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    Aug. 22, 2013

How Can Emerging Managers Raise Institutional Capital While Avoiding Regulatory Pitfalls?

The current capital-raising and regulatory environments are challenging for all hedge fund managers, but particularly for emerging managers.  Institutional investors expect institutional quality infrastructure at the managers to which they allocate capital – and those expectations are not materially adjusted or abridged for manager size.  Start-up and emerging managers therefore face considerable obstacles to entry: they have to build institutional operations before having institutional cash flows.  Accordingly, third-party capital is increasingly perceived as necessary to starting a management company, though not sufficient.  Sufficiency requires more these days – a brand, an identifiable competitive advantage, a coherent strategy and other attributes.  An event recently hosted by the law firm Herrick, Feinstein LLP – which included participants from third-party capital providers, administrators and other service providers, in addition to Herrick partners – focused on the challenges facing emerging managers and identified solutions to many of those challenges.  In particular, the event highlighted strategies for marketing by emerging managers to institutional investors; manager selection criteria employed by institutional investors; methods whereby emerging managers may enhance their operating and compliance systems; and regulatory hurdles that emerging managers must surmount.  This article highlights the pertinent points raised at the event.  See also “SEI Study Offers a Reality Check to Hedge Fund Managers on What Actually Works When Marketing to Institutional Investors,” Hedge Fund Law Report, Vol. 6, No.15 (Apr. 11, 2013).

How Can Hedge Fund Managers Use Profits Interests, Capital Interests, Options and Phantom Income to Incentivize Top Portfolio Management and Other Talent?

The competition for key talent among hedge fund managers is fierce, and many have resorted to offering their key employees a stake in the manager’s business to attract the best and the brightest.  “Equity” compensation has become so prevalent that more than one-quarter of hedge fund manager employees have reported owning an equity interest in their firms.  See “Hedge Fund Manager Compensation Survey Addresses Employee Compensation Levels and Composition Across Job Titles and Firm Characteristics, Employee Ownership of Manager Equity and Hiring Trends,” Hedge Fund Law Report, Vol. 6, No. 8 (Feb. 21, 2013).  The forms of equity compensation that hedge fund managers can offer include profits interests, capital interests, options and phantom income in the firm.  Each of these options has economic and other ramifications, both for the offering firm and the offeree.  A recent program provided an overview of the various forms of equity participation that a hedge fund manager can offer its personnel.  Among other things, the panelists discussed the intricacies of profits interests; the current status of carried interest legislation; four different types of equity compensation that managers can offer personnel (including profits interests, capital interests, options and phantom income); tax consequences of becoming a “partner” as a result of the receipt of equity participation in the firm; and the applicability of Section 409A of the Internal Revenue Code to various forms of equity compensation offered by managers.  This article summarizes the key takeaways from the program.

Important Implications and Recommendations for Hedge Fund Managers in the Aftermath of the SEC’s Settlement with Philip A. Falcone and Harbinger Entities

A new era in SEC enforcement has begun.  On August 19, 2013, Philip A. Falcone, Harbinger Capital Partners LLC (Harbinger) and other Harbinger entities agreed to a consent settling SEC charges.  The charges related to: (1) an improper loan effected between Falcone and the Harbinger Capital Partners Special Situations Fund; (2) improper arrangements between Falcone, Harbinger Capital Partners Fund I and various large fund investors that provided such investors with undisclosed preferential redemption terms; and (3) improper trading in the distressed high yield bonds issued by Canadian manufacturing company MAAX Holdings, Inc.  The groundbreaking settlement affirms the SEC’s commitment to extracting admissions of wrongdoing as a condition of settlement in select cases involving egregious conduct or significant harm to investors, which stands in direct contrast to its previous policy of allowing defendants to “neither admit nor deny the charges” in settlement agreements.  The settlement has broad implications for hedge fund managers, and it behooves such managers to understand how to address such issues.  This article describes the facts as admitted by the defendants; outlines the sanctions agreed to by the defendants; highlights important issues that hedge fund managers must address in light of the settlement agreement and the SEC’s new settlement policy; and provides practical recommendations for addressing such issues.  For a discussion of the SEC’s enforcement action initiated against the defendants, 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).

Recent SEC Settlement Clarifies the Scope of Supervisory Liability for Chief Compliance Officers of Hedge Fund Managers

For hedge fund manager general counsels (GCs) or chief compliance officers (CCOs) – or persons serving in both roles simultaneously – the prospect of liability for supervisory failures is real and frightening.  Two factors in particular make this a perilous area for GCs and CCOs: ambiguities in the caselaw mixed with the limited decision-making authority typically associated with the roles – a state of affairs that some view as overweight on downside and underweight on upside.  One of the more productive prophylactic measures that professionals can take in the area of GC and CCO supervisory liability is developing a real command of the handful of cases addressing the topic – understanding the facts, and how regulators and courts have applied relevant law and regulation to the facts.  A recent SEC settlement is instructive in this regard, taking its place among the narrow but important group of matters focused on CCO supervisory liability.  In the matter, the SEC alleged that the CCO of an investment advisory firm failed reasonably to supervise a rogue employee – and thereby violated the Investment Advisers Act of 1940 – by failing reasonably to implement the firm’s policies relating to custody, transaction reviews, books and records, e-mail and annual office audits.  This article provides a deeper discussion of the facts of the matter, the SEC’s legal claims and the terms of the settlement.  For articles discussing other matters in this genre, see “Scope of Supervisory Liability of Senior Legal and Compliance Professionals at Hedge Fund Managers Remains Uncertain after SEC Dismissal of Urban Action,” Hedge Fund Law Report, Vol. 5, No. 5 (Feb. 2, 2012); “FSA Imposes Fine and Statutory Ban on Compliance Officer of Investment Advisory Firm for Failure to Safeguard Client Assets,” Hedge Fund Law Report, Vol. 5, No. 20 (May 17, 2012); and “SEC Administrative Law Judge Holds that a Broker-Dealer’s General Counsel Could Be Held Liable as a Supervisor of a Financial Adviser Over Whom He Had No Actual Supervisory Authority,” Hedge Fund Law Report, Vol. 3, No. 42 (Oct. 29, 2010).

How Can Hedge Fund Managers “Manuscript” D&O and E&O Insurance Policies to Broaden Coverage without Increasing Cost?

Unbeknownst to an alarmingly high proportion of hedge fund managers, directors and officers (D&O) and errors and omissions (E&O) insurance contracts are not adhesion contracts.  Rather, from the perspective of insurers, such contracts are up for negotiation – or “manuscripting,” in insurance industry lingo.  Hedge fund managers accordingly have the ability – and arguably in light of their fiduciary duties, the obligation – to negotiate for the best D&O and E&O policy language possible.  (This presumes that managers have such types of insurance in the first instance, which they almost invariably should.  See “Hedge Fund D&O Insurance: Purpose, Structure, Pricing, Covered Claims and Allocation of Premiums Among Funds and Management Entities,” Hedge Fund Law Report, Vol. 4, No. 41 (Nov. 17, 2011).)  In a guest article, Mark Dellecave and Ray Santiago, both experienced insurance professionals at Willis, identify some of the key D&O and E&O policy terms that managers should endeavor to manuscript, and offer guidance on negotiating and manuscripting those terms.  Having gone through the manuscripting process with hedge fund industry participants, Dellecave and Santiago know the pressure points, and the preferences of insurers; and this article embodies their market color.  In addition, the authors provide guidance on selecting the most appropriate D&O and E&O carriers, and the right categories of coverage.

SEC’s Corporation Finance Chief Counsel Thomas Kim Joins Sidley in D.C.

On August 8, 2013, Sidley Austin LLP announced that Thomas J. Kim, the Chief Counsel and Associate Director of the SEC’s Division of Corporation Finance since 2007, is joining the firm as a partner.  For analysis from Sidley, 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).

Jane Jarcho Named Head of SEC’s Investment Adviser/Investment Company Examination Program

On August 20, 2013, the SEC announced that Jane E. Jarcho has been named the National Associate Director of the Investment Adviser/Investment Company examination program in the Office of Compliance Inspections and Examinations.  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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