Sep. 27, 2018

A Fund Manager’s Guide to the Initial Margin Rules for Uncleared Swaps (Part One of Two)

Regulators in the U.S., E.U. and other jurisdictions are in the process of implementing margin requirements for uncleared over-the-counter derivatives transactions, including rules regarding bilateral posting of initial margin (IM Rules). Although the IM Rules in the U.S. and the E.U. will not take effect until September 1, 2020, compliance with them requires advance planning, and many swap dealers are beginning to contact their clients to determine which of them will be in scope and when. Affected funds will be required to amend existing uncleared swap documentation (or enter into new documentation); establish custody relationships; determine the amount of initial margin (IM) they will be required to post and collect; and monitor threshold calculations. In this guest article, the first in a two-part series, Sidley Austin partners Elizabeth Schubert and Leonard Ng, along with associate Kate Lashley, provide an overview of the IM Rules and discuss the IM threshold that affected parties may adopt; the requirement to segregate IM; the changes an affected fund will be required to implement to accommodate compliance; and the models and methodologies available to calculate IM. The second article will explore which funds will be in scope of the IM Rules and review the timing for the implementation of the IM Rules. For a discussion of the variation margin requirement, see “Steps Hedge Fund Managers Should Take Now to Ensure Their Swap Trading Continues Uninterrupted When New Regulation Takes Effect March 1, 2017” (Feb. 9, 2017). For additional insight from Ng, see “What Are the Implications for Investment Managers of the Revised Prudential Framework for E.U. Investment Firms?” (Mar. 22, 2018); and “E.U. Market Abuse Scenarios Hedge Fund Managers Must Consider” (Dec. 17, 2015).

SEC Reiterates Ratification of ALJs and Spells Out Process for Rehearings of Pending Actions

The SEC recently issued an order (Order) that addresses some of the unresolved issues left in the wake of the recent U.S. Supreme Court (Court) ruling in Lucia v. SEC, in which the Court held that the SEC’s administrative law judges (ALJs) must be appointed by either the President or the Commission itself – not SEC staff. In response to the Lucia decision, the SEC had issued a 30-day stay, halting all cases that were pending before ALJs and the Commission at the time of the decision. The Order allows that stay to expire as of August 22, 2018, and among other things, grants new hearings for all of the previously stayed actions. This article reviews the Lucia decision and explains the key elements of the Order, including the process for the new hearings. For more on Lucia, see “What Are the Implications of the Supreme Court’s Decision in Lucia v. SEC for Fund Managers?” (Jul. 19, 2018); and “D.C. Circuit Delivers Significant Victory for the SEC in Upholding the Use of Administrative Law Judges in Enforcement Proceedings” (Sep. 8, 2016).

As Cross Trades Between Client Accounts Continue to Draw SEC Scrutiny, Fund Managers Should Review Internal Policies and Client Disclosures

With appropriate disclosures and controls, an investment adviser can use cross trades to balance client accounts and save transaction costs. Cross trading, however, carries significant risks, including those associated with disclosure, valuation and conflicts of interest. A recent SEC settlement order against an investment adviser illustrates some of those risks. Even though the adviser disclosed to clients that it would engage in cross trading and did not benefit from that cross trading, the SEC charged that those transactions benefitted certain clients at the expense of others; that the adviser failed to adopt adequate cross trading policies and procedures; and that it failed to follow the policies it did have. This article analyzes the terms of the order, with additional insight from an experienced industry practitioner. For more on hedge fund manager cross-trading practices, see “Katten Forum Identifies Best Practices for Hedge Fund Managers Regarding Best Execution, Soft Dollars, Principal Trades, Agency Cross Trades, Cross Trades and Trade Errors” (Mar. 13, 2014).

Mitigating Insider Trading Risks: Relevant Laws and Regulations; Internal Controls; Restricted Lists; Confidentiality Agreements; Personal Trading; Testing; and Training (Part One of Two)

Insider trading is a perennial SEC focus area. A recent ACA Compliance Group (ACA) program featuring Joel Stocksdale and Erika Chua, ACA senior principal consultant and principal consultant, respectively, offered a comprehensive overview of common insider trading risks and the controls that fund managers can implement to mitigate those risks. This article, the first in a two-part series, covers the portions of the program that addressed relevant laws and regulations; internal controls applicable to all advisers; restricted lists; confidentiality agreements; personal trading; testing; and training. The second article will highlight specific controls related to common sources of insider trading risk, including expert networks, political intelligence, meetings with management, data rooms, information barriers and office sharing. For additional commentary from ACA, see “ACA Panel Reviews Effects of Impending MiFID II on U.S. Advisers” (Dec. 7, 2017); and “The SEC’s Proposed Form CRS: Does It Accomplish Its Goals? (Part Two of Two)” (Jun. 7, 2018).

Adviser’s Failure to Identify and Disclose Conflict of Interest Arising Out of Its Use of Soft Dollars Results in Compliance Rule Violation

There is nothing inherently wrong with an investment adviser’s purchase of services from an affiliated entity with its own money. An adviser should be cautious, however, when client funds are used for that purpose. In a recent settled SEC enforcement proceeding, the SEC claimed that an investment adviser used clients’ soft dollars to purchase investment software from a company controlled by the firm’s chief investment officer without disclosing that conflict of interest to its clients. This article analyzes the SEC settlement order. For another recent SEC action involving conflicts of interest, see “Advisers Must Disclose Conflicts of Interest and Heed the Terms of Client Agreements, or Risk Stiff SEC Sanctions” (Jun. 28, 2018). See also “Eight Bad Excuses Fund Managers Have Raised Trying to Avoid SEC Sanctions for Fee and Expense Allocation Violations and Undisclosed Conflicts of Interest” (Oct. 13, 2016).

Despite Headwinds, Enforcement Remains Strong, Notes Co-Director of SEC Enforcement Division

In a recent speech, Stephanie Avakian, Co-Director of the SEC’s Division of Enforcement (Division), assessed the Division’s effectiveness and impact over the prior fiscal year. Avakian argued that the Division’s performance should be measured by the quality – not the number or penalties – of the enforcement actions it has brought, and by that measure, this fiscal year has been successful for the regulator, despite staff vacancies and other challenges. Her remarks provide fund managers with valuable insight into the Division’s goals in pursuing enforcement actions; outline the Division’s areas of focus; and illuminate the Division’s treatment of cryptocurrency and initial coin offerings, as well as the recently announced Share Class Selection Disclosure Initiative. This article highlights the key points from her speech most relevant to fund managers. For further commentary from Avakian, see our two-part series “SEC Officials Flesh Out Cybersecurity Enforcement and Examination Priorities” (May 11, 2017); and “SEC Officials Discuss Cybersecurity Examination Priorities and Provide Guidance on When to Disclose Cyber Events” (May 18, 2017).

Commercial Litigation Partner Philip M. Bowman Joins Cooley’s New York Office

Cooley has expanded its New York office with the addition of Philip M. Bowman as a partner in its commercial litigation group. Bowman represents financial institutions in securities, commodities, financial products and antitrust litigation, and he has experience handling domestic and international disputes in London Court of International Arbitration proceedings and FINRA arbitrations. For insight from other Cooley attorneys, see “When Hedge Funds Initiate the Bidding on Bankruptcy Assets Then Get Outbid, Can They Collect Break-Up Fees or Expense Reimbursements?” (May 7, 2009).