Jun. 29, 2017

Practical Considerations for Hedge Fund Managers Establishing Deferred Compensation Plans: Vesting Schedules, Deferral Amounts and Compliance With Section 409A (Part Two of Two)

When designing programs and incentives to attract and retain critical employees, deferred compensation plans warrant thoughtful consideration by hedge fund managers. Individuals who plan to remain with a firm for the long term often welcome these plans as a way to invest a portion of their income on a pre-tax basis and allow it to grow on a tax-deferred basis. Conversely, junior employees or those more fluid in their careers may prefer to receive cash compensation at the time it is earned. This two-part series provides an overview of deferred compensation plans in the hedge fund industry and key factors managers should consider when developing these plans. This second article examines how commonly these plans are adopted; discusses technical aspects of these plans, such as vesting schedules and forfeiture events; identifies categories of employees who are likely to participate in these plans; and reviews Section 409A of the Internal Revenue Code as it relates to these plans. The first article explored the intended goals of these programs and tax consequences associated with pre- and post-tax deferral plans. For discussion of other methods used by hedge fund managers to incentivize employees, see “Use by Hedge Fund Managers of Profits Interests and Other Equity Stakes for Incentive Compensation” (Apr. 18, 2014); “How Can Hedge Fund Managers Use Profits Interests, Capital Interests, Options and Phantom Income to Incentivize Top Portfolio Management and Other Talent?” (Aug. 22, 2013); and “Key Considerations for Hedge Fund Managers in Developing a Succession Plan (Part Two of Two)” (Feb. 23, 2012).

Steps Hedge Fund Managers May Take Today to Avoid Being Deemed a Fiduciary Under the DOL’s New Fiduciary Rule

In February 2017, many investment advisers were relieved when President Trump ordered the Department of Labor to evaluate the likely impact of the revised fiduciary rule that, in its current form, expands the range of persons considered “fiduciaries” under the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code. The initial set of requirements under the fiduciary rule became applicable on June 9, 2017; therefore, hedge fund managers may need to take steps to ensure they are not deemed fiduciaries under the rule in connection with their marketing activities. In a guest article, K&L Gates partner Robert L. Sichel provides an overview of the fiduciary rule, identifies the types of activities that may trigger fiduciary status thereunder, addresses common misconceptions under the rule and provides a roadmap for how a manager can avoid becoming a fiduciary under the rule in connection with its marketing activity. For a discussion of the evaluation of the fiduciary rule ordered by President Trump, see “Despite the DOL Fiduciary Rule’s Uncertain Future Under the Trump Administration, Managers Should Continue Preparing for Its April 2017 Implementation (Part Two of Two)” (Feb. 23, 2017).

Investor Pressure Drives New Performance Compensation Models and Increased Disclosure Obligations for Managers

As investors grow increasingly aggressive and savvy about striking a reasonable balance between fund managers’ and their own objectives, new terms and provisions are finding their way into fund documents. Old models are increasingly unsustainable as new types of funds change the face of the market and as investors demand not only new fee and compensation arrangements but a slew of disclosures for almost every conceivable event that could significantly affect a fund’s operations and performance. These disclosures include redemptions by fund principals; changes of control or ownership; violations of securities laws; breaches of fiduciary duties; and changes in investment strategies or objectives. Investors and managers must have a nuanced grasp of the radically changing expectations to successfully manage relations with one another, avoid regulatory trouble and realize a fund’s investment objectives. These points came across in a panel discussion at the tenth annual Advanced Topics in Hedge Fund Practices Conference: Manager and Investor Perspectives recently hosted by Morgan Lewis. The panelists were Morgan Lewis partners Richard A. Goldman, Christopher J. Dlutowski and Jedd H. Wider. This article presents the key takeaways from the panel discussion. For additional insights from Goldman, Wider and Dlutowski, see “How Can Private Fund Managers Grant Preferential Rights? Delaware Chancery Court Decision Stresses Need for Fund Document Integration” (Jun. 30, 2016). For coverage of former SEC Chair Christopher Cox’s keynote talk at the conference, see “Hedge Funds’ Image Crisis: Fighting Public Perceptions Against the Backdrop of Potential Financial Sector Reforms” (Jun. 22, 2017).

Navigating the Intersection of ERISA Fiduciary Duties and Cybersecurity Data Breach Protections

A hedge fund manager may become subject to the provisions of the Employee Retirement Income Security Act of 1974 (ERISA) if it manages a “plan assets fund” or provides advice to retirement account clients. See our four-part series “A ‘Clear’ Guide to Swaps and to Avoiding Collateral Damage in the World of ERISA and Employee Benefit Plans”: Part One (Jul. 28, 2016); Part Two (Aug. 4, 2016); Part Three (Aug. 11, 2016); and Part Four (Aug. 25, 2016). A recent program presented by Poyner Spruill considered the relationship between cybersecurity and ERISA, looking at recent breaches and litigation involving ERISA plans; evaluating whether cybersecurity is a fiduciary duty under ERISA; analyzing whether ERISA preempts state cybersecurity and data-protection laws; and exploring how plan sponsors can implement effective cybersecurity measures. The panel featured Poyner Spruill partners Saad Gul and Michael E. Slipsky, along with associate Brenna A. Davenport. This article summarizes their key insights. See also our overview of ERISA issues for fund managers, “Happily Ever After? – Investment Funds That Live With ERISA, For Better and For Worse”: Part One (Sep. 4, 2014); Part Two (Sep. 11, 2014); Part Three (Sep. 18, 2014); Part Four (Sep. 25, 2014); and Part Five (Oct. 2, 2014).

Transparency Tops Investment Considerations in Northern Trust Survey

Northern Trust, in collaboration with The Economist Intelligence Unit, recently took the pulse of alternative investment managers and other institutional investors regarding transparency and other investment considerations. The study – as discussed in the white paper summarizing its results – found that transparency is a top investment consideration, the importance of which has increased following the 2008 financial crisis. Northern Trust also considered how respondents gather and manage data and oversee their transparency requirements. This article summarizes the key findings from the study. For additional insights from Northern Trust, see “Don Muller and Joshua Satten of Northern Trust Hedge Fund Services Discuss the Impact of OTC Derivatives Reforms on Hedge Fund Managers” (Feb. 7, 2013). For more on transparency from a fund manager’s perspective, see “How Are Your Peers Responding to the Most Intrusive Requests From Hedge Fund Investors?”: Part One (Mar. 17, 2016); and Part Two (Mar. 31, 2016).

Run-Risk Scenarios Idiosyncratic to the Asset Management Industry Require Enhanced Monitoring and Information-Sharing by Regulators

When assessing risks to financial stability, it is important to appreciate that the investment funds sector has its own unique risks relative to other markets, including fire sales of fund assets; investor herding; unintentionally synchronized actions by managers due to industry interconnectedness; and exacerbated trends resulting from automated trading strategies. Recognizing these dangers and protecting market stability require regulators to not only vigorously monitor the market, but also to acquire and share information on fund portfolios. These points came across in a recent speech delivered by Scott Bauguess, Acting Director and Chief Economist of the SEC’s Division of Economic and Risk Analysis. This article summarizes the key takeaways from Bauguess’ talk. For more on systemic risk, see “FSB Recommends Essential Risk Mitigation Requirements for Asset Managers” (Aug. 25, 2016); and “FSOC Report Focuses on Liquidity, Leverage and Other Risks Facing Hedge Fund and Asset Managers” (Apr. 28, 2016).

Joachim Kayser Joins Dechert in Frankfurt

Dechert has enhanced its Frankfurt office’s financial services and alternative investment practice with the addition of Joachim Kayser as a partner. He advises asset managers and institutional investors on the structuring and marketing of funds, along with a range of tax and regulatory issues. Kayser has particular expertise in Undertakings for Collective Investment in Transferable Securities and exchange-traded funds. For coverage of other recent hires at Dechert, see “Rob Bradshaw Joins Dechert in London” (Apr. 27, 2017); “Jeff Mackey Joins Dechert in Dublin” (Mar. 9, 2017); and “Michael Wong Joins Dechert in Hong Kong” (Feb. 16, 2017).

Clifford Chance Expands Its New York Private Equity Practice

Michael Sabin has joined Clifford Chance as a partner in its private equity and M&A corporate practice in New York. Sabin specializes in advising sponsors on the structuring and formation of private funds and accounts. For more from Clifford Chance, see “MiFID II Will Affect Market Structure, Registration and Soft Dollars for Hedge Funds Trading in Europe” (May 19, 2016); and “Hedge Fund Managers Trading Distressed Debt Must Understand LMA Standard Form Documentation” (Feb. 25, 2016).