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Forex Funds and Forex Managed Accounts
Customer Testimonial It is hard to believe that Hannah and her team are even available for less than a small fortune. CMSG is efficient and knowledgeable yet extremely patient and understanding in dealing with clients at various levels of development. I received my initial advice from CMSG years before actually committing. Our legal needs seemingly transformed every few months, yet Hannah and her team were supportive and responsive at every turn. That level of effort was far more than I expected but has certainly become the benchmark for all others. I look forward to many years of excellence and superior service from Ms. Terhune and her team at Capital ManagementServices Group October 25, 2010 Mxxxxxxx D. Sxxxxxxxxxr II
Forex Funds and Forex Advisory Services If you operate a fund that trades forex or you provide forex trading advice to customers you are subject to a regulatory framework that puts you on equal footing with commodity trading advisors (CTA) that trade on-exchange commodity future and option contracts (commodities). CFTC regulations require you to register with the NFA and meet the disclosure, record keeping, reporting, and other requirements applicable to CTAs trading commodities. Even those trading in "foreign ordinaries" (i.e., equity securities exclusively traded overseas) may result in exposure to forex-related regulation (either now or in the near future) by the SEC, CFTC, NFA, or FINRA.
Our attorneys and staff have both regulatory experience and the understanding of the foreign exchange market. We know how to navigate the compliance with forex rules and regulations in the United States as well as in regulated jurisdictions such as United Kingdom, Singapore, Hong Kong, Canada and the British Virgin Islands. Each client receives a personalized attention from our attorneys and staff. No client is too large or small though because of our boutique size we pride ourselves in providing personal attention to each client.
Background on Forex Regulation In passing the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), Congress intends to close loopholes in the regulation of retail foreign exchange (forex) transactions. Prior to 2000, foreign currency trading by retail customers was largely unregulated. Congress attempted to address this situation in Commodity Futures Modernization Act of 2000. This law gave the CFTC the authority to regulate over-the-counter (OTC) futures transactions involving a retail customer on one side of the trade. The CFTC was not given jurisdiction to regulate OTC spot transactions, which normally settle in two days.
Acting on this authority, the CFTC brought an enforcement case against a foreign exchange dealer that was offering retail customers the opportunity to buy and sell foreign currency contracts that nominally settled in two days (the normal settlement cycle for foreign currency trades), but in reality were virtually always rolled over into a new contract without settlement actually taking place until the transaction was offset. The case was appealed to the Seventh Circuit Court of Appeals, which ruled in CFTC v. Zelener that rolling spot transactions were, in fact, spot transactions and, therefore, the CFTC had no jurisdiction to pursue its enforcement case.
Congress tried again in 2008 to address retail forex trading by amending the Commodities Exchange Act to regulate any OTC forex transaction involving a retail customer that did not, in fact, settle in two days by actual delivery of foreign currency. However, the law contained various exceptions for entities that were regulated by other regulators, such as insurance regulators or the SEC. The law excluded "investment banking holding companies" which include all affiliates for a broker-dealer holding company. This allowed enterprising entrepreneurs to avoid regulation by affiliating with an excluded entity.
Congress has tried to get it right now by including expanded regulatory authority over retail forex transactions in Dodd-Frank. Congress has given regulatory jurisdiction to a number of federal regulators, hoping to close the loophole created in 2008.
Who are the Regulators and Whom do They Regulate?
CFTC The CFTC is authorized to adopt registration rules and other requirements for retail forex dealers subject to its exclusive jurisdiction or unregulated by another federal agency. This would include FCMs that are registered with the CFTC but not subject to SEC or banking regulation, as well as dealers that are not regulated by any federal regulator (RFEDs). The CFTC also is permitted to regulate any person soliciting retail forex transactions, including introducing brokers, as long as the person is not regulated by the SEC or a banking regulator.
SEC and Other Regulators Under Dodd-Frank the SEC now has express authority to adopt rules regulating forex dealers that are broker-dealers. The statutory provisions would prohibit a broker-dealer from acting as a forex dealer absent enabling SEC regulations. On July 13, 2011, the SEC adopted rules that impose no new requirements for broker-dealers acting as forex dealers for one year in order for the SEC to study the impact of regulations in trading in foreign ordinaries among other issues.
Self-Regulatory Organizations Applicable statutory provisions do not prohibit self-regulatory organizations from regulating the activities of their members even though the federal regulator itself is prohibited from regulating those subject to its jurisdiction. As a result, both the NFA and FINRA have adopted rules governing retail forex activities of their members.
NFA The NFA amended its rules to establish a new category of membership, a Forex Dealer Member. As of October 1, 2011, this category includes any NFA member that acts as counter-party or offers to act as counterpart to a retail customer in a forex trade. Thus, any broker-dealer that is an NFA member and is acting as principal in retail forex trades would have to register as an NFA Forex Dealer Member and would be subject to a variety of NFA regulations.
Do I have to register with the National Futures Association (NFA)? Yes, as of October 18, 2010. As part of the reauthorization of the Commodity Futures Trading Commission (CFTC) in May 2008, Congress amended the Commodity Exchange Act to require forex solicitors, account managers and pool operators to register with the CFTC as Introducing Brokers (IBs), Commodity Trading Advisors (CTAs) or Commodity Pool Operators (CPOs) and become Members of National Futures Association (NFA). In addition, forex managers need to take the Series 34 Exam.
The new requirements apply to all registered CPOs, CTAs, IBs, and APs that also trade forex (e.g., retail off-exchange foreign exchange transactions). Before they can begin soliciting customers, CTAs and CPOs must submit a Disclosure Document (e.g., offering documents) for the forex fund to the NFA for approval. Based on our experience so far with the NFA, the forex pool process seems virtually identical to the NFA process governing commodity pool review and approval.
Must I Register with the NFA I Trade of Foreign Ordinaries in a hedge fund or managed accounts? Yes. Many broker-dealers offer the opportunity to buy and sell foreign ordinaries. In order to settle these transactions, brokers must convert customer monies into foreign currency and back again. In the typical transaction, a broker forwards a customer order to a correspondent overseas, who executes the transaction in the foreign market in the local currency. On settlement date, the executing firm settles the transaction in the local currency, thereby necessitating another currency conversion. Ultimately, the U.S. customer of the broker settles the trade in U.S. dollars without being involved in the actual currency conversion (similar to the way credit card companies settle foreign credit card purchases with their customers in U.S. dollars). Under Dodd-Frank, the issue is whether the purchase and sale of foreign ordinaries involves a retail forex transaction. Spot forex transactions normally settle on the second day after trade date and are expressly excluded from Dodd-Frank. However, securities transactions, including trades in foreign ordinaries settle on the third day after trade date. As a result, forex trading that is incurred in connection with trading of foreign ordinaries may involve broker-dealers in regulated retail forex transactions.
In recognition of this issue, on July 13, 2011, the SEC issued temporary final rules that operate to extend the effective date of forex regulation on broker-dealers for one year. Notwithstanding this deferral, brokers are on notice that that self-regulators have not deferred the applicability of their regulations with respect to retail forex transactions by broker-dealers.
Currently, various NFA rules applicable to its members apply with respect to a broker-dealer's retail forex activities, such as NFA Compliance Rule 2-29 on Communications with the Public and Promotional materials. Broker-dealers not required to register as Forex Dealer Members are subject to a variety of NFA regulations. In addition, in 2008, FINRA issued Notice 08-66 advising them that certain FINRA rules will apply to members with respect to their retail forex transactions. FINRA maintains that it will look to NFA rules and interpretations as the applicable standards under Rule 2110.
Given the universe of rules applicable to FINRA members involved in retail forex, directly or indirectly, through trading in foreign ordinaries, those trading foreign ordinaries on behalf of third parties for a fee, whether in an "equity" hedge fund or managed accounts, it is better to assume that squaring up with the NFA is the better path.
Customer Testimonial Hannah, With the closing of our first milestone, I thought it necessary to send a note thanking you and your staff for helping us to get our fund launched successfully. Without your expertise, care and introductions to your network of professionals, I sincerely believe that we would not have been successful. You were with us every step of the way, and your personal care and attention to our specific needs gave us the solution we needed. It was wonderful working with you, and I look forward to doing the same in the new year. Best wishes and a Happy New Year! As always, best regards, Dxxxx
How do I Start a Forex Fund? To become a forex fund, you must (1) pass the Series 3 Exam and Series 34 Exam; (2) join the National Futures Association (NFA) as a CTA; and (3) submit your Forex Disclosure Document to the NFA comment and approval for use with your customers. Forex trading advisors should have been registered with the NFA by October 18, 2010. If you are not NFA registered, you should not provide spot forex account management services to a fund until you are registered with the NFA. Associated persons (AP) of an NFA registered firm can provide spot forex account management services only if they have passed the Series 34 Exam. APs registered before May 22, 2008 do not have to take and pass the Series 34 Exam. Forex Disclosure Documents Both forex CTAs and forex CPOs need to have their forex disclosure documents reviewed and approved for use with customers by the NFA. While registration can be completed quickly if a forex manager has completed the forex exams and the fingerprint requirement, the disclosure document review process takes a little time as the NFA scrutinizes the documents. While forex disclosure documents are similar to futures/commodities disclosure documents, there are a few specific forex disclosures managers need to include in the forex disclosure documents. Forex disclosure documents and forex managed account agreements are legal documents used with customers and should be drafted by an experienced attorney, such as Hannah Terhune. Spot Forex Introducing Brokers (IB) Persons who solicit or accept orders for Futures Commission Merchants (FCM) or Retail Foreign Exchange Dealer (RFED) for spot forex must register with the NFA as an Introducing Broker. Forex IBs must either maintain the net capital requirements applicable to futures and commodity options IBs or to enter into guarantee agreements with the FCMs and RFEDs they deal with. To become an Introducing Broker you must (1) pass the Series 3 Exam (2) join the NFA as an Introducing Broker and (3) set up a clearing arrangement with a Futures Commission Merchant.
A forex IB can choose (1) to meet the minimum net capital requirements applicable to futures and commodity options IBs, or (2) to enter into a guarantee agreement with an FCM or an RFED. The NFA requires an IB to have a net worth of $45,000. If you cannot meet this capital requirement you can establish a Guaranteed Introducing Broker where the clearing FCM provides the equity. As a guaranteed IB, the IB can only clear through its guaranteeing FCM. As an IB cannot be a party to more than one guarantee agreement at a time, it effectively makes IBs that can't maintain the minimum net capital requirements exclusive sales agents for the FCM or RFED which they deal with. An independent IB (one that meets the net worth requirement) can establish clearing relationships with multiple FCMs. Series 3 National Commodity Futures Exam First of all, the Series 3 Exam has nothing to do with spot forex trading. If you have no futures/commodities knowledge, prepare yourself accordingly. The Series 3 National Commodity Futures Exam is required to register with the National Futures Association as an Associated Person, Commodity Trading Adviser, Commodity Pool Operator, or Introducing Broker. You do not need a sponsor to take the Series 3 Exam. You can study for the Series 3 Exam while your application forms are being created and processed.
How Can We Help You? We can help with test registration if you wish. We offer consulting services for NFA and CFTC applicants. We will complete Introducing Broker application forms and assist in office procedure set-up, compliance guidelines, and internal control. We will prepare the Disclosure Document plus all NFA applications.
Customer Testimonial Capital Management Services Group and Hannah Terhune have been instrumental in helping me establish a forex fund. I have been particularly impressed with Hannah's willingness from the beginning to advise me on the various options I had, and in helping me chart the appropriate course given my goals. She was very helpful in addressing and answering my many questions and I greatly appreciate her advice. As someone who was launching his first fund, I've greatly appreciated the support I received from her and her staff. I look forward to my ongoing relationship with Hannah Terhune and CMSG.
Regulation of Commodity Trading Advisors Trading Forex If you operate a fund that trades forex or you provide forex trading advice to customers you are subject to a regulatory framework that puts you on equal footing with commodity trading advisors (CTA) that trade on-exchange commodity future and option contracts (commodities). CFTC regulations require you to register with the NFA and meet the disclosure, record keeping, reporting, and other requirements applicable to CTAs trading commodities.
How Do I Become a Forex CTA? To become a forex CTA, you must (1) pass the Series 3 Exam and Series 34 Exam; (2) join the National Futures Association (NFA) as a CTA; and (3) submit your Forex Disclosure Document to the NFA comment and approval for use with your customers. Forex trading advisors should have been registered with the NFA by October 18, 2010. If you are not NFA registered, you should not provide spot forex account management services until you are registered with the NFA. Associated persons (AP) of an NFA registered firm can provide spot forex account management services only if they have passed the Series 34 Exam. APs registered before May 22, 2008 do not have to take and pass the Series 34 Exam.
Forex Disclosure Documents Both forex CTAs and forex CPOs need to have their forex disclosure documents reviewed and approved for use with customers by the NFA. While registration can be completed quickly if a forex manager has completed the forex exams and the fingerprint requirement, the disclosure document review process takes a little time as the NFA scrutinizes the documents. While forex disclosure documents are similar to futures/commodities disclosure documents, there are a few specific forex disclosures managers need to include in the forex disclosure documents. Forex disclosure documents and forex managed account agreements are legal documents used with customers and should be drafted by an experienced attorney, such as Hannah Terhune. Spot Forex Introducing Brokers (IB) Persons who solicit or accept orders for Futures Commission Merchants (FCM) or Retail Foreign Exchange Dealer (RFED) for spot forex must register with the NFA as an Introducing Broker. Forex IBs must either maintain the net capital requirements applicable to futures and commodity options IBs or to enter into guarantee agreements with the FCMs and RFEDs they deal with. To become an Introducing Broker you must (1) pass the Series 3 Exam (2) join the NFA as an Introducing Broker and (3) set up a clearing arrangement with a Futures Commission Merchant. A forex IB can choose (1) to meet the minimum net capital requirements applicable to futures and commodity options IBs, or (2) to enter into a guarantee agreement with an FCM or an RFED. The NFA requires an IB to have a net worth of $45,000. If you cannot meet this capital requirement you can establish a Guaranteed Introducing Broker where the clearing FCM provides the equity. As a guaranteed IB, the IB can only clear through its guaranteeing FCM. As an IB cannot be a party to more than one guarantee agreement at a time, it effectively makes IBs that can't maintain the minimum net capital requirements exclusive sales agents for the FCM or RFED which they deal with. An independent IB (one that meets the net worth requirement) can establish clearing relationships with multiple FCMs.
Series 3 National Commodity Futures Exam First of all, the Series 3 Exam has nothing to do with spot forex trading. If you have no futures/commodities knowledge, prepare yourself accordingly. The Series 3 National Commodity Futures Exam is required to register with the National Futures Association as an Associated Person, Commodity Trading Adviser, Commodity Pool Operator, or Introducing Broker. It's a 2.5 hour 120 question exam divided into rules and market knowledge. You need a 70% on both parts at one sitting to pass. You do not need a sponsor to take the Series 3 Exam. You can study for the Series 3 Exam while your application forms are being created and processed.
Customer Testimonial I would like to state unequivocally that I have had a completely positive experience in dealing with Capital Management Services Group. Truly, from the first phone call that I made to Capital Management and Barry Shapiro speaking with me, to the conference call that he arranged between the two of us and Hannah Terhune and the time that she took in answering all of my questions, and, finally, to the follow-up by Amy Hong, my case, establishment of a Forex Incubator Fund, has been thoroughly handled. Hannah Terhune responded promptly to my subsequent phone calls and Amy Hong is absolutely 100% efficient. I, certainly, plan to enlist Capital Management's services for my legal needs in the future concerning fund management. I would rate my experience and results 5 out of 5 stars! Totally satisfied, Rxxxxxx Sxxxx, Sept.22, 2010
Should I Set Up a Forex Managed Account Business or a Forex Pool? It's not a tough decision! It costs more money to set up a forex pool and the process takes a little longer. If you have customers ready, willing and able to commit money now, start by setting up a forex managed account business and add a forex pool later. With a forex managed account business, you do not have to hire an auditor and an administrator. Your customers will open and fund forex trading accounts at the forex broker you direct them to and you will manage their accounts pursuant to the NFA approved Disclosure Document you ask them to read and sign before committing to you and your trading program.
What is the NFA Registration Process? The Commodity Futures Trading Commission (CFTC) is the most prominent regulatory organization in spot forex and the National Futures Association (NFA) operates in association with the CFTC. The CFTC registration and disclosure document review process is handled exclusively by the NFA.
Why does it take so long for the NFA to approve Disclosure Documents? CTAs and CPOs both need to have their disclosure documents reviewed by the NFA. The disclosure document review and approval process takes a while. The disclosure document review process can be straight-forward or painfully miserable, depending on how experienced the document examiner assigned to the review is. The experience of the reviewer impacts on the time line leading to approval of the disclosure document for use with customers. Inexperienced reviewers will increase your legal costs. As our law firm completes many CTA and CPO registrations, we have observed this fact directly. We could submit virtually identical disclosure documents to the NFA at the same time and receive deficiency letters for each that are completely disparate. This would be due to the fact they were assigned to two different examiners. This is our repeated experience with the NFA. The NFA review process is labor intensive and how long it takes for your disclosure document to be approved depends on the luck of the draw!
Customer Testimonial I am extremely pleased with the high level of service provide by Hannah and her team of associates. They were easy to work with and their professionalism and the timeliness of deliverables far exceeded my expectations. Not only do I recommend using Capital Management Services Group to others contemplating forming a fund but I look forward to using them again in the future as my fund's needs grow. July 01, 2008 Axxx Mxxxx, Lxxxxxx Capital Management
How is a Forex Fund Structured? An incubator fund is typically structured by forming two separate entities: (1) a limited partnership (LP) or a limited liability company (LLC) which will serve as the fund; and (2) a limited liability company (LLC) which will serve as the investment manager / general partner of the fund (or managing member if the fund is an LLC). The individual who is actually managing capital would typically serve as the managing member of the investment manager. This structure grants you and your investors limited personal liability, as well as beneficial tax treatment.
Forex Fund Incubation and Incubator Forex Hedge Funds There is an alternative approach for those who want to test the waters before spending $10k or more to set up a fund or family office. Setting up an incubator forex hedge fund allows you to develop a track record which will assist in attracting investors later in time. The incubator hedge fund is created by breaking down the fund development process into two stages. The first stage sets up the fund and investment management company. Completion of the first stage allows you trade and develop a performance record using your own or other's money as seed capital. In the second stage your offering documents are written and the fund's trading history is compiled. Learn More About Incubator Forex Funds Finding Investors: What are Accredited Investors? Generally, accredited investors include individuals with a minimum annual income or $1 million in net worth and most institutions with $5 million in assets. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act the definition of an accredited investor has changed slightly. A U.S. hedge fund can accept up to 35 non accredited investors. The new financial reform law is effective on July 21, 2011. Learn More About Accredited Investors
Should I Avoid Non-Accredited Investors? No. If you allow non-accredited investors to invest in the fund, you need to have an initial (low-cost) launch audit. Make sure that your non-accredited investors are have sufficient knowledge and experience in financial matters in order to evaluate the merits and risks of investing in your hedge fund. A U.S. hedge fund may have up to 35 non-accredited investors.
Taxes on Forex Trading Foreign currency gains and losses (including gains and losses on forward, future and option contracts) are taxed under Section 988. That means that forex trading gains are taxed at the short-term (ordinary) tax rates. There is an exception for what is called a "qualified fund" where an election can be made to treat profits from foreign currency trades under Section 1256 (mark-to-market and a blended rate of 60% long-term gain and 40% short-term gain (regardless of how long a position is held). However, the fund must be meet a statutory definition of "qualified fund" which has its principal business the trading of forward, future and option contracts. There are also other tests to meet the definition of a qualified fund. In a qualified fund currency futures--otherwise known as regulated futures contracts--are taxed under Section 1256. Forward contracts and over-the-counter options in other traded currencies for which there is also trading in regulated futures qualify as Section 1256 contracts (but after 2007, some doubt). Gains in a qualified fund from futures trading are taxed at the 60/40 blended rate. Call the IRS first if you are tempted to take wild tax return positions based on you have read elsewhere on the Internet on this topic.
Customer Testimonial Hannah Terhune and her associates have provided legal advice and services to me for over a year. She provided initial guidance to help determine the kind of fund most suitable for my goals, created the legal documents that are the framework for my hedge-fund, and assisted with ADV submissions to register my company as an Investment Advisor. I continue to rely on her for ongoing compliance issues in this complex and dynamic industry. I found Ms Terhune and her associates to be extremely knowledgeable and helpful in a very responsive way, with friendly and professional manners. Overall a very good experience. Highly recommended. Marty Cawthon ChipChat Technology Group
I trade forex. Why are we talking about commodities? The Act defines a commodity pool as an "investment trust, syndicate or similar form of enterprise operated for the purpose of trading commodity interests." Generally, a person who operates a commodity pool must register as a commodity pool operator (CPO) unless an exemption applies. However, a person operating a pool that limits its trading solely to forex and only trades with authorized counterparties is not required to register as a CPO, but may do so voluntarily. Do I need a Series 7 or Series 65 to run a forex fund? No. But it your forex fund will also trade in futures contracts, commodity options (including options on futures contracts), leverage contracts involving certain precious metals, or futures contracts and commodity options traded on a board of trade, foreign futures and foreign options, you must register as a commodity pool operator (CPO) and your fund is also a commodity pool. If your forex fund also trades equities, you may need to be a registered investment adviser (depending on where you live). Click Here to Learn More About Investment Adviser Registration
Customer Testimonial I wanted to thank you and your staff for the professional and timely services that you provided in setting up a CTA business. As an individual trader for almost 20 years I have a full grasp of markets but had very little knowledge in setting up a trading business for clients. Everyone at your firm was extremely friendlyand helpful in giving me guidance in this new startup. Your prices were fair and while I looked at different firms to handle the process yours was head and shoulders above the rest. Thanks so much, Sxxx Sxxxr Managing Partner Sxxxxx Capital Management LLC. June 18, 2010.
Legal Development Process The legal development process is one that requires careful planning. A variety of regulatory issues intersects concurrently when developing a hedge fund: tax, registration, entity type and classification, jurisdiction, security type, and so on. The wisest course of action for those thinking about developing a hedge fund is to consult with qualified legal counsel before taking definitive steps.
Due to the many regulatory issues that must be complied with, it is best to define the structure of your fund properly before commencing any form of fund development or engaging the services of administrators or service providers. The legal development process normally begins with a planning consultation with an attorney experienced in forming hedge funds. This is where important determinations such as registration, jurisdiction choice, and utilization of safe harbors are made. The consultation may expose areas (outside the legal process) that need further planning, thus requiring the manager to deal with those issues before proceeding. After clearing up any such issues, a full engagement is entered into and the legal development process begins.
The hedge fund and investment manager are formed in their appropriate jurisdictions. This enables the fund manager to begin the process of opening bank and brokerage accounts and setting up the administrative functions of the hedge fund. After the entities are formed, the legal team gathers the necessary information to form the operating agreements for the entities and then the offering documents, first in draft stage and then finalized for distribution to prospective investors. The process of setting up a hedge fund usually can be completed within 60-90 days, though registration as an investment adviser, specialized circumstances, or delays in providing information can lengthen the process.
Who regulates forex in the United States? In the United States, regulatory oversight for financial and futures industry for U.S. clients or those looking to do business in the United States falls under the jurisdiction of the Securities and Exchange Commission (SEC), Financial Industry Regulatory Authority (FINRA), Commodity Futures & Trading Commission (CFTC) and/or the National Futures Association (NFA). The CFTC was begun in 1974 to protect investors in the futures and commodities trades. The CFTC determines the rules regulating the commodity brokerage industry, and its stated mission to investors, trader and the public from unethical practices in the commodity and financial futures and options markets. In addition, the CFTC is responsible with creating the regulatory environment that will foster a free market environment that fosters competition. The CFTC has the authority to close any unregulated entity in the retail forex industry. For 150 years prior to the development of the CFTC futures had been traded on the stock market under federal restrictions but those rulings only kept actual market stability fair without actually regulating how companies worked with clients. Futures trading have always been a primary interest for investors and pertain to the trade of future promised goods such as fruits, grains, and juices still un-harvested but with a 'future' date for market. The futures market also deals with currency trading and the ever fluctuating foreign currency values against the dollar. With the new public offerings of forex and massive influxes of individuals never before entering the finance world the need for protection from fraud and manipulation was heightened to new levels. The CFTC has undergone many changes and improvements, all with the focus on promoting open and competitive forex and commodities trading in a safe and secure environment.
In 2000, the U.S. Congress gave the CFTC basic levels of authority over forex dealers operating in the United States. The wording in that particular bill was pretty vague, and left a whole range of other players in the forex markets, such as introducing brokers, pretty much unregulated. A 2004 court case created the Zelner loophole (now closed in 2010) which allowed off-exchange spot forex market makers to duck CFTC authority. The NFA (National Futures Association) is an organization within the U.S futures market that was created in 1982. It is industry-wide and is self regulated. The NFA enforces adherence to certain capital requirements, and maintenance of a sound financial structure by its members. It also requires that member firms actively supervise their employees, agents and affiliates to prevent fraud and unlawful activities.
Paying Hedge Fund Management Hedge fund managers receive a management fee (typically between 1%-2% annually) plus a percentage of the fund's performance (often set at 20%). Performance is typically calculated on a cumulative basis (with incentive fees calculated against a ceiling or "high-water mark") so that any losses experienced by a hedge fund in one or more prior years must first be recouped (in whole or in part) by compensating gains before further (or full) incentive fees are paid. An example would be a $15 million loss in one year followed by a $20 million gain in the next year for which an incentive fee would be assessed only on the net $5 million gain. In addition, hedge fund managers allocate expenses to their funds and the investors in those funds.
Best Practices The fund's offering materials and legal documents must clearly spell out the manager's approach to charging fees. Include a description of the fee schedule; the exact formula used to calculate fees owed, including where appropriate example calculations; the time period for fee calculations; and the source of information to be used to calculate the fee payments. Hedge fund fees should be calculated based on audited portfolio valuations. Where the period of audited financial valuations does not coincide with the fee calculation period, investors should familiarize themselves with the hedge fund manager's portfolio valuation methodologies and the processes used to prepare the fee calculation. Once audited financials become available, the fee calculations should be reviewed and adjusted for any valuation differences. Calculate performance fees based on dollars of value added, not percentage returns or average capital invested for the calculation period. Performance fees computed as carried interest should be calculated on net value added as opposed to gross value added. Offering documents should adequately define "net value added" upon which performance fees are calculated (gross value added less any other expenses charged to the hedge fund). Offering documents should also adequately delineate all types of possible expenses and other charges that potentially could be deducted from fund assets. These expenses may include, but are not limited to: legal expenses, accounting expenses, trustee fees, administrative fees, marketing and sales fees, custodial fees, and general investment management charges. Performance fees should be calculated over a period of time that is appropriate given the volatility of the hedge fund strategy's returns and any lock-up period required by the hedge fund manager. Generally, the more volatile the investment strategy, the longer the period included for calculating the performance fee.
Charging Fees The Investment Advisers Act of 1940 prohibits a registered fund manager (including a state registered manager) from entering into an advisory contract that provides for a performance fee. Section 205(a)(1) provides that "no investment advisor...shall...enter into, extend or renew any investment advisory contract...if such contract provides for compensation to the Investment Advisor on the basis of a share of capital gains or capital appreciation of the funds or any portion of the funds of the client." The point behind this law is to prevent fund managers from being compensated based on appreciation of the fund's assets.
Management Fees Section 205(b)(1) provides that the prohibition on performance fees shall not be construed to prevent an investment adviser receiving compensation based upon the total value of a fund averaged over a definite period, or as of definite dates, or taken as of a definite date. This provision allows for management fees based on a percentage of assets under management. The management fee is paid whether the fund loses money or makes money.
Performance Fees (Incentive/Performance Allocations) Section 205-3 of the Investment Advisers Act allows for performance-based fees (or incentive allocations) to be charged to qualified clients. The point behind this law is to allow sophisticated investors who are capable of evaluating and understanding investment risks to enter into performance based fee contracts. Rule 205-3(d) defines a "qualified client" as 1. A natural person or company that has $750,000 under management of the adviser; or 2. A natural person or company whom the adviser believes (a) has a net worth of $1.5 million or (b) is a qualified purchaser as defined in section 2(a)(51) of the Investment Company Act (ICA). When determining whether a hedge fund is a qualified client the SEC has specific requirements to insure that non-qualified clients do not pool their assets and form a company or hedge fund to become qualified for this exemption. To avoid this, the SEC requires that all equity owners of the company or fund qualify on their own as qualified clients. More detailed rules apply to multiple tiers of hedge funds where again each equity owner of each fund needs to be a qualified client. Rule 205-3(b) thus requires a registered investment adviser intending to charge a hedge fund relying on ICA section 3(c)(1) to look through the hedge fund to ascertain that an investor has at least $750,000 of AUM with the adviser or a net worth of more than $1.5 million when the investment is made (this test applies to individuals and companies).
Qualified Purchasers The net worth test is also met if the investor is a qualified client under ICA Section 2(a)(51)(A) (this is the test for qualifying as an investor under ICA section 3(c)(7)). As a practical matter, this means that, if the fund is a section 3(c)(7) fund, a performance fee can always be taken against each investor. However, in a section 3(c)(1) fund, this is not necessarily true. A purpose of the subscriber questionnaire is to provide written guidance from each investor on its status on many vital issues including whether it is a qualified purchaser. When conducting a compliance examination, the SEC audit team may review the procedures that a fund manager uses to ensure that any clients charged performance meet the applicable criteria and evidence of satisfaction of these tests should be on hand. Keep good records.
Example 1 All taxpayers are domestic persons subject to the highest income tax rates. Hedge Fund, LP, has a General Partner LLC. On January 1, 2008, new limited partner RL makes his only capital contribution of the year of $1 million. His ending book capital account prior to reallocation is $2 million. He is subject to a 20% performance re-allocation. As of December 31, 2008, $200,000 of capital account value is re-allocated from RL's account to LLC's. RL's ending book capital account is $1.8 million. High-Water Mark It is common for the performance allocation to be subject to a "high-water mark" provision. The high-water mark's function is to ensure that a manager who has made money for an investor and then loses part of that capital cannot take a performance allocation (or fee) until the loss has been made up. Thus, performance can be taken only on the profits above the high-water mark. Investors must recall that performance is always calculated on the fund's economic performance, which will include the net of the yield (e.g., dividends, interest) less fees and expenses chargeable to the investor, and both realized and unrealized profits and losses. When investing in a fund, investors should determine whether performance fees are subject to a high-water mark. Investors should determine the period of time to which the high-water mark limitations apply, and confirm that it is consistent with their redemption rights and investment objectives. High water marks are widely used and are considered a market standard best practice. Further, since investors may join a hedge fund investment at different times, investors should confirm that high water marks are specific for each investor and separately tracked. Example 2 Same as Example 1, except that in 2009 RL's capital account is now $900,000 because the fund lost 50%. No incentive fee is chargeable. In 2010, RL's capital account increases to $1.35 million because the fund was up 50%. If there is a high-water mark provision, LLC gets no performance allocation. If there is no high-water mark provision, LLC gets a performance allocation of $90,000 even though RL is still in the hole. Example 3 Same as Example 2, except that in 2020, the fund makes 100% (economic) return and RL's (tentative) book capital account is $2.7 million. LLC is entitled to a re-allocation of $180,000 ($2.7 million less the high-water mark of $1.8 million x 0.20). If there is no high-water mark, LLC's re-allocation is $270,000 ($1.35 million x 0.20) and RL would have been subject to a re-allocation twice on the same amount. If the investor is a fiduciary account (trust account, pension plan, endowment, etc.) the prudential concerns of the fiduciary may well require that the fiduciary invest in a fund that has a high-water mark.In any event, the absence of a high-water mark provision may be viewed as indicative of a fund manager not overly concerned with issues of fairness to investors.
Hurdle Rate Many funds also have a "hurdle rate" provision. Hurdle rates are also used to guarantee that the hedge fund achieves a minimum investment performance before the fund's adviser may receive any incentive allocation. Hurdle rates establish a floor that the investment adviser must exceed to obtain the incentive allocation or performance- based fee. The underlying concept is that an investor could keep its funds in tax-exempt bonds and earn a safe, tax-free return (assume 3.5%). The investor demands that the incentive allocation be calculated only if the manager makes at least that rate -- a hurdle rate. There are two basic types: 1. The incentive allocation is charged only on economic profits made above the hurdle rate. 2. Once the hurdle rate is achieved, the performance is based on the entire economic profit.
Combing a Hurdle Rate and a High Water Mark A high-water mark and a hurdle rate can be combined.
Example 4 Same as Example 1, except that the incentive allocation is chargeable only after RL's book capital account earns a rate exceeding the federal funds rate plus 200 basis points, determined each year based on the rate in effect on the first business day of that year, and that the performance is chargeable only to profits exceeding that hurdle rate. With a hurdle rate of 4.5% for 2008, the incentive reallocation of profit is $155,000 ($1 million x [0.2 - 0.045]).
Example 5 Same as Example 4, except that the incentive allocation is chargeable in full to the profits, provided that the hurdle rate is met for that year. The incentive allocation is $200,000 (same as Example 1). The hurdle rate is optional; it provides an additional layer of computational complexity to whichever of the two alternatives is chosen, although the first alternative is clearly more complex. In some funds, the hurdle rate is quarterly, or even monthly, which is certainly an additional complexity and administrative expense as these calculations must be checked by the fund's accountants. Further, in some funds, the hurdle rate is cumulative; thus in Example 3 above, RL's hurdle rate would have to be calculated separately to determine what the performance allocation is when profitable years kick in.
Withdrawals Many issues go into the performance's calculation. For example, how is performance calculated when an investor withdraws, in whole or in part, prior to the end of the tax year; if there is a hurdle rate, should it be annualized or applied in full?
Example 6 Same as Example 4, except that RL withdraws June 30, 2008. Should the hurdle rate be 4.5% or 2.25%? Proration is the standard practice.
What about the high-water mark when an investor withdraws only part of their capital?
Example 7 Same as Example 2, except that RL withdraws half his (much depleted) capital account of $900,000 on December 31. Should his high-water mark be $1.8 million or prorated to $900,000? If $1.8 million, the manager is unlikely to realize a penny of performance from RL for a very long time, if ever. If prorated to $900,000, LLC at least has a fighting chance of making good and earning performance. Again, proration is the standard practice.
Keep Fund Accounting Simple The manager who has a highly complex performance allocation and expects the financials and tax returns by March 1 is tempting fate. The manager must recall that once the investor is promised something, less cannot be given. At the very least, no manager wants to go back to investors and ask them to sign amended fund documents about how the manager's own cut of the profits is determined.
The preceding article discussed critical points to be considered in drafting the performance/incentive provisions, both from the manager's and the investor's standpoint. This article does not discuss the rules for commodity pool operators (CPOs) under the jurisdiction of the CFTC. The CFTC (and the industry self-regulatory organization, National Futures Association) have no comparable restrictions on a CPO's entitlement to performance, provided that the investor receives appropriate disclosure and consents in writing to a performance-based compensation (or allocation of profits). Because many funds trade both securities and commodities, the SEC rules on performance typically govern the outcome.
Written By Hannah Terhune, Esquire (Copyright 2008 - All Rights Reserved) Reprinted with Permission. Portions of this article were originally published in part "Derivatives: Financial Products Report" an RIA publication, September 2005, as 'Hedge Funds - Do's and Don'ts for Crafting Hedge Fund Performance Allocations' by Hannah Terhune, Esq. and Roger Lorence, Esq.
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