NY Metro Hedgefund Law & News

UK Remunerations Code Applicability Expanded to Limit Incentive Compensation for Many Financial Services Firms Based in or Doing Business in the UK

Consultation Paper 10/19

On July 29, 2010, the United Kingdom’s Financial Services Authority (“FSA”) promulgated   “Consultation Paper 10/19 – Revising the Remuneration Code”   to greatly expand the number of financial services firms who will need to comply with its provisions.

The prior version of the Remuneration Code (“Code”) applied to a relatively limited group of firms in the UK (essentially 30 or so of the largest British financial institutions).   Now the Code will apply to all institutions falling within the scope of UK capital oversight, including  banks , asset managers, hedge fund managers, UCITS (Undertakings for the Collective Investment of Transferable Securities) and  investment firms as well as some firms that engage in corporate finance, venture capital, the provision of financial advice and stockbrokers.

Personnel Subject to Compensation Restrictions

The Code will limit  the remuneration to be paid to so-called “Code Staff”   of  covered  firms.  These comprise any staff which "have a material impact on a firm's risk profile".  The FSA expects the definition  to apply both with respect to employees and to most partners with limited liability, including members of English limited liability partnerships (LLPs).

The FSA's proposed guidance suggests Code Staff should include:

(i)   a person who performs a significant influence function, as defined in the FSA's rule

(ii)  a Senior Manager, defined as "an individual employed by the firm to whom the governing body (or a member of the governing body) of the firm has given responsibility for management and supervision, and who reports directly to the governing body, a member of the governing body, the chief executive, or the head of a significant business group"; and

(iii)  all staff whose remuneration takes them into the same bracket as senior management and "risk takers", whose professional activities could have a material impact on a firm's risk profile.

 Restrictions

The following are some of the significant restrictions on Code Staff compensation.

• Deferral –  At least 40 percent of any Code Staff bonus must be deferred, vesting over a minimum three-year period.  The deferred portion of a bonus exceeding £500,000 must be at least 60 percent. Firms that operate long‑term incentive plans will need to structure them so that half of the award vests after not less than three years and the remainder after five years
• Payment of Bonuses in Kind - At least 50% of  variable remuneration will  have to be paid in shares, non-cash instruments or other share-equivalent instrument subject to a minimum retention policy
• Guaranteed bonuses can only be offered in exceptional circumstances to new hires for the first year of service.  The payments should not be more generous in either amount or term than the variable remuneration awarded or offered by the previous employer and should be subject to performance adjustment.
• A  current de minimis level which exempts from deferral requirements staff whose bonus forms less than 25% of their total remuneration, and whose total remuneration is less than or equal to £500,000 will be extended to Code Staff whose variable pay is up to 33% of total remuneration. It is proposed that such staff would not be subject to rules relating to deferral, performance adjustment, proportion of remuneration paid in shares, and guaranteed bonuses.

Proportionality

The FSA will have a degree of flexibility in implementing the  Code so that  smaller firms  only need to be subject to the remuneration requirements in a ”proportionate manner” —although  at the present time it is not clear what this will mean for hedge fund managers.

The Consultation Paper proposes the following structure of application of the Code's provisions to reflect the proportional approach:

i.   minimum requirements that all firms would be expected to comply with. These requirements are mainly the high-level principles that form part of the Code in its current version, including the requirement to ensure variable and fixed components of remuneration are appropriately balanced; 

ii.   rules which could be applied proportionally in line with a firm's nature, scale, scope and complexity; and

iii.   rules which could be applied on a "comply or explain basis" (which includes the requirements relating to bonus deferrals, guaranteed bonuses, severance pay, share-based awards, performance adjustment, discretionary pension benefits, and voiding and claw-back, as discussed below).  A firm will have the option whether or not to implement  such rules, but if it decides not to implement them, it must provide acceptable reasons for its decision.

Furthermore, a firm may be able to rely on the proportionality provisions in the Code and the FSA Handbook as a  justification for not complying with the Code's requirements relating to remuneration structures by  January 1,  2011, provided  that it takes reasonable steps to comply as soon as is reasonably possible, and in any event by July 1 2011.

Effective Dates

The finalized rules will apply to:

• remuneration awarded on or after  January 1, 2011;
• remuneration due on the basis of contracts concluded before January 1, 2011 which is awarded or paid on or after that date; and
• remuneration awarded, but not yet paid, before January 1, 2011, for services provided in 2010.

USA Law On Incentive Compensation

Section 956 of the Dodd Frank Act takes a principles based view of incentive compensation in the financial services industry.  More specifically Dodd Frank grants  the appropriate federal regulators rule making authority to prohibit any type of incentive-based payment arrangement, or any feature of such an arrangement, that the regulators determine encourages inappropriate risks by a covered financial institution, either by providing excessive compensation, fees, or benefits or by potentially leading to material financial losses to the institution. Section 956 requires the federal banking agencies, the SEC, federal credit union authorities, and federal housing finance authorities  to jointly develop, no later than April 21, 2011, regulations or guidelines implementing these disclosures and prohibitions concerning incentive-based compensation at "covered financial institutions" with at least $1 billion in assets. That seems to be a much higher threshold than the UK Remunerations Code for smaller firms looking for relief.

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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com. Nothing in this blog is legal advice and readers should not rely on anything in this blog as being legal advice.

SEC's Initial Proposed Regulations over the Swaps Markets

New Proposal

The SEC made its first proposal last week toward regulating the swaps market. See  SEC Proposes Rules to Mitigate Conflicts of Interest Involving Security-Based Swaps.  The initial foray is an attempt to minimize conflicts of interest situations in security-based derivatives clearing and trading markets.

Background - Dodd-Frank

Under the Dodd-Frank Act security based swaps (generally speaking swaps on stocks, stock indexes,  bonds,   and stock options – but not generally on commodities, interest rate swaps,  currencies or futures which will be the province of the Commodities Futures Trading Commission)  will be regulated by the SEC.

 Among other things under Dodd-Frank:  (1) absent an exemption,  a  security- based swap  must be cleared through a clearing agency if it is of a type the SEC determines must be so cleared (2) transactions in security- based swaps  must be reported and  (3) security based swaps subject to clearing requirements must generally be traded on a registered trading platform.

Dodd Frank also required the SEC to adopt rules to mitigate conflicts of interest by limiting institutional control (covered institutions are called “Specified Entities”) over securities swaps agencies or exchanges.  These facilities are technically called “security-based swap execution facilities”.

Dodd-Frank defines "security-based swap execution facility" ("security-based SEF") to mean "a trading system or platform in which multiple participants have the ability to execute or trade security-based swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility that (A) facilitates the execution of security-based swaps between persons; and (B) is not a national securities exchange."

SEC Concerns About Concentration and Conflicts of Interest

The  OTC derivatives market is highly concentrated. The SEC reports that: “For example, five large commercial banks currently represent 97 percent of the total U.S. banking industry notional amounts of derivatives outstanding (Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2010).”  The SEC feels that if there is similar concentration in the clearing agencies (and even if such concentration continues on OTC transactions)  there will be adverse effects on the markets.

 Three key areas of adverse effect of such control  over clearing agencies have been identified by the SEC (1) limiting access to participation in the security based swap clearing agencies to persons who are not already part of the club of participants in the clearing agency (2) limiting  the scope of products eligible for clearing to “push” those products to OTC markets where participant profits are greater and (3) lowering risk management control to reduce the amount of financial resources participants  would have to expend as collateral margin or guaranty funds to the security based swap agency.

Accordingly the SEC is proposing Regulation MC.  

 Proposed Regulation MC - Securities Swap Clearing Agencies

Regulation MC contains two alternate structures to limit financial institutional control over securities swap clearing agencies.

The first alternative focuses on limiting the voting interests held by directly or indirectly by participants of a security-based swap clearing facility to no greater than a 20% individual position or a 40% aggregate position for all participants.  Participants in excess of these positions would be required to divest their excess holdings.  35%  of the Board would need to be independent  directors. The nominating committees would have to be composed of a majority of independent directors.

The second alternative focuses on governance restrictions as the primary means to mitigate conflicts of interest although it does contain a 5% direct or indirect individual voting limitation but no 40% aggregate voting interest limitation.  The majority of the Board would have to be independent directors. The nominating committee would have to be composed solely of independent directors.

Proposed Regulation MC -  Exchanges and other Swap-trading Venues

Regulation MC    would also cover exchanges and other swap-trading venues, the rule would prevent participants or members from controlling 20% of the voting shares. Those markets would also need to have a majority of  independent directors  on their boards as well as nominating committees consisting solely of independent directors. Additionally, a regulatory oversight committee consisting of solely independent directors would be required.  Finally,  disciplinary panels of such organizations would have to be balanced in terms of composition and include at least one independent director.

Comment Sought

The SEC is seeking public comment on the proposal.

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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com. Nothing in this blog is legal advice and readers should not rely on anything in this blog as being legal advice.

 

SEC Proposes New Family Office Definition Under Dodd-Frank Act

Recently, the Securities and Exchange Commission (“SEC”) announced its timeline for the implementation of financial reform under the Dodd-Frank Act.  See Implementing Dodd-Frank Wall Street Reform and Consumer Protection Act - Upcoming Activity. 

In accordance with that timeline, the SEC has released its proposed definition for “family office” under the Dodd-Frank Act.  See SEC Proposes New Family Office Definition Under Dodd-Frank Act, Release No. IA-3098 (October 12, 2010).

Repeal of 15-Client Exemption for Investment Advisers

Previously, section 203(b)(3) provided that investment advisers were eligible for exemption from registration under the Advisers Act if, during the course of the preceding 12 months, it had fewer than 15 clients and did not offer its services to the general public.  The new definition, in accordance with the Dodd-Frank Act, will no longer include the 15-client exemption contained in section 203(b)(3) of the Advisers Act.

Of consequence, advisers to those companies fitting the definition of a family office will be still exempt from registration under the Investment Advisers Act of 1940 (“Advisers Act”).

Definition of Family Office

 The SEC is proposing to define a family office as any firm that:

             (1) Provides investment advice only to family members, as defined by the rule; certain key employees, charities and trusts established by family members and entities wholly owned and controlled by family members;

             (2) Is wholly owned and controlled by family members; and

             (3) Does not hold itself out to the public as an investment adviser.

 Public Comments

 Public comments on the proposed rule should be received by the SEC by November 18, 2010.

 Effective and Compliance Dates

 During the period of April to July 2011, and following the review of public comments, the SEC plans to adopt a final rule based on the submitted proposal for the definition of family office.

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 Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.

 

Hedge Funds Post 3.5% Average Gain for Month of September

Hedge funds recorded their largest monthly gain since May 2009 last month, posting an average gain of 3.5% for the month of September, according to Hennessee Group LLC. 

Despite the gains, performance was significantly outpaced by broader market indices.    Over that same period, the Dow Jones Industrial Average (“DJIA”) was up 8 percent, with the S&P 500 gaining more than 9 percent.  However, for the year hedge funds are up 4.7%, a slightly better pace than broader market indices. 

In August, hedge funds posted an average loss of 0.55%, while July saw hedge funds post an average gain of 1.9%.  This followed losses the previous two months, with 1.35% and 3.01% declines in June and May, respectively, according to Hennessee Group.

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 Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.

Commodities Futures Trading Commission (“CFTC”) to Investigate Possible “Flash Crash” Quote Stuffing and Spoofing

The CFTC will review algorithmic trading to see if there is anything “inherently disruptive” about it. Algorithmic trading was implicated in the infamous “flash crash” of May 6, earlier this year – when markets plunged dramatically in a matter of seconds and then almost equally quickly recovered. 

The CFTC will examine these algorithmic strategies in which traders’ computers robotically submit and then robotically cancel thousands of orders in milliseconds. One of the issues that the CFTC will examine is whether these strategies were designed to trick other computers into making decisions that the instigating traders’ computers could exploit for profit. (When used for those kinds of ends the “mal”- trades are known as “spoofing” and “quote stuffing”).  For example, there was a trade of 75,000 E-mini futures (notional amount approx $4,125,000,000.00) on  May 6, 2010 executed algorithmically that had no apparent regard for price or timing that is sure to be scrutinized by the CFTC.

As to the E-Mini trade,  an  already published SEC report on the Flash Crash noted that:  “Starting at 2:45:28 p.m. [on May 6, 2010], CME’s Globex stop logic functionality initiated a brief pause in trading in the E-mini S&P 500 futures. This functionality is initiated when the last transaction price would have triggered a series of stop loss orders that, if executed,  would have resulted in a cascade in prices outside a predetermined ‘no bust’ range (6 points in either direction in the case of the E-mini). The purpose of this functionality is to prevent sudden, cascading declines (or increases) in price caused by order book imbalances.”  SEC report "Preliminary Findings Regarding the Market Events of May 6, 2010"

Of  considerable legal interest, under Dodd Frank,  the standard by which the CFTC will review such trades as being illegal has been reported to have been reduced from showing  manipulation down to one of showing  recklessness – a considerably lower level of culpability.

Finally, a company called Nanex has reported in great analytical detail on the Flash Crash in its  Flash Crash Analysis. For those interested in the technical aspects of this topic, the Nanex analysis is compelling reading indeed.

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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com. Nothing in this blog is legal advice and readers should not rely on anything in this blog as being legal advice.

SEC Publishes Timeline for Implementation of Investment Adviser and Broker-Dealer Reform Under Dodd-Frank Bill

The Securities and Exchange Commission (“SEC”) has announced its timeline for the implementation of financial reform under the Dodd-Frank Bill.  See Implementing Dodd-Frank Wall Street Reform and Consumer Protection Act - Upcoming Activity.  While the timeline covers the entire range of financial reform efforts under the bill, such as rules governing consumer protection and credit rating agency oversight, this article will focus on those items affecting investment adviser and broker-dealer registration and compliance.

 The timeline for proposal and adoption of these rules is as follows:

 October 2010

 Oversight of Investment Advisers

 §409: Propose rules defining “family office”

 Family offices and their investment officers may be exempt from registration under the Investment Advisers Act of 1940 (“Advisers Act”) if they provide investment services to fewer than 15 family members, trusts or entities and do not offer services to the general public.  Of consequence, proposed rule changes may affect how multiple families and trusts are counted under the exemption.

 November - December 2010

 Oversight of Investment Advisers

 §§407 and 408: Propose rules implementing the exemptions from registration for advisers to venture capital firms and for certain advisers to private funds

The Dodd-Frank Bill provides that investment advisers “solely” to venture capital funds will be exempt from registration with the SEC, but will be subject to certain reporting and recording keeping requirements.  Private equity firms, however, were not provided a similar exemption under the bill.  Nonetheless, the SEC is to provide its definition of ‘venture capital firm’, with private equity firms possibly meeting that definition.  Otherwise, those firms will be subject to the same registration requirements as other private fund managers.

 §410: Propose rules and changes to forms to implement the transition of mid-sized investment advisers (between $25 and $100 million in assets under management (“AUM”) from SEC to State regulation, as provided in the Act

An item previously covered by the blog, the SEC recently increased the AUM level required to register with the Commission.  This set of proposals will cover the transition to state registration authorities for those investment advisers not meeting the required AUM level.

 §418: Propose rules to adjust the threshold for “qualified client”

Qualified clients not only invest more assets in a fund, but also allow for investment advisers to charge a performance fee.  Currently, a qualified client is defined as a natural person who or a company that immediately after entering into the contract has at least $750,000 under the management of the investment adviser, or has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $1,500,000 at the time the contract is entered into.

 Under the Dodd-Frank Bill, the current requirements will be adjusted for inflation in the upcoming year, and then again every five years, each time by an increment of $100,000.

 Exempt Offerings

 §413: Propose rules to revise the “accredited investor” standard

 In order to qualify for exemption under the Regulation D "Safe Harbor" provisions of the Securities Act of 1933, a fund is not permitted to offer securities to more than 35 non-accredited investors.  These proposed rules will detail the Dodd-Frank Bill exclusion of primary residence from the ‘net worth’ standard, the more prominent of two categories for individuals seeking to qualify as an accredited investor. 

 §926: Propose rules disqualifying the offer or sale of securities in certain exempt offerings by certain felons and others similarly situated

 These proposed rules will detail the disqualification of certain felons from participating in the offering or sale of securities.  As set forth in the Dodd-Frank Bill, the SEC will promulgate rules that disqualify “bad actors” from relying on the Rule 506 exemption under Regulation D.  Currently, these rules only apply to Rule 505 exemptions. 

 January - March 2011

Oversight of Investment Advisers and Broker-Dealers

 §§404 and 406: Propose (jointly with the CFTC for dual-registered investment advisers) rules to implement reporting obligations on investment advisers related to the assessment of systemic risk

 The SEC and CFTC recently announced the formation of a joint committee that will address emerging regulatory issues.  The effort of this committee, and the focus of these proposals, will focus on identifying emerging regulatory risks, assessing and quantifying the impact of such risks and their implications for investors and market participants, and furthering SEC and CFTC efforts on regulatory harmonization.

 §913: Report to Congress regarding the study of the obligations of brokers, dealers and investment advisers

 This report will focus on such recent broker-dealer items as audit requirements and procedures, and for investment advisers, registration, reporting and recordkeeping requirements.  In addition, the SEC will likely report on standards of care owed to investors for both broker-dealers and investment advisers, with the Commission recently issuing for public comment whether there are gaps, shortcomings, or overlaps in the current legal or regulatory standards of such care.

 §914: Report to Congress regarding the need for enhanced resources for investment adviser examinations and enforcement

 This report will detail the increased resources necessary for the SEC and CFTC to effectively promulgate and oversee financial reform measures under the Dodd-Frank Bill.

 §919B: Complete study of ways to improve investor access to information about investment advisers and broker-dealers

 The SEC recently promulgated rules updating Form ADV, Part 2 disclosure requirements.  The study will seek to further efforts to improve the quality, nature and scope of information provided to investors.

 April - July 2011

 During this period, the SEC plans to adopt rules based on the submitted proposals for the items outlined above.

 

In addition, the §913 and §914 studies may result in rule proposals by the SEC or CFTC, although the time period for such action is not defined.

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 The publication of the SEC timeline for implementation of the Dodd-Frank Bill marks a continuation in the financial reform effort.  In this evolving regulatory landscape, investment managers and broker-dealers should move forward with a focus on transparency, documentation of compliance and communication with investors.  The blog will post important updates as the new regulatory system takes shape.

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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com. As always, nothing in this blog is legal advice and readers w should not rely on anything in this blog as being legal advice.