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    Mar. 14, 2013

How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part Two of Three)

Trade errors can prove to be catastrophic for hedge fund managers, particularly where the firm fails to adopt policies, procedures and controls designed to appropriately identify, prevent, detect and handle such errors.  The task of instituting robust trade error practices has been complicated by the lack of significant guidance in this area.  Nonetheless, regulators and investors remain keenly focused on evaluating how hedge fund managers approach trade errors.  With this backdrop, the Hedge Fund Law Report is publishing this second installment in a three-part article series designed to help hedge fund managers understand and navigate the legal, investment and operational challenges presented by trade errors.  This article outlines measures to: prevent trade errors; detect trade errors after they occur; report trade errors once identified; resolve trade errors; and calculate losses resulting from trade errors.  This article also discusses whether soft dollars can be used to correct trade errors.  The first article in this series discussed the challenge of defining a trade error; a manager’s legal obligations relating to the handling of trade errors; and the policies and procedures that managers should consider to prevent, detect, resolve and document trade errors.  See “How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part One of Three),” Hedge Fund Law Report, Vol. 6, No. 10 (Mar. 7, 2013).  The third installment in this series will discuss the allocation of losses and gains resulting from trade errors among a manager and its clients; limitations on the allocation of trade error losses; documentation of trade errors; whether managers can obtain insurance to cover losses resulting from trade errors; and common mistakes managers make in handling trade errors.

Best Practices for Due Diligence by Hedge Fund Managers on Research Providers

Recent high-profile enforcement actions, including that involving Mathew Martoma and CR Intrinsic, an affiliate of SAC Capital, highlight the SEC Division of Enforcement’s continuing commitment to aggressively prosecuting hedge fund insider trading cases.  See “Fund Manager CR Intrinsic and Former SAC Portfolio Manager Are Civilly and Criminally Charged in Alleged ‘Record’ $276 Million Insider Trading Scheme,” Hedge Fund Law Report, Vol. 5, No. 44 (Nov. 21, 2012).  While registered hedge fund managers are required by Rule 206(4)-7 under the Investment Advisers Act of 1940 to adopt policies and procedures reasonably designed to prevent and detect insider trading and other federal securities law violations, it behooves all hedge fund managers (even those that are not registered) to adopt such policies and procedures.  See “Three Recent SEC Orders Demonstrate a Renewed Emphasis on Investment Adviser Compliance Policies and Procedures by the Enforcement Division,” Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).  Many hedge fund managers have recognized the insider trading risks posed by the use of expert network firms and have adopted policies and procedures designed to address these risks.  But other types of research firms also present insider trading and other regulatory risks.  Before using any investment research firm, it is imperative for hedge fund managers to conduct thorough due diligence to appropriately assess and address those risks.  In a guest article, Susan Mathews and Sanford Bragg describe the different types of research providers in the marketplace; the general approach to research provider due diligence; and some best practices for conducting due diligence on research providers.  Bragg is CEO of Integrity Research Associates, LLC, a consulting firm specializing in evaluating investment research providers, including their compliance platforms.  Mathews is Counsel and head of Integrity Research Compliance.

What Critical Issues Must Hedge Fund Managers Understand to Inform Their Preparation of Schedules K-1 for Distribution to Their Investors?

Most hedge funds are taxed as partnerships and therefore pass through items of income, gains and losses to their fund investors, rather than facing taxation on such items at the partnership level.  As a result, hedge fund managers are responsible for preparing and distributing to their investors a Schedule K-1 to Form 1065, which shows an investor’s share of a fund’s income, gains, losses, credits and other items for each tax year that must be reported to the Internal Revenue Service on the investor’s individual income tax return.  Nonetheless, preparation of this schedule can present a litany of challenges which can confound many hedge fund managers.  Moreover, preparation of K-1s cannot be entirely outsourced to an accounting firm; a manager must understand what the accounting firm is doing and be able to evaluate its work.  Recognizing the complexity and importance of this topic, a recent webinar provided a top-level refresher course on the tax considerations that influence the structuring of hedge funds and addressed numerous issues involved in the preparation of Schedule K-1, such as the difference between “trader funds” and “investor funds,” and allocation and adjustment rules that have tax consequences for hedge fund investors.  This article summarizes key takeaways from that program.

Proskauer Partner and SEC Enforcement Division Veteran Ronald Wood Explains the Implications for Hedge Fund Managers of Structure and Staffing Changes at the SEC

In the past few years, the SEC’s Division of Enforcement has refocused its efforts with respect to the investment management industry via structure and staffing.  On the structuring side, the Division of Enforcement has established specialized units, such as the Asset Management Unit, devoted to addressing investor and systemic risks raised by private funds and their managers.  On the staffing side, the Division of Enforcement has hired investment management industry professionals – including hedge fund managers, analysts, operating professionals and due diligence experts – to staff these units.  With this new-found expertise, SEC staff not only “know where the bodies are buried,” but also “understand how they got there,” according to Bruce Karpati, Chief of the Asset Management Unit.  See “OCIE Director Carlo di Florio and Asset Management Unit Chief Bruce Karpati Address Examination and Enforcement Priorities for Hedge Fund Managers,” Hedge Fund Law Report, Vol. 6, No. 4 (Jan. 24, 2013).  On the foundation of its new expertise, the Division of Enforcement initiated 147 enforcement actions against investment advisers and investment companies in fiscal year 2012.  To provide deeper insight and actionable analysis on what the structuring and staffing changes at the Division of Enforcement mean for hedge fund managers, the Hedge Fund Law Report recently interviewed Ronald Wood.  Wood is a partner in the Securities Litigation Group at Proskauer Rose LLP, and prior to Proskauer spent a decade in the Division of Enforcement.  Our interview covered topics including SEC enforcement priorities; the use of reports filed with the SEC to identify enforcement targets; the SEC’s aberrational performance initiative; insider trading best practices; paid access to corporate executives; track record portability; due diligence on Chinese companies; pay to play issues; “big boy” letters; and FCPA concerns for hedge fund managers.  This article contains the transcript of our interview with Wood.  This interview was conducted in connection with the Regulatory Compliance Association’s upcoming Regulation, Operations & Compliance 2013 Symposium, to be held at the Pierre Hotel in New York City on April 18, 2013.  That Symposium is scheduled to include a panel entitled “Post SAC Capital – Investigation, Enforcement & Prosecution of Hedge & PE Managers.”  Subscribers to the Hedge Fund Law Report are eligible for a registration discount.

Credit Suisse Survey Reveals Allocation Preferences of Hedge Fund Investors, With Particular Attention on Preferences of Pension Funds and Insurance Companies

Credit Suisse AG recently released a survey covering institutional investor strategy and allocation preferences and return expectations for this year, as well as investors’ perspectives on topics such as fund fees, perceived risks and manager start-ups.  The survey focused in particular on the perspectives of pension funds and insurance companies, because those investors are a primary source of growth in hedge fund assets under management.  This article summarizes key findings from that survey.

U.K. Tax Tribunal Overturns Hedge Fund Manager’s Attempt to Avoid Tax on Hedge Fund Profits through the Acquisition and Disposition of Film Distribution Rights

On February 13, 2013, a U.K. tax tribunal (Tribunal) overturned a tax avoidance scheme in which a prominent hedge fund manager attempted to create artificial losses through the acquisition and disposition of film distribution rights to shelter millions of pounds in personal income generated from his hedge fund.  This case is the latest victory for Her Majesty’s Revenue and Customs in its recent vigorous enforcement against aggressive tax avoidance schemes by hedge fund managers.  See “U.K. Hedge Fund Manager Taxed on Bonuses Delivered Through Tax-Avoidance Scheme,” Hedge Fund Law Report, Vol. 5, No. 34 (Sep. 6, 2012).  This article summarizes the Tribunal’s factual findings and legal analysis in this case.

Dechert Boosts Middle East Financial Services Practice with National Partner Hire

On March 12, 2013, Dechert LLP announced that Jacques Visser has joined the firm’s financial services and investment management group as a national partner in Dubai.  For insight from Dechert partners, see “Rajaratnam Prosecutor and Dechert Partner Jonathan Streeter Discusses How the Government Builds and Prosecutes an Insider Trading Case against a Hedge Fund Manager,” Hedge Fund Law Report, Vol. 5, No. 45 (Nov. 29, 2012); and “Navigating the Patchwork of Global Insider Trading Regulations: An Interview with Adam Wasserman of Dechert,” Hedge Fund Law Report, Vol. 5, No. 38 (Oct. 4, 2012).

Hedge Fund Industry Operating Veteran Robert Shustak Joins Untracht Early, LLC

Robert Shustak has been appointed in a senior advisory capacity to accounting firm Untracht Early, LLC on a part-time basis, effective March 12, 2013.

Warshaw Burstein Welcomes Financial Institutions and Investment Management Partner Meryl E. Wiener

Meryl E. Wiener recently joined Warshaw Burstein, LLP as a partner.  Having moved from Katten Muchin Rosenman LLP, Wiener will continue her practice advising financial institutions, investment managers and hedge funds on a broad range of regulatory, compliance, securities, registration, inspection, enforcement, organizational and structuring matters.

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