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BUSINESS OF TRADING

Forex hedgefund managementThenumberofhedgeundsandhedgeundinvestorshassoared.Forextradersookingo startafundneedtounderstandherulesandregulationseforeheyquittheirdayjobs.

BYHANNAHTERHUNEANDROGERLORENCE

I t's understandable why hedgefunds have become so popularin recent years - from a trad-er's perspective. A talentedhedge-fund manager can accrue sub-stantial income, and while starting ahedge-fund obviously isn't for thenovice forex trader, it's not as compli-cated as it seems.Let's assume a trader has a modest$3million under management and hisforex hedge fund has a I-percent man-agement fee and a 20-percent perform-ance allocation fee (Le.,a share of theprofits). Assume the fund was startedon the first day of the year andreturned 15percent.In this case, the trader would havegross income of $120,000,consisting ofa $30,000managementfee($3million*1%= $30,000)and a $90,000perform-ance allocation ($3 million * 15%return = $450,000 * 20% = $90,000).Using all the same assumptions, ahedge-fund manager with $10 millionunder management would make$400,000.Also, because prospective investorslike to see fund managers' risk theirpersonal capital, assume the fundmanager has a significant portion ofhis own money invested in the fund.Because there are no fees assessed (itwould just increase taxes), the traderearns an additional 30 percent on hisown investment in the fund.However, before a trader can poten-tially enjoy these rewards, he or shemust structure a proper business. Thegood news is forex traders are nowpositioned to quickly launch a forex

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fund with minimal regulatory over-sight.Forex fund basicsRegulation D, Rule 506, of theSecurities Act of 1933 defines a forexfund as an unregistered securityoffered as a private placement.Regulation D provides "safe harbor"provisions which, if complied with,exempt the private offering from com-pliance with the registration andprospectus delivery requirements offederal securities laws. However,Regulation D does not exempt theoffering from compliance with thefraud provisions of the federal andvarious state securities laws.

forward contracts, and over-the-count-er options in currencies for which thereis also trading in regulatedfutures, allqualify as "Section 1256 contracts."Gains in these instruments are taxed ata maximum federal rate of 23 percent(60percent of the gains and losses arelong-term and 40 percent is short-term). In addition, the fund usuallyqualifies as a "trader in commodities,"so the investors are able to deduct thefund's expenses more favorably thanexpenses in an investment partner-ship.Performance-based compensationfor fund advisers is usually structuredas an allocation of profits, but it issometimes structured as fees - in

Mostforeigncurrencyradingiseligibleorfavorableederalincomeaxtreatment.Forex funds must supply allinvestors with comprehensive infor-mation about the offering in "disclo-sure documents." The purpose of thesedocuments is to limit the hedge fund's

potential risk by providing full disclo-sure to investors.A typical set of disclosure docu-ments includes a private placementmemorandum, an investor question-naire and subscription agreement, andan operating agreement for the fund.Most foreign currency trading is eli-gible for favorable federal income taxtreatment. Regulated futures contracts,regulated commodity option contracts,

either event typically between 10 and20 percent of trading profits. In someinstances, the compensation agree-ment specifies that funds be only paidwhen the profits of the fund exceed aminimum rate, or "hurdle rate."Exempt lorex fundsTobe exempt from registration underthe SecuritiesAct of 1933,a fund musthave no more than 100beneficial own-ers (also known as the "100 investortest") and must not publicly offer itsinterests.Under the Section 3(c)(7)exemption,a fund must offer its securities to

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"qualified purchasers." There are nolimitations on the number of qualifiedpurchasers under the InvestmentCompany Act of 1940.However, when there are more than500 investors in the limited partner-ship, the entity mybe subject to classi-fication as a "publicly traded entity."If that occurs, the entity could lose itsflow-through tax treatment (i.e., apartnership) which is one of the pri-mary benefits of the hedge fund'sstructure.Accredited vs. non-accreditedinvestorsGenerally, "accredited" investorsincludes persons whose net worth (orjoint net worth with spouse) exceeds$1,000,000,or whose income was inexcessof$200,000in both the two pre-ceding years (or, with a spouse, inexcessof$300,000in both the two pre-ceding years), and who reasonablyexpect to reach the same level ofincome in the current year.If you plan to have "non-accreditedinvestors" in your fund, you will notonly need a detailed set of disclosuredocuments, but also audited documen-tation of the source of initial capitalinvested in the fund. This initial auditis referred to as a "launch audit" or asa "seed-capital audit." Regulation Dlimits the number of non-accreditedinvestors to 35.Taking on non-accredited investorsis risky because if there are ever anyproblems with the fund's performanceand investors seek relief in the courts,

a judge would probably take the sideof the non-accredited investor.Howdol~dinvestors?Rule 502(C) of Regulation D prohibitsany form of a general solicitation orgeneral advertising. Generally, inter-ests in your hedge fund may be soldby registered broker dealers, regis-tered investment advisors or officersof the fund's management to thosepersons with whom they have exist-ing relationships.Your marketing efforts must be per-continuedonp. 54CURRENCY TRADER. March 2005

Steps to launch a lorex hedge fund1. If you need to register as a Commodity Pool Operator (CPO), start theprocess, which you will continue while executing the rest of these steps. Seewww.iard.com to get started.2. Determine what will make your hedge fund unique. Finalize the fund'sinvestment objective and investment strategies, prepare biographical data onyourself for the offering documents, and make decisions that will affect howoften you accept investors, how you will be compensated, what expensesyour fund (as opposed to the management company) will bear, how you willbe set up regarding trader tax status, etc. I3. If you are forming a commodity hedge fund, start the process of becominga member of the NFA. See this page: http://www.nfa.futures.orgJregistra-tion/nfa_membership.asp. You will need to register as a Commodity PoolOperator with the NFA. See http://www.nfa.futures.org/registration/cpo.asp.4. Obtain a first draft of your offering documents (Private PlacementI Memorandum, LLC Agreement, and Subscription Materials) from yourprovider(the firm advisingyou on settingup your hedgefund). Formyour Ibusiness 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 yourdocuments. This is an important part of the preparation of your fund.6. If you are registered as an Investment Adviser or registered with the NFAas a Commodity Pool Operator, make sure the regulators have approved anysuch applications.7. Your provider should give you the SEC Form D and the blue sky filings for

I the initial stateswhere you expect to distributeyour offeringdocuments.Make sure your provider gives you instructions on how and where to file theI various documents,and general instructionsregardingthe distributionof Iyour offering documents. You should now have a final set of offering docu-ments.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 bindingmethod. Remember that you can have no marketing materials other than II your offering documents.9. Mail your SEC Form D. You can check here to see that it was processedby the SEC: http://www.sec.gov/edgar/searchedgar/companysearch.html.File your blue sky filings within the appropriate time - either before distribu-

I tionorwithin15daysof the first sale in that state,dependingon the state'srules.10. Start distributing your offering documents and attracting investors. Keep

. a logof all individualsto whomyoudistributeyourdocuments.Deposityourseed capital and start the initial trading of the fund.

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sonally directed toward investors whoare known to you. The SECviews non-personal communications as "generalsolicitations," even when the targetedrecipients of the communicationscould reasonably be expected to bequalified investors.However, it is possible to complywith the prohibitions against generalsolicitation or advertising by using asecure Web page for which access islimited to accredited investors.Blue skyWithin 15 days of the first sale of youroffering, you will have to me yourForm D (Notice of Sale) with the SECas well as comply with filing require-ments of the states in which each ofyour investors are located. Then youneed to be sure that your securities aresold with out violating the prohibitionon general advertising.NFA registrationIf your forex fund invests in currencyfutures contracts, currency futuresoptions, or forward contracts, it mustbe approved as a commodity pool bythe Commodity Futures TradingCommission (CFfC). In addition, youmust register with the National FuturesAssociation (NFA) and become aCommodity Pool Operator (CPO).This raises the differences betweenregistration as a CPO and a commodi-ty-trading advisor (CfA). A CfA man-ages individual accounts, while a CPOmanages only the hedge fund, or pool.Many people lose interest in the CfAoption when they realize the adminis-trative hassles associated with manag-ing separate accounts.Spot forex trading is not regulatedby the CFTCand does not require CPOregistration if the fund trades spot cur-rencies exclusively.Legally, "spot cur-rency" refers to contracts that settle bythe second business day after the datethe trade is entered.While CFTC registration is notrequired for spot forex traders, it isimportant for fund managers to tradewith firms that are NFA registered, as

NFAregistered members are subject to54

arbitration, capital requirement rules,and customer account regulations.Nosponsor isneeded totaketheSeries3 exam, also known as the NationalCommodityFuturesExamination.whichis administeredunder theauspicesof theNASD's testing program. You can findthe nearest testing location atwww.nasd.com/NASDW 010803.The CFfC has allowed the NFA tobecome the primary regulator offutures and commodity products (as aself-regulatory organization, similar tothe NASD's status with the SEC).The item that will typically take themost time for processing of a CPOapplication is the fingerprint card,which is supplied by the NFA.A CPOwill take it to their local police stationand have their fingerprints taken. Thecard is then mailed to the NFA, which

sends it to the FBIfor processing. Thistakes six to eight weeks, and there isno rush service available, so take careof this very early in the applicationprocess.The NFA must approve all disclo-sure documents before they can beused to solicit clients. If the NFA hascomments, it will usually give them tothe CPO candidate verbally, and inwriting if the CPO candidate requests.The guide for CPOs and CfAs (see"Web resources") is an invaluable toolfor creating disclosure documents. TheNFAessentially uses that document asa checklist, and every item must beaddressed to their satisfaction beforethey will approve disclosure docu-ments.The disclosure document mustinclude information about the CPOand its principals (including perform-ance record), commodity trading advi-sors, futures commission merchants,brokers, details of the commodityinterests, expenses associated with thepool, conflicts of interest, minimuminvestment amounts, transferabilityissues, and any litigation (material,administrative, civil, or criminal)against anyone involved in the man-agement of the fund. Additionally, anyperson who is involved in the com-modity pool must register as an associ-

ate of the CPO.The disclosure document must befiled with the NFA at least 21 daysprior to the delivery of the documentsto a prospective participant, andupdated periodically. The CPO mustreceive a written confirmation fromeach participant in the pool that theyreceived the Disclosure Documentprior to accepting the participant'sfunds.CPO registration exemptionsThe CFTCprovides for several exemp-tions from CPO regulations. A personis not required to register as a CPO ifthe person did not receive any com-pensation or payment directly or indi-rectly, operated only one commoditypool at a time, or was not otherwiserequired to register with the CFfC.This is referred to as the "closely heldpool exemption."Registration as a CPO is also notnecessary from registration when totalgross capital contributions for partici-pation units in all pools that are oper-ated (or intended to be operated) donot in the aggregate exceed $400,000and there are less than 15participantsin the pool.Also exempt from registration as aCPO with respect to the pool, wherethe interests have been sold exclusive-ly to participants that the CPO reason-ably believes at the time of their invest-ments were QEPs, and the pool tradescommodities in de minimis amounts.The de minimis limitations are: 1) thepool limits its commodity interestspositions such that the aggregatenotional value of such positions doesnot exceed the liquidation value of thepools portfolio, or 2) the total amountthe pool commits as initial margin andpremiums to establish commoditypositions does not exceed 5 percent ofthe liquidation value of the pool'sportfolio. Another requirement is theinterests in the relevant pool are notmarketed as participants in a vehiclefor trading in commodity interests.CFTC Rule 4.13(a)(4) establishes aCPO registration exemption for a CPOwith respect to a pool where interests

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are offered and sold without marketingto the public in the United States, andare sold exclusively to participants thatthe CPO reasonably believes are QEPs.Are you going to tradestocks, too?If you plan to execute more than anoccasional stock trade, you might alsohave to register as an investmentadviser. Beginning in February 2006,hedge fund mangers will be requiredto register with the SECas investmentadvisers when a fund has assets of $25million or more and has 15 or moreinvestors in the hedge fund.Until then, the hedge fund itself isconsidered the "client" of the adviser,

which affords the adviser an exemp-tion from registration if there are lessthan 15 clients and the adviser doesnot hold itself out to the public as aninvestment adviser.Funds with less than $25 millionwill not be permitted to register andwill be subject to applicable state law.State investment adviserregistrationEach state has its own registrationrequirements which are also interpret-ed in conjunction with the NationalSecurities Market Improvement Act of1996.In some instances, where the invest-ment adviser has a particular kind ofclient, has fewer than a certain numberof clients within a 12-month consecu-tive period, and does not hold itselfout to the public as an "investmentadviser," it may be exempt from thatstates' registration requirement. Ineach instance, it is important that thelaw of the state in question bereviewed for compliance.More rules and regsIn addition to the registration andsolicitation guidelines summarizedabove, there are also federal and statelaws governing the operation of thefund. These laws govern marketingand advertising, the compensation offund advisers, fund management, per-sonal trading, the use of soft dollars,CURRENCYTRADER' March 2005

Web resourceshttp://www.nfa.futures.orglThe home page for the National Futures Association (NFA).http://www.nfa.futures.orglcomplianceflSSues_cpo_cta.asp andhttp://www.nfa.futures.orglcompliancelpublicationsldd2001/DD2004.pdfThe web pages are related to the NFA's Guidance to Commodity PoolOperators (CPOs) and Commodity Trading Advisers (CTAs). The secondlink is particularly valuable. It essentially defines the sections that need tobe included witha CPO document that is submitted to the NFA. It also dis-cusses 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. TheQEP exemption allows you to not have to take the Series 3, not have tobecome a member of the NFA, and not have the NFA or the CFTC as aregulator. Other exemptions, such as those related to small pools, may beof 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 isaccomplished. It includes a link to a page for an REasyReference GuideRtoexemptions from registrationhere: http://www.nfa.tutures.orglregistration/easyReferenceGuidePart4.pdf.http://www.nfa.futures.orglregistrationlcta.aspThe equivalentto #3, above,exceptthat it is for CTAs.http://www.nfa.futures.orglregistrationlnfa_membership.aspData related to becoming a member of the NFA.All CPOs and CTAs must bemembers of the NFA, unless they achieve an exemption. Note the reducedfee schedule that became effective on July 1, 2004.http://www.nfa.futures.orglbasicnetlThis 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 mem-bers, including regulatory status and sanctions.http://www.cftc.gov/cftclcftclawreg.htm#ceaThis is an invaluable site to review the underlying federal law related to CFTCissues. Note the various links in the body of the page as well as on the leftnavigation buttons.Securities Law: http://www.law.uc.eduiCCUsldtoc.htmlState Securities Administrators: http://nasaa.org/members_only/CFTC Lawand Regulation links: http://www.cftc.gov/cftclcftclawreg.htm#ceaInvestment Adviser application (for most states): www.iard.comOur website (tons of additional data):http://www.greencompany.comlHedgeFundslindex.shtmlreporting requirements, and recordkeeping.Although the process is involved,experienced forex traders who wish toexpand into professional money man-agement can save themselves a great

deal of trouble later by learning nowabout the forex hedge fund registra-tion process and regulations they willhave to abide by in the future. 0Fur infonnation on the author seep. 8.

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