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    Feb. 9, 2012

Key Legal and Operational Considerations for Hedge Fund Managers in Establishing, Maintaining and Enforcing Effective Personal Trading Policies and Procedures (Part Three of Three)

One of the principal challenges many hedge fund managers face is effectively and efficiently enforcing a firm’s compliance policies and procedures given limited compliance resources.  This problem has been historically acute with respect to personal trading compliance because of the significant manual effort required to ensure compliance with applicable rules and in-house personal trading requirements.  Nonetheless, in the past decade, technology vendors have made significant progress in developing personal trading compliance solutions that can significantly enhance the effectiveness and efficiency of personal trading compliance programs, at relatively modest prices.  Technological solutions can facilitate personal trading reporting as well as enforcement of a firm’s personal trading restrictions and prohibitions.  Furthermore, vendors can now tailor such solutions to meet the needs of hedge fund managers with varying operational requirements.  As such, hedge fund managers should explore and understand the various personal trading compliance solutions available to them to determine whether any such solutions will further advance the goals of their personal trading compliance programs.  This is the third article in a three-part series on personal trading policies and procedures for hedge fund managers.  The first article in this series discussed general considerations for hedge fund managers in developing effective personal trading policies; the scope of persons that may be covered by such personal trading policies; and the reporting obligations imposed on registered hedge fund managers by Rule 204A-1 under the Investment Advisers Act of 1940 (Advisers Act).  See “Key Legal and Operational Considerations for Hedge Fund Managers in Establishing, Maintaining and Enforcing Effective Personal Trading Policies and Procedures (Part One of Three),” Hedge Fund Law Report, Vol. 5, No. 3 (Jan. 19, 2012).  The second article discussed various personal trading restrictions and prohibitions, including limitations on the number of brokerage firms covered persons can use to effect personal trades; pre-clearance requirements for personal trades; blackout periods during which personal trades cannot be effected; holding periods applicable to securities owned by covered persons; and other types of personal trading restrictions and prohibitions.  See “Key Legal and Operational Considerations for Hedge Fund Managers in Establishing, Maintaining and Enforcing Effective Personal Trading Policies and Procedures (Part Two of Three),” Hedge Fund Law Report, Vol. 5, No. 4 (Jan. 26, 2012).  This third article in the series describes various solutions designed to facilitate monitoring of personal trading compliance by hedge fund managers.  Specifically, this article discusses various technological solutions designed to facilitate personal trading reporting, including the various methods for obtaining electronic personal trading data (instead of paper data) from broker-dealers; various solutions for automating personal trade monitoring; automated trade pre-clearance solutions; and a summary of key considerations for hedge fund managers when evaluating personal trading compliance solutions.  See generally “How Hedge Fund Managers Can Use Technology to Enhance Their Compliance Programs,” Hedge Fund Law Report, Vol. 4, No. 41 (Nov. 17, 2011).

Does Social Media Have a Place in the Hedge Fund Industry?

While social media has captivated society and propelled it deeper into the communication age, the hedge fund industry has not yet embraced it on a meaningful scale.  See “Legal Considerations for Hedge Fund Managers that Use Social Media,” Hedge Fund Law Report, Vol. 4, No. 14 (Apr. 29, 2011).  In fact, a recent survey of hedge fund managers found that the vast majority of hedge fund managers are simply not using social media.  On the one hand, it is surprising that hedge fund managers have been slow to explore social media given the otherwise cutting edge nature of the hedge fund industry.  On the other hand, many compliance professionals are simply stretched too thin by the introduction of new regulatory challenges arising from the Dodd-Frank Act, and thus are unable to devote resources to exploring this new frontier.  In reality, there appears to be very little dialogue regarding whether social media could be used effectively in the hedge fund industry, and if so, how to do so in compliance with applicable laws and regulations.  Therefore, in a guest article, John Herbert Roth, Counsel and Chief Compliance Officer of Venor Capital Management LP, initiates that dialogue by asking whether social media can have a place in the hedge fund industry, and then proposing a comprehensive framework within which hedge fund managers may think about social media and its compliance implications.  See also “SEC Enforcement Action and Bulletins Shine Spotlight on Use of Social Media by Investment Advisers,” Hedge Fund Law Report, Vol. 5, No. 2 (Jan. 12, 2012).

Hedge Fund Managers May Be Required to File TIC Form SHC by March 2, 2012

Hedge fund managers should consider as soon as possible whether they are required to file Treasury International Capital (TIC) Form SHC, Report of U.S. Ownership of Foreign Securities, Including Selected Money Market Instruments.  Basically, Form SHC requires the reporting of information regarding foreign securities owned by U.S. residents.  A hedge fund manager is required to file Form SHC if it meets a $100 million threshold for “reportable securities” determined on an aggregate basis for all funds under management.  For 2011, Form SHC is due by March 2, 2012, and reporting is based on the fair value of assets determined as of December 31, 2011.  In a guest article, Philip Gross and Allison Bortnick, Member and Associate, respectively, at Kleinberg, Kaplan, Wolff & Cohen, P.C., discuss the parameters of Form SHC, including a discussion of who must file Form SHC and what securities are covered; the composition of Form SHC; and the approach that hedge fund managers may take to determine whether they must file Form SHC, and, if reporting is required, how to complete Form SHC.

Staff of SEC Division of Investment Management Clarifies the Scope of the Family Office Rule

Family offices historically have been considered “investment advisers” as defined in the Investment Advisers Act of 1940 (Advisers Act) because they provide investment advice for compensation.  However, family offices historically have avoided registration by availing themselves of the private adviser exemption in Section 203(b)(3) of the Advisers Act or by seeking and obtaining exemptive relief from the SEC.  Under the Dodd-Frank Act, Congress eliminated the private adviser exemption and directed the SEC to adopt a definition of single family office that would be “consistent with previous exemptive policy” and recognize “the range of organizational, management, and employment structures and arrangements employed by family offices.”  On June 22, 2011, the SEC adopted Rule 202(a)(11)(G)-1 under the Advisers Act (Family Office Rule).  The Family Office Rule generally provides that family offices are excluded from the definition of investment adviser under the Advisers Act and defines family offices for purposes of the exclusion.  Under the Family Office Rule, an entity is a family office if it: (1) has only family clients; (2) is wholly owned and exclusively controlled by family members or family entities; and (3) does not hold itself out to the public as an investment adviser.  For a comprehensive discussion of the Family Office Rule, see “Developments in Family Office Regulation: Part Three,” Hedge Fund Law Report, Vol. 4, No. 23 (Jul. 8, 2011).  So, as a matter of administrative law, Congress adopted a general principle with respect to family offices and the SEC put that principle into practice via rulemaking.  But while rules are more specific than laws, even rules often fail to capture the rich variety of factual circumstances to which they apply.  This is particularly the case with respect to family offices, a vast and heterogeneous group of entities engaged in a wide range of activities.  Accordingly, to offer industry participants more guidance on applying the Family Office Rule, the staff of the SEC’s Division of Investment Management recently published responses to five categories of questions relating to the scope of the Family Office Rule.  Specifically, the staff responded to questions on: (1) ownership and control of family offices; (2) key employees; (3) family members; (4) non-advisory services; and (5) the Family Office Rule’s grandfathering permission.  This article summarizes the staff responses.  These staff responses are important to two general categories of hedge fund managers: those that have or solicit investments from family offices, and those considering conversion to a family office format.  With respect to investments in hedge funds by family offices, see “Public Pension Funds and Endowments Increase Allocations to Hedge Funds, While Allocations from Family Offices Slide,” Hedge Fund Law Report, Vol. 4, No. 36 (Oct. 13, 2011).  And with respect to conversion by hedge fund managers to a family office format, see “Legal Mechanics of Converting a Hedge Fund Manager to a Family Office,” Hedge Fund Law Report, Vol. 4, No. 43 (Dec. 1, 2011).

Massachusetts Superior Court Dismisses Investors’ Claims Against Hedge Fund Manager Dutchess Capital, its Auditor, Administrator, Principals and Affiliate

Plaintiffs in this action were investors in two hedge funds managed by Dutchess Capital Management, LLC (Dutchess Capital).  When those investments failed, plaintiffs commenced suit against Dutchess Capital, an affiliate, its principals, its outside auditor and its administrator.  They alleged breach of contract, breach of fiduciary duty, malpractice, fraud and similar claims.  The Court granted defendants’ motion to dismiss, holding that plaintiffs lacked standing to bring certain derivative claims, that the Court lacked jurisdiction over the fund administrator and that the remaining claims were barred by the applicable statutes of limitations.  This article summarizes the Court’s decision.

FSA Fines Former J.C. Flowers Europe CEO for Fraudulent Invoicing Scheme

On January 31, 2012, the UK Financial Services Authority (FSA) issued a Final Notice announcing that it fined Ravi Shankar Sinha, former UK Chief Executive Officer (CEO) of private equity fund manager J.C. Flowers.  The fine, UK £2.87 million (US $4.52 million), represents one of the largest penalties ever imposed by the FSA on an individual in a non-market abuse case.  The Final Notice also banned Sinha from working in financial services in the UK.  Notably, this fine is the latest in a series of recent and vigorous enforcement actions by the FSA against private fund managers.  It comes only a week after the FSA imposed a £7.2 million (US $11 million) fine on David Einhorn and his hedge fund management company, Greenlight Capital, for allegedly using confidential information to trade in the stock of a British pub chain.  See “FSA Imposes £7.2 Million Penalty on Hedge Fund Manager David Einhorn and Greenlight Capital for Unintentional Insider Dealing in Shares of British Pub Owner Punch Taverns Plc,” Hedge Fund Law Report, Vol. 5, No. 5 (Feb. 2, 2012).  This article summarizes: the structure of the various J.C. Flowers entities (as described in the FSA’s Final Notice); the Final Notice with regard to Sinha; the rationale for the FSA’s actions; and the criteria used by the FSA in assessing financial penalties or imposing prohibition orders against private fund industry participants.

Survey Highlights Compliance Professionals’ Attitudes and Practices Concerning Electronic Communications Compliance

Electronic communications compliance has become more important for hedge fund managers in recent years as the amount of business done electronically and the amount of regulatory focus on electronic communications compliance have grown significantly.  At the same time, compliance professionals have struggled to keep up with ever-changing circumstances that make electronic communications compliance, including the capture and archiving of electronic communications, even more difficult.  In May 2011, Smarsh, Inc. published a report (Report) that detailed the findings of a survey of compliance professionals at various types of financial institutions, including investment advisers and broker-dealers, designed to identify trends in and opinions about electronic communications compliance.  The survey comprised 29 questions which were asked of 223 individuals with direct compliance supervisory responsibilities, including C-level management personnel, chief compliance officers and compliance staff members.  This article summarizes some of the key findings of the Report and lessons for hedge fund managers.  See also “Does Social Media Have a Place in the Hedge Fund Industry?,” above, in this issue of the Hedge Fund Law Report.

Chief of the Securities & Commodities Fraud Task Force at the SDNY to Join Weil

On February 8, 2012, Weil, Gotshal & Manges LLP announced that Christopher L. Garcia, Chief of the Securities & Commodities Fraud Task Force at the United States Attorney’s Office for the Southern District of New York, will join the firm as Litigation partner and member of the Securities Litigation and White Collar Defense & Investigations practices.  Garcia will be based in New York.  During his tenure as a prosecutor, Garcia supervised the investigation and prosecution of cases involving, among others, Refco, Galleon and Madoff.  On Refco, see “Two Key Levels of Risk Facing Hedge Funds That Buy or Sell Bankruptcy Claims,” Hedge Fund Law Report, Vol. 4, No. 27 (Aug. 12, 2011).  On Galleon, see “Is the ‘Mosaic Theory’ a Viable Defense to Insider Trading Charges Against Hedge Fund Managers Post-Galleon?,” Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).  And on Madoff, see “Two Recent Federal Court Decisions Clarify the Differing Treatment under SIPA of Returned Principal and Fictitious Profits,” Hedge Fund Law Report, Vol. 4, No. 34 (Sep. 29, 2011).

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