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    Apr. 4, 2013

Can Hedge Fund Managers Contract Out Of Default Fiduciary Duties When Drafting Delaware Hedge Fund and Management Company Documents?

Most hedge funds and their management entities are organized as Delaware limited liability companies (LLCs) or limited partnerships (LPs).  By statute, the members or partners (partners) of these entities are given “maximum flexibility” to define their respective rights and obligations in the entity’s operating agreement or partnership agreement.  Despite this clearly announced statutory policy favoring freedom of contract, Delaware courts also have developed a body of corporate-style fiduciary duties that prescribe and measure the conduct of the partners of Delaware LPs and LLCs.   The tension between the partners’ contractual rights and obligations, on the one hand, and their fiduciary duties, if any, on the other, is a common and important theme running through the caselaw.  Late last year, the Delaware Supreme Court issued an opinion that sheds new light on the important relationship between contractual and fiduciary duties, and that highlights once again the need for a cautious, detail-oriented approach to negotiating and drafting the agreements that govern hedge funds and their management entities.  That opinion and other recent decisions by Delaware courts raise a number of important questions for practitioners who regularly advise or litigate on behalf of hedge funds and their principals.  In a guest article, Sean R. O’Brien and Sara A. Welch, Managing Partner and Counsel, respectively, at O’Brien LLP, analyze these developments and provide practical guidance to assist practitioners in drafting and reviewing LLC and LP agreements.

Former Deputy U.S. Attorney and WilmerHale Partner Boyd M. Johnson III Addresses Risk Management Imperatives for Hedge Fund Managers: Insider Trading, Defense Strategy, Crisis Management, Money Laundering, Cyber Security and Tax Shelters

Risk plays a different role in investments and operations.  In investments, as a general matter, returns are broadly correlated with risk.  In operations, on the other hand, quality tends to be inversely related with risk; there is no greater upside potential from increased operational risk, just a greater likelihood of fundamental error.  At the same time, operational risk is generally more dangerous to hedge fund managers than investment risk.  Investors understand that generating returns inevitably involves mistakes, but operational failures call into question a manager’s basic competence as a steward of capital.  Managing and mitigating operational risk are thus increasingly critical aspects of the hedge fund business.  But doing so is easier said than done.  In the first instance, it is challenging to identify the full range of operational risks facing a manager.  There is a group of usual suspects, but the less obvious and more insidious risks are unique to a manager’s strategy and operations.  Once risks are identified, best practices for addressing risks are hard to come by.  In an effort to assist hedge fund managers on both counts – identifying relevant risks and deciding what to do about them – the Hedge Fund Law Report recently interviewed Boyd M. Johnson III, a partner in the Litigation/Controversy Department and member of the Investigations and Criminal Litigation Practice Group and the Business Trial Group at WilmerHale.  Prior to joining WilmerHale, Johnson served as Deputy U.S. Attorney in the Southern District of New York with supervisory authority over 230 Assistant U.S. Attorneys.  As Deputy U.S. Attorney, Johnson managed the largest crackdown on Wall Street insider trading in history, including the prosecution of Raj Rajaratnam of the Galleon Group; criminal prosecutions and civil forfeiture proceedings related to the Bernard Madoff fraud; the investigation and prosecution of individuals and entities responsible for structuring and promoting international tax shelters; and numerous cyber security and other investigations.  For our interviews with other leading prosecutors in the Rajaratnam insider trading case, see “Former Rajaratnam Prosecutor Reed Brodsky Discusses the Application of Insider Trading Doctrine to Hedge Fund Research and Trading Practices,” Hedge Fund Law Report, Vol. 6, No. 13 (Mar. 28, 2013); and “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).  The bulk of our interview with Johnson covered various aspects of insider trading – not surprising, given that insider trading remains primus inter pares among the various risks faced by managers in many strategies.  Specifically, with respect to insider trading, we discussed with Johnson: challenges in defending simultaneous civil and criminal insider trading actions; challenges in coordinating defenses to insider trading charges levied by multiple jurisdictions; considerations in evaluating an insider trading plea deal; strategies for obtaining prosecutorial leniency in insider trading cases; addressing insider trading risks from communications among investment professionals at different managers; maximizing the effectiveness of insider trading training; insider trading crisis management; and strategies for documenting findings from insider trading internal investigations.  Beyond insider trading, we also covered: anti-money laundering and cyber security risks confronting managers; identifying risky tax shelter pitches; and navigating fraud risks in healthcare investing.  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 covering government investigation and prosecution of hedge fund and private equity fund managers entitled “Post SAC Capital – Investigation, Enforcement & Prosecution of Hedge & PE Managers.”  Subscribers to the Hedge Fund Law Report are eligible for a registration discount.

How Can Private Fund Managers Use Subscription Credit Facilities to Enhance Fund Liquidity?

Private fund managers, particularly private equity and real estate fund managers, desire enhanced fund liquidity for various reasons, notably including the ability to act on attractive investments that require immediate action.  However, the time lag involved in having to wait for investors to fund capital calls can potentially close the door on a prospective investment opportunity.  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).  To plug such funding gaps, some lenders offer subscription credit facilities, which provide revolving lines of credit – which are typically secured by investors’ capital commitments – to fund a private fund’s investment activities.  To help private fund managers understand the subscription credit facility landscape, law firms Mayer Brown LLP and Appleby recently hosted the Third Annual Subscription Credit Facilities Symposium.  Participants at the Symposium discussed the mechanics of subscription credit facilities; why subscription credit facilities are attractive; the market for terms of subscription credit facilities; and what documentation is required for a subscription credit facility.  This article highlights the salient takeaways from the Symposium.

Why and How Do Corporate and Government Pension Plans, Endowments and Foundations Invest in Hedge Funds?

A growing proportion of the capital flowing into hedge funds is coming from institutional investors.  Therefore, hedge fund managers looking to raise capital effectively must understand the financial condition, motivations and allocation preferences of different institutional players.  To help hedge fund managers develop and refine such an understanding, we have recently published a series of articles on institutional investor investment preferences, each focusing on a different category of investor.  The first article in the series focused on family offices.  See “Why and How Do Family Offices and Foundations Invest in Hedge Funds?,” Hedge Fund Law Report, Vol. 6, No. 1 (Jan. 3, 2013).  The second article in the series focused on sovereign wealth funds.  See “Why and How Do Sovereign Wealth Funds Invest in Hedge Funds?,” Hedge Fund Law Report, Vol. 6, No. 13 (Mar. 28, 2013).  This article, as the title implies, focuses on corporate and government pension plans, endowments and foundations.  See also “The Four P’s of Marketing by Hedge Fund Managers to Pension Plan Managers in the Post-Placement Agent Era: Philosophy, Process, People and Performance,” Hedge Fund Law Report, Vol. 2, No. 45 (Nov. 11, 2009).

Four Recommendations to Help Private Equity Fund Managers Reduce the Risk of Conveying Misleading Valuation Information to Prospective and Existing Investors

The SEC has recently followed through on warnings that it would specifically target improper valuation practices employed by private equity fund managers.  See “SEC Asset Management Unit Chief Bruce Karpati Addresses Private Equity Enforcement Trends, Initiatives and Priorities,” Hedge Fund Law Report, Vol. 6, No. 6 (Feb. 7, 2013).  The SEC recently entered into a settlement with two affiliated managers of a fund of private equity funds after charging both managers with misleading prospective and existing investors concerning the valuation of a private equity fund of funds that they managed and concerning the practices used to value the fund’s assets.  In light of this enforcement action and the SEC’s stepped-up efforts to target private fund managers for enforcement activity, managers should proactively review their compliance policies and practices as a whole, and specifically those relating to valuation of fund assets.  See “SEC’s OCIE Director, Carlo di Florio, Discusses Examination Strategies and Expectations for Impending Examinations of Private Equity Advisers,” Hedge Fund Law Report, Vol. 5, No. 19 (May 10, 2012).  This article summarizes the SEC’s factual and legal allegations as well as the terms of the settlement with the managers.  This article also makes four important recommendations to assist private equity managers in avoiding the improper valuation practices that were the subject of this enforcement action.

NFA Adopts Rule Permitting Certain Loans from Commodity Pools to Commodity Pool Operators and Their Affiliates

Hedge fund managers that take personal loans from their hedge funds without the authority to do so, or without full disclosure of such loan arrangements, can trigger enforcement activity from regulators.  For a discussion of such an action, see “SEC Charges Philip A. Falcone, Harbinger Capital Partners and Related Entities and Individuals with Misappropriation of Client Assets, Granting of Preferential Redemptions and Market Manipulation,” Hedge Fund Law Report, Vol. 5, No. 26 (Jun. 28, 2012).  Such loans can also trigger rule violations, depending on the circumstances.  Since 2009, commodity pool operators (CPOs) that are registered or required to register as such with the U.S. Commodity Futures Trading Commission and become members of the National Futures Association (NFA) have been subject to NFA Rule 2-45 (Rule), which generally prohibits CPOs from permitting the commodity pools (pools) they operate to make loans or advances to the CPO or any affiliated person or entity, which can include other pools operated by the CPO.  In response to concerns raised by prospective CPO registrants who, in the ordinary course of their business, regularly effect transactions (such as repurchase agreements and securities lending transactions) with and among pools they operate “that have characteristics similar to a loan” and that may be deemed to be impermissible loans or advances from the pool to the CPO, the NFA recently amended Rule 2-45 to except certain delineated transactions from the Rule’s coverage.  This article summarizes the changes to the Rule adopted by the NFA, including a discussion of the specific types of transactions that are no longer prohibited by the Rule.  For a discussion of considerations for loan transactions between a hedge fund manager and its funds, see “Key Legal Considerations in Connection with Loans from Hedge Funds to Hedge Fund Managers,” Hedge Fund Law Report, Vol. 3, No. 28 (Jul. 15, 2010).

Schulte Roth & Zabel Adds Leading European Restructuring Partners to London Office

On April 2, 2013, Schulte Roth & Zabel announced the expansion of its London office with the addition of partners Peter J.M. Declercq and Sonya Van de Graaff to the business reorganisation practice.  For insight from SRZ on European restructurings, see, “The Impact of Asymmetric Information, Trade Documentation, Form of Transfer and Additional Terms of Trade on Hedge Funds’ Trade Risk in European Secondary Loans (Part Two of Two),” Hedge Fund Law Report, Vol. 4, No. 38 (Oct. 27, 2011).

Leading SEC Enforcement and Regulatory Practice to Join Sidley Austin LLP

On April 2, 2013, Sidley Austin LLP announced that a group of 11 lawyers – ten partners and one counsel – will be joining the firm in multiple offices, including New York and Washington, D.C.  For analysis from Sidley recently published in the HFLR, see “How Can Hedge Fund Managers Understand Recent SEC Developments to Mitigate Enforcement Risk?,” Hedge Fund Law Report, Vol. 6, No. 8 (Feb. 21, 2013).

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