The Hedge Fund Law Report

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

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By Topic: Service Providers

  • From Vol. 11 No.25 (Jun. 21, 2018)

    The Importance of Exercising Due Diligence When Hiring Auditors and Other Vendors

    The SEC recently announced that it had issued an order against an accounting firm and two partners for willfully aiding and abetting violations of Rule 206(4)-2 (the so-called “custody rule”) of the Investment Advisers Act of 1940 relating to the audits of funds’ financial statements. The order bars the certified public accounting firm and two certified public accountants (CPAs) from appearing or practicing before the SEC as accountants for certain periods, and it requires payment of disgorgement, interest and civil penalties. The settlement of this enforcement action is relevant to registered investment advisers because it illustrates how critical errors by the accountants auditing a fund’s financial statements can result in custody rule violations by the adviser. This article examines the mistakes made by the accountants in the case; discusses the importance of exercising due diligence when engaging accounting firms and other vendors; and presents analysis from an attorney who is also a CPA. See “What Role Should the GC or CCO Play in the Audit of a Fund’s Financial Statements?” (Feb. 23, 2017).

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  • From Vol. 11 No.25 (Jun. 21, 2018)

    What Robo-Advisers Can Expect From SEC Examinations

    There are no compliance shortcuts available to robo-advisers; investment advisers that offer automated advice must fully comply with all the duties imposed by the Investment Advisers Act of 1940 and its rules, as well as the obligations pertaining to technology platforms. A recent ACA Compliance Group (ACA) program offered a view from the trenches as to what the SEC looks for when it examines robo-advisers. The program featured Burton J. Esrig, managing director at ACA Technology; Luis Garcia, principal consultant with ACA; and Susan I. Gault-Brown, partner at Morrison & Foerster. This article summarizes their insights. For coverage of ACA’s 2018 compliance survey, see our two-part series: “Compliance Programs and SEC Examination Priorities” (May 31, 2018); and “Electronic Communications, Personal Trading and Corruption Risk” (Jun. 14, 2018).

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  • From Vol. 11 No.24 (Jun. 14, 2018)

    How the GDPR Will Affect Private Funds’ Use of Alternative Data

    The E.U.’s General Data Protection Regulation (GDPR), which took effect May 25, 2018, primarily affects investment managers and private funds that are based in the E.U. The GDPR’s restrictions on the processing of “personal data” of individuals in the E.U., however, may affect managers and funds that are located outside the E.U. if they process the data of individuals located in the E.U. in connection with the offering of services to those individuals. Because more funds are using alternative data in their operations – notably in driving their trading strategies and making investment decisions – the GDPR may impact how these funds obtain and use alternative data if that data contains what is arguably considered the personal data of individuals in the E.U. To help readers understand the potential impact of the GDPR on funds’ use of alternative data, The Hedge Fund Law Report interviewed Peter D. Greene, partner and vice-chair of the investment management group at Lowenstein Sandler. This article presents his insights. For more from Greene, see our three-part series on the opportunities and risks presented by big data: “Acquisition and Proper Use” (Jan. 11, 2018); “MNPI, Web Scraping and Data Quality” (Jan. 18, 2018); and “Privacy Concerns, Third Parties and Drones” (Jan. 25, 2018).

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  • From Vol. 11 No.24 (Jun. 14, 2018)

    ACA 2018 Compliance Survey Examines Electronic Communications, Personal Trading and Corruption Risk (Part Two of Two)

    ACA Compliance Group (ACA) director Danielle Joseph and principal consultant Ken Harman discussed the results of ACA’s 2018 Alternative Fund Manager Compliance Survey in a recent presentation. This article, the second in a two-part series, details the portions of the survey that covered electronic communications, personal trading and corruption risk, and offers insights from the speakers. The first article examined compliance programs and SEC examination priorities. For coverage of ACA’s 2016 compliance survey, see “SEC Exams; Compliance Staffing and Budgeting; Annual and Ongoing Compliance Reviews; and AML/Sanctions Compliance” (Jan. 19, 2017); and “Custody; Fee Policies and Arrangements; Safeguarding of Assets; and Personal Trading” (Feb. 2, 2017).

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  • From Vol. 11 No.23 (Jun. 7, 2018)

    Why Fund Managers Must Review Their Positions on Succession Planning and CCO Outsourcing (Part One of Three)

    The SEC proposed – and recently withdrew – a rule that would have required registered investment advisers to adopt and implement detailed business continuity and transition plans. Despite the rule’s withdrawal, however, the SEC has signaled that it will continue to scrutinize the robustness of advisers’ plans. To the extent that advisers’ business continuity and transition plans cover the departure of key personnel, they generally do so only with respect to founders; yet, from a business and regulatory perspective, they should also cover others, including chief compliance officers (CCOs). The proposed rule would have also required advisers to evaluate third-party service providers’ business continuity and transition plans, including those of outsourced CCOs. This article, the first in a three-part series, discusses the SEC’s proposed rule on business continuity and transition plans; the impact, if any, of the rule’s withdrawal; the importance of CCO succession planning; and the risks of using an outsourced CCO. The second article will examine CCO hiring and onboarding; whether managers should separate their compliance departments from their legal departments; and the risks of high CCO turnover. The third article will evaluate the risks of poor succession planning and provide a roadmap for developing a robust succession plan. See “Pro-Business Environment of New Administration Continues to Have Challenges and Pitfalls for Private Funds” (Sep. 14, 2017).

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  • From Vol. 11 No.22 (May 31, 2018)

    Preparing for Brexit a Key FCA Priority for 2018/2019

    The U.K. Financial Conduct Authority (FCA) recently published its 2018/19 Business Plan (Plan), its 2018 Sector Views and a consultation paper on 2018/19 fees and levies. A recurring theme of the Plan is the potential impact of the U.K.’s impending withdrawal from the E.U. In a press release, Andrew Bailey, the FCA’s Chief Executive, emphasized that the priorities discussed in the Plan “reflect the high level of resource we need to dedicate to EU Withdrawal, given its impact both on our regulation and on the firms we regulate.” The Plan focuses on the seven “cross-sector priorities” affecting some or all of the business sectors within its purview. It also delineates the FCA’s priorities in each of seven distinct sectors, including investment management. This article summarizes the FCA’s cross-sector priorities, as well as the other portions of the FCA materials most relevant to private fund managers. For coverage of prior FCA business plans, sector views and mission statements, see “FCA Details Three of Its 2017 Priorities: Competition in the Asset Management Market, Liquidity Management and Custodians” (May 4, 2017); and “FCA 2016-2017 Regulatory and Supervisory Priorities Include Focus on AML, Cybersecurity and Governance” (Apr. 14, 2016).

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  • From Vol. 11 No.22 (May 31, 2018)

    ACA 2018 Compliance Survey Examines Compliance Programs and SEC Examination Priorities (Part One of Two)

    ACA Compliance Group (ACA) recently completed its 2018 Alternative Fund Manager Compliance Survey, which included responses from 280 illiquid and hedge fund managers on a variety of compliance topics, and the results were discussed in a presentation by ACA director Danielle Joseph and principal consultant Ken Harman. This article, the first in a two-part series, details the portions of the survey that covered compliance programs and SEC examination priorities, and offers insights from the speakers. The second article will examine electronic communications, personal trading and corruption risk. For coverage of ACA’s 2017 compliance survey, see “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. 11 No.16 (Apr. 19, 2018)

    Business and Legal Issues in Raising Capital for Cryptocurrency Funds

    A recent installment of the Cryptocurrency Fund Workshop Series presented by the Capital Fund Law Group offered a capital-raising primer for funds that seek to invest in cryptocurrencies and cryptocurrency-related strategies. The program, which covered both legal and business issues in setting up a cryptocurrency-focused fund, featured John S. Lore and Beth‑ann Roth, managing partner and partner, respectively, at Capital Fund Law Group, along with Alex Mascioli, CEO of North Street Global. This article summarizes their insights. For a look at the technology underlying cryptocurrency, see our three-part series on blockchain and the financial services industry: “Basics of the Technology and How the Financial Sector Is Currently Employing It” (Jun. 1, 2017); “Potential Uses by Private Funds and Service Providers” (Jun. 8, 2017); and “Potential Impediments to Its Eventual Adoption” (Jun. 15, 2017).

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  • From Vol. 11 No.15 (Apr. 12, 2018)

    How Fund Managers Should Structure Their Cybersecurity Programs: Stakeholder Communication, Outsourcing, Co-Sourcing and Managing Third Parties (Part Three of Three)

    Cybersecurity stakeholders, particularly those in information security and legal/compliance, must communicate effectively to ensure that a fund manager’s cybersecurity program is fully implemented and able to respond to cyber attacks. Although managers of all sizes should aim to build in-house cybersecurity expertise to increase responsiveness, some may benefit from outsourcing or co-sourcing certain cybersecurity functions given the involved costs and shortage of qualified workers. Managers must, however, ensure that they properly vet and oversee third-party cybersecurity vendors, and this requires coordination between the chief compliance officer (CCO) and on-site technology leaders. This article, the third in our three-part series, evaluates methods for facilitating communication between cybersecurity stakeholders; outsourcing and co-sourcing of cybersecurity functions; and best practices for employing and overseeing third-party cybersecurity vendors. The first article discussed the risks and costs associated with cyber attacks; the global focus on cybersecurity; relevant findings observed by the Office of Compliance Inspections and Examinations during the examination of SEC registrants; and cybersecurity best practices. The second article analyzed the reasons why fund managers should hire a dedicated chief information security officer, reviewed information security governance structures and explored the role of the CCO as a strategic partner. See “Fund Managers Must Supervise Third-Party Service Providers or Risk Regulatory Action” (Nov. 16, 2017); and “How Managers Can Identify and Manage Cybersecurity Risks Posed by Third-Party Service Providers” (Jul. 27, 2017).

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  • From Vol. 11 No.13 (Mar. 29, 2018)

    Key Considerations for Hedge Fund Managers in Evaluating the Use of Cloud Computing Solutions

    Investors increasingly expect hedge fund managers to have best-of-breed technology and applications designed to, among other things, conduct business effectively and efficiently; safeguard the firm’s data; and facilitate compliance with applicable regulations and investor demands. These expectations pose an obstacle for many hedge fund managers because of the significant costs required to implement and maintain a robust technological infrastructure. Cloud solutions have helped to partially alleviate this burden by making numerous applications and functions available online, thus reducing or eliminating the need for a firm to establish and maintain heavy technological infrastructure, as well as the capital, personnel and real estate costs associated with that infrastructure. While particularly attractive for smaller hedge fund managers wishing to minimize the amount of launch capital spent on technology, cloud solutions have also become attractive to larger, more well-established managers seeking cost-savings and other benefits. This two-part series discusses cloud computing solutions for hedge fund managers. The first article defines cloud computing services; outlines key differences between different types of cloud computing solutions; describes the functions available through cloud solutions; and highlights the benefits and risks of using cloud solutions. The second article discusses how to evaluate the various cloud computing solutions and providers; describes best practices in creating and implementing policies and procedures for using cloud solutions; and identifies common mistakes made by hedge fund managers in selecting and using cloud solutions. For more on working with cloud service providers, see “Key Considerations for Fund Managers When Selecting and Negotiating With a Cloud Service Provider” (Sep. 21, 2017).

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  • From Vol. 11 No.11 (Mar. 15, 2018)

    CFTC Enforcement Action Spotlights Fund Managers’ Duty to Supervise IT Providers

    The CFTC recently announced a settlement with a registered futures commission merchant (FCM) that had tens of thousands of client records compromised after its information technology vendor installed a backup drive on the FCM’s network that included an unsecured port of which the vendor was unaware. Although this case concerned an FCM, it puts all CFTC registrants on notice that they are responsible for protecting sensitive information. “Entities entrusted with sensitive information must work diligently to protect that information,” CFTC Director of Enforcement James McDonald noted, adding that, “[a]s this case shows, the CFTC will work hard to ensure regulated entities live up to that responsibility, which has taken on increasing importance as cyber threats extend across our financial system.” Further, the settlement reminds fund managers and other CFTC-registered entities that, under CFTC Regulation 166.3, they must monitor third-party service providers to avoid similar regulatory action. This article analyzes the terms of the settlement order, including the facts that led up to the settlement, the penalties imposed and the remedial steps the FCM agreed to take. For more from the CFTC, see “Virtual Currencies Present Significant Risk and Opportunity, Demanding Focus From Regulators, According to CFTC Chair” (Feb. 8, 2018).

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  • From Vol. 11 No.6 (Feb. 8, 2018)

    SEC Order Warns Fund “Gatekeepers” That They Remain a Focus of SEC Scrutiny

    So-called “gatekeepers” have been in the SEC’s crosshairs for years. Although fund administrators and other service provides are neither required to register with nor directly regulated by the SEC, the Commission has taken action against administrators for causing, or being a cause of, securities law violations by regulated fund managers. The most recent SEC action of this kind ended with a cease-and-desist order against a fund administrator that allegedly calculated the net asset value of a mutual fund it administered by including fake loans held by the fund, even though it allegedly knew that, absent requisite documentation, the fund’s custodian had refused to book those loans as fund assets. This article details the SEC’s allegations and settlement terms. See “What the SEC’s Enforcement Statistics Reveal About the Regulator’s Focus on Hedge Funds and Investment Advisers” (Oct. 20, 2016). For discussion of SEC concerns about attorneys and accountants as gatekeepers, see “How Can Hedge Fund Managers Update Their Insider Trading Compliance Programs to Reflect the SEC’s Focus on Systemic Violators, Gatekeepers, Trading Patterns, Profitable Trades and Expert Networks?” (Aug. 19, 2011).

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  • From Vol. 11 No.4 (Jan. 25, 2018)

    A Fund Manager’s Roadmap to Big Data: Privacy Concerns, Third Parties and Drones (Part Three of Three)

    A fund manager’s use of new technologies and processes to streamline its business and generate improved performance comes with significant risk, which is pronounced when using big data, as few best practices currently exist within the industry. One of the most significant concerns about big data involves the acquisition or use of personally identifiable information (PII). Although PII enjoys broad protection under U.S. law, many state laws impose even more stringent restrictions on the use of personal data, and the E.U. General Data Protection Regulation provides a comprehensive and onerous framework for data tied to E.U. citizens. Managers must also understand how to deal with third-party data vendors, including how to conduct due diligence on and negotiate contractual provisions with those service providers. Finally, as growing numbers of drones are used to capture images, managers must recognize and comply with a web of federal regulations, as well as state laws, surrounding this use. This third article in our three-part series discusses the risks associated with data privacy, the acquisition of data from third parties and the use of drones, as well as recommended methods for mitigating those risks. The first article explored the big-data landscape, along with how fund managers can acquire and use big data in their businesses. The second article analyzed issues and best practices surrounding the acquisition of material nonpublic information; web scraping; and the quality and testability of data. For more on the adoption by fund managers of new technology, see our three-part series on blockchain: “Basics of the Technology and How the Financial Sector Is Currently Employing It” (Jun. 1, 2017); “Potential Uses by Private Funds and Service Providers” (Jun. 8, 2017); and “Potential Impediments to Its Eventual Adoption” (Jun. 15, 2017).

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  • From Vol. 10 No.45 (Nov. 16, 2017)

    Fund Managers Must Supervise Third-Party Service Providers or Risk Regulatory Action

    It is not enough for a fund manager to have its own cybersecurity defenses; a manager must also exercise appropriate oversight of the defenses of third parties acting on its behalf. A recent CFTC settlement affirms the notion that registrants are not only responsible for their own compliance programs, but are also charged with the duty of supervising third-party vendors and are expected to maintain appropriate procedures to monitor those third parties. Further, a fund manager may be held responsible for the actions of third parties, even when the fund manager itself lacks the power to directly take those actions or when the fund manager itself is the victim of a third party’s missteps. This article analyzes the underlying facts and terms of the CFTC settlement order. For coverage of other recent CFTC enforcement efforts, see “New CFTC Chair Outlines Enforcement Priorities and Approaches to FinTech, Cybersecurity and Swaps Reform” (Nov. 9, 2017); “Newly Revealed CFTC Self-Reporting and Cooperation Regime Could Offer Benefits to Fund Managers, or Lead to Increased Enforcement” (Oct. 19, 2017); and “Two Recent Settlements Demonstrate CFTC’s Continued Focus on Spoofing” (Oct. 12, 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.37 (Sep. 21, 2017)

    How Fund Managers Can Develop an Effective Third-Party Management Program

    Private fund managers rely on third parties for a variety of critical services. Identifying and managing those relationships in a systematic way is essential to minimizing enterprise risk and ensuring compliance with regulatory requirements. A recent MyComplianceOffice (MCO) presentation provided a framework for developing a program for managing third-party relationships. Although the primary focus of the program was on the broader financial services industry, the principles discussed are relevant to outsourcing decisions made by fund managers and their dealings with administrators, technology vendors, research firms and other key third parties. The program was hosted by Joe Boyhan of MCO and featured Linda Tuck Chapman, president of Ontala. This article summarizes the key takeaways from the presentation. For coverage of other MCO programs, see “Reading the Regulatory Tea Leaves: Recent White House and Congressional Action and Insights From SIFMA and FINRA Conferences” (Jul. 20, 2017); and “What the Record Number of 2016 SEC and FINRA Enforcement Actions Indicates About the Regulators’ Possible Enforcement Focus for 2017” (Dec. 15, 2016).

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

    Key Considerations for Fund Managers When Selecting and Negotiating With a Cloud Service Provider

    Operating an asset management business remains a resource-intensive endeavor, particularly as fund fees have come under pressure from investors. See “Investor Pressure Drives New Performance Compensation Models and Increased Disclosure Obligations for Managers” (Jun. 29, 2017). Some managers have sought to reduce their operational costs by moving at least some of their technological infrastructure – e.g., data storage, trade execution, accounting systems, client-relationship-management systems and disaster recovery services – to the cloud. While hosting these services in the cloud offers cost-effective and convenient technology solutions, fund managers must be cognizant of the potential cybersecurity risks associated with relying upon a cloud solution, including the legal risks that may be lurking in the standard service level agreements with cloud service providers. Considerations of potential risks and liabilities associated with engaging a cloud service provider, along with tips on how to conduct due diligence on a cloud vendor, were addressed at PLI’s Eighteenth Annual Institute on Privacy and Data Security Law. The panel featured Matthew Kelly, vice president and senior corporate counsel at cloud computing company ServiceNow, Inc. This article offers Kelly’s insights as to what an investment manager should and should not expect from cloud service providers, along with key provisions to understand in their service level agreements. For background on how private fund managers are using cloud computing, see “Can Emerging Hedge Fund Managers Use Technology to Satisfy Business Continuity Requirements and Mitigate Third-Party Risk?” (Sep. 3, 2016); and “Greenwich Associates Report Argues That Hedge Fund Managers Can Use the Cloud to Obtain Greater Computing Power at Lower Cost With Acceptable Risk” (Jun. 6, 2014).

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  • From Vol. 10 No.36 (Sep. 14, 2017)

    Insights on Operational Due Diligence From the IMDDA and the U.K. Pension Protection Fund

    The Investment Management Due Diligence Association (IMDDA) recently kicked off its year-long “Ask the Experts” question-and-answer series with industry professionals, the first of which focused on operational due diligence (ODD). Moderated by Herbert M. Chain, director of education at the IMDDA, and featuring Kevin J. Eastwood, ODD manager at the U.K. Pension Protection Fund and a member of the IMDDA advisory board, the program provided valuable insights to fund managers about ODD, including best practices for conducting ODD on managers and third-party service providers; advice for emerging managers; thoughts about fee and expense transparency; and considerations about cybersecurity. This article summarizes the key takeaways from Chain and Eastwood. For coverage of other IMDDA events, see “How Due Diligence Professionals Approach the Private Fund Review Process” (Jun. 15, 2017); “How Fund Managers Can Prepare for Investor Due Diligence Queries About Cybersecurity Programs” (Feb. 2, 2017); and “How Studying SEC Examinations Can Enhance Investor Due Diligence” (Oct. 6, 2016).

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  • From Vol. 10 No.30 (Jul. 27, 2017)

    How Managers Can Identify and Manage Cybersecurity Risks Posed by Third-Party Service Providers

    Weak cybersecurity practices of service providers pose material risks to private fund managers. As connectivity grows, managers run the risk that data entrusted to vendors could be compromised, or that the manager’s own system may be breached through one of its vendors. Consequently, it is critical to understand and manage the risks posed by vendors. See “Surveys Show Cyber Risk Remains High for Investment Advisers and Other Financial Services Firms Despite Preventative Measures” (Jul. 20, 2017); and “Study Reveals Weaknesses in Asset Managers’ Third-Party and Vendor Risk Management Programs” (Mar. 9, 2017). A recent program presented by Advise Technologies discussed ways to assess vendor risk; best practices for managing vendors; uses of due diligence questionnaires; and common errors in vendor management. Advise’s chief regulatory attorney and managing director, Jeanette Turner, moderated the discussion, which featured Jason Elmer, managing director at Duff & Phelps, and Aaron K. Tantleff, partner at Foley & Lardner. This article summarizes their insights. For recent commentary from Advise and Turner, see “A Roadmap of Potential Landmines for Fund Managers to Avoid When Completing the Revised Form ADV” (May 25, 2017); and “The ‘Why’ Behind the Recent Form ADV Amendments: What Information the SEC Will Require and How the Agency Intends to Use It” (May 4, 2017).

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  • From Vol. 10 No.29 (Jul. 20, 2017)

    Surveys Show Cyber Risk Remains High for Investment Advisers and Other Financial Services Firms Despite Preventative Measures

    The potential price tag of a cyber breach is immense and continuing to rise in the U.S. See “Investment Adviser Penalized for Weak Cyber Policies; OCIE Issues Investor Alert” (Oct. 1, 2015). This article summarizes three recent surveys conducted by the Ponemon Institute; TD Bank; and ACA Aponix, in conjunction with the National Society of Compliance Professionals, each of which provides insight into the current state of vulnerabilities of investment advisers and other financial firms. See also “How Hedge Fund Managers Can Meet the Cybersecurity Challenge: A Plan for Building a Cyber-Compliance Program (Part Two of Two)” (Dec. 10, 2015); and “RCA Panel Outlines Keys for Hedge Fund Managers to Implement a Comprehensive Cybersecurity Program” (Jun. 18, 2015).

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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.9 (Mar. 2, 2017)

    Winding Down Funds: How Managers Make the Decision and Communicate It to Investors and Service Providers (Part One of Two)

    A fund manager typically spends most of its time not only contemplating how to maximize returns for investors, but also navigating the array of compliance and regulatory concerns involved in running a private fund. Because the manager is so caught up in thinking about these daily considerations, it may lose sight of the multitude of issues that arise when it comes time to wind down that same fund. If the manager exercises some foresight regarding the fund’s eventual wind-down and puts proper procedures in place, however, the whole process can be both smoother and less fraught with legal and regulatory risks. In a recent interview with The Hedge Fund Law Report, 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, shared his detailed insights about the various considerations caused by winding down a fund. For additional commentary from Neus, see “Practical Solutions to Some of the Harder Fiduciary Duty and Other Legal Questions Raised by Side Letters” (Feb. 21, 2013). This first article in a two-part series presents Neus’ thoughts on the factors leading to the decision to wind down a fund, which personnel should lead that process and how it should be disclosed to investors and service providers. The second article will explore what types of fees and expenses investors should be charged during the wind-down, as well as how managers can maximize the value of illiquid assets during a liquidation. For more on winding down funds, see “Practical Tips for Fund Managers to Mitigate Litigation Risk From Regulators, Investors and Vendors When Winding Down Funds” (Oct. 27, 2016).

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  • From Vol. 10 No.6 (Feb. 9, 2017)

    Why Funds Should Confirm Clear Contractual Obligations and Liabilities With Their Administrators

    In recent years – following the Madoff scandal and the corresponding increase in regulatory scrutiny of hedge funds – investors have increasingly pressured managers to hire third-party fund administrators. See “Implications of Demands by Institutional Investors for Independent Hedge Fund Administrators” (Jan. 21, 2009). Administrators add an extra layer of review and verification to mitigate the insularity and lack of oversight that allowed Madoff’s fraud to flourish undetected for decades. Notwithstanding the critical role that administrators play in the financial services industry, they are not subject to the same level of regulatory oversight as other service providers, such as a fund’s prime broker or auditor. Accordingly, when an administrator’s processes break down, causing losses directly to the fund and indirectly to its investors, the fund’s only option may be to pursue a civil action against the administrator. The success of such a claim will then depend on not only the facts of the case, but also the provisions setting forth the administrator’s obligations and liabilities contained in the agreement between the fund and the administrator. In a guest article, Lisa Solbakken, a partner at Arkin Solbakken, provides insight on the proper role of the administrator, details ongoing litigation in which funds allege that their administrators breached their contractual duties to the funds and offers advice on how funds should approach the negotiation of their administration agreements. For more on administrator liability, see “‘Gatekeeper’ Actions by the SEC and Investors Against Administrators Challenge Private Fund Industry” (Sep. 8, 2016). 

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  • From Vol. 10 No.5 (Feb. 2, 2017)

    ACA 2016 Compliance Survey Addresses Custody; Fee Policies and Arrangements; Safeguarding of Assets; and Personal Trading (Part Two of Two)

    In its 2016 Alternative Fund Manager Compliance Survey, ACA Compliance Group (ACA) covered various issues pertinent to hedge fund and illiquid private fund managers. ACAs Brian Lattanzio, a senior compliance analyst and private equity associate, and Danielle Joseph, a senior principal consultant, discussed the survey results in a recent webinar. This article, the second in a two-part series, explores the survey findings concerning the custody of fund assets and certificated securities; procedures around and types of fees charged by illiquid fund managers; steps to safeguard assets; and personal trading. The first article summarized the surveys results pertaining to SEC examinations; compliance staffing and budgeting; compliance reviews, testing and training; and anti-money laundering and sanctions compliance. For additional insights from ACA experts, see Recommended Actions for Hedge Fund Managers in Light of SEC Enforcement Trends” (Oct. 22, 2015); and The SECs Broken Windows Approach: Compliance Resources, CCO Liability and Technology Concerns for Hedge Fund Managers (Part Two of Two)” (Oct. 1, 2015).

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  • From Vol. 10 No.3 (Jan. 19, 2017)

    Cyber Insurance Coverage, Pre-Breach Mitigation Efforts and Post-Breach Response Plans Can Reduce Harm to Fund Managers From Cyber Attacks 

    Cyber insurance policies are indispensable for investment firms operating in an age of widespread cyber attacks and data breaches costing millions of dollars in damages and liability. Investment fund manager principals need to have a nuanced grasp of what those policies cover and ensure they maximize their value. Doing so can put their firms in a good position to reduce reputational and financial harm in the event of a cyber breach or investigation of their cyber preparedness by a regulatory agency. See “Essential Tools for Hedge Fund Managers to Combat Escalating Cyber Threats” (Feb. 4, 2016). These points were explored in a panel discussion presented by Haynes and Boone. Moderated by Haynes and Boone partner Werner Powers, the panel included Ron Borys, managing director of Crystal & Company; Sandy Crystal, executive vice president of Crystal & Company; Christopher Liu, head cyber specialist for financial institutions at AIG; and Haynes and Boone partners Ricardo Davidovich and David Siegal. This article presents the key insights communicated by the panel. For additional insight from Davidovich, see “Understanding the Regulatory Regime Governing the Use of Social Media by Hedge Fund Managers and Broker-Dealers” (Dec. 13, 2012); as well as our two-part series on closing hedge funds: “How to Close a Hedge Fund in Eight Steps” (May 8, 2014); and “When and How Can Hedge Fund Managers Close Hedge Funds in a Way That Preserves Opportunity, Reputation and Investor Relationships?” (Jun. 2, 2014).

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  • From Vol. 9 No.49 (Dec. 15, 2016)

    Investor Gatekeepers Advise Emerging Managers on How to Stand Out When Pitching and Marketing Their Funds

    As emerging managers pitch their funds to investment committees, they must be fully aware of how the competitive marketing environment has increased the need for them to distinguish themselves from competitors. See “Marketing and Reporting Considerations for Emerging Hedge Fund Managers” (Jun. 16, 2016); and “How Can Emerging Managers Raise Institutional Capital While Avoiding Regulatory Pitfalls?” (Aug. 22, 2013). Part of this process includes having a nuanced grasp of the criteria – e.g., their track record, pitchbook length and pedigree – investment committees will consider before ultimately selecting or rejecting them. Further, it is vital for managers to remember that the industry is driven by interpersonal relations and that poor first impressions can doom a fund’s prospects. These were among the points discussed during a panel at the Hedge Fund Association’s (HFA) recent Hedgeopolis New York Conference. Moderated by Holly Singer, president of HS Marketing, LLC, the panel featured Meredith Jones, partner and head of emerging manager research for Aon Hewitt Investment Consulting; Sean Cover, director of treasury and investment operations for the Wildlife Conservation Society; and Thomas Pacilio, senior director of RSM U.S. Wealth Management. This article presents the key points communicated by the panelists. For additional coverage of the HFA conference, see “U.S., U.K. and Cayman Regulators Address Upcoming Areas of Focus, Passporting Concerns and Intra-Agency Collaboration” (Nov. 17, 2016). For insight from another HFA panel, see “Procedures for Hedge Fund Managers to Safeguard Trade Secrets From Rogue Employees” (Jul. 21, 2016).

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  • From Vol. 9 No.39 (Oct. 6, 2016)

    How Hedge Fund Managers Can Protect Trade Secrets by Providing DTSA-Compliant Notice 

    To many hedge fund managers, there is little more important than protecting the fund’s trade secrets – whether they are trading models, track records, client lists or trading positions – from wrongful disclosure. On May 11, 2016, hedge fund managers were given a powerful new tool to protect this proprietary information when President Obama signed into law the Defend Trade Secrets Act of 2016 (DTSA). See “DTSA Provides Hedge Fund Managers With Protection for Proprietary Trading Technology and Other Trade Secrets” (Jun. 23, 2016). In a guest article, David I. Greenberger, partner at Bailey Duquette P.C., describes how hedge funds can take full advantage of the protections and remedies the DTSA affords – including the right to recover punitive damages and reasonable attorney’s fees – by complying with its requirements to provide certain notices to their employees, consultants and contractors. Additionally, Greenberger suggests that hedge fund managers take immediate steps to ensure that any agreements they enter into with such individuals related to trade secret usage are in writing and contain the requisite notices. Finally, he describes how managers should modify operative agreements that existed prior to the enactment of the DTSA to include the necessary immunity notice provisions. For more on protecting trade secrets, see “Procedures for Hedge Fund Managers to Safeguard Trade Secrets From Rogue Employees” (Jul. 21, 2016); and “How Can Hedge Fund Managers Protect Themselves Against Trade Secrets Claims?” (May 16, 2014).

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  • From Vol. 9 No.39 (Oct. 6, 2016)

    Former Prosecutors Address Trends in Cybersecurity for Alternative Asset Managers, Diligence When Acquiring a Company and Breach Response Considerations

    Alternative asset managers must contend with numerous cybersecurity issues, including emerging threats; potential breaches in a pre-acquisition and post-acquisition context; special considerations for breaches of investor or consumer data; the handling of cybersecurity issues in the investment fund context; and the proper response to breaches. These topics were addressed in a recent panel hosted by Brian T. Davis and Dimitri G. Mastrocola, partners at international recruiting firm Major, Lindsey & Africa (MLA), and featuring Debevoise & Plimpton partners Luke Dembosky and Jim Pastore, both of whom are former federal prosecutors. This article highlights the key points from the presentation. For more on cybersecurity, see “Growing SEC Enforcement of Hedge Fund Managers Requires Greater Focus on Cybersecurity and Financial Disclosure” (Jul. 7, 2016); “SEC Chief of Staff Outlines Asset Management Initiatives on Cybersecurity and Transition Planning and Emphasizes Robust Enforcement Environment” (Jul. 7, 2016); and “SEC Guidance Update Suggests a Three-Step Framework for Investment Manager Cybersecurity Programs” (May 7, 2015). For coverage of a prior program hosted by MLA, see our two-part series on SEC examinations: “What Hedge Fund Managers Need to Know” (Jun. 16, 2016); and “Fees, Conflicts, Investment Allocations and Other Hot Topics” (Jun. 30, 2016).

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  • From Vol. 9 No.37 (Sep. 22, 2016)

    Seward & Kissel Private Funds Forum Explores How Managers Can Mitigate Improper Dissemination of Sensitive Information (Part One of Two)

    In the current heightened regulatory environment, the SEC has focused on safeguards that managers employ to prevent the dissemination of sensitive information and to ensure it is not used for improper trading. This was among the critical issues addressed by one of the panels at the second annual Private Funds Forum produced by Seward & Kissel and Bloomberg BNA, held on September 15, 2016. Moderated by Seward & Kissel partner Patricia Poglinco, the panel included Rita Glavin and Joseph Morrissey, partners at Seward & Kissel; Laura Roche, chief operating officer and chief financial officer at Roystone Capital Management; and Scott Sherman, general counsel at Tiger Management. This article, the first in a two-part series, reviews the panel’s discussion about risks associated with the inflow and outflow of material nonpublic information, as well as steps that fund managers can take to prevent its improper use. The second article will discuss the types of conflicts of interest targeted by the SEC, the current progress of the SEC’s whistleblower program and the difficulty of prosecuting insider trading. For coverage of the 2015 Seward & Kissel Private Funds Forum, see “Trends in Hedge Fund Seeding Arrangements and Fee Structures” (Jul. 23, 2015); and “Key Trends in Fund Structures” (Jul. 30, 2015). For additional commentary from Glavin, see “FCPA Compliance Strategies for Hedge Fund and Private Equity Fund Managers” (Jun. 13, 2014). For more from Sherman, see “RCA Asset Manager Panel Offers Insights on Hedge Fund Due Diligence” (Apr. 2, 2015).

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  • From Vol. 9 No.36 (Sep. 15, 2016)

    How Fund Managers Can Prevent or Remedy Improper Fee and Expense Allocations (Part Three of Three)

    In recent years, the SEC has targeted perceived fee and expense improprieties by private fund managers, with each enforcement action causing managers to fortify their internal practices in an attempt to avoid similar regulatory scrutiny. This increased SEC focus has also caused managers to proactively remedy improper fee or expense allocations revealed by their newly enhanced policies and procedures. This final article in our three-part series provides practical guidance about preventative measures fund managers can take to ensure fees and expenses are properly allocated, as well as post-violation efforts they can perform to remedy any improper allocations. Taken together, these can help managers ensure their procedures meet industry standards and may mitigate the severity of any future SEC sanctions. The first article in this series detailed trends in the types of expense allocations most aggressively scrutinized by the SEC. The second article in the series examined the role of inadequate disclosure and failed policies and procedures in causing expense allocation violations and provided steps managers can take to buttress each of those areas. For more on expense allocations, see “Fees, Conflicts, Investment Allocations and Other Hot Topics Hedge Fund Managers Should Expect During an SEC Examination (Part Two of Two)” (Jun. 30, 2016); and our two-part series entitled “How Should Hedge Fund Managers Approach the Allocation of Expenses Among Their Firms and Their Funds?”: Part One (May 2, 2013); and Part Two (May 9, 2013).

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  • From Vol. 9 No.35 (Sep. 8, 2016)

    “Gatekeeper” Actions by the SEC and Investors Against Administrators Challenge Private Fund Industry

    Fund administrators have been the target of several recent SEC enforcement actions and civil lawsuits by investors that seek to make administrators liable for the misconduct of fund managers and their principals. These aggressive enforcement actions and civil lawsuits are the first of their kind to argue that administrators serve in a gatekeeper role. For more on the SEC’s focus on another category of gatekeepers, see “How Can Hedge Fund Managers Update Their Insider Trading Compliance Programs to Reflect the SEC’s Focus on Systemic Violators, Gatekeepers, Trading Patterns, Profitable Trades and Expert Networks?” (Aug. 19, 2011). In a guest article, Marc Powers and Jonathan Forman, partner and senior associate, respectively, at BakerHostetler, review recent SEC enforcement actions and civil lawsuits against administrators as gatekeepers and outline implications of these actions for hedge fund administrators, managers and investors. For additional insight from Powers, see “A New Look at an Old Standard: The Power of Minority Bondholders Under the Trust Indenture Act” (Mar. 5, 2015); and “Chapter 15 of the Bankruptcy Code Presents Litigation Risks and Liability for Creditors, Counterparties, Service Providers and Others Doing Business With Bankrupt Offshore Hedge Funds” (Oct. 3, 2013). For coverage of fund managers shadowing administrators, see “Certain Hedge Fund Managers Are Moving from Full to Partial Shadowing of Administrator Functions” (Sep. 12, 2013); and “When and How Should Hedge Fund Managers Shadow Functions Performed by Their Fund Administrators?” (Mar. 8, 2012).

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  • From Vol. 9 No.32 (Aug. 11, 2016)

    Perspectives From In-House and Private Practice: Cadwalader Special Counsel Garret Filler Discusses Hedge Fund Culture, Law Firm Selection and Counterparty Risk (Part One of Two)

    Garret Filler recently rejoined Cadwalader, Wickersham & Taft as special counsel in the firm’s New York office, where he represents both start-up and established hedge funds and private equity funds, as well as family offices, banks and broker-dealers. The Hedge Fund Law Report recently interviewed Filler in connection with his return to Cadwalader, during which he discussed numerous topics of import to hedge fund managers. This article, the first in a two-part series, sets forth Filler’s thoughts on the cultures of private fund managers; selection of outside counsel, including law firm relationships with regulators and their willingness to enter into alternative fee arrangements; and counterparty risk. In the second installment, Filler will discuss family office transitions into asset managers; broker-dealer registration issues for fund managers; considerations when negotiating counterparty agreements; the implications to hedge funds of increased capital and liquidity requirements for banks and broker-dealers; and the impact of new margin requirements for uncleared derivatives. For additional insight from Cadwalader partners, see “Best Practices for Hedge Fund Managers to Adopt in Anticipation of Enactment of FinCEN AML Rule Proposal” (Aug. 4, 2016).

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  • From Vol. 9 No.28 (Jul. 14, 2016)

    What D&O and E&O Insurance Will and Will Not Cover, and Other Hot Topics in the Hedge Fund Insurance Market

    As hedge fund managers anticipate potential fallout from regulatory enforcement actions, it is critical to have a sophisticated understanding of the mechanics of directors and officers (D&O) and errors and omissions (E&O) insurance, as well as the types of liability covered by those policies. These issues were the subject of a recent webinar hosted by Seward & Kissel. During the discussion, Mark Hyland, a partner at Seward & Kissel, and Jason Duffy, a partner and founder of Fieldstone Insurance Group, explained how insurance can be used to anticipate and mitigate the adverse financial impact of covered acts or omissions. This article analyzes the key points from the webinar. For a comprehensive overview of D&O and E&O insurance, see “Hedge Fund D&O Insurance: Purpose, Structure, Pricing, Covered Claims and Allocation of Premiums Among Funds and Management Entities” (Nov. 17, 2011). For additional insight from Seward & Kissel, see “Reduced Management Fees and Narrower Liquidity Among Trends in New Hedge Funds” (Mar. 31, 2016); and our two-part coverage of the Seward & Kissel private funds forum: “Trends in Hedge Fund Seeding Arrangements and Fee Structures” (Jul. 23, 2015); and “Key Trends in Fund Structures” (Jul. 30, 2015). 

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  • From Vol. 9 No.26 (Jun. 30, 2016)

    Expanded “Gatekeeper” Responsibilities May Impact Relationship Between Hedge Funds and Service Providers

    The Dodd-Frank Act expanded the SEC’s authority and oversight of the fund industry, in part by subjecting previously unregistered advisers to registration requirements. Two recent SEC enforcement actions have further increased this authority, finding that a service provider to hedge funds – not itself subject to fiduciary or other obligations under the Investment Advisers Act of 1940 (Advisers Act) – was responsible for Advisers Act violations by two of its clients. On June 16, 2016, the SEC announced the resolution of two enforcement actions against a private fund administrator that, by missing various red flags raised by activities of its private fund clients, allegedly caused those clients to violate antifraud provisions of the Advisers Act. This article analyzes the facts that led up the SEC’s allegations, resolution of the enforcement actions and potential industry implications. For more on the SEC’s focus on gatekeepers, see “How Can Hedge Fund Managers Update Their Insider Trading Compliance Programs to Reflect the SEC’s Focus on Systemic Violators, Gatekeepers, Trading Patterns, Profitable Trades and Expert Networks?” (Aug. 19, 2011).

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  • From Vol. 9 No.21 (May 26, 2016)

    Hedge Fund Service Providers Must Exercise Caution When Communicating With Investors or Face Liability

    A recent unanimous decision reinstated a hedge-fund investor’s negligent misrepresentation claim against a fund manager’s outside counsel. Although some coverage suggests that the decision represents a departure from New York law’s established “near-privity” requirement for negligent misrepresentation claims, the decision is consistent with prior case law. It also serves as a reminder of the care that hedge-fund service providers must exercise in dealing with a fund’s investors and potential investors. In a guest article, Anne E. Beaumont and Nora Bojar, partner and associate, respectively, at Friedman Kaplan Seiler & Adelman, discuss the case, negligent misrepresentation claims by hedge fund investors against service providers and lessons for hedge fund service providers. For additional insight from Beaumont, see “BDC Finance v. Barclays: Derivatives Collateral Calls in a Chaotic Market” (Mar. 19, 2015); “Eighteen Major Banks Agree to Adopt FSB/ISDA Resolution Stay Protocol That Postpones Exercise of Right to Terminate Derivatives on Bank Counterparty Failure” (Nov. 20, 2014); “The 1992 ISDA Master Agreement Says Notice Can Be Given Using an ‘Electronic Messaging System’; If You Think That Means ‘Email,’ Think Again” (May 23, 2014); and “Five Steps for Proactively Managing OTC Derivatives Documentation Risk” (Apr. 25, 2014).

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  • From Vol. 9 No.14 (Apr. 7, 2016)

    SEC Chair Outlines Expectations for Fund Directors

    The board of directors plays a central role in mitigating conflicts inherent in the relationship between a hedge fund and its manager. See “Conflicts Remain an Overarching Concern for the SEC’s Asset Management Unit” (Mar. 12, 2015). In her keynote address at the Mutual Fund Directors Forum 2016 Policy Conference, SEC Chair Mary Jo White shared her view on the role of directors in assessing risks to mutual funds and conveyed her perspective on what fund directors should be considering and doing in 2016. Delivered to mutual fund directors, White’s remarks also provide valuable guidance to hedge funds and other private investment funds as to SEC expectations for director oversight. Specifically, White suggested appropriate questions for fund directors to ask, explored the limits of director oversight and provided the enforcement perspective on fund directors. This article summarizes the portions of White’s speech most relevant to hedge fund managers. For more on hedge fund governance, see “Walkers Fundamentals Hedge Fund Seminar Addresses Fund Structuring Trends, Governance Best Practices, Fee and Liquidity Terms, Irish Vehicles, Marketing in Asia and FATCA” (Feb. 12, 2015); and “Former SEC Commissioner Roel Campos Discusses Hedge Fund Governance With The Hedge Fund Law Report” (Mar. 8, 2012). For additional insight from White, see “SEC Chair Emphasizes Enforcement Focus on Strong Remedies and Individual Liability” (Nov. 12, 2015); “SEC Chair Highlights Two Types of Risks Hedge Fund Managers Must Consider” (Oct. 29, 2015); and “SEC Chair White Describes the SEC’s Game Plan With Respect to the Asset Management Industry” (Dec. 18, 2014).

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  • From Vol. 9 No.9 (Mar. 3, 2016)

    Hedge Fund Managers Are Advised to Build Robust Infrastructure

    As investors conduct deeper due diligence into infrastructure – such as compliance policies and procedures, technology systems and cybersecurity protections – hedge fund managers must ensure that their programs and systems are robust and able to withstand scrutiny. See “Legal, Operational and Risk Considerations for Institutional Investors When Performing Due Diligence on Hedge Fund Service Providers” (Jul. 8, 2010). Managers may choose to supplement their in-house infrastructure by outsourcing and delegating to third-party service providers, while monitoring those providers to ensure quality. At a recent seminar hosted by Backstop Solutions Group and ACA Compliance Group, panelists discussed the integration of technology and compliance, outsourcing of business functions to third parties, due diligence of service providers and investor scrutiny of hedge fund managers. This article highlights the salient points raised during the program. For additional insight from Backstop, see “Essential Tools for Hedge Fund Managers to Combat Escalating Cyber Threats” (Feb. 4, 2016). For coverage of a recent program jointly offered by the HFLR and ACA, see “Recommended Actions for Hedge Fund Managers in Light of SEC Enforcement Trends” (Oct. 22, 2015).

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  • From Vol. 9 No.8 (Feb. 25, 2016)

    Operational Considerations Hedge Fund Managers Must Address When Redomiciling Their Hedge Funds (Part Two of Two)

    When making the decision to redomicile its hedge fund to a more favorable jurisdiction, a manager must consider more than the potential marketing or other advantages the move promises. Redomiciliation involves potential regulatory burdens, conflicts of interest and operational issues, including investor notification and redemption obligations. In a recent interview with The Hedge Fund Law Report, Jonathan Law and Donnacha O’Connor, partners at Dillon Eustace, discussed the prime reasons hedge fund managers consider redomiciliation of their hedge funds. This article, the second in a two-part series, details the potential drawbacks and operational considerations of redomiciliation. The first article addressed the regulatory implications of, and potential conflicts of interest inherent in, the decision to redomicile. For more on redomiciliation, see “Redomiciling Offshore Investment Funds to Ireland, the European Gateway” (Mar. 4, 2011). For additional commentary from Law and O’Connor’s colleague, Derbhil O’Riordan, see “Four Strategies for Hedge Fund Managers for Accessing E.U. Capital Under the AIFMD” (Feb. 13, 2014).

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  • From Vol. 9 No.8 (Feb. 25, 2016)

    Hedge Fund Managers Face Imminent NFA Cybersecurity Deadline

    The NFA’s recent Interpretive Notice on cybersecurity is poised to become effective in a matter of days. NFA members, including hedge fund managers registered with the NFA as commodity pool operators or commodity trading advisers, are now required to adopt an Information Systems Security Program. See “NFA Notice Provides Cybersecurity Guidance to Hedge Fund Managers Registered As CPOs and CTAs” (Nov. 19, 2015). To help NFA members prepare for the impending deadline, the NFA recently held a “Cybersecurity Workshop” featuring a number of senior NFA personnel and industry experts. Among other topics discussed during the presentation, panelists offered an overview of the requirements set out in the Notice and insight into what NFA examiners will look for after the notice takes effect. This article summarizes the panelists’ discussion of these issues. For more on CFTC and NFA requirements applicable to hedge fund managers, see our three-part CPO Compliance Series: “Conducting Business With Non-NFA Members (NFA Bylaw 1101)” (Sep. 6, 2012); “Marketing and Promotional Materials” (Oct. 4, 2012); and “Registration Obligations of Principals and Associated Persons” (Feb. 7, 2013).

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  • From Vol. 9 No.5 (Feb. 4, 2016)

    Essential Tools for Hedge Fund Managers to Combat Escalating Cyber Threats

    Cybersecurity breaches can cause untold financial and reputational damage, spawn private litigation and draw adverse regulatory scrutiny. A recent webinar sponsored by Backstop Solutions Group reviewed the evolving cyber threat landscape and related regulatory environment, and suggested tools to mitigate vendor risks and ensure appropriate cybersecurity governance and employee training. The program, “Cybersecurity – Protecting Investor Data,” was moderated by Chris DeNigris, a Backstop manager. It featured Kevin Holl, vice president at Evanston Capital Management; Natasha G. Kohne, a partner at Akin Gump; and Michael Neuman, a Backstop vice president. This article summarizes the primary takeaways from the discussion. See “How Hedge Fund Managers Can Meet the Cybersecurity Challenge: A Snapshot of the Regulatory Landscape (Part One of Two)” (Dec. 3, 2015); and “Benchmarking and Best Practices for Hedge Fund Manager Cybersecurity” (Feb. 5, 2015).

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  • From Vol. 8 No.48 (Dec. 10, 2015)

    PLI “Hot Topics” Panel Addresses Operational Due Diligence and Registered Alternative Funds

    A recent panel discussion at The Practising Law Institute’s Hedge Fund Management 2015 program, “Hot Topics for Hedge Fund Managers,” offered insight on current investor due diligence practices and a look at the challenges of starting a registered alternative fund, in addition to providing the perspective of an SEC counsel on cybersecurity and a summary of significant developments in swaps regulation.  Nora M. Jordan, a partner at Davis Polk & Wardwell, moderated the discussion, which featured Jessica A. Davis, chief operating officer and general counsel of investment adviser Lodge Hill Capital, LLC; Jennifer W. Han, associate general counsel at the Managed Funds Association; and Aaron Schlaphoff, an attorney fellow in the Rulemaking Office of the SEC Division of Investment Management.  This article summarizes the key takeaways from the program with respect to operational due diligence and registered alternative funds.  For additional coverage of PLI’s Hedge Fund Management 2015 program, see “PLI ‘Hot Topics’ Panel Addresses Cybersecurity and Swaps Regulation,” The Hedge Fund Law Report, Vol. 8, No. 43 (Nov. 5, 2015); and “SEC’s Rozenblit Discusses Operations and Priorities of the Private Funds Unit,” The Hedge Fund Law Report, Vol. 8, No. 37 (Sep. 24, 2015).

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  • From Vol. 8 No.45 (Nov. 19, 2015)

    NFA Notice Provides Cybersecurity Guidance to Hedge Fund Managers Registered as CPOs and CTAs

    Cybersecurity in the futures and derivatives market is “perhaps the single most important new risk to market integrity and financial stability,” Commodity Futures Trading Commission (CFTC) Chairman Timothy Massad stated in a keynote address.  The National Futures Association (NFA) recently received CFTC approval of its Interpretive Notice to several existing NFA compliance rules related to supervision, titled “Information Systems Security Programs [ISSPs].”  The new guidance will provide more specific standards for supervisory procedures and will require hedge fund managers and other entities that are NFA members to adopt and enforce written policies and procedures to protect customer data and electronic systems.  “The approach of the Interpretive Notice is to tie cybersecurity best practices to a firm’s supervisory obligations,” Covington & Burling partner Stephen Humenik said.  This article summarizes the guidance.  See also “PLI ‘Hot Topics’ Panel Addresses Cybersecurity and Swaps Regulation,” The Hedge Fund Law Report, Vol. 8, No. 43 (Nov. 5, 2015).  For more on CFTC and NFA requirements applicable to hedge fund managers, see our three-part CPO Compliance Series: “Conducting Business with Non-NFA Members (NFA Bylaw 1101),” Vol. 5, No. 34 (Sep. 6, 2012); “Marketing and Promotional Materials,” Vol. 5, No. 38 (Oct. 4, 2012); and “Registration Obligations of Principals and Associated Persons,” Vol. 6, No. 6 (Feb. 7, 2013).

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  • From Vol. 8 No.33 (Aug. 27, 2015)

    Establishing a Hedge Fund Manager in Seventeen Steps

    Wall Street traders often consider leaving large investment houses to launch their own hedge funds.  They have built solid track records; made money for their firms and clients; and figure it’s time to be their own bosses and take the show on the road.  What these emerging managers may not understand, however, is that running a hedge fund means overseeing a full-service business, not just a trading strategy.  While the trading strategy is very important and generating returns is paramount, there is much more to consider when establishing and sustaining a successful hedge fund operation.  In this guest article, Marni Pankin of Marcum provides a checklist for emerging managers to follow when launching a hedge fund in order to meet various operational, accounting, compliance and regulatory requirements.  In a companion article to be published in a forthcoming issue of the HFLR, Vinod Paul of Eze Castle Integration will discuss technology and infrastructure considerations applicable to emerging hedge fund managers.  For more insight from Marcum, see “Prime Broker Merlin Securities Develops Spectrum of Hedge Fund Investors; Event Hosted by Accounting Firm Marcum LLP Examines Marketing Implications of the Merlin Spectrum,” The Hedge Fund Law Report, Vol. 3, No. 39 (Oct. 8, 2010).  For more on emerging managers, see “Key Accounting and Legal Hurdles in Starting a Hedge Fund Management Business, and How to Surmount Them,” The Hedge Fund Law Report, Vol. 7, No. 18 (May 8, 2014).

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  • From Vol. 8 No.23 (Jun. 11, 2015)

    WilmerHale Attorneys Discuss FCPA Risks Applicable to Private Fund Managers (Part Two of Two)

    The financial services industry is under increased scrutiny from anti-corruption enforcement authorities in the U.S. and abroad.  Foreign Corrupt Practices Act (FCPA) enforcement actions have the potential to implicate hedge funds, private fund managers and even fund investors themselves.  Accordingly, hedge fund managers must be aware of FCPA risks and take steps to mitigate them.  See “FCPA Compliance Strategies for Hedge Fund and Private Equity Fund Managers,” The Hedge Fund Law Report, Vol. 7, No. 23 (Jun. 13, 2014); and “FCPA Considerations for the Private Fund Industry: An Interview with Former Federal Prosecutor Justin Shur,” The Hedge Fund Law Report, Vol. 7, No. 20 (May 23, 2014).  This article, the second in a two-part series, summarizes the main points raised at a recent program regarding FCPA risks threatening private fund managers and summarizes recent FCPA enforcement actions involving financial institutions.  The program featured WilmerHale partners Kimberly A. Parker and Erin G.H. Sloane.  The first article in this series summarized the key points from that presentation regarding the current U.S. and global anti-corruption enforcement climate and the relevant provisions of the FCPA.

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  • From Vol. 8 No.19 (May 14, 2015)

    FRA Liquid Alts 2015 Conference Highlights Due Diligence Concerns with Alternative Mutual Funds (Part Three of Three)

    With the significant expansion of the liquid alternatives (or alternative mutual fund) space in recent years and the increase in offerings of alternative mutual funds by hedge fund managers, the importance of conducting proper due diligence has commensurately grown.  Investors looking to allocate funds to alternative mutual funds need to consider numerous factors when evaluating potential candidates for investments, and managers deciding to launch alternative mutual funds must also conduct thorough due diligence on service providers for their structures.  This topic was among those discussed at the recent Liquid Alts 2015 conference hosted by Financial Research Associates, LLC.  This article, the third in a three-part series, focuses on the panel discussions of issues investors should consider while conducting due diligence on an alternative mutual fund, as well as due diligence issues managers should consider while establishing a fund structure under the Investment Company Act of 1940 (the ’40 Act).  The first article discussed the keys to successfully launching and operating an alternative mutual fund.  The second article explored ’40 Act fund structures and regulatory concerns with liquid alternative funds.  For more on alternative mutual funds, see “Five Key Compliance Challenges for Alternative Mutual Funds: Valuation, Liquidity, Leverage, Disclosure and Director Oversight,” The Hedge Fund Law Report, Vol. 7, No. 28 (Jul. 24, 2014).

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  • From Vol. 8 No.16 (Apr. 23, 2015)

    Is the Use of an Independent Valuation Firm Superior to a Manager’s Internal Valuation Process?  

    As private equity valuations have become subject to increasing review from investors and regulators, certain private equity managers have turned to independent valuation firms to assist in their valuation processes.  The practice, which can be expensive and time-consuming, can benefit managers with hard-to-value holdings.  However, the use of an independent valuation firm in addition to a manager’s internal valuation process remains above and beyond standard industry practice.  In a recent interview with The Hedge Fund Law Report, Scott A. Arenare and Joseph P. Cunningham, partners at Willkie Farr & Gallagher and members of its Asset Management Group, shared insight on the use of independent valuation firms by private equity and hedge fund managers.  The interview specifically covered, among other topics, benefits of engaging independent valuation firms, trends in such engagements, allocation of independent valuation expenses and best practices for managers conducting internal valuations.  For more on valuation, see “Three Pillars of an Effective Hedge Fund Valuation Process,” The Hedge Fund Law Report, Vol. 7, No. 24 (Jun. 19, 2014).

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  • From Vol. 8 No.14 (Apr. 9, 2015)

    Operational Conflicts Arising Out of Simultaneous Management of Hedge Funds and Alternative Mutual Funds Following the Same Strategy (Part Two of Three)

    The simultaneous management of hedge funds and alternative mutual funds (or liquid alternative funds) is rife with potential conflicts and the corresponding risk that the manager or hedge fund investors can benefit at the expense of the mutual fund investors, despite the manager’s fiduciary duty to manage each fund in the best interests of that fund’s investors as well as requirements under the Investment Company Act of 1940 that joint enterprises involving a mutual fund and certain affiliates be fair to the mutual fund.  See “SEC and FSA Impose Heavy Fines on Investment Manager for Failing to Address Conflicts of Interest Associated with Side by Side Management of a Registered Fund and a Hedge Fund,” The Hedge Fund Law Report, Vol. 5, No. 21 (May 24, 2012).  In addition to the incentive for the manager to allocate trades to the hedge fund over the mutual fund in certain circumstances (including in order to earn higher fees in the hedge fund), operational and other conflicts arise out of such simultaneous management.  This article, the second in a three-part series, discusses conflicts arising out of simultaneous management of a hedge fund and alternative mutual fund, including operational conflicts, conflicts of fee-related investment decisions, cross trades, soft dollar allocations, valuation concerns, reporting conflicts and marketing conflicts.  The first article provided an overall assessment of conflicts of interest in simultaneous management; outlined the conflicts inherent in allocation of investments between a hedge fund and an alternative mutual fund following the same strategy; and discussed leverage limits, liquidity issues and diversification requirements applicable to alternative mutual funds.  The third article will address ways to mitigate identified conflicts of interest.

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  • From Vol. 8 No.13 (Apr. 2, 2015)

    FRA Compliance Master Class Highlights Operational and Regulatory Issues for Hedge Fund Managers Considering Launching Alternative Mutual Funds

    Seeking to access a vast source of capital that is not readily accessible by traditional hedge funds, hedge fund managers have been launching or contemplating the launch of alternative mutual funds.  Aside from the opportunity to expand the manager’s investor base, launching an alternative mutual fund allows a hedge fund manager to expand and diversify its product offering.  In the U.S., such funds are governed by the Investment Company Act of 1940 and, as such, must meet a broad array of regulatory and compliance requirements.  See “The First Steps to Take When Joining the Rush to Offer Registered Liquid Alternative Funds,” The Hedge Fund Law Report, Vol. 7, No. 42 (Nov. 6, 2014).  For a general discussion of ways that hedge fund managers can enter the retail alternatives space, see “How Can Hedge Fund Managers Organize and Operate Alternative Mutual Funds to Access Retail Capital (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 6 (Feb. 7, 2013).  Speakers at FRA LLC’s Private Investment Funds Compliance Master Class – including Marie Noble, partner, general counsel and CCO at SkyBridge Capital; and Robert Schwartz, general counsel and CCO at Loeb King Capital Management – discussed issues to consider when converting a hedge fund strategy to a mutual fund structure, due diligence of mutual fund service providers, alternative mutual fund compliance and marketing.  This article highlights the key points discussed on each of the foregoing topics.  For additional coverage of this conference, see “Five Steps That CCOs Can Take to Avoid Supervisory Liability, and Other Hedge Fund Manager CCO Best Practices,” The Hedge Fund Law Report, Vol. 8, No. 12 (Mar. 27, 2015).  For a discussion of another kind of conversion, see “Legal Mechanics of Converting a Hedge Fund Manager to a Family Office,” The Hedge Fund Law Report, Vol. 4, No. 43 (Dec. 1, 2011).

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  • From Vol. 8 No.6 (Feb. 12, 2015)

    Why Should Hedge Fund Investors Perform On-Site Due Diligence in Addition to Remote Gathering of Information on Managers and Funds? (Part Three of Three)

    On-site visits have become de rigueur in operational due diligence, with many investors putting a high premium on face-to-face meetings with fund managers.  But the difference between a superficial and an effective on-site visit can be profound.  Merely showing up is not sufficient.  In fact, going on site without the right strategy can create the illusion of a “deep dive” without the substance.  Effective on-site due diligence is not just a matter of staying longer, asking more questions and reviewing more documents.  It is a discipline unto itself, with techniques that are proven to work.  Usually, those techniques can only be learned through trial and error.  This article, the third in a three-part series, aims to minimize the “error” part of that learning process by revealing best practices learned by long-time ODD practitioners.  Specifically, this article details: workable and effective on-site diligence procedures, including evaluating cybersecurity programs; red flags to identify; and an investor’s options following the on-site visit.  The first article focused on the rationale for the on-site visit and the mechanics of preparation.  The second article discussed how investors should conduct due diligence visits, and how managers can prepare for them effectively.  See also “Operational Due Diligence from the Hedge Fund Investor Perspective: Deal Breakers, Liquidity, Valuation, Consultants and On-Site Visits,” The Hedge Fund Law Report, Vol. 7, No. 16 (Apr. 25, 2014).

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  • From Vol. 8 No.6 (Feb. 12, 2015)

    Investment Firm Pentwater Accuses Baker, Donelson of Fraud in Reneging on Agreement to Defer Fees Owed by a Company to which Pentwater Extended Credit

    In January 2014, investment adviser Pentwater Capital Management, L.P. (Pentwater), through certain funds it managed, extended credit to American Standard Energy Corporation (ASEN).  Pentwater claims that, to satisfy a condition to making that loan, ASEN’s counsel, Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C. (Baker), agreed to defer certain legal fees that were owed to it.  That agreement was reflected in a letter agreement between ASEN and Baker.  However, Pentwater claims that Baker surreptitiously replaced that letter agreement with a revised agreement containing more favorable terms.  Pentwater and its funds have sued Baker, asserting several claims of fraudulent misconduct and seeking a declaration that the original letter agreement is binding on Baker.  This article summarizes the facts alleged by the plaintiffs and their specific claims against Baker.  For coverage of another suit by a hedge fund manager against an attorney for allegedly deceptive conduct, see “In Lawsuit by Hedge Fund Manager against Law Firm, the Viability of a Statute of Limitations Defense Turns Not on the Length of the Limitations Period, But on When the Period Starts Running,” The Hedge Fund Law Report, Vol. 6, No. 8 (Feb. 21, 2013).

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  • From Vol. 8 No.3 (Jan. 22, 2015)

    How Do Regulatory Investigations Affect the Hedge Fund Audit Process, Investor Redemptions, Reporting of Loss Contingencies and Management Representation Letters?

    A fund’s financial auditors are charged with taking reasonable steps to assure that the fund’s financial statements are free from material misstatements.  A regulatory investigation or allegation of misconduct against a fund or its manager can delay completion of an audit, lead to a qualified audit opinion or even derail the audit and lead to resignation of the auditor.  In that regard, a recent PracticeEdge session offered by the Regulatory Compliance Association (RCA) considered the steps a fund manager should take when faced with a regulatory investigation or allegation of misconduct, how to develop an effective response plan, and the impact that the matter will have on the annual audit process and the firm’s financial statements.  See also “Is This an Inspection or an Investigation? The Blurring Line Between Examinations of and Enforcement Actions Against Private Fund Managers,” The Hedge Fund Law Report, Vol. 5, No. 13 (Mar. 29, 2012).  In April of this year, the RCA will be hosting its Regulation, Operations and Compliance (ROC) Symposium in Bermuda.  For more on ROC Bermuda 2015, click here; to register for it, click here.

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  • From Vol. 7 No.44 (Nov. 20, 2014)

    Eight Important Regulatory and Operational Differences Between Managing Hedge Funds and Alternative Mutual Funds

    Participants at a recent Financial Research Associates (FRA) event analyzed eight of the most important regulatory and operational considerations in managing alternative mutual funds.  Participants also highlighted how each of those considerations applies differently to hedge funds and alternative mutual funds.  For example, both hedge funds and alternative mutual funds need to be concerned with leverage limitations.  However, the sources of such limitations, their impact on investment strategy, the operational infrastructure necessary to implement and monitor such limitations, relevant compliance issues and other dynamics are different for the different products.  While superficially similar – especially when following similar strategies – hedge and mutual funds are very different products from the perspectives of operations and regulatory compliance.  That was the core thesis of the FRA program; and this article conveys both the key points of difference and the business consequences of such product variation.  See also “The First Steps to Take When Joining the Rush to Offer Registered Liquid Alternative Funds,” The Hedge Fund Law Report, Vol. 7, No. 42 (Nov. 6, 2014); “How Can Hedge Fund Managers Organize and Operate Alternative Mutual Funds to Access Retail Capital? (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 6 (Feb. 7, 2013).

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  • From Vol. 7 No.32 (Aug. 28, 2014)

    SEC Action Against Custodian to Fraudulent Hedge Fund Manager Limns the Spectrum of Service Provider Culpability

    The SEC recently charged a brokerage firm and its president (Defendants) with helping a hedge fund manager conceal trading losses from investors and misappropriate investor funds.  According to the SEC, the Defendants were necessary to the success of the fraud, and the Defendants received payments from the manager for participating in his scheme.  If the SEC’s factual allegations are accurate, then the Defendants were knowingly complicit in the underlying fraud, and thus effectively participants.  But what if the Defendants were not knowingly complicit but rather received “storm warnings” of the fraud, or identified red flags then did nothing, or not enough?  Or what if red flags could have been uncovered with reasonable investigation, but the Defendants failed to uncover them?  This article describes the factual and legal allegations in this matter, and briefly considers the foregoing questions.  For a stark illustration of the challenges facing a service provider to a fraudulent hedge fund manager, see “Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices,” The Hedge Fund Law Report, Vol. 4, No. 25 (Jul. 27, 2011).

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  • From Vol. 7 No.24 (Jun. 19, 2014)

    How Can Service Providers to Cayman Islands Hedge Funds Enforce Rights to Contracts to Which They Are Not Parties?

    In the hedge fund world, as in all commercial spheres, exclusion and limitation of liability of, and the right of indemnity for, service providers, is a key element in the structure.  See “Indemnification Provisions in Agreements between Hedge Fund Managers and Placement Agents: Reciprocal, But Not Necessarily Symmetrical,” The Hedge Fund Law Report, Vol. 3, No. 41 (Oct. 22, 2010).  This structure creates a tension between two competing commercial factors: the need to attract service providers of sufficient quality, and who expect such terms, and commercial acceptability, in particular to prospective investors.  A particular problem has been the enforcement of such terms by service providers or their associates, who are intended to be covered by the protection afforded by such terms, but who are not themselves parties to the contract that creates those terms.  The new Cayman Islands statute, The Contracts (Rights of Third Parties) Law 2014 (the 2014 Law), which came into force on May 21, 2014, directly impacts, and assists, in this area.  In a guest article, Christopher Russell and Jonathan Bernstein, partner and senior associate, respectively, at Appleby, Cayman Islands, provide a thorough analysis of the 2014 Law and its consequences for the allocation of risk among hedge fund service providers, managers and investors.  On hedge fund service providers generally, see “Evolving Operational Due Diligence Trends and Best Practices for Due Diligence on Emerging Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 7, No. 15 (Apr. 18, 2014) (section entitled “Due Diligence on Service Providers”).

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  • From Vol. 7 No.18 (May 8, 2014)

    How to Close a Hedge Fund in Eight Steps (Part One of Two)

    In concept, hedge funds are “continuously offered” and, unlike their private equity cousins, have no built-in end date.  In practice, however, hedge funds do not last forever.  For various reasons – this article catalogues nine of them – hedge fund managers may wish to close their funds, or may close their funds without wishing to.  More often than not, a hedge fund manager that closes a fund remains in the investment management business, and continues to interact with the same employees, investors and service providers – even if that interaction occurs under a different structure.  Closing a fund is a complex process involving hard legal and business issues, often with an overlay of meaningful personal dynamics.  This article – the first in a two-part series – aims to add some structure to what can be a fraught and unruly process by presenting an eight-step framework for hedge fund closures.  The second article in this series will highlight a number of challenges that managers typically encounter in the course of those eight steps, and suggest best practices for negotiating the challenges.  It should be emphasized that this series is about winding down the business and investment affairs of a hedge fund.  In industry parlance, “closing” also refers to a situation in which a hedge fund is not accepting new investors or investments.  That latter type of “closing” is not the subject of this series, but was the subject of prior articles in the HFLR.  See “Legal and Investment Considerations in Connection with Closing Hedge Funds to New Investors or Investments,” The Hedge Fund Law Report, Vol. 3, No. 37 (Sep. 24, 2010); “Primary Legal and Business Considerations in Structuring Hedge Fund Capacity Rights,” The Hedge Fund Law Report, Vol. 3, No. 22 (Jun. 3, 2010).

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  • From Vol. 7 No.15 (Apr. 18, 2014)

    Evolving Operational Due Diligence Trends and Best Practices for Due Diligence on Emerging Hedge Fund Managers

    On March 25 and 26, 2014, at the Princeton Club in New York, Financial Research Associates held the most recent edition of its annual Hedge Fund Due Diligence Master Class.  This article summarizes a series of panels at the event focusing on operational due diligence from the manager perspective.  In particular, this article covers evolving operational due diligence trends, due diligence on emerging hedge fund managers, due diligence on service providers, corporate governance and cybersecurity considerations for hedge fund managers.  A prior article in the HFLR covered an overview presentation at the same event.  See “Seward & Kissel Partner Steven Nadel Identifies 29 Top-of-Mind Issues for Investors Conducting Due Diligence on Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 7, No. 13 (Apr. 4, 2014).  And a subsequent article will cover panels at the event focusing on operational due diligence from the investor perspective.

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  • From Vol. 6 No.45 (Nov. 21, 2013)

    Do Hedge Fund Investors Have Standing to Bring Direct, As Opposed to Derivative, Claims against the Auditor of a Hedge Fund Whose Manager Overvalued Portfolios Securities?

    On November 8, 2013, reversing an earlier decision of the U.S. District Court for the Southern District of New York (SDNY), the U.S. Court of Appeals for the Second Circuit (Second Circuit) allowed investors to proceed in their federal securities fraud lawsuit against accounting firm PricewaterhouseCoopers LLP (PwC) and its former client, Lipper Convertibles, L.P. (Lipper or the fund), a now defunct hedge fund.  The investor-plaintiffs alleged that PwC overlooked red flags when it audited the fund from 1996 to 2000, resulting in auditor opinion letters that fraudulently induced the plaintiffs to invest in Lipper at inflated prices set forth in financial statements and reports reviewed by PwC.  The SDNY previously dismissed the suit, holding that the investors lacked standing to sue because their claims were derivative, rather than direct, meaning that they had not shown injuries separate from harm to the fund.  See “U.S. District Court Holds That Hedge Fund Investors Do Not Have Standing to Bring a Direct, As Opposed to Derivative, Claim against Hedge Fund Auditor PricewaterhouseCoopers LLP,” The Hedge Fund Law Report, Vol. 3, No. 47 (Dec. 3, 2010).  The Second Circuit reversed, arguing that there were triable issues of fact critical to the determination of whether the investors suffered harm separate from that suffered by other Lipper investors.  This article summarizes the factual and procedural background of the case as well as the Second Circuit’s reasoning in allowing the plaintiffs to proceed to trial.  See also, “When Can Hedge Fund Investors Bring Suit Against a Service Provider for Services Performed on Behalf of the Fund?,” The Hedge Fund Law Report, Vol. 6, No. 18 (May 2, 2013); and “Massachusetts Appeals Court Holds That Hedge Fund Investors Can Sue Hedge Fund Auditor Based on Payment of Taxes on Fraudulent ‘Phantom Income,’” The Hedge Fund Law Report, Vol. 6, No. 34 (Aug. 29, 2013).

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  • From Vol. 6 No.38 (Oct. 3, 2013)

    Chapter 15 of the Bankruptcy Code Presents Litigation Risks and Liability for Creditors, Counterparties, Service Providers and Others Doing Business with Bankrupt Offshore Hedge Funds

    Chapter 15 of the United States Bankruptcy Code (Bankruptcy Code) provides certain protections and tools to offshore hedge funds in liquidation and opens up parties that do business with such funds to possible litigation risk.  That chapter was created to preserve, protect and maximize the recovery of a foreign debtor’s assets located in the United States so that all creditors of that debtor may share in their value.  It is available to foreign liquidators and trustees in foreign bankruptcies, such as those filed in the Cayman Islands, British Virgin Islands and Bermuda, three popular countries in which offshore hedge funds organize.  It allows these foreign liquidators to come to the United States and use its courts and laws to seek, through discovery and lawsuits, the return of assets purportedly belonging to the foreign estates.  It is not a well-known bankruptcy proceeding, and it can create uncertain and substantial legal costs and liability for uninformed persons and entities who have dealt with offshore funds.  To best protect information and assets when dealing with an offshore hedge fund, it is critical for parties dealing with such funds to understand the possible discovery and recovery rights that a foreign liquidator of a bankrupt hedge fund may have under Chapter 15.  In a guest article, Marc D. Powers and Natacha Carbajal, senior partner and associate, respectively, at BakerHostetler, describe Chapter 15 proceedings, including highlighting how such proceedings work and what types of relief are available to the petitioner.  Powers and Carbajal also provide practice tips to help those dealing with offshore hedge funds mitigate the risks associated with Chapter 15 proceedings.  For additional coverage of Chapter 15 proceedings, see “Cayman Islands Liquidations of Failed Bear Stearns Hedge Funds Denied Access to US Bankruptcy Court,” The Hedge Fund Law Report, Vol. 1, No. 13 (May 30, 2008).

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  • From Vol. 6 No.34 (Aug. 29, 2013)

    Massachusetts Appeals Court Holds That Hedge Fund Investors Can Sue Hedge Fund Auditor Based on Payment of Taxes on Fraudulent “Phantom Income”

    Can a hedge fund investor sue the hedge fund’s auditor if the fund turns out to be a fraud?  While courts have come down on both sides of this question, the thrust of the caselaw has thus far been unfavorable to investors and favorable to auditors and other service providers seeking to avoid liability.  See, e.g., “When Can Hedge Fund Investors Bring Suit Against a Service Provider for Services Performed on Behalf of the Fund?,” The Hedge Fund Law Report, Vol. 6, No. 18 (May 2, 2013).  However, the Massachusetts Appeals Court (Court) recently upheld a trial court decision allowing investors in a fraudulent hedge fund to proceed with a suit against the funds’ auditor.  In particular, the Court identified various direct claims available to the hedge fund investors based on (among other things) the passing through of profits and losses to investors and the payment of taxes by investors on phantom income that did not exist.  For more on phantom income and the tax consequences of it, see “How Can Hedge Fund Managers Use Profits Interests, Capital Interests, Options and Phantom Income to Incentivize Top Portfolio Management and Other Talent?,” The Hedge Fund Law Report, Vol. 6, No. 33 (Aug. 22, 2013).  The Court’s decision may create opportunities for investors in similar factual scenarios (and in disputes governed by Delaware law) to take direct action against auditors and other hedge fund service providers, at least where investors suffer a harm independent of any harm suffered by the fund.  This article summarizes the factual background of the case, the Court’s legal analysis and the implications of the Court’s decision.

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  • From Vol. 6 No.24 (Jun. 13, 2013)

    How Should Hedge Fund Managers Select Accountants, Prime Brokers, Independent Directors, Administrators, Legal Counsel, Compliance Consultants, Risk Consultants and Insurance Brokers for Their Funds?

    This article discusses what hedge fund managers should look for in the companies that provide accounting, brokerage, directorial, administration, legal, consulting, risk management and technology services to a fund.  To do so, this article focuses on questions that hedge fund managers should ask and issues they should address when retaining or changing service providers.

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  • From Vol. 6 No.11 (Mar. 14, 2013)

    Best Practices for Due Diligence by Hedge Fund Managers on Research Providers

    Recent high-profile enforcement actions, including that involving Mathew Martoma and CR Intrinsic, an affiliate of SAC Capital, highlight the SEC Division of Enforcement’s continuing commitment to aggressively prosecuting hedge fund insider trading cases.  See “Fund Manager CR Intrinsic and Former SAC Portfolio Manager Are Civilly and Criminally Charged in Alleged ‘Record’ $276 Million Insider Trading Scheme,” The Hedge Fund Law Report, Vol. 5, No. 44 (Nov. 21, 2012).  While registered hedge fund managers are required by Rule 206(4)-7 under the Investment Advisers Act of 1940 to adopt policies and procedures reasonably designed to prevent and detect insider trading and other federal securities law violations, it behooves all hedge fund managers (even those that are not registered) to adopt such policies and procedures.  See “Three Recent SEC Orders Demonstrate a Renewed Emphasis on Investment Adviser Compliance Policies and Procedures by the Enforcement Division,” The Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).  Many hedge fund managers have recognized the insider trading risks posed by the use of expert network firms and have adopted policies and procedures designed to address these risks.  But other types of research firms also present insider trading and other regulatory risks.  Before using any investment research firm, it is imperative for hedge fund managers to conduct thorough due diligence to appropriately assess and address those risks.  In a guest article, Susan Mathews and Sanford Bragg describe the different types of research providers in the marketplace; the general approach to research provider due diligence; and some best practices for conducting due diligence on research providers.  Bragg is CEO of Integrity Research Associates, LLC, a consulting firm specializing in evaluating investment research providers, including their compliance platforms.  Mathews is Counsel and head of Integrity Research Compliance.

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  • From Vol. 6 No.8 (Feb. 21, 2013)

    In Lawsuit by Hedge Fund Manager against Law Firm, the Viability of a Statute of Limitations Defense Turns Not on the Length of the Limitations Period, But on When the Period Starts Running

    A recent decision by the New York State Supreme Court, Appellate Division, First Department, takes its place among the limited but growing body of caselaw involving lawsuits by hedge fund managers and others against law firms.  See, e.g., “Dismissal of Fortress’ Complaint Against Dechert Illustrates the Limits of a Hedge Fund Manager’s Ability to Rely on a Legal Opinion Issued by a Law Firm of Which It Is Not a Client,” The Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011); “SEC Receiver for Arthur Nadel’s Scoop Capital Hedge Funds Moves to Settle Malpractice Claim Against Law Firm Holland & Knight,” The Hedge Fund Law Report, Vol. 5, No. 36 (Sep. 20, 2012).  This decision addressed the question: When does the limitations period start running in a suit by a hedge fund manager principal against a law firm for deceit?  For hedge fund managers, the decision provides important insight on when to bring such a claim.  For law firms, the decision illustrates how to effectively deploy a statute of limitations defense.

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  • From Vol. 5 No.42 (Nov. 9, 2012)

    To What Legal Standard Is a Law Firm Held When Its Client Hedge Fund Invests or Engages in a Fraud?

    A perennial question in the case of hedge fund frauds is: How wide is the scope of civil liability?  A hedge fund manager that engages in fraud is almost definitely liable civilly, but frequently has few or no assets to satisfy a judgment.  (A criminal conviction of a manager that engages in fraud may offer symbolic satisfaction to investors, but cannot make investors whole.)  On the other hand, the chain of culpability connecting a hedge fund service provider to a fraud is often attenuated, but service providers usually remain robustly solvent even after a client is exposed as a fraud.  Therefore, in the wake of hedge fund frauds, investors have sued service providers (e.g., law or accounting firms) in an effort to recoup losses.  See “SEC Receiver for Arthur Nadel’s Scoop Capital Hedge Funds Moves to Settle Malpractice Claim Against Law Firm Holland & Knight,” The Hedge Fund Law Report, Vol. 5, No. 36 (Sep. 20, 2012).  Investor claims against hedge fund service providers are often tenuous, but offer a real possibility to collect on any judgment.  A recent federal court decision illustrates these themes in connection with a malpractice suit brought against law firm Winston & Strawn (W&S) by the trustee of the estate of bankrupt hedge funds.  This article discusses the factual background in the action; the trustee’s claims against W&S; and the Court’s decision and analysis.

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  • From Vol. 5 No.37 (Sep. 27, 2012)

    Second Circuit Upholds Dismissal of Hedge Fund Investors’ Securities Fraud and Negligence Suits Against Fund Auditors, KPMG and Ernst & Young, Based on their Alleged Failure to Detect Madoff Fraud

    Individuals and hedge funds that invested in certain Bernard L. Madoff feeder funds that were managed by Tremont Group Holdings, Inc. and its affiliates (Tremont) initiated lawsuits in the U.S. District Court for the Southern District of New York (District Court) against Tremont and accounting firms KPMG LLP, KPMG (Cayman) and Ernst & Young LLP (together, Auditors).  The plaintiffs claimed that the Auditors were liable for securities fraud, common law fraud, negligence and breach of fiduciary duty arising out of their audit of certain Tremont funds that invested with Bernard L. Madoff Investment Securities, LLC (Madoff) and their failure to detect the Madoff fraud.  The District Court granted the Auditors’ motion to dismiss the complaint for failure to state a claim against the Auditors.  The U.S. Court of Appeals for the Second Circuit has upheld that dismissal.  This article summarizes the investors’ claims as well as the Court of Appeals’ decision and reasoning.

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  • From Vol. 5 No.36 (Sep. 20, 2012)

    SEC Receiver for Arthur Nadel’s Scoop Capital Hedge Funds Moves to Settle Malpractice Claim Against Law Firm Holland & Knight

    In January 2009, hedge fund sponsor Arthur Nadel disappeared, and his $300 million Ponzi scheme collapsed.  Law firm Holland & Knight LLP, and one of its partners (together, H&K), had provided legal services to Nadel’s funds and management companies.  A receiver for Nadel’s funds was appointed at the request of the Securities and Exchange Commission.  As part of his efforts to recover funds for investors, the receiver sued H&K for malpractice.  H&K has recently agreed to settle that malpractice litigation for $25 million.  The receiver has asked the court supervising the receivership to approve the settlement.  This article provides background on Nadel’s fraud and summarizes the terms of the H&K settlement.

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  • From Vol. 5 No.29 (Jul. 26, 2012)

    Corgentum Survey Illustrates the Views of Hedge Fund Investors on the Roles, Duties, Risks and Performance of Service Providers

    Corgentum Consulting, LLC, a specialist consulting firm that performs operational due diligence reviews of fund managers, recently conducted a survey asking hedge fund investors five questions about their views on service providers, including questions concerning the functions provided by service providers and the risks associated with them.  This article describes the survey findings.

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  • From Vol. 5 No.13 (Mar. 29, 2012)

    SEC Enforcement Action Against Investment Adviser Highlights Importance of Conducting Due Diligence on a Hedge Fund’s Auditor to Avoid Fraud

    Although hedge fund investment decisions are based on numerous factors, information relating to a hedge fund’s financial condition and performance results remains a critical component of any such decision.  See “Legal and Operational Due Diligence Best Practices for Hedge Fund Investors,” The Hedge Fund Law Report, Vol. 5, No. 1 (Jan. 5, 2012).  Various parties have a hand in creating and confirming the information that goes into financial statements and performance reporting.  Those parties include the manager, the administrator and the auditor.  Many investors pay particularly close attention to reports from auditors because of the rigorous standards governing the accounting profession and the presumably uniform application of those standards across different contexts.  However, information about a hedge fund provided by an accountant is only as good as the accountant itself.  A good accountant can provide, directly or indirectly, good information to an investor – even though the accountant’s duty typically does not flow to the investor – while a bad accountant can provide a false sense of security or, worse, cover for a fraud.  Indeed, a recurring feature of frauds in the hedge fund industry is an accountant that does not exist, is much smaller or less experienced than claimed or that is affiliated with the manager.  An accounting firm that was both fictitious and affiliated with the manager was a notable feature of the Bayou fraud.  See “Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices,” The Hedge Fund Law Report, Vol. 4, No. 25 (Jul. 27, 2011).  A fraudulent auditor and fictitious financial statements also featured prominently in a recently filed SEC action against an investment adviser.  This article summarizes the SEC’s Complaint in that action and describes five techniques that hedge fund investors can use to confirm the existence, competence and reliability of hedge fund auditors.

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  • From Vol. 5 No.11 (Mar. 16, 2012)

    Use of SSAE 16 (SAS 70) Internal Control Reports by Hedge Fund Managers to Credibly Convey the Quality of Internal Controls, Raise Capital and Prepare for Audits

    An “institutional” quality infrastructure is becoming a prerequisite for hedge fund managers looking to raise capital from sophisticated investors.  But institutional is a difficult quality to define with precision in the hedge fund industry, a function of, among other things, the relative youth of the industry, asymmetry in the size and structure of management companies and the reluctance on the part of managers to disclose information.  As used by hedge fund investors, consultants, managers, regulators, service providers and others, institutional is more of a conclusion than a characteristic.  Managers are said to be institutional when they have fund directors with substance, gray hair in key operational roles, best-of-breed technology, brand name service providers, top tier investment talent and high caliber personnel focused on aspects of the business other than investing.  But a manager may be institutional without some of these elements, and even a manager with these elements can have holes in its processes that undermine the veneer of competence.  So how can investors reliably assess the institutional caliber of a manager, and how can managers credibly demonstrate their level of institutionalization?  Along similar lines, how can investors make institutional apples to apples comparisons when hedge fund management businesses are radically different in terms of size, structure, strategy and operations?  One method is to focus on the robustness of a manager’s internal controls, since robust internal controls are a necessary – though not sufficient – element of an institutional quality infrastructure.  Unlike other indicia of institutionalization, the robustness of internal controls can be measured at a single manager and compared across managers.  Such measurement can be accomplished by having an independent auditor conduct an internal control audit and issue an internal control report in accordance with Statement on Standards for Attestation Engagements No. 16 (SSAE 16), which replaced the long-standing Statement on Auditing Standards 70 (SAS 70).  While SSAE 16s have been in use in other industries for some time, they are a relatively new technique in the hedge fund industry.  However, in a climate of heightened regulator and investor scrutiny of non-investment aspects of the hedge fund business, SSAE 16s offer one of the most objective available barometers of institutionalization.  This article provides an introduction to the SSAE 16 audit process as applied to the hedge fund industry, including a description of the SSAE 16 audit and the corresponding internal control report; provides guidance regarding fund service providers a hedge fund manager should request an internal control report from and what should be covered in such internal control reports; outlines the reasons why hedge fund managers may consider obtaining an SSAE 16 audit on themselves, including a discussion of key benefits and costs of obtaining an internal control audit and report; describes the process for hedge fund managers to obtain an internal control audit and report; addresses who should pay for the internal control audit and report; addresses how often a hedge fund manager should obtain an internal control audit and report; identifies the challenges hedge fund managers face in obtaining an internal control audit and report; and explores whether there are any suitable alternatives to the internal control audit and report.

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  • From Vol. 4 No.44 (Dec. 8, 2011)

    Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part Two of Four)

    Many hedge fund managers based in the U.S. or Europe have considered opening an office in Asia, but few are conversant with the benefits and burdens of the various Asian jurisdictions, and fewer still are familiar with the specific steps necessary to open an Asian office.  To address this information gap, Maria Gabriela Bianchini, founder of Optionality Consulting, is publishing a four-part series in The Hedge Fund Law Report.  The first article in this series identified factors that hedge fund managers should consider in determining whether to open an office in Asia and compared the relative merits of Hong Kong and Singapore as locations for an office.  See “Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part One of Four),” The Hedge Fund Law Report, Vol. 4, No. 43 (Dec. 1, 2011).  This article – the second in the series – discusses technical steps and considerations for the actual process of opening an office in either Hong Kong or Singapore.  Many of these steps are applicable to the establishment of any new office outside of a manager’s home jurisdiction, but they are discussed in this article in the context of an Asian office opening.  Part three of this series will discuss the changing regulatory landscape affecting managers in Singapore and part four will conclude with a discussion of Hong Kong.

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  • From Vol. 4 No.44 (Dec. 8, 2011)

    Dismissal of Fortress’ Complaint Against Dechert Illustrates the Limits of a Hedge Fund Manager’s Ability to Rely on a Legal Opinion Issued by a Law Firm of Which It Is Not a Client

    On November 29, 2011, the New York State Appellate Division, First Department – the state’s intermediate appellate court (Court) – dismissed a complaint brought in December 2009 by Fortress Credit Corp. and FCOF UL Investments LLC (together, Fortress) against the law firm Dechert LLP (Dechert).  See “Business Issues with Legal Consequences: A Wide-Ranging Interview with Dechert Partner George Mazin about the Most Important Challenges Facing Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 4, No. 40 (Nov. 10, 2011).  The Court’s decision helps define the scope of a law firm’s obligations to a non-client in connection with the issuance of a legal opinion.  Accordingly, the decision is relevant to law firms that issue such opinions and hedge fund managers that rely on them.  This article summarizes the allegations in the complaint, the decision below and the Court’s legal analysis.

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  • From Vol. 4 No.39 (Nov. 3, 2011)

    Anti-Bribery Compliance for Private Fund Managers

    Managing the risks inherent in dealing with foreign officials should be a top priority for managers of hedge funds and private equity funds.  This is especially true in the current climate of expansive government interpretations of anti-bribery laws, new incentives for whistleblowers and the recent government scrutiny of the inner workings of fund managers.  It has become standard fare for fund managers to have regular interactions with foreign officials or their representatives in the ordinary course of raising capital and making investments.  There is nothing inherently wrong with such interactions.  Still, those dealings need to be informed by a heightened sensitivity to the possible appearance that something of value was given to a foreign official in connection with a particular investment or transaction.  The risk is that, regardless of the intent of the fund manager, certain conduct may be viewed in hindsight as an effort to improperly influence the actions of a foreign official.  As a result, a fund manager needs to focus on more than just the substance of the transaction and needs to consider both how the transaction might be perceived and the record that is being created.  As cross-border investments continue apace, fund managers can protect themselves by having adequate policies and procedures in place to identify potential bribery risks and to prevent violations from occurring.  Aggressive enforcement of the Foreign Corrupt Practices Act (FCPA) by U.S. authorities and the comprehensive overhaul of anti-corruption laws in the U.K., culminating in the new Bribery Act 2010 (Bribery Act), highlight the importance of implementing effective anti-corruption compliance policies and procedures.  In these circumstances, fund managers must do more than assure themselves that they are not acting with a corrupt intent; they also need to be alert to the risk of misunderstandings and to be diligent in creating a record of compliance.  In a guest article, Paul A. Leder and Sarah P. Swanz, partner and counsel, respectively, in the Washington D.C. office of Richards Kibbe & Orbe LLP, outline steps to take to identify and manage the compliance risks faced by fund managers both directly (through their own dealings with foreign officials) and indirectly (through investments in operating companies that operate overseas).  Specifically, Leder and Swanz identify conduct at the fund manager level that can put the manager at risk; discuss the importance of strong internal controls and compliance programs to mitigate corruption risks; and highlight categories of conduct at the portfolio company level that can put the manager at risk.  The authors then make specific suggestions for identifying potential bribery risks and managing such risks.  They conclude with a case study of a criminal prosecution that demonstrates the potential exposure for managers when making foreign investments.

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  • From Vol. 4 No.37 (Oct. 21, 2011)

    Technical and Operational Considerations for Hedge Fund Managers in Connection with Preparing, Filing and Updating Form PF

    The Financial Stability Oversight Council (FSOC) recently approved a proposed rule and guidance setting out the metrics and process it would use to designate a nonbank financial company as systemically important under the Dodd-Frank Act.  In that proposed rule, the FSOC noted that “[w]ith respect to hedge funds and private equity firms . . . less [systemic risk related] data is generally available about these companies than about certain other types of nonbank financial companies.”  Accordingly, “[b]eginning in 2012, advisers to hedge funds and private equity firms and commodity pool operators and commodity trading advisors will be required to file Form PF with the Securities and Exchange Commission or the Commodity Futures Trading Commission, as applicable, on which form such companies will make certain financial disclosures.  Using these and other data, the [FSOC] will consider whether to establish an additional set of metrics or thresholds tailored to evaluate hedge funds and private equity firms and their advisers.”  In its proposed form, Form PF calls for voluminous and detailed disclosure of financial, risk, counterparty and other information by hedge fund managers.  Understanding the scope of required information presents complicated legal challenges, and complying with the anticipated disclosure obligations presents unique operational challenges.  Accordingly, on October 25, 2011 – Tuesday of next week – Advise Technologies and The Hedge Fund Law Report will be co-sponsoring a seminar on legal and operational considerations for hedge fund managers in connection with completing, filing and updating Form PF.  The seminar will take place from 8:00 a.m. to 10:00 a.m. at the Helmsley Hotel at 212 East 42nd Street in Manhattan.  To register, click here or call 212-576-1170.  In anticipation of the seminar, The Hedge Fund Law Report interviewed Stephen Casner, CEO of HazelTree Fund Services, on how hedge fund managers can negotiate some of the more complex operational challenges presented by Form PF.  The full text of our interview is included in this issue of The Hedge Fund Law Report.

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  • From Vol. 4 No.35 (Oct. 6, 2011)

    FINforums’ Annual Hedge Fund Summit Focuses on Operations, Marketing and Hedge Fund Strategies in Non-Hedge Fund Structures

    On September 14, 2011, FINforums held its Annual Hedge Fund Summit.  Participants at the summit discussed hedge fund service providers; outsourcing; business continuity and disaster recovery plans; five important points with respect to hedge fund marketing; five specific steps to be taken by hedge fund managers seeking seed capital; and the evolution of hedge fund strategies in non-hedge fund structures, including managed accounts, investable hedge fund indices, hedge fund-like mutual funds and UCITS.  This article summarizes the key points made by presenters at the Summit.

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  • From Vol. 4 No.33 (Sep. 22, 2011)

    Primary Legal and Practical Considerations for Hedge Fund Managers Looking to Outsource Their Operational Functions

    In September 2011, financial report publisher ClearPath Analysis released a report entitled “Fund Outsourcing: Assessing the Critical Issues and Considerations When Outsourcing Operational Functions as a Fund Manager” (Report).  The Report is a compilation of interviews, roundtables and white papers designed to guide fund managers through the outsourcing process.  This article summarizes the most important topics discussed in the Report including: (1) whether or not to outsource at all; (2) how to select a service provider (including how to think about track record, portfolio of clients and size); (3) the relevant legal and regulatory frameworks, including considerations under the AIFMD; and (4) how to properly manage and monitor the service provider.  For a further discussion of best practices related to outsourcing, see “BNY Mellon’s Pershing Unit Releases White Paper Detailing Best Practices for Hedge Fund Outsourcing Solutions,” The Hedge Fund Law Report, Vol. 2, No. 42 (Oct. 21, 2009).

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  • From Vol. 4 No.32 (Sep. 16, 2011)

    How Can Hedge Fund General Counsel Use Project Management to Manage the Cost and Evaluate the Performance of Outside Counsel?

    One result of the current economic downturn is a heightened, and probably enduring, price sensitivity among hedge fund general counsel and fund CFOs.  The response from the legal profession has been confined mostly to discussions of “alternative fee arrangements.”  However, discussions regarding the cost of legal services need to go deeper, penetrating how in-house and outside counsel do our work.  The legal profession must address cost, staffing, timing and deliverables; and addressing these issues will yield insight into value.  Fortunately, there is a well-developed tool for addressing these issues – an alternative, if you will, to alternative fee arrangements.  That tool is project management.  Project management has been used effectively across a wide range of businesses for a considerable time, but only recently has made inroads into the legal business.  In the area of hedge fund law specifically, project management has rarely been mentioned.  However, if properly implemented, project management offers hedge fund general counsel the opportunity to save money, comparison shop, budget, plan, manage and evaluate performance with respect to outside counsel.  Accordingly, in a guest article, Jonathan Baum – Principal of Avenir Law, with more than 30 years of experience as a hedge fund, securities, corporate and finance lawyer – offers a detailed discussion of project management generally, and how project management may be applied specifically in the context of engagements by hedge fund general counsel of outside counsel.

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  • From Vol. 4 No.26 (Aug. 4, 2011)

    Hedge Fund-Specific Issues in Portfolio Management Software Agreements and Other Vendor Agreements

    Hedge fund managers require various third party vendor-provided products and services to manage their daily operations.  Typical agreements entered into by hedge fund managers for such products and services include trading system agreements, license agreements for investment analysis tools, risk management and portfolio valuation software, market data license agreements, software development agreements, hardware purchase agreements, website design agreements, consulting agreements and administration agreements.  All vendor agreements cover a common set of issues, including vendor performance obligations, indemnification and limitations on liability.  In addition to these common issues, vendor agreements entered into by hedge fund managers contain a few distinctive issues arising from the unique structure and the private nature of hedge fund groups.  In a guest article, Robert R. Kiesel, a Partner at Schulte Roth & Zabel LLP and chair of the firm’s Intellectual Property, Sourcing & Technology Group, and David L. Cummings, an Associate in Schulte’s Intellectual Property, Sourcing & Technology Group, discuss: selection of vendors and vendor breach; hedge fund structuring as it relates to vendor agreements; party selection; IT agreement standard scope restrictions; liability for trades; use of output and results; issues related to hedge fund secrecy; confidentiality; in-house systems versus third-party systems; privacy; arbitration; and publicity.

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  • From Vol. 4 No.25 (Jul. 27, 2011)

    Fourteen Due Diligence Lessons to Be Derived from the SEC’s Recent Action against a Serial Practitioner of Hedge Fund Fraud

    On July 13, 2011, the SEC issued an Order making findings and imposing remedial sanctions against an individual hedge fund manager.  The Order describes a career involving modest and infrequent investment successes, and predominantly characterized by repeated, serial and egregious frauds.  The diversity and audacity of the frauds make for lurid reading, but the relevance of the Order for The Hedge Fund Law Report and our subscribers resides in the due diligence lessons to be derived from the factual findings.  This article details the factual findings in the Order, then extracts 14 distinct due diligence lessons from those facts.  Many of our institutional investor subscribers will read the factual findings and say, “This could never happen to me.”  And they may be right.  But we never cease to be amazed by the level of sophistication of investors caught up in even the most crude and simple frauds.  Perhaps this is because our industry is based on trust, and despite the salience of fraud, fraud remains (fortunately) the exception to the wider rule of ethical conduct.  Perhaps it is because frauds that look simple in retrospect were difficult to discover in the moment.  Regardless of the reason, hedge fund investors of all stripes and sizes can benefit from ongoing refinement of their due diligence practices.  And we continue to believe that the best way to refine due diligence practices is to look at what went wrong in actual cases and to revise your list of questions and techniques accordingly.  Here is a useful test for hedge fund investors: read the facts of this matter, as described in this article, then pause to ask yourself: Would our current due diligence practices have discovered all of these facts and caused us to pass on this investment or to redeem?  If the answer is yes, you can stop reading.  But if the answer is no – that is, if your due diligence practices may have missed any aspect of this fraud – we strongly encourage you to read and incorporate our fourteen lessons.  We would also note that we have undertaken similar exercises with respect to prior SEC actions.  That is, we have reviewed allegations of hedge fund manager fraud and detailed the due diligence steps that may have uncovered such frauds.  All of our thinking on this topic is available in the “Due Diligence” section of our Archive.

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  • From Vol. 4 No.21 (Jun. 23, 2011)

    Questions Hedge Fund Managers Need to Consider Prior to Making Investments in Chinese Companies

    The negative publicity surrounding Chinese companies listed in the United States seemingly has reached a fevered pitch.  In April 2011, the Securities and Exchange Commission, or SEC, acknowledged that it had established a task force to address what it deemed to be abuses by Chinese companies accessing the U.S. markets through the use of reverse merger transactions.  SEC Commissioner Luis Aguilar referred to the proliferation of these companies as a “disturbing trend that seems to have challenging implications for capital formation and investor protection.”  In addition to the SEC, the U.S. national stock exchanges have been taking more aggressive actions against Chinese companies.  During 2011, almost two dozen Chinese companies have seen trading in their securities halted or have been delisted in large part due to accounting irregularities.  Against this backdrop, it has become increasingly difficult for investors in this space to separate the undervalued from the fraudulent.  In a guest article, Cavas S. Pavri, a Member in the Business Law Department of Cozen O’Connor, discusses areas that hedge fund managers should focus on in performing their due diligence on investments in Chinese companies.  Specifically, Pavri discusses, among other things: relevant PCAOB guidance; specific factors to consider in evaluating a Chinese company’s accounting firm; specific factors to consider in assessing a Chinese company’s chief financial officer and accounting staff; what to look for when evaluating the corporate governance of a Chinese company; considerations in connection with “variable interest entity” structures; local financial reporting; SAFE registration; the importance of a prior underwritten offering; and insurance considerations.

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  • From Vol. 4 No.2 (Jan. 14, 2011)

    The Investment Funds Amendment Act 2010: Key Changes for Hedge Funds Established in Bermuda, and Their Managers

    The Bermuda Investment Funds Amendment Act 2010 (Amendment Act), which received the assent of the Governor General on December 22, 2010, amends the Investment Funds Act 2006 (Act) in making new provisions for the regulation of investment funds in Bermuda.  In a guest article, Neil Henderson, an Associate in the corporate department in the Bermuda office of Conyers Dill & Pearman, describes the changes introduced by the Amendment Act which have particular relevance for hedge funds established in Bermuda, and their managers.

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  • From Vol. 3 No.47 (Dec. 3, 2010)

    U.S. District Court Holds That Hedge Fund Investors Do Not Have Standing to Bring a Direct, As Opposed to Derivative, Claim against Hedge Fund Auditor PricewaterhouseCoopers LLP

    The U.S. District Court for the Southern District of New York has granted hedge fund auditor PricewaterhouseCoopers LLP (PWC) summary judgment, dismissing the direct fraud claims brought by certain investors in hedge fund Lipper Convertibles, L.P. (Fund).  Following the Fund’s collapse in 2002, Andrew E. Lewin and other Fund investors commenced an action against PWC, the Fund, the Fund’s general partner and certain Fund affiliates and principals, alleging a variety of direct and derivative claims.  At the time of the subject decision, the only surviving claims were the investors’ direct claims against PWC for fraud in the inducement under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 under that Act, common law fraud and negligent misrepresentation.  The investors alleged that they were induced to invest in the Fund by PWC’s false and misleading auditor’s opinions that the Fund’s operations had been audited in accordance with generally accepted auditing standards and that its financial statements were prepared in accordance with generally accepted accounting principles.  The Court granted PWC’s motion for summary judgment, deciding that the investors’ claims were derivative in nature and could not be maintained in a direct action against PWC.  The investors offered no proof that they received less than they bargained for at the time of their respective investments in the Fund.  We summarize the key legal and factual provisions of the Court’s decision.

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  • From Vol. 3 No.29 (Jul. 23, 2010)

    Can Hedge Fund Managers Use Whistleblower Hotlines to Help Create and Demonstrate a Culture of Compliance?

    The January 2009 Report of the Asset Managers’ Committee to the President’s Working Group on Financial Markets remains one of the most eloquent and credible statements of best practices in the hedge fund industry.  That Report emphasized the importance of a culture of compliance to the success of any hedge fund management business.  It stated: “Critical to the success of [a hedge fund manager’s] compliance and business practices framework is a culture of compliance, grounded in the commitment and active involvement of the most senior leaders of the firm and fostered throughout the organization.  Particularly important to creating a culture of compliance are the following: (a) [e]ncouragement by senior management to personnel to raise any concerns or questions (facilitated by an environment that is free from fear of retribution); (b) [a]bility to communicate concerns to senior management; [and (c) s]enior management should consult regularly and encourage employees to consult regularly with the Chief Compliance Officer and his or her delegates whenever issues arise that could raise compliance issues.”  See “President’s Working Group Releases Final Best Practices Reports for Hedge Fund Managers and Investors,” The Hedge Fund Law Report, Vol. 2, No. 5 (Feb. 4, 2009).  With growing frequency, hedge fund managers are implementing whistleblower hotlines to help create and demonstrate a culture of compliance.  Whistleblower hotlines are telephone numbers (and similar communication channels) that an employee or even a principal of a hedge fund manager or service provider can call to anonymously report violations of law or internal policy by another employee or principal of the hedge fund manager.  Such hotlines can help effectuate the goals identified by the Asset Managers’ Committee: encouraging voicing of concerns; minimizing fear of retribution; facilitating communication with senior management; and encouraging consultation with the CCO and his or her delegates.  While public companies are required under the Sarbanes-Oxley Act of 2002 to have whistleblower hotlines, hedge fund managers are not legally required to have such hotlines and they traditionally have not.  Nonetheless, a growing number of managers are looking to such hotlines as part of a coordinated response to a heightened enforcement environment.  See, e.g., “The SEC’s New Focus on Insider Trading by Hedge Funds,” The Hedge Fund Law Report, Vol. 3, No. 22 (Jun. 3, 2010); “Regulatory Compliance Association Hosts Program on Increased Risk for Hedge Fund Directors and Officers in the New Era of Heightened Regulation and Enforcement,” The Hedge Fund Law Report, Vol. 2, No. 50 (Dec. 17, 2009).  To assist hedge fund managers in evaluating the appropriateness of a whistleblower hotline to their businesses, this article details: the general goals and purposes of whistleblower hotlines; how such hotlines work in the public company context; the use by private equity fund advisers of such hotlines at their portfolio companies; the mechanics of whistleblower hotlines in the hedge fund context (including who reports, to whom, what is reported, and what actions should be taken in response to reports); advantages and disadvantages to hedge fund managers of implementing hotlines; attorney-client privilege issues as applied to hedge fund managers generally; and attorney-client privilege issues raised by hedge fund manager whistleblower hotlines specifically.  Also, this article includes a discussion of the potentially perverse incentives created by Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  A fuller discussion is below, but in brief, that section creates a system of financial incentives and protections for whistleblowers who disclose “original information” about securities or commodities law violations that leads to successful SEC or CFTC enforcement actions.  Therefore, Section 922 may give employees of hedge fund managers (and others) a financial incentive not to report misconduct through a hotline established by the manager so as to preserve the originality of the information and the potential for a financial bounty if that information is reported to and used by an agency in a successful enforcement action.

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  • From Vol. 3 No.28 (Jul. 15, 2010)

    New York Court of Appeals Affirms Summary Dismissal of Fraud Action by Investors in Lipper Convertibles Hedge Fund Against Its Accountant PricewaterhouseCoopers

    On June 29, 2010, the New York Court of Appeals affirmed a trial court decision to enter summary judgment on behalf of accounting firm PricewaterhouseCoopers, LLC (PwC) in ongoing litigation over its part in a fraud committed by its client, hedge fund Lipper Convertibles, LP (the fund).  The fund had intentionally overstated its assets using improper methods for valuing securities.  PwC, tasked with auditing these financial statements, fraudulently attested to their accuracy and their conformity with generally accepted accounting principles (GAAP).  Those disclosures, in turn, induced the Plaintiffs to invest in the fund, which resulted in extensive litigation once the fraud was discovered and the investors lost millions.  The Court of Appeals terminated the fraud aspect of the litigation against PwC by the investors because an overlapping, independent action against PwC, litigated by the fund’s Trustee in bankruptcy for the benefit of all investors, provided them with a direct remedy for the damages they claimed to have suffered.  We summarize the background of the action and the Court’s legal analysis.

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  • From Vol. 3 No.27 (Jul. 8, 2010)

    Legal, Operational and Risk Considerations for Institutional Investors When Performing Due Diligence on Hedge Fund Service Providers

    The old paradigm of hedge fund due diligence focused on the hedge fund manager and the new paradigm focuses on hedge fund service providers.  That is, the purpose of hedge fund due diligence used to be (broadly, pre-2008) to ensure that the hedge fund manager itself had, internally, sufficient people, process and plant to maintain its return and risk profile.  However, the credit crisis that began in 2008, and the frauds it brought to the fore, highlighted the franchise risk posed by service providers to hedge funds and managers.  Consequently, post-crisis hedge fund due diligence has focused more squarely and thoroughly on service providers.  For example, in a June 2010 study, hedge fund operational due diligence consulting firm Corgentum Consulting analyzed data from over 200 hedge fund allocators and concluded that hedge fund “investors are focusing the bulk of their due diligence efforts on legal, compliance and regulatory risks.”  The primary reason for this shift in focus – from managers and performance (then), to service providers and operations (now) – relates to the estimated harm from adverse outcomes.  In relative terms, most investment losses are high probability, low magnitude events, while most operational failures are low probability, high magnitude events.  The chief goal of due diligence is to avoid low probability, high magnitude events; and, moreover, the credit crisis taught that the probability of some operational failures may not be so low after all.  Lehman Brothers provides the most sobering example.  Hedge funds that used Lehman’s U.S. or U.K. brokerage entities as their only prime brokers and that did not perform adequate due diligence on Lehman’s custody and cash management arrangements – or that did perform such diligence but did not incorporate its lessons – wound up with significant investor assets tied up for long periods in bankruptcy, SIPA or administration proceedings.  The purpose of service provider diligence is to identify operational issues that can have a material adverse effect on investment outcomes – issues such as the commingling of hedge fund customer assets by certain Lehman brokerage entities.  With the twin goals of providing guidance to investors conducting due diligence on hedge fund service providers, and to hedge fund managers and service providers anticipating such diligence, this article: identifies key hedge fund service providers; details ten specific areas on which investors should focus when conducting service provider diligence; highlights areas of diligence specific to certain service providers; discusses strategies for accessing the data necessary to perform adequate due diligence; and incorporates recommendations regarding the timing and frequency of service provider due diligence.

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  • From Vol. 3 No.24 (Jun. 18, 2010)

    How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part Three of Three)

    This is the third of three articles in a series intended to acquaint – or reacquaint – hedge fund managers, investors, service providers and others with the basic principles and prohibitions of, and exemptions from, the Employee Retirement Income Security Act of 1974 (ERISA).  The first article in this series explained how hedge fund managers can become – or avoid becoming – subject to ERISA.  That article focused primarily on the “25 percent test,” which generally provides that if benefit plan investors (e.g., corporate pension funds) own less than 25 percent of any class of equity interests issued by a hedge fund, the hedge fund manager will not be subject to ERISA.  See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part One of Three),” The Hedge Fund Law Report, Vol. 3, No. 19 (May 14, 2010).  The second article in the series detailed the consequences to a hedge fund manager of becoming subject to ERISA, which can happen, for example, if a large non-ERISA investor redeems, causing the proportionate ownership of benefit plan investors to exceed 25 percent of a class of equity interests.  Those consequences most notably include the imposition of a heightened fiduciary duty and a prohibition on many transactions between the hedge fund and “parties in interest” to a benefit plan invested in the hedge fund.  See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part Two of Three),” The Hedge Fund Law Report, Vol. 3, No. 20 (May 21, 2010).  As that second article noted, ERISA’s list of prohibited transactions is so long, and ERISA’s definition of “party in interest” (and the parallel definition of “disqualified person” under the Internal Revenue Code) so expansive, that strict compliance by investment managers with ERISA’s prohibited transaction provisions would undermine the basic purpose of ERISA; broadly, that purpose is to ensure the ethical, unconflicted and competent management of retiree money.  Accordingly, Congress (by statute) and the Department of Labor (by regulation and other action) have created a series of exemptions from the prohibited transaction provisions.  These exemptions enable a hedge fund to accept investments from benefit plan investors above the 25 percent threshold and to engage in many transactions that otherwise would be prohibited by ERISA.  That is, many hedge fund managers heretofore have taken the view that a fund can have significant ERISA money or a manager can have unfettered investment discretion, but not both.  But the prohibited transaction exemptions, properly understood and implemented, come close to reconciling that dichotomy.  To assist hedge fund managers in obtaining ERISA assets while retaining investment discretion, this article provides a comprehensive roadmap to the prohibited transaction exemptions most relevant to hedge fund managers.  Specifically, this article discusses: ERISA’s definition of “party in interest”; prohibited transactions under ERISA by category; typical hedge fund transactions that would (absent statutory and regulatory relief) be prohibited by ERISA; the conditions required to be satisfied for a hedge fund manager to qualify as a qualified professional asset manager (QPAM); the impact of the financial regulation overhaul bills on hedge fund managers’ eligibility for the QPAM exemption; the conditions required to be satisfied for a transaction to be eligible for the QPAM exemption; the impact of ERISA’s anti-self-dealing provisions on the timing of disposition of investments in private equity funds and hybrid funds; the service provider exemption; the eleven conditions that must be satisfied for performance compensation to comply with ERISA; the cross trading exemption; the foreign exchange transaction exemption; the electronic communication networks exemption; the block trading exemption; individual exemptions, including a discussion of a recent individual exemption granted to Ivy Asset Management Corporation in connection with a proposed sale of shares of offshore hedge funds owned by a hedge fund of funds; and a provocative provision included in the Restoring American Financial Stability Act of 2010, passed by the U.S. Senate on May 20, 2010, that threatens to undermine the ability of certain hedge funds to enter into swaps with prime brokers.

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  • From Vol. 3 No.19 (May 14, 2010)

    Second Circuit Upholds Dismissal of Suit by Investment Manager PIMCO Against Refco’s Attorneys, Holding that for Attorneys to be Liable for Securities Fraud as “Secondary Actors” Under Rule 10b-5, the Allegedly False Statements Must Actually Be Attributable to the Attorneys at the Time the Statements Are Made

    The United States Court of Appeals for the Second Circuit has enunciated a “bright line” standard for imposing liability on so-called “secondary actors” under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.  Lead plaintiffs Pacific Investment Management Company LLC and RH Capital Associates LLC (the Funds) lost money in the 2005 collapse of brokerage Refco Inc. (Refco).  The Funds alleged that Refco engaged in a series of sham loan transactions in an effort to conceal a substantial amount of uncollectible debt.  The Funds sued Refco, along with certain of its affiliates, underwriters and outside counsel, including law firm Mayer Brown LLC (Mayer Brown) and former firm partner Joseph P. Collins (Collins), alleging securities fraud.  Mayer Brown and Collins were involved in negotiating and drafting the documents for many of the sham loan transactions.  They also prepared a private placement memorandum and registration statements for three Refco securities offerings.  Significantly, however, none of the allegedly false statements made in the memorandum or either of the registration statements was specifically attributed to either Mayer Brown or Collins.  Those defendants moved to dismiss the Funds’ claims against them for failure to state a cause of action.  The District Court and the Second Circuit agreed, holding that the mere act of helping to prepare the allegedly false statements did not give rise to liability under Rule 10b-5.  In order for liability to attach, the alleged false statements must be clearly attributed to the secondary actors.  In addition, the court held that, because the Funds admittedly had no idea that Mayer Brown and Collins were involved in negotiating and documenting the sham transactions, they could not have relied on any actions by those two defendants.  Consequently, the Funds’ claim of “scheme liability” also failed.  This article discusses the factual background, including a review of the mechanics of the Refco fraud, and the Second Circuit's legal analysis.

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  • From Vol. 3 No.17 (Apr. 30, 2010)

    Hedge Fund Operations and Technology Conference Focuses on SEC Reviews, Outsourcing of Operations, Operational Due Diligence, Multiple Prime Broker Relationships and More

    On April 21, 2010, Financial Technologies Forum LLC hosted its Third Annual Hedge Fund Operations & Technology conference in New York City.  The backdrop for the conference was a hedge fund industry coming out of two years of turmoil and refocused on hedge fund organizational structures, risk profiles, counterparties, trade processes, compliance policies, valuation approaches, information technology infrastructure and manager backgrounds.  The underlying question that the conference sought to address was how hedge fund operations and technology are evolving in light of the lessons learned during the crisis.  This article focuses on the more noteworthy points discussed during the conference, including potential new regulation and registration requirements; compliance policies and strategies (including use of a compliance calendar); anticipated increases in the frequency and depth of SEC reviews of hedge funds (including specific areas on which the SEC is expected to focus); demands from investors for increased transparency; outsourcing of operational functions (including appropriate service levels and due diligence to be performed on service providers); the specific components of operational due diligence, especially as it relates to service providers; and the rationale for and management of multiple prime brokerage relationships.

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  • From Vol. 3 No.7 (Feb. 17, 2010)

    Key Elements of a Hedge Fund Adviser Business Continuity Plan

    The credit crisis changed the nature of institutional investor due diligence of hedge fund managers.  While performance remains a critical diligence point, aspects of the hedge fund advisory business other than performance now play a more prominent role in the investment decision-making process of institutional investors.  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).  The idea is that even hedge fund managers with years of competitive fund performance and deep benches of investment talent can be laid low by inadequate risk management, compliance and controls.  Galleon is the paradigmatic example.  See “Best Practices for a Hedge Fund Manager General Counsel or Chief Compliance Officer that Suspects or Discovers Insider Trading by Manager Employees or Principals,” The Hedge Fund Law Report, Vol. 2, No. 48 (Dec. 3, 2009).  One element of hedge fund adviser infrastructure that has received significant attention of late from institutional investors (as well as regulators) is the business continuity plan (BCP).  Broadly, as the name implies, a BCP is a written plan (often included in the compliance manual) in which a hedge fund manager identifies the range of events and risks that can interrupt business operations and investment activities, and details the steps that the manager will take if those events or risks come to fruition.  Events that may trigger the procedures in a BCP can be natural (e.g., hurricanes, earthquakes, pandemics), man-made (e.g., terrorism, theft, other crimes) or technological (e.g., power outages, disruption of exchanges, computer viruses).  And the procedures used to address those risks must be tailored to the manager’s strategy, technology, network of service providers and geographic location.  Moreover, the BCP has to be a living document – something that is tested, communicated to employees and other constituents, and updated as relevant.  It cannot be boilerplate: at this point, institutional investors have seen a healthy number of BCPs, and they will know when they see a BCP that reflects inadequate customization – and that can make the difference between investment and non-investment.  This article offers a comprehensive analysis of BCPs in the hedge fund context, as well as reporting from a recent webinar on the topic hosted by hedge fund technology firm Eze Castle Integration and prime broker Pershing Prime Services.  In particular, this article: defines a BCP more particularly; enumerates key elements of a hedge fund manager BCP (including, among others, development of an impact analysis, communications plans, backup facilities, coordination with third-party service providers and succession planning); and discusses: the impact of a hedge fund’s strategy on its manager’s BCP; regulatory requirements, including what the SEC looks for with respect to BPCs in the course of inspections and examinations; institutional investor expectations; disclosure considerations; communicating a BCP to hedge fund manager employees; and the frequency with which a BCP should be reviewed and updated.  This article is the first in a two-part series.  The second article in the series will deal with disaster recovery plans, which are close cousins of BCPs and are outlined in this article.

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  • From Vol. 2 No.52 (Dec. 30, 2009)

    Affiliates of Hedge Fund Manager Fortress Investment Group Sue Dechert Over Opinion Letter Endorsing Marc Dreier

    On December 21, 2009, Fortress Credit Corp. and FCOF UL Investments LLC (together, Fortress) sued law firm Dechert LLP in New York state court for malpractice.  Fortress accused Dechert of issuing a false opinion letter on behalf of Marc S. Dreier, without conducting any due diligence.  Fortress claims that as a result of the opinion letter, it entered into a purported $50 million loan agreement with Solow Realty & Development Company (Solow Realty) which, in reality, was a sham arranged by Dreier to misappropriate funds from Fortress for his personal use.  (Briefly, by way of background, on May 11, 2009, Dreier pleaded guilty to a complex scheme in which, among other things, he sold fraudulent notes to investors, including various hedge funds, who collectively lost at least $400 million.  On July 13, 2009, Dreier was sentenced to 20 years in prison.  See Bryan Burrough, “Marc Dreier’s Crime of Destiny,” Vanity Fair, Nov. 2009.)  We detail the allegations in the Fortress complaint – which have yet to be proven – and the relief requested by Fortress.  The parties and allegations in the Fortress complaint – the financing unit of a hedge fund manager suing a law firm in connection with a lending transaction – recall another complaint covered in last week’s issue of The Hedge Fund Law Report.  See “Cerberus Financing Unit Sues its Former Law Firm and Two of Its Partners for $55 Million for Allegedly Giving Bad Advice,” The Hedge Fund Law Report, Vol. 2, No. 51 (Dec. 23, 2009).  The complaint also parallels other efforts by hedge fund managers (and in some cases hedge fund investors) – many of which have been unsuccessful – to seek redress from service providers for losses incurred during the credit crisis.  See “Appellate Division Upholds Dismissal of Complaint by Hedge Funds Holding More than $190 Million of Defaulted Loans Against Credit Suisse, as Arranger of Financing and Administrative and Collateral Agent, for Aiding and Abetting Fraud and Breach of Fiduciary Duty,” The Hedge Fund Law Report, Vol. 2, No. 31 (Aug. 5, 2009); “New York Court Rules that Limited Partners of Collapsed Hedge Fund Cannot Sue Fund’s Outside Legal Counsel for Fraud and Breach of Fiduciary Duty,” The Hedge Fund Law Report, Vol. 2, No. 24 (Jun. 17, 2009); “New York Supreme Court Dismisses Hedge Fund Investors’ Claims Against Prime Broker,” The Hedge Fund Law Report, Vol. 1, No. 18 (Aug. 11, 2008); “Hedge Fund Service Professionals Do Not Owe Fiduciary Duty to Investors But May be Subject to Liability for Aider and Abettor Claims if Provided by State Statute,” The Hedge Fund Law Report, Vol. 1, No. 6 (Apr. 7, 2009); “Madoff Feeder Funds Sue Casualty Insurers for Breach of Contract and Seek to Recoup Costs of Defending Against Liability Suits,” The Hedge Fund Law Report, Vol. 2, No. 33 (Aug. 19, 2009); “New York Supreme Court orders separate trial on existence of attorney-client relationship between former hedge fund principal and outside lawyer and firm,” The Hedge Fund Law Report, Vol. 1, No. 1 (Mar. 3, 2008).

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  • From Vol. 2 No.51 (Dec. 23, 2009)

    Cerberus Financing Unit Sues Its Former Law Firm and Two of Its Partners for $55 Million for Allegedly Giving Bad Advice

    On December 11, 2009, the financing unit of private equity and hedge fund manager Cerberus Capital Management, L.P., Ableco Finance LLC (Ableco), filed an amended complaint in New York State Supreme Court against Paul, Hastings, Janofsky & Walker LLP (Paul Hastings), claiming the law firm gave it bad advice in connection with a $125 million loan Ableco made last year to Bay Harbour Management (Bay Harbour), a company looking to bring retailer Steve & Barry’s out of bankruptcy.  Ableco alleges that Paul Hastings failed to inform Ableco about an earlier agreement between Steve & Barry’s and Bay Harbour that prevented Ableco from taking over all of Steve & Barry’s inventory.  Ableco claims it would not have made the loan if Paul Hastings had advised it that the buyer, Bay Harbour, would not have rights to all of Steve & Barry’s inventory, which Ableco had understood would back the loan.  This article details the factual and legal allegations in the complaint.

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  • From Vol. 2 No.49 (Dec. 10, 2009)

    Stars in Transition: A New Generation of Private Fund Managers

    The economic events of 2008 and 2009 resulted in significant displacement of star talent from market-leading investment banks and similar financial institutions, some of which have ceased to exist.  Some of those stars have moved on to their own ventures, and are launching their own investment management firms to raise hedge or private equity funds.  For most of their careers, some of these individuals, or entire teams of talent, may have thrived in larger institutional environments; however, now many are facing new challenges with practical issues they never had to address, or be bothered with, in the past.  Basic questions can range from something as fundamental and potentially complicated as “do I need to register with the SEC and what rules apply to me?” to something much more basic like “are the terms of this office lease a good deal for me?”  Any manager starting a hedge fund or private equity fund advisory business, whether an experienced veteran or first-timer, will need to think about many issues that could be broadly grouped within the following five categories: (1) seed investors/compensation arrangements; (2) registration requirements for the investment manager and its funds; (3) other regulatory issues impacting private funds; (4) the fund’s offering and operating documents; and (5) the investment manager’s business operations and service providers.  In a guest article, Ira P. Kustin, a Partner in the investment funds practice group at Akin Gump Strauss Hauer & Feld LLP, details the relevant considerations for start-up managers in each of these five categories.

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  • From Vol. 2 No.38 (Sep. 24, 2009)

    Boutique Prime Brokers are Emerging to Provide Services to Small and Mid-Size Hedge Funds Marginalized by Larger Prime Brokers

    The recent financial crisis witnessed a bifurcation in the prime brokerage business: big hedge fund clients got the same or better terms from big prime brokers, and smaller hedge fund clients got worse terms or got shut out altogether.  In large part, this was the result of frozen credit markets and pervasive risk aversion.  One of the key services provided by prime brokers to hedge funds is lending, see “In Frozen Credit Markets, Enhanced Prime Brokerage Arrangements Offer a Rare Source of Hedge Fund Leverage, But Not Without Legal Risk,” The Hedge Fund Law Report, Vol. 2, No. 8 (Feb. 26, 2009), and just as banks ceased making loans to all but their most creditworthy borrowers, so did big prime brokers cease making loans (or providing other services) to all but their most creditworthy hedge fund clients.  Creditworthiness in this context generally was assessed based on assets under management (AUM).  As a rough rule of thumb, from the perspective of the larger prime brokers, AUM of less than $500 million generally presented an unpalatable level of risk.  To compensate for that perceived risk, the big prime brokers charged higher or separate fees to funds below that threshold, and cut back on the range and level of services offered to smaller funds.  In some cases, the big prime brokers “fired” smaller hedge fund clients altogether.  A new crop of boutique prime brokers has arisen to fill the services void left by the retrenchment among the larger prime brokers.  While smaller hedge funds may be perceived as too risky or not sufficiently profitable for the larger prime brokers, smaller hedge funds are precisely the type of client that the new group of boutique prime brokers is structured to serve.  In other words, supply has arisen to meet the market demand.  This article details the services provided by prime brokers (large and small); the terms that are becoming “market” in agreements between hedge funds and boutique prime brokers; terms in prime brokerage agreements that warrant special attention from hedge funds and their counsel when such agreements are being negotiated; the arrangements between boutique prime brokers and larger prime brokers with respect to trade execution and clearing; custody of assets, and in particular, services whereby prime brokers will offer custody of assets with a trust partner or affiliate; the rationale for the rise of smaller prime brokers; and the likely future shape of the small prime brokerage industry.

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  • From Vol. 2 No.34 (Aug. 27, 2009)

    Interview with HedgePort Associates’ CEO Andrew Springer on the New Firm’s Operational and Marketing Services for Startup Hedge Fund Managers

    Although the hedge fund industry continues to recover from a year of unprecedented underperformance and record redemptions, and is still reeling from an economic recession, opportunities remain for startup hedge funds.  A new firm, HedgePort Associates, has been established to provide operational, regulatory and marketing services to hedge fund managers as they start and grow their businesses.  Andrew Springer is the founder and CEO of HedgePort Associates; he also founded hedge fund operations consulting firm Resolve Inc.  The Hedge Fund Law Report spoke with Springer about HedgePort and the services the firm provides.  The full transcript of that interview is included in this issue of The Hedge Fund Law Report, and covers topics including: the market for startup hedge funds; whether and how certain operational functions can be outsourced; where liability resides in the event of a compliance violation if compliance functions are outsourced; the difference between track records compiled at hedge funds and on proprietary trading desks; HedgePort’s compensation structure; wind-down services offered by HedgePort; the SEC’s new pay to play rules; structuring matters; and more.

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  • From Vol. 2 No.30 (Jul. 29, 2009)

    Second Circuit Holds that Recommendations by Hennessee Group that Clients Invest in Bayou Hedge Funds Did Not Violate Federal Securities Laws

    On July 14, 2009, the Second Circuit affirmed the dismissal of South Cherry Street, LLC’s complaint which alleged that hedge fund consultant Hennessee Group LLC (i) violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder and (ii) breached an oral contract to conduct suitable due diligence by recommending that its clients invest in the “Bayou” group of funds, which turned out to be part of a Ponzi scheme.  The Second Circuit determined that the alleged oral contract was unenforceable by reason of the New York statute of frauds because it could not be fully performed within one year.  It also determined that South Cherry failed to allege sufficient facts to show that defendants acted with the requisite intent to sustain a claim for securities fraud under Section 10(b) of the Exchange Act.  We summarize the court’s findings and reasoning and its potential impact on hedge fund investors and the consultants who assist them in selecting hedge fund investments.

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  • From Vol. 2 No.27 (Jul. 8, 2009)

    Hedge Fund Managers Retaining “Private Regulators” to Demonstrate a Credible Commitment to Compliance

    Trust is at the heart of the relationship between hedge fund managers and hedge fund investors.  While some investors have bargained for significant transparency, managers are almost always at an informational advantage vis-à-vis their investors with respect to their specific investment activities.  Those gaps in information are generally filled by two elements: law and trust.  Since law is an imperfect and often ex post remedy, trust remains the glue that holds the investment management relationship together.  But in the wake (or the midst) of a lengthy credit crisis, the Madoff scandal and a wave of redemption suspensions and gate impositions, trust is in short supply among hedge fund investors.  In practical terms, this translates into one of the toughest money-raising and money-retaining environments on record.  In response to these dynamics, the role of third-party service providers to hedge funds and managers has been evolving in ways that would have been difficult to foresee in early 2007.  Specifically, a growing number of hedge fund managers have been granting third-party administrators and other service providers unprecedented powers over their investments and operations.  For example, as discussed more fully in this article, the London-based manager of the recently-launched Gyldmark Liquid Macro Fund has empowered PCE Investors to block trades outside of the fund’s mandate and to liquidate the fund (consistent with its governing documents) if the fund is down more than ten percent in a given year.  Managers are granting such powers to service providers as a way of credibly demonstrating to current and potential investors an irrevocable commitment to compliance and best practices.  In such circumstances, the role of the service provider has evolved from solely providing services to the manager or fund to providing an objective check on the manager’s activities.  For this reason, service providers retained to provide such a role have come to be known as “private regulators.”  And in various cases they are providing a level of de facto regulation more draconian than anything proposed in Congress, by the Obama administration or by EU authorities.  We outline the services traditionally provided to hedge funds and hedge fund managers by third-party service providers; the shift to private regulation and the specific types of powers granted to private regulators; doubts expressed by some market participants about the practicability of private regulation; liability and indemnification concerns; and procedures regarding reporting of violations or suspected violations and “noisy withdrawals.”

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  • From Vol. 2 No.18 (May 7, 2009)

    Consequences of the Mortgage Loan Servicer Safe Harbor for Hedge Funds Invested in Securities Backed by Primary Mortgages

    One of the primary reasons why troubled loans do not receive meaningful modifications is that the loan servicers fear lawsuits from the investors who own securities backed by the loans.  As a result, the government effort so far to address the problem of troubled mortgages has focused on creating incentives to get loan servicers to begin workouts.  President Obama gained their favor in his housing rescue plan by promising up to $9 billion in TARP funds to cover the fees associated with modification and proposing as part of the comprehensive Housing Act a legal “safe harbor” from litigation that might arise in reworking a deal.  The bill is intended to give loan servicers, including big banks like Bank of America and Citi, breathing room to modify loans more easily without having to worry about investor lawsuits.  But recent reports, including one by the Amherst Security Group, found that many of the supposed loan modifications are simple repayment plans that actually increase the balance of the mortgage and result in bigger fees payable to the loan servicers.  Now, there is another major stumbling block as investors holding mortgage-backed securities realize just how big a threat a servicer safe harbor poses to them.  We provide a comprehensive discussion of the legislative background, the mechanics of the proposed servicer safe harbor, a discussion of the necessity of such a safe harbor and a summary of the Amherst Security Group report.

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  • From Vol. 2 No.8 (Feb. 26, 2009)

    Ogier Discusses Potential Causes and Courses of Action Available to Investors in Madoff “Feeder Funds” Organized in the British Virgin Islands

    On December 11, 2008, having admitted to masterminding what would appear to have been a $50 billion Ponzi scheme through his brokerage firm, Bernard L Madoff Investment Securities LLC (BMIS),  Bernard Madoff was arrested and charged with securities fraud.  On December 15, 2008, the Securities Investor Protection Corporation commenced liquidation proceedings against BMIS and a Bankruptcy Trustee was appointed over it.  Concerned that they are very unlikely to make any significant recoveries out of the liquidation of BMIS, investors in the Madoff “feeder funds” are now looking at possible ways of recovering their losses from the feeder funds and their third party service providers such as their administrators, custodians and investment managers.  In an exclusive contributed article, Robert Foote, Managing Associate and Barrister in the British Virgin Islands (BVI) office of leading offshore law firm Ogier, explores some of the causes and courses of action that might be open to such investors under BVI law.  The discussion has particular relevance for investors in Madoff feeder funds organized as BVI entities.

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  • From Vol. 1 No.28 (Dec. 16, 2008)

    Federal Court Bars Investors’ Claims Against Hedge Fund Administrator

    Hedge fund investors sued hedge funds’ prime broker and custodian, their former administrator and their former auditor for fraud, alleging that that the defendants should have known that the funds’ manager was actively engaged in fraud, and that the defendants should have warned plaintiff investors.  We detail the precise allegations, the applicable legal standards, the outcome and the potential implications of the case for future investor suits against third party hedge fund service providers.

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  • From Vol. 1 No.24 (Nov. 12, 2008)

    Petters’ Fraud Underlines Need for Vigilant Due Diligence

    Several hedge funds have been caught in a large-scale fraud alleged against Tom Petters, former CEO of Petters Companies Inc.  Based on a review of court filings and interviews with managers and attorneys at or representing funds who declined investments in Petters Co., we offer specific suggestions on how hedge funds can approach pre- and post-investment due diligence to avoid getting caught in fraudulent situations.

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  • From Vol. 1 No.22 (Oct. 10, 2008)

    How Can Hedge Funds Structure Their Prime Brokerage Arrangements to Protect Themselves?

    With the recent upheaval in the credit markets generally and in the prime brokerage industry specifically, it has become increasingly important for hedge funds to structure their prime brokerage arrangements to include protections against a potential liquidation of the prime broker or bankruptcy of the prime broker’s holding company.  Key considerations include: the use of multiple prime brokers, collateral policies, rehypothecation rights, margin requirements, margin lock-ups and margin lock-up termination events.  As evidenced by recent prime broker failures or near-failures, the structure of prime brokerage arrangements can have a profound impact on a fund’s access to its own cash and securities at precisely the time when it needs them most.

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  • From Vol. 1 No.16 (Jul. 22, 2008)

    New York Supreme Court Grants Summary Judgment to Auditor on Fund Liquidators’ Claim that Auditor Negligently Failed to Detect and Report Fraudulent Valuations by Fund Managers

    On June 19, 2008, the New York State Supreme Court in Manhattan granted summary judgment to the auditor of a failed Cayman Islands hedge fund on claims of negligence brought by the fund’s joint official liquidators. In the factual circumstances of the case, the court determined that the auditor’s failure to detect fraudulent valuations of portfolio securities by the fund’s managers, and the auditor’s resulting failure to alert the fund’s directors to the fraudulent valuations, did not constitute negligence. The case illustrates the standard of care to which US-based courts will hold auditors of Cayman Islands funds, and sheds light on the limits of the duties owed by auditors to fund investors and directors.

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  • From Vol. 1 No.10 (May 6, 2008)

    New York Court Allows Suit to Progress Against Hedge Fund Manager for Allegedly Terminating its Contract in Bad Faith to Avoid Paying Finder’s Fees

    • Hedge fund manager entered into a finder’s agreement that provided for payment to the finder of a finder’s fee and, for larger investments, a “structuring payment,” so long as the investor invested within a year of the finder’s last contacts with the investor.
    • A Norwegian bank made a substantial investment in an Ellington fund more than a year after the finder’s last contact with the bank, and the court held that the finder was not entitled to its fee, but might (pending more fact finding) be entitled to its structuring payment.
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  • From Vol. 1 No.6 (Apr. 7, 2008)

    Hedge Fund Service Professionals Do Not Owe Fiduciary Duty to Investors But May be Subject to Liability for Aider and Abettor Claims if Provided by State Statute

    • State appeals court dismissed hedge fund investors’ $200 million lawsuit against fund’s outside counsel for lack of any fiduciary duty owed to investors.
    • State appeals court ruled that preparation of offering memo not a representation, fraudulent or otherwise, to investors.
    • Oregon investor who invested and lost $2.75 million in the fund and filed a separate federal fraud case survived outside counsel’s motion to dismiss because Oregon law grants private right of action against aiders and abettors.
    • Federal case particularly significant because aider and abettor claims against lawyers or accountants in securities fraud cases generally barred under federal law, under recent Stoneridge Supreme Court case.
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  • From Vol. 1 No.1 (Mar. 3, 2008)

    New York Supreme Court Orders Separate Trial on Existence of Attorney-Client Relationship between Former Hedge Fund Principal and Outside Lawyer and Firm

    • Helie, former principal of hedge fund adviser Gramercy, sued Gramercy’s outside law firm alleging malpractice resulting in Helie’s receipt of less than the market value of his interest in Gramercy upon termination.
    • Defendant law firm subpoenaed documents containing financial information from Gramercy.
    • Question was whether enforcement of the subpoena would result in improper revelation of client confidences or secrets.
    • Court held that client financial information sought by subpoena constitutes client confidences or secrets.
    • Court noted that “right to part of the curtain of confidentiality must be sparingly applied.”
    • Instead of deciding whether to enforce subpoena, court ordered separate trial on whether an attorney-client relationship existed between Helie and outside firm, which was a necessary element of Helie’s malpractice claim.
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