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.

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