The Securities and Exchange Commission (SEC) has attempted to stop insider trading since its creation.  Eliminating this misconduct has proven to be an elusive goal, as the Boesky scandal of the 1980s demonstrated.  The growth of the hedge fund industry has heightened the SEC’s challenge.  There is a longstanding and widespread belief among law enforcement personnel that insider trading involving hedge funds is a systemic problem.  Until recently, however, very few of the SEC’s insider trading cases involved hedge funds.  Today, the SEC is committed “to root[ing] out insider trading on Wall Street and in the hedge fund industry.”  It is bringing to bear more resources and new investigative tools to do the job.  A restructured Enforcement Division has new units ramping up that will concentrate on, among other things, insider trading by market professionals, including hedge funds.  In addition, joint investigations with the Department of Justice (DOJ) are now more common, allowing the SEC to take advantage of investigative strategies and tools long used in criminal cases.  Several insider trading cases involving hedge funds were brought in the past year, and more can be expected.  It has been reported that the SEC sent “at least” three dozen subpoenas to hedge funds and brokerages in “an expanding sweep of potential insider trading violations” relating to health care mergers in the past three years.  Also, the SEC filed charges in May 2010 against a Walt Disney Company executive and her companion, who allegedly shopped confidential earnings information about the company to over 30 hedge funds (some – but not all – of which reported the overture to the government).  Given this unprecedented level of enforcement attention, hedge funds and their investment advisers need to make sure that adequate procedures, customized for their particular business models and strictly enforced, are in place to minimize the risk of insider trading violations.  Fund managers that fail to consult counsel now may discover, only when it is too late, that they are the target of an extensive undercover government investigation.  In a guest article, Michael D. Trager, Richard L. Jacobson and Christopher Rhee, respectively, Senior Partner, Counsel and Partner at Arnold & Porter LLP, offer a comprehensive analysis of the current developments in insider trading law most relevant to hedge funds and hedge fund managers. Read full article …

Traditionally, hedge funds and private equity funds have used different funding models.  Private equity funds have used a capital on call model, in which investors agree by contract to contribute a certain amount of capital to the fund, and retain possession of that capital until the manager requests it.  Hedge funds, by contrast, have used an immediate funding model, in which investors actually contribute capital to the fund at the time of investment, and the fund’s custodian retains possession of that capital for the duration of the investment.  (But see “Can a Capital On Call Funding Structure Fit the Hedge Fund Business Model?,” Hedge Fund Law Report, Vol. 2, No. 44 (Nov. 5, 2009).)  However, there is a narrow exception to the immediate funding rule in the hedge fund context.  That exception applies to seed investors and other large, usually early investors in hedge funds (who often simultaneously invest in the hedge fund management entity).  Such investors frequently condition their investments on rights to make additional investments in the fund.  In the hedge fund world, those additional investment rights generally are known as capacity rights.  In effect, investors with capacity rights have the opposite of capital on call.  Instead, they have what might be termed “capital on put.”  Whereas a private equity fund manager has the right to call its investors’ capital, a hedge fund investor with capacity rights has the right to put its capital into the fund.  Capacity rights agreements offer business benefits to managers and investors.  Most notably, they enable start-up managers to bring in anchor investors, and offer anchor investors the opportunity to maximize the value of risky investments with new managers.  But capacity rights agreements also present a variety of legal and practical complications.  The purpose of this article is to highlight some of those complications and, where practicable, offer remedies or solutions.  In particular, this article discusses: the definition of capacity rights; the business rationales for granting (from the manager perspective) or requesting (from the investor perspective) capacity rights; the documents in which such rights are usually memorialized; how such rights are generally structured, including the pros and cons of structuring capacity rights based on dollar amount versus percentage of assets under management (AUM) or total capacity; and various specific concerns raised by capacity rights agreements, including ERISA concerns, concerns relating to most favored nations (MFN) clauses in side letters, the frequently less advantageous economics associated with capital invested pursuant to capacity rights, and fiduciary duty concerns. Read full article …

In the mist of the liquidity crisis of 2008, Steven Winters, President of Gemini Strategies and Portfolio Manager of the Gemini Master Fund Ltd (an investor in small-cap and micro-cap U.S. companies), took a novel approach to a substantial wave of redemption requests.  Rather than using any of the typical liquidity management tools such as gates, redemption suspensions or payments in kind, Winters and his advisers split the fund into a continuing fund and a redeeming fund.  The move enabled the fund to return cash to redeeming investors, generate considerable returns and retain relationships.  It was a creative structure and a good outcome, and can offer a model for any hedge fund faced with heavy redemptions (which can happen even when the macro environment is positive).  The Hedge Fund Law Report recently discussed with Winters the background, rationale, mechanics and outcome of the split.  The full transcript of that interview is included in this issue of the Hedge Fund Law Report. Read full article …

As previously reported in the Hedge Fund Law Report, in Fall 2008, the hedge funds SageCrest II, LLC (SC II), SageCrest Finance, LLC, SageCrest Dixon, Inc., and an offshore affiliate, SageCrest Holdings, Ltd. (collectively, SageCrest), filed for Chapter 11 bankruptcy protection.  See “SageCrest Files for Chapter 11 Bankruptcy, a Rare Move by a Hedge Fund,” Hedge Fund Law Report, Vol. 1, No. 21 (Sept. 22, 2008).  In so doing, SageCrest informed its investors that the actions of Deutsche Bank, its primary lender, in demanding that SageCrest liquidate assets to accelerate repayment on its loans and in freezing a $400 million line of credit, as well as litigation with an investor, Wood Creek Capital Management, caused the bankruptcy filing.  In March 2010, SageCrest, its fund manager Windmill Management, LLC (Windmill), and Windmill principals Alan and Philip Milton (the Milton Brothers), the largest secured creditor Deutsche Bank, and the Official Committee of Equity Investors moved for court approval of a Settlement Agreement pursuant to Federal Rule of Bankruptcy Procedure 9019(a), that required, among other things, the replacement of Windmill with an interim manager, Ralph Harrison, the Equity Committee’s financial consultant.  Two creditors, Topwater and Art Capital, opposed the agreement, claiming that it was a sub rosa plan, and that Harrison was not a “disinterested” party.  On May 18, 2010, the United States Bankruptcy Court for the District of Connecticut approved the settlement after finding that it satisfied the “standard of reasonableness.”  We detail the background of the action and the Bankruptcy Court’s legal analysis. Read full article …

Hedge fund managers operating globally face a variety of overlapping legal regimes.  Few of those regimes are as cumbersome, counterintuitive and rife with pitfalls as the European Union laws relating to data privacy.  EU privacy laws go well beyond U.S. privacy laws, and in some case can even give rise to conflicting obligations.  To help explicate this complicated terrain for global hedge fund managers and other types of U.S.-based companies with international operations, White & Case LLP and Mesirow Financial Consulting, LLC hosted a seminar on May 25, 2010 entitled “EU Data Privacy Compliance: Practical Strategies for Processing Imported European Data Legally.”  This article outlines the key topics discussed at the seminar, focusing on those most relevant to hedge fund managers, including the details of the EU data privacy directive, specific strategies for transferring data from the EU to the U.S., specific compliance strategies for U.S.-based global hedge fund managers and the interaction of EU data privacy laws and Sarbanes-Oxley requirements. Read full article …