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    Sep. 12, 2013

How Can Hedge Fund Managers Structure Their In-House Marketing Activities to Avoid a Broker Registration Requirement?  (Part One of Three)

In-house marketers play a central role in raising and retaining assets for hedge fund managers.  While the role means different things at different firms and even within a firm, the job of an in-house marketer often involves some combination of: directly sourcing investments; indirectly sourcing investments via investment consultants, third-party marketers and others; persuading investors to remain invested, especially during turbulent periods; persuading investors to make follow-on investments; crisis management of various kinds; management of side letter obligations; preparation of investor-facing materials (PPMs, pitchbooks, etc.); coordination of public communications, to the extent permitted by the JOBS Act and otherwise; and more.  Hedge fund managers have asked (usually in hushed tones) whether the activities of in-house marketers require the manager or its marketing department to register as a broker, or require members of the department to register as associated persons of a broker.  For years, there was essentially no regulatory activity on this topic – no enforcement actions or speeches by SEC officials – and many in the industry construed the absence of such activity as tacit approval of typical structures.  See “Is the In-House Marketing Department of a Hedge Fund Manager Required to Register as a Broker?,” Hedge Fund Law Report, Vol. 4, No. 10 (Mar. 18, 2011).  However, an April 5, 2013 speech by David W. Blass, Chief Counsel of the SEC’s Division of Trading and Markets, indicated that regulators are aware of this issue and provided some insight into how the SEC thinks about it.  The Blass speech refocused attention on this issue and highlighted some important questions to ask, but the speech did not provide conclusive answers to the hard practical questions being asked by hedge fund managers.  See “Do In-House Marketing Activities and Investment Banking Services Performed by Private Fund Managers Require Broker Registration?,” Hedge Fund Law Report, Vol. 6, No. 16 (Apr. 18, 2013) (analyzing the Blass speech).  In an effort to move the discussion further along and address important practice points, the Hedge Fund Law Report is publishing a three-part series outlining steps that managers can take to mitigate the risk of triggering a broker registration obligation based on in-house marketing activities.  This article, the first in the series, explores the activities that could trigger a broker registration requirement, as well as other factors that bear on the registration analysis, including the time devoted to marketing by an employee, the employee’s job title and the employee’s other responsibilities.  The second installment will evaluate whether specific types of compensation constitute “transaction-based compensation”; discuss the applicability of the Rule 3a4-1 issuer safe harbor; and advise on how managers can operate in-house marketing activities within the “spirit” of the safe harbor to minimize the risk of triggering a broker registration requirement.  The third installment will examine alternative solutions for managers looking to structure in-house marketing activities in a manner that accomplishes the fundamental business goals (most notably, capital raising) without triggering a broker registration requirement.

How Can Hedge Funds Recoup Overwithholding of Tax on Non-U.S. Source Interest and Dividends?

Many hedge fund managers may be surprised to learn that their funds and investors are overpaying on taxes levied in relation to cross-border investment income earned by their funds.  Foreign governments often withhold taxes on income earned from such investments at higher rates than are delineated in tax treaties because they cannot ascertain the ultimate beneficial owners of such investments.  Nonetheless, the process to recoup such overpayments – dubbed tax reclamation – is complex and varies widely from jurisdiction to jurisdiction.  To help our subscribers understand the benefits, process and intricacies of tax reclamation, the Hedge Fund Law Report recently conducted an interview with Len Lipton, Managing Director at GlobeTax, a tax reclamation services provider.  Specifically, our interview with Lipton covered, among other topics: what tax reclamation is; general steps in the tax reclamation process; statutes of limitations for filing reclaims; the feasibility of self-filing; operational, legal and other challenges fund managers face in the tax reclamation process; the decision whether to self-file or to outsource tax reclamation to a third-party service provider; conducting due diligence on third-party tax reclamation service providers; whether certain fund structures increase tax reclamation challenges; types of information to be disclosed to file a reclaim; whether the type of investor impacts the tax reclamation process and recovery; whether a fund must disclose its portfolio to file for a reclaim; and whether there are regulatory or other drawbacks facing managers pursuing tax reclamation.  This article contains the full transcript of our interview with Lipton.

Understanding the Intricacies for Private Funds of Becoming and Remaining FATCA-Compliant

The Foreign Account Tax Compliance Act (FATCA) heralds a new world order for the disclosure of tax information related to offshore accounts.  FATCA requires Foreign Financial Institutions (FFIs), including offshore private funds, to provide tax information on accounts maintained by specified U.S. persons, recalcitrant investors or nonparticipating financial institutions.  Given the IRS’ unprecedented extraterritorial powers to gather information on FFIs operating as private funds, FATCA will impose tremendous burdens (both in terms of time and cost) on such offshore private funds.  Yet, the law offers little practical guidance on how managers can establish and maintain programs to become and remain FATCA-compliant.  With this in mind, this guest article – authored by Peter Stafford, an Associate Director at DMS Offshore Investment Services – is designed to help offshore private funds identify and address some of the challenges they face in becoming FATCA-compliant.  Among other things, this article, organized in a question and answer format, addresses: the timeline for FATCA compliance; steps necessary to register with the IRS; whether certain funds are exempt from FATCA; the roles and responsibilities of the FATCA Responsible Officer (FRO); who should serve as the FRO; FATCA reporting to regulators; components of an effective FATCA compliance program; effective investor due diligence procedures; FATCA disclosures in fund documents; insurance coverage for and indemnification of the FRO; and allocation of FATCA-related expenses between the fund and the manager.  For more background on FATCA and its obligations, see “What Impact Will FATCA Have on Offshore Hedge Funds and How Should Such Funds Prepare for FATCA Compliance?,” Hedge Fund Law Report, Vol. 6, No. 5 (Feb. 1, 2013).

Certain Hedge Fund Managers Are Moving from Full to Partial Shadowing of Administrator Functions

Since the 2008 financial crisis, hedge fund managers have faced conflicting pressures from investors.  On one hand, heightened pressures on fees have prompted some managers to outsource certain back- and middle-office functions to third-party service providers.  On the other hand, the crisis and concurrent frauds caused investors to demand that managers implement more rigorous controls over fund operations, custody of assets and reporting.  To provide investors an additional level of comfort, managers that outsource delineated functions to administrators typically replicate, or “shadow,” those functions in-house, enabling them to verify the quality of the administrator’s work.  However, this duplication of effort is costly and time-consuming.  Moreover, shadowing may distract managers from effectively performing other essential functions, especially investment management and investor relations.  Consequently, some managers have moved towards “partial shadowing” – monitoring and assuring the quality of certain outsourced work without replicating that work in-house.  A recent panel discussion sponsored by the Regulatory Compliance Association provided an overview of the current climate for administrator shadowing and addressed the pros and cons of a move toward partial shadowing.  This article summarizes the key takeaways from that discussion.

When Are the Personal Legal Disputes of a Hedge Fund Manager Principal “Material” and Therefore Required to Be Disclosed in Fund Offering Documents?

Massachusetts’ highest court, the Supreme Judicial Court (Court), recently handed down a ruling in a case in which Jack Welch, the legendary former CEO of GE, sued the founder of a hedge fund manager after suffering nearly $7 million in losses in one of the manager’s funds.  Welch claimed that the principal failed to disclose his involvement in housing-related litigation that occurred several years before Welch invested in the fund.  Welch claimed he made his investment, nearly all of which he subsequently lost, based in large part on the principal’s character.  Had he known that the principal “had made threats to people and their property, I would have run so far from a character like this, and I would not put a dollar in there.”  The case raises an interesting question recently explored by academics and financial commentators: How relevant are an executive’s personal legal disputes to issues like securities fraud, or, in legal terms, are such personal disputes material to an investor’s consideration of a fund investment?  The Court’s decision sheds some light on this question, which in turn is relevant to investors in hedge funds.  Accordingly, this article summarizes the Court’s decision as well as a New York Times article describing the results of an academic study on whether executives who are willing to violate non-securities laws in their day-to-day lives are more likely to violate securities laws.  For a discussion of materiality in a different but related context, see “Are Hedge Fund Managers Required to Disclose the Existence or Outcome of Regulatory Examinations to Current or Potential Investors?,” Hedge Fund Law Report, Vol. 4, No. 32 (Sep. 16, 2011).

SEC Charges Fund of Private Equity Funds Portfolio Manager with Misleading Investors Concerning Fund Valuation and Performance

The SEC is committed to ferreting out improper valuation practices utilized by private equity fund managers and is willing to initiate action against employees engaged in such misconduct.  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).  Towards this end, on August 20, 2013, the SEC instituted administrative and cease and desist proceedings against a former portfolio manager of a fund of private equity funds.  The SEC generally alleges that the portfolio manager provided fund investors with misleading marketing materials – which misstated the fund’s internal rate of return and improperly valued one of the fund’s investments – and misled fund investors as to his own role in valuing the relevant investment.  The SEC claims that the portfolio manager engaged in fraudulent and deceptive conduct in violation of the federal securities laws.  This article summarizes the SEC’s factual allegations and charges.  For a discussion of valuation best practices and related enforcement issues, see “DLA Piper Hedge Fund Valuation Webinar Covers Fair Value Methodologies, Valuation Services, Valuing Illiquid Positions and Handling Valuation Inquiries During SEC Examinations,” Hedge Fund Law Report, Vol. 6, No. 31 (Aug. 7, 2013); and “WilmerHale and Deloitte Identify Best Legal and Accounting Practices for Hedge Fund Valuation, Fees and Expenses,” Hedge Fund Law Report, Vol. 6, No. 28 (Jul. 18, 2013).

Sidley Austin LLP Adds Investment Funds Lawyers to Its Singapore Office

On September 10, 2013, Sidley Austin LLP announced the expansion of the firm’s Investment Funds practice in Singapore with the addition of Josephine Law, who will serve as counsel; senior associate Joel Seow; and associate Reina Chua.  This group previously worked with new Sidley partner Han Ming Ho, a prominent investment funds lawyer now resident in Sidley’s Singapore office and co-head of the firm’s Asia Investment Funds practice.  See “Structuring, Regulatory and Tax Guidance for Asia-Based Hedge Fund Managers Seeking to Raise Capital from U.S. Investors (Part One of Two),” Hedge Fund Law Report, Vol. 5, No. 31 (Aug. 9, 2012); “Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part Three of Four),” Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).

Walkers Expands Its Presence in Hong Kong

On September 11, 2013, Walkers announced that Mark Cummings has joined the firm as Counsel in its Hong Kong office’s Investment Funds group.  See “How Can Hedge Fund Managers Understand and Navigate the Perils of Insider Trading Regulation and Enforcement in Hong Kong and the People’s Republic of China,” Hedge Fund Law Report, Vol. 6, No. 13 (Mar. 28, 2013).

KPMG Hires Hedge Fund Veteran as Firm Expands Its Alternative Investments Team in the Southeast

KPMG LLP, the U.S. audit, tax and advisory firm, recently hired 30-year industry veteran Michael Cross as director of account relationships as the firm continues to expand its Alternative Investments team serving the Southeast.  See “Survey by AIMA and KPMG Identifies the Key Drivers of the Bifurcation of the Hedge Fund Industry Between Larger and Smaller Managers,” Hedge Fund Law Report, Vol. 5, No. 21 (May 24, 2012).

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