Structuring, Drafting and Enforcement Recommendations for Hedge Fund Managers Considering Employee Compensation Clawbacks (Part One of Two)

Hedge fund compensation discussions have typically focused on upside – on how structuring acumen, tax strategy and legal legerdemain can be used to maximize post-tax compensation to good performers.  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).  However, in the wake – or in the midst – of unprecedented insider trading and other enforcement in the hedge fund industry, there is a growing recognition among managers that compensation can also be used to mitigate downside.  In particular, hedge fund managers are increasingly exploring, implementing and using employee compensation clawbacks to minimize the ex ante risk of bad acts and mitigate the ex post impact of such acts.  For example, S.A.C. Capital Advisors, LLC (SAC Capital) announced in May 2013 – shortly before various SAC Capital entities were indicted for securities fraud and wire fraud – that it planned to implement a policy allowing the firm to claw back compensation from employees engaged in misconduct.  See “SAC Capital Entities Indicted for Securities Fraud and Wire Fraud in Connection With Employees’ Alleged Insider Trading,” Hedge Fund Law Report, Vol. 6, No. 29 (Jul. 25, 2013).  In October 2012, Morgan Stanley went beyond mere implementation to actual enforcement, suing former FrontPoint Partners, LLC portfolio manager Joseph “Chip” Skowron to recoup compensation paid to Skowron.  Morgan Stanley generally alleged that it had the right to claw back such compensation because of Skowron’s 2011 guilty plea to insider trading and obstruction of justice charges.  See “Morgan Stanley Sues Former FrontPoint Partners Portfolio Manager Joseph F. ‘Chip’ Skowron III for Losses Allegedly Caused by Skowron’s Insider Trading and Subsequent Cover-Up,” Hedge Fund Law Report, Vol. 5, No. 44 (Nov. 21, 2012).  Employee compensation clawbacks offer powerful advantages to hedge fund managers, particularly in the current heightened enforcement climate.  They can deter bad acts, preserve reputation and broadcast a manager’s commitment to compliance.  However, clawbacks are not without legal and practical risk, including potential civil and criminal liability for managers that do not properly structure or enforce clawbacks.  To help hedge fund managers in evaluating the utility of clawbacks to their businesses, Hedge Fund Law Report is publishing a two-part series on employee compensation clawbacks in the hedge fund industry.  This article, the first installment, provides an overview of employee clawbacks at hedge fund managers; discusses the types of employees, misconduct and triggering events covered by clawbacks; and highlights the benefits of implementing clawbacks.  The second installment will identify drawbacks of clawbacks; outline legal and other considerations for managers in structuring and enforcing clawbacks; describe documentation of clawbacks; enumerate best practices for structuring clawbacks; and provide sample employee clawback provisions.

To read the full article

Continue reading your article with a HFLR subscription.