INVESTMENT MANAGEMENT ADVISORY HEDGE FUND MANAGERS: TIME FOR YOUR ANNUAL CHECK-UP? QUICK TIPS ON DOING A SELF-DIAGNOSIS

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1 SEPTEMBER 2007 HEDGE FUND MANAGERS: TIME FOR YOUR ANNUAL CHECK-UP? QUICK TIPS ON DOING A SELF-DIAGNOSIS INVESTMENT MANAGEMENT ADVISORY The Compliance Team of the Ontario Securities Commission recently released its 2007 Annual Report (OSC Staff Notice ) summarizing the results of the sweeps and compliance audits conducted during the year ended March 31, Commission staff carried out various reviews of advisers, fund managers and limited market dealers and have identified in the 2007 Report the most common deficiencies they uncovered. Many of those deficiencies could have been easily avoided. As the majority of hedge fund managers in Ontario are registered both as advisers (IC/PMs) and dealers (LMDs), now might be a good time for all hedge fund managers to perform a self-diagnosis of their compliance regime. If you are responsible for compliance at your firm, the following is not intended to be a complete review of all compliance matters applicable to managers of privately offered pooled funds, but is a reminder of some basic compliance issues and some simple fixes. It is based as much on the 2007 Report as it is on our experience in working with our clients. The Annual Check-up: OSC Rule Conditions of Registration requires the ultimately responsible person (URP) designated by a registered adviser to report directly to the firm s board of directors at least annually concerning the discharge of the firm s obligations under Ontario securities law. Presumably, the URP will work with the firm s Chief Compliance Officer (CCO) to prepare the report, as Rule requires the CCO to supervise the firm s adherence to the policies and procedures which the URP is required to develop and implement. For smaller firms, the URP, the CCO and the "Board of Directors" may be one and the same. This is not a problem a memo to file (the file that OSC compliance staff will be reviewing) outlining the results of a review of a checklist of compliance matters can help satisfy this requirement.

2 Where to start?: Read the 2007 Report. For that matter, read all of the recent compliance review reports published by OSC staff (and, if you are registered with other regulators, read their reports as well). The OSC website ( should be consulted often. Compliance reports can be found under the Dealers & Advisers Compliance tabs. The Related Links tab can take you to the other securities commissions websites. Fundamental compliance matters for OSC registrants can be found in Rule , as well as OSC Rule Proficiency Requirements for Registrants. Requirements set out in Rule , such as the requirement to "establish and enforce written procedures for dealing with clients that conform to prudent business practice" and to "deal fairly, honestly and in good faith with its clients", form the basis of many deficiencies, even "significant deficiencies", identified by OSC staff in their reviews. Common Deficiencies: Addressing the common deficiencies should be the first step in any self-diagnosis. The following is the top 10 list of deficiencies for IC/PM firms that were identified in the 2007 Report: Maintenance of books and records Policy for fairness in the allocation of investment opportunities Know-your-client and suitability information Marketing Portfolio management, including advisory contracts Statement of policies Policies and procedures manual Personal trading Capital calculations Registration issues. The Report offers "suggested practices" which you should also consider. You may wish to work with your legal counsel or other compliance advisers to adopt and implement practices that are appropriate for your firm. 2

3 Statement of Policies: One of the documents you or your counsel filed with your original registration application was a statement of policies concerning conflicts of interest, as required by section 223 of the Ontario Regulation, as well as a policy to ensure fairness in the allocation of trades and brokerage fees among your managed accounts and your funds. Not only should these policies be reviewed as part of your annual check-up, any revised versions must be filed with registration staff at the Commission. Although not required to be filed with the Commission, registrants are expected to have adopted, implemented and monitored a personal trading policy for employees to avoid conflicts of interest and inadvertent breaches of securities law. Know-Your-Client and Suitability: If you don t have a know-your-client form yet, develop one. If you do not have a completed form signed by the client in each client s file, start catching up. Fund managers registered as LMDs who have sold fund units to investors through other registered dealers would not be expected to discharge the know-your-client and suitability obligations in respect of those investors, but should have something in writing from the participating dealers confirming that those dealers have discharged those requirements. Are you managing a few individual accounts? Make sure that you have a signed managed account agreement setting out your duties, your fees and the client s investment mandate. Your funds may have all of that set out in their constating documents (declaration of trust or limited partnership agreement, for example) but if not, or if not in sufficient detail, then a separate investment management agreement ought to be entered into. Regulatory Capital: How s your regulatory capital? When was the last time you checked? All registrants are required to ensure that they maintain minimum regulatory capital at all times and to keep a record of a "reasonable calculation of capital required, prepared for each month within a reasonable time after the month". Any capital deficiency must be reported to the OSC within 48 hours. Offering Memorandum: When was the last time you updated your funds offering memorandum? Did you file it with the OSC? Certain provinces, such as Ontario, require an offering memorandum to be filed within 10 days of the first closing of the sale of units or other securities in respect of which the offering memorandum was used (in Quebec, the offering memorandum must be filed "without delay"). Each time the offering memorandum is updated, a new copy should be filed. 3

4 Report of Trades: Year end is approaching. If you have not been reporting fund sales made in 2007 (in reliance on the accredited investor and $150,000 exemptions, among others), on an as-issued basis, don t forget that you have until January 30, 2008 to file the report. The report must be filed on Form F1 (except in British Columbia, which has its own form) with the securities commission in each province in which you sold units in Fees may be payable in certain provinces Financial Statements: Registrants must file their audited annual financial statements within 90 days of their fiscal year end. So too must reporting issuers, and mutual funds that are not reporting issuers unless organized under the laws of certain provinces. (You may have to discuss with counsel whether your fund is a "mutual fund" for securities law purposes. If its units or shares are redeemable on demand at net asset value, the fund probably is a mutual fund.) Mutual funds in Ontario are governed by National Instrument Investment Fund Continuous Disclosure and, although exempt from many of the requirements of NI if they are not reporting issuers, they must prepare annual audited and semi-annual unaudited financial statements and make them available to their investors. If you do not want to have to file those statements with the securities commissions (which you are otherwise required to do in each province in which you have sold units), you must prepare and file a "Section 2.11 Notice" indicating your intention not to file. A similar note must go in the financial statements. Soft Dollar Arrangements: Although the proposed rule was published only for comments in July 2006, (the comment period ended in October 2006), OSC compliance staff have chosen to enforce, under the "prudent business practices" banner, certain elements of proposed National Instrument Use of Client Brokerage Commissions as Payment for Order Execution Services or Research ("Soft Dollar Arrangements") as best practices to be adopted by registrant firms. Referral Arrangements: Referral arrangements have been considered on many occasions by the regulators, but there has been no definitive set of guidelines as to how they must be dealt with across Canada, other than for mutual fund dealers. Apart from registration issues, the major issue with referral arrangements is the potential conflict of interest for those referring fund products to investors and receiving payment for those referrals. The best remedy for a conflict of interest is obtaining the informed written consent of the investors and documenting the referral fee arrangements between the applicable parties. Trade Matching and Settlement: As of October 1, 2007, National Instrument Institutional Trade Matching and Settlement, requires IC/PM firms whose clients use delivery-against-payment (DAP) or receipt- 4

5 against-payment (RAP) accounts (primarily institutional clients whose securities are held by a custodian) to: establish, maintain and enforce policies in accordance with NI enter into a trade-matching agreement or be provided a trade-matching statement and complete and deliver an exception report if they have failed to match the trade within the required time period during any quarter. BLG s September 2007 Investment Management Advisory October 1, 2007 Deadline for Institutional Trade- Matching by Canadian Capital Markets Participants will provide you with useful information about the regulators expectations and the National Instrument. BLG s Investment Management Advisories are available at Anti-Terrorism and Anti-Money Laundering: Often forgotten (apart from the monthly anti-terrorism filings registrants must make with their securities regulator), there is another compliance regime you must keep in mind: that of anti-money laundering and anti-terrorism legislation. Policies and Procedures Manual: All of the above, and more, should be set out in or addressed in a written policies and procedures manual that has been developed for your own organization. Off-the-shelf compliance manuals should only be used as a good head start and not as the beginning and the end of the development process. As important as the manual is, proper implementation is even more important to OSC Compliance staff, and you must be prepared to produce written documentation evidencing that implementation failure to comply with your own written procedures can constitute a "significant deficiency" and will impact your firm s risk ranking with the OSC. New Registration Regime: As we previously reported to you, the registration regime in Canada is being overhauled. Although not law yet (and not likely to be law before Summer 2008), you should be keeping an eye on the proposed changes with a view to determining the impact on you of the increased capital, insurance, proficiency and procedural requirements. Also, OSC staff regularly point to the proposed procedural requirements as representing best practices for registrants today. 5

6 BLG s eight-part series "Keeping Reforms in Sight: Understanding the Registration Reform Proposals" released in March 2007 provide useful background to help you understand the regulators aims and proposals. These publications are available at BLG s Hedge Fund Services BLG assists fund managers in the preliminary stages to structure a new fund or derivative product by providing the necessary securities, banking and tax advice. For new funds, we prepare the constating documents (trust agreement, limited partnership agreement or articles of incorporation) and material contracts (management, administration and advisory agreements, custodial and prime broker agreements, and/or swaps and forward contracts) and assist in the preparation of offering documents (prospectus or offering memorandum, subscription agreement and marketing materials). Securities law in Canada requires fund advisers to be registered and we assist our clients in determining the necessary registrations and completing the registration application process. BLG s Registrant Regulation and Compliance Practice is the largest practice of its kind in Canada, with recognized experts in this field. We work with Canadian and international advisers (portfolio managers and investment counsel), fund managers and dealers, including SRO members and limited market dealers. We act for the Investment Dealers Association of Canada, the Mutual Fund Dealers Association of Canada and the Investment Industry Association of Canada and have excellent working relationships with the Canadian securities regulators and other government officials. We participate fully in the activities of the Alternative Investment Management Association (AIMA). We provide a full range of legal services, including advice and assistance on becoming and continuing to be registered with the Canadian securities regulators and/or members of the SROs. Our services for our clients have included developing and designing, as well as reviewing and assessing, compliance procedures and practices relating to regulatory and internal policy requirements, assisting in building or strengthening compliance capability, conducting audits and investigations, identifying operational problems and devising appropriate solutions and responding to regulatory developments. We have assisted many registrants regarding their compliance functions and structures, including developing their policies, practices and procedures. 6

7 This Investment Management Advisory was written by: Ronald Kosonic (Toronto) Tel: Fax: If you would like more information about the compliance obligations that apply to hedge fund or pooled fund managers, please call your usual lawyer in BLG s Investment Management Group, the author of this Advisory or any one of the following Investment Management Group practice leaders: John E. Hall (Toronto) National Group Leader Lynn M. McGrade (Toronto) jhall@blgcanada.com lmcgrade@blgcanada.com Jason J. Brooks (Vancouver) Jeremy S.T. Farr (Ottawa) jbrooks@blgcanada.com jfarr@blgcanada.com Fred Enns (Montréal) Brad J. Pierce (Calgary) fenns@blgcanada.com bpierce@blgcanada.com 7

8 The Investment Management Group at Borden Ladner Gervais LLP consists of a team of over 40 lawyers located in offices across Canada who understand the business, regulatory and administrative issues that face participants in the Canadian investment management industry. We have the largest and most experienced investment management practices in Canada, having provided legal services to Canadian and international industry participants for over 50 years. Our clients, both Canadian and international, include open-and closedend investment fund complexes, providers of alternative investment, pooled and private equity products, investment advisers and dealers, financial institutions, service providers, securities regulators, self-regulatory organizations and industry trade associations. Our lawyers have long-standing working relationships with the Canadian securities regulators and other government officials, as well as with The Investment Funds Institute of Canada and key industry leaders. Borden Ladner Gervais LLP Lawyers Patent & Trademark Agents C algary 1000 Canterra Tower 400 Third Avenue S.W. Calgary, Alberta, Canada T2P 4H2 tel: fax: Montréal 1000 de La Gauchetière Street West Suite 900, Montréal, Québec, Canada H3B 5H4 tel: fax: Ottawa World Exchange Plaza 100 Queen St., Suite 1100 Ottawa, Ontario, Canada K1P 1J9 tel: legal fax: IP fax: We publish Investment Management Advisories from time to time on matters of interest to the investment management industry. If you did not receive this Advisory directly, please contact us by calling BLG-LAW1 or ing subscriptions@blgcanada.com and we will add you to our mailing list for future Advisories. If you received this Advisory in error, or if you do not wish to receive further Advisories, you may also ask to have your contact information removed from our mailing lists. This Investment Management Advisory was prepared as a service to our clients and other persons dealing with investment management issues. It is not intended to be a complete statement of the law or an opinion on the subject. Although we endeavour to ensure its accuracy, no one should act upon it without a thorough examination of the law after the facts of a specific situation are considered. No part of this publication may be reproduced without prior written permission of Borden Ladner Gervais LLP. We respect your privacy, and wish to point out that our privacy policy relative to our publications may be found at Toronto Scotia Plaza, 40 King Street West Toronto, Ontario, Canada M5H 3Y4 tel: fax: V ancouver 1200 Waterfront Centre 200 Burrard Street, P.O. Box Vancouver, British Columbia, Canada V7X 1T2 tel: fax: Waterloo Region 508 Riverbend Drive, Suite 303 Kitchener, Ontario, Canada N2K 3S2 tel: fax: Borden Ladner Gervais LLP Borden Ladner Gervais LLP is an Ontario Limited Liability Partnership Printed in Canada