Forex hedge
fund management
Thenumberofhedgefundsandhedgefundinvestorshassoared.Forextraderslookingto starta
fundneedto understandtherulesandregulationsbeforetheyquittheirdayjobs.
BYHANNAHTERHUNEANDROGERLORENCE
I t's understandable why hedge
funds have become so popular
in recent years - from a trader's
perspective. A talented
hedge-fund manager can accrue substantial
income, and while starting a
hedge-fund obviously isn't for the
novice forex trader, it's not as complicated
as it seems.
Let's assume a trader has a modest
$3 million under management and his
forex hedge fund has a I-percent management
fee and a 20-percent performance
allocation fee (Le., a share of the
profits). Assume the fund was started
on the first day of the year and
returned 15 percent.
In this case, the trader would have
gross income of $120,000,consisting of
a $30,000managementfee($3million*
1% = $30,000)and a $90,000performance
allocation ($3 million * 15%
return = $450,000 * 20% = $90,000).
Using all the same assumptions, a
hedge-fund manager with $10 million
under management would make
$400,000.
Also, because prospective investors
like to see fund managers' risk their
personal capital, assume the fund
manager has a significant portion of
his own money invested in the fund.
Because there are no fees assessed (it
would just increase taxes), the trader
earns an additional 30 percent on his
own investment in the fund.
However, before a trader can potentially
enjoy these rewards, he or she
must structure a proper business. The
good news is forex traders are now
positioned to quickly launch a forex
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fund with minimal regulatory oversight.
Forex fund basics
Regulation D, Rule 506, of the
Securities Act of 1933 defines a forex
fund as an unregistered security
offered as a private placement.
Regulation D provides "safe harbor"
provisions which, if complied with,
exempt the private offering from compliance
with the registration and
prospectus delivery requirements of
federal securities laws. However,
Regulation D does not exempt the
offering from compliance with the
fraud provisions of the federal and
various state securities laws.
forward contracts, and over-the-counter
options in currencies for which there
is also trading in regulatedfutures, all
qualify as "Section 1256 contracts."
Gains in these instruments are taxed at
a maximum federal rate of 23 percent
(60 percent of the gains and losses are
long-term and 40 percent is shortterm).
In addition, the fund usually
qualifies as a "trader in commodities,"
so the investors are able to deduct the
fund's expenses more favorably than
expenses in an investment partnership.
Performance-based compensation
for fund advisers is usually structured
as an allocation of profits, but it is
sometimes structured as fees - in
Mostforeigncurrencytradingiseligiblefor
favorablefederalincometaxtreatment.
Forex funds must supply all
investors with comprehensive information
about the offering in "disclosure
documents." The purpose of these
documents is to limit the hedge fund's
potential risk by providing full disclosure
to investors.
A typical set of disclosure documents
includes a private placement
memorandum, an investor questionnaire
and subscription agreement, and
an operating agreement for the fund.
Most foreign currency trading is eligible
for favorable federal income tax
treatment. Regulated futures contracts,
regulated commodity option contracts,
either event typically between 10 and
20 percent of trading profits. In some
instances, the compensation agreement
specifies that funds be only paid
when the profits of the fund exceed a
minimum rate, or "hurdle rate."
Exempt lorex funds
To be exempt from registration under
the Securities Act of 1933,a fund must
have no more than 100beneficial owners
(also known as the "100 investor
test") and must not publicly offer its
interests.
Under the Section 3(c)(7)exemption,
a fund must offer its securities to
March 2005 .CURRENCY TRADER
"qualified purchasers." There are no
limitations on the number of qualified
purchasers under the Investment
Company Act of 1940.
However, when there are more than
500 investors in the limited partnership,
the entity my be subject to classification
as a "publicly traded entity."
If that occurs, the entity could lose its
flow-through tax treatment (i.e., a
partnership) which is one of the primary
benefits of the hedge fund's
structure.
Accredited vs. non-accredited
investors
Generally, "accredited" investors
includes persons whose net worth (or
joint net worth with spouse) exceeds
$1,000,000,or whose income was in
excess of $200,000in both the two preceding
years (or, with a spouse, in
excess of $300,000in both the two preceding
years), and who reasonably
expect to reach the same level of
income in the current year.
If you plan to have "non-accredited
investors" in your fund, you will not
only need a detailed set of disclosure
documents, but also audited documentation
of the source of initial capital
invested in the fund. This initial audit
is referred to as a "launch audit" or as
a "seed-capital audit." Regulation D
limits the number of non-accredited
investors to 35.
Taking on non-accredited investors
is risky because if there are ever any
problems with the fund's performance
and investors seek relief in the courts,
a judge would probably take the side
of the non-accredited investor.
Howdol~dinvestors?
Rule 502(C) of Regulation D prohibits
any form of a general solicitation or
general advertising. Generally, interests
in your hedge fund may be sold
by registered broker dealers, registered
investment advisors or officers
of the fund's management to those
persons with whom they have existing
relationships.
Your marketing efforts must be percontinuedon
p. 54
CURRENCY TRADER. March 2005
Steps to launch a lorex hedge fund
1. If you need to register as a Commodity Pool Operator (CPO), start the
process, which you will continue while executing the rest of these steps. See
www.iard.com to get started.
2. Determine what will make your hedge fund unique. Finalize the fund's
investment objective and investment strategies, prepare biographical data on
yourself for the offering documents, and make decisions that will affect how
often you accept investors, how you will be compensated, what expenses
your fund (as opposed to the management company) will bear, how you will
be set up regarding trader tax status, etc. I
3. If you are forming a commodity hedge fund, start the process of becoming
a member of the NFA. See this page: http://www.nfa.futures.orgJregistration/
nfa_membership.asp. You will need to register as a Commodity Pool
Operator with the NFA. See http://www.nfa.futures.org/registration/cpo.asp.
4. Obtain a first draft of your offering documents (Private Placement
I Memorandum, LLC Agreement, and Subscription Materials) from your
provider(the firm advisingyou on settingup your hedgefund). Formyour I
business entities, get tax ID numbers, make the appropriate IRS elections,
and prepare resolutions so you can open bank and brokerage accounts.
5. Your provider's attorney should be actively involved in the review of your
documents. This is an important part of the preparation of your fund.
6. If you are registered as an Investment Adviser or registered with the NFA
as a Commodity Pool Operator, make sure the regulators have approved any
such applications.
7. Your provider should give you the SEC Form D and the blue sky filings for
I the initial states where you expect to distributeyour offeringdocuments.
Make sure your provider gives you instructions on how and where to file the
I various documents,and general instructionsregardingthe distributionof I
your offering documents. You should now have a final set of offering documents.
8. Have your offering documents printed and bound. Consider the image you I
I wish your fund to project when choosing the printing materials and binding
method. Remember that you can have no marketing materials other than I
I your offering documents.
9. Mail your SEC Form D. You can check here to see that it was processed
by the SEC: http://www.sec.gov/edgar/searchedgar/companysearch.htIml.
File your blue sky filings within the appropriate time - either before distribu-
I tion or within 15days of the first sale in that state,dependingon the state's
rules.
10. Start distributing your offering documents and attracting investors. Keep
. a log of all individualsto whomyou distributeyourdocuments.Deposityour
seed capital and start the initial trading of the fund.
- - - -
53
sonally directed toward investors who
are known to you. The SECviews nonpersonal
communications as "general
solicitations," even when the targeted
recipients of the communications
could reasonably be expected to be
qualified investors.
However, it is possible to comply
with the prohibitions against general
solicitation or advertising by using a
secure Web page for which access is
limited to accredited investors.
Blue sky
Within 15 days of the first sale of your
offering, you will have to me your
Form D (Notice of Sale) with the SEC
as well as comply with filing requirements
of the states in which each of
your investors are located. Then you
need to be sure that your securities are
sold with out violating the prohibition
on general advertising.
NFA registration
If your forex fund invests in currency
futures contracts, currency futures
options, or forward contracts, it must
be approved as a commodity pool by
the Commodity Futures Trading
Commission (CFfC). In addition, you
must register with the National Futures
Association (NFA) and become a
Commodity Pool Operator (CPO).
This raises the differences between
registration as a CPO and a commodity-
trading advisor (CfA). A CfA manages
individual accounts, while a CPO
manages only the hedge fund, or pool.
Many people lose interest in the CfA
option when they realize the administrative
hassles associated with managing
separate accounts.
Spot forex trading is not regulated
by the CFTCand does not require CPO
registration if the fund trades spot currencies
exclusively. Legally, "spot currency"
refers to contracts that settle by
the second business day after the date
the trade is entered.
While CFTC registration is not
required for spot forex traders, it is
important for fund managers to trade
with firms that are NFA registered, as
NFAregistered members are subject to
54
arbitration, capital requirement rules,
and customer account regulations.
No sponsoris needed to take the Series
3 exam, also known as the National
CommodityFutures Examination.which
is administeredunder the auspicesof the
NASD's testing program. You can find
the nearest testing location at
www.nasd.com/NASDW 010803.
The CFfC has allowed the NFA to
become the primary regulator of
futures and commodity products (as a
self-regulatory organization, similar to
the NASD's status with the SEC).
The item that will typically take the
most time for processing of a CPO
application is the fingerprint card,
which is supplied by the NFA.A CPO
will take it to their local police station
and have their fingerprints taken. The
card is then mailed to the NFA, which
sends it to the FBIfor processing. This
takes six to eight weeks, and there is
no rush service available, so take care
of this very early in the application
process.
The NFA must approve all disclosure
documents before they can be
used to solicit clients. If the NFA has
comments, it will usually give them to
the CPO candidate verbally, and in
writing if the CPO candidate requests.
The guide for CPOs and CfAs (see
"Web resources") is an invaluable tool
for creating disclosure documents. The
NFAessentially uses that document as
a checklist, and every item must be
addressed to their satisfaction before
they will approve disclosure documents.
The disclosure document must
include information about the CPO
and its principals (including performance
record), commodity trading advisors,
futures commission merchants,
brokers, details of the commodity
interests, expenses associated with the
pool, conflicts of interest, minimum
investment amounts, transferability
issues, and any litigation (material,
administrative, civil, or criminal)
against anyone involved in the management
of the fund. Additionally, any
person who is involved in the commodity
pool must register as an associate
of the CPO.
The disclosure document must be
filed with the NFA at least 21 days
prior to the delivery of the documents
to a prospective participant, and
updated periodically. The CPO must
receive a written confirmation from
each participant in the pool that they
received the Disclosure Document
prior to accepting the participant's
funds.
CPO registration exemptions
The CFTCprovides for several exemptions
from CPO regulations. A person
is not required to register as a CPO if
the person did not receive any compensation
or payment directly or indirectly,
operated only one commodity
pool at a time, or was not otherwise
required to register with the CFfC.
This is referred to as the "closely held
pool exemption."
Registration as a CPO is also not
necessary from registration when total
gross capital contributions for participation
units in all pools that are operated
(or intended to be operated) do
not in the aggregate exceed $400,000
and there are less than 15 participants
in the pool.
Also exempt from registration as a
CPO with respect to the pool, where
the interests have been sold exclusively
to participants that the CPO reasonably
believes at the time of their investments
were QEPs, and the pool trades
commodities in de minimis amounts.
The de minimis limitations are: 1) the
pool limits its commodity interests
positions such that the aggregate
notional value of such positions does
not exceed the liquidation value of the
pools portfolio, or 2) the total amount
the pool commits as initial margin and
premiums to establish commodity
positions does not exceed 5 percent of
the liquidation value of the pool's
portfolio. Another requirement is the
interests in the relevant pool are not
marketed as participants in a vehicle
for trading in commodity interests.
CFTC Rule 4.13(a)(4) establishes a
CPO registration exemption for a CPO
with respect to a pool where interests
March 2005 .CURRENCY TRADER
are offered and sold without marketing
to the public in the United States, and
are sold exclusively to participants that
the CPO reasonably believes are QEPs.
Are you going to trade
stocks, too?
If you plan to execute more than an
occasional stock trade, you might also
have to register as an investment
adviser. Beginning in February 2006,
hedge fund mangers will be required
to register with the SECas investment
advisers when a fund has assets of $25
million or more and has 15 or more
investors in the hedge fund.
Until then, the hedge fund itself is
considered the "client" of the adviser,
which affords the adviser an exemption
from registration if there are less
than 15 clients and the adviser does
not hold itself out to the public as an
investment adviser.
Funds with less than $25 million
will not be permitted to register and
will be subject to applicable state law.
State investment adviser
registration
Each state has its own registration
requirements which are also interpreted
in conjunction with the National
Securities Market Improvement Act of
1996.
In some instances, where the investment
adviser has a particular kind of
client, has fewer than a certain number
of clients within a 12-month consecutive
period, and does not hold itself
out to the public as an "investment
adviser," it may be exempt from that
states' registration requirement. In
each instance, it is important that the
law of the state in question be
reviewed for compliance.
More rules and regs
In addition to the registration and
solicitation guidelines summarized
above, there are also federal and state
laws governing the operation of the
fund. These laws govern marketing
and advertising, the compensation of
fund advisers, fund management, personal
trading, the use of soft dollars,
CURRENCYTRADER' March 2005
Web resources
http://www.nfa.futures.orgl
The home page for the National Futures Association (NFA).
http://www.nfa.futures.orglcomplianceflSSues_cpo_cta.asp and
http://www.nfa.futures.orglcompliancelpublicationsldd2001/DD2004.pdf
The web pages are related to the NFA's Guidance to Commodity Pool
Operators (CPOs) and Commodity Trading Advisers (CTAs). The second
link is particularly valuable. It essentially defines the sections that need to
be included with a CPO document that is submitted to the NFA. It also discusses
some of the various exemptions from registration that are available.
Some of these exemptions (particularly the Qualified Eligible Person [QEP]
- only pools) are very powerful and should be strongly considered. The
QEP exemption allows you to not have to take the Series 3, not have to
become a member of the NFA, and not have the NFA or the CFTC as a
regulator. Other exemptions, such as those related to small pools, may be
of more benefit to certain clients.
http://www.nfa.futures.orglregistration/cpo.asp.
The NFA'sguidance related to who has to register as a CPO, and how it is
accomplished. It includes a link to a page for an REasyReference GuideRto
exemptions from registrationhere: http://www.nfa.tutures.orglregistration/
easyReferenceGuidePart4.pdf.
http://www.nfa.futures.orglregistrationlcta.asp
The equivalentto #3, above, exceptthat it is for CTAs.
http://www.nfa.futures.orglregistrationlnfa_membership.asp
Data related to becoming a member of the NFA.All CPOs and CTAs must be
members of the NFA, unless they achieve an exemption. Note the reduced
fee schedule that became effective on July 1, 2004.
http://www.nfa.futures.orglbasicnetl
This is the equivalent of the NASDR's website, except that it is for the NFA.
Through this page, you can access a summary of the status of all NFA members,
including regulatory status and sanctions.
http://www.cftc.gov/cftclcftclawreg.htm#cea
This is an invaluable site to review the underlying federal law related to CFTC
issues. Note the various links in the body of the page as well as on the left
navigation buttons.
Securities Law: http://www.law.uc.eduiCCUsldtoc.html
State Securities Administrators: http://nasaa.org/members_only/CFTC Law
and Regulation links: http://www.cftc.gov/cftclcftclawreg.htm#cea
Investment Adviser application (for most states): www.iard.com
Our website (tons of additional data):
http://www.greencompany.comlHedgeFundslindex.shtml
reporting requirements, and record
keeping.
Although the process is involved,
experienced forex traders who wish to
expand into professional money management
can save themselves a great
deal of trouble later by learning now
about the forex hedge fund registration
process and regulations they will
have to abide by in the future. 0
Fur infonnation on the author seep. 8.
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