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News June 20, 2005 Issue

Two Hedge Fund Trading Traps To Avoid

Two trading issues for hedge fund managers to keep in mind:

Donít be caught short on Reg M. Make sure you are familiar with Rule 105 of Reg. M, which prohibits covering short sales made within five business days of the pricing of an offering with securities obtained in the offering.

"If youíre firm is doing short sales, you should develop some kind of written policies and procedures on how to handle short sales, especially on how you are going to cover the shorts," said Dechert associate Roderick Cruz. "You donít want to violate Reg. M." He described the SECís cases last month against DB Investment Managers, Galleon Management and Oaktree Capital Management as "a wake up call." Cruz predicted that when the SEC starts sweeping hedge fund advisers, "one of the thing they are going to check to see is whether they do short sales and how they cover those shorts."

The lesson to be learned from those cases: the SEC doesnít take kindly to fund managers that structure a series of transactions in an attempt to avoid the Reg. M restrictions. Contracting with a third-party to purchase the covering shares in the primary offering wonít get you off the hook: the SEC views that as a "sham transaction" designed to accomplish indirectly what cannot be done directly. Similarly, if the manager constructs a series of transactions designed to have the same effect as if the manager had purchased the covering securities in the primary offering directly, that too could be deemed a sham transaction.

Cruz also pointed out the Hilary Shane case, which involved covering a short position with securities obtained in a PIPE transaction. There, the SEC did not allege a Reg M violation, but rather a Section 5 securities registration violation and insider trading, he noted.

12(d): Know your limits. Three percent. Thatís how much a hedge fund can buy of a registered fund, per ICA Section 12(d)(1)(A). Over the years, that limit has taken some hedge fund managers by surprise, as it is buried deep within a very convoluted section of the 1940 Act that, at first glance, appears only to apply to registered investment companies.

Making things a bit trickier: when counting up to the three percent limit, a hedge fund should include not only its holdings, but holdings of funds or other companies controlled by the hedge fund. So, for example, say you manage a Fund X, a fund of hedge funds. Fund X holds 30 percent of Fund B. If Fund X and Fund B both sweep into money market Fund Q, their combined holdings of Fund Q canít exceed three percent of Fund Qís total outstanding shares.

Also of note: the prohibition applies only when a hedge fund "purchase[s] or otherwise acquire[s]." If a hedge fundís existing holdings of shares of a registered fund grows to represent more than three percent, perhaps due to other shareholders in the registered fund redeeming their shares, the hedge fund would not violate 12(d)(1). In other words, it takes an affirmative purchase or acquisition to violate the provision. However, once a hedge fundís holdings grow past that three percent level, the hedge fund could not purchase or acquire any additional shares of the registered fund.

Incidentally, the five and ten percent limits in Section 12(d)(1) do not apply to 3(c)(1) or 3(c)(7) funds, as the 3(c)(1) and 3(c)(7) exceptions treat hedge funds as investment companies only for purposes of the three percent limit.