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    May 9, 2013

How Should Hedge Fund Managers Approach the Allocation of Expenses Among Their Firms and Their Funds? (Part Two of Two)

For hedge fund managers, how to allocate expenses among their management entities and their funds is a high-stakes and challenging topic for at least five reasons.  First, the quantity and variety of expenses involved in operating a hedge fund management business have increased dramatically in recent years, thanks in large part to recent regulation.  Second, there is little regulatory guidance on best practices for expense allocations.  Third, institutional investors are bringing a stricter level of scrutiny to bear on expense allocations.  Fourth, it is difficult to ascertain how other managers are treating similar expenses.  Fifth, as explained more fully below, there are trends afoot in hedge fund disclosure documents that raise the stakes in this area.  In short, allocation of expenses is a classic hard question for hedge fund managers.  This article – the second in a two-part series – tackles some of the thorniest sub-issues head-on.  In particular, this article discusses expense allocation methodologies and practices actually used by hedge fund managers, and the rationales for their use; challenges associated with disclosure of expense allocation practices; approaches for handling allocation of expenses when disclosures are ambiguous or silent with respect to specific expenses; best practices in this area; and the appropriate role of independent boards, advisory committees and service providers in reviewing a manager’s expense allocation policies or decisions.  The first article in this series provided an overview of the key issues and challenges inherent in allocation decisions, and outlined various regulatory and other concerns posed by allocation practices.  See “How Should Hedge Fund Managers Approach the Allocation of Expenses Among Their Firms and Their Funds? (Part One of Two),” Hedge Fund Law Report, Vol. 6, No. 18 (May 2, 2013).

ACA Compliance Group Survey Provides Benchmarks for a Range of Hedge Fund Manager Compliance Functions, Including Dual-Hatting, Annual Compliance Reviews, Forensic Testing, Custody, Fees and Signature Authority

On April 16, 2013, ACA Compliance Group hosted a webinar in which it discussed findings from its recent survey of hedge and private equity fund managers regarding annual compliance reviews, forensic testing, risk management, custody, safeguarding of client assets, fee calculations and resources dedicated to compliance.  This article summarizes the survey findings and the practical takeaways from those findings as communicated by ACA in the course of the webinar.

What Measures Can Hedge Fund Managers Take to Prevent Employees from Forging Checks to Steal Assets from Client Accounts?

The SEC recently entered into a settlement order with a private fund manager that was accused of: failing to supervise an employee that forged checks to misappropriate assets from fund investors; engaging in violations of the custody rule (Rule 206(4)-2 under the Investment Advisers Act of 1940); and failing to have policies and procedures reasonably designed to prevent violations of the custody rule.  See “How Does the SEC Approach Custody Issues in the Course of Examinations of Hedge Fund Managers?,” Hedge Fund Law Report, Vol. 5, No. 18 (May 3, 2012).  This settlement is important for several reasons.  First, it highlights the dangers of failing to implement proper controls with respect to signing authority over client accounts.  See also, on this topic, “Ten Steps That Hedge Fund Managers Can Take to Avoid Improper Transfers among Funds and Accounts,” Hedge Fund Law Report, Vol. 4, No. 13 (Apr. 21, 2011).  Second, it represents one of the most prominent actions initiated against a private fund manager for a custody rule violation.  Additionally, the settlement sheds light on the SEC’s current approach to the imposition of sanctions against an investment adviser where the respondent self-reports violations to the staff and cooperates with the staff in its investigation.  For a discussion of another enforcement action in the private funds context involving self-reporting, see “SEC Enforcement Action Against a Private Equity Fund Manager Partner Calls into Question the Value of Self-Reporting in the Private Funds Context,” Hedge Fund Law Report, Vol. 4, No. 36 (Oct. 13, 2011).  This article describes the factual background, legal violations and sanctions in this case.  This article also offers several recommendations to reduce the risk of employee misappropriation of fund assets in similar situations.

Rothstein Kass 2013 Hedge Fund Outlook Highlights Managers’ Perspectives on Performance and Economic Trends, Leverage, Capital Raising Strategies, Due Diligence, Staffing, Operational Changes and Regulatory Concerns

International services firm Rothstein Kass recently released a report detailing findings from its survey of 358 professionals at hedge fund managers regarding performance and economic outlook, use of leverage, capital raising concerns and strategies (including seed deals, use of separately managed accounts and fee breaks), investor due diligence, staffing issues and regulatory priorities.  This article summarizes the key takeaways from the survey.  For an article summarizing the 2012 version of this annual Rothstein Kass report, see “Rothstein Kass Report Discusses Marketing, Structuring, Tax, Leverage, Due Diligence, Hiring and Other Dominant Concerns for Hedge Fund Managers in a Competitive Capital Raising Environment,” Hedge Fund Law Report, Vol. 5, No. 22 (May 31, 2012).

U.S. District Court Interprets Extraterritorial Reach of Commodities Exchange Act in Private Lawsuits

Longstanding precedent has held that the Commodity Exchange Act (CEA) does not apply “extraterritorially.”  However, what constitutes “domestic” conduct has been the subject of much recent debate.  In 2010, in Morrison v. National Australia Bank, the U.S. Supreme Court overturned longstanding precedent and established a “transactional” test for determining the extraterritorial reach of the Securities Exchange Act of 1934.  Then, in 2012, in Absolute Activist Master Value Fund v. Ficeto, the U.S. Court of Appeals for the Second Circuit provided specific guidance on when securities transactions would be considered “domestic.”  See “Second Circuit Clarifies When Offshore Hedge Funds Can Make Section 10(b) Securities Fraud Claims in Connection with ‘Domestic Transactions’ with Conduct and Effects in the United States,” Hedge Fund Law Report, Vol. 5, No. 11 (Mar. 16, 2012); and “Update: Are There Still Avenues for Recovery in United States Courts for Overseas Hedge Fund Losses After Morrison v. National Australia Bank Ltd.?,” Hedge Fund Law Report, Vol. 3, No. 27 (Jul. 8, 2010).  The U.S. District Court for the Southern District of New York recently considered whether the “transactional” test in Morrison also applies to a private suit for fraud perpetrated in a non-U.S. fund brought under the CEA.  This article summarizes the Court’s decision and reasoning in this action.  See also “Does the U.S. Commodity Exchange Act Apply to Investments in Non-U.S. Commodity Funds?,” Hedge Fund Law Report, Vol. 6, No. 15 (Apr. 11, 2013).

Sidley Austin Ramps Up Singapore Practice with Addition of Gregory Salathé

On May 6, 2013, Sidley Austin LLP announced that Gregory Salathé has joined the firm as a partner.  He will reside in Sidley’s Singapore office after a transition period in Tokyo.  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).

Cayman Director Services Company Challenges CIMA’s Private Sector Consultation Process to Promote Fund Governance Reforms

On April 2, 2013, Cayman Private Manager II Limited (CPM), a Cayman director services company and an affiliate of DMS Group, which provides professional directors for many hedge funds and other private funds, filed an application in the Grand Court of the Cayman Islands.  The application sought leave to apply for judicial review of its request for relief based on its allegations that the private sector consultation process used by the Cayman Islands Monetary Authority (CIMA) to reform private fund governance was flawed because CIMA did not satisfy its legal obligations with respect to the consultation process.  The allegations arise out of CIMA’s publication of a consultation paper (Consultation Paper) on January 14, 2013 that outlined various proposed fund governance reforms that will invariably impact Cayman-domiciled hedge funds and other private funds.  For an in-depth discussion of CIMA’s proposed reforms described in the Consultation Paper, see “Cayman Islands Monetary Authority Introduces Proposals to Apply Revised Governance Standards to CIMA-Regulated Hedge Funds and Require Registration and Licensing of Fund Directors,” Hedge Fund Law Report, Vol. 6, No. 4 (Jan. 24, 2013).  If the Court grants CPM leave to apply for judicial review, this could delay any decision-making by CIMA on its corporate governance reform proposals.  This article provides a summary of CPM’s allegations as well as a description of the requested relief.

Andrew Nagel Joins Mintz Levin’s New York Corporate Practice

On May 6, 2013, Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. announced the expansion of its New York Corporate & Securities Section with the addition of Andrew Nagel, who joins as a Member.  For analysis from Mintz Levin recently published in the HFLR, see “How Can Hedge Fund Managers Identify and Navigate Pitfalls Associated with the JOBS Act’s Rollback of the Ban on General Solicitation and Advertising?,” Hedge Fund Law Report, Vol. 6, No. 10 (Mar. 7, 2013).

SEC Names Andrew Bowden Director of OCIE and Leader of the National Exam Program

On May 2, 2013, The Securities and Exchange Commission announced that Andrew J. Bowden has been named Director of the agency’s Office of Compliance Inspections and Examinations and will lead its National Exam Program.  The National Exam Program conducts inspections and examinations of SEC-registered investment advisers, investment companies, broker-dealers, self-regulatory organizations, clearing agencies and transfer agents.  See “Is This an Inspection or an Investigation? The Blurring Line Between Examinations of and Enforcement Actions Against Private Fund Managers,” Hedge Fund Law Report, Vol. 5, No. 13 (Mar. 29, 2012).

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