The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

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By Topic: Performance Advertising

  • From Vol. 11 No.2 (Jan. 11, 2018)

    HFLR Program Parses OCIE’s Recent Advertising Risk Alert: Misleading Claims of GIPS Compliance, Past Specific Investment Recommendations and Results of SEC’s Touting Initiative (Part Two of Two)

    SEC commentary provides valuable insight to compliance personnel on the hot-button issues being prioritized by the Commission, as well as the sort of conduct that does, and does not, lead to a referral to the SEC’s Division of Enforcement. By staying informed of the SEC’s approach to certain issues, advisers can learn from the mistakes of similarly situated advisers. A recent webinar presented by The Hedge Fund Law Report discussed six deficiencies identified in a National Exam Program Risk Alert that violate Rule 206(4)-1 of the Investment Advisers Act of 1940 – the so-called “Advertising Rule” – as well as other compliance issues that frequently arise with respect to an adviser’s advertising practices. Kara Bingham, Associate Editor of The Hedge Fund Law Report, moderated the discussion, which featured Todd Kaplan, founder and principal of Cloudbreak Compliance Group; Christine M. Lombardo, partner at Morgan Lewis; and Richard F. Kerr, partner at K&L Gates. This article, the second in a two-part series, explores the disclosures required when presenting gross performance in a one-on-one presentation to prospective investors, the circumstances under which claims of compliance with voluntary performance disclosure standards may be deemed misleading, ways to avoid deficiencies when discussing past specific recommendations in advertisements and the results of the touting initiative conducted by the SEC’s Office of Compliance Inspections and Examinations. The first article discussed the broad view that the SEC takes when deciding which communications fall within the definition of an advertisement, as well as four examples of deficiencies frequently found in performance advertising. See “Risk Alert Highlights Six Most Frequent Advertising Rule Compliance Issues” (Oct. 19, 2017).

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  • From Vol. 11 No.1 (Jan. 4, 2018)

    HFLR Program Parses OCIE’s Recent Advertising Risk Alert: Identifying Advertisements and Common Deficiencies in Performance Advertising (Part One of Two)

    On September 14, 2017, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a National Exam Program Risk Alert that highlighted six common deficiencies under Rule 206(4)-1 of the Investment Advisers Act of 1940 – the so-called “Advertising Rule” – identified by OCIE during examinations of SEC-registered investment advisers. A recent webinar presented by The Hedge Fund Law Report discussed in detail each of the deficiencies, along with other compliance issues that frequently arise with respect to an adviser’s advertising practices. Kara Bingham, Associate Editor of The Hedge Fund Law Report, moderated the discussion, which featured Todd Kaplan, founder and principal of Cloudbreak Compliance Group; Christine M. Lombardo, partner at Morgan Lewis; and Richard F. Kerr, partner at K&L Gates. This article, the first in a two-part series, discusses the broad view the SEC takes when deciding which communications fall within the definition of an advertisement, as well as four examples of deficiencies frequently found in performance advertising. The second article will explore the disclosures required when presenting gross performance in one-on-one presentations to prospective investors, circumstances under which claims of compliance with voluntary performance disclosure standards may be deemed misleading, ways to avoid deficiencies when discussing past specific recommendations in advertisements and the results of the touting initiative conducted by OCIE. See our three-part series on advertising compliance: “Ten Best Practices for a Fund Manager to Streamline Its Compliance Review” (Sep. 14, 2017); “Five High-Risk Areas for a Fund Manager to Focus on When Reviewing Marketing Materials” (Sep. 21, 2017); and “Six Methods for a Fund Manager to Test Its Advertising Review Procedures” (Sep. 28, 2017).

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  • From Vol. 10 No.48 (Dec. 7, 2017)

    ACA Panel Reviews Effects of Impending MiFID II on U.S. Advisers

    A recent ACA Compliance Group (ACA) program examined the impact that the recast Markets in Financial Instruments Directive (MiFID II) will have on fund managers when it takes effect in January 2018, covering delegated portfolio management; market reforms; third-country managers; research payments; best execution; transaction reporting; marketing and product governance rules; recording of telephone conversations; algorithmic trading; and commodity derivatives. See also our two-part series “Simmons & Simmons and Advise Technologies Provide Comprehensive Overview of MiFID II”: Part One (Jun. 18, 2015); and Part Two (Jun. 25, 2015). The program featured Sally McCarthy and Martin Lovick, ACA director and senior principal consultant, respectively. This article summarizes the key takeaways from their presentation. For further insights from ACA, see “Challenges and Solutions in Managing Global Compliance Programs” (Oct. 5, 2017); and our coverage of its 2017 fund manager compliance survey: “Continued SEC Focus on Compliance, Conflicts of Interest and Fees, and Common Measures to Protect MNPI” (Jun. 1, 2017); and “Variety in Expense Allocation Practices and Business Continuity Measures” (Jun. 8, 2017).

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  • From Vol. 10 No.44 (Nov. 9, 2017)

    ACA Offers Roadmap to Maintaining Books and Records: Document Retention and SEC Expectations (Part Two of Two)

    Investment advisers are faced with the ongoing challenge of ensuring compliance with the numerous rules and regulations governing their books and records. A recent ACA Compliance Group (ACA) program offered a comprehensive overview of the documents and records that investment advisers are required to maintain, focusing on ways advisers can ensure that those records be complete, accessible and in the proper form in the event of an SEC examination. The program featured Beth Manzi, chief operating officer of private fund administrator PEF Services LLC, and Theodore E. Eichenlaub, partner at ACA. This second article in our two-part series considers the electronic storage of records, document destruction, testing of compliance programs and SEC examinations. The first article discussed the regulatory background surrounding the maintenance of adviser-specific records, including corporate and accounting documents; marketing documents; and emails. For additional insights from ACA, see our two-part series “A Roadmap for Advisers to Comply With Marketing and Advertising Regulations”: Part One (Aug. 3, 2017); and Part Two (Aug. 10, 2017).

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  • From Vol. 10 No.43 (Nov. 2, 2017)

    A Roadmap to Maintaining Books and Records: Compliance With Applicable Regulations (Part One of Two)

    Investment advisers are subject to numerous rules and regulations regarding their books and records. A recent ACA Compliance Group (ACA) program, featuring Beth Manzi, chief operating officer of private fund administrator PEF Services LLC, and Theodore E. Eichenlaub, partner at ACA, offered a comprehensive overview of the documents and records that investment advisers are required to maintain. The program also focused on methods for ensuring that those documents and records be complete, accessible and in a proper form in the event of an SEC examination. This article, the first in a two-part series, discusses the regulatory background surrounding the maintenance of adviser-specific records, including corporate and accounting documents; marketing documents; and emails. The second article will consider the electronic storage of records, document destruction, testing of compliance programs and SEC examinations. For additional commentary from ACA, see “How Private Fund Managers Can Avoid Common Pitfalls When Calculating and Advertising Internal Rates of Return” (Sep. 7, 2017); and “Compliance Corner Q4-2017: Regulatory Filings and Other Considerations That Hedge Fund Managers Should Note in the Coming Quarter” (Oct. 12, 2017).

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  • From Vol. 10 No.41 (Oct. 19, 2017)

    Risk Alert Highlights Six Most Frequent Advertising Rule Compliance Issues

    Rule 206(4)-1 under the Investment Advisers Act of 1940 prohibits investment advisers from including testimonials, certain past specific recommendations and misleading information in marketing materials. The SEC Office of Compliance Inspections and Examinations (OCIE) recently issued a Risk Alert that discusses the six most frequent advertising issues identified in deficiency letters from more than 1,000 adviser examinations, as well as the results of its 2016 “Touting Initiative,” which focused on nearly 70 advisers’ use of awards, rankings, professional designations and testimonials in their marketing materials. This article summarizes OCIE’s findings. See also our three-part advertising compliance series: “Ten Best Practices for a Fund Manager to Streamline Its Compliance Review” (Sep. 14, 2017); “Five High-Risk Areas to Focus on When Reviewing Marketing Materials” (Sep. 21, 2017); and “Six Methods to Test Advertising Review Procedures” (Sep. 28, 2017).

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  • From Vol. 10 No.38 (Sep. 28, 2017)

    SEC Continues Its Pursuit of Firms That Licensed F‑Squared Indices

    In yet another reminder that fund managers must be scrupulously accurate when making performance claims – and must perform appropriate due diligence when using the track records of third-party advisers – the SEC recently commenced an enforcement action against an investment adviser and its principal (collectively, the Defendants). The SEC’s complaint alleges that the Defendants breached their fiduciary duties and committed fraud by using materially misleading marketing materials created by F‑Squared Investments, Inc. (F‑Squared) for F‑Squared’s “AlphaSector” strategies. Worse, the SEC claims that the Defendants continued to use those materials after the investment adviser’s principal learned that the materials contained fraudulent performance claims, and later sold the business to avoid potential liability for advertising a fraudulent track record. This article summarizes the complaint. For other enforcement actions stemming from third-party advisers licensing F‑Squared’s products, see “SEC Settlements Highlight Need for Managers to Verify Performance Claims of Others Prior to Use” (Sep. 22, 2016); and “Hedge Fund Managers May Be Liable for Performance Claims of Others” (Mar. 3, 2016).

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  • From Vol. 10 No.37 (Sep. 21, 2017)

    Advertising Compliance Series: Five High-Risk Areas for a Fund Manager to Focus on When Reviewing Marketing Materials (Part Two of Three)

    The chief compliance officer of a small fund manager is likely the individual responsible for reviewing and approving all advertisements, while a larger adviser may employ a team of individuals dedicated to this function. In either case, mere familiarity with the applicable rules is not enough to ensure that the reviewer will identify content that poses risks from a regulatory perspective. Rather, an effective compliance reviewer must understand all aspects of the adviser’s business, its investment strategies and instruments traded, as well as possess a general understanding of how the markets operate. Certain categories of content, because of the very nature of the information being presented, pose greater risks from a regulatory perspective and thus warrant special attention by compliance officers. This second article in our three-part series discusses five of these high-risk areas, provides guidance to compliance officers on what to look for when encountering high-risk content and suggests ways for presenting this information that meet the needs of both the business-development and compliance teams. The first article in the series outlined what documents fall within the advertisement definition and described ten best practices that managers should consider implementing when designing or evaluating their advertising review procedures. The third article will explore six different testing mechanisms firms can employ to verify compliance with their advertising procedures. See “Ten Key Risks Facing Private Fund Managers in 2017” (Apr. 6, 2017); and “K&L Gates Partners Outline Six Compliance Requirements and Four Enforcement Themes for Private Fund Advisers (Part Three of Three)” (Jan. 8, 2015).

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  • From Vol. 10 No.35 (Sep. 7, 2017)

    How Private Fund Managers Can Avoid Common Pitfalls When Calculating and Advertising Internal Rates of Return

    Presentation of performance information to prospective and current investors is a perennial focus of SEC scrutiny. A recent ACA Compliance Group (ACA) program discussed the process of calculating and presenting internal rates of return and other performance information from a compliance perspective, as well as common pitfalls in those calculations and presentations. The program was moderated by Gabe Glass, senior principal consultant at ACA Performance Services, and featured Ken Harman, principal consultant at ACA, and James Hendricksen, manager at USAA Real Estate Company. This article summarizes key points raised by the panelists. For additional recent commentary from ACA, see “Compliance Corner Q3-2017: Regulatory Filings and Other Considerations That Hedge Fund Managers Should Note in the Coming Quarter” (Jul. 20, 2017); and our two-part series covering ACA’s 2017 Fund Manager Compliance Survey: “Continued SEC Focus on Compliance, Conflicts of Interest and Fees, and Common Measures to Protect MNPI” (Jun. 1, 2017); and “Variety in Expense Allocation Practices and Business Continuity Measures” (Jun. 8, 2017).

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  • From Vol. 10 No.32 (Aug. 10, 2017)

    A Roadmap for Advisers to Comply With Marketing and Advertising Regulations (Part Two of Two)

    An ongoing challenge for advisers is ensuring compliance with the complex set of regulations that govern their marketing practices. A recent program hosted by ACA Compliance Group (ACA) distilled some of the nuances that arise when applying these regulations to the marketing of interests in private funds. The program featured Mark Lawler, ACA senior principal consultant, Matthew Shepherd, ACA principal consultant, and Erika Roess, senior principal consultant at ACA Performance Services. This second article in a two-part series discusses the permissibility of using backtested performance and partial client lists in advertising materials; portability of track records; compensation of solicitors referring separately managed account clients; marketing to investors in private funds; and compliance with private placement requirements. The first article discussed regulations governing performance advertising, compliance with GIPS, recordkeeping requirements relating to marketing materials and the use of past-specific recommendations. For coverage of other ACA events, see “Hedge Fund Managers Are Advised to Build Robust Infrastructure” (Mar. 3, 2016); and “Recommended Actions for Hedge Fund Managers in Light of SEC Enforcement Trends” (Oct. 22, 2015).

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  • From Vol. 10 No.31 (Aug. 3, 2017)

    A Roadmap for Advisers to Comply With Marketing and Advertising Regulations (Part One of Two)

    Advertising by investment advisers is subject to numerous rules and regulations, and rife with potential traps for the unwary. A recent ACA Compliance Group (ACA) program provided a comprehensive overview of the relevant rules and SEC guidance that govern these advertising practices and discussed multiple potential pitfalls. The program featured Mark Lawler, ACA senior principal consultant, Matthew Shepherd, ACA principal consultant, and Erika Roess, senior principal consultant at ACA Performance Services. This article, the first in a two-part series, discusses regulations governing performance advertising, compliance with GIPS, recordkeeping requirements relating to marketing materials and use of past specific recommendations. The second article will consider the permissibility of advertising backtested performance and partial client lists; portability of track records; use of solicitors to raise capital; marketing to investors in private funds; and compliance with private placement requirements. For additional insight from Roess, see “Expert Panel Provides Roadmap for Hedge Fund Managers Looking to Present Performance in Compliance With GIPS” (Aug. 1, 2013).

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  • From Vol. 10 No.15 (Apr. 13, 2017)

    FCA Report Details the Failure of Actively Managed Funds to Eclipse Benchmarks Despite High Investor Charges and Poor Cost Controls (Part Two of Two)

    The U.K. Financial Conduct Authority (FCA) has directed its attention toward manager practices in the asset management industry that could have the effect of stifling competition in a manner detrimental to investors. The FCA recently surveyed a broad segment of investors, asset managers and other stakeholders to determine the scope of this problem, publishing the results in its Asset Management Market Study – Interim Report, MS15/2.2. Fund managers should carefully review this exhaustive report to understand potential future FCA examination topics, while investors can use the findings to enhance their diligence of funds prior to investing. This second article in a two-part series examines the report’s findings concerning the performance of actively managed funds, the amount of charges passed on to investors by managers and certain deficiencies in fund cost-control efforts. The first article evaluated fund fees and competition through the prisms of platform usage, manager compensation and fund governance. For coverage of additional issues pertinent to U.K. managers and investors, see “Dechert Partners Discuss How Cross-Border European Fund Managers Can Prepare for Brexit’s Momentous Regulatory Effect” (Apr. 6, 2017); and “FCA Emphasizes Need for Fund Managers to Monitor and Clearly Communicate Financial Benchmarks and Investment Practices” (Apr. 28, 2016).

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  • From Vol. 10 No.14 (Apr. 6, 2017)

    Ten Key Risks Facing Private Fund Managers in 2017

    A recent seminar presented by Proskauer Rose provided valuable insight on emerging risks for hedge fund managers, including the uncertain regulatory landscape, and perennial SEC targets such as conflicts of interest, valuation and performance marketing. The program was moderated by Proskauer partner Timothy W. Mungovan and featured partner Joshua M. Newville; associates Michael R. Hackett and William Dalsen; and special regulatory counsel Anthony Drenzek. This article summarizes their key insights. For additional commentary from Drenzek, see our two-part series on The SEC’s Recent Revisions to Form ADV and the Recordkeeping Rule: “Managed Account Disclosure, Umbrella Registration and Outsourced CCOs” (Nov. 3, 2016); and “Retaining Performance Records and Disclosing Social Media Use, Office Locations and Assets Under Management” (Nov. 17, 2016).

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  • From Vol. 10 No.11 (Mar. 16, 2017)

    Considerations When Winding Down Funds: Navigating Illiquid Assets, Unanticipated Windfalls and Fees and Expenses During Liquidation (Part Two of Two)

    Once a manager decides to wind down a fund, it must navigate myriad considerations and decisions during the process. The manager needs to disclose the wind-down to investors at the outset without triggering liabilities to service providers or diminishing asset values, and the fund needs to retain appropriate personnel and working capital to perform a wind-down that could take months or even years to complete. To address these and other issues that arise when winding down a fund, The Hedge Fund Law Report recently interviewed Michael C. Neus, senior fellow in residence with the Program on Corporate Compliance and Enforcement at New York University School of Law and former managing partner and general counsel of Perry Capital, LLC. This second article in our two-part series analyzes how illiquid assets should be treated during a wind-down; what fees can and should responsibly be charged to investors; and how managers should allocate an unanticipated windfall received after the wind-down is completed. The first article in the series described the roles that a fund’s general counsel and chief compliance officer play in the wind-down, as well as best practices for communicating the decision to wind down to service providers and investors. For more on considerations when winding down a fund in the Cayman Islands, see “How Can Investors in Cayman Hedge Funds Maximize Protection of Their Investments When the Fund Is Near or at the End of Its Life? (Part One of Two)” (Dec. 5, 2013); and our two-part series on navigating the loss of a fund’s substratum requirement: “Analysis of the Conflicting Cayman Islands Standards” (Jan. 5, 2017); and “Steps to Ensure a Fund’s Soft Wind-Down Does Not Result in a Winding-Up Order” (Jan. 12, 2017).

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  • From Vol. 9 No.49 (Dec. 15, 2016)

    Recent NY Appeals Court Rulings Clarify How Fund Managers May Pursue Former Employees for Breach of Fiduciary Duty and Improper Use of Performance Record

    In the latest chapter of litigation that began in 2008, the New York State Appellate Court issued two rulings that provide meaningful guidance to industry participants on certain employment-related matters. Specifically, the Appellate Court ruled that a hedge fund manager may pursue two former employees for breach of fiduciary duty, including to recoup certain penalties assessed by the SEC against the firm for violating Rule 105 of Regulation M; misuse of the manager’s performance track record; theft of trade secrets; tortious interference with contract; and defamation. In a guest article, Sean O’Brien, managing partner of O’Brien LLP, along with associates A.J. Monaco and Michael Ahern, provide the litigation history of the case and discuss the claims against the employees and the factual details surrounding such allegations. For additional insights from O’Brien, see “DTSA Provides Hedge Fund Managers With Protection for Proprietary Trading Technology and Other Trade Secrets” (Jun. 23, 2016); and “Can Hedge Fund Managers Contract Out of Default Fiduciary Duties When Drafting Delaware Hedge Fund and Management Company Documents?” (Apr. 4, 2013). For coverage of other employment disputes involving hedge fund managers, see “Quant Fund Manager Moves Aggressively Against Former Employee Who Allegedly Stole Trade Secrets and Other Proprietary Information” (Mar. 21, 2014); and “Highland Capital Management Sues Former Private Equity Chief for Breach of Employment and Buy-Sell Agreements” (May 17, 2012).

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  • From Vol. 9 No.48 (Dec. 8, 2016)

    SEC Settlement With PIMCO Highlights the Importance of Proper Valuation and Performance Disclosures

    Valuation and performance claims are perennial SEC enforcement priorities. See “SEC Division Heads Enumerate Enforcement Priorities, Including Conflicts of Interest, Valuation, Performance Advertising and CCO Liability (Part Two of Two)” (May 5, 2016). Pacific Investment Management Company LLC (PIMCO) recently agreed to pay over $19.8 million in disgorgement, interest and penalties to settle SEC charges that it overvalued the securities in its exchange-traded fund (ETF). Although the action involved an ETF, it provides a timely reminder to all fund managers of the obligation to value assets accurately, to disclose their funds performance correctly and to implement appropriate policies and procedures for these purposes. This article summarizes the alleged conduct that gave rise to the enforcement proceeding and the other terms of the settlement order. For other actions involving inaccurate valuations and internal controls failures, see “GLG Partners Settlement Illustrates SEC Views Regarding Valuation Controls at Hedge Fund Managers” (Jan. 16, 2014); and “SEC’s Recent Settlement With a Hedge Fund Manager Highlights the Importance of Documented Internal Controls When Managing Conflicts of Interest Associated With Asset Valuation and Cross Trades” (Jan. 9, 2014).

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  • From Vol. 9 No.47 (Dec. 1, 2016)

    How Investment Managers Can Advertise Sub-Adviser Performance Without Violating SEC Rules 

    In a series of recent enforcement actions, the SEC has held investment advisers responsible for performance claims included in their marketing materials that they received from sub-advisers and that turned out to be false and misleading. Although the SEC acknowledged that the investment advisers may have been unaware that the performance information was false and misleading, the regulator concluded that they were nevertheless responsible for ensuring that the overall reported performance record from their sub-advisers was compliant with the Investment Advisers Act of 1940. To avoid running afoul of applicable law, investment advisers conveying third-party performance returns should obtain adequate documentation to verify their accuracy and establish policies and procedures that govern what due diligence they will conduct on the sub-advisers’ performance. In a guest article, Daniel G. Viola, partner at Sadis & Goldberg, and Antonella Puca, head of the investment performance attestation practice at RSM US, review the key aspects of the recent enforcement activity of the SEC on performance advertising and provide guidance on how to address some of the SEC’s concerns. For additional insight from Viola, see “Hedge Fund Managers Advised to Prepare for Imminent SEC Examination” (Jan. 28, 2016). For more on performance advertising, see “The SEC’s Recent Revisions to Form ADV and the Recordkeeping Rule: What Investment Advisers Need to Know About Retaining Performance Records (Part Two of Two)” (Nov. 17, 2016); and “Liquidity and Performance Representations Present Potential Pitfalls for Hedge Fund Managers” (Mar. 31, 2016).

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  • From Vol. 9 No.45 (Nov. 17, 2016)

    Trending Issues in Employment Law for Private Fund Managers: Non-Compete Agreements, Intellectual Property, Whistleblowers and Cybersecurity

    Attracting, compensating and retaining talented employees is a critical part of a fund manager’s business. Managers routinely use non-compete agreements and other measures to ensure that employees do not harm the manager’s business when they depart. A recent program presented by EisnerAmper offered an overview of the law of non-compete agreements and insight into other common employment issues that private fund managers face, including portability of track records, status of employees, protection of intellectual property and cybersecurity. Moderated by EisnerAmper director Frank L. Napolitani, the program featured Cole-Frieman & Mallon partner John Araneo. This article highlights the key takeaways from the presentation. For additional insight from EisnerAmper, see our three-part series on how hedge funds can mitigate FIN 48 exposure in certain jurisdictions: Europe (Mar. 17, 2016); China (Mar. 24, 2016); and Australia and Mexico (Mar. 31, 2016); as well as our two-part series on hedge fund audit holdbacks: “Operational Considerations” (Sep. 10, 2015); and “Implementation” (Sep. 17, 2015).

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  • From Vol. 9 No.41 (Oct. 20, 2016)

    What the SEC’s Enforcement Statistics Reveal About the Regulator’s Focus on Hedge Funds and Investment Advisers

    The SEC recently announced that it brought a record 868 enforcement actions in fiscal year 2016, which closed on September 30. As in prior years, these cases were brought against a broad spectrum of players in the financial industry – including investment advisers, investment companies, industry gatekeepers and broker-dealers – covering a wide range of securities law violations, including insider trading, market manipulation, delinquent filings and Foreign Corrupt Practices Act violations. SEC Chair Mary Jo White stated in the press release that the agency’s enforcement program is a “resounding success.” She credited the increase in actions to the use of new data analytics to uncover fraud, which has enhanced the SEC’s ability to litigate such cases and its capability to bring novel and significant actions to protect investors and the markets. For more on the SEC’s use of technology in the examination process, see “SEC’s Rozenblit and Law Firm Partners Explain the SEC’s Enforcement Priorities and Offer Tips on How Hedge Fund and Private Equity Managers Can Avoid Enforcement Actions (Part Three of Four)” (Jan. 15, 2015); and “OCIE Director Andrew Bowden Identifies the Top Three Deficiencies Found in Hedge Fund Manager Presence Exams and Outlines OCIE’s Examination Priorities” (Oct. 10, 2014). This article summarizes key data from the report relevant to hedge fund and private equity managers and includes reactions from industry experts regarding the SEC’s enforcement priorities. 

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  • From Vol. 9 No.37 (Sep. 22, 2016)

    SEC Settlements Highlight Need for Managers to Verify Performance Claims of Others Prior to Use

    In February 2016, the SEC settled claims that investment adviser Cantella & Co. improperly relied on and disseminated materially misleading marketing materials prepared by F-Squared Investments, Inc. (F-Squared) for its so-called “AlphaSector” strategies. See “Hedge Fund Managers May Be Liable for Performance Claims of Others” (Mar. 3, 2016). The fallout from F-Squared’s improper use of backtesting in those marketing materials continues to spread to others who used its services. The SEC recently settled 13 additional enforcement proceedings against advisers who allegedly disseminated some or all of F-Squared’s erroneous claims without attempting to confirm their veracity. This article summarizes the allegations contained in the settlement orders, along with the terms of each settlement. For more on performance advertising, see “Liquidity and Performance Representations Present Potential Pitfalls for Hedge Fund Managers” (Mar. 31, 2016); and our two-part series entitled “How Can Hedge Fund Managers Market Their Funds Using Case Studies Without Violating the Cherry Picking Rule?”: Part One (Dec. 5, 2013); and Part Two (Dec. 12, 2013). For other performance advertising issues, see our articles on GIPS compliance claims; testimonials and social media; the use of gross performance results; and the use of other firms’ track records.

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  • From Vol. 9 No.35 (Sep. 8, 2016)

    D.C. Circuit Delivers Significant Victory for the SEC in Upholding the Use of Administrative Law Judges in Enforcement Proceedings

    On August 9, 2016, the U.S. Court of Appeals for the District of Columbia Circuit (D.C. Circuit) ruled in favor of the SEC, rejecting a challenge to the constitutionality of the agency’s practice of bringing enforcement actions in front of administrative law judges (ALJs). In finding for the SEC against a registered investment adviser, the D.C. Circuit validated a long-standing practice utilized by the SEC to try certain enforcement cases in administrative proceedings. In addition to reviewing the D.C. Circuit’s decision, this article provides background on the SEC’s history of bringing contested cases before ALJs, discusses some of the recent criticism surrounding these tribunals and explores ways the decision may influence the SEC’s enforcement of hedge fund managers. For additional discussion of the SEC’s use of administrative proceedings, see “Four Insider Trading Enforcement Trends with Direct Impact on Hedge Fund Trading Strategies (Part One of Three)” (Nov. 13, 2014); and “Compliance Obligations for Registered CPOs and CTAs, OTC Derivatives Trading, SEC Examinations of Private Fund Managers and the JOBS Act (Part Two of Two)” (Feb. 6, 2014).

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  • From Vol. 9 No.17 (Apr. 28, 2016)

    FCA Emphasizes Need for Fund Managers to Monitor and Clearly Communicate Financial Benchmarks and Investment Practices

    Investors base high-stakes decisions on hedge fund marketing materials, disclosure documents and investment mandates, so it is imperative for hedge fund managers to ensure that those documents accurately and clearly describe the funds’ operations. In a recent thematic review, the U.K. Financial Conduct Authority (FCA) assessed whether U.K.-authorized investment funds and segregated mandates are operating in line with investor expectations set by marketing and disclosure materials. While managers generally ensure that their behavior lines up with disclosure, the FCA found room for them to improve and exercise vigilance in managing investor expectations. This article enumerates the FCA-recommended practices for asset managers to ensure that product descriptions are clear and correct, fund governance is effective for the life of the product and distribution channels are adequately monitored. For additional insight from the FCA, see “FCA 2016-2017 Regulatory and Supervisory Priorities Include Focus on AML, Cybersecurity and Governance” (Apr. 14, 2016); “FCA Expects Hedge Fund Managers to Focus on Liquidity Risk” (Mar. 3, 2016); and “FCA Report Enjoins Hedge Fund Managers to Improve Due Diligence” (Feb. 25, 2016).

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  • From Vol. 9 No.13 (Mar. 31, 2016)

    Liquidity and Performance Representations Present Potential Pitfalls for Hedge Fund Managers

    Hedge fund managers must guard against insidious issues that can give rise to conflicts of interest or trigger anti-fraud violations, such as liquidity issues caused by a manager’s operation of multiple funds. See “Operational Conflicts Arising Out of Simultaneous Management of Hedge Funds and Private Equity Funds (Part Two of Three)” (May 14, 2015). Similarly, performance representations present potential issues for hedge fund managers, including possible misrepresentations caused by improper valuation practices and fee deferrals. Both the enforcer and industry perspectives of these and other topics were explored at a recent Practising Law Institute program. Barry P. Barbash, a former Director of the SEC Division of Investment Management and now a partner at Willkie Farr & Gallagher, moderated the program, which featured Stephanie R. Breslow, a partner at Schulte Roth & Zabel; and Igor Rozenblit, co-leader of the Private Funds Unit of the SEC Office of Compliance Inspections and Examinations. This article highlights the panelists’ commentary on these matters. For more from Breslow, see our two-part series on “Gates, Side Pockets, Secondaries, Co-Investments, Redemption Suspensions, Funds of One and Fiduciary Duty”: Part One (Dec. 4, 2014); and Part Two (Dec. 11, 2014). For insight from Rozenblit, see “SEC’s Rozenblit Offers Perspectives From the Private Funds Unit” (Feb. 11, 2016); and “Operations and Priorities of the Private Funds Unit” (Sep. 24, 2015).

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  • From Vol. 9 No.9 (Mar. 3, 2016)

    Hedge Fund Managers May Be Liable for Performance Claims of Others

    Performance advertising is a minefield for fund managers. Besides ensuring that their own performance is accurate, a recently settled SEC enforcement action makes clear that hedge fund managers and other investment advisers can be held liable for disseminating another adviser’s inaccurate claims. See also “Hedge Fund Managers Must Refrain From Combining Actual and Hypothetical Performance Results to Avoid Misleading Investors and Avert SEC Enforcement Action” (Feb. 11, 2016). When a registered investment adviser licensed proprietary trading strategies from another firm, it also began using performance information prepared by that firm. However, those performance claims were inaccurate because, rather than being based on actual track records as purported, they were hypothetical and backtested. See “SEC Settles Enforcement Action and Pursues Company Over Use of Backtested Performance Data” (Jan. 8, 2015). This article summarizes the SEC’s allegations against the relying investment adviser, as well as the terms of the settlement order. For more on backtesting, see “Under What Conditions Can a Hedge Fund Manager Present Hypothetical Backtested Performance Results?” (Feb. 1, 2013). For a discussion of performance advertising, see our two-part series on hedge fund managers’ use of target returns: “Common Practices, Benefits and Drawbacks” (Apr. 23, 2015); and “Legal Risks” (Apr. 30, 2015). For other performance advertising issues, see the HFLR’s articles on GIPS compliance claims; testimonials and social media; cherry picking and case studies; the use of gross performance results; and the use of other firms’ track records.

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  • From Vol. 9 No.6 (Feb. 11, 2016)

    Hedge Fund Managers Must Refrain From Combining Actual and Hypothetical Performance Results to Avoid Misleading Investors and Avert SEC Enforcement Action

    Advisers that are not scrupulous in how they present performance results to investors may face potentially dire consequences. See “OCIE Director Andrew Bowden Identifies the Top Three Deficiencies Found in Hedge Fund Manager Presence Exams and Outlines OCIE’s Examination Priorities” (Oct. 10, 2014). In an extreme example of a hedge fund manager providing investors with misleading performance information, the SEC recently settled an enforcement action against an unregistered investment adviser that, among other things, presented investors with a “misleading mixture of hypothetical and actual returns when providing the fund’s performance history” without adequate disclosure. This article provides an overview of the facts, the SEC’s allegations and the settlement terms. For another case involving improper performance advertising, see “SEC Settles Enforcement Action and Pursues Company Over Use of Backtested Performance Data” (Jan. 8, 2015).

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  • From Vol. 9 No.6 (Feb. 11, 2016)

    Hedge Fund Managers Must Prepare for Benchmark Regulation

    In a speech delivered at the European Regulation Forum sponsored by the Chartered Institute for Securities & Investment, Edwin Schooling Latter, Head of Markets Policy of the U.K. Financial Conduct Authority (FCA), discussed the E.U. Benchmarks Regulation and the impact the regulation is expected to have on benchmark administrators, contributors and users, including hedge fund managers. In his remarks, Schooling Latter discussed the need for benchmark regulation and the anticipated effect of the E.U. regulations, before providing advice to hedge fund managers and other market participants as to what they should be doing to prepare for the regulation and manage the risks inherent to benchmarks. This article summarizes the points raised by Schooling Latter. For insight from Schooling Latter’s colleague, see “FCA Director Summarizes 2015 Regulatory Initiatives Applicable to Hedge Fund Managers and Financial Markets” (Jan. 7, 2016); and “FCA Urges Hedge Fund Managers to Prepare for MiFID II” (Oct. 29, 2015). For discussion of the relevance of benchmarks to the hedge fund industry, see our two-part series on “The Use of Benchmarks to Measure Hedge Fund Performance by Pension Funds and Institutional Investors”: Part One (Jul. 30, 2015); and Part Two (Aug. 6, 2015).

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  • From Vol. 8 No.31 (Aug. 6, 2015)

    Practical Consequences of the Use of Benchmarks to Measure Hedge Fund Performance by Pension Funds and Institutional Investors (Part Two of Two)

    Hedge funds seek absolute returns and, unlike mutual funds, are not legally required to identify a benchmark or report performance against certain indices.  However, as pension funds and other institutional investors evaluate hedge funds’ performance, either explicitly or implicitly, against benchmarks, hedge fund managers themselves may also provide benchmarked performance information.  The first article in our two-part series explored the extent to which, and the means by which, pension funds and institutional investors employ benchmarks in their assessments of hedge fund performance.  This article examines the practical consequences of subjecting hedge funds to performance benchmarks, including whether this practice could cause hedge funds to shift away from their traditional absolute returns-based performance emphasis, toward a focus on benchmarked results; whether hedge fund managers have themselves been influenced to publish benchmarked performance information and the implications of doing so; and the parameters surrounding the use of benchmarks for hedge fund performance evaluation.  For discussion of another practice of measuring hedge fund performance, see “Legal Risks for Hedge Fund Managers of Using Target Returns (Part Two of Two),” The Hedge Fund Law Report, Vol. 8, No. 17 (Apr. 30, 2015).

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  • From Vol. 8 No.30 (Jul. 30, 2015)

    The Use of Benchmarks to Measure Hedge Fund Performance by Pension Funds and Institutional Investors (Part One of Two)

    While mutual funds are required to identify a benchmark and state performance over certain timeframes and against certain indices, hedge funds are not legally required to do so.  As such, hedge fund managers typically do not benchmark their performance.  However, pension funds and other institutional investors may assess hedge fund returns, either explicitly or implicitly, in light of a benchmark.  This first article in our two-part series discusses the use of benchmarks as a performance measure, exploring if, and how, pension funds and institutional investors evaluate hedge fund performance against a benchmark.  The second article will discuss the practical consequences of subjecting hedge funds to performance benchmarks; consider whether such a practice could shift the performance emphasis of hedge funds away from absolute returns toward a focus on benchmarked results; and analyze the parameters surrounding the use of benchmarks for evaluating hedge funds.  For discussion of another method of performance measurement, see “Common Practices, Benefits and Drawbacks for Hedge Fund Managers of Using Target Returns (Part One of Two),” The Hedge Fund Law Report, Vol. 8, No. 16 (Apr. 23, 2015).

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  • From Vol. 8 No.19 (May 14, 2015)

    K&L Gates Panel Offers Advice on Taxation, Regulatory and Business Integration Issues with M&A Transactions in the Asset Management Industry (Part Two of Two)

    As firms in the asset management industry structure merger and acquisition transactions – including joint ventures, acquisitions of minority interests and lift-outs of teams – they need to be aware of the potential issues that arise with such transactions.  Integrating two businesses may result in tax consequences, regulatory issues or other compliance concerns.  A panel of domain experts from K&L Gates recently discussed current trends in the asset management industry and a number of considerations in planning an acquisition or other deal with an asset manager, broker-dealer or adviser, including choice of partner, due diligence, structuring, taxation and various regulatory and compliance considerations.  Moderated by Michael S. Caccese, a practice area leader, the program featured partners Kenneth G. Juster and Michael W. McGrath; and practice area leaders D. Mark McMillan and Robert P. Zinn.  This article, the second in a two-part series, summarizes the key takeaways from that program with respect to taxation, regulatory and business integration concerns.  The first article addressed asset management industry trends, choosing a partner, due diligence and structuring considerations.  See also “PLI Panel Addresses Recent Developments with Respect to Prime Brokerage Arrangements, Alternative Registered Funds and Hedge Fund Manager Mergers and Acquisitions,” The Hedge Fund Law Report, Vol. 6, No. 41 (Oct. 25, 2013).

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  • From Vol. 8 No.17 (Apr. 30, 2015)

    Legal Risks for Hedge Fund Managers of Using Target Returns (Part Two of Two)

    In addition to the potentially negative consequences – including the loss of investor credibility, potential investor dissatisfaction, client redemptions and reputational harm – that can result from it, the use of target returns or performance targets by hedge fund managers in offering documents or marketing materials also gives rise to legal and regulatory risks.  See “Aite Group Report Identifies the Building Blocks of Institutional Credibility for Hedge Fund Managers: Operational Efficiency, Robust Risk Management, Integrated Technology and More,” The Hedge Fund Law Report, Vol. 6, No. 36 (Sep. 19, 2013).  Hedge fund managers need to consider these potential legal and regulatory risks, along with the potential benefits and other consequences, when deciding to use target returns.  This article, the second in a two-part series, analyzes the legal risks associated with target returns and weighs the benefits of using target returns against those risks.  The first article discussed common practices for the use of target returns by hedge funds; analyzed reasons for using target returns; and highlighted some potential drawbacks of using target returns.

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  • From Vol. 8 No.16 (Apr. 23, 2015)

    Common Practices, Benefits and Drawbacks for Hedge Fund Managers of Using Target Returns (Part One of Two)

    The use of target returns or performance targets by hedge fund managers in offering documents and marketing materials can potentially lead to negative consequences.  For example, Meredith Whitney’s Kenbelle Capital LP aimed for a target return of 12-17%; yet, when the fund returned -11%, BlueCrest Capital Management – its largest investor – filed a lawsuit to redeem its investment.  See “Citing Persistent Losses, Seed Investor BlueCrest Capital Sues Meredith Whitney and Her Hedge Fund for Return of Seed Capital,” The Hedge Fund Law Report, Vol. 8, No. 10 (Mar. 12, 2015).  Other notable fund managers have lowered or revised their target returns in recent months, garnering negative press as a result.  Accordingly, hedge fund managers must take care when using target returns and first consider the potential risks and consequences of doing so.  This article, the first in a two-part series, discusses common practices for the use of target returns by hedge funds; analyzes reasons for using target returns; and highlights some potential drawbacks of using target returns.  The second article will analyze the legal risks associated with target returns and weigh the benefits of using target returns against such risks.

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  • From Vol. 8 No.12 (Mar. 27, 2015)

    Five Steps That CCOs Can Take to Avoid Supervisory Liability, and Other Hedge Fund Manager CCO Best Practices

    Participants at FRA’s Private Investment Funds Compliance Master Class, held on February 17, 2015 in New York City, addressed testimonials and past-specific recommendations in hedge fund marketing; whether performance should be presented net or gross of fees; presenting performance under different fee structures; use, placement and monitoring of third-party news articles; broker registration of in-house marketers and marketing departments; reverse solicitation and remuneration under AIFMD; bad actor rule compliance; three theories of CCO liability; three categories of enforcement actions involving CCOs; and five steps that CCOs can take to avoid liability.  See also “Stroock Seminar Identifies Five Strategies for Mitigating the Risk of Supervisory Liability for Hedge Fund Manager CCOs,” The Hedge Fund Law Report, Vol. 7, No. 2 (Jan. 16, 2014).

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  • From Vol. 8 No.4 (Jan. 29, 2015)

    2014 Was a Series of “Firsts” in the SEC’s Focus on Investment Advisers and Investment Companies

    Ever since the SEC created the Asset Management Unit back in 2010, the amount of scrutiny investment advisers face has continued to intensify.  And with this intense scrutiny, the SEC is forging new ground in its regulation of investment managers.  In a guest article, Andrew Dunbar, a partner at Sidley Austin LLP, discusses the series of “firsts” in SEC enforcement actions we saw in 2014 relating to investment advisers.  These firsts included the SEC’s increasing requirement in seeking admissions, as well as actions relating to “pay to play” and fees and expenses.  Understanding these new areas of enforcement, which may develop into trends, can help investment managers navigate the 2015 enforcement climate and update their compliance programs and risk inventories appropriately.  For additional insight from Dunbar, see “How Can Hedge Fund Managers Understand Recent SEC Developments to Mitigate Enforcement Risk?,” The Hedge Fund Law Report, Vol. 6, No. 8 (Feb. 21, 2013).

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  • From Vol. 8 No.1 (Jan. 8, 2015)

    SEC Settles Enforcement Action and Pursues Company Founder over Use of Backtested Performance Data

    Performance advertising remains an SEC enforcement priority and can be a minefield for hedge fund managers.  See “OCIE Director Andrew Bowden Identifies the Top Three Deficiencies Found in Hedge Fund Manager Presence Exams and Outlines OCIE’s Examination Priorities,” The Hedge Fund Law Report, Vol. 7, No. 38 (Oct. 10, 2014).  The use of hypothetical or backtested performance is particularly problematic.  See “Under What Conditions Can a Hedge Fund Manager Present Hypothetical Backtested Performance Results?,” The Hedge Fund Law Report, Vol. 6, No. 5 (Feb. 1, 2013).  Consistent with these regulatory priorities, the SEC recently settled an enforcement proceeding against an investment adviser whose founder claimed that the adviser’s strategy had been used to manage actual client assets since 2001, even though the strategy was not devised until late 2008.  The claimed performance was, in fact, backtested.  This article discusses the enforcement action.  For a discussion of other performance advertising issues, see the HFLR’s articles on GIPS compliance claims, testimonials and social media, cherry picking and case studies, use of gross performance results and use of other firms’ track records.

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  • From Vol. 7 No.37 (Oct. 2, 2014)

    Top Ten GIPS Compliance Challenges for Hedge Fund Managers

    The Global Investment Performance Standards (GIPS) are a set of best practices designed to ensure consistency in the presentation of investment performance results.  See “Expert Panel Provides Roadmap for Hedge Fund Managers Looking to Present Performance in Compliance with GIPS,” The Hedge Fund Law Report, Vol. 6, No. 30 (Aug. 1, 2013).  Though theoretically voluntary, institutional investors often condition investments on, among other things, performance information presented in compliance with GIPS.  Accordingly, GIPS compliance is viewed by many as a de facto requirement for hedge fund managers seeking institutional capital.  See “Is GIPS Compliance and Verification Thereof a De Facto Requirement for Access by Hedge Fund Managers to Institutional Assets?,” The Hedge Fund Law Report, Vol. 7, No. 29 (Aug. 1, 2014).  At the CFA Institute’s 2014 GIPS Standards Annual Conference, Karyn D. Vincent, a Managing Partner of ACA Performance Services, LLC, discussed the top ten GIPS compliance issues that she sees when acting as a GIPS verifier.  Jonathan A. Boersma, CFA, Executive Director of GIPS Standards at the CFA Institute, also participated in the discussion.  See also “A Step-By-Step Guide to GIPS Compliance for Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011).  This article summarizes Vincent’s top ten list, and identifies strategies for incorporating Vincent’s points into the marketing, reporting, disclosure and compliance efforts of hedge fund managers.

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  • From Vol. 7 No.29 (Aug. 1, 2014)

    Is GIPS Compliance and Verification Thereof a De Facto Requirement for Access by Hedge Fund Managers to Institutional Assets?

    First introduced in 1999, the Global Investment Performance Standards (GIPS) were designed and promulgated by the CFA Institute as a way of ensuring that investment managers report their performance in a consistent and transparent way.  A recent survey of investment managers and investment consultants looked at how many firms comply with GIPS and why.  This article summarizes the results of that survey and a related event.  In particular, this article discusses rates of GIPS compliance and verification among investment managers; manager perspectives on electing or eschewing GIPS compliance and verification; consultant and investor perspectives on GIPS compliance and verification; general trends in GIPS compliance; and the impact of those trends on hedge fund managers.  See also “Expert Panel Provides Roadmap for Hedge Fund Managers Looking to Present Performance in Compliance with GIPS,” The Hedge Fund Law Report, Vol. 6, No. 30 (Aug. 1, 2013).

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  • From Vol. 7 No.29 (Aug. 1, 2014)

    ALJ Decision Highlights the Critical Difference between “Audited” and “Verified” Returns in GIPS-Compliant Performance Advertising by Hedge Fund Managers

    This article discusses the facts and legal analysis in a recent decision by an SEC Administrative Law Judge relating to shortcomings in GIPS compliance by a registered investment adviser.  See “A Step-By-Step Guide to GIPS Compliance for Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011).  This article also identifies seven compliance lessons – arising out of the case and related materials – applicable to performance advertising by hedge fund managers.  On the topic of performance advertising, see also “How Can Hedge Fund Managers Market Their Funds Using Case Studies Without Violating the Cherry Picking Rule? (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 47 (Dec. 12, 2013); and “Can Hedge Fund Managers Use Gross (Rather Than Net) Results in Performance Advertising? (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 42 (Nov. 1, 2013).

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  • From Vol. 7 No.15 (Apr. 18, 2014)

    SEC Issues Guidance for Investment Advisers on the Interplay of the Testimonial Rule and Social Media

    From the SEC’s perspective, testimonials about investment advisers are misleading for the same reason as cherry picking: because testimonials present positive information without the context of offsetting negative information.  See “How Can Hedge Fund Managers Market Their Funds Using Case Studies Without Violating the Cherry Picking Rule? (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 47 (Dec. 12, 2013).  Rule 206(4)-1 under the Investment Advisers Act of 1940 (Act), accordingly, prohibits the use of testimonials by investment advisers.  However, that rule was drafted to cover a static media landscape consisting of print, television and radio; the rule is an imperfect fit with social media, a dynamic, ubiquitous and increasingly commercial channel.  Not surprisingly, the SEC has received a regular clip of questions over the past several years about how the prohibition on testimonials applies to statements about an investment adviser on social media websites.  Last month, the SEC’s Division of Investment Management addressed some of those questions in a Guidance Update.  This article describes the Guidance Update, focusing in particular on the principles in the Guidance Update most relevant to hedge fund managers.  This article concludes with the HFLR’s thoughts on the limited utility of the Guidance Update for hedge fund manager marketing.  See also “Understanding the Regulatory Regime Governing the Use of Social Media by Hedge Fund Managers and Broker-Dealers,” The Hedge Fund Law Report, Vol. 5, No. 47 (Dec. 13, 2012).

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  • From Vol. 6 No.47 (Dec. 12, 2013)

    How Can Hedge Fund Managers Market Their Funds Using Case Studies Without Violating the Cherry Picking Rule? (Part Two of Two)

    For a hedge fund manager to stand out in a crowded capital raising environment, its marketing must be lucid, coherent, consistent, credible and compelling.  The core purpose of hedge fund marketing is to convey the manager’s sustainable competitive advantage, and in doing so, managers typically find case studies persuasive.  If properly structured, case studies can demonstrate how a manager achieved reported results rather than merely communicating what those results were.  That is, a good case study can help substantiate a manager’s claim to competitive advantage, while at the same time illustrating the sustainability of the advantage.  However, the use of case studies by hedge fund managers in marketing is constrained by law and regulation, some of it counterintuitive to a logical portfolio manager.  For example, if a marketing presentation describes a successful investment with 100% accuracy, that presentation may nonetheless be materially misleading under the federal securities laws.  In short, case studies have obvious business value, but sometimes non-obvious legal risk.  This article is the second in a series seeking to untangle that risk for hedge fund managers that wish to capture the upside of case studies in marketing.  This article continues the discussion of risks associated with use of case studies (initiated in the first article in this series), and provides five best practices for managers wishing to use case studies in marketing.  The first article in the series described the purposes and typical contents of case studies; identified the types of managers and strategies that use and benefit from case studies; and began the discussion of risks associated with use of case studies in marketing, including an analysis of the cherry picking rule.  See “How Can Hedge Fund Managers Market Their Funds Using Case Studies Without Violating the Cherry Picking Rule? (Part One of Two),” The Hedge Fund Law Report, Vol. 6, No. 46 (Dec. 5, 2013).

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  • From Vol. 6 No.46 (Dec. 5, 2013)

    How Can Hedge Fund Managers Market Their Funds Using Case Studies Without Violating the Cherry Picking Rule? (Part One of Two)

    Hedge fund due diligence is a courtship process in which institutional investors and their consultants spend considerable time and resources getting to know a manager’s philosophy, people, processes and performance.  See “Getting to Know the Gatekeepers: How Hedge Fund Managers Can Interface with Investment Consultants to Access Institutional Capital (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 28 (Jul. 18, 2013).  Headline performance numbers (phrased gross or net of fees), statements of strategy and similar routine and comparable data points are necessary but not sufficient to tell a manager’s story, or to convey what is unique in the manager’s value proposition.  See “Can Hedge Fund Managers Use Gross (Rather Than Net) Results in Performance Advertising? (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 42 (Nov. 1, 2013).  Investment and operational due diligence focus not only on what performance the manager achieved, but also on how the manager achieved that performance.  And there is no more comprehensive or persuasive way to convey the “how” of a manager’s processes than to walk investors step-by-step through the lifecycle of actual investments – in other words, to present case studies.  However, the instinct of managers (and their marketing and sales people) to put their best feet forward when presenting case studies is constrained by general and specific prohibitions in the federal securities laws and rules.  Generally, the federal securities laws and rules prohibit materially misleading statements or omissions in communications with investors and potential investors.  Applied to case studies, this general prohibition typically means that managers cannot discuss good investments without also discussing bad investments.  Specifically, Rule 206(4)-1(a)(2) under the Investment Advisers Act of 1940 (Advisers Act) – the so-called “cherry picking” rule – prohibits a manager from disseminating, directly or indirectly, advertisements that refer to specific past profitable recommendations unless the advertisement offers to provide a list of all of the manager’s recommendations for at least the past year.  In short, managers often have a compelling business rationale for telling their stories via case studies (and likely will have more opportunities to do so now that the JOBS Act rules have been finalized), but managers’ ability to present case studies is constrained by a patchwork of law and regulation.  See “A Compilation of Important Insights from Leading Law Firm Memoranda on the Implications of the JOBS Act Rulemaking for Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 6, No. 30 (Aug. 1, 2013).  This article is the first in a two-part series designed to untangle that patchwork and enable managers to market via case studies within the scope of applicable authority.  In particular, this article describes the purposes and typical contents of case studies; identifies the types of managers and strategies that use and benefit from case studies; and highlights risks associated with use of case studies in marketing, including a discussion of the cherry picking rule.  The second article in the series will discuss additional risks of using case studies and provide best practices for managers wishing to use case studies in marketing.

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  • From Vol. 6 No.42 (Nov. 1, 2013)

    Can Hedge Fund Managers Use Gross (Rather Than Net) Results in Performance Advertising? (Part Two of Two)

    Hedge fund managers work long and hard for every basis point of return they achieve.  Therefore, it often comes as a surprise to managers to learn that they do not have plenary rights in their performance information.  Such information is not fully portable.  See “Portability and Protection of Hedge Fund Investment Track Records,” The Hedge Fund Law Report, Vol. 4, No. 40 (Nov. 10, 2011).  Investors often require performance information to be presented in a composite, while managers often think about performance per fund or per strategy.  See “A Step-By-Step Guide to GIPS Compliance for Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011).  And, as a default rule, regulators require performance to be presented net of fees, which, among other things, complicates apples-to-apples comparisons among funds with different fee structures.  See “Can Hedge Fund Managers Use Gross (Rather Than Net) Results in Performance Advertising? (Part One of Two),” The Hedge Fund Law Report, Vol. 6, No. 41 (Oct. 25, 2013).  However, there are exceptions to that default rule – circumstances in which regulators permit managers to present performance information gross of fees.  It is important for hedge fund managers to understand the existence and limits of situations in which they can present performance information gross of fees, for at least two reasons.  First, as managers hardly need to be reminded, performance remains central to marketing and capital raising.  See “Why and How Do Corporate and Government Pension Plans, Endowments and Foundations Invest in Hedge Funds?,” The Hedge Fund Law Report, Vol. 6, No. 14 (Apr. 4, 2013); “Why and How Do Family Offices and Foundations Invest in Hedge Funds?,” The Hedge Fund Law Report, Vol. 6, No. 1 (Jan. 3, 2013); “Why and How Do Sovereign Wealth Funds Invest in Hedge Funds?,” The Hedge Fund Law Report, Vol. 6, No. 13 (Mar. 28, 2013).  Second, regulators are taking a harder look at performance information in private fund marketing materials and activities, as Norm Champ, Director of the SEC’s Division of Investment Management, explicitly stated in a September 12, 2013 speech at the Practising Law Institute.  Accordingly, this article – the second in a two-part series – describes three circumstances in which hedge fund managers may present performance information gross of fees; analyzes four “hard cases” involving presentation of hedge fund performance information that do not fall neatly within the scope of no-action letters or other guidance; and discusses two categories of best practices that all managers should consider when presenting performance information.  The first article in this series provided an overview of relevant law, rules and SEC authority and offered practical guidance on calculating and presenting net performance results.

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  • From Vol. 6 No.41 (Oct. 25, 2013)

    Can Hedge Fund Managers Use Gross (Rather Than Net) Results in Performance Advertising? (Part One of Two)

    The hedge fund industry’s enthusiasm for the JOBS Act has been tempered by the recognition that while the law and related rules expand the opportunities for advertising by managers, they do not alter much of the long-standing authority governing such advertising.  See “Schulte, Cleary and MoFo Partners Discuss How the Final and Proposed JOBS Act Rules Will Impact Hedge Fund Managers and Their Funds,” The Hedge Fund Law Report, Vol. 6, No. 29 (Jul. 25, 2013).  In particular, the JOBS Act rules did not abridge or relax the regulatory regime governing performance advertising 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,” The Hedge Fund Law Report, Vol. 6, No. 30 (Aug. 1, 2013).  Norm Champ, the Director of the SEC’s Division of Investment Management, emphasized this point in a September 12, 2013 speech at the Practising Law Institute, cautioning, “I’ve instructed Division of Investment Management rulemaking and risk and examination staff to pay particular attention to the use of performance claims in the marketing of private fund interests.  In particular, this review will endeavor to identify potentially fraudulent behavior and to assess compliance with the federal securities laws, including appropriate Investment Advisers Act provisions.”  What hedge fund managers can and cannot do in the course of performance advertising is the product of law, SEC rules, no-action precedent and decades of practice; it is largely a function of principles and experience rather than explicit or rules-based guidance.  At the same time, performance remains a dominant factor in the capital allocation decisions of institutional investors.  See “Goldman Prime Brokerage Survey Relays the Views of Institutional Investors on Hedge Fund Fees, Manager Selection, Due Diligence, Return Expectations, Liquidity, Managed Accounts, UCITS and Alternative Mutual Funds,” The Hedge Fund Law Report, Vol. 6, No. 25 (Jun. 20, 2013).  Accordingly, hedge fund managers want (and need) to know how to put their best foot forward in performance advertising without causing that foot to trip a regulatory wire.  And in analyzing this area, managers are particularly concerned with whether they can advertise using gross performance results; if so, how; and, if not, how to calculate and present net performance results in a way that passes legal muster while still reflecting positively on the manager.  This article is the first in a two-part series that aims to help managers think through these and similar questions relating to the calculation and presentation of performance results in marketing, advertising, governing documents and other contexts.  Specifically, this article provides an overview of relevant law and SEC guidance (including relevant no-action letters), and offers practical guidance on calculating and presenting net performance results.  The second installment will identify situations in which managers may, consistent with relevant regulation, present gross performance results; outline the mechanics of calculating and presenting performance results in a number of challenging scenarios that hedge fund managers regularly face; and describe best practices for hedge fund managers in presenting their performance results.

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  • From Vol. 6 No.30 (Aug. 1, 2013)

    Expert Panel Provides Roadmap for Hedge Fund Managers Looking to Present Performance in Compliance with GIPS

    Historically, there has been little uniformity in how hedge fund managers present performance results.  As a result, hedge fund investors have faced difficulty in comparing returns across managers.  At the same time, the Global Investment Performance Standards (GIPS) – a set of voluntary best practices designed to ensure consistency in the presentation of performance results, and one of the few potential sources of uniformity – have lacked meaningful guidance for hedge fund managers.  This changed in 2012, when the GIPS Executive Committee issued the Guidance Statement on Alternative Investment Strategies and Structures (Guidance Statement) to provide hedge fund-specific guidance.  Since then, institutional investors and their consultants have frequently encouraged hedge fund managers to present performance results in compliance with GIPS.  See “Getting to Know the Gatekeepers: How Hedge Fund Managers Can Interface with Investment Consultants to Access Institutional Capital (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 28 (Jul. 18, 2013).  Yet despite the Guidance Statement, many hedge fund managers are still struggling to understand and navigate the complexities of GIPS compliance.  Against this backdrop, ACA Compliance Group recently hosted a webinar addressing GIPS compliance, focusing on issues specific to hedge fund managers, such as valuation, construction of GIPS composites, calculation of returns, side pocket reporting and benchmark selection.  Managers that provide more clarity in their performance results may be able to court institutional investors more frequently and effectively.  This article summarizes the main points from the webinar.  For more on the GIPS standards, see “A Step-By-Step Guide to GIPS Compliance for Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011).

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  • From Vol. 6 No.11 (Mar. 14, 2013)

    Proskauer Partner and SEC Enforcement Division Veteran Ronald Wood Explains the Implications for Hedge Fund Managers of Structure and Staffing Changes at the SEC

    In the past few years, the SEC’s Division of Enforcement has refocused its efforts with respect to the investment management industry via structure and staffing.  On the structuring side, the Division of Enforcement has established specialized units, such as the Asset Management Unit, devoted to addressing investor and systemic risks raised by private funds and their managers.  On the staffing side, the Division of Enforcement has hired investment management industry professionals – including hedge fund managers, analysts, operating professionals and due diligence experts – to staff these units.  With this new-found expertise, SEC staff not only “know where the bodies are buried,” but also “understand how they got there,” according to Bruce Karpati, Chief of the Asset Management Unit.  See “OCIE Director Carlo di Florio and Asset Management Unit Chief Bruce Karpati Address Examination and Enforcement Priorities for Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 6, No. 4 (Jan. 24, 2013).  On the foundation of its new expertise, the Division of Enforcement initiated 147 enforcement actions against investment advisers and investment companies in fiscal year 2012.  To provide deeper insight and actionable analysis on what the structuring and staffing changes at the Division of Enforcement mean for hedge fund managers, The Hedge Fund Law Report recently interviewed Ronald Wood.  Wood is a partner in the Securities Litigation Group at Proskauer Rose LLP, and prior to Proskauer spent a decade in the Division of Enforcement.  Our interview covered topics including SEC enforcement priorities; the use of reports filed with the SEC to identify enforcement targets; the SEC’s aberrational performance initiative; insider trading best practices; paid access to corporate executives; track record portability; due diligence on Chinese companies; pay to play issues; “big boy” letters; and FCPA concerns for hedge fund managers.  This article contains the transcript of our interview with Wood.  This interview was conducted in connection with the Regulatory Compliance Association’s upcoming Regulation, Operations & Compliance 2013 Symposium, to be held at the Pierre Hotel in New York City on April 18, 2013.  That Symposium is scheduled to include a panel entitled “Post SAC Capital – Investigation, Enforcement & Prosecution of Hedge & PE Managers.”  For a fuller description of the Symposium, click here.  To register for the Symposium, click here.  Subscribers to The Hedge Fund Law Report are eligible for a registration discount.

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  • From Vol. 6 No.10 (Mar. 7, 2013)

    How Can Hedge Fund Managers Identify and Navigate Pitfalls Associated with the JOBS Act’s Rollback of the Ban on General Solicitation and Advertising?

    The Jumpstart Our Business Startups Act (JOBS Act) provisions allowing general solicitation and general advertising in private offerings (JOBS Act Marketing Provisions), upon becoming effective, will profoundly change how hedge fund managers can market their funds.  Before taking advantage of the JOBS Act Marketing Provisions, however, hedge fund managers should be aware of a number of potential pitfalls.  First, hedge fund managers may be prohibited from engaging in general solicitation and general advertising if they rely on exemptions from registration under certain Commodity Futures Trading Commission rules, or under certain state and federal investment adviser laws.  Second, hedge fund managers that are able to take advantage of the provisions need to be aware of several potential compliance issues under the Investment Advisers Act of 1940, including issues that arise when using social media, publicly available websites and publicly advertised performance history.  In a guest article, Adam Gale, a Member in the New York office of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C., identifies potential regulatory pitfalls associated with reliance on the JOBS Act Marketing Provisions and provides some recommendations to address compliance issues in connection with reliance on the JOBS Act Marketing Provisions.

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  • From Vol. 6 No.9 (Feb. 28, 2013)

    SEC’s National Examination Program Publishes Official List of Priorities for 2013 Examinations of Hedge Fund Managers and Other Regulated Entities

    On February 21, 2013, the SEC’s National Examination Program (NEP) published its list of priorities for examinations of investment advisers (including hedge fund managers) and other regulated entities for 2013.  The NEP list not only addresses presence examinations of newly registered investment advisers, but also discusses focus areas for examinations of previously-registered advisers.  Also, unlike prior speeches addressing adviser examination priorities for 2013, this announcement reflects an official SEC statement on the matter.  This article offers a deep dive into the SEC’s thinking on each of the specified examination priorities.

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  • From Vol. 6 No.5 (Feb. 1, 2013)

    Under What Conditions Can a Hedge Fund Manager Present Hypothetical Backtested Performance Results?

    Hedge fund managers (particularly early-stage managers) that lack a robust track record to demonstrate their investment prowess may use hypothetical backtested performance results to show how their investment strategies would have performed on an historical basis.  However, the SEC and investors strictly scrutinize the use of hypothetical backtested performance results by hedge fund managers because such results do not represent actual performance data.  The concern is that hypothetical results may reflect rosy assumptions as opposed to real results, and potential investors may not be sufficiently apprised of the difference.  In an expression of such concern, the SEC recently entered into a consent order with an investment adviser and its principal to settle an enforcement action in connection with the misleading use of hypothetical backtested performance results.  The results at issue purported to show how the performance of the manager’s investment portfolios would have compared to designated benchmarks.  This article summarizes the factual background, legal violations and settlement terms in this case.  The article also describes prior SEC enforcement actions that were based on other impermissible practices in connection with the use of hypothetical backtested performance results.  For another example of an SEC action premised on the use of misleading performance advertising, see “SEC Charges Hedge Fund Manager and Its Founder with Securities and Investment Adviser Fraud Based on ‘Cherry Picking’ of Trades,” The Hedge Fund Law Report, Vol. 6, No. 1 (Jan. 3, 2013).

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  • From Vol. 5 No.47 (Dec. 13, 2012)

    NFA Workshop Details the Registration and Regulatory Obligations of Hedge Fund Managers That Trade Commodity Interests

    The National Futures Association (NFA) held a workshop (workshop) in New York on October 23, 2012 to help commodity pool operators (CPOs) and commodity trading advisors (CTAs) – including hedge fund managers that trade commodity interests – determine whether they must register with the U.S. Commodity Futures Trading Commission and the NFA, and to understand their regulatory obligations if they are required to do so.  Topics discussed during the workshop included popular CPO and CTA registration exemptions; reporting requirements for registrants, including those related to disclosure documents and financial reports; requirements related to promotional materials and sales practices for registrants; and the NFA audit process.  This article provides feature length coverage of the key topics discussed during the workshop.

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  • From Vol. 5 No.38 (Oct. 4, 2012)

    CPO Compliance Series: Marketing and Promotional Materials (Part Two of Three)

    Commodity pool operators (CPOs) that must soon register with the U.S. Commodity Futures Trading Commission (CFTC) and become members of the National Futures Association (NFA) because of the rescission of the CFTC Regulation 4.13(a)(4) registration exemption will shortly need to undertake numerous CFTC and NFA compliance obligations.  One of the key compliance obligations arises from CFTC Regulation 4.41 and NFA Compliance Rule 2-29, each of which sets forth various prohibitions and guidelines for marketing activities and promotional materials for both CPOs and commodity trading advisors (CTAs).  This article discusses in detail the CFTC and NFA prohibitions and guidelines for marketing activities and promotional materials for CPOs and CTAs contained in CFTC Regulation 4.41 and NFA Compliance Rule 2-29 and its related interpretive notices and provides practical guidance on how to comply with these prohibitions and guidelines.  This article is the second of a three-part series of articles that focus in detail on various compliance obligations of CPOs under CFTC and NFA regulations and guidance.  The first article addressed NFA Bylaw 1101, which addresses conducting business with non-NFA members.  See “CPO Compliance Series: Conducting Business with Non-NFA Members (NFA Bylaw 1101) (Part One of Three),” The Hedge Fund Law Report, Vol. 5, No. 34 (Sep. 6, 2012).  The third article will address reporting of principals and registration of associated persons.  For additional coverage of each of these topics and the topics discussed in this article, see “Do You Need to Be a Registered Commodity Pool Operator Now and What Does It Mean If You Do?  (Part One of Two),” The Hedge Fund Law Report, Vol. 5, No. 8 (Feb. 23, 2012).

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  • From Vol. 5 No.26 (Jun. 28, 2012)

    Delaware Chancery Court Decision Highlights the Imperative of Thorough Due Diligence on Potential Hedge Fund Business Partners

    As a hedge fund manager, you are required as a legal matter to “know your customers,” that is, your investors.  In addition, you are required as a practical matter to know your partners.  In many cases, this imperative is beside the point: many hedge fund management businesses are founded by partners that have been working together for years.  In other cases, however, management companies are organized by partners that met only recently.  In such cases, the partners should perform thorough due diligence on one another.  It may seem contrary to the optimism, trust and team spirit required to scale the increasingly high barriers to beginning in the hedge fund business.  But a recent Delaware Chancery Court (Court) opinion highlights the fact that the stakes are too high to rely on gut feelings.  The stakes are even too high to rely on routine due diligence conducted by credible service providers.  The stakes are nothing less than your personal reputation, and in the investment management business, that is all you have or can have.  Diligence in this context should be deep, customized and cross-checked.  Once you get into bed with a bad actor in the investment management business, it is virtually impossible – from a reputation point of view – to get out.

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  • From Vol. 5 No.15 (Apr. 12, 2012)

    Brockton Retirement Board Files Class Action Lawsuit Against Oppenheimer Fund of Private Equity Funds and Executive Officers for Allegedly False Claims Relating to Fund Performance and Investment Valuations Contained in Fund Marketing Materials

    The Jumpstart Our Business Startups Act may portend good news for hedge funds that seek to raise capital from investors.  However, hedge fund managers should approach their investor solicitation efforts with caution, particularly in light of the increasing scrutiny from both regulators and investors with respect to fund performance and valuation.  A recent example of this scrutiny is a class action lawsuit initiated on March 26, 2012 by a Massachusetts retirement fund, Brockton Retirement Board (Brockton), against a private equity fund of funds manager and related entities.  The Complaint generally alleges that the Defendants made false and misleading statements in marketing materials.  This article summarizes the factual allegations in the Complaint, the causes of action and the remedies sought by Brockton.  For a similar story of alleged failure by a fund of funds manager to perform claimed due diligence, see “Federal Court Decision Holds That a Fund of Funds Investor May Sue a Fund of Funds Manager That Fails to Perform Specific Due Diligence Actions Promised in Writing and Orally,” The Hedge Fund Law Report, Vol. 4, No. 27 (Aug. 12, 2011).

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  • From Vol. 5 No.9 (Mar. 1, 2012)

    SEI and Greenwich Associates Survey Identifies Institutional Investors’ Expectations With Respect to Hedge Fund Performance, Transparency and Liquidity

    On February 22, 2012, SEI Knowledge Partnership and Greenwich Associates released the second installment of a two-part report summarizing the results of their September and October 2011 survey of hedge fund investors.  For a detailed analysis of Part I, see “Survey by SEI and Greenwich Associates Highlights the Importance to Hedge Fund Investors of a Clearly Articulated, Comprehensible and Credible Value Proposition,” The Hedge Fund Law Report, Vol. 5, No. 4 (Jan. 26, 2012).  The second installment, entitled “The Shifting Hedge Fund Landscape, Part II of II: The New Dynamics of Hedge Fund Competitiveness” (Report), details investors’ greatest concerns when investing in hedge funds as well as their hedge fund selection criteria and expectations.  This article summarizes the findings of the Report and outlines the Report’s five key recommendations for hedge fund managers.

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  • From Vol. 5 No.4 (Jan. 26, 2012)

    Survey by SEI and Greenwich Associates Highlights the Importance to Hedge Fund Investors of a Clearly Articulated, Comprehensible and Credible Value Proposition

    In October 2011, SEI Knowledge Partnership (SEI) and Greenwich Associates conducted their fifth annual survey of institutional hedge fund investors.  On January 25, 2012, they released a report summarizing part one of the results of that survey (Report), including current trends affecting the hedge fund industry, including institutional hedge fund allocations, objectives, performance and preferences in investment strategies and vehicles.  The Report, entitled “The Shifting Hedge Fund Landscape, Part I of II: Institutions Put Fund Managers to the Test,” identifies a deepening commitment to hedge funds on the part of institutional investors, and foreshadows increased institutional allocations.  At the same time, however, the Report finds that institutions keep creating new challenges and requirements for hedge fund managers.  Notably, the Report also details what hedge fund managers must do in order to maintain investor confidence.  Part two of the survey will explore investors’ chief concerns regarding hedge fund investing, as well as the continuing evolution of institutional standards for hedge fund evaluation, selection and monitoring.  This article summarizes the findings of the Report and the key takeaways for hedge fund managers.  See also “SEI Report Describes the Growth Opportunity for Hedge Fund Managers in Regulated Alternative Funds,” The Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011).

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  • From Vol. 4 No.44 (Dec. 8, 2011)

    A Step-By-Step Guide to GIPS Compliance for Hedge Fund Managers

    The Hedge Fund Law Report and others have reported on the post-crisis ascendance of non-performance factors in hedge fund due diligence and investment decision-making.  In short, before 2008, hedge fund allocations were driven largely by a manager’s past performance.  After 2008, factors such as transparency, liquidity and robust risk management surpassed performance in the hierarchy of concerns of institutional hedge fund investors.  See “Survey by SEI and Greenwich Associates Identifies the Primary Decision Factors and Concerns of Institutional Investors When Investing in Hedge Funds,” The Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 11, 2011).  However, we do not wish to overstate the case or the duration of the trend.  The long-term lesson of the crisis likely will be that robust risk management, appropriate liquidity and transparency and well-developed infrastructure are necessary to justify a hedge fund investment, but not sufficient.  Hedge fund managers without institutional caliber businesses will often be passed over, but as between two managers with good businesses, the deciding factor will often be past performance.  Thus the immediate and important question for hedge fund managers: how can managers present performance information in a manner that maximizes capital raising efforts while complying with relevant law and standards?  An increasingly common answer to this question in the hedge fund community is: by complying with the Global Investment Performance Standards (GIPS), an evolving set of practice standards designed to ensure consistency and uniformity in the presentation of investment performance results.  Compliance with GIPS is ostensibly voluntary, but in practice, more and more institutional hedge fund investors are asking to see GIPS-compliant performance information.  Accordingly, GIPS compliance is becoming a de facto requirement for hedge fund managers, and hedge fund managers are actively seeking to become GIPS compliant.  The main challenge for hedge fund managers is that GIPS were originally designed for a long-only world.  They have been an imperfect fit for managers with complex investment structures, side pockets, illiquid or hard-to-value assets and other typical elements of the hedge fund business.  Sensitive to this, the GIPS Executive Committee recently promulgated guidance specific to alternative investment managers, and service providers have adapted their businesses to help hedge fund managers comply with GIPS and certify such compliance.  However, despite the guidance and available assistance, GIPS compliance remains a challenge for hedge fund managers.  This article aims to assist hedge fund managers in rising to that challenge and surmounting it.  To do so, this article starts by providing a comprehensive overview of GIPS.  The article then identifies five discrete categories of benefits of GIPS compliance and two categories of burdens of compliance.  Next, and most importantly, this article provides a step-by-step process by which hedge fund managers can become GIPS compliant.  In the course of this discussion, this article details the material points from two recent webinars and one recent white paper promulgated by leading GIPS service providers.  Reading this article will enable a hedge fund manager to, among other things: revise its marketing materials to comply with GIPS; organize its front, middle and back offices to collect the data necessary to support a GIPS-compliant presentation; manage service providers with a view to GIPS compliance; ask the right questions of outside counsel; determine whether to engage a specific GIPS compliance service provider; define the scope of any such engagement; and respond effectively to due diligence inquiries on GIPS.

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  • From Vol. 4 No.44 (Dec. 8, 2011)

    Hedge Fund Managers with Unexplained Aberrational Performance Are More Likely to Become Targets of SEC Enforcement Actions

    In a December 1, 2011 press release, the Asset Management Unit of the SEC’s Division of Enforcement (Division) announced the Aberrational Performance Inquiry (Inquiry), a new initiative to identify and combat hedge fund fraud.  Under the Inquiry, the Division is using proprietary risk analytics to screen hedge funds’ performance returns to determine whether the stated returns are consistent with the fund’s investment strategy or appropriate benchmarks.  If the Division identifies a hedge fund whose performance is aberrational – too high, too low or inconsistent with the fund’s strategy – the Division is likely to undertake additional quantitative and qualitative screens to determine the source of the aberration.  Such screens may include contacting the fund’s manager directly, looking more closely at the sources of stated returns and examining factors other than returns.  This article: discusses the Inquiry in greater depth; details the factual and legal allegations in the SEC’s administrative proceeding against unregistered investment adviser LeadDog Capital Markets LLC and its general partners – an action that was brought as part of the Inquiry; and identifies specific practices for hedge fund managers to consider in light of the Inquiry.  For more on the Inquiry based on information that was publicly available as of April of this year, see “SEC’s Hedge Fund Focus to Include Review of Funds That Outperform the Market,” The Hedge Fund Law Report, Vol. 4, No. 14 (Apr. 29, 2011).

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  • From Vol. 4 No.40 (Nov. 10, 2011)

    Portability and Protection of Hedge Fund Investment Track Records

    A hedge fund’s performance history, or track record, can be one of its most valuable assets.  A fund that has developed a successful track record will want to promote that track record as evidence of its own capabilities and protect that track record from being claimed or distorted by others.  On the other hand, a portfolio manager or other employee who has developed a successful track record will want to take that track record with him when he leaves the fund and use it to attract his own investors.  A fund or portfolio manager with a poor track record may want to avoid or limit the disclosure of past performance.  In a guest article, Sean R. O’Brien and Sara A. Welch, Managing Partner and Counsel, respectively, at O’Brien LLP, along with Joel A. Blanchet, a Partner at Kirkland & Ellis LLP, explore the manner in which the law affects investment funds, investment adviser firms and individuals when it comes to the portability of track records, and identify steps that funds and portfolio managers can take to protect their respective rights with respect to those track records.  At the outset, this article discusses who owns an investment track record and therefore, who can use such a track record.  The following sections detail regulatory guidance provided by the Securities and Exchange Commission (SEC), industry guidance provided by the CFA Institute and court decisions on the ownership and portability of track records.  The article concludes with a discussion of contractual provisions hedge fund managers can use to protect their investment track records from misappropriation and misuse.  For more on O’Brien LLP, see “Sean R. O’Brien Launches Boutique Law Firm Focused on Hedge Fund Litigation,” below, in this issue of The Hedge Fund Law Report.  For more by O’Brien LLP attorneys, see “Protecting Hedge Funds’ Trade Secrets: The Federal Government’s Enforcement of Criminal Laws Protecting Proprietary Trading Strategies,” The Hedge Fund Law Report, Vol. 3, No. 48 (Dec. 10, 2010).

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  • From Vol. 4 No.40 (Nov. 10, 2011)

    Principals of Paron Capital Management Sue Rothstein Kass for Negligence, Fraud and Breach of Contract Based on Alleged Failure to Obtain Third-Party Verification of Performance Results

    Plaintiffs Peter McConnon (McConnon) and Timothy Lyons (Lyons) are the current principals of plaintiff investment manager Paron Capital Management, LLC (Paron).  In April 2010, McConnon and Lyons were introduced to James Crombie (Crombie), who claimed to have run a successful commodity futures trading business and desired to form a new trading business with McConnon and Lyons.  McConnon and Lyons claim that Paron retained defendant accounting firm Rothstein, Kass & Company, LLP (Rothstein Kass) to verify Crombie’s claimed returns.  In particular, they asked Rothstein Kass to obtain third-party confirmation of data provided by Crombie.  According to the complaint, Rothstein Kass never did so.  It turned out that the historical performance data supplied by Crombie was a complete fabrication.  That false data formed the basis of Paron’s marketing materials.  Following investigations and enforcement actions by the National Futures Association and the U.S. Commodity Futures Trading Commission, Paron and Crombie were banned from futures trading and Paron’s business collapsed.  The plaintiffs seek damages from Rothstein Kass for negligence, fraud and breach of contract.  We detail the plaintiffs’ allegations and the allegations and findings in the enforcement actions.  Rothstein Kass told The Hedge Fund Law Report with respect to this matter: “We have no comment on these meritless claims.”

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  • From Vol. 4 No.19 (Jun. 8, 2011)

    Alternative Investment Management Association Publishes Institutional Investor Guide Covering Hedge Fund Governance, Risk, Liquidity, Performance Reporting, Investor Relations, Marketing, Operations, Valuation, Due Diligence and Other Topics

    On May 31, 2011, the Alternative Investment Management Association (AIMA), published a guide aimed at communicating institutional investors’ views, expectations and preferences to the hedge fund industry.  As described by AIMA Chairman Todd Groome, the guide was published “[i]n light of the ongoing ‘institutionalisation’ of the hedge fund industry and the growth of institutional investor participation.”  The authors of the guide, members of the AIMA Investor Steering Committee, and “some of the most influential investors and advisors in the industry,” include Luke Dixon of Universities Superannuation Scheme, Andrea Gentilini of Union Bancaire Privée, Kurt Silberstein of the California Public Employees Retirement Scheme, Michelle McGregor-Smith of British Airways Pension Investment Management and Adrian Sales of Albourne.  See “CalPERS ‘Special Review’ Includes Details of Misconduct and Recommendations That May Fundamentally Alter the Hedge Fund Placement Agent Business,” The Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011).  The guide covers a range of increasingly relevant operational and organizational issues that institutional investors consider in their due diligence reviews, including: hedge fund governance, constitutional documents, the role of the board of directors, performance reporting practices and transparency, counterparty risk, operations, fund liquidity, risk controls, ownership of the management company, sales and marketing, valuation, business continuity planning, compliance, service provider relationships and more.  This article offers a comprehensive discussion of the key principles, ideas and recommendations presented in the guide.

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  • From Vol. 4 No.12 (Apr. 11, 2011)

    GIPS Committee Provides Eagerly-Anticipated Guidance on Presentation of Hedge Fund Performance Information for Master-Feeder Structures, Side Pockets, Illiquid Assets and Other Assets, Strategies and Structures

    As established by the CFA Institute in 1999, the “Global Investment Performance Standards” (GIPS) for the presentation of investment performance information aims to create ethical, global and industry-wide methods of communicating investment results to prospective clients.  On March 15, 2011, the GIPS Executive Committee released its “Exposure Draft of the Guidance Statement on Alternative Investment Strategies and Structures” (Guidance Statement) in an effort to provide dedicated guidance to firms that manage hedge funds, funds-of-funds, master-feeder funds and other alternative investment strategies so they may better understand and meet the GIPS standards.  The Executive Committee decided to produce these standards due to the perception among many alternative investment firms that the lack of such guidance complicated compliance with GIPS.  Accordingly, the GIPS standards, which focus on the underlying GIPS principles of “fair representation and full disclosure,” provide a framework that substantially all hedge fund and other private fund managers can apply to a variety of assets, structures and strategies.  The exposure draft is open for public comment until June 15, 2011.  This article provides a comprehensive summary of the exposure draft, focusing on the items most relevant to presentation of hedge fund performance information.

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  • From Vol. 4 No.4 (Feb. 3, 2011)

    Key Legal Considerations in Connection with the Movement of Talent from Proprietary Trading Desks to Start-Up or Existing Hedge Fund Managers: The Hedge Fund Manager Perspective (Part Three of Three)

    This is the third installment in our three-part series on the movement of talent from bank proprietary (prop) trading desks to hedge fund managers.  The series focuses on the legal and business considerations raised by such moves, and highlights the different considerations faced by the different constituencies.  The first article in the series focused on the talent perspective, that is, the considerations that investment and non-investment personnel should address when moving from a bank to a hedge fund manager.  See “Key Legal Considerations in Connection with the Movement of Talent from Proprietary Trading Desks to Start-Up or Existing Hedge Fund Managers: The Talent Perspective (Part One of Three),” The Hedge Fund Law Report, Vol. 3, No. 49 (Dec. 17, 2010).  The second article in the series focused on the bank perspective, and demonstrated that while banks face many of the same issues as talent in this context, banks often face those issues from a different perspective, and weight those issues differently.  See “Key Legal Considerations in Connection with the Movement of Talent from Proprietary Trading Desks to Start-Up or Existing Hedge Fund Managers: The Bank Perspective (Part Two of Three),” The Hedge Fund Law Report, Vol. 4, No. 2 (Jan. 14, 2011).  This article focuses on the perspective of the hedge fund manager to which talent moves.  While the legal and business issues faced by such recipient managers are complex, at a broad level, they can be broken down into a simple binary question: Are your hiring decisions motivated by the goal of buying talent or access?  Generally, if you are looking to buy talent, you are okay, but if you are looking to buy access, you are in trouble.  Put slightly differently, while a variety of legal disciplines govern the relationships between hedge fund managers and their employees, the unifying theme among those disciplines is ensuring that business success or failure is based on merit commercialized on a level playing field.  If this sounds too pious to be plausible, read on – and also read some of our cautionary tales of recent access-buying in the hedge fund arena.  To illustrate this general idea, this article discusses the following categories of considerations for hedge fund managers receiving talent: avoiding insider trading violations based on material, non-public information possessed by incoming talent; the three-step process for avoiding liability for aiding and abetting a breach by a new employee of that employee’s employment or post-employment covenants with his or her former bank employer, including non-competition agreements (non-competes), non-solicitation agreements (non-solicits), termination, severance and option agreements; special considerations in connection with the movement of teams (as opposed to individuals); avoiding liability for unauthorized use by an incoming employee of trade secrets or other intellectual property owned by a former bank employer; use of data regarding employee performance at a prior bank employer; avoiding pay-to-play violations; and what to look for when performing background checks.

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  • From Vol. 3 No.49 (Dec. 17, 2010)

    Key Legal Considerations in Connection with the Movement of Talent from Proprietary Trading Desks to Start-Up or Existing Hedge Fund Managers: The Talent Perspective (Part One of Three)

    Talent has always been mobile in the hedge fund industry.  But at least seven factors are increasing the pace with which hedge fund talent − investment talent (portfolio managers, analysts, traders) as well as non-investment talent (professionals focusing on marketing, operations, law, accounting, compliance and technology) − is moving from proprietary trading desks at investment or commercial banks (prop desks) to a range of other entities, most notably, start-up and existing hedge fund managers.  First, the Volcker Rule generally prohibits U.S. banking institutions and non-U.S. banking institutions with U.S. banking operations from: (1) proprietary trading unrelated to customer-driven business; and (2) sponsoring or investing in hedge funds or private equity funds, or engaging in certain covered transactions with advised or managed hedge funds or private equity funds.  See "Implications of the Volcker Rule – Managing Hedge Fund Affiliations with Banks," The Hedge Fund Law Report, Vol. 3, No. 10 (Mar. 11, 2010).  Second, many of the investment and commercial banks that house proprietary trading desks have been subject to explicit or implicit restrictions on or reviews of compensation of key personnel.  Third, the availability of hedge fund seed funding has increased.  For example, a December 2010 survey conducted by private fund data provider Preqin found that the number of hedge fund investors expressing an interest in seed investments has almost doubled, from 11 percent in 2009 to 21 percent in 2010.  See also "How to Structure Exit Provisions in Hedge Fund Seeding Arrangements," The Hedge Fund Law Report, Vol. 3, No. 40 (Oct. 15, 2010).  Fourth, many existing hedge fund managers have renegotiated, reset or regained their high water marks.  See "How Are Hedge Fund Managers with Funds Under their High Water Marks Renegotiating Performance Fees or Allocations?," The Hedge Fund Law Report, Vol. 2, No. 33 (Aug. 19, 2009).  Fifth, many hedge fund industry professionals have no choice: they have been fired from prop desks, and plying their trade at a new institution is their highest value opportunity.  Sixth, according to a Fall 2010 Institutional Investor Survey conducted by Bank of America Merrill Lynch Capital Introductions, institutional investors are considerably more “bullish” on alternative investments than they are about traditional equities and fixed income investments.  Seventh, and finally, there is a considerable volume of dormant savings, particularly in the developing world (especially the so-called BRIC countries) and parts of developed Asia; many of the new funds being launched (by new or existing managers) are intended to tap this well of savings.  See "Local Currency Hedge Funds Expand Marketing and Investment Opportunities, but Involve Currency Hedging and Other Challenges," The Hedge Fund Law Report, Vol. 3, No. 1 (Jan. 6, 2010).  Despite these seven factors (and there are likely others) motivating and hastening the movement of talent into and within the hedge fund industry, talent does not move in an entirely free market.  Rather, the mobility of talent is bound up in a web of legal and practical restrictions.  The basic purpose of this article − the first in a three-part series − is to identify relevant legal issues and offer practical suggestions to help talent negotiate the transition from a prop desk to the next hedge fund opportunity.  (The second article in this series will look at talent moves from the bank perspective, and a third article will look at talent moves from the perspective of the hedge fund management company to which the talent moves.)  To serve its purpose, this article discusses the following: the definition of "talent" (we are using the word as shorthand for a variety of typical job descriptions); the working definition of proprietary trading; the various types of entities from which and to which talent may move; which types of entities are likely to be the biggest winners in the movement of talent away from prop desks, and why; examples of recent talent moves from prop desks to other institutions; key legal considerations applicable to all moving hedge fund talent, whether such talent is moving to an existing hedge fund manager or starting its own shop (this discussion includes subtopics such as non-competition agreements, non-solicitation agreements, ownership of performance data and intellectual property, etc.); the key legal considerations specific to talent leaving a prop desk to start a new hedge fund management company; and the chief practical and cultural issues faced by talent that departs a prop desk to start or participate in running a hedge fund management company.

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  • From Vol. 3 No.9 (Mar. 4, 2010)

    Global Investment Performance Standards Facilitate Reliable, Apples-to-Apples Comparisons by Hedge Fund Investors, and Offer Marketing Opportunities for Hedge Fund Managers

    Various factors – including the closing of investment bank proprietary trading desks and layoffs at hedge fund managers – have contributed to a quickening pace of hedge fund entrepreneurship.  See “What Is Proprietary Trading, and Why Does Its Definition Matter to Hedge Fund Managers?,” The Hedge Fund Law Report, Vol. 3, No. 8 (Feb. 25, 2010).  At the same time, a noteworthy proportion of the assets that redeemed from hedge funds over the past two years are looking to return, along with new assets.  In short, both the supply of hedge fund management options and the demand for such management by institutional investors are increasing.  As a swelling pool of assets evaluates a growing number of managers, performance remains one of the key determinants of where assets get allocated.  See “How Can Start-Up Hedge Fund Managers Use Past Performance Information to Market New Funds?,” The Hedge Fund Law Report, Vol. 2, No. 50 (Dec. 17, 2009).  (Performance used to be the key determinant of allocations, now it is merely primus inter pares; transparency and liquidity also loom large.  See “Hedge Funds Using 3WayNAV to Enhance Visibility into Portfolio Liquidity,” The Hedge Fund Law Report, Vol. 3, No. 2 (Jan. 13, 2010); “Rolling Lock-Up Periods Enable Hedge Fund Managers to Pursue Less Liquid Strategies While Managing Investors’ Liquidity Expectations,” The Hedge Fund Law Report, Vol. 3, No. 2 (Jan. 13, 2010).)  For hedge fund managers in this environment, the reliability, comparability and utility of performance data are, collectively, as important as the levels of performance.  That is, investors want to know that the numbers are accurate; they want to be able to compare them to numbers from other funds following the same strategy, funds following different strategies and funds organized in different jurisdictions; and they want to be able to plug the numbers into their own models and perform analytics.  The Global Investment Performance Standards (GIPS standards), promulgated by the CFA Institute, facilitate these three values – reliability, comparability and utility.  The GIPS standards are legally voluntary but, increasingly, practically required guidelines establishing a consistent method for presentation by investment advisers of performance and valuation data.  While not designed specifically with hedge fund managers in mind, hedge fund managers are increasingly adopting the guidelines, retaining third parties to verify their adoption and using their adoption offensively in marketing to institutional investors.  To assist hedge fund managers in determining whether the benefits of compliance with the GIPS standards outweigh the burdens, this article details: what the GIPS standards are; their specific application to hedge fund managers; recent revisions of the GIPS standards; interaction of the GIPS standards with conflicting country or state laws; specific steps required to become compliant; the third party verification regime; the benefits and burdens to hedge fund managers of compliance; and practical strategies for mitigating the burdens.

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  • From Vol. 2 No.50 (Dec. 17, 2009)

    How Can Start-Up Hedge Fund Managers Use Past Performance Information to Market New Funds?

    Recent market dislocations have given rise in the hedge fund industry, as in other industries, to an increasing crescendo of entrepreneurship.  According to data from Hedge Fund Research Inc., 224 hedge funds launched worldwide during the third quarter of this year, while 190 closed in the same period – the first time since early 2008 that the number of new launches exceeded the number of closures.  While compensation has come down on average, especially at firms under their high water marks, so has the opportunity cost of casting out on one’s own.  See “How Are Hedge Fund Managers with Funds Under their High Water Marks Renegotiating Performance Fees or Allocations?,” The Hedge Fund Law Report, Vol. 2, No. 33 (Aug. 19, 2009).  In short, for star traders on broker-dealer prop desks, second chairs, co-managers and trusted lieutenants, the climate for hedge fund entrepreneurship is unusually fertile.  See “As Banks Close Prop Desks and Traders Move to Hedge Funds, Hedge Fund Managers Focus on Permissible Scope of Use of Confidential Information,” The Hedge Fund Law Report, Vol. 2, No. 18 (May 7, 2009).  While hedge fund entrepreneurs face all of the usual issues involved in entrepreneurship – employment matters, office leases, professional services fees, etc. – they also face certain issues unique to the hedge fund industry.  See “Stars in Transition: A New Generation of Private Fund Managers,” The Hedge Fund Law Report, Vol. 2, No. 49 (Dec. 10, 2009).  Chief among those unique issues are the legal and regulatory limitations on what a hedge fund entrepreneur can communicate to potential investors in the new funds or management entity with respect to prior performance.  Specifically, despite the ubiquity of the disclaimer stating that past performance does not guarantee future results, there remains no more reliable predictor of future results than past performance.  Accordingly, new investors are keenly interested in past performance, and for any hedge fund entrepreneur that seeks to create a viable business, the question is not whether to communicate past performance, but how.  The short answer is: carefully.  Few topics are as central to marketing discussions when launching a new hedge fund management company and new hedge funds, and few topics are as fraught with legal risk.  In an effort to help hedge fund entrepreneurs navigate the thicket of relevant regulation, this article analyzes in depth the laws, rules, regulatory pronouncements (in particular, no-action letters) and market practices governing the permissible and impermissible uses of past performance data when launching new funds or managers.  While the authority is complex and fact-specific, this article extracts and drills down on five broad principles that new managers would be well-advised to keep in mind during (and even after) new fund or manager launches.  Within those five broad principles, this article describes concrete strategies that managers can follow to stay within the rules governing the use of past performance information in marketing efforts.  This article also details the key points from the seminal Clover Capital no-action letter.

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  • From Vol. 1 No.29 (Dec. 24, 2008)

    NFA Letter to CFTC Broadens Marketing Restrictions Applicable to Forex Dealer Members

    The use by or on behalf of a Forex Dealer Member (FDM) of the National Futures Association (NFA) of hypothetical performance results in the context of promotional materials has long been a controversial subject.  A new NFA letter to the CFTC tweaks the rule book in this area, applying to off-exchange hypotheticals the same restrictions that have applied for more than a decade to on-exchange hypotheticals.  We detail the substance of the amendments, and changes they may require in the presentation of performance information and other policies and procedures of FDMs.

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  • From Vol. 1 No.26 (Dec. 3, 2008)

    SEC Cuts Back on Anti-Cherry Picking Rules

    On November 7, 2008, the SEC’s Division of Investment Management issued a no-action letter to The TCW Group Inc. indicating that the division will not recommend enforcement action if wholly-owned investment advisory subsidiaries of TCW distribute marketing materials to prospective and current clients where the materials highlight certain portfolio investments and contain other analytical information, so long as TCW complies with conditions designed to prevent subjectivity and misleading cherry-picking of results.  We explain how this no-action letter may expand the range of investment-specific information that hedge fund managers may communicate to investors.

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