• |

    Oct. 11, 2013

Why and How Should Hedge Fund Managers Conduct Background Checks on Prospective Employees? (Part Two of Three)

This is the second article in our three-part series on employee background checks in the hedge fund industry.  The occasion for this series is a growing recognition in the industry that people can be either the best asset of a manager or a manager’s worst liability.  The potential value of people is implicit in the impressive returns of some managers; the road of good returns invariably leads back to human insight.  And – less pleasantly – the industry graveyard is littered with management companies laid low by human foibles rather than investment mistakes.  See, e.g., “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).  How can managers obtain the data necessary to identify aspects of a prospective employee’s background that are or may become problematic?  The high-level answer is: By conducting background checks.  But since a background check is a capacious concept – covering everything from a Google search to a private investigation – managers can benefit from more detail on the topic.  This series is designed to provide that detail.  In particular, the first article in this series outlined the case for conducting background checks, cataloging the wide range of regulatory and other risks presented by employees (including discussions of insider trading, Rule 506(d), pay to play, track record portability, restrictive covenants and other topics).  See “Why and How Should Hedge Fund Managers Conduct Background Checks on Prospective Employees? (Part One of Three),” Hedge Fund Law Report, Vol. 6, No. 38 (Oct. 3, 2013).  This article discusses the mechanics of conducting a background check, including four specific activities that managers or their service providers should undertake; identifies three common mistakes made by hedge fund managers in conducting background checks; and details four legal risks in conducting background checks.  The final article in this series will weigh the benefits and burdens of outsourcing background checks versus conducting them in-house.

How Can Hedge Fund Managers Negotiate the Structuring, Operational and Due Diligence Challenges Posed by the Bad Actor Disqualification Provisions of Rule 506(d)?

Generally, rulemaking under the JOBS Act has relaxed decades-old restrictions on marketing by hedge fund managers.  See “A Compilation of Important Insights from Leading Law Firm Memoranda on the Implications of the JOBS Act Rulemaking for Hedge Fund Managers,” Hedge Fund Law Report, Vol. 6, No. 30 (Aug. 1, 2013).  However, the JOBS Act rulemaking also added a new subsection (d) to Rule 506, which generally prohibits “bad actors” from accessing the expanded marketing rights under the JOBS Act.  Specifically, Rule 506(c) allows hedge fund managers to engage in general solicitation and advertising, but Rule 506(d) provides that hedge funds may not offer securities in reliance on Rule 506 if covered persons associated with the hedge fund (including the manager, distributors and certain investors, officers and directors) have engaged in specified misconduct.  See “SEC JOBS Act Rulemaking Creates Opportunities and Potential Burdens for Hedge Funds Contemplating General Solicitation and Advertising,” Hedge Fund Law Report, Vol. 6, No. 28 (Jul. 18, 2013).  For hedge fund managers that wish to partake of the expanded marketing opportunities offered by the JOBS Act, Rule 506(d) creates structuring, operational and due diligence challenges.  Some of those challenges are obvious from the face of the rule, for example, identifying covered persons within the management company.  Other challenges are less obvious but no less important.  For example, under what circumstances, if any, can sub-advisers or fund of funds investors constitute covered persons?  When and how should managers conduct a covered person analysis on their range of relationships?  How does Rule 506(d) interact with the manager’s hiring program?  Does the bad actor disqualification regime impact the negotiation of settlement agreements with the SEC and CFTC?  To address these and other challenging issues raised by Rule 506(d), the Hedge Fund Law Report recently interviewed Rory Cohen, currently a partner at Mayer Brown, formerly a managing director at Bear Stearns, and a practitioner with decades of experience in hedge fund and broker-dealer law, regulation and operations.  Our interview with Cohen – the full transcript of which is included in this article – was conducted in connection with the Regulatory Compliance Association’s upcoming Compliance, Risk & Enforcement 2013 Symposium, to be held at the Pierre Hotel in New York City on October 31, 2013. Subscribers to the Hedge Fund Law Report are eligible for a registration discount.

Can an Investor Who Invests Through a Nominee Shareholder in a Cayman Islands Hedge Fund Rely on a Side Letter To Which Its Nominee Is Not a Party?

It is a fundamental rule of common law legal systems that, absent statutory intervention, a person who is not a party to a contract, even if the contract is made for that party’s benefit, cannot rely on or enforce the terms of that contract; this is the so-called “privity of contract” rule.   Its origins lie in the common law’s centuries old regard for the notion of bargain, whereby only a party who himself contributes value to an agreement can enforce it, in preference to regard for the intentions of the parties that a third party should benefit.  Many jurisdictions provide a statutory entitlement for a third party to a contract made for its benefit to enforce the benefit of that contract, subject to conditions.  The Cayman Islands have, as yet, no such legislation.  The current position, accordingly, gives rise to issues of the enforceability of side letters between a Cayman Islands fund and an underlying investor who invests through a nominee shareholder, and recent cases reveal a sharp divergence of judicial view – should the court hold the investor to the legal structure it has set up for its own benefit and reasons, and refuse to allow its nominee to enforce a side letter to which it is not a party, or should the court have regard to the perceived commercial reality that the underlying investor and its nominee are effectively one entity, and are to be treated as such, with the consequence that the nominee can enforce the side letter even though not a party to it?  Judicial clashes between observance of legal correctness, and perceived commercial reality, are not uncommon and the common law has over the centuries endeavoured, by various devices, to circumvent the privity of contract rule, in particular by the devices of collateral contracts, trusts of a promise and agency.  These devices are sometimes described as exceptions to the privity rule, but in reality they are not true exceptions, but the application of different legal principles.  Such a judicial clash appears to currently be taking place in the Grand Court of the Cayman Islands as can be seen in the judgments in three recent cases.  In a guest article, Christopher Russell and Sebastian Said, partner and senior associate, respectively, in the Litigation & Insolvency Practice Group of Appleby (Cayman) Ltd, discuss the background and ruling in each of these cases and outline important lessons and recommendations for hedge fund managers arising out of the decisions.

ACA Compliance Report Facilitates Benchmarking of Private Fund Manager Compliance Practices (Part Two of Two)

ACA Compliance Group recently released a report and sponsored a webcast describing the results of its most recent survey of hedge fund and private equity fund manager compliance practices.  This article, the second in a two-part series covering the survey results, discusses: insider trading issues (including information barriers, online data rooms, non-disclosure agreements, restricted and watch lists, political intelligence, expert networks and public company contacts); and expense practices (including the use of expense caps, the allocation of expenses among a manager and its funds, expense allocation reasonableness reviews and other expense-related controls).  The first article in this series summarized survey results relating to fund managers’ preparation and completion of regulatory filings (e.g., Form ADV, Form PF and non-U.S. regulatory filings), including a discussion of how many managers are making various regulatory filings; what resources are being used to prepare such filings; how Form PF expenses are being allocated among a manager and its funds; and whether Form PF is being shared with fund investors.  The first article also discussed survey results relating to presence examinations.  See “ACA Compliance Report Facilitates Benchmarking of Private Fund Manager Compliance Practices (Part One of Two),” Hedge Fund Law Report, Vol. 6, No. 38 (Oct. 3, 2013).

FCA Fines Hedge Fund Manager for Violating U.K.’s Client Money Protection Rules

Hedge fund managers operating in the U.K. are required to take various measures to safeguard client money, and the U.K. Financial Conduct Authority (FCA) has stepped up enforcement efforts against firms that fail to comply with such requirements.  For background on U.K. client money rules, see “U.K. Court Decision Helps Define the Amount of ‘Client Money’ That Hedge Funds and Other Clients Are Entitled to Receive After a Brokerage Firm Fails,” Hedge Fund Law Report, Vol. 6, No. 7 (Feb. 14, 2013).  On September 2, 2013, the FCA fined a hedge fund manager more than £7 million in connection with its failure to comply with U.K. client money protection rules.  According to the FCA, while no client money was lost, the firm jeopardized client funds by using improper naming conventions that created confusion about who was the beneficial owner of client accounts and by failing to require that banks holding client accounts confirm the trust status of client money.  See “FCA 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).  This article provides a brief overview of U.K. client money rules and summarizes the factual allegations and fines imposed against the firm.

Ernst & Young Report Explains How Prime Brokers Select, Onboard and Charge Hedge Fund Clients

Ernst & Young (EY) recently took the pulse of the prime brokerage industry by surveying executives from eight leading prime brokers, each of which operates as part of a global bank or other global financial institution.  It found that prime brokers have been facing “crucial challenges” and urged prime brokers to learn the actual profitability of their respective hedge fund clients in order to price their services appropriately.  EY asked survey participants about a number of topics, including their organizational structure, processes for onboarding clients, liquidity management, revenue allocation, lockup agreements and leverage arrangements.  In that regard, the report provides useful insights for hedge fund managers into how prime brokers evaluate and manage their hedge fund business.  For the hedge fund manager’s perspective on such matters, see “Prime Brokerage Arrangements from the Hedge Fund Manager Perspective: Financing Structures; Trends in Services; Counterparty Risk; and Negotiating Agreements,” Hedge Fund Law Report, Vol. 6, No. 2 (Jan. 10, 2013).  This article summarizes the key findings from EY’s survey.

Chadbourne Welcomes Private Funds Partner Beth Kramer

On October 8, 2013, Chadbourne & Parke announced that investment management lawyer Beth Kramer has joined the firm as a partner in its private funds practice.

SEC Chief Litigation Counsel Matthew Martens to Join WilmerHale in November

On October 9, 2013, Wilmer Cutler Pickering Hale & Dorr LLP announced that Matthew Martens will be joining the firm as a partner in its securities and litigation practices.  In one of the SEC’s highest-profile enforcement matters arising out of the 2008 financial crisis, Martens served as lead trial counsel in the agency’s recent jury-awarded victory against Fabrice Tourre, a former Goldman Sachs Group Inc. trader.  See also “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).

Jones Day Strengthens Tax and Finance Practices with Addition of Siamak Mostafavi in Paris

Jones Day recently announced that Siamak Mostafavi, who advises financial institutions on the tax aspects of financial and derivatives products in France, is joining the firm’s Tax Practice this month in Paris.  See “European Court of Justice Invalidates French Withholding Tax that Applied Only to Dividends Paid to Non-Resident Open-End Investment Funds,” Hedge Fund Law Report, Vol. 5, No. 25 (Jun. 21, 2012).

Most-Read Articles