From the July 01, 2009 issue of Futures Magazine • Subscribe!

Master-feeder structure

The solicitor-managed funds that placed their investors’ money with BMIS were simply investors that opened BMIS accounts in the solicitor-managed fund’s name, giving the latter the same legal status as any other investor. They were not, for example, parties to the administration agreement that includes both the Master Fund and all Feeder Funds in the Master-Feeder structure.

Once the Madoff investor’s money left the solicitor-managed fund account and was deposited in the BMIS account, there was a break in oversight. The solicitor-managed fund’s administrator, if indeed it employed one, had no standing to receive notification of the investment’s movements or verification of its money’s whereabouts or safety. In the master-feeder fund example, a single Independent Fund Administrator is responsible for tracking every transfer and action that alters the value of each investor’s investment both in the feeder fund and in the master fund of which the feeder fund owns shares.

Madoff’s solicitor-managed funds may have been audited by large and reputable accounting firms but, since these funds did not own shares of BMIS, the auditors of the solicitor-managed funds had no standing to audit BMIS.

The master-feeder relationship is useful because it allows for greater flexibility. Once an investment manager forms a master fund, he can easily add feeder funds that offer investors different features including, but not limited to: daily or monthly liquidity, alternative collateral management, and foreign or domestic domiciles. He can do this without having to open a new futures account or collateral account for each feeder fund, an effort which is both costly and time consuming.

It simplifies fund operation because all trades are executed for the master fund and distributed pro rata according to each feeder fund’s ownership interest in the master fund.

From the moment of payment (subscription) to a feeder fund, up to its deposit (purchase) of an ownership interest in the master fund and its deployment via its clearing broker in the market, all the way through to the investor’s ultimate redemption, a proper master-feeder structure enhances the safety of the investment. Some of the requisite elements of oversight involved include the independent administrator sending the investor a monthly report of the funds’ performance and NAV based not on the information sent to it by the investment manager, but by the clearing broker and the funds’ banks. Independent accounting, banking, brokerage, and control entities that generate client reports which, all together, work to ensure that the clients’ money is directed.

Contrast this process with what is known of Madoff.

Although the investment manager is called the feeder fund’s member-manager, he is meant to act solely as an advisor to the independent fund administrator in matters of money transfer and to the feeder and master fund in matters of investment and de-investment choices and as the implementer of trades on behalf of the master fund.

The agreement between the feeder fund and the feeder fund’s bank provides that money placed by the investor with the feeder fund’s bank can be transferred by the bank only when the transfer is authorized by the funds’ independent fund administrator (which, to ensure this is so, is indeed the sole signatory on the account).

Similarly, the agreement between the master fund and the master fund’s bank provides that money can be transferred only for the purposes and entities described below and in all cases only with the authority of the funds’ independent fund administrator whose right to provide such authority is similarly limited:

• To transfer investors’ subscription money from the feeder fund’s bank account to the master fund’s bank account.

• To transfer from the master fund’s bank account to the clearing broker’s segregated customer margin account an amount of the client’s investment money sufficient to cover the initial or variation margin that must be paid to an exchange’s clearing house as an initial and subsequently as an additional margin deposit caused first by investment and by changes in the value of investments.

• To transfer from the master fund’s bank account to the clearing broker’s segregated customer margin account enough of the client’s investment money to cover the initial or variation margin that must be paid to an exchange’s clearing house first as an initial and subsequently as an additional margin deposit caused first by investment and later by changes in the value of investments.

• To transfer the rest of the money that is in the master fund’s bank account to the master fund’s collateral account, for this is the safe way to hold assets at the master fund’s custodian bank.

• To pay to investors who redeem their fund ownership interest such amounts as the independent fund administrator calculates they are due.

• To pay the feeder and master funds’ expenses, i.e. to pay to the pre-identified service providers the administrative, accounting, auditing, legal, and investment management fees the funds have contractually incurred

The agreement between the master fund and the custodian bank holding the master fund’s collateral account should provide that money can be transferred by the investment manager out of the master fund’s collateral account only to the master fund’s bank account and the clearing broker’s segregated customer margin account, (both safe places from which only the Independent Fund Administrator has the signatory authority to transfer money to third parties).

The futures account agreement between the master fund and the clearing broker should provide that the investment manager of the master fund and the clearing broker can authorize transfers from the clearing broker’s segregated customer margin account only to the master fund’s collateral account and the master fund’s bank account.

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