CFTC Regulation and Compliance: Not Just for Commodities Brokers Anymore

Posted by Susan Mangiero on November 03, 2012

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Although the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed over two years ago, regulators and financial market participants are still grappling with its complexities. Some aspects are still being finalized which adds to the challenge of compliance. According to "U.S. regulators yet to implement one-third of Dodd-Frank rules" by reporter Pat Dulnier (Bank Credit News, November 2, 2012), about 40 percent of the 398 mandate creation requirements have not been met. The U.S. Commodity Futures Trading Commission ("CFTC") is cited as having "made the most progress" in doing what it is required by law, "having finalized 40 of the 60 rule-makings for which it was responsible."

Any information that experts can shed on compliance is welcome. One of the areas that is both important and yet not fully understood is the extent to which firms must register with various government bodies. To fill the knowledge gap, Day Pitney LLP investment attorneys Samuel A. Jennings, Henry  ("Hank") Nelson Massey and Joseph F. Morcos are speaking as part of a complimentary webinar about CFTC regulation and compliance. Topics to be discussed include:

  • How the definition of "commodities" has been expanded;
  • Loss of exemption previously relied upon by hedge funds and other private funds;
  • Looming end-of-year 2012 compliance deadlines;
  • What firms must do to register by December 31, 2012;
  • Who must take proficiency exams; and
  • Details related to National Futures Association ("NFA") examinations.

According to Attorney Massey, "The recent changes to CFTC regulations have the greatest impact on funds whose wealthy investors have traditionally been viewed by the private fund community and the public generally as having the ability to fend for themselves. Private funds with large, sophisticated investors may cope by way of Rule 4.7 registration, or 'CFTC Lite', which removes some of the more burdensome compliance requirements of full-scale CFTC registration. However, the deadline for registration is fast approaching, so affected funds need to start the process right away." 

Click to register for "CFTC Regulation and Compliance: Not Just for Commodities Brokers Anymore." Continuing legal credits ("CLE") will be offered.

QPAM and INHAM Compliance Audit 101 For ERISA Asset Managers

Posted by Susan Mangiero on October 11, 2012

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In this timely and informative webinar hosted by FTI Consulting, legal and compliance experts will provide critical information about the Qualified Professional Asset Manager ("QPAM") exemption and related compliance audit requirement that applies to numerous financial institutions that manage or want to manage ERISA pension money. Speakers will likewise address the merits of managing money for captive ERISA benefit plans and what it means to be an In House Asset Manager ("INHAM").

Getting the right team to conduct the required audit is one important way to mitigate litigation and enforcement risk and to attract and retain institutional dollars. Having a proper audit conducted and using the information to correct deficiencies is another critical step for anyone who understands that non-compliance can be costly.

This timely and informative webinar will address issues that include the following:

  • Background information about the new ERISA rule for a Qualified Professional Asset Manager (“QPAM”) audit;
  • What it means to be a Qualified Professional Asset Manager or In-House Asset Manager ("INHAM");
  • Who must comply and in what timeframe;
  • Who can carry out a QPAM /INHAM audit;
  • What a QPAM audit entails in terms of information-gathering and scheduling;
  • Case study discussion; and 
  • How the results of a QPAM audit can be used to improve operations and client relationships.

Who Should Attend:

  • Chief Compliance Officers of asset managers
  • Business development executives for asset managers
  • Internal legal counsel for asset managers and other financial firms
  • ERISA consultants and investment advisors

Please join Timothy Brennan, Assistant General Counsel at The Hartford; Howard Pianko, Partner, Seyfarth Shaw LLP; and Susan Mangiero, Managing Director, FTI Forensic & Litigation Consulting as they address these issues and your questions. To attend this free webcast scheduled for Tuesday, October 23, at 1:00 pm Eastern, please click to register for "Managing ERISA Pension Money - QPAM and INHAM 101."

For further information, click to read "Amendment to Prohibited Transaction Exemption (PTE) 84-14 for Plan Asset Transactions Determined by Independent Qualified Professional Asset Managers," Federal Register, July 6, 2010.

Investment Style Drift and Litigation

Posted by Susan Mangiero on September 18, 2012

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Unlike Confucius who extolled the virtues of travel when he said that "A thousand miles begins with a single step," change may not be a good thing for asset managers and their investors. In recent presentations by attorneys, I have heard more said about litigation related to investment style drift than ever before. The notion is that portfolio managers need to disclose any change in the way they trade so that presumably investors can make an informed decision about whether to stay or go.

According to hedge fund attorney Judy Gross, we are likely to see more litigation around disclosures (or lack thereof) about what a fund manager promises to do with other people's money. In "Is Your Hedge Fund Style 'Drifting'? Quick, Catch It" (Forbes, June 25, 2012), she cites the matter of the United States Securities and Exchange Commission v. Patrick G. Rooney and Solaris Management, LLC as a prime example. Among other things, the hedge fund is accused of having overly concentrated positions instead of diversifying. With Form PF and other mandatory filings a reality, investors and the plaintiffs' bar will arguably be better able to compare what a fund says it will do and what it does.

In "When investing, what you see may not be what you get," TIAA-CREF economist Brett Hammond asserts that style purity is akin to "truth in advertising." He adds that when style drift occurs, it makes it difficult for the investor to properly benchmark. This in turn means that one might end up over- or under-weighting a particular asset class or issuer or both. I would add that for some types of investors such as ERISA pension plans, the danger is that an Investment Policy Statement could be violated. As a result, allegations of fiduciary breach might ensue, with benefit plan committee members being accused of not doing sufficient due diligence on the errant money manager.

Some investment managers have long been granted tremendous latitude in how they invest. I remember calling an equity fund manager during our last bull market and asking why his performance was lagging. It turns out that he had parked a large amount of the portfolio in cash because he was uncertain about directional moves. Unfortunately, given his freedom to take this action, much of the rest of the market ran ahead of expectations while this fund's performance suffered, with investors paying the price. More recently, my work as a financial expert entailed offering an opinion about whether a fund manager had wronged investors because he and his partners had prettied up performance with capital injections on behalf of some and not others. What caught my attention in that matter was a description in the Private Placement Memorandum that granted the managers full freedom to invest as they pleased. The language about style was overly broad, perhaps intentionally so.

What will likely remain a challenge in some situations is to accurately define the investment strategy in order to discern whether drift has occurred. Moreover, it will be important to identify when a fund manager is allowed to switch strategies in order to preserve capital versus "flagrantly" ignoring the desires of its institutional and individual clients.

Hedge Fund Succession Planning

Posted by Susan Mangiero on June 28, 2012

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As a trained appraiser, it always surprises me when private fund organizations have no succession plan and/or key person insurance in place. After all, a hedge fund or private equity fund is a business like any other. Should a marquee name trader quit or a partner says "I'm out of here," investors get jittery and the future prosperity of an investment organization can take a real hit.

If a June 27, 2012 article in FIN Alternatives is true, the tide may be turning in favor of mitigating the risk of a disappearing asset in the form of a "hard to replace" individual. According to "'Key Man' Insurance Sales Rising" in which David Parker, the president of the SKCG Group, is cited, "If a fund loses one of those individuals, the next step is often the dissolution of the company. Key man insurance can make the difference between an orderly wind down and a chaotic one." He adds that institutional investors have pressed for protection against the departure of anyone who is deemed material to the operations of a fund. General partners whose compensation depends on a trader or team of traders staying put are another driving force behind the rise in key person insurance.

According to a recent Baronsmead trends survey, other insurance policies are finding favor with hedge fund managers as well. They report that 93% of directors are covered by Directors & Officers ("D&O") insurance versus 83% last year. Professional indemnity insurance has been purchased by 82% of managers in their sample which is up from 64% last year.

Increased litigation against hedge fund general partners and board members may be one reason for the uptick in protective policies. According to its company website, Baronsmead senior partner Robert Kelly cites the Weavering Capital fraud case and a recent Alternative Investment Fund Managers ("AIFM") directive as two of several reasons for insurance policy purchases.

As long as more insurance means better coverage against any action that could destabilize a fund or impair its ability to stay in business, institutions such as pension funds, endowments, family offices and foundations should be encouraged. Of course they can and should ask to see copies of the various policies and verify for themselves that adequate limits are in in place.

Hedge Fund Fees - More Questions

Posted by Susan Mangiero on May 03, 2012

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A financial advisor approached me the other day with a question about whether his endowment client should be expected to pay a management fee on assets that are subject to lock-up and likely to be liquidated.He added "I understand that the 20% fee on any profit wouldn't apply since there are no profits but I cannot imagine that paying a management fee of whatever amount on an asset carried at its purchase price, but likely to be worthless at the end of the lock-out period, would be the act of a prudent fiduciary. But perhaps the endowment would be obliged to pay a fee based on the terms of the contract."

While I don't like to answer questions without having adequate information, my immediate immediate response was to say that a lock-up does not necessarily translate to an asset having little or no value.

Being curious about what others would say, I asked two hedge fund experts, Attorney Tim Selby and Attorney Joyce Heinzerling. They have each given me permission to reproduce their answers herein.

According to Attorney Tim Selby:

"It is common practice for a manager to charge a management fee on an illiquid asset.  Even though the asset is illiquid, the manager may in fact still be actively managing and monitoring the asset.  In private equity funds, the manager will typically reduce the management fee on assets under management once the investment period ends because its activity lessens.  This is not, however, a common practice with hedge fund managers who manage an illiquid portion of a fund’s portfolio. Typically they will still charge the full management fee but it will be based on the cost of the investment rather than its fair market value which may not be determinable. Depending on the amount invested by the investor it may be able to negotiate for a reduced fee."

According to Attorney Joyce Heinzerling says:

  • Quite ofen a hedge fund manager side-pockets an illiquid investment and when that ocurs, generally speaking, the manager will not typically charge a management fee on the side-pocketed assets. But that is not always the case. I know of several hedge fund managers that continue to charge management fees on side-pocketed assets from back in the 2008-2009 period. That is not a best practice. Ultimately, the fund's Private Placement Memorandum ("PPM") will disclose whether the manager will charge fees on side-pocketed assets. If that language is not included in the PPM, then the manager would have to send a letter to investors stating the intent to charge fees on side-pocketed assets. With that, the hedge fund manager would attest that there is no constituent document language or other legal reasons the prehobits the hedge from manager from proceeding in that direction.
  • If the financial advisor is asking about the "fund" being in a lock-up period because liquidity is so bad that it cannot honor redemptions (if they are allowed in the first place), the answer to the fee question should be found in the PPM. The standard practice is to continue to charge a management fee because the manager is tending to portfolio investments in order to gain liquidity. You are correct  that one cannot make an assumption about the value of an asset just because it is carried at cost. Even if an asset is illiquid, there is bascially a chance that the asset will eventually reset to a higher value. One cannot assume today that any particular asset will have no value at the end of a lock-up period, whether it is in the case of a side-pocket or a suspension of redemptions.
  • All investors are treated the same in these cases, it would not matter that the investor is a endowment versus a pension plan versus a high net worth individual.

    • When I recounted these answers to the inquiring financial advisor, his response suggested that such terms would be deemed onerous by his client. A natural reaction is to advise all parties involved to carefully review the terms of any investment, hedge fund or not.

Recent studies suggest that pressure on hedge fund and private equity fund manager to lower fees will continue. No doubt discussions will address redemption, valuation and liquidity as well.

Investment Fraud Early Warning Signs

Posted by Susan Mangiero on April 14, 2012

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My comments on April 3 about investment fraud and risk governance struck a chord. As a co-presenter for "Going Beyond the Essential Background Checks: Accessing Crucial Information About the Management Team, Board of Directors, the Economics for the Team and the Succession of the Investment Staff," 4th Annual Due Diligence & On-Going Monitoring of Alternative Investments Summit, Financial Research Associates, LLC, I talked about the numerous reasons why a typical background check is necessary but insufficient.

Send an email to Dr. Susan Mangiero if you would like more information about investment fraud thought leadership under way.

In the meantime, some hot button items that should be considered by institutional investors and asset managers that want to be green lighted by pensions, endowments, foundations, family offices and sovereign wealth funds include, but are not limited to, the following:

  • Legal Ownership Structure - Ask for information about who owns what, who has voting rights and whether or when assets can be transferred across legal and tax jurisdictions. If an asset manager cannot or will not provide an organization chart and legal documentation that explains an often complex ownership structure, think twice about taking next steps. I resigned from an assigment to value a U.S. hedge fund limited liability partnership ("LLP") when the CEO and the company's attorney begrudgingly provided by-laws and an organization chart that illustrated firsthand a hard-to-understand web of cross-ownership (offshore and onshore). Should trouble occur, it is imperative to understand how economic rights are distributed and on what basis.
  • Job Descriptions - A titular executive is not the same thing as having an experienced and knowledgeable person fill a critical function. As an expert witness, I wrote a report that pointed out, among other things, that the Chief Risk Officer was in name only. The actual person who bore that title was anything but a risk management professional.
  • Internal Controls - Entire books have been written about the importance of vetting operational risks and internal controls. Suffice it to say, make sure that important tasks such as trading and approving wire transfers are each carried out by different individuals. Transactions should be verified on a regular basis by independent parties. Checks and balances should be in place to avoid breach for items such as surpassing trade size, making a material change to investment reports and/or modifying the approval process for moving money.
  • Complexity and Model Risk - As I discussed in "Model Risk and A $242 Million Overlay" (February 3, 2011), models can be nested so that mistakes made at one level can be catastrophic if not caught early and corrected. That is exactly what happened in a matter relating to AXA Rosenberg, costing the firm nearly $250 million. Someone has to kick the tires on a regular basis. Model audits should be conducted by individuals who are not going to be compensated on the basis of a model's outcome(s).  When trading strategies are complex, it is sometimes tough to identify problem areas. I remember the words of one of my doctoral professors vividly because they still ring true today. "If you can't explain a trading strategy or make-up of a model, you don't know enough to make important decisions."
  • Key Person Risk - Marquee name traders may be a draw for institutional and high net worth investors but proceed with caution. First of all, banking on a name trader does not guarantee that good processes are in place. Second, it is critical to know if key person insurance is in place to address the early exit of a trader or executive and the exact nature of the coverage. Also inquire about what happens if a key person gets a divorce and an ownership stake in the asset management firm becomes part of the settlement. Investigate whether the firm has a succession plan, a non-compete contract for departing executives and/or buy-sell agreement to guide how partners leave or join the firm.
  • Intellectual Property - Ask about ownership of a patent, trademark, proprietary technology and/or marketing/sales collateral. In one situation, there was a real concern that the head of sales would have carte blanche to use the client list on behalf of a competitor. Depending on the costs to acquire each client, use of a list elsewhere could deal a crushing blow to a firm and by extension, destroy value for limited partners and/or investors in a particular fund or fund family.
  • Governance and Committee Structure - A board of advisors can serve as a line of defense for investors in a fund as long as its members do their job well. I recall being interviewed to serve as an expert for a large hedge fund litigation. After having read the initial documents, I told the attorneys that the existence of a pricing committee and a risk management committee was impressive and asked to see the meeting minutes. The response was that neither committee had ever met. Of course a committee could meet on a regular basis but never address critical issues and thereby be ineffective, offering no safeguard for an investor(s).
  • Vendor Contracts - Unless someone is doing a comprehensive review of service provider contracts, an investor is likely to encounter a coverage gap. In the matter of hard-to-value investing for example, many times an independent verification of prices is left undone when fund of funds managers, prime brokers, custodian banks and/or consultants accept numbers from hedge fund and private equity funds "as is" as part of their respective contracts.
  • Investment Reports - Financial statements, audited or otherwise, do not always provide the same information on investment reports. The topic of performance reporting is left for another post as it is both broad and complicated. Suffice it to say however, all investors should be treated equally in terms of information access. With side letters and side pocket arrangements, disclosure may be limited and provided on a selective basis. As an expert on a regulatory enforcement case, I explained what industry standards exist for reporting true economic risks and returns versus statements that may be misleading at best. The hedge fund being investigated had topped off losses for some investors but not others and used some creative ways to report results.
  • Borrowing Capacity - In 2008 and 2009, numerous investors were taken by surprise when asset managers were unable to honor redemptions (if allowed in the first place). One indicator (and there were many) of a liquidity crisis was the inability for some asset managers to borrow enough cash to keep going. Even worse, some prime brokers pulled back existing credit lines and/or charged considerably more which in turn depressed potential upside for investors. Ask about the current costs of borrowing and the capacity and sources for an asset manager to borrow more if needed. Depending on the leverage inherent in an asset manager's trading strategy, it may be necessary to ask for a copy of borrowing agreements and to understand what could trigger a margin call(s).

The list of problem areas is long and worthy of close scrutiny, ideally by an independent third party who can work with the internal auditor, external auditor and/or board of directors (assuming that all of these parties are focused on best practices and not contributing to a fund's downfall). Institutional and high-net worth investors alike should monitor these and other risk factors before writing a check.

Background checks are invaluable tools for investors who want to conduct proper due diligence. Importantly however, a background check is simply not going to provide the kind of information described above that can make a difference between investment success and failure.

Insider trading, anti-money laundering, investment fraud techniques and much more are left for future blog posts...

ERISA Pension Plans: Due Diligence for Hedge Funds and Private Equity Funds

Posted by Susan Mangiero on April 02, 2012

Join me on May 1, 2012 for a timely and interesting program about alternative investment fund due diligence and other considerations for ERISA plan sponsors, their counsel and consultants. Click here for more information.

This CLE webinar will provide ERISA and asset management counsel with a review of effective due diligence practices by institutional investors. Best practices will be offered to mitigate government scrutiny and suits by plan participants.

Description

With the DOL's and SEC's new disclosure rules and heightened concerns about compliance and valuation, corporate pension plans that invest in alternatives must focus on properly vetting asset managers more than ever before or risk being sued for poor governance and excessive risk-taking.

The urgencies are real. The use of private funds by asset managers is crucial for 401(k) and defined benefit plan decision makers. Understanding the obligations of private funds is essential to any retirement funds with limited partnership interests.

In addition, suits and enforcement actions against asset managers make it incumbent on counsel to hedge fund and private equity fund managers to fully grasp and advise on full compliance with the duties of ERISA fiduciaries to plan participants.

Listen as our ERISA-experienced panel provides a guide to the legal and investment landmines that can destroy portfolio values and expose institutional investors and fund managers to liability risks. The panel will outline best practices for implementing effective due diligence procedures.

Outline

  • ERISA fiduciary duties for institutional investors
    1. Hedge funds and private equity funds compared to traditional investments
  • Regulatory developments
    1. Disclosure
    2. Compliance
    3. Valuation
  • Developments in private litigation involving pension plan fiduciaries and alternative fund managers
  • Best practices for developing due diligence plans

    • Benefits

    The panel will review these and other key questions:

  • What are the regulatory concerns for ERISA pension plans that allocate assets to hedge funds and private equity funds?
  • What are the potential consequences for service providers that fail to comply with new fee, valuation and service provider due diligence regulations?
  • What can counsel to pension plans and asset managers learn from recent private fund suits relating to collateral, risk-taking, pricing, insider trading and much more?
  • How should ERISA plans and asset managers prepare to comply with expanded fiduciary standards?

    • Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.

    Faculty

    Susan Mangiero, Managing Director
    FTI Consulting, New York

    She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors as well as offered expert testimony and behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary for various investment governance, investment performance, fiduciary breach, prudence, risk and valuation matters.

    Alexandra Poe, Partner
    Reed Smith, New York

    She has over 25 years of experience in investment management practice counseling managers of hedge funds, private equity funds, institutional accounts, mutual funds and broker-dealer advised programs. She counsels hedge and private equity fund advisers in all stages of their business and due diligence matters.

    ERISA Fiduciaries Under Attack: Key Litigation and Regulatory Developments

    Posted by Susan Mangiero on June 27, 2011

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    Courtesy of Strafford Publications, Dr. Susan Mangiero spoke on the topic of ERISA investment fiduciary pain points and the role of service providers. She was joined by esteemed colleagues Andrew L. Oringer (Partner, Ropes & Gray) and Christine A. Dart (Vice President, Chubb & Son) in a lively and informative debate about current ERISA litigation trends, "must do" action items regarding ERISA fiduciary liability insurance procurement and the vetting of investment decisions relating to fees, third parties, use of derivatives, hard-to-value investing, leverage and risk management.

    Click to read the transcript of comments by Dr. Susan Mangiero on the topic of ERISA investment fiduciary considerations.

    Click to order a recording of the full 90-minute program entitled "ERISA Fiduciaries Under Attack: Key Litigation and Regulatory Developments."

    Should Onshore Hedge Funds Have Outside Directors?

    Posted by Susan Mangiero on March 08, 2011

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    According to former fund of hedge funds Chief Operating Officer Rajiv Jaitly, pension funds and other institutional investors should be able to "nominate independent directors to hedge fund boards." This would satisfy the goal of making sure that no conflicts of interest exist between directors and fund managers and to "meet the increasingly stringent demands of institutional investors." Pierre Emmanuel Crama, head of operations-related due diligence at fund of hedge funds Signet Group offers that the Cayman Island model is in need of repair since some offshore entity directors sit on too many boards and cannot devote sufficient time to each individual fund. The author of "Hedge fund directors should be nominated by investors, says former COO," Charles Gubert (COO Connect, March 7, 2011) goes on to say that large hedge funds may not be too interested in this kind of set-up. Capital-hungry funds or start-ups may be more open to the idea.

    At the strong suggestion of a prominent hedge fund attorney, I am exploring service as an independent board member. Given my background in due diligence and investment best practices, along with time spent on several trading desks and many years in risk management and valuation, I am confident that I can add value in numerous ways. While my sample so far is only three funds (each of which invests in the billions and has a reputation for good governance), there does not seem to be enthusiasm in having someone "poke around" and comment accordingly. One hedge fund compliance officer told me that several pension funds would not greenlight them without an independent director in place for their onshore vehicle but the legal department was reluctant to have outsiders gain access to highly confidential documents. Two other hedge funds said they liked the idea but were not yet ready to act.

    Invariably, this concept will take hold but not without a push from institutional investors and/or regulatory mandates. As an advocate of free markets, it would be better by far to have industry respond willingly versus being forced to comply with a "one size fits all" statute.

    More broadly, there seems to be a shifting balance of power in favor of cash-rich institutional investors such as pensions, endowments, foundations and sovereign wealth funds in some situations. Supply and demand forces will determine whether a U.S. hedge fund chooses to move in the direction of independent oversight at the board level. I understand the need to keep certain pieces of information under wraps. Moreover, hedge funds have their hands full right now with new rules. Discussions I've had with several other hedge fund attorneys suggest that private company managers are reluctant to give up control over the kinds of strategic decisions that would fall under the purview of a board that includes outsiders.

    Only time will tell. Institutional investors, especially pension funds, are under great pressure to evidence that they've conducted a comprehensive due diligence study of their asset managers (not just at inception of a relationship but on an ongoing basis). I've talked to pension auditors, executive directors and trustees who tell me that they plan to continue voting with their feet if they cannot get the kind of information and assurances they need.

    Should the concept of independent directors for onshore funds take hold, the next challenge will be how to compensate outsiders for their time and what kind of liability insurance terms they will need before agreeing to serve.

    Fiduciary Duties, Post Madoff

    Posted by Susan Mangiero on March 02, 2011

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    In "The Post-Madoff Emergence of a Fiduciary Duty of Due Diligence - Recent Regulatory Enforcement Actions and Their Impact on Best Practices for Investment Managers" (Practical Compliance & Risk Management For The Securities Industry, September-October 2009), Attorneys Scott A. Meyers and James G. Martignon describe a renewed scrutiny of the relationship between hedge funds, investment advisers, broker-dealers and their investors. As a follow-up, Chicago-based Attorney Martignon (with Ulmer & Berne LLP) answered additional questions about the investment world in the aftermath of highly publicized financial fallout.

    Q: Jim, I came across your interesting article in research for my new book on investment risk governance. You and Attorney Meyers did a terrific job of elaborating on fiduciary duties and the relationship between asset managers and their clients. Thanks for joining me today to talk further about this important topic. Let's start with understanding your motivation to write the article.

    A: It's pretty straightforward. Our clients are mostly asset managers and broker-dealers. With so much news about regulatory mandates and the increased number of lawsuits being filed in the last few years, our clients asked for more information about their responsibilities to investors and what they should be doing differently, if anything, to mitigate their risks.

    Q: Whom do you think bears the responsibility for compliance at a fund and is good governance seen as a differentiator?

    A: Good fund managers care about doing the right thing for their investors. It's always a balancing act between the general counsel and chief compliance officer and the sales team. However, unless a fund is around for the long haul, everyone loses. Business development professionals have a lot to gain by supporting their colleagues in legal and compliance. Importantly, it's not just adhering to the letter of the law. Fiduciary duty means applying common sense as well. I recall hearing the former head of the SEC's Office of Compliance and Investigations and Examinations tell a story that stayed with me. A hedge fund chose not to do something that was legal but didn't quite pass the smell test. The examiners were impressed that the fund was sensitive to going the extra mile. 

    Q: Is there a difference between vulnerability to litigation for a fund that trades more frequently?

    A: Probably. For example, the trigger factors for a hedge fund that actively trades are likely to be different than let's say a private equity fund that can perhaps dedicate more resources to monitor fewer positions. With more active trading (and I'm not even addressing high frequency trading issues here), issues that attract scrutiny include compensation, performance reports, trading across multiple entities and delegation of some work to others (such as a custodial bank or prime broker).

    Q: You write extensively about fiduciary duties that include (a) good faith, full and fair disclosure (b) prudence in selecting agents and in making and monitoring investments (c) fulfilling representations made to clients and(d) furnishing information to clients, obtain material information and disclose limitations on inquiry or investigation. Are you saying that these duties are more important now than in the past?

    A: No. Discharging one's fiduciary duties have always been important. It's just that so many investors were surprised by situations involving investment fraud as well as those that reflected poor oversight of operational and financial risks. Things go in waves and financial reform is no different. The Madoff scandal revealed chinks in the armor. You had a name fund manager that consistently reported great returns and continued to attract investors. Given the scale of losses, it's no surprise that people took a further look at what went wrong. We've lived through investment fraud before but never had multiple catalysts occurring at the same time. After news broke about Lehman Brothers, Bear Stearns and others, investors clamored for answers about systemic vulnerability. For example, if an investor allocates money to a hedge fund, they have to understand that they are exposed to a wide array of risks, not just the price movement of what's inside the hedge fund's portfolio.

    Continue Reading

    The Views From An Activist Investor

    Posted by Susan Mangiero on February 07, 2011

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    Always a fighter for truth and clarity, Phillip Goldstein shared his insights about regulations, hedge fund transparency, activist investing and board accountability with me on February 7, 2010. Co-founder of Bulldog Investors, the name of this former engineer may sound familiar to you. Besides winning a skirmish with the U.S. Securities and Exchange Commission ("SEC") a few years ago about its right to require registration of investment professionals who work with hedge funds, Mr. Goldstein is now battllng the State of Massachusetts over the issue ofwhether the First Amendment allows asset managers like himself to engage in truthful speech about his business without fear of punishment. For more background on that case and the various briefs, see "Banned in Boston: The Bay State trots out a paternalistic rationale for its latest infringement on free speech" by John Berlau (Wall Street Journal, January 6, 2011) or click to read the motion to file amici curiae as relate to "Bulldog Investors General Partnership v Secretary of the Commonwealth, December 13, 2010.

    In a phone interview that easily could have gone on for hours no doubt, we covered a lot of ground with a focus on my continued passion for investment best practices.

    Q: Welcome and thank you for agreeing to talk about important issues for investors today. You co-founded Bulldog Investors after spending over twenty years as a civil servant. You invest primarily in closed-end funds, small-cap operating companies and special purpose acquisition companies or SPACs. What's your take on investing, post Madoff?

    A: Pension funds and what I'll call allocators have a hard job. They need to vet numerous money managers and proposals that cross their desk. However, that doesn't absolve them from their fiduciary duties. Asset manager due diligence remains important but must encompass much more than just a review of numbers. I liken the process to picking a spouse. If you're an institutional investor, ask whether you want someone who looks like Angelina Jolie (Brad Pitt) for your wife (husband) or someone less flashy and able to offer depth for a long-term and successful marriage. I think it's critical for investors to consider the character of an asset manager and ask whether that person is honest and sufficiently talented to generate good returns on an ongoing basis. Investors must assess whether an asset manager has a "long-term sustainability edge." These are not easy tasks.

    Q: You consider yourself a value investor, correct?

    A: Over the last eighteen years, our fund has used what I call an activist's tool kit on behalf of our investors. It's a lot of work but we think due diligence and care should be present over the full range of economic cycles. Our strategy is not the only way to go but we are happy with our efforts.

    Q: What worries you about investing in a particular company?

    A: We like to find companies with hard assets that are undervalued in the marketplace. For example, a company may count raw land as a major asset that may be able to create value for investors, independent of what person is running the organization.

    Q: I realize that you can't say anything specific about the open court case with the State of Massachusetts but can you comment on what is known to the general public? As I understand the issue, your fund published performance information on your website for anyone to read, even those who are not accredited investors. What do you think about the support you have received from several financial journalists who assert that hedge fund transparency is tantamount to free speech and necessary for them to track the industry on behalf of readers.

    A: There seems to be an inconsistency with respect to hedge fund reporting. Tiffany & Co. showcases its jewels for everyone, rich and not rich. Should there be a rule that only allows people with a certain net worth to window shop? Some states, including Massachusetts, have a website devoted to state lotteries. As far as I can tell, the sites are not password protected to prevent young persons who are ineligble to buy tickets from reading the information. Furthermore, there is a real clamor for more information about hedge funds but advertising - which is broadly defined - is prohibited so the veil of secrecy remains.

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    Transparency and Globetrotting

    Posted by Susan Mangiero on February 02, 2011

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    As more and more enforcement actions and lawsuits focus on who knew what and when, it's no surprise that politicians are clamoring for more transparency. One issue that has caused agita raised eyebrows is the extent to which pension trustees travel for business.

    As reported in "Detroit pension trustees take flight on funds' tab" by Jennifer Dixon (Detroit Free Press, June 14, 2009), some individuals may have taken perks to a whole new level by attending conferences in far flung corners of the world, miles from Detroit. Attending conferences is not a bad thing. To the contrary, trustees need to be well-informed about the investment decisions they make, including possible allocations to global money managers. As I was quoted then, I still maintain that "Public pensions need 'a clear policy about travel...It's public money, and taxpayers and plan participants would like to know the money is being properly spent." I further added that prudence requires a policy that explains what constitutes a "legitimate and reasonable expense, from a governance aspect and budget aspect."

    In an effort to shed light on expenses incurred by public pension trustees, Michigan State Representative Tom McMillin has introduced House Bill No. 4156 to amend current legislation by mandating investment fiduciaries to "publish and make available to the public on a website all expenditures made by the board of the system, including, but not limited to, travel expenditures by board members and the system budget."

    Expect more of these initiatives to shed light on how pension plan dollars are being spent.

    • The U.S. Department of Labor now mandates more disclosure about service provider arrangements with its Form 5500 Schedule C filing rules. 
    • Various states are busy at work to curb "pay to play" abuses by making information available as to how asset managers are selected to control billions of dollars.
    • The U.S. Government Accountability Office has urged that more information be shared about retirement plan dollars making their way into hedge funds and private equity funds.

    For further reading, check out the following items:

     

    Liquidity Risk and Economic Damages

    Posted by Susan Mangiero on January 23, 2011

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    According to "Insider Probe Impact Felt by Pension Funds" by Steve Eder (Wall Street Journal, January 24, 2011), those hedge funds that are being investigated by the FBI may find themselves confronted with even more challenges. If they are forced to sell positions that are deemed "bad" because they resulted from the use of material, non-public information, they could realize an economic loss on top of incurring transaction fees not originally anticipated, including the disgorgement of specified profits. Additionally, if any worried institutional investors want out early, hedge funds being probed may find themselves facing unplanned redemptions. Unless their prime broker (assuming they have one) provides offsetting capital in the form of a cost-effective credit line, a liquidity squeeze could occur.

    Although some institutions such as pensions, endowments and foundations invest in hedge funds to diversify their respective portfolios over the long-term, uncertainty about a manager's ability to remain in business can trigger a run which in itself has the potential to hasten its demise. In some cases, a fund manager may offer reduced fees to its investors as a way to buy time and try to get back on the road to recovery.

    In the event that a lawsuit is filed, there are numerous liquidity risk factors that must be taken into account. For one thing, it is necessary to know if lockups were accepted by investors. If so, on what terms? If redemption rights existed but a hedge fund chooses not to allow redemptions (which has occurred as an unwelcome surprise to investors), economic damages would have to take into account what (if any) provisions the hedge fund management team had made in order to satisfy withdrawal requests before trouble began. In addition, an analysis would have to take into account whether and on what terms (cost) a hedge fund could sell off part of its holdings to raise cash and whether (and why) credit facilities could be rescinded. The ability to raise cash from new and/or existing investors is another issue, along with whether a hedge fund is overly dependent on just a handful of investors.

    The foregoing is not an exhaustive list. Every situation relies on relevant facts and circumstances but one thing is certain. There is no free lunch. There is a cost associated with illiquidity risk.