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    Jan. 21, 2011

Thirteen Important Due Diligence Lessons for Hedge Fund Investors Arising Out of the SEC’s Recent Action against a Fund of Funds Manager Alleging Misuse of Fund Assets

The SEC recently obtained an emergency asset freeze and temporary restraining order against a hedge fund of funds manager, Stanley J. Kowalewski (Kowalewski), and his management entity, SJK Investment Management LLC (SJK).  The SEC’s complaint, filed in federal district court in Atlanta, generally alleges that Kowalewski and SJK engaged in two categories of conduct in violation of federal securities laws.  First, Kowalewski and SJK allegedly used fund assets to pay management company and personal expenses.  Second, Kowalewski allegedly launched a hedge fund in which his fund of funds invested, but failed to disclose to his fund of funds investors either the existence of the underlying hedge fund or the investment by his fund of funds in it.  Neither the dollar values nor the creativity in this matter are particularly noteworthy.  The alleged fraud itself was trite, brief and straightforward.  However, a close reading of the SEC’s complaint offers a veritable treasure trove of insight into how investors in hedge funds and funds of funds can sharpen their due diligence practices.  We have extracted 13 key lessons from the matter that investors can use to revise their approach to hedge fund due diligence – or, even better, to confirm that their approach reflects current best practices.  This article details the SEC’s factual and legal allegations against Kowalewski and SJK, briefly discusses the procedural posture of the matter, then discusses in detail the 13 key lessons.

Strategic Turnaround Judgment Provides Welcome Guidance for the Hedge Fund Industry on the Suspension of Redemptions

Among the most debated issues in the funds industry over the last two years are the questions to what extent, and when, can a fund suspend redemptions, and what is the effect on a redeeming investor of a suspension imposed by the fund after the investor’s redemption notice has expired?  The recent judgment of the Judicial Committee of the Privy Council in Culross Global SPC Limited v Strategic Turnaround Master Partnership Limited provides helpful and authoritative guidance about how provisions in a fund’s contractual documentation addressing redemptions and suspensions of redemptions should be interpreted, and how to determine which of the various documents constituting the investment agreement between a fund and its investor should take priority if the documents contain inconsistent provisions.  In a guest article, Jeremy Walton, a Partner and the Litigation and Insolvency Practice Group Head at Appleby in the Cayman Islands: outlines the facts of the Strategic Turnaround matter; discusses the lower court decisions and the Privy Council’s legal analysis; identifies five practice points for hedge fund industry participants arising out of the Privy Council’s judgment; highlights issues that remain unresolved even after the Privy Council’s judgment; and explores whether the decision may be a Pyrrhic victory for hedge fund investors.

Federal Court Decision Provides Guidance to Newly Registered Hedge Fund Managers on Litigation Strategy in Enforcement Actions Brought by the SEC

On December 2, 2010, Magistrate Judge Sheila Finnegan of the U.S. District Court for the Northern District of Illinois issued an order partially granting a discovery motion filed by Eric A. Bloom, the former President and CEO of Sentinel Management Group, Inc., a registered investment adviser, in a civil enforcement action brought by the U.S. Securities and Exchange Commission (SEC) against Sentinel, Bloom and Sentinel Senior Vice President Charles K. Mosley.  The SEC had accused Bloom and Mosley of engaging in a massive fraud from around October 2002 through August 2007 relating to their use of client assets.  In response, Bloom sought the SEC’s file for Sentinel from an examination it conducted in January and February 2002, in the hope that it may contain relevant information, and sought answers to his interrogatories relating to any witness interviews the SEC conducted with Sentinel staff in preparation for litigation.  Although Sentinel was a registered investment adviser that managed cash for hedge funds, rather than being a hedge fund manager itself, this decision is nonetheless relevant to hedge fund managers, especially as more hedge fund managers become subject to a registration requirement, SEC examinations and resulting enforcement actions.  Specifically, the decision sheds light on the merits of a litigation strategy adopted by a hedge fund industry participant and its principals in litigation against the SEC.  Thus, the decision offers lessons regarding when to litigate or settle, how to craft a litigation strategy, and which documents may be obtained via discovery requests.  We detail the background of the action and the court’s pertinent legal analysis.

California Appellate Court Upholds Arbitration Award Against Plaintiff Hedge Fund, Even Though One of the Defendant Law Firms in the Arbitration Never Filed a Separate Petition to Compel the Arbitration

A California appeals court has rejected an attempt by hedge fund Vigilant Investors, L.P. (Vigilant) to have a second bite at the apple after receiving an unfavorable arbitration award in an action against its former attorneys.  In a legal fee and malpractice dispute arising out of Vigilant’s underlying action against its prime broker ABN Amro (which action was also arbitrated), Vigilant sued various attorneys and law firms that represented Vigilant in the underlying suit.  Vigilant was dissatisfied with the arbitration award made in favor of one of those law firms and moved in California Superior Court to overturn the arbitration award, primarily on procedural grounds.  The Superior Court upheld the award and Vigilant appealed.  The Court of Appeal ruled that, because all parties had consented to the arbitration of all claims, Vigilant could not now challenge the arbitral award.  We summarize the procedural background and the Court’s reasoning.  For a recent discussion of the “exceedingly heavy burden” imposed by the Federal Arbitration Act on a party seeking to overturn an arbitration award, see “A Prime Broker that Fails to Diligently Investigate the Sources of Funds in a Hedge Fund’s Margin Account May Be Jointly and Severally Liable, with the Fund and Its Manager, for Fraud by the Manager, to the Extent of Funds in the Account” Hedge Fund Law Report, Vol. 3, No. 47 (Dec. 3, 2010).

The Case in Favor of Focused, Experienced and Independent Hedge Fund Directors

In a letter to the Editor of Hedge Fund Law Report, Kevin Ryan, Founder of HedgeDirector, addresses points raised in our article: “The Case In Favor of Non-Executive Directors of Offshore Hedge Funds with Investment Expertise, Fewer Directorships and Independence from the Manager,” Hedge Fund Law Report, Vol. 3, No. 50 (Dec. 29, 2010).  Ryan argues that while our article paraphrased the arguments in his firm’s white paper clearly, it nonetheless made some unrealistic assumptions about the information disparity between fund managers and investors, and did not reflect the experiences of most hedge fund investors on a day-to-day basis.  Ryan’s letter is an eloquent and important contribution to the ongoing debate on the appropriate qualifications of hedge funds directors.

2010 Greenwich Associates Global Custodian Prime Brokerage Study Discusses Counterparty Risk Concerns, Sources of Assets, Balance Spreading, Leverage Levels, Separately Managed Accounts and Hedge Fund Staffing Benchmarks

In the 2010 Greenwich Associates Global Custodian Prime Brokerage Study, institutional financial services consulting and research firm Greenwich Associates offered insight on the relationship between hedge funds and prime brokers, high water marks, counterparty risk concerns among hedge fund managers, hedge fund money raising, spreading of hedge fund cash and non-cash balances, use by hedge funds of leverage and separately managed accounts and hedge fund manager staffing.  The insights in the study were based on interviews with over 1,800 hedge fund managers across North America, Europe and Asia-Pacific.  This article summarizes the key findings of the study.

SEC Names Eileen Rominger as Director of Division of Investment Management

On January 18, 2011, the Securities and Exchange Commission announced that Eileen Rominger has been named Director of the Division of Investment Management.  Rominger will begin her work at the agency in February 2011.

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