chief compliance officer and to adopt and implement written policies and procedures to prevent violations of federal securities laws. "I've dedicated a huge amount of time to compliance," Gallerstein says. The rule is designed to deter abuses uncovered by the SEC and state enforcement authorities involving advisers and broker-dealers, including self-dealing, misuse of nonpublic information, failure to supervise employee activities, and improper practices such as market timing and late trades.

The SEC has provided some general guidelines to help advisers follow the rule. "You should be tweaking your programs over time, not simply waiting until the annual review," Lori Richards, head of the SEC's Office of Compliance Inspections and Examinations, advised in a speech earlier this year. Yet the road to compliance isn't all that clear-cut.

Many investment advisers still are not sure what they need to do to meet the new guidelines, especially when it comes to recordkeeping. Although the rule doesn't explicitly mention retaining e-mails and other correspondence, it's widely viewed as requiring advisers to archive e-mails, in line with earlier broker-dealer rules that were issued by the SEC and the National Association of Securities Dealers.

The compliance rule comes about three years after the SEC issued a rule permitting advisers to maintain and preserve all forms of records, including documents received in any non-electronic format, on electronic media such as tapes or disks. That rule, which was meant to encourage greater use of electronic storage, did not explicitly mandate the use of electronic archiving, but did state that advisers "must have procedures to reasonably protect electronic records from loss, alteration, or destruction, to limit access to electronic records, and to assure that electronic records that are created from hard copy are complete, true, and legible." The earlier SEC rule also cited the "unique vulnerability of unprotected electronic records to undetectable alteration and falsification."

Anxious to avoid Eliot Spitzer's A list, the appetite of investment firms for new, more sophisticated archiving and search capabilities has grown with each developing scandal. The challenge is to fine-tune search capabilities to comb through ever-larger archives with greater precision, so that if regulators come calling or a case goes to court, the relevant records can be produced in a timely, cost-effective manner.

One case in point is UBS. Last year, the investment firm was sanctioned by a federal judge for destroying or failing to produce in a timely manner e-mails in a gender-discrimination lawsuit. The judge found UBS personnel had erased relevant e-mails-some were recovered from backup tapes; others were lost altogether. The case proves that all firms, including investment advisers, need to rethink their policies for routinely recycling or erasing such tapes, especially if they contain any evidence that may be used in a legal proceeding.

Investment advisers are now required to index records in a way that allows easy location, access, and retrieval; provide on demand a legible and complete copy of a record; and separately store, for the time required to preserve the original document (typically five years), a duplicate copy of the record on any medium. Dechert LLP, a Washington-based law firm, issued a memo this summer recommending investment advisers either save all of their e-mails, including personal e-mails and spam, or else save only those pertinent to business, while maintaining some system of surveying all deleted e-mails.

In the absence of more specific rulings from the SEC, many advisers, especially smaller, less-sophisticated ones, are finding themselves caught in a Catch-22. "They are uncertain whether they need to retain every electronic communication, including spam, explains Elizabeth Knoblock, an attorney in Dechert's financial services group.

Most regulatory experts urge advisers to be conservative. "The big question right now is, What do I save?'" says Mont Levy, a principal with Buckingham Asset Management, an investment adviser in St. Louis that provides advisory services to small investment advisers. Levy's answer: Save it all.

Other tips: Clearly mark e-mails that fall under attorney-client privilege, or else they're fair game for regulators. Also, do careful due diligence when evaluating vendors of e-mail retention systems; some are more robust than others, especially in litigation support, Levy says.

Most advisers are choosing to save everything. But merely saving e-mails to a hard drive isn't enough. "As I understand it, all business-related e-mails have to be maintained, be tamper-proof, well-organized, retrievable, and searchable by keywords and by categories," Gallerstein says. She's using AdvisorMail Lite, an e-mail compliance system from LiveOffice Corp. that's designed for investment advisers with 15 employees or less.

The product is a scaled-down version of AdvisorMail, which is used by 20% of the nation's largest broker-dealers to monitor, retain, and archive thousands of e-mails, attachments, and instant messages in a secure location. Both products allow for fast retrieval of electronic communications during audits, investigations, or litigation; monitor all inbound and outbound communications; and index communications by indicators like keyword, sender, recipient, and date.

The service costs about $2,500 annually, and includes one hour of compliance consulting services from National Regulatory Services (NRS), a regulatory consulting firm. (NRS and Financial Planning are both owned by Thomson Media). Despite the considerable sum, Gallerstein says that she has no choice: "I can't stay in business without being in compliance." She suggests e-mail retention is only part of an overall compliance strategy, which includes portfolio management processes, trading practices, accuracy of disclosures and advertising, safeguarding of client assets and privacy, and business continuity planning.

The pairing of LiveOffice and NRS is an example of the multidisciplinary approach needed to ensure advisers get the right blend of technology and regulatory advice. Shilanski and Associates, an Anchorage, Alaska-based investment adviser with 11 employees, uses Data Quality Institute, which provides a combination e-mail archiving and consulting service. The package costs about $3,000 a year, but again, it's a mandatory cost of doing business, says Rosa Shilanski, one of the firm's principals. She adds that the firm prohibits sending of any personal e-mails and instant messaging.

The key to meeting needs of investment advisers is keeping the costs down while providing the highest quality service, says Larry Nagelberg, president of Data Quality Institute in Richboro, Pa. Since the new compliance rule went into effect, customer inquiries have been rising noticeably, he notes. Data Quality Institute recently retained the services of Global Relay Communications, an e-mail archiving provider. Global Relay's core e-mail system, Record Keeper, connects to an investment adviser's internal e-mail system-such as Microsoft Exchange-in real time over a secure Internet connection; captures inbound, internal, and outbound e-mail; and then stores it on either the adviser's or Global Relay's servers.

Record Keeper captures, serializes, time-stamps, and duplicates each e-mail, concurrently storing a copy of each one in a primary database utilizing RAID (redundant arrays of inexpensive disks), in a secondary database using robotic tape libraries, and in a tertiary, offsite tape-storage database for disaster recovery and long-term storage. The system features lifecycle management of e-mail, including audit trails and action logs, to ensure that all retention and disposal schedules are met.

The system's Compliance Reviewer is a rules-based engine that scans an e-mail's header, body, and attachments, stripping all relevant text and metadata (data about data) from the e-mail. Users configure the rules to flag any keywords and phrases contained in the e-mail.

Bigger investment advisers with their own in-house information technology departments have to sort through a glut of technical and legal issues, such as complying with laws and regulations, protecting themselves from lawsuits and reducing the cost of e-mail environments. Among the technical decisions are whether to archive all incoming and outgoing e-mails, or just those for specific users or user groups, and whether to archive e-mails before or after they're sent or received.

Another technical decision is whether to rely on a pure e-mail archiving solution or a more comprehensive records management system aimed at handling a variety of paper and electronic records, including e-mail, documents, transactions, and voicemail. The two alternatives aren't mutually exclusive.

"For regulatory compliance purposes, a firm needs to get a solution up quickly. But for long-range purposes it needs to think about more than e-mail-it needs to implement a comprehensive records management policy where all information is maintained in one place," says Erica Rugullies, an analyst with Forrester Research, a market research firm in Cambridge, Mass.

E-mail archiving systems-offered by firms such as iLumin Software Services, Open Text, Veritas, and Zantaz-offer the ability to review a sample of messages randomly or based on a lexicon and to implement supervisory features such as alerts, holds, and workflow. Records management systems-offered by EMC, FileNet, IBM, Interwoven, and Stellent, among others-manage e-mail as part of a comprehensive document policy and don't offer supervisory features.

Although the e-mail archiving market is growing rapidly as firms seek compliance, that growth will slow as archiving functions are subsumed by records management systems, and as a new generation of mail servers emerges with built-in archiving capabilities. Forrester projects that the market for e-mail archiving systems, $200 million in 2003, will peak at $1 billion in 2006, then scale back to $660 million in 2008.

By that time, according to Forrester, 41% of the e-mail archiving market will be owned by vendors offering integrated records management and archiving products that will allow companies to define automated classification schemes and retention policies for all records, including e-mail. They'll also offer storage management features-allowing, for example, newer records to be stored on fast, erasable media and older records to be moved to slower, nonerasable media according to predefined rules.

Whatever happens on the technology front, it's clear that investment advisers need to make compliance part of their everyday routine. Those who flunk the compliance test could find themselves out of business-or in jail.

Andrew Miller is a freelance writer in New York specializing in business topics.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

http://www.thomsonmedia.com http://www.Financial-Planning.com

The Dark Side of 3rd Party Marketing

2005-02-27T15:21:00.000-08:00

Hedge Funds Can Be Headache
For Broker, as CIBC Case Shows

By SUSANNE CRAIG
Staff Reporter of THE WALL STREET JOURNAL
February 22, 2005; Page C1

On Wall Street, hawking hedge funds has become hugely profitable. But a recent arbitration award against Canadian Imperial Bank of Commerce shows the downside for brokerage firms that market these lightly regulated investment vehicles.

A three-person arbitration panel this month ordered the bank's brokerage arm, CIBC World Markets, to pay almost $3.6 million to 11 wealthy investors who lost $5.5 million investing in a New York-based hedge fund marketed by the firm. One of the investors was former professional baseball player Bobby Bonilla.

The case is a cautionary tale for both brokers who are pushing hedge funds more aggressively and for investors who are putting more of their savings into them. Hedge funds are private investment partnerships that traditionally have catered to the wealthy and big institutions, but they increasingly are available to smaller investors. The funds sometimes make high-stakes bets on stocks, currencies and other investments, often using borrowed money to boost returns.

U.S. hedge funds today manage about $1 trillion in assets, up from around $400 billion just four years ago.

In the CIBC case, the aggrieved investors claim that the bank's brokerage conducted almost no "due diligence," or research, on the fund that it sold its client, part of a hedge-fund family known as Red Coat, and failed to disclose that some of Red Coat's other funds were losers. Then, after they learned that the fund was tanking, they weren't allowed to cash out -- even though a CIBC employee involved in the brokerage's marketing efforts for Red Coat was allowed to pull his money, documents in the arbitration show.

"This case sends a message that firms can be held accountable if they market a virtually unregulated product to their customers without performing proper due diligence and then fail to monitor once it has been sold," says Philip Aidikoff, the investors' lawyer.

CIBC declined to comment. During the arbitration process, it said it did extensive background research on Red Coat and argued that the investors were well aware of the risky nature of the investment, having signed agreements stating Red Coat was "designed for sophisticated persons who are able to bear the risk of substantial loss."

Most people who put money in hedge funds have few legal options if they feel they were wronged when investments go sour, other than going through the costly process of suing. Brokerage clients, however, agree ahead of time to settle any disputes through arbitration, usually overseen by the National Association of Securities Dealers. That restricts their access to the courts, but provides a lower-cost alternative.

The CIBC case is one of the first big ones involving a hedge fund to snake its way through the arbitration process, so it could be a harbinger. Unlike judges in court cases, arbitration panels don't formally create precedents that subsequent panels must follow because each case is decided independently on its merits. But arbitrators sometimes look to other decisions for guidance.

Because most of their investors are very wealthy and sophisticated, regulators have approached hedge funds with a laissez-faire, buyer-beware attitude. But U.S. federal regulators have moved to increase scrutiny of the vehicles as they have become more available to the middle class.

That trend has been driven in part by the desire of Wall Street firms like CIBC World Markets to get into the lucrative game, selling their own hedge funds, creating investment vehicles based on multiple hedge funds (so-called funds of funds) and marketing independently run hedge funds in exchange for a share of the fees that investors pay.

Traditionally, hedge funds have required an initial investment of at least $1 million. But some clients who invested in Red Coat through CIBC World Markets put down as little as $75,000, suggesting that some might not have been as wealthy as typical hedge-fund investors. Red Coat charged investors a 1% management fee, plus 20% of any profits the fund earned. CIBC World Markets got one-fourth of both fees for clients it steered toward Red Coat -- or one-quarter of a penny for every dollar invested plus 5% of any fund profits, the brokerage firm said during the arbitration process. CIBC shared those proceeds with its brokers.

Red Coat also steered stock-trading business -- and the commissions it paid for such services -- to the CIBC brokerage. That provided an added incentive for CIBC brokers to steer investment clients to Red Coat, Mr. Aidikoff says. In September 2000, the executive who ran the CIBC World Markets office in Los Angeles told the CIBC executive in charge of deciding which hedge funds to market to CIBC clients that Red Coat had promised to double the amount of stock-trading commissions it would pay the brokerage to $3 million in 2002.

"This is a very sharp group of individuals that are worthy of our consideration and hopefully your department's approval," CIBC's Los Angeles-based Richard Wisely said in the letter to Howard Singer, the chief of the brokerage's Alternative Investments Group. Mr. Wisely no longer works for CIBC and didn't respond to requests for comment.

Mr. Aidikoff says most of his clients were persuaded to invest in Red Coat by CIBC in early 2001 -- without being told that Red Coat's other funds weren't doing very well. In a letter to Red Coat investors the previous November, the former mutual-fund executive who ran the hedge fund, Ken Londoner, said 2000 performance for one of his other funds was "very disappointing." Mr. Aidikoff says CIBC would have known about this letter if had done proper due diligence on Red Coat.

CIBC told the aggrieved investors that Red Coat was a good way to invest in a broad range of companies, Mr. Aidikoff said in the arbitration proceeding, adding that the clients also were told the fund wouldn't invest more than 5% of its assets in any one stock and would automatically sell any stock that dropped in value by 15%.

In September 2001, the hedge fund's performance took a turn for the worse, and CIBC canceled its sales agreement with the hedge fund a month later. But CIBC's clients were locked into the fund because they had signed documents agreeing to keep their money in the fund for a year unless the fund gave them permission to withdraw earlier. All 11 of the aggrieved investors tried to cut their losses by liquidating their investments, but Mr. Londoner refused to let them, Mr. Aidikoff says.

One of that fund's investors, however, was allowed to liquidate: Mr. Wisely, the man who used to run CIBC World Markets' Los Angeles office and who told CIBC's alternative investment chief, Mr. Singer, that Red Coat's managers were "worthy." Mr. Wisely had told Red Coat's Mr. Londoner in an August 2001 letter that he needed the money so he could help out a brother who was going through a divorce.

Later, in a letter to another CIBC executive, Mr. Singer called Mr. Wisely's move a "preferential" liquidation that constituted "a significant ethical breach." Mr. Singer couldn't be reached for comment.

By the end of 2001, Mr. Aidikoff said during the arbitration process, the fund's assets had fallen in value by 71%, and investors learned that most of Red Coat's assets -- including some borrowed funds -- were invested in the poorly performing stock of one health-care company: e-MedSoft.com, which is now known as Med Diversified and has been in bankruptcy proceedings since late 2002.

Write to Susanne Craig at susanne.craig@wsj.com1

URL for this article:
http://online.wsj.com/article/0,,SB110902566097860225,00.html

Loopholes to SEC HF RIA Reg (II 2/9/05)

2005-02-09T10:13:00.000-08:00

February 9, 2005
Lawyers Spot Loopholes To Hedge Fund Registration

Hedge funds torn with the unappetizing choice of registering with the Securities and Exchange Commission by February 2006 or talking their clients into a two-year lockup are casting around for other loopholes. While it's unlikely most hedge funds will go to such lengths, Section 3 of the Investment Company Act of 1940 contains 12 exemptions besides the lock-up period that could offer an escape hatch. Some lawyers are also looking at the way the 40 Act defines "investment company" to see if this, too, can offer a way out.

One alternative is Section 3-c3, which exempts banks and insurance company pooled funds from SEC regulation. There are some lawyers who wonder why any hedge fund firm could not just adopt the guise of an insurance company in one of several states that regulate insurance very lightly. Robert Rosenblum, partner in Kirkpatrick & Lockhart, thinks that view is simplistic. But he does believe a large financial conglomerate, which already happens to own a bank or insurance company, could set up a common trust fund to function as a hedge fund.

The 1940 Act definition of what is an "investment company" subject to registration also raises possibilities. The SEC takes the position that futures are not securities so a hedge fund trading solely in futures would not be covered by either 40 Act registration or the new IAA rule. It would even be possible to put some portion of the portfolio into the spot market, since a company may trade in securities up to 40% of assets without being a registered investment company. Hedge funds concentrating on mortgages or taking title to real estate could use another exemption, Section 3-c5.

Latest on SEC PIPEs Probe

2005-02-07T06:08:00.000-08:00

Short-selling probe snags three hedge fund managers
Fri Feb 4, 2005 07:37 PM ET

By Michael Flaherty
NEW YORK, Feb 4 (Reuters) - U.S. and Canadian regulators have charged three hedge fund managers with insider stock trading violations as part of a broad investigation launched last spring into a string of alleged short-selling abuses.

CompuDyne Corp. (CDCY.O: Quote, Profile, Research) said this week it recently learned that former investor Hilary Shane faces NASD charges of violating securities laws in a financing deal the security company did in October 2001.

Shane, a former hedge fund manager at First New York Securities, LLC, made $1.1 million from inside information of the deal, according to an NASD complaint filed in late December.

Michael Finkelstein and Elizabeth Leonard, of Toronto-based Stonestreet LP, face similar charges by the Investment Dealers Association, a Canadian regulatory agency.

The charges come less than a year after the U.S. Securities and Exchange Commission and the NASD pursued allegations of hedge funds profiting from inside knowledge of private investments in public equity, a transaction known on Wall Street as a PIPE.

PIPEs help cash-strapped companies raise money quickly by selling discount-priced shares to a group of investors. The stock of a company conducting a PIPE usually falls in the short-term because the transaction floods the market with additional shares.

Regulators are investigating whether individuals who helped finance a PIPE profited from selling short the company's shares before the deal closed, knowing its stock was about to fall.

Shane, who left First New York in 2002, is accused of doing exactly that.

Short sellers borrow shares of a company and then sell them in anticipation of a decline. They profit when the stock falls since they can buy back the shares at a lower price and pocket the difference.

In September 2001, a representative at investment bank Friedman, Billings, Ramsey Group Inc. (FBR.N: Quote, Profile, Research) contacted Shane about doing a PIPE with CompuDyne, according to the NASD complaint.

The complaint says Shane made false representations about her investment intent, obtained the right to acquire 475,000 shares of CompuDyne and then engaged in unlawful insider trading by selling the company's stock short while in possession of material, nonpublic information.

First New York has not been charged in relation to the case. Shane could not be reached for comment.

The complaint does not list charges against FBR, but FBR said on Nov. 9, 2004 that the SEC and the NASD were investigating the bank's role as a placement agent for an unspecified PIPE transaction in 2001. An FBR spokesman declined to comment further.

Finkelstein and Leonard face similar charges stemming from a PIPE involving Novatel Wireless Inc. (NVTL.O: Quote, Profile, Research) in 2001 and another with Trikon Technologies Inc. (TRKN.O: Quote, Profile, Research) a year later.

Stonestreet LP's Web site lists Finkelstein and Leonard as officers of the investment firm. The IDA complaint says that Stonestreet maintains a non-client account at Canaccord Capital Corp.'s Toronto office that operates as a hedge fund, which Finkelstein and Leonard co-manage.

The fund would hedge against its anticipated investment in a PIPE by "shorting the issuer's underlying stock," according to the complaint that was filed on Jan. 7.

Reached by telephone at Stonestreet, Finkelstein said he would not comment. Leonard could not be reached.

Last week drugmaker Nuvelo Inc. (NUVO.O: Quote, Profile, Research) said the SEC had contacted it about a private transaction the company did in 2002.

"We're concerned about instances in which hedge funds executed profitable short sales in an issuer's underlying equity after learning about a pending PIPE transaction," said SEC spokesman John Heine. "Our review is continuing."

--------------------------------------------------------------------------------

New RIA Rules - Some Effective 2/10/05 (Opalesque 2/7/05)

2005-02-07T06:00:00.000-08:00

Bryan Cave alerts some hedge fund rules will be effective Feb. 10th While the new rules only require registration by February 1, 2006, certain provisions of the new rules will be effective on February 10, 2005. First, the Advisers Act prohibits registered hedge fund managers from charging a performance fee unless the client is a "Qualified Client" (as defined in Rule 205-3 under the Advisers Act). The New Rules contain a grandfathering provision that allows hedge fund managers registering under the New Rules to continue charging performance fees to existing clients that are not "Qualified Clients". However, the grandfathering provision only applies to existing investors as of February 10, 2005. As a result, currently unregistered hedge fund managers that will be required to register under the New Rules may only charge a performance fee to a client admitted to a fund or otherwise investing with the hedge fund manager after February 10, 2005, if the client is a "Qualified Client".
Second, a registered investment adviser must keep and maintain certain books and records supporting its performance history in order to advertise such performance history. As with the performance fee rule, the New Rules contain a grandfathering provision that allows hedge fund managers required to register under the New Rules to continue advertising on the basis of their (or their hedge funds') performance despite not having kept adequate books and records. However, an unregistered hedge fund manager that will be required to register under the New Rules may only rely on this grandfathering provision if it keeps and maintains appropriate records relating to performance beginning February 10, 2005.

NASD BD Registration Still Needed

2005-02-03T07:48:00.000-08:00

Finders Keepers

The SEC is hearing new demands to make it easier for small companies to raise capital.

Ronald Fink, CFO Magazine
February 01, 2005

It's no secret that small businesses have an especially hard time raising capital. But risk-averse banks and investors don't deserve all, or perhaps even most, of the blame, according to some observers. The real culprit, they charge, is federal regulation — in particular, a 70-year-old rule that bars companies from hiring unregistered intermediaries, or "finders," to help them raise money.

The rule, part of the Securities Exchange Act of 1934, was obviously designed to keep middlemen from engaging in securities fraud and other unsavory financial activities (see "Under the Radar," at the end of this article). But critics believe the rule has outlived its usefulness. One is Bill Evers, a retired attorney in San Francisco who is trying to start a chain of weight-management clinics but is unsure where to turn for financing. Evers complains that traditional sources for start-ups, such as venture capitalists, are now more interested in providing second- or even third-round financing, or in refinancing better-established but struggling companies.

Meanwhile, says Evers, small, federally registered broker-dealers that might once have provided capital have either gone under or merged into larger investment banks that don't consider start-ups worth their time. "The system starves start-ups," he insists. While Evers says legitimate but unregistered finders are common, he complains that the rules make them publicity-shy. As a result, he says, "small-business guys can't find the finders."

Support for Evers's views comes from the CEO Council, a group representing some 200 senior executives of public companies whose stocks trade in the over-the-counter market and 150 broker-dealers that back their deals and execute their transactions. In recommendations recently delivered to the Securities and Exchange Commission, the council noted that "a major difficulty facing small business is obtaining equity capital," and that the current regulatory environment, including registration rules for broker-dealers, "unfairly restricts capital formation for small businesses."

Such groups have sought relief from the SEC for years, most recently at a forum on small-business capital formation that the commission held last September. But so far, their demands have fallen on deaf ears. Brian Bussey, assistant chief counsel for the SEC's division of market regulation, told the forum that "the possibility of lesser regulation...is a massive undertaking," and indicated that the commission has yet to receive hard evidence of how companies are being hurt by its broker-dealer registration rules.

A License to Deal
Now, however, the SEC is facing new pressure to reconsider its stance. A task force of the American Bar Association (ABA) has been studying the issue since 2002, and is expected to offer its recommendations to the SEC around the time of the ABA's spring meeting next month. Although details weren't available as this article went to press, experts familiar with the task force's deliberations expect it to recommend that the SEC ease its registration requirements under certain circumstances.

"It is time to seek out a way to permit the capable, honest financial intermediaries who are not presently registered to find a means to attain compliance," stated Hugh Makens, a former securities commissioner for the state of Michigan and a partner in law firm Warner Norcross & Judd LLP in Grand Rapids, in a report he presented at the SEC forum.

Under federal securities law, anyone can become a broker-dealer of securities by obtaining a license from the National Association of Securities Dealers (NASD) and registering with the SEC and state authorities. But because of rising costs and competition, the industry is now dominated by large investment banks.

At the minimum, Makens contends, the commission should ease the registration requirements for finders that limit their services to asset sales. "A significant number of M&A transactions [use] unregistered finders who receive transaction-based compensation," he noted in his report. Yet Makens says many of the deals are legitimate and that more would take place if finders didn't have to obtain a Series 7 license, as NASD and the SEC require, for purposes of promoting stocks. "These finders act more like business brokers" than dealers in securities, he observes.

Makens contends the test involved is essentially irrelevant to M&A transactions. Not to mention time-consuming and costly: the Series 7 exam lasts six hours and typically requires months of preparation. Also, an examinee must be sponsored by a member firm of the NASD.

Take Money, Run
But as Bussey makes clear, the SEC is unconvinced that its registration rules are overly onerous and thus hinder capital formation. Of course, the SEC's priority is to protect investors from fraud, but while it's also required by law to consider the interests of companies, the latter, too, are often victimized by unregistered brokers.

The SEC isn't alone in its defense of registering broker-dealers. In line with the 1934 act, state laws generally prohibit finders that aren't registered with the SEC from accepting payment for transactions. "It's not that difficult to find a broker-dealer willing to raise capital for small business," insists Joe Borg, director of the Alabama Securities Commission and chairman of the enforcement section of the North American Securities Administrators Association. "A lot of issuers don't want to go to the trouble of finding a licensed finder," he adds.

But he warns that they're taking a big risk in not doing so, since deals arranged by such finders can run afoul of regulators, sending companies in need of capital back to square one. Nonetheless, says Borg, "a lot of issuers want to get the money in a hurry, and worry about the problem later."

Also, lawyers who specialize in this area report that companies often pay unregistered brokers big upfront fees only to see the brokers abscond. Steven Hecht, a partner in the Roseland, New Jersey, law firm of Lowenstein Sandler PC, says he is litigating a number of cases on behalf of small companies seeking to recover at least some of the money they've lost in this fashion. Hecht declines to identify any of these clients by name, but explains that in one case, a finder who claimed to be helping his client actually used his position to drive down the price of the company's stock in hopes of taking over control. "Unfortunately," says the attorney, "you get what you pay for."

Despite the SEC critics' arguments, Hecht and other attorneys believe that the regulators should not bow to pressure for easier registration requirements. He notes that broker-dealer registration "goes hand in hand with corporate governance" and that the SEC cannot relent on such issues in light of the widespread fraud revealed in the wake of the failure of Enron and other companies. "They're still trying to reinstill confidence in the public markets," says Hecht.

The Singing Rolodex
What's more, the SEC has already made exceptions to registration possible through a number of "no-action" letters. The most widely cited letter involved the singer Paul Anka, whom the SEC allowed in 1991 to receive payment in return for introducing the general partner of the Ottawa Senators hockey team to several acquaintances who became limited partners in the franchise. Essentially, the SEC ruled that Anka's payment complied with the 1934 act so long as he confined his involvement to the introduction and didn't make a practice of such activities. "He was able to sell his Rolodex once," explains Bruce MacKenzie, a partner in the Minneapolis office of Dorsey & Whitney LLP.

Makens contends that the exception the SEC made for Anka is far too narrow to address the needs of small businesses. But recent actions by the SEC suggest that it's trying to narrow its scope even further. In 2000, the commission withdrew a no-action letter that it had issued to Dominion Resources 15 years earlier allowing the utility to arrange a wide array of securities transactions without registering as a broker-dealer. (That makes it more onerous for CFOs to cut out the middleman by issuing securities themselves.)

Also, as a result of Sarbanes-Oxley, the SEC has amended its auditor-independence rules to include a specific prohibition against certified public accounting firms acting as promoters or underwriters of an audit client's securities, whether or not the CPA firm was registered as a broker-dealer.

In light of all this, MacKenzie predicts that lobbying efforts to get the SEC to loosen its registration rules will amount to "an uphill battle." And even if the SEC or lawmakers were inclined to change course, either would most likely run into stiff resistance from a lobby more influential than the CEO Council — the NASD polices broker-dealers for the SEC. As a government-sanctioned monopoly, observers say, the NASD would surely oppose any move to ease registration requirements, since that would invite smaller, less-well-capitalized brokers into the business, threatening its members' market share and profit margins. "Why would the NASD welcome the competition?" wonders attorney Hecht.

For that reason, Bill Evers says that the federal regulatory regime needs fundamental reform to benefit start-ups. "We need a small-business alternative to the NASD," he insists.

But he isn't counting on one in time to help get his weight-management clinics off the ground.

Ronald Fink is a deputy editor of CFO.

--------------------------------------------------------------------------------

Under the Radar

Just how many unregistered finders try to fly under the regulatory radar is anyone's guess. But the Securities and Exchange Commission can cite plenty of fraud cases in support of its current regulatory requirements for broker-dealers. One recent case involved Vector Medical Technologies Inc., a biotech company based in Boca Raton, Florida. The commission sued several of Vector's stock promoters in late 2001 on charges of defrauding 450 investors — primarily individual physicians from around the country — of roughly $16 million in 1999 and 2000. The SEC claimed that Michael H. Salit, Vector's chairman and CEO, along with other individuals, sold the investors stock in the company based on false claims that their capital would help Vector market a "breakthrough" transdermal patch it had developed that was capable of delivering insulin and similar drugs.

Since neither Salit nor any of the other individuals named in the complaint were registered broker-dealers, the SEC argued that they acted as illegal finders when they pocketed hefty commissions from the money they raised instead of using it as promised. A federal district court in Florida agreed in October 2004, barring Salit from ever again serving as an officer or director of a publicly held company, and all of the defendants from participating in penny-stock offerings.

The SEC may see the Vector case as one more reason not to loosen its registration rules. But representatives of small business contend the commission should draw the opposite conclusion. These critics argue that a looser regime would help the SEC oversee activity that is now widespread but unregulated. The current rules, they say, have the unintended effect of discouraging scrupulous brokers from registering, leaving more of the field to those inclined toward fraud.

Meanwhile, the potential abuse of investors by unregistered finders is by no means limited to the promotion or sale of securities. Consider the case of Frank E. Walsh Jr., former lead director and compensation-committee chairman of Tyco International Inc. Walsh received a $20 million finder's fee for recommending that Tyco acquire financial-services firm CIT Group, and for arranging an initial meeting between the companies' CEOs. Within a year of buying CIT for $9.2 billion in June 2001, however, a series of corporate-governance scandals rocked Tyco, forcing it to unload CIT for less than half of the purchase price.

In this case, however, the SEC went after the payment to Walsh not because he wasn't registered as a broker-dealer, but because the fee wasn't publicly disclosed, and the SEC considered it a material event. Walsh settled with the SEC in December 2002 by agreeing to disgorge the $20 million and never again serve as an officer or director of a publicly held company. —R.F.

New Provision of HF RIA Rule On 2/10/05

2005-01-26T06:25:00.000-08:00

Registering with SEC as an Investment Adviser Will Change Life as a Hedge Fund Manager…Here's One Change that Starts February 10, 2005

posted by southport on Tuesday 25 Jan 2005 19:29 GMT

The December 2, 2004 decision by the SEC to extend its oversight to a large portion of the hedge fund industry will result in the need for changes in a number of common hedge fund industry business practices.

One common practice that is likely to change is the criteria utilized for screening of potential U.S. investors.

Currently, many hedge funds screen investments by U.S. persons or entities for “accredited investor’ status so that the fund they manage may remain “private” under the exemption available under Reg D.

This practice will likely be adjusted once an adviser becomes registered as investment adviser with the SEC.

As registered investment adviser, a firm will be subject to Rule 205-3; which largely restricts the practice of charging performance fees to funds that satisfy the exemptions available under 3(c)(1) and 3(c)(7).

The financial requirements for investor eligibility under each of these exemptions are generally more stringent than the tests for eligibility as an “accredited investor”.

Funds utilizing the exemption under 3(c)(1) may have up to 100 investors that meet the test of “qualified clients”. The tests for “qualified client” are generally more stringent than those for “accredited investors”. For instance, the net worth test for an individual “accredited investor” is $1 million. While the net worth test for “qualified clients” is $1.5 million.

The financial tests for eligibility under 3(c)(7) are substantially greater than 3(c)(1) and “accredited investor” tests.

The practical effect of this new regime will be that unless investors pass the “qualified client” test, the manager will not be able to charge a performance fee to that client and will probably not view that prospect as an attractive candidate for investing in his fund.

The SEC, under a grandfather provision, will allow managers to charge performance fees to hedge fund investors who meet the “accredited investor” test, but not the “qualified client” test, if the client invested in the fund prior to February 10, 2005.

So, if a prospect is an “accredited investor” but does not quite meet the “qualified client” test, February 10, 2005 is the last day that he can invest in the fund and be eligible to pay a performance fee once the investment adviser registers with the SEC.

If you have any questions with respect to this matter or any other questions relating to the forthcoming regulation of hedge fund managers give a call to Emmett Ryan or Paul Taylor at Buchanan Hedge Fund Services (212 809-7171) and we will try to get you an answer.