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    Jul. 23, 2009

What Precisely Is “Fiduciary Duty” in the Hedge Fund Context, and To Whom is it Owed?

The concept of fiduciary duty is at the heart of the relationship among hedge fund managers, hedge funds and hedge fund investors.  But until recently, “fiduciary duty” was not defined by any bill or law.  Rather, it was the creature of caselaw, and much of that caselaw dealt with whether and to whom the fiduciary duty is owed, rather than the content of the duty.  That has changed with the Obama administration’s proposal on July 10, 2009 of the Investor Protection Act of 2009 (IPA).  While the IPA has received significant attention because it would impose a fiduciary duty on broker-dealers that provide investment advice (currently, broker-dealers are subject to a less stringent “suitability” standard), for the hedge fund community, the IPA is noteworthy as the first proposed codification of the substance of a fiduciary duty.  In addition, the IPA delegates to the SEC rulemaking authority to define the “client” to whom a fiduciary duty is owed.  This could empower the SEC to resolve an ambiguity that has existed since the D.C. Circuit’s 2006 decision in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), as to whether a hedge fund manager owes a fiduciary duty to the hedge fund itself, or its underlying investors.  That is, the IPA may enable the SEC to provide by rule that a hedge fund manager owes a fiduciary duty to each investor in a hedge fund, and not just to the hedge fund itself.  For practical purposes, if the IPA were to become law and if the SEC were to provide by rule that a hedge fund manager owes a fiduciary duty to hedge fund investors, it likely would become easier for hedge fund investors to sue managers based on a range of manager conduct.  This is because such a law and rule would more explicitly confer standing on hedge fund investors to challenge various manager actions.  In this article, we explain precisely what “fiduciary duty” means in the hedge fund context, and explore to whom the duty is owed (the answer is by no means straightforward).  We also explore: the practical consequences of identifying either the hedge fund or its investors as the manager’s “client”; Investment Advisers Act Rule 206(4)-8, the anti-fraud rule with a negligence standard; whether fiduciary duty can be waived; the definition of “client” in the Private Fund Investment Advisers Registration Act of 2009; and the executive compensation provisions of the IPA.

U.S. Treasury Department Proposes Legislation Requiring Registration of Hedge Fund Advisers

On July 15, 2009, the United States Treasury Department published its proposed Private Fund Investment Advisers Registration Act of 2009 (Act).  The Act reflects proposals contained in the Obama Administration’s recent White Paper on financial reform.  (For more on the White Paper, see “The Obama Administration Outlines Major Financial Rules Overhaul, Announces Greater Scrutiny for Hedge Funds and Derivatives,” Hedge Fund Law Report, Vol. 2, No. 25 (Jun. 24, 2009)).  If passed, the Act would amend the Investment Advisers Act of 1940 (Advisers Act) and require registration with the SEC of nearly all advisers to hedge funds and other large private investment funds.  The Act would not require the funds to register directly, but their advisers would have to report, albeit confidentially, on the funds they advise.  This article summarizes the Act’s most salient provisions and its implications for the hedge fund community.

Are There Avenues for Recovery in United States Courts for Overseas Hedge Fund Losses?

It has become increasingly apparent that the world’s financial markets are deeply interconnected.  U.S. banks regularly lend money to foreign borrowers, foreign investors and companies invest in real estate and securities in the U.S., and American investors, in particular hedge funds, routinely buy and sell shares of foreign companies on foreign stock exchanges.  What happens, then, when a foreign company that only trades its securities on a foreign exchange commits acts that would constitute violations of the anti-fraud provisions of the U.S. securities laws, but are not necessarily violations of its own country’s securities laws, and American investors are harmed?  Do those investors have any legal remedy?  Will a court in the U.S. apply the U.S. securities laws to a case involving the purchase or sale of shares of a foreign company on a foreign exchange?  In a guest article, Christopher F. Robertson and Erik W. Weibust, Partner and Associate, respectively, at Seyfarth Shaw LLP, address these questions as they relate to hedge funds.  Their discussion includes a detailed examination of the legal consequences of Porsche’s disclosure in October 2008 that it held a majority interest in Volkswagen, and the resulting short squeeze that caused substantial losses for many hedge funds.

Andrew Baker, CEO of the Alternative Investment Management Association, Discusses the AIFM Directive, UK Tax, Short Selling and Other Topics with the Hedge Fund Law Report

Andrew Baker, formerly Chief Operating Officer for Schroder Investment Management, became the Deputy Chief Executive of the Alternative Investment Management Association (AIMA) in August 2007, and the Chief Executive Officer in December 2008.  In those capacities, he has played a key role in shaping the AIMA’s response to recent developments in international hedge fund law and regulation.  On July 17, 2009, the Hedge Fund Law Report spoke to him about current and potential regulatory changes in Europe and the U.S., the tax climate in the UK, “grey” tax havens and laws and proposals that have or would mandate transparency with respect to short positions.  A full transcript of that interview is included in this issue of the Hedge Fund Law Report.

SEC Obtains Permanent Injunction Against Hedge Fund Colonial Fund LLC for Illegal Short Sales; Opinion Addresses Fund Manager's Faulty Internal Compliance and Accounting Systems

On July 7, 2009, the United States District Court for the Southern District of New York, after a bench trial, entered a permanent injunction against Cary G. Brody and two entities he controlled, the hedge fund Colonial Fund LLC and its adviser, Colonial Investment Management LLC.  The court found that the defendants engaged in illegal trading in violation of Rule 105 of Regulation M under the Securities Exchange Act of 1934, which prohibits manipulative trading by short sellers prior to registered offerings, with regard to 18 registered public offerings.  The defendants violated the rule by purchasing shares in the offerings to cover short sales they made during the restricted periods, thereby making over $1.4 million in profits.  The court also imposed a fine of $450,000.  We outline the various problems presented, including the Fund’s faulty internal compliance and accounting practices and its attempts to claim that it relied on the advice of counsel.

Luxembourg Authorities Create Fast-Track Procedure for Approval of Transfers of Illiquid Assets to Hedge Fund Side Pockets

The financial regulatory authority in the Grand Duchy of Luxembourg, the Commission de Surveillance du Secteur Financier (CSSF), has approved a new fast-track authorization procedure for the use of side pockets by hedge funds in two specific situations: the spin-off from an existing share/unit class to a new share/unit class and the spin-off from an existing subfund to a new subfund.  The fast track procedure is not to be used if the assets to be side pocketed represent more than 20 percent of the total assets of the relevant fund or subfund.  Also, the procedure requires that the board of directors of the management company of the affected fund confirm that the proposed side pocketing complies with the fund’s articles of incorporation or rules; that the administrator is technically capable of servicing the contemplated side pocket; and that it not be implemented to solve “temporary valuation problems” or to address a merely “potential or presumed illiquidity.”  Managers must also undertake to “promptly realize the asset as soon as the asset is once again liquid.”  We offer additional details on the specifics of the fast-track procedure, and shed light on some of the more complicated definitional questions raised by the terms used in the procedure.  For example, we address how the CSSF is likely to construe, in this context, concepts such as “temporary valuation problems” and “promptly realize the asset as soon as the asset is once again liquid.”

Investors’ Working Group Recommends Delayed Disclosure of Holdings to Regulators and Registration of Hedge Fund Advisers

As the calls for additional regulation of the hedge fund industry continue to mount, the Investors’ Working Group (IWG) has added its recommendations to the growing list of proposals to oversee the industry.  The IWG is an independent task force sponsored by the CFA Institute Centre for Financial Market Integrity and the Council of Institutional Investors.  On July 15, 2009, the IWG issued a report (Report) recommending that investment managers, including managers of hedge funds and private equity funds, be required to make regular disclosures to regulators on a real-time basis to protect against systemic risk.  The IWG also advocated requiring hedge fund managers to register as investment advisers with the SEC, a proposal that has been echoed by various legislators and the U.S. Treasury.  We offer a detailed description of the parts of the Report most relevant to hedge funds, and include industry responses to the Report.

AIMA Welcomes UK Release of White Paper for Further Reform of Financial Markets and Hedge Funds

On July 8, 2009, the United Kingdom (UK) Treasury released proposed reforms designed to ensure that banks and financial markets will be more resilient to future shocks to the global financial system.  The recommendations set out in the UK White Paper include tougher regulations of individual firms, better monitoring and management of systemic risk, the creation of a Council for Financial Stability, measures to deal with potential institutional failures, and greater protection for depositors.  Most significantly, the White Paper recommends granting more power to the UK Financial Services Authority (FSA).  These powers would include enforcing new disclosure requirements for hedge funds in order to gather information regarding their funding, leverage and investment strategies.  In a speech to launch the White Paper, Chancellor of the Exchequer Alistair Darling said that the UK government would be tasked with taking “account of new developments in the financial sector – including expanding regulation where necessary – for example of systemically important hedge funds.”  The UK government plans to introduce legislation recommended by the White Paper in the 2009-2010 parliamentary session.  We detail the new disclosure requirements for hedge funds outlined in the White Paper and the AIMA’s reaction.

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