Advice for CEOs of Newly Registered Hedge Funds: Pay Close Attention to Compliance Regulations

Interview with Michael T. Jackson

March 30, 2006
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HedgeCo Q&A with Michael T. Jackson, the retired chairman and CEO of the San Francisco based registered investment advisor EGM Capital Corporation.

Six years ago, Michael T. Jackson was preparing for a much-deserved retirement. The firm he founded, the former EGM Capital, had successfully built a family of hedge funds focused on investing in high-quality, publicly traded U.S. emerging growth companies. Under Jacksonís guidance, the firm grew from a very modest beginning in 1986 to approximately $1.2 billion in client assets in 2001. As EGM built one of the best performance records in the hedge fund industry, Jacksonís own professional success was featured in the book Investment Visionaries alongside the creative thinkers behind Intel, Apple and Cisco. Then, a single trading allocation put the firm and its soon-to-be retired CEO in the crosshairs of the SEC.

In this candid Q&A interview, Jackson tells his side of the story as a case study for newly registered hedge funds, and offers a word of advice to these CEOs now faced with the challenge of increased SEC oversight.

HedgeCo: The SEC settlement was the result of a single trading error in one of EGM’s hedge funds. In your view, what specifically happened?

Jackson: The SEC found that in November 2000 EGM mistakenly oversold a biopharmaceutical stock that was held in several client hedge fund accounts, resulting in an unintended short position. When the transaction took place, most hedge funds were not regulated by the SEC, however EGM was registered since the firm had conducted an investment advisory business prior to founding its hedge funds. After the error was discovered, EGM covered the short at a loss of approximately $404,000. EGM treated the erroneous trade as a normal transaction, and allocated the loss to hedge fund accounts that held the oversold stock. However, SEC investment advisor regulations, when applied to a hedge fund, lead to the exclusion of certain transactions. Clearly, if the transaction had taken place in a non-hedge fund account, EGM would have handled it differently since EGM was familiar with SEC regulations.

At the time of the transaction, I was transitioning into retirement and looking forward to spending more time with my wife and family. My focus at EGM was directed toward new product development and long-term portfolio strategy. The firm was managed day-to-day by an operating committee which reported to the Board and was chaired by EGMís President. All trades for the hedge fund in question were made by three portfolio managers, two of whom had to sign off on each transaction, and one of whom was the Chief Compliance Officer. I was not directly involved in the placing or booking of the trade, and EGMís approach to the trade settlement was in accordance with the hedge fund agreements with its clients. Rather than continue to engage in an expensive legal battle, EGM and I signed a settlement agreement in April 2005 for violations under sections 203(f) and 203(k) of the Investment Advisors Act. The agreement was settled without admitting or denying liability.

The total extent of the settlement was no association with a registered investment adviser for nine months and a fine of $75,000. At the time of the settlement, I was retired. After more than thirty-four successful years in asset management and many accolades from our clients, the settlement, while minor, was not a welcomed event at the end of a career built on integrity and trust, as well as outstanding investment returns.

HedgeCo: Was there any financial motivation for EGM to allocate the trade the way it did?

Jackson: The transaction was handled exactly as I believed the partners would expect. The understanding of the hedge fund partners was that all trades made for the hedge fund would be included in the hedge fund, regardless of whether they were a profit or a loss.
The hedge fund strategy in which the transaction occurred had invested assets of over $500 million. The total loss on the transaction was approximately $404,000 but only approximately $326,000 after EGMís and my interests were taken out. Relative to the hedge fund profits earned in 2000, the loss on the transaction was less than 1/3 of 1 percent of the well over $100 million in partner profits that year.
From another perspective, the advantage gained on the transaction by EGM was less than 1% of the firmís profits earned in 2000, the majority of which was paid out in yearend bonuses to employees. None of these numbers suggest that there was a financial motivation behind the firmís handling of the transaction.

HedgeCo: Was there any recourse or legal channel you could pursue?

Jackson: Despite an extensive audit which failed to uncover any other SEC regulation mistakes, a no-fault settlement and relatively small fine seemed to be the only course to a timely solution. To engage the SEC legally is to damage your reputation, regardless of the outcome. In addition, there were pressing family health problems that needed my immediate fulltime attention. Importantly, I was led to believe by legal counsel that the SEC would keep any comments in a press release within the bounds of the no-fault settlement language, and I could refuse settlement if that were not the case. The opposite turned out to be the reality.

HedgeCo: As of February 2006, the SEC began requiring registration under the Advisers Act of certain hedge fund advisers. Under this new regulatory framework, firms with 15 or more investors and at least $25 million in assets under management must, among other regulations, designate a chief compliance officer, implement formal compliance policies and monitor and retain all client communications. Based on your experiences, what advice can you offer these newly registered firms?

Jackson: These rules were passed by a slim 3-2 majority vote. In a dissenting SEC commissioner’s words, “It is the wrong solution to an undefined problem using an ineffective examination model.” This tells me it will be a tedious process for newly registered hedge funds to get up-to-speed on the compliance policies.

As hedge fund firms adjust to heightened regulation, their chief executives should give extra attention to team oversight and trade handling procedures. They must realize the importance of this segment of their business – company compliance procedures should receive equal, if not greater, daily attention as the investment side of the business. CEOs of hedge funds face a clear increase in personal and business risk, and must take meaningful steps to protect themselves.

We are living in a highly charged environment for all corporate executives. High profile scandals at mutual funds and public companies like Enron and WorldCom have paved the way for the SECís move into the hedge fund space. To some degree, EGM and I may have been the victim of the SEC's drive to bring hedge funds under their regulation. In my case, when the SEC announced the settlement they also took the opportunity to sensationalize the matter without regard to the fact that the settlement was agreed to on a no fault basis. I know Iíve led a professional life that I can look back on with great pride, and have always been dedicated to the best interests of my clients. All hedge funds should strive to do the same.

Source: HedgeCo.Net

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