In its first meeting, the SEC’s recently convened Investor Advisory Committee identified defining fiduciary duty as one of its discussion topics.  In response, four financial planning and investment advisory industry groups sent a letter to the Investor Advisory Committee opposing a definition of fiduciary duty and supporting the “workability” of the current approach which, according to the letter, involves applying common law principles to specific facts and circumstances.  This debate over whether to define fiduciary duty has been given added relevance by the Obama administration’s proposal on July 10, 2009 of the Investor Protection Act of 2009 (IPA), which would for the first time define fiduciary duty by statute.  See “What Precisely Is ‘Fiduciary Duty’ in the Hedge Fund Context, and To Whom is it Owed?,” Hedge Fund Law Report, Vol. 2, No. 29 (Jul. 23, 2009).  For hedge fund managers, there are two primary questions arising out of this debate: (1) to whom is a fiduciary duty owed; and (2) what is the standard for breach of fiduciary duty?  The answers to these questions can dramatically alter the legal landscape in which hedge funds operate.  Accordingly, this article addresses both questions, both under current law and as the law may evolve following passage of the IPA. Read full article …

At the end of 2008, hedge fund manager Steel Partners LLC (Steel Partners) adopted a novel and controversial approach in response to requests to redeem approximately 38 percent of the net assets in its Steel Partners II family of funds (Steel Partners II Funds).  In a nutshell, Steel Partners proposed a restructuring plan in which investors could receive a cash distribution and either (1) shares (of limited or no liquidity) in a new publicly-traded entity that would hold the funds’ assets, or (2) a pro rata distribution of the funds’ (largely illiquid) holdings.  Certain limited partners sued to enjoin that plan and demanded an “orderly liquidation” of the funds.  On June 19, 2009, the Delaware Chancery Court denied the plaintiffs’ demand for a preliminary injunction.  See “Delaware Chancery Court Permits Hedge Fund Manager Steel Partners to Restructure Fund and Redeem Certain Limited Partnership Interests,” Hedge Fund Law Report, Vol. 2, No. 26 (Jul. 2, 2009).  In light of the legal imprimatur of the Delaware Chancery Court, the following question has been floating around the hedge fund community: is the Steel Partners approach a precedent or an anomaly?  Based on original research and interviews with market participants, the Hedge Fund Law Report has concluded that the answer is likely the latter: the Steel Partners approach, while legally plausible, is practically and optically cumbersome, and unlikely to be imitated precisely (though parts of the approach may inform responses to heavy redemption requests by similarly situated managers).  In fact, quite apart from serving as a precedent for an anti-redemption technique, the Steel Partners case may induce hedge fund investors to demand language in the governing documents of future funds prohibiting such techniques.  We describe the Steel Partners redemption plan; discuss the legal challenge to it; identify three reasons why it is unlikely to serve as a precedent; and offer insight into how the plan and the reactions to it may affect drafting of future fund documents. Read full article …

The hedge fund industry has found itself in the crosshairs of various regulators and legislators recently, with a spate of bills and proposed regulations relating to governance of the industry.  What’s less known, yet equally if not more relevant, is that the Internal Revenue Service (IRS) has a managed funds audit team that was created two years ago and is currently stepping up its audits of hedge funds and hedge fund managers and its investigations of hedge fund tax compliance issues.  (The unit also focuses on private equity funds and their managers.)  The IRS noted in a statement: “The service seeks to identify any areas of possible non-compliance in the income tax reporting of hedge fund and private equity fund investors and managers, as well as possible non-compliance in the reporting of withholding obligations.”  The managed funds audit team focuses on areas such as compliance with filing requirements, income recognition, characterization of income as ordinary or capital gains, the flow of funds between onshore and offshore entities, the allocation and timing of incentive payments and other income and the accounting methods used to reflect and record income.  The IRS has focused significantly on training auditors on tax issues related to the hedge fund industry.  Within the hedge fund industry, tax audit activity has increased in the last year.  In September 2008, hedge funds experienced the team’s first real push to conduct audits.  We discuss the formation of the managed funds audit team; what actions may trigger an audit; key areas of focus in audits (including a discussion of the wash sale and straddle tax rules); offshore concerns (including deferral and UBTI issues); violations and remedies; how to prepare for an IRS audit; differences between IRS audits and SEC or financial audits; and the length of audits and appeals. Read full article …

Federal Rule of Bankruptcy Procedure 2019(a) (Rule 2019(a)) generally requires disclosure by an “entity or committee representing more than one creditor” of the identity of each creditor involved, the nature and amount of its interest, the times when the entity’s interests were acquired and the amounts paid for them.  This rule has relevance for hedge funds that invest in distressed debt because the timing of an acquisition of such debt and the amounts paid for it may provide insight into the fund’s trading strategy – information that can be used by other market participants to the detriment of the disclosing fund in debt transactions and bankruptcy negotiations.  The scope of disclosure required under Rule 2019(a) has been in doubt since two decisions by the U.S. Bankruptcy Court for the Southern District of New York in the Northwest Airlines bankruptcy in 2007, and another decision shortly thereafter by the U.S. Bankruptcy Court for the Southern District of Texas in the Scotia Pacific Company (Scopac) matter.  The issue has come to the fore again recently in the bankruptcy of Washington Mutual Inc. (WMI).  This article examines the caselaw on the subject as it relates to distressed debt trading by hedge funds, and the disclosures required in connection with such trading.  In particular, we offer a detailed examination of the relevant points from the WMI bankruptcy, the Northwest Airlines cases, the Scopac case and the May 2008 Sea Containers case in the U.S. Bankruptcy Court for the District of Delaware.  This article is part one of a two-part series, and focuses primarily on the cases.  Part two will focus on analysis of the cases and issues, incorporating the views of leading practitioners in bankruptcy and other relevant legal areas. Read full article …

Investors are aware that investing in a hedge fund comes at a cost and that certain expenses of the fund will be passed through.  However, there is no set rule for what expenses are passed through and some funds have or are developing unique strategies to deal with expenses.  Most hedge funds have implemented arrangements that permit the manager to pass certain expenses through to the fund and to investors, as add-ons to the management fee.  Other funds have included some or all of these costs into the management fee itself.  Still others have or are exploring the use of an expense pass-through in lieu of a fixed management fee.  While the approaches may be different, the goal of most hedge funds is the same: to retain investors and cover expenses.  In good times, investors tend to look less at the actual cost of fees and expenses, and focus more on the returns.  But, after a year and change of generally poor performance, more focus has been placed on expenses and how expenses affect returns.  We detail what expenses are and are not being passed through; soft dollar considerations; treatment and amortization of organizational expenses; tax implications of various approaches to expense pass-throughs; and the negotiability of management fees in the current investment environment. Read full article …

Although the hedge fund industry continues to recover from a year of unprecedented underperformance and record redemptions, and is still reeling from an economic recession, opportunities remain for startup hedge funds.  A new firm, HedgePort Associates, has been established to provide operational, regulatory and marketing services to hedge fund managers as they start and grow their businesses.  Andrew Springer is the founder and CEO of HedgePort Associates; he also founded hedge fund operations consulting firm Resolve Inc.  The Hedge Fund Law Report spoke with Springer about HedgePort and the services the firm provides.  The full transcript of that interview is included in this issue of the Hedge Fund Law Report, and covers topics including: the market for startup hedge funds; whether and how certain operational functions can be outsourced; where liability resides in the event of a compliance violation if compliance functions are outsourced; the difference between track records compiled at hedge funds and on proprietary trading desks; HedgePort’s compensation structure; wind-down services offered by HedgePort; the SEC’s new pay to play rules; structuring matters; and more. Read full article …

According to an August 2009 report issued by Greenwich Associates, corporations and financial institutions around the world have expressed strong levels of support for many of the key components of financial regulation reform proposed by governments in the United States and Europe.  Greenwich Associates surveyed 458 large corporations and financial institutions in North America, Europe and Asia about their opinions on various reform proposals and their assessments of how governments and regulators have performed since the start of the global financial crisis.  The results reveal strong support for regulatory proposals including: the establishment of systemic risk regulators, the mandatory separation of investment banking and commercial banking activities, the tightening of hedge fund regulations and derivatives markets reform.  Still, many survey participants pointed out that they are cautiously watching the progress of regulatory reform, even as they broadly support the specific regulatory proposals in question.  We offer a detailed review of the report. Read full article …

Continuing its strategic growth in Southern California and nationally, Bingham McCutchen LLP announced on August 24, 2009 that it had expanded its investment management practice with the addition of Michael Glazer as a partner in the Los Angeles office. Read full article …

UBP Asset Management, a fund of funds management company of Union Bancaire Privée, has appointed Matt Auriemma as co-head of structural risk analysis.  Auriemma was previously head of operational due diligence for Barclays Wealth. Read full article …