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    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.”

UCITS: An Opportunity for Hedge Fund Managers

In recent months, there has been a renewed interest by both U.S. and European hedge fund managers in Undertakings for Collective Investment in Transferable Securities or UCITS.  Given the likely regulation of hedge funds and/or hedge fund managers in both Europe and the United States in some shape or form as well as the demand from many institutional investors for a more liquid and transparent product from certain hedge fund managers, the interest in UCITS is likely to grow on both sides of the Atlantic.  In a guest article, Christopher D. Christian and Stephanie A. Barkus, Partner and Associate, respectively, at Dechert LLP, highlight the benefits and limitations of the UCITS structure as well as several of the driving forces behind a renewed interest in the product by hedge fund managers.

Early and Often: Compliance Training Pays Big Dividends for Private Fund Advisers

Rule 206(4)-7 under the Investment Advisers Act of 1940 requires advisers to adopt policies and procedures “reasonably designed” to prevent violations of the Act.  This responsibility includes a mandate that the Chief Compliance Officer identify potential and actual conflicts of interest and compliance risks and then address them.  Training will be central to the response by private fund advisers to significant compliance breaches, changes in business arrangements and regulatory developments.  Just as importantly, employees of private fund advisers will be far better equipped to avoid violations of the Act if they understand it.  In a guest article, Philip Thomas, an investment management attorney at Garrity, Graham, Murphy, Garofalo and Flinn, P.C., offers ideas on how to build a training program that works for private fund advisers.

SEC Commissioner Aguilar Recommends Tougher Regulation of Hedge Funds and Investment Advisers

On June 18, 2009, Commissioner Luis A. Aguilar of the Securities and Exchange Commission spoke at the Spring 2009 Hedgeworld Fund Services Conference in New York, New York.  In his speech, Aguilar discussed the causes of the renewed calls to regulate the hedge fund industry, including lack of transparency, the imbalance of power between investors and managers and the potential for impact on the entire capital market.  On June 23, 2009, Commissioner Aguilar also spoke at the International Institute for the Regulation and Inspection of Investment Advisers in Washington, D.C., and announced the SEC’s intention to improve its regulatory regime.  We provide detailed coverage of both speeches.

Equities of Bankrupt Companies Offer Hedge Funds a High Risk, Potentially High Return Method of Investing in Restructurings

Common wisdom holds that common stock is invariably wiped out in a chapter 11 reorganization.  Experience, however, has taught that sometimes common stock retains some value in a reorganization, and in light of the perception that equity will have no value, equities of companies in or near bankruptcy can often be picked up at a major discount.  Even a little recovery, therefore, can yield a lot of return (with, of course, a lot of risk).  Indeed, hedge funds of various stripes, including historic bankruptcy investors and others, have been purchasing bankruptcy equities in the conviction that the issuer will survive a chapter 11 reorganization, and emerge stronger than when it entered.  Many such investments are predicated on one or more of three ideas: (1) that the debt investors are greatly undervaluing the assets of the company; (2) that a major event, such as a lawsuit, will significantly expand the value of the estate; or (3) that industry-wide conditions will improve dramatically (e.g., that many players went into bankruptcy but only few, including the issuer of the subject equity, will emerge).  On the second point, see “Should Hedge Funds Purchase Unsecured Debt of Lehman Brothers Holdings Inc.? Key Legal Issues Impacting Returns,” Hedge Fund Law Report, Vol. 2, No. 26 (Jul. 2, 2009).  We discuss the risks inherent in such investments; reasons (some of which may be surprising) why equity may not be wiped out in a bankruptcy; ways to mitigate the risk of investments in bankruptcy equities; and the formation, purpose and downside of equity committees.

Delaware Chancery Court Dismisses Cable Company’s Suit against Hedge Fund for Lack of Privity

On June 11, 2009, the Delaware Chancery Court ruled that James Cable LLC, a cable company, could not hold the hedge fund Highland Capital and its management company Highland Management (collectively, Highland), liable for the failure of a company Highland owns, Millennium Digital Media Systems LLC, to perform on its contract to purchase the assets of James Cable.  The court reasoned that James Cable failed to state a valid cause of action notwithstanding its allegation that Highland represented that it would be the source of funding for the transaction.  We discuss the factual allegations and the court’s legal analysis.

Class Action Suit Against Hedge Fund that Invested in Madoff Feeder Fund Highlights the Standard of Care to which ERISA Fiduciaries are Held

On February 12, 2009, the Pension Fund for Hospital and Health Care Employees (Fund) filed a complaint in the U.S. District Court for the Eastern District of Pennsylvania against Austin Capital Management Ltd. (Austin) for millions of dollars of losses due to allegedly improper investments in securities controlled by Bernard L. Madoff and his company.  Specifically, the complaint claimed that Austin “directed significant amounts of investment, estimated at present to be $184 million, into Madoff-related securities, virtually all of which were lost when the Ponzi scheme became known in December 2008.”  As a result, the complaint alleged that Austin failed to prudently invest the Fund’s assets, in violation of the Employee Retirement Income Security Act of 1974 (ERISA).  Then, on June 12, 2009, Spector Roseman Kodroff & Willis, P.C. (SRKW), a Philadelphia-based law firm, filed a second class action against Austin for more losses due to improper investments in securities controlled by Madoff.  This suit, brought on behalf of the Pittsburgh-based Board of Trustees of the Steamfitters Local 449 Retirement Security Fund and a nationwide class of similar funds, similarly alleged that Austin failed to prudently invest the benefit funds’ assets, in violation of ERISA.  These class actions are two of the many suits that have been brought in recent months against the “feeder funds” that contributed to Madoff’s Ponzi scheme, or funds that invested in such feeder funds.  The case highlights three issues relevant to hedge funds: (1) the question of when an alleged class of plaintiffs bringing suit against a hedge fund will be certified by a court; (2) the standard of care applicable to ERISA fiduciaries; and (3) the standard for consolidation and transfer of MDL cases.  The article analyzes each of those issues in detail.

Bingham, McKee Nelson Sign Letter of Intent to Combine

On July 6, 2009, Bingham McCutchen LLP and McKee Nelson LLP announced that they had signed a letter of intent to combine on or before August 1, 2009.  The combined firm, which will use the Bingham McCutchen name, creates a broad range of practices focused on global financial services firms and Fortune 100 companies.

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