SEC Sues U.K.-based Hedge Fund for Late Trading and Market Timing

On April 10, 2008, the SEC filed suit in the U.S. District Court for the Southern District of New York against Headstart Advisers Limited ("Headstart"), a United Kingdom-based hedge fund, alleging that Headstart violated the securities laws by engaging in late trading and deceptive market timing in connection with its trading in mutual fund shares (SEC v. Headstart Advisers Limited, 08 CV 3484 (SDNY)).  The SEC's suit seeks disgorgement of $198 million of allegedly illicit gains as well as other relief.

Mutual fund share prices are set once daily based on the fund's total net asset value ("NAV") as of a certain time of each trading day, typically 4 p.m.  Rule 22c-1(a) under the Investment Company Act of 1940 requires mutual funds to price transactions in their shares based on the next computed NAV following the receipt of the order.  Therefore, orders placed before 4 p.m. are normally executed at that day's 4 p.m. NAV, while orders placed after 4 p.m. are executed at the NAV calculated at 4 p.m. on the following trading day. 

The SEC alleges that Headstart arranged with various broker-dealers to execute late trades as if they were received prior to market close, allowing Headstart to trade based on information released after 4 p.m.-such as earnings results-that was not reflected in the NAV set at 4 p.m.  For example, the SEC claims Headstart would give "preliminary" trading instructions to a broker-dealer before 4 p.m. but call to confirm or cancel its orders after monitoring news released after 4 p.m. 

"Market timing" of mutual fund trades includes frequent buying and selling of shares of the same mutual fund or attempts to exploit inefficiencies in mutual fund pricing.  The SEC claims that Headstart engaged in a variety of deceptive practices in order to prevent mutual funds from detecting its market timing activities and to allow it to continue trading even after being detected and blocked by funds.  The SEC complaint states that Headstart created numerous trading subsidiaries with names that did not indicate any relationship to Headstart.  Many of its trading subsidiaries included "401" in their names, which the SEC claims was an attempt to appear as if they were associated with 401(k) plans.  In all, Headstart opened more than 500 brokerage accounts.  When one account would be blocked by a fund for market timing, Headstart would use another seemingly unrelated account to continue.

In addition, the SEC claims that Headstart attempted to hide its market timing activities by splitting trades into smaller dollar amounts-below the amount Headstart believed mutual funds monitored.

Headstart's practices were illegal, according to the SEC, as they were intended to conceal and misrepresent its identity in order to induce mutual funds to accept Headstart's trades. 

The SEC is seeking disgorgement of $198 million dollars it claims were the profits from Headstart's allegedly illegal trading, as well as other relief.  Headstart has called the suit "utterly misguided" and said it plans to "vigorously defend the SEC's contentions."

Industry Update

Private-Sector Committees of the President's Working Group on Financial Markets Release Best Practices for Hedge Funds and Hedge Fund Investors

On April 15, 2008, two private-sector committees of the President's Working Group on Financial Markets (the "PWG") released detailed reports setting forth best practices recommendations for hedge fund managers (the report of the Asset Managers' Committee (the "AMC")) and for investors in hedge funds (the report of the Investors' Committee (the "IC")).  The reports are designed to work in conjunction to increase accountability across the industry and its numerous participants, and the recommendations of the committees are also intended to be consistent with "work that was done in the United Kingdom to improve hedge fund oversight," noted the PWG's press release.

According to Eric Mindich, the AMC's Chair, "the hedge fund industry has a critical responsibility to adopt strong business practices that reflect both its growth and the important role it plays in global financial markets."  Therefore, the AMC's report, "Best Practices for the Hedge Fund Industry," suggests a variety of reforms to the business practices of hedge funds, including enhancements to firms' risk management and back-office operations, designed to reduce the industry's contribution to systemic risk in the broader financial system.  The AMC's report also suggests that hedge funds provide their investors with significantly enhanced disclosures modeled on the disclosure regime applicable to public companies.  Additionally, the report encourages hedge fund managers to send their investors information statements detailing (i) the percentage of the fund comprised of various categories of difficult-to-value assets as set forth in Financial Accounting Standard 157 and (ii) the realized and unrealized profits and losses attributable to such assets.

The AMC consists of a variety of veteran hedge fund managers, including representatives from AETOS Capital, LLC, Avenue Capital Group, Cantillon Capital Management, D.E. Shaw & Co., L.P., Eton Park Capital Management, Highfields Capital Management, Kynikos Associates LP, Och-Ziff Capital Management, Reservoir Capital Group and Silver Point Capital.  According to a fact sheet accompanying the release of the AMC's report, all of these firms will implement its recommendations.

The Chair of the IC, Russell Read, stated that the IC's goal is "to have [its] recommendations become common practice throughout the industry."  The IC's report is broken down into two primary sections-a Fiduciary's Guide and an Investor's Guide.  The Fiduciary's Guide provides a framework for fiduciaries to analyze whether to invest in hedge funds, including recommendations for conducting due diligence on hedge funds.  The Investor's Guide focuses on investment professionals charged with maintaining a hedge fund investment program.  Both guides emphasize that hedge funds should be considered a "legal construct" and not a distinct asset class.  Therefore, the IC's report suggests investors in hedge funds perform "in-depth" and "continuous oversight" of their investments.

The IC consists of a diverse group of institutional investors, pension funds, university endowments and consultants for such investors, including, but not limited to, representatives from CalPERS, Princeton University Investment Company, Cambridge Associates, LLC and the AFL-CIO.

SEC's Donohue Discusses Division of Investment Management's Top Regulatory Initiatives

In a recent speech before the IA Week and the Investment Adviser Association's 10th Annual IA Compliance Best Practices Summit 2008, Andrew J. Donohue, director of the SEC's Division of Investment Management (the "Division") discussed some of the top regulatory initiatives that the Division is working on.

Form ADV Part II.  The SEC has proposed amendments to Part II of Form ADV to substantially improve disclosures by advisers to their clients.  As the primary disclosure document advisers provide to clients, Donohue sees the goal of Part 2 as allowing investors to make informed choices in selecting their investment adviser as well as evaluating any conflicts the adviser may have.  As the federal securities laws generally favor disclosure rather than setting minimum experience, qualifications, maximum fees or conflict of interest rules, Donohue sees it as critical that Part 2 provide sufficient information that would allow an investor to make an informed decision.  According to Donohue, the proposed amendments are intended to result in "more client-friendly disclosures" that are "more meaningful, more effective, and easier to understand."

Rand Report. In January 2008, the SEC released a copy of the RAND Report (the "Report") which the SEC commissioned to study the broker-dealer and investment advisory industries and each of their regulatory regimes. Discussing the Report, Donohue reviewed the vast growth and development of both the broker-dealer and investment advisory industries and how the industries have changed and intersected over the past seventy years. While Donohue believes that the Investment Advisers Act of 1940 (the "Advisers Act") represents "principals-based regulation" that allows for flexibility to accommodate change, he acknowledges that even such regulatory schemes may need adjustment.  Together with Erik Sirri, the Director of the Division of Trading and Markets, Donohue is studying the Report and preparing a range of options for Chairman Cox's Consideration. 

Temporary Principal Trading Rule. While investment advisers are required by the Advisers Act to receive written consent before engaging in principal trading with a client, broker-dealers engage in principal trading as a regular part of their business. Historically, fee-based broker-dealers who were also investment advisers avoided the consent requirement through a special exemption from the definition of "investment adviser." The U.S. Court of Appeals for the District of Columbia Circuit struck down this exemption in March 2007, subjecting these broker-dealers to the Advisers Act and the consent requirement for principal trading. (See April 2007 Investment Management Regulatory Update).

Soon thereafter the SEC passed Temporary Rule 206(3)-3T to ease the burden of consent on the newly subject broker-dealers. Subject to a number of conditions discussed in the October 2007 Investment Management Regulatory Update, the Temporary Rule allows an adviser that is also registered as a broker-dealer to give oral disclosure to clients prior to each principal trade, rather than the written disclosure otherwise required by the Advisers Act. 

Donohue reported that the SEC has received several comments on the temporary rule and plans to make recommendations to the SEC shortly.  Donohue also noted that dual registrants should expect examiners to focus on how their firms are conducting principal trades, what compliance procedures they have in place to assure that the trades are in clients' best interests and how their firms advise clients on what type of account is appropriate for them.

Separately Managed Accounts / Unified Managed Accounts.  According to Donohue, the Division has taken an interest in the rapid growth of managed accounts.  While such accounts can provide cost savings through bundling of services, they can create compliance challenges requiring careful disclosure of the adviser's different roles.  Donohue specifically called attention to assuring that firms meet their best execution obligations, especially if trades will be placed with the managed account's sponsor.

Donohue further expressed concern regarding whether firms relying on Rule 3a-4 under the Investment Company Act of 1940 as an exemption from registration as an investment company were fully complying with all the conditions of the Rule.  Further, Donohue indicated that the Division may review whether the conditions in Rule 3a-4 continue to ensure an appropriate level of individualized treatment to support the exemption.

Soft Dollars.  Discussing soft dollars, Donohue noted positive developments in the marketplace.  The increased use of electronic methods in securities trading, Donohue believes, has increased transparency of the costs associated with execution.  In light of the progress, Donohue believes new guidance would be beneficial and the Division has been preparing recommendations for the SEC.

Books and Records.  In light of advances in technology, how firms create and maintain books and records has fundamentally changed.  Nonetheless, according to Donohue, the Adviser Act rules governing adviser recordkeeping "have not been updated in a comprehensive fashion since they were adopted in the 1960s."  The Division is looking into how the rules can be updated to "go beyond the role of current technology."  Further, Donohue said the Division is looking into whether each requirement can be satisfied in a better or less burdensome manner as well as recommending guidance on the use of outsourcing and the use of third parties for record creation and retention.