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    May 13, 2009

401(k) Plans Offer a Powerful Distribution Channel for Hedge Fund Managers Willing to Tackle ERISA, Liquidity and Non-Discrimination Concerns

Traditionally, the investment options available to participants in 401(k) plans have been staid and sleepy, consisting primarily of stock and bond mutual funds, money market funds and similar products.  However, since around 2005, 401(k) plan sponsors have been offering hedge funds or hedge fund strategies as alternative investment options for plan participants.  Inclusion of hedge funds can benefit both sides.  For participants, it can expand the range of investment and diversification opportunities.  For hedge fund managers, it can offer a potentially far-reaching distribution channel and access to a large and largely untapped market.  But offering hedge funds in 401(k) plans raises legal and practical issues, for both hedge fund managers and plan sponsors.  On the legal side, hedge fund managers are concerned that the 401(k) plan or its participants can be construed by the Department of Labor as “benefit plan investors.”  If such investors hold more than 25 percent of any class of equity interests offered by one of the manager’s funds, the manager can be subject to the Employee Retirement Income Security Act of 1974 (ERISA).  Plan sponsors have to contend with non-discrimination rules, which generally require participants at different income levels in the same plan to receive the same investment options.  At many companies, certain employees would qualify as “accredited investors” and “qualified purchasers,” and thus would be eligible to invest in most hedge funds, while other employees would not qualify.  Plan sponsors that wish to offer hedge funds have to figure out how to do so without discriminating against the employees who would not qualify, outside of the plan, to invest in hedge funds.  Plan sponsors also have to be cognizant of unrelated business taxable income issues.  On the practical side, hedge fund managers and plan sponsors have to contend with potential discrepancies in the liquidity offered to plan participants and investors in the relevant hedge fund.  This article explores structures and approaches being used by plan sponsors and hedge fund managers to address or mitigate the various legal and practical hurdles involved in including hedge funds or hedge fund strategies in 401(k) plans.  In the course of our discussion, we offer specific strategies for addressing ERISA concerns and the liquidity mismatch between 401(k) plans and most hedge funds, and thereby provide the beginning of a roadmap for managers interested in vastly expanding the scope of their distribution into retail or quasi-retail channels.

Consensus in Financial Services Committee Hearing on Castle and Capuano Bill (Hedge Fund Adviser Registration Act of 2009) Suggests Support for Comprehensive Overhaul, Increased Transparency and Exemption from Registration for Smaller Advisers

On May 7, 2009, the Subcommittee on Capital Markets of the House Committee on Financial Services conducted a hearing on the Hedge Fund Adviser Registration Act of 2009 (HFAR), a bill proposed on January 27, 2009 by Reps. Michael Castle (R-Del.) and Michael E. Capuano (D-Mass.).  The HFAR (H.R. 711) would remove Section 203(b) from the Investment Advisers Act of 1940.  The removal of Section 203(b)(3) would effectively require many currently unregistered hedge fund managers to register with the SEC as investment advisers, thereby subjecting them to the various obligations of registered investment advisers, including annual disclosure requirements, advertising and marketing restrictions and recordkeeping requirements.  (Under current law, hedge fund managers generally would have to register with the SEC as investment advisers but for the “private adviser” exemption in Section 203(b)(3), which exempts an adviser from the obligation to register if it: (1) had fewer than 15 clients during the preceding 12 months; (2) does not hold itself out generally to the public as an investment adviser; and (3) does not advise any registered investment companies.)  As Rep. Capuano previously explained to the Hedge Fund Law Report, in discussing his rationale for proposing the change: “No one can look me in the eye and tell me they know how many hedge funds there are or how many assets they manage.”  The consensus among both the members of Congress and the witnesses at the hearing was summed up by the Chairman of the Subcommittee, Paul E. Kanjorski (D-Pa.), who said that he considers it important to “put in place a system to obtain greater transparency for the hedge fund industry” and to make  decisions “about who will monitor them and how.”  We offer details of testimony from representatives of the Government Accountability Office, Managed Funds Association, Alternative Investment Management Association, Coalition of Private Investment Companies and Teacher Retirement System of Texas, relate the details of a lively exchange and offer insights from industry participants on the substance of the testimony.

Hedge Fund Managers Organize Ethics Boards to Advise on Close Ethical Calls, and to Credibly Demonstrate (to Regulators, Investors, Employees and Others) a Commitment to Best Practices

Deserved or not – and in this case it is mostly not – the global financial crisis has taken a toll on the reputation of hedge funds as a group.  The Madoff debacle, for example, whipped the public and political class into high dudgeon over the ostensibly mean and malicious activities of hedge funds – despite the fact that Madoff never managed a hedge fund (he purported to manage what would more appropriately be called separate accounts), and most credible hedge fund managers who looked under the hood of Madoff’s obscure operation steered widely clear of it.  Hedge funds have not asked for nor have they received bail out money, and their returns during the crisis, while negative, have been less negative than the returns in other asset classes.  They bought Chrysler debt and prolonged the life of the automaker outside of bankruptcy court, but then were charged by the President with breaching their patriotic duty (by satisfying their fiduciary duty).  In short, much of the malign recently visited upon hedge funds and their managers has been unjustified.  But politicians often respond to volume over veracity, so the merits of criticisms of the industry often get lost amid the vehemence of such criticisms.  In the context of such criticism, hedge fund managers have been establishing boards of ethics to advise on close ethical calls and best professional practices, and to credibly demonstrate to various constituencies – including regulators, investors, employees, lenders, counterparties, deal partners and others – that they take ethical matters seriously.  We discuss what ethics boards are, precedents for such boards, the types of issues typically presented to such boards, how such boards interact with compliance staff, how binding the recommendations from such boards are and the potential liability of board members.

The Fund of Hedge Funds Regulatory Loophole

From a regulatory perspective, both in the United States and abroad, a hedge fund is essentially the same type of legal entity as a fund of hedge funds (FOHF).  As such all of the current and proposed hedge fund regulations apply virtually the same legal and compliance standards to both hedge funds and fund of hedge funds.  While such a distinction may have been too fine a regulatory point to make during the early stages of the modern hedge fund resurgence, this distinction can no longer be ignored.  Fund of hedge funds aggregate capital and allocate it to hedge funds.  They are supposed to be performing a certain minimum amount of due diligence (both investment and operational).  Unfortunately, as Madoff and the current Ponzimonium have demonstrated, FOHF were not performing such due diligence adequately.  All of the proposed hedge fund regulations dangerously ignore the opportunity to protect investors and institutions which place their capital within this lax due diligence framework.  In a guest article, Jason Scharfman, Managing Partner of Corgentum Consulting, LLC, critiques what he calls the “fund of hedge funds regulatory loophole.”

Providing Certainty on Death and Taxes: The IRS Issues Initial Guidance for Sellers and Purchasers of Life Insurance Policies

On May 1, 2009, the Internal Revenue Service (IRS) issued two Revenue Rulings.  In the first of these Rulings, Revenue Ruling 2009-13, the IRS addressed three different situations in which a U.S. individual insured disposed of his rights under a life insurance policy.  In the second of these Rulings, Revenue Ruling 2009-14, the IRS addressed three separate situations in which a third party investor acquired the rights under a life insurance policy from the original owner and insured.  While neither Ruling addresses all of the issues presented by the burgeoning life settlement industry in the United States, each does provide some much needed guidance in the area.  In a guest article, Mark Leeds, a Shareholder with Greenberg Traurig LLP, provides a detailed discussion of the IRS guidance.

Directive on Alternative Investment Fund Managers Likely to Occasion Substantial Ongoing Debate Over the Appropriate Scope of Regulation of European Hedge Fund Managers

On April 29, 2009, the European Commission (EC) issued the Directive on Alternative Investment Fund Managers (AIFM Directive), which includes draft rules for more thorough regulation of a broad range of alternative investment managers, including hedge fund and private equity fund managers.  In doing so, it has initiated a new plan to resolve a long-running feud over the shape of Europe’s common regulation of the financial system.  Market participants who spoke to the Hedge Fund Law Report agreed that more burdensome regulations are likely to result, though the particulars are very much open for negotiation.  The negotiation process is all but certain to prove contentious.  This article reviews the points that the contending sides are likely to make as they work to implement or re-work AIFM Directive.

SEC Brings First-Ever Credit Default Swaps Insider Trading Case

On May 5, 2009, the Securities and Exchange Commission (SEC) charged Jon-Paul Rorech, a salesman at Deutsche Bank Securities, and Renato Negrin, a former Millennium Partners, L.P. hedge fund portfolio manager with insider trading in credit default swaps of VNU N.V., a Dutch media conglomerate (VNU).  According to the SEC, this case is the first insider trading enforcement action it has brought with respect to credit default swaps (CDSs).  Rorech allegedly learned information from Deutsche Bank investment bankers about a change to a proposed VNU bond offering that was expected to increase the price of CDSs on VNU bonds.  Rorech then purportedly illegally tipped Negrin about the contemplated change.  Negrin then purchased CDSs (which are not registered securities, and are used to insure against the default of debt and certain related credit events) on VNU for a Millennium hedge fund.  According to the SEC, when news of the restructured bond offering became public in late July 2006, the price of VNY credit default swaps increased, and Negrin closed Millennium’s VNU credit default position at a profit of about $1.2 million.  The SEC seeks an injunction barring further securities laws violations, disgorgement of profits and civil penalties.  We detail the SEC’s factual allegations and legal claims.

Basel Committee Issues New Guidelines on Fair Value for Financial Instruments

On April 15, 2009, the Basel Committee on Banking Supervision, which includes banking regulators from the world’s biggest financial markets, issued a final series of guidelines intended to help banks improve their valuation of complex financial instruments.  The guidelines, which the Committee circulated in draft form last November, aim to help regulatory supervisors assess the soundness of bank valuation practices for the purposes of determining the adequacy of their capital reserve.  Since the overvaluation of complex financial instruments helped trigger the current financial crisis and contribute to the global economic meltdown, the “fair valuation” of complex or illiquid financial instruments has become particularly important.  We provide an in-depth discussion of the Basel Committee’s guidelines.

Texas Federal Court Orders Emergency Relief after SEC Accuses Connecticut-Based Hedge Funds of Fraud

On April 27, 2009, the U.S. District Court for the Western District of Texas issued an emergency order freezing the assets of a Connecticut-based hedge fund manager, Francesco Rusciano, and the funds, Ponta Negra Fund I, LLC and Ponta Negra Offshore Fund I, Ltd., which he controls through Ponta Negra Group, LLC.  The Securities and Exchange Commission (SEC) accused the defendants of forging documents, making false promises to clients and misrepresenting the assets under management.  We outline the allegations in the SEC’s complaint.

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