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    Mar. 16, 2017

Nine Risks That Inform FINRA’s Examination and Surveillance Program

FINRA has a broad purview when it comes to examining and investigating firms, and enforcing regulations and rules, within the financial industry. There are nine areas of risk that continually arise in the discussions between FINRA and representatives of its member firms. These fall into two general categories: financial and operational risks; and sales practices and business conduct risks. These points came across in a panel discussion presented by FINRA, moderated by Chip Jones, FINRA’s Senior Vice President for Member Relations and Education, and featuring Bill Wollman, FINRA’s Executive Vice President for the Office of Risk Oversight and Operational Regulation, and Mike Rufino, FINRA’s Executive Vice President for the Office of Sales Practice. The panel discussion provided valuable insight for any fund manager with an affiliated broker-dealer, as well as all fund managers that trade with broker-dealers, about the principle risks those firms face. This article explores the nine risks outlined by the panelists. For more on FINRA, see “OCIE 2017 Examination Priorities Illustrate Continued Focus on Conflicts of Interest; Branch Offices; Advisers Employing Bad Actors; Oversight of FINRA; Use of Data Analytics; and Cybersecurity” (Jan. 26, 2017); and “What the Record Number of 2016 SEC and FINRA Enforcement Actions Indicates About the Regulators’ Possible Enforcement Focus for 2017” (Dec. 15, 2016).  

ESMA Opinion Sets Forth Four Common Principles for UCITS Share Classes

Following a lengthy consultation, the European Securities and Markets Authority (ESMA) published an opinion on 30 January 2017 concerning the use of share classes by E.U. Undertakings for Collective Investments in Transferable Securities (UCITS) structures. Specifically, ESMA outlined four key principles that all UCITS funds must follow when setting up different share classes and considering whether certain existing share class hedging techniques comply with such principles. The opinion particularly impacts share classes that use a derivative to hedge against a particular risk. In a guest article, Monica Gogna, a partner in Ropes & Gray’s London office, reviews and explains the expected impact of the four principles articulated by ESMA and discusses whether hedging techniques may continue to be executed in a share class as opposed to setting up a separate sub-fund. Gogna provides practical guidance on next steps, including whether the manager may continue to offer the share class to new investors after the transition period expires, as well as whether managers will need to provide updated disclosures to investors. For additional insights from Gogna, see “Leading Law Firms Debate Effect of Hard vs. Soft Brexit on Hedge Fund Managers (Part One of Two)” (Jul. 7, 2016). For commentary on other E.U. regulations from Ropes & Gray attorneys, see “A Fund Manager’s Guide to Calculating and Reporting Short Sales Under European Regulations” (Jan. 5, 2017); and “Ropes & Gray Attorneys Discuss Implications for U.S. Hedge Fund Managers of the European Market Infrastructure Regulation” (Jul. 18, 2014).

Considerations When Winding Down Funds: Navigating Illiquid Assets, Unanticipated Windfalls and Fees and Expenses During Liquidation (Part Two of Two)

Once a manager decides to wind down a fund, it must navigate myriad considerations and decisions during the process. The manager needs to disclose the wind-down to investors at the outset without triggering liabilities to service providers or diminishing asset values, and the fund needs to retain appropriate personnel and working capital to perform a wind-down that could take months or even years to complete. To address these and other issues that arise when winding down a fund, the Hedge Fund Law Report recently interviewed Michael C. Neus, senior fellow in residence with the Program on Corporate Compliance and Enforcement at New York University School of Law and former managing partner and general counsel of Perry Capital, LLC. This second article in our two-part series analyzes how illiquid assets should be treated during a wind-down; what fees can and should responsibly be charged to investors; and how managers should allocate an unanticipated windfall received after the wind-down is completed. The first article in the series described the roles that a fund’s general counsel and chief compliance officer play in the wind-down, as well as best practices for communicating the decision to wind down to service providers and investors. For more on considerations when winding down a fund in the Cayman Islands, see “How Can Investors in Cayman Hedge Funds Maximize Protection of Their Investments When the Fund Is Near or at the End of Its Life? (Part One of Two)” (Dec. 5, 2013); and our two-part series on navigating the loss of a fund’s substratum requirement: “Analysis of the Conflicting Cayman Islands Standards” (Jan. 5, 2017); and “Steps to Ensure a Fund’s Soft Wind-Down Does Not Result in a Winding-Up Order” (Jan. 12, 2017).

FCA Outlines Priorities of Liquidity and Fair Practices for Open-End Funds Investing in Illiquid Assets

Open-end funds that invest in illiquid assets, such as buildings and infrastructure, are quite appealing, as well as seriously risky, to investors. They offer the potential for higher returns than certain other funds, but there are also problems and dangers inherent in their structure and strategy. These risks flow in part from a tension between the fund’s ostensible long-term investment objectives and the propensity for some investors to redeem, regardless of the liquidity available to the fund at a given moment or the effect of those redemptions on remaining investors. All of these points come across in a discussion paper recently published by the U.K. Financial Conduct Authority (FCA) assessing the risks when consumers turn to open-end investment funds to gain exposure to illiquid assets and outlining several liquidity management mechanisms that funds can use. This article analyzes, and presents insights from partners of law firms at the forefront of interactions between the global funds industry and regulatory agencies on, the issues outlined in the discussion paper and the potential for further regulation of open-end funds that invest in illiquid assets. For discussion of another recent FCA statement on liquidity issues, see “FCA Expects Hedge Fund Managers to Focus on Liquidity Risk” (Mar. 3, 2016). 

Types, Terms and Negotiation Points of Short- and Long-Term Financing Available to Hedge Fund Managers 

As hedge funds move into relatively illiquid assets in an effort to improve returns, traditional short-term margin and repurchase agreement financing may no longer be appropriate or available. Instead, hedge fund managers are pursuing short- and long-term financing through prime brokers, private-equity-style capital call facilities, term facilities and special purpose vehicles. See “Can a Capital on Call Funding Structure Fit the Hedge Fund Business Model?” (Nov. 5, 2009). A recent presentation by Dechert partner Matthew K. Kerfoot provided an overview of these types of financing arrangements and some of their key negotiating points. This article summarizes his insights. For additional commentary from Kerfoot, see “The Current State of Direct Lending by Hedge Funds: Fund Structures, Tax and Financing Options” (Oct. 27, 2016); and “Dechert Panel Discusses Recent Hedge Fund Fee and Liquidity Terms, the Growth of Direct Lending and Demands of Institutional Investors” (Jun. 14, 2016).

Registered Fund Advisers Delegating to Subadvisers Gain Greater Flexibility From U.S. District Court Ruling to Charge Management Fees

In 2011, five individuals commenced a derivative action in U.S. federal court on behalf of several mutual funds in which they had invested, alleging that the advisory fees charged by the investment managers of those mutual funds were excessive considering their efforts were delegated to a subadviser. On February 28, 2017, the court ruled that, in light of the type and quality of the services provided by the defendants, the management fees provided for in the applicable investment management agreements were not disproportionate and could have been the result of an arm’s-length bargain. This article summarizes the court’s reasoning and the evidence on which it is based. The decision should be of particular interest to advisers that delegate investment management services for registered funds, including alternative mutual funds, to subadvisers. Fees charged by advisers are a perennial source of regulatory concern. See “Current and Former Directors of SEC Division of Investment Management Discuss Hot Topics Under the Investment Company Act” (Mar. 10, 2016); and “PLI ‘Hot Topics’ Panel Addresses Operational Due Diligence and Registered Alternative Funds” (Dec. 10, 2015).

Mae Rogers Joins Mayer Brown in New York

Mayer Brown has expanded its banking and finance practice in New York with the hiring of Mae Rogers as a partner. Rogers advises private equity funds and their portfolio companies on recapitalizations, leveraged buyouts, credit facilities, second-lien financings, workouts and debtor-in-possession financings. For coverage of other recent hires at Mayer Brown, see “Robert Woll Joins Mayer Brown in Hong Kong” (Jan. 19, 2017); and “Mayer Brown Enhances Its Banking and Fund Finance Practices in New York” (Dec. 15,  2016). For further insight from Mayer Brown lawyers, see “How Private Fund Managers Can Access Investor Capital in Hong Kong and China” (Feb. 23, 2017); and “Private Equity FCPA Enforcement: High Risk or Hype?” (Feb. 19, 2015). 

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