Conquering Form PF

The American Civil War didn’t just cost Americans a quarter million of their sons and brothers—for the first time, it also cost them a portion of their income. War expenses led President Abraham Lincoln to sign the Revenue Acts of 1861 and 1862, which were to terminate after the war. Congress tried again to impose such a tax in 1894 with the Wilson–Gorman Tariff Act, which established the first peace-time income tax.

New York congressman Bourke Cockran illustrated the vociferous debate that raged over the bill, telling Congress: “We stand here with Thomas Jefferson, who was opposed to internal revenue taxation. We stand here with Thomas F. Bayard, who declared internal taxation abominable. We stand with Allen Thurman, and we stand with Alexander H. Stephens of Georgia, who declared an internal revenue tax indefensible in this country.”

Mind you, Cockran’s Democratic party was the one supporting the measure. He got what he wanted when the Supreme Court ruled Wilson–Gorman unconstitutional the following year. 

Income tax finally found its footing in 1913 with the passage of the 16th Amendment to the Constitution. While tax rates and tax brackets have swung wildly over the years, the fundamental idea of taxing income has become entrenched. These days, even flat tax advocates wouldn’t suggest doing away with income taxes altogether.

Filing taxes has followed a similar path. Imagine the confusion during the early days when there were no tax preparation services like H&R Block, no W2 forms neatly summarizing an individual’s annual tax payments, and no blueprint for filing with the Internal Revenue Service (IRS). But eventually, people got the hang of it, and despite the complexity of today’s tax code, we all know what we have to do every year by April 15.

[T]here are some questions that are open to interpretation, so we are going to check it very carefully when we sign off because we know this is important. —Michael Liberman, BlueMountain Capital Management

In the same vein, there is hope for the hedge funds staring down the barrel at Form PF. Understanding the requirements of the new mandate—part of the Dodd–Frank Act, created to allow the US Securities and Exchange Commission (SEC) to monitor for systemic risk—has not been easy for them, nor has the process of aggregating and storing the data required for the Form PF filings from multiple sources.

But as with tax filing, it will become simpler as it becomes an annual ritual—because like the 16th Amendment, it is probably here to stay.

On August 29, hedge funds with regulatory assets under management (RAUM) of $5 billion or more were required to submit their first quarterly Form PF filing. Those same firms will have to file again in November. Nearly every other hedge fund in the US will be required to start filing come December 31. (See chart below.)

Specificity Needed
At first, technology might not appear to be one of the biggest factors involved in complying with Form PF, but as with many regulatory initiatives, technology has a major role to play.

With about $820 million under management, Venor Capital Management is preparing to file in the first quarter of 2013. The New York-based hedge fund has begun to work with its fund administrator, HedgeServ Limited, to ensure that it can “slice and dice” its portfolio and add new tags to positions so that it can assimilate the right types of information, according to John Roth, Venor’s counsel and chief compliance officer.

“With a lot of the new regulatory regimes, whether it’s Form PF, or Form 13H, or Commodity Futures Trading Commission (CFTC) registration, I do not think it is uncommon for firms to wait until closer to deadline—maybe uncomfortably so—in case the applicable regulatory agency issues guidance,” Roth says. “The concern is that if you start doing too much too early, you may have headed down the wrong path, which can be a little bit frustrating. In addition, many firms are simply trying to keep pace and triage based on the next deadline. But it's because Form PF is such a massive undertaking that will involve a great deal of time, thought and coordination, it simply demands early attention."

In preparation, Venor, Hedge­Serv and a third-party technology vendor are working to strengthen the firm’s audit trail for when it needs to make assumptions or add a caveat for a particular answer, Roth says—and this is key, as many initial filers have voiced their concerns about the vagueness of some of the form’s questions.

New York-based BlueMountain Capital Management, which manages $14.6 billion, worked with both its internal operations team and third-party vendors to develop a Form PF system. Michael Liberman, chief risk and operating officer at BlueMountain, says the firm would proceed with extra caution on its first go-around because of how much firms are forced to read into questions.

"We're in good shape [on Form PF] because we've always valued capturing information correctly in our systems, so a lot of questions we can answer well," Liberman told Waters ahead of BlueMountain's filing deadline of August 29. "But there are some questions that are open to interpretation, so we are going to check it very carefully when we sign off because we know this is important."

One hedge fund director, who has already filed with the SEC and requests not to be named, says preparing for the form was challenging because of "relatively limited SEC-issued guidance."

This source's firm worked with HedgeServ, and advises other organizations that haven't already filed to get help, as Form PF requires a significant time commitment, even while utilizing a third party. "If you are the person within your organization responsible for the filing, plan on using team members from groups across the organization: accounting, treasury, compliance, risk, and the front desk," the source says.

Conrad Gann, COO of San Francisco-based Cerebellum Capital, adds that while his firm has yet to file, his greatest concern is the lack of definite direction provided by the SEC. "Our biggest concern is the vagueness of some of the questions, which, in fact, look a bit naïve," Gann says. "However, for the poorly written questions, we view this as a common problem for all respondents and don't anticipate any difficulties so long as we make a good faith effort to respond to the intent of the questions."

While many Form PF challenges are definition-related, there are significant technology underpinnings needed to gather the data and to ensure that the firm is covered in case the SEC comes knocking.

As Venor's Roth says, having a strong audit trail system in place will be important when it comes to this first filing, as the SEC will most likely be looking for firms to display that they were acting responsibly while providing subjective answers. "It will be very important to create an audit trail to document our responses so that we are able to both defend those responses and maintain consistency from filing to filing," Roth says. "This is particularly important with respect to questions for which a subjective determination is required, because we will need to be able to show that we are being reasonable in our response."

Inequality
Both fund administrators and the hedge funds themselves say that while there are a lot of vendors claiming to offer robust and sophisticated Form PF solutions, many of those solutions are simply repackaged services that do not specifically address this new paradigm.

One chief compliance officer who recently filed says that while he doesn't have much specific advice for firms that have yet to submit their first form, after going through the process, he is incredulous at certain vendors' claims that they are trying to "retrofit" their current services for Form PF.

Pierre-Aloïs Koche, business develop manager for Misys, which serves as a consultancy to firms filing for Form PF, says that several clients were dismayed by what was promised by the vendor community and what was delivered.

"The biggest challenge was figuring out who really did Form PF," Koche says. "For a while, everyone was claiming that they could do Form PF-vendors and fund administrators-but I don't think there is really any truth to that. Nobody can really do Form PF except for the client gathering the data."

Leo LaForce, managing director at HedgeServ, says, "Funds face a lack of truly institutional-quality Form PF solutions from the service provider space." But he adds that what was learned from this first deadline will help firms that have to meet deadlines in 2013. "We do believe that the experiences and investments in automating the Form PF lifecycle that went into helping initial filers successfully meet their deadlines will pay dividends for the current filers," he says.Massive

Volumes
State Street's Chris Farias, senior managing director of the bank's alternative solutions division, says that his client roster of first filers was taken aback by the sheer scale of information that ended up in the final "form," something of a misnomer given that in some instances, the filing ran to more than 800 pages.

"The sheer volume of the data that we were pulling in from a variety of sources and getting into a form-ready format was significant," Farias says. "This being the first time that anyone has ever done this, there are significant challenges in working with other administrators, pulling in data from a variety of systems internally, pulling in data from the client, and getting that all ready to be reviewed and filed."

While the filing of such a massive form can be time-consuming, there are options out there for hedge funds to consider as they go through this process. MIK Fund Solutions, for example, offers a free filing service to any hedge fund-client or non-client.

Marshall Saffer, chief compliance officer for the New York-based firm, says that Form PF is more of a data problem than a filing one. He says the entering of the data into the form is solvable, but the real challenges are the data calculations and how those calculations are performed, the data management, and the standardization of the data across the firm. "I think that people were taking their eyes off the ball thinking that this was solely a filing problem," he says.

Change Still to Come
While this first filing wasn't a trial run by any means, there is no doubt that modifications will be made as both the regulators and the hedge funds themselves learn from this first effort. In early August, adjustments were made to some of the interfaces that led to some strategy and regional exposure fields to move from zero to four decimal places, says Phil Christianson, product manager for ConvergEx's Eze Castle Software. This further emphasized the need for hedge funds to have solutions in place that are adaptable to change, because more clarifications are coming.

"The Financial Industry Regulatory Authority (Finra) contacted us recently and said that they have another round of changes that they are going to implement in late September," Christianson says. "Firms have to be ready for that and have a tool in place and a team that can accommodate those changes and not throw the whole thing off its timeline."

Just as with the income tax code in the US, change will be constant when it comes to Form PF. These first filings will be the most arduous, but just as the tax code proved challenging and controversial, the underlying idea was to develop a better system that would help everyone.

This is a sentiment that should be embraced by the hedge fund community, Roth says. "As difficult as Form PF and other regulatory filings may be on fund managers, if the information obtained can help regulators stave off another Great Recession, the hedge fund industry and larger economy will certainly benefit."