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The lawsuit, filed in Delaware state court on Tuesday, claims Falcone’s hedge fund, Harbinger Capital Partners, improperly grabbed a 93.3 percent stake in Harbinger Group, Falcone’s holding company, which trades on The lawsuit, filed in Delawa New York Stock Exchange.

Hedge-fund bigwig Phil Falcone used a controversial stock swap involving his holding company to take advantage of small investors, a new lawsuit charges.  

Alan Kahn, an investor in the holding company, saidthe complicated transaction came at a time when the holding company’s stock was trading at a 25 percent discount to its liquid assets, thus only benefiting Falcone and his hedge fund.  

“This transaction was reviewed at Harbinger Group by an independent committee of directors advised by outside financial and legal advisers,” a Harbinger spokesman said. “The conclusion from this process was that the transaction was in the best interests of the shareholders. We are confident that the court will not disagree.”

Read more: http://www.nypost.com/p/news/business/harbinger_big_sued_on_swaps_o62XE04fCMnjLiJbSUnqCN#ixzz18wOtNaT1

 Posted by Carmine Angone, Director, ICS Compliance - Confidence in Compliance for Hedge Fund Managers, Investment Advisors and Broker-Dealers

Max Holmes, founder of the embattled hedge fund Pla embattled hedge fund Plainfield Asset Management, is on the hot seat yet again.

The former Drexel Burnham trader has been hit with a second whistleblower complaint — this one by a small investor in a company partially controlled by Stamford, Conn.-based Plainfield.

The complaint, obtained by The Post, was filed by John Wust, a Minnesota doctor who said he lost half a million dollars in a little-known manufacturing company, Wolverine Tube, which recently filed for bankruptcy protection.

Wust, who saw his three percent stake go up in smoke in the bankruptcy, wants the Securities Exchange and Commission to investigate whether Plainfield hammered out a deal with the manufacturer to raise $28 million in common stock in 2007 as part of a financial rescue, while secretly gunning for a bankruptcy.

Wust made similar accusations to the Delaware bankruptcy judge overseeing the case in November.

“Any complaints by unhappy shareholders in the Wolverine case are being dealt with by the Delaware bankruptcy court, which is the appropriate forum for any complaints, particularly frivolous ones like those at issue here,” said Whit Clay, a Plainfield spokesman.

Clay also said the Manhattan District Attorney’s office, which had been investigating complaints of loan-to-own at Plainfield, “advised us that they have no further questions for us regarding so-called ‘predatory lending.’”

A spokeswoman for Cyrus Vance, the Manhattan DA, declined to comment. The SEC also declined to comment.

Earlier this year, an anonymous SEC whistleblower accused Holmes of intentionally overvaluing the firm’s assets for excess fees.

Read more: http://www.nypost.com/p/news/business/new_complaint_hits_hedge_exec_wOE4nYlA9K9IRfrmoDOvbJ#ixzz18wNO6NFS

Posted by Carmine Angone, Director, ICS Compliance - Confidence in Compliance for Hedge Fund Managers, Investment Advisors and Broker-Dealers

 

 

 

 

 

The SEC and CFTC recently have proposed rules that would clarify which types of swaps traders would be subject to the new derivatives regulations mandated under the Dodd-Frank Act.  Dodd-Frank defines two critical terms at the heart of the new regulatory regime, ”Swap Dealers” and “Major Swap Participants.”  The legislation leaves it to the CFTC and SEC to hone the definitions of each term to cover the appropriate financial actors.  The broadness of the statutory definitions of each, and the subsequent proposals by the SEC and CFTC attempting to further refine these definitions, have caused some concern amongst mutual funds, because even those not qualifying as “Swap Dealers” may find themselves within the definition of “Major Swap Participant,” and therefore fall into an additional new realm of regulatory provisions, including registration, capital and margin requirements, and business conduct restrictions.  

Though there is a de minimus requirement, that is, a minimum threshold of swap activity must be met, and swaps employed for financial hedging and minimizing commercial risk are excluded, there is some risk that a mutual fund, fund complex, or even a hedge fund, may be considered a “Major Swap Participant” if the CFTC and SEC rules are finalized.   

The CFTC and the SEC are scheduled to vote on final rules in July 2011.

The fact sheet for the proposed joint SEC and CFTC Rules to define Swap Related Terms is available at:  http://sec.gov/news/press/2010/2010-237.htm

A memorandum by Dechert LLP laying out some of the issues in more detail is available at:  http://www.dechert.com/library/FS_30_12-10_CFTC_SEC_Propose_Definitions.pdf 

Posted by Carmine Angone, Director, ICS Compliance - Confidence in Compliance for Hedge Fund Managers, Investment Advisors and Broker-Dealers

 

 

 

The rate of change that the prime brokerage industry has undergone in recent months exceeds almost all expectations. With overall trading volumes lagging and an increased focus on risk controls, prime brokerage firms have either chosen or have been forced to change some of their longstanding business models. This is especially true with smaller introducing prime brokers. Some of these firms have merged with other small firms or exited the business altogether; some have consolidated their custody and clearing relationships for cost savings, and some have been acquired by larger firms in order to increase their product offerings and shore up their balance sheets. All of these changes have given rise to a new space that is being called “mid prime,” “integrated prime” or “independent prime.” 

The smaller introducing primes that have merged did so largely in part to create greater economies of scale. As less well capitalized introducing primes closed up shop, clients began to place greater scrutiny on the stability and balance sheets of the firms that remained. While client assets were safely held in custody at their respective clearing firms during these closures, the hedge funds using these providers were left scrambling to find new homes. Despite these concerns, these smaller independent introducing brokers may still be good solutions for the very smallest start-up hedge funds because of their ability to offer strong custody and clearing services to managers who may fall below the minimum asset size requirements of middle-tier prime brokers as well as traditional bulge-bracket firms.

Other smaller prime brokers that emerged in the mid 2000s grew fast enough that they became acquisition targets for larger financial services and technology firms. Their recurring revenue model and loyalty of clients was attractive to companies with a desire to expand their services. These new prime services providers have created more alternatives to traditional bulge bracket prime brokers, especially for medium sized hedge funds. The larger balance sheet and increased global reach of the new “integrated prime services” companies offer clients the enhanced risk controls and broader services that had heretofore only be available to the largest of hedge funds. Firms that have taken on corporate owners now have access to very large technology budgets and hundreds of additional employees that can be leveraged to provide greater services worldwide. These larger integrated prime services providers are now an industry segment unto themselves due to the fact that they provide services that were previously only available to clients of bulge bracket firms while still focusing on providing very personalized service.

Another trend that has shaped the industry that emerged following the turmoil of 2008 was the use of multiple custody and clearing options in order to mitigate potential systemic risks and to further protect assets with an alternative clearing relationship. Hedge funds as well as prime brokerage firms formed relationships with second and even third clearing brokers in order to facilitate a “multi-prime” solution. There is still great demand for this protection from medium and larger size hedge fund clients, but some smaller prime brokerage firms were not able to support the additional financial and logistical obligations that these relationships brought with them. Capitalization issues at these brokers made the multi-prime approach less feasible and there has been a move recently for some of the mini-prime brokers to discontinue one clearing relationship in order to protect their primary one.

Some smaller prime brokers who may or may not have had the ability to merge with another firm or join a larger entity have chosen to stay independent. These firms believe that they have the resources to stand alone. They may have invested heavily in proprietary systems or they may have other business lines that they believe will allow them to grow their business organically. These prime providers may have a loyal client base and staff and believe that independence outweighs the benefits of further reach. Prime brokerage began with this spirit and there will probably always be stand-alone firms that subscribe to that school of thought.

In every industry the landscape constantly changes. At the moment that rate of change is high in the prime brokerage space. It will be interesting to see whether traditional bulge bracket firms make an attempt to gain market share by courting smaller funds or whether they continue to compete with one another for the largest players in the industry. It will also be worth watching to see which firms consolidate further with one another and which ones give up on independence and seek out an acquisition. One way or another, healthy competition in the prime services space remains.

Michael DeJarnette, president of ConvergEx’s NorthPoint Trading Partners

Posted by Carmine Angone, Director, ICS Compliance - Confidence in Compliance for Hedge Fund Managers, Investment Advisors and Broker-Dealers

As banks spin off their proprietary trading groups into hedge funds to comply with a new law, traders will find themselves in a tougher environment.

Independent hedge funds face higher funding costs and often have less capacity to nimbly take advantage of opportunities in tough markets, traders said. 

Without the infrastructure of their parent banks, senior hedge fund managers may have to spend more time on such matters as marketing and managing accounting staff than their counterparts on proprietary trading desks.

Add it all up, and investors are likely to be skeptical of the funds’ ability to generate outsize returns, bank executives and hedge fund experts said. 

“Being out on your own as a hedge fund is a totally different animal from being inside a bank,” said Brad Alford, founder of Alpha Capital Management, a firm that advises high net worth individuals about investments, including hedge funds.  “I don’t want my clients to be a guinea pig in this kind of an experiment,” Alford added.  Still, banks are hopeful. With the Dodd-Frank financial reform law putting limits on dealers’ proprietary trading, major banks are considering how to change that business. 

Goldman Sachs Group Inc is planning to turn its proprietary equity trading unit into a hedge fund that raises money from outside investors, sources familiar with the firm said. 

Morgan Stanley might also be close to spinning off its FrontPoint Partners unit, according to news reports. 

Many have made the transition from proprietary trading to hedge fund management before. Eric Mindich, for example, was a senior proprietary trader at Goldman Sachs before starting up Eton Park Capital Management in 2004. 

But professionals who have made the move said it can be tough. Proprietary traders have a single boss — the bank that supplies them capital — while hedge fund managers have many bosses, namely their investors.

 Reporting to a financial institution can have real advantages. For example, Goldman Sachs’ traders are usually assigned a strategy, but can stray from that remit if they convince their managers they have a great idea. 

“I’ve interviewed traders from Goldman before and they say, ‘I can try anything I want,’” said one senior executive at a rival. 

NOT HAPPY 

Hedge fund managers usually have less flexibility, because their investors demand that they follow a particular strategy.

“I might see an opportunity in Asian equities, but my investors don’t pay me to invest there,” said one former Goldman trader who now works at a U.S. hedge fund. 

That means hedge fund managers often have less capacity to pursue unusual trades. One of Goldman’s great assets, according to many former employees, is its ability to seize opportunities quickly in markets, as long as trades stand up to scrutiny from within the firm. 

Hedge fund managers face other constraints, too. They typically need to keep cash on hand to meet investor redemption requests, which can weigh down returns. 

When markets are particularly tempestuous, hedge fund managers fear big redemptions and therefore have to keep more cash, making them less able to seize opportunities. 

Proprietary traders often have lower capital costs than hedge funds, which means a strategy that demands a lot of borrowed capital, such as fixed income arbitrage, is harder to execute profitably outside of a bank. 

Goldman Sachs is still unsure about what to do with their fixed income and credit proprietary trading operations, CNBC reported on Thursday, which experts said may be because more of those strategies rely on cheap leverage. 

To be sure, there may be opportunities as banks reduce their proprietary trading businesses. For example, if multiple banks stop trading fixed income arbitrage, the opportunities in that strategy may increase even for hedge funds with higher borrowing costs. And the best traders will likely be able to raise money in any environment. 

But life in a hedge fund will be different enough to be jarring for most proprietary traders, experts said. 

“Traders will not be happy about this change,” said Steve Kohlhagen, who ran derivatives businesses at First Union and later Wachovia.

 

Posted by Carmine Angone, Director, ICS Compliance - Confidence in Compliance for Hedge Fund Managers, Investment Advisors and Broker-Dealers

The impressive ETF boom that has unfolded over the last several years has been the result of a number of attractive features of the exchange-traded structure relative to traditional mutual funds. In addition to considerably lower expenses, intraday liquidity and enticing tax breaks have fueled interest in ETPs, which now number nearly 1,100 in the U.S. and hold close to $1 trillion in assets. As ETFs have become more targeted and specialized, they have allowed all types of investors to gain exposure to securities and strategies that were previously hard-to-reach. ETFs such as the Market Vectors China ETF (PEK) offer exposure to unique assets like China’s A-shares market, a new opportunity for U.S. investors [see Closer Look At The China A-Shares ETF (PEK)]. ETFs have also been instrumental in making commodities a widely available asset class, making it possible for all types of investors to access both futures-based and physically backed funds focusing on everything from gold and silver to natural gas and crude oil [see Top 25 ETFs By Trading Volume].

 

Just as ETFs have democratized commodities, so too have they brought another previously hard-to-access asset class within reach. As evidenced by huge inflows and a surge in the number of product offerings, more and more investors are embracing volatility exposure as an effective tool. Perhaps the most popular volatility index is the VIX, or the Chicago Board Options Exchange Market Volatility Index, which measures the implied volatility of S&P 500 index options. The VIX was introduced in 1993 by Duke University’s Professor Robert Whaley, and is a hypothetical measure of volatility based on metrics involving options trades and expectations of stock market volatility over the next 30 day period. As such, investors obviously cannot invest directly in a volatility index such as the VIX. But financial innovations of recent years have created opportunities for tapping into this asset class; futures on the VIX began trading back in 2004, and the first VIX-linked options debuted in 2006. More recently, ETNs linked to VIX-related indexes popped up, and have multiplied in recent weeks and months [see also Technical Trading Ideas: SPY, VXX, GLD].

The appeal of exposure to volatility through VIX futures contracts is generally related to the strong inverse correlation with stock markets. Also known as the “fear index,” the VIX tends to climb when anxiety over the short-term outlook for equity market spikes and fall when markets push higher. As such, exposure to the VIX can be an effective hedging tool for various strategies or a way to bet on turmoil in U.S. equity markets. A great example comes from the May 6th “flash crash” where the popular VIX ETN surged over 35% intraday as markets went into a furious downward spiral. Most investors use these funds for short term exposure, as they are subject to hefty price swings, but as the ETF space expands, so too do the strategies that follow the fear index [see also Short-Term Volatility ETN (VXX) To Undergo Reverse Split].

As interest in these funds has grown, recent weeks has see wave of activity in the ETF space, with numerous options now available for various kinds of VIX exposure. Below we outline the options that are currently available to investors, and their differing strategies that all track volatility [see all options in the Volatility ETFdb Category]:

Short-Term VIX ETNs

It is important to note that none of the options, futures, or ETNs linked to the VIX offer exposure to changes in the spot price of the index. But short-term VIX ETNS, which generally establish long positions in the first and second month VIX contracts on a rolling basis, will often move in line with the spot VIX–at least in the short term. Because the market for VIX futures contracts is often contangoed and sloping steeply upward in the short term, the “roll yield” incurred by a short term strategy can be significant. Currently, there are two short-term VIX ETNs:

• iPath S&P 500 VIX Short-Term Futures ETN (VXX): The first VIX ETN to hit the market, VXX has become a popular option for short-term investors seeking out volatility exposure. Though VXX has seen some big jumps this year and can be an efficient component of more sophisticated strategies, it has faced some stiff headwinds in the form of contango as well. VXX has lost over 65% on the year, while the change in the spot VIX in 2010 has been minimal.

• VIX Short-Term ETN (VIIX): This VelocityShares fund is set up very similarly to that of VXX. VIIX, however tracks a slightly different index, as it is linked to the S&P 500 VIX Short-Term Futures Index Excess Return (the iPath product is linked to the total return version of the same index). The ETN is a recent addition, having debuted in late November.

Mid-Term VIX ETNs

These ETNs offer investors the opportunity to invest in contracts that are several months out, as opposed to the first and second month futures that are offered by short-term VIX funds. As a result, mid-term VIX ETNs are generally less sensitive to changes in the spot VIX, but also less vulnerable to the impact of contango in futures markets [see also VelocityShares Debuts Its Lineup Of VIX ETNs].

• iPath S&P 500 VIX Mid-Term Futures ETN (VXZ): VXZ offers returns based on rolling long positions in the fourth, fifth, sixth, and seventh month VIX contracts. While VXZ may seem very similar to its short-term counterpart, the risk/return profile is actually very different. This ETN will exhibit less volatility than VXX (which in turn generally exhibits less volatility than the spot VIX), and the focus on longer-dated contracts mitigates the impact of contango somewhat.

• VIX Medium-Term ETN (VIIZ): VIIZ is another VelocityShares fund that launched at the end of November. The fund will track the mid-term version of the same index as VIIX, giving investors another option besides the iPath ETN for exposure to mid-term volatility exposure.

Leveraged VIX ETNs

Just as there are ETFs offering leveraged exposure to many popular stock and bond indexes, it is now possible for investors to establish amplified daily exposure to VIX-related indexes. By adding leverage to an asset class that often shows big price swings, the result is an extremely volatile security. Currently, there are three leveraged VIX ETNs available:

• Daily 2x VIX Short-Term ETN (TVIX): This ETF is a leveraged version of VIIX, as it offers daily 2x leverage to an index comprised of short-term VIX futures contracts. The leveraged VIX products offered by VelocityShares feature a daily reset mechanism, making them similar to the leveraged products offered by ProShares and Direxion. In other words, the daily leverage offered by TVIX and TVIZ will reset to 200% daily, while the exposure for XIV and ZIV will reset to -200% daily. This differs somewhat from the iPath products, as discussed more below.

• Daily 2x VIX Medium-Term ETN (TVIZ): TVIZ is the 2x version of VIIZ, the recently-launched mid-term volatility index from VelocityShares. While it won’t generally deliver price swings as big as TVIX, this fund is still likely to show big price movements, and is designed primarily for sophisticated traders with a short time horizon.

• iPath Long Enhanced S&P 500 VIX Mid-Term Futures ETN (VZZ): This iPath product offers another option for leveraged VIX exposure, seeking to deliver a leveraged return on the index consisting of a daily rolling long position in the fourth, fifth, sixth, and seventh month VIX futures contracts. The leverage established by VZZ is effective between the inception of the note and the maturity date, meaning that depending on movements on the underlying index the effective leverage will change daily (the same type of leverage offered by the recently-launched iPath ETNs linked to popular equity indexes).
  

Inverse VIX ETNs

Inverse VIX ETPs are a relatively new introduction, and can be useful for investors looking to bet on a decline in expected equity market volatility. These funds are probably not for “buy-and-hold” investors, but may offer advantages to traders who utilize more complex strategies to generate returns.

• Barclays ETN+ Inverse S&P 500 VIX Short-Term Futures ETN (XXV): This inverse VIX fund measures short term contract, and trades under reverse ticker of the original Barclays iPath volatility fund, VXX. The fund offers inverse exposure to the S&P 500 VIX Short-Term Futures Index Excess Return, which is designed to reflect the returns that are potentially available through an unleveraged investment in short-term futures contracts on the CBOE Volatility Index. Again, this product doesn’t offer leverage in the same manner that daily reset products (such as those from ProShares and Direxion) do; the amplified returns are sought over the life of the underlying debt security.

• Daily Inverse VIX Short-Term ETN (XIV): This fund will measure a similar index as XXV and is also a short-term inverse VIX fund. Like the +200% counterpart, this VelocityShares product resets exposure on a daily basis (as does ZIV).

• Daily Inverse VIX Medium-Term ETN (ZIV): VelocityShares also offers an option for inverse exposure to a mid-term VIX index; ZIV should appreciate when stocks jump and will struggle when the VIX is on the rise.

Long/Short VIX ETN

Access to the VIX is no longer just limited to the traditional sub-sets–long, inverse, leveraged, etc. UBS recently debuted its E-TRACS Daily Long-Short VIX ETN (XVIX), a product that offers exposure to a strategy designed to exploit the nuances of futures-based access to volatility markets. XVIX’s strategy involves establishing a 100% long position in the S&P 500 VIX Mid-Term Futures Index Excess Return with a short 50% position in the S&P 500 VIX Short-Term Futures Index Excess Return, with daily rebalancing of the long and short positions.

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The investment thesis behind XVIX focuses on the systematically high risk premium for near-term VIX futures relative to mid-term contracts. By maintaining long exposure to mid-term contracts–those that are between four and seven months from expiration–and short exposure to those contracts nearing expiration, XVIX presents an opportunity to capture some of that risk premium regardless of whether equity market volatility is increasing or decreasing. The fund charges an expense ratio of 0.85% [see UBS Debuts Long-Short VIX ETN].

VEQTOR ETN

One of the recent additions to the ETF lineup came from Barclays, which rolled out an ETN linked to a strategy depending on the level of volatility observed in the market. The Barclays ETN+ S&P VEQTOR ETN (VQT) is linked to the S&P 500 Dynamic VEQTOR, an index that provides exposure to large cap U.S. equities with an implied volatility hedge by allocating assets to three asset classes: stocks, volatility, and cash. Depending on the magnitude and trend of volatility, the equity allocation maintained by the ETN will shift between 60% (if volatility spikes to more than 45% and an uptrend is detected) and 97.5% (if realized volatility drops to less than 10% and no trend is detected).

Non-VIX Volatility ETN

While the VIX is the popular measure of volatility, there are other volatility indexes available that use their own metrics to track market uncertainty:

• C-Tracks ETN Citi Volatility Index Total Return (CVOL): This ETF tracks the Citi Volatility Index Total Return, which is designed to measure directional exposure to the implied volatility of large cap U.S. stocks. The fund bases its investments off of the volatility calculated by Citigroup with a return due date of November 12, 2020.

Word Of Caution

As the ETF world continues to expand, so too does the complexity of the new products hitting the market. There are now nearly 1,100 exchange traded products available to U.S. investors, and while many of the first generations of products are “plain vanilla” funds designed with buy-and-holders in mind, recent innovations have increasingly targeted sophisticated investors. The majority of VIX funds, for example, aren’t designed to be held over the long term and can exhibit significant volatility. So far in 2010, the average daily change (in absolute terms) of VXX was 3%, with the maximum movement coming in at a 14% change in just one day (the fund has also moved by over 10% on eight separate days this year).

Besides the volatility, contango in futures markets introduces additional drivers of performance and layers of complexity to the risk/return profiles. The VIX ETNs now available to investors can be very powerful tools, facilitating sophisticated trading strategies or serving as effective hedges. But they are complex products, and as such should be used with caution [see also Using ETFs As “Portfolio Insurance”].

Posted by Carmine Angone, Director, ICS Compliance - Confidence in Compliance for Hedge Fund Managers, Investment Advisors and Broker-Dealers

The newly created Financial Stability Oversight Council, which includes the Treasury secretary and 14 U.S. supervisors, including the Fed, are in the early stages of determining which non-bank firms pose a threat to the financial system.

Firms labeled as “systemically important” will be subject to rigorous oversight by the Fed but will also have access to the central bank’s emergency lending facilities.

The indication that hedge funds might escape this designation is sure to send a huge sigh of relief through the $1.7 trillion industry, which has long avoided the tighter controls imposed on mutual funds, for example.

In exchange for looser regulations, hedge fund firms promise to allow only wealthy and sophisticated investors like pension funds and endowments into their portfolios.

The Fed’s view will carry considerable weight among the Financial Stability Oversight Council, which was created by the Dodd-Frank legislation to monitor risks to the financial system in the aftermath of the 2007-2009 credit crisis.

The source said the Fed does not think any one hedge fund can be “systemically important” but believes that information about the funds’ positions could give the council insight into potential risks. The source requested anonymity while discussing talks held with the Fed.

The Fed did not immediately return a call seeking comment.

INDUSTRY SAYS NO

Already a number of financial industry firms, ranging from insurers to mutual funds, are trying to convince regulators they are do not pose a threat.

Mutual funds tend to manage much more money than hedge funds. The world’s biggest mutual fund, Pimco Total Return Fund, managed by Bill Gross, oversees $250 billion. By comparison, John Paulson’s hedge fund firm Paulson & Co, ranked among the world’s largest hedge funds, oversees about $30 billion.

The Managed Funds Association, which lobbies for the hedge fund industry, argues that individual funds do not pose a systemic risk.

It told regulators that the industry made risk management changes after the 1998 collapse of Long-Term Capital Management roiled financial markets and prompted a bailout by other industry players at the urging of the Clinton administration.

“The resulting changes may be one of the reasons that hedge funds were not the focus of the recent global financial crisis,” the group said in a November 5 letter to Treasury Secretary Timothy Geithner, who chairs the Financial Stability Oversight Council.

The council, which also includes the heads of the Securities and Exchange Commission and the Federal Deposit Insurance Corp, is seeking input on what criteria to use to decide which non-bank firms and clearinghouses should be considered “systemically important.” It is unclear when they will start designating firms.

NEW RULES FOR HEDGE FUNDS ANYWAY

Even if hedge funds are not labeled “systemically important,” they will still face increased supervision and forced to be more transparent because of the Dodd-Frank legislation and recent SEC actions.

“They have been able to exploit inefficiencies in the marketplace, by mining information that is not readily known to others,” said Daniel Crowley, a partner at law firm K&L Gates, who represents financial services firms including hedge funds.

“Their job will become harder when they have to register. Their trading strategies will become public,” he said.

The SEC now has the power to regulate the trillion-dollar industry. Many of the world’s largest hedge funds have already registered with the SEC, agreeing to divulge certain details about how they run their businesses and how much money they oversee.

The funds’ activities have also been curtailed with the SEC’s recently adopted short sale rule, which restricts short selling in a company’s stock if the stock falls more than 10 percent. Hedge funds, unlike mutual funds, have long relied on short selling, or betting that a stock price will fall, to make money even in down markets.

Under Dodd-Frank, hedge funds, banks and others that deal in the estimated $600 trillion over-the-counter derivatives market will be forced to set aside extra funds to trade the financial instruments.

The Commodity Futures Trading Commission’s plan to limit speculation in energy and metals will also impact certain funds’ activities.

(Additional reporting by Svea Herbst-Bayliss in Boston; Editing by Leslie Adler)

Posted by Carmine Angone, Director, ICS Compliance - Confidence in Compliance for Hedge Fund Managers, Investment Advisors and Broker-Dealers

The U.S. Securities and Exchange Commission wants Galleon Group co-founder Raj Rajaratnam to turn over his copies of wiretaps made by the Justice Department for a related civil suit after a judge ruled they’re admissible in the government’s criminal prosecution of insider trading.

U.S. District Judge Richard J. Holwell in New York, who is presiding over the criminal case, ruled on Nov. 24 that U.S. prosecutors had properly complied with federal laws in using wiretaps to investigate Rajaratnam and former hedge fund consultant Danielle Chiesi. Holwell said the U.S. could use the wiretapped conversations in their prosecution of the two defendants.

Rajaratnam, 53, and Chiesi, 44, are accused of illegally using tips from company executives, hedge fund employees and other insiders. They were charged in October 2009 as part of the biggest insider-trading prosecution in history. The scheme reaped $52 million in illegal profits, according to the SEC.

“Given that the legality of the wiretaps has now been established, and given that the SEC is only seeking relevant intercepts, the SEC’s ‘significant’ right to obtain the relevant intercepts outweighs whatever arguable remaining privacy interests defendants and others may have,” the SEC said in court papers.

Rakoff Ruling

In February, U.S. District Judge Jed Rakoff, who is presiding over the SEC’s civil enforcement case, directed Rajaratnam and Chiesi to turn over the wiretaps. They had received the recordings from federal prosecutors as part of preparing their defense in the criminal case.

In September, a panel of judges from the U.S. Court of Appeals for the Second Circuit in New York reversed that ruling, saying Rakoff abused his discretion in issuing his order before Holwell, who is presiding over the criminal case, had a chance to rule on the legality of the recorded conversations.

A federal appeals court ruled in September the SEC couldn’t have access to the tapes until after Holwell ruled on the legality of the tapes. The ruling didn’t bar the agency from obtaining the wiretaps later in the case after Holwell issued his decision on the legality of the tapes.

Relevant Conversations

The SEC said Rajaratnam has had the wiretapped communications since Dec. 23, 2009, and said in court papers filed on Dec. 17, that these conversations are relevant to proving the agency’s claims that the defendants provided, received and sought material nonpublic information for the purpose of insider trading.

“Most of the relevant communications will likely consist of conversations by market professionals and public company insiders about stock trading and publicly traded companies,” the SEC said.

Material that isn’t relevant can be redacted, in light of Holwell’s ruling, the SEC said. Failure to obtain the wiretaps from the defendants will mean substantial prejudice to the agency’s case.

“The SEC’s significant right of access to relevant, legally intercepted communications relating to the defendants’ insider trading scheme, and the substantial prejudice it will suffer if deprived of these intercepts, clearly outweighs any remaining, diminished privacy interests implicated in disclosing the relevant intercepts,” the SEC said. “Without the recordings, the SEC likely will be deprived of important admissions and in many instances the best, most direct evidence of wrongdoing.”

According to Rajaratnam and Chiesi, the government wiretapped conversations involving 18,150 communications involving 550 people on 10 phones over the course of 16 months.

A Rajaratnam spokesman, Jim McCarthy, declined to comment, as did Alan R. Kaufman, a lawyer for Chiesi.

The case is Securities and Exchange Commission v. Rajaratnam, 10-CV-462, U.S. Court of Appeals for the Second Circuit (Manhattan).

To contact the reporter on this story: Patricia Hurtado in New York at pathurtado@bloomberg.net

Posted by Carmine Angone, Director, ICS Compliance - Confidence in Compliance for Hedge Fund Managers, Investment Advisors and Broker-Dealers

 

By Carmine Angone, Director, ICS Compliance - Confidence in Compliance for Hedge Fund Managers, Investment Advisors and Broker-Dealers

Hedge funds, as well as all other private funds (including venture capital funds) with less than $150 million in assets under management although exempt from registering with the United States Securities and Exchange Commission would now, under the proposed NASAA Model Rule, be required to register with the state in which it conducts business.  The Model Rule would apply to funds that are exempt under section 3 (c) (1) of  the Investment Company Act of 1940 (the “1940 Act”) but would not apply to funds that are exempt under section 3(c) (7) (or ”qualified purchasers”) of the 1940 Act.

It appears as though this NASAA proposed model rule is attempting to close the gap under the SEC proposed rules that exempts hedge funds and other private funds from registering with the SEC with assets under management of less than $150 million.   However, please bear in mind that although the SEC exempts this category of private funds from the formal registration process, it does require, under separate proposed reporting rules, a scaled back version of Form ADV Part I to be filed with SEC much like any other investment adviser.  These proposed SEC rule requirements for registration and reporting appear to make a difference between private funds that are required to register and those that are exempt from registration without a real distinction when it comes to filing Form ADV. 

If the rules being proposed that are designed to regulate hedge funds keeps getting more and more complex with nuanced caveats between state and federal regulations, it is going to make running a private fund much more difficult.   

By Carmine Angone, Director, ICS Compliance, Confidence in Compliance for Hedge Fund Managers, Investment Advisers and Broker/Dealers

Link to NASAA Proposed Model Rule - http://www.nasaa.org/content/Files/Exempt_Report_Adviser_Model%20Rule.pdf

 

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act established a comprehensive framework for regulating the over-the-counter swaps markets. Among other things, Title VII of the Dodd-Frank Act requires security-based swap transactions to be cleared through a clearing agency if those transactions are of a type that the SEC determines must be cleared.

Essentially, the clearing agency generally acts as a middleman between the parties to a transaction, and assumes the risk should there be a default. When structured and operated appropriately, such clearing agencies can provide benefits such as improving the management of counterparty risk and reducing outstanding exposures through multilateral netting of trades. In other words, by “clearing” security-based swap transactions, a clearing agency helps to reduce the risk of cascading harm throughout the financial system in the event a party to a transaction fails to meet its obligations.

Through clearing agencies, regulators are more easily able to monitor transactions, including prices and positions taken by traders.

In some cases, though, the Dodd-Frank Act exempts certain types of transactions from the mandatory clearing requirement. In particular, the Dodd-Frank Act creates an “end-user clearing exception” that exempts clearing for a security-based swap transaction if one party to the transaction:

• Is not a financial entity.
• Is using the swap to hedge or mitigate commercial risk.
• Notifies the SEC (in a manner set forth by the SEC) how it generally meets its financial obligations associated with entering into non-cleared security-based swaps (the “end-user clearing exception”).

In addition, the Dodd Frank Act requires the SEC to consider whether to provide an exemption for certain financial institutions — small banks, savings associations, farm credit systems institutions and credit unions — including specifically those with total assets of $10 billion or less, that would permit them to use the end-user clearing exception. The SEC is considering such an exemption as an additional proposal.

Proposed Rule Regarding the End-User Exception

Title VII of the Dodd-Frank Act requires that a counterparty electing to use the end-user clearing exception must notify the SEC of how it generally meets its financial obligations associated with non-cleared security-based swaps.

The proposed rule would require that a counterparty relying on the end-user clearing exception submit information to the SEC regarding how it generally expects to meets its financial obligations associated with a security-based swap by using one of the following:

1. A written credit support agreement.
2. A written agreement to pledge or segregate assets.
3. A written third-party guarantee.
4. Solely the counterparty’s available financial resources.
5. Means other than those described in 1, 2, 3, and 4

The proposed rule also requires counterparties relying on the end-user clearing exception to submit additional information to the SEC intended to aid the SEC in its efforts to prevent abuse of the end-user clearing exception. The information required includes:

1. The identity of the counterparty relying on the clearing exception;
2. Whether the counterparty invoking the clearing exception is a “financial entity” as defined in the Dodd-Frank Act;
3. Whether the counterparty invoking the clearing exception is a finance affiliate meeting certain requirements described in the Dodd-Frank Act;
4. Whether the security-based swap is used by the counterparty invoking the clearing exception to hedge or mitigate commercial risk as defined in the Exchange Act and through rules separately proposed by the SEC; and
5. Whether the counterparty electing to use the clearing exception is an issuer of securities registered under Section 12 of the Exchange Act or subject to reporting requirements pursuant to Section 15(d) of the Exchange Act (”SEC Filer”). SEC filers are also required to provide two additional pieces of information:
   • The relevant Commission Central Index Key number for the counterparty invoking the clearing exception.
   • Whether an appropriate committee of the board of directors (or equivalent body) of the counterparty invoking the clearing exception has reviewed and approved the decision to enter into a security-based swap subject to the clearing exception.

The information reported to the SEC under this proposed rule would be delivered to a security-based swap data repository together with other information that will be required to be submitted to a security-based swap data repository concerning all non-cleared security-based swaps. The rules detailing how data will be reported to a security-based swap data repository are the subject of a separate SEC proposal published last month.

Proposed Rule Regarding Exemptions for Certain Financial Institutions

The SEC is required under the Dodd-Frank Act to consider whether to allow small banks, savings associations, farm credit system institutions and credit unions with total assets under $10 billion to use the end-user clearing exception on the same terms as end-users. The SEC is considering a proposed rule that would implement such a proposal.

Recent Rulemaking

Under the Dodd-Frank Act, the Commission has been engaging in significant rulemaking:

• Defining Security-based swap terms: Proposed — jointly with the Commodity Futures Trading Commission — new rules that would further define a series of terms related to the security-based swaps market, including “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant” and “eligible contract participant.”
• Security-based swap reporting and dissemination: Proposed new rules entailing how security-based swap transactions should be reported and publicly disseminated.
• Security-based swap data repositories: Proposed new rules that would specify the requirements for security-based swap data repositories.
• Security-based swap fraud: Proposed a new rule to help prevent fraud, manipulation, and deception in connection with the offer, purchase or sale of any security-based swap — as well as in connection with ongoing payments and deliveries under a security-based swap.
• Security-based swap conflicts: Proposed rules intended to mitigate conflicts of interest for security-based swap clearing agencies, security-based swap execution facilities, and national securities exchanges that post security-based swaps or make them available for trading.
• Reporting of pre-enactment security-based swaps: Adopted an interim rule that requires certain swaps dealers and other parties to report any security-based swaps entered into prior to the July 21 passage of the Dodd-Frank Act. This rule applies only to such swaps whose terms had not expired as of July 21.
• Strengthening oversight of investment advisers: Proposed new rules to facilitate the registration of advisers to hedge funds and other private funds with the SEC; implement a mandate to require reporting by certain advisers that are otherwise exempt from SEC registration; increase the asset threshold for advisers to register with the SEC; and define “venture capital fund.”
• Asset-backed securities: Proposed rules that would enhance ABS disclosure by:
  • Requiring registered ABS issuers to perform a review of the assets that underlie the ABS.
  • Requiring an ABS issuer to disclose the nature, findings and conclusions of this review of assets.
  • Requiring the issuer or underwriter for both registered and unregistered ABS offerings to disclose the findings and conclusions of any review performed by a third party that was hired to conduct such a review.
• Whistleblower: Proposed a whistleblower program and rules that would reward individuals who provide the agency with high-quality tips that lead to successful enforcement actions.
• Say-on-Pay: Proposed rules that would enable shareholders to cast advisory votes on executive compensation and “golden parachute” arrangements.
• Municipal advisor registration: Adopted a temporary rule requiring municipal advisors to register with the SEC.

What’s Next?

The proposal seeks public comment and data on a broad range of issues relating to the proposed rule, including the costs and benefits associated with the proposal. Public comments are due 45 days after the proposal is published in the Federal Register. After careful review of comments, the SEC will consider whether or not to adopt or modify the proposed rule regarding the end-user exemption and the additional proposal regarding exemptions for certain financial institutions.

For SEC proposed requirements subject to public comment, see SEC website   http://www.sec.gov/rules/proposed/2010/34-63557.pdf

 

By Carmine Angone, Director, ICS Compliance - Confidence in Compliance for Hedge Fund Managers, Investment Advisors and Broker-Dealers