Hedge Fund Update: News You May Have Missed
The ACA Hedge Fund Update is a blog series designed to complement our ongoing alerts and formal communications. This series will include insights in areas where we may not have traditionally been your primary trail guide. We hope you find this content informative and insightful.
Media Sources Report Gary Gensler to be named SEC Chair
In our December 7, 2020 issue of Hedge Fund Update, we discussed possible candidates for the Securities and Exchange Commission (SEC) chair role. As of January 13, 2021, media sources suggest former Commodity Futures Trading Commission (CFTC) chair and Goldman Sachs partner, Gary Gensler will be tapped for the role. Gensler has a well-documented reputation as a tough regulator with the Gensler CFTC bringing enforcement actions against five financial institutions for the manipulation of LIBOR and other benchmark interest rates, resulting in over $1.7 billion in penalties, and changing the way many industry participants regarded LIBOR - signaling a global need to restore integrity to benchmark rates. He also oversaw significant structural changes in the derivatives market required by Dodd Frank in response to the 2008 financial crisis. Gensler will likely oversee an SEC with increased resources and a stronger enforcement and examination posture under his tutelage.
Amended Executive Order 13959, SEC Risk Alert, and FAQs Associated with Executive Order Prohibiting Transactions with Issuers Associated with the Chinese Military
In our December 7, 2020 issue of Hedge Fund Update, we summarized President Trump’s November 12, 2020 Executive Order Addressing the Threat from Securities Investments that Finance Communist Chinese Military Companies (“EO 13959”).
The U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) issued guidance in the form of FAQs (see FAQs 857-874) on December 28, 2020 aimed to assist U.S. investors with:
- whether publicly traded securities of subsidiaries of the prohibited companies are subject to the ban
- clarification of the names of the prohibited issuers, including a published list of the prohibited Communist Chinese military companies
- clarification of the interpretation of the term “publicly traded securities”
- examples of financial instruments covered by the prohibition
- application of EO 1359 to U.S. Persons investing in pooled vehicles that hold prohibited companies
- guidance on clearing, execution, settlement, and other support services associated with prohibited securities for U.S. persons
- application of EO 1359 to a company subsidiary with a name that exactly or closely matches the name of an entity identified in the annex of the order
- clarification of intermediaries and other participants facilitation of divestment from publicly traded securities of Communist Chinese military companies for U.S. persons that are not prohibited and a reminder on the permissible divestment timeline
On December 28, 2020, U.S. Secretary of State, Michael R. Pompeo, also issued a statement, entitled “Protecting U.S. Investors from Financing Communist Chinese Military Companies,” summarizing the scope of EO 1359 and specifically stating, “…Executive Order 13959 prohibits the ownership of any CCMC shares by exchange-traded funds (ETFs) and index funds, as well as any of their 50 percent or greater majority-owned subsidiaries that have been publicly listed by the Treasury or Defense Departments. This ensures U.S. capital does not contribute to the development and modernization of the People’s Republic of China’s (PRC) military, intelligence, and security services. The Executive Order applies to all transactions by U.S. persons, including individuals, institutional investors, pension funds, university endowments, banks, bond issuers, venture capital firms, private equity firms, index firms, and other U.S. entities, including those operating overseas.” EO 13959 explained that U.S. persons are permitted to divest from affected securities acquired up to the effective date of January 11, 2021 until November 11, 2021. OFAC’s FAQ 862 also clarified that EO 13959 does not require U.S. persons, including U.S. funds and related market intermediaries and participants, to divest their holdings in publicly traded securities (and securities that are derivative of, or are designed to provide investment exposure to such securities) of the Communist Chinese military by January 11, 2021. However, Secretary Pompeo’s recent statement appears to suggest divestment by November 11, 2021 may not be voluntary. He said, “Beginning on January 11, 2021, U.S. investors will no longer be able to transact in publicly traded or private market debt or equity securities, or any securities that are derivative thereof, regardless of the percentage ownership of CCMCs, with full divestment required by November 11, 2021.”
President Trump also issued an executive order amending EO 13959 on January 13, 2021. The amended order supports Secretary Pompeo's recent statement by clarifying that, among other things, effective at 11:59 PM EST on November 11, 2021, possession of any such prohibited securities by a United States person is prohibited. OFAC also added FAQs on January 14, 2021 with FAQ 872 drawing attention the amended order and highlighting that effective at 11:59 PM EST on November 11, 2021, possession of any such Communist Chinese military company as defined in section 4(a)(i) of EO 13959 by a United States person is prohibited.*
The newly renamed Division of Examinations also issued a risk alert on January 6, 2021 that encouraged market participants, including investment advisers and broker-dealers, to review and assess the impact of EO 13059 on their own investments as well as investments on behalf of investors and clients. The alert also included a link to the SEC’s tips, complaints, and referrals (TCRs) online reporting system.
In what many feel illustrates the complications of EO 13959 to market participants of all sizes, starting on December 31, 2020 the NYSE issued 3 separate press releases on the application of EO 13959 to the listing of 3 American Depositary Receipts (ADRs). The most recent, dated January 6, 2021, states the NYSE Regulation will delist the issuers to comply with U.S. law.
With the issuance of the FAQs and Secretary Pompeo’s statement, U.S. domiciled hedge fund managers have been afforded additional clarity. However, it appears that non-U.S. domiciled managers will still need to thoughtfully consider how EO 13959 will impact U.S. fund investors in their non-U.S. private funds, including any new prohibitions their U.S. investors may look to impose. For non-U.S. domiciled managers with U.S. investors, it appears it would be prudent to liaise closely with their U.S. investors as well as fund counsel to evaluate how any portfolio structuring changes should be disclosed to investors or consider if their offering documents allow for designation (i.e., side pockets) of the prohibited companies or other changes to fund structures or subscriptions to reduce regulatory risk. U.S. domiciled hedge fund managers should also continue to work closely with their U.S. financial intermediaries (i.e., prime and executing brokers, ISDA counterparties) to ensure they have adequate processes to help facilitate any potential divestment plan considerations. U.S. managers should also consider reviewing their front-end processes (i.e., restricted list protocols used for firm orders and personal trading) and back end processes (i.e., trading partner controls), including how to check and process updates to the banned list. Finally, as we mentioned in our prior issue of Hedge Fund Update, it remains to be seen how the order will be impacted as the Biden/Harris administration takes office.
2020 CFTC Enforcement Record High and $95 Million Bribery and Corruption-Based Fraud
On December 1, 2020 the CFTC’s Division of Enforcement issued its annual report that included a record number of enforcement actions brought (113), including the largest monetary relief in CFTC history ($920 million) associated with a spoofing case.
Days later, on December 3, 2020, the CFTC announced its first ever case involving foreign corruption. The settled order with a Texas-based multination energy and commodities trading firm (the corporation) alleged a 15 year span of foreign corruption in the U.S. and global oil markets and benchmarks. The Department of Justice’s Fraud Section and the United States Attorney’s Office for the Eastern District of New York simultaneously announced entry of a Deferred Prosecution Agreement (DPA) with the corporation, deferring criminal prosecution on charges of conspiracy to violate the Foreign Corrupt Practices Act.
The order alleged that the corporation committed fraud by making corrupt payments in the form of bribes and kickbacks to employees and agents of certain state-owned entities (SOEs) in Brazil, Ecuador, and Mexico to obtain preferential treatment and access to trades with the SOEs to the detriment of the SOEs and other market participants. In exchange for corrupt payments, the SOE agents, who had access to confidential information, and who, according to the order, owed a duty to the SOE under law and applicable employment policies to keep the information confidential, would disclose nonpublic information, including information material to the corporation’s transactions with the SOE or related trading. Traders of the corporation in possession of the confidential information would then enter into physical transactions and related futures transactions. The order also finds that in August 2014 and July 2015, the corporation acted to manipulate two Platts fuel oil benchmarks for the purpose of benefiting its related physical and derivatives positions, including positions obtained while in possession of confidential information.
SEC Charges Former Day Trader with Market Manipulation tied to False Rumors
On December 18, 2020, the SEC announced charges against an individual related to the creation of false rumors about public companies to profitably trade around the temporary price increases caused by the publication of the rumors. The SEC alleges the individual and several others disseminated the false rumors through real-time financial news services, financial chat rooms, and message boards, and generated illicit profits tied to temporary price increases. This enforcement action highlights an opportunity for compliance teams to review their anti-market manipulation policies and procedures and could also be constructive content for compliance trainings or a staff compliance reminder.
Large Trader Risk Alert
On December 16th, 2020, the SEC examination staff issued a risk alert that contains observations from its recent examinations of SEC-registered investment advisers and broker-dealers for compliance with Rule 13h-1. The risk alert stated that during examinations, exam staff observed that some SEC-registered investment advisers and broker-dealers were unaware of Rule 13h-1 or its specific requirements, and numerous instances of potential non-compliance with Rule 13h-1, including where Large Traders may not have self-identified with the SEC and/or may not have filed their annual Form 13H.
The risk alert also reminded large broker-dealers of Consolidated Audit Trail (CAT) reporting that will be required for their Large Trader customers starting on April 26, 2021, and the CAT reporting that will be required of all broker-dealers with Large Trader customers by December 13, 2021.
The Division of Examinations further encouraged SEC-registered investment advisers to review its Rule 13h-1 compliance policies and processes. Consequently, it would be prudent for hedge fund managers to review their written policies and processes associated with Rule 13h-1 policies and procedures in lieu of this risk alert. Compliance teams may also consider incorporating this assessment into their annual compliance program review.
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* ACA updated this article on January 15, 2021 to include information about President Trump's executive order issued on January 13, 2021 amending EO 13959 and OFAC's FAQs published on January 14, 2021 that were not included in our initial update published on January 14, 2021.