Sep. 7, 2017

Decision by U.S. Court of Appeals Sets Precedent for Emboldened Stance Toward Spoofing

On August 7, 2017, the U.S. Court of Appeals for the Seventh Circuit (Court) issued a ruling in a long-running case of a high-frequency trader charged with violating the anti-spoofing provision of the Commodity Exchange Act (CE Act) along with commodities fraud. The Court dismissed the defendant’s argument that the anti-spoofing provision of the CE Act was unconstitutionally vague and that a conviction based on the provision was therefore invalid. The case is of monumental significance for the financial sector because it is likely to embolden the government to pursue and prosecute traders it deems to have fallen afoul of the anti-spoofing provision. The implications of the case may be troubling for some traders who feel that, despite the Court’s finding, the legal definition of spoofing may need further clarification. Just as importantly, there are instances where traders, acting with no scienter or illegal intent, will legitimately cancel orders. Given the centrality of the cancellation of orders to regulators’ view of spoofing, traders need to take the utmost care to ensure that they can prove their normal market activities did not amount to illegal market manipulation and fraud. To help readers understand the issues that came to light in the Court’s ruling, and to inform them about steps they can take to insulate legitimate trading activities from suspicions of spoofing and disastrous legal consequences, this article summarizes the ruling and presents insights from attorneys with expertise in anti-spoofing enforcement. For more on spoofing, see “WilmerHale Attorneys Detail 2016 CFTC Enforcement Actions and Potential Priorities Under Trump Administration” (Feb. 16, 2017).

Cyber Crisis Communication Plans: What Works and What Fund Managers Should Avoid (Part Two of Two)

Even a small cyber incident can erupt into a high-profile event depending on whether and how it becomes public. Because of the potentially damaging impact press coverage can have, fund managers should be prepared with a thorough communications plan that contemplates more than just technical answers. For more on mitigating reputational risks, see “Hedge Funds’ Image Crisis: Fighting Public Perceptions Against the Backdrop of Potential Financial Sector Reforms” (Jun. 22, 2017). This second installment of our two-part series on cyber crisis communication plans offers advice on strategies for handling external communications to the media, regulators and others; controlling and coordinating with a third-party vendor; and overcoming common pitfalls and challenges. The first article discussed how to identify key personnel and their roles; detailed crucial playbook components and the benefits of planning ahead; and offered guidance on how to approach internal communications during a cyber crisis event. For more on combatting cybersecurity breaches, see “Essential Tools for Hedge Fund Managers to Combat Escalating Cyber Threats” (Feb. 4, 2016); and our two-part series on how hedge fund managers can meet the cybersecurity challenge: “Snapshot of the Regulatory Landscape” (Dec. 3, 2015); and “A Plan for Building a Cyber-Compliance Program” (Dec. 10, 2015).

CIMA Regulator Discusses Key Issues for Advisers That Manage Cayman Funds: AML, Fund Governance and the Cayman LLC (Part One of Two)

Offshore funds play an integral role in most private fund structures. Foreign investors appreciate the anonymity that these vehicles provide from U.S. tax authorities, while U.S. tax-exempt investors often prefer offshore corporate vehicles to shield them from receiving Unrelated Business Taxable Income. As the preferred offshore fund venue, the views and actions of the regulators in the Cayman Islands significantly impact most U.S. managers. In a recent interview with the Hedge Fund Law Report, Garth Ebanks, Deputy Head of the Investments and Securities Division at the Cayman Islands Monetary Authority (the Authority), provided his insights on the most salient issues from the perspective of a local Cayman regulator. This first article in our two-part series provides Ebanks’ thoughts into how managers are using the much-anticipated Cayman Islands limited liability company structure; how the Authority approaches the regulation of different types of private funds and other fund governance issues; and common deficiencies by private funds identified by the Authority concerning anti-money laundering and other applicable supervisory regulations. In the second installment, Ebanks will discuss the steps being taken by the Authority to ensure that Cayman vehicles are well positioned to obtain a marketing passport under the Alternative Investment Fund Managers Directive; three important regulatory initiatives being pursued by the Authority; the new Cayman Islands whistleblower law; and how the Cayman Islands has remained competitive as an offshore funds jurisdiction despite an onslaught of competition. For additional commentary from Ebanks, see our two-part series highlighting the views of U.S., U.K. and offshore regulators: “Best Ways for Hedge Fund Managers to Approach Regulation” (May 12, 2016); and “Cybersecurity, AML, AIFMD, Advertising and Liquidity Issues Affecting Hedge Fund Managers” (May 19, 2016). For more on offshore funds, see “Offshore Fund Vehicles: Do U.S. Investment Managers Need Them?” (Feb. 4, 2010).

ESMA Opinion Resolves Inconsistent U.S. and European Asset Segregation Models, Thereby Facilitating Cross-Border Transactions by European Funds

The European Securities and Markets Authority (ESMA) issued a long-awaited opinion (Opinion) on July 20, 2017, affecting the custody, brokerage and trading structure of Europe-based investment funds. The Opinion could affect European funds managed by U.S. advisers as well as the brokerage firms that service these entities and advisers. It is an important step toward facilitating the market activities of European investment funds, including Undertakings for Collective Investment in Transferable Securities (UCITS) vehicles, Alternative Investment Funds (AIFs) and their respective managers, and seeks to better harmonize the European depositary regime with market infrastructure and the laws of various countries engaged in the European investment funds market. In a guest article, Sadis & Goldberg counsel Richard Shamos and partner Dan Viola, review how the European asset segregation model, generally applicable to UCITS funds and AIFs, conflicts with market-wide practice by prime and clearing brokers of using omnibus accounts – particularly the “legally segregated, operationally commingled” framework adopted under the Dodd-Frank Act – and analyze the guidance by ESMA that would resolve this conflict, thereby facilitating market activities and cross-border transactions by UCITS funds and AIFs. For additional insights from Viola, see “How Investment Managers Can Advertise Sub-Adviser Performance Without Violating SEC Rules” (Dec. 1, 2016); and “Hedge Fund Managers Advised to Prepare for Imminent SEC Examination” (Jan. 28, 2016). For related discussions of U.S. and European asset segregation models for derivatives, see “EMIR Offers Three Models of Asset Segregation to Fund Managers That Trade OTC Derivatives” (Apr. 16, 2015); “A Practical Guide to the Implications of Derivatives Reforms for Hedge Fund Managers” (Jul. 25, 2013); and “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).

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

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

Improper Use by Managers of Fund Cash to Pay Other Funds’ Legal Expenses May Result in Serious Penalties

In 2010, the SEC commenced an enforcement action in the U.S. District Court for the District of Connecticut (Court) against a hedge fund manager and two investment adviser entities that he controlled. The SEC alleged that the defendants had engaged in securities and investment adviser fraud by ignoring the investment strategy disclosed in certain fund offering documents, inflating the value of certain portfolio securities and diverting money from two of the funds they managed to cover the legal defense costs of three other funds. In August 2017, the Court issued a partial final judgment against the defendants on the SEC’s fraud claims, imposing an injunction, disgorgement totaling almost $8 million and a $5 million civil penalty. This article summarizes the terms of the judgment, drawing on insights from the manager’s hearing testimony and the parties’ submissions related to the SEC’s 2016 motion for summary judgment. See our three-part series on fee and expense allocation practices: “Practices Fund Managers Should Avoid” (Aug. 25, 2016); “Flawed Disclosures to Avoid” (Sep. 8, 2016); and “Preventing and Remedying Improper Allocations” (Sep. 15, 2016).

Lee Morlock Joins Kirkland & Ellis in Chicago

Kirkland & Ellis has expanded its tax practice in Chicago with the hiring of Lee Morlock as a partner. Morlock advises clients on tax and tax-planning issues related to corporate and fund transactions. His areas of expertise include private equity investments; financings; mergers and acquisitions; divestitures; and restructurings, and his clients run the gamut from fund sponsors and investors to corporations. For additional insight from Kirkland partners, see “Former SEC Senior Counsel Offers Insight on SEC Enforcement Focus and Priorities” (Sep. 1, 2016); and our two-part series on SEC remote examinations: “What Managers Can Expect” (May 12, 2016); and “How Managers Can Prepare” (May 19, 2016).