Apr. 16, 2010

Does the IOSCO Hedge Fund Disclosure Template Foreshadow the Content of Hedge Fund and Hedge Fund Adviser Disclosures to be Required by the SEC?

On February 25, 2010, the International Organization of Securities Commissions’ (IOSCO) Technical Committee published a global template (IOSCO Template) listing suggested categories of information to be collected from hedge funds and hedge fund managers by national securities regulators.  According to Kathleen Casey, Chairman of the IOSCO Technical Committee and a Commissioner of the U.S. Securities and Exchange Commission (SEC), the IOSCO Template seeks to: (1) enable the collection of comparable data by regulators in different jurisdictions; (2) facilitate sharing of that data among regulators; (3) facilitate monitoring of systemic risk; (4) prevent gaps in regulatory reporting requirements; and (5) inform the legislative processes in jurisdictions considering hedge fund adviser registration bills, such as the U.S.  See “U.S. House of Representatives Holds Hearing on Hedge Fund Adviser Registration,” Hedge Fund Law Report, Vol. 2, No. 42 (Oct. 21, 2009).  Broadly, the IOSCO Template seeks to effectuate these goals by collecting data in four categories: (1) hedge fund trading activities; (2) the markets in which hedge funds operate; (3) hedge fund credit and funding information; and (4) hedge fund counterparty data.  The IOSCO Template builds on the principles embodied in the IOSCO Technical Committee’s June 2009 report endorsing mandatory registration for hedge fund managers.  See “IOSCO Report Suggests Mandatory Registration for Hedge Fund Managers and Prime Brokers,” Hedge Fund Law Report, Vol. 2, No. 26 (Jul. 2, 2009).  IOSCO is an international organization whose members include national securities regulators.  Generally, its pronouncements have persuasive, but not legal, force.  See “Will Hedge Fund Industry Self-Regulatory Codes, Such as the ‘Standards’ Promulgated by The Hedge Fund Standards Board, Preempt Additional Hedge Fund Regulation or Complement It?,” Hedge Fund Law Report, Vol. 2, No. 16 (Apr. 23, 2009). In parallel, on March 15, 2010, Senate Banking Committee Chairman Christopher Dodd (D-CT) released a Chairman’s Mark of the comprehensive financial reform bill (Dodd Bill) that he introduced as a Discussion Draft in November 2009.  A week later, the Senate Banking Committee passed Chairman Dodd’s bill on a party line vote, thereby sending the bill to the Senate floor for debate, and approved a package of technical amendments to the bill.  Notably, the Dodd Bill would rescind the “private adviser exemption” of Section 203(b)(3) of the Investment Advisers Act of 1940, thus requiring most hedge fund managers to register with the SEC as investment advisers.  Also, the Dodd Bill would require hedge fund advisers to maintain, and potentially to file with the SEC, records and reports pertaining to assets under management, leverage, counterparty exposure, other trading and operational matters and “such other information as the SEC determines is necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.”  Importantly, the Dodd Bill includes provisions requiring the SEC, a to-be-created Financial Stability Oversight Council (FSOC) and any department, agency or self-regulatory organization that receives reports or information from the SEC (which the SEC in turn received from a hedge fund manager) to maintain the confidentiality of those reports and that information.  The IOSCO Template contains no analogous confidentiality provision. In short, the Dodd Bill lists categories of information required to be disclosed by registered hedge fund advisers and delegates considerable rulemaking authority to the SEC to expand those categories or add additional categories.  Generally, the IOSCO Template calls for a broader range of disclosures from hedge fund advisers than the Dodd Bill.  Especially given SEC Commissioner Casey’s role as Chairman of the IOSCO Technical Committee, hedge fund industry participants are wondering whether the SEC will look to the IOSCO Template when proposing rules relating to required disclosures by registered hedge fund advisers.  (This presumes, of course, that the hedge fund adviser registration provision in the Dodd Bill or a similar provision in another bill will become law, and the broad industry consensus is that such a provision will become law.)  Sources interviewed by the Hedge Fund Law Report suggested that SEC-required hedge fund adviser disclosures are likely to include more than what is included in the Dodd Bill but less than what is included in the IOSCO Template.  In an effort to assist hedge fund managers in preparing for an imminent registration requirement, and the concomitant disclosures it may require, this article: provides a chart comparing the categories of disclosure called for by the IOSCO Template and the Dodd Bill, showing precisely what is included in each and where they differ; discusses the confidentiality provisions in the Dodd Bill; and analyzes the potential downsides of such disclosures, as well as the potential upsides of such disclosures.  (Counterintuitive though it may sound, there may be practical benefits associated with the required disclosures.)

SEC Charges Goldman, Sachs & Co. and a Goldman V.P. with Securities Fraud; Hedge Fund Manager Paulson & Co. Named in Complaint, But Not Charged with Any Violation of Law or Regulation

On April 16, 2010, the Securities and Exchange Commission charged Goldman, Sachs & Co. (Goldman Sachs) and one of its vice presidents with defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter.  See SEC v. Goldman Sachs & Co. and Fabrice Tourre, S.D.N.Y.  The SEC’s complaint alleges that Goldman Sachs structured and marketed a synthetic collateralized debt obligation (CDO), the performance of which depended on the performance of subprime residential mortgage-backed securities.  Goldman Sachs allegedly failed to disclose to investors material information about the CDO, in particular the role that Paulson & Co., a significant hedge fund manager, played in the portfolio selection process and the fact that a Paulson fund had taken a short position in credit default swaps against the CDO.  On CLOs, a type of CDO, see “Key Legal and Business Considerations for Hedge Fund Managers When Purchasing Collateralized Loan Obligation Management Contracts,” Hedge Fund Law Report, Vol. 3, No. 13 (Apr. 2, 2010).

Brokered CDs Offer a Cash Management Alternative for Hedge Funds

In the course of their operations and investments, hedge funds (or their service providers) obtain and generate cash.  For example, when a new investor allocates capital to a hedge fund, that investor generally sends cash to the hedge fund’s administrator, who in turn sends the cash to one or more designated prime brokers once Anti-Money Laundering, Know Your Customer and similar compliance checks have been performed.  Also, when a hedge fund sells out of a position, the cash proceeds generally are deposited (or “swept”) into the fund’s prime brokerage account.  Similarly, to trade using margin from a prime broker, a hedge fund generally must deposit cash or cash equivalents into its prime brokerage account.  Like stocks, bonds and real assets, cash is a type of asset owned by hedge funds.  Like any asset, cash must be managed.  But the goals of cash management differ from the goals of managing other assets.  In general, the primary goal of cash management, at least for hedge funds, is safety and preservation of capital and access to it across all conceivable outcomes.  Secondary goals of cash management include obtaining incremental yield and keeping pace with or beating inflation.  Also, in the post-Lehman era, counterparty risk looms large as a concern to be addressed when managing hedge fund cash.  By contrast, the general goals of managing other assets involve accepting a certain level of risk for a target return.  Hedge funds traditionally have used a number of techniques to manage their cash, including purchases of U.S. Treasury bonds and other Treasury obligations, purchases of highly rated non-U.S. sovereign credit, purchases of money market fund shares and maintenance of cash balances at prime brokers.  See “Why Do Hedge Funds Have So Much Dry Powder, and What Are They Doing to Keep It Safe?,” Hedge Fund Law Report, Vol. 2, No. 20 (May 20, 2009).  Mechanically, hedge funds frequently have purchased Treasuries via overnight repurchase agreements, so that the money sleeps in Treasuries and the manager has cash available for investment during the day.  A relatively new approach to cash management, at least in the hedge fund industry, involves investing cash in brokered certificates of deposit, or brokered CDs.  Generally, a brokered CD is a financial product in which multiple CDs issued by different regional banks, of different durations and paying different interest rates, are pooled together by a broker and sold as a single offering or in a single account.  For hedge funds looking to manage cash, brokered CDs offer certain advantages over regular CDs and other cash management approaches, but they also involve potential downsides.  This article highlights, by way of context, continuing concerns about counterparty risk, then explains the mechanics of brokered CDs in more detail; evaluates the benefits and burdens for hedge fund managers of brokered CDs; and suggests reasons why some of the burdens (and benefits) of brokered CDs may be moot in light of the realities of FDIC procedure.

White & Case Hosts Program on “Financial Regulatory Reform: Current Status and Developments,” Highlighting Key Legislative Proposals Impacting Hedge Fund Managers, Broker-Dealers and Derivatives Industry Participants

As previously reported in the Hedge Fund Law Report, on March 26, 2009, the U.S. Department of the Treasury outlined a new framework for financial regulatory reform, including a proposal to require advisers to hedge funds (and other private pools of capital) with assets under management above a certain threshold to register with the SEC, along with certain other regulatory reforms.  See “Treasury Calls for Registration of Hedge Fund Managers with Assets Under Management Above a Certain Threshold and Outlines Framework for Other Regulatory Reforms Aimed at Limiting Systemic Risk,” Hedge Fund Law Report, Vol. 2, No. 13 (Apr. 2, 2009).  Some of these reforms have been incorporated into current and pending legislation, including, most notably, the Private Fund Investment Advisers Registration Act of 2009, which was incorporated into Title V of the Wall Street Reform and Consumer Protection Act of 2009 and was passed by the House of Representatives on December 11, 2009 (House bill), and the Restoring American Financial Stability Act of 2009, which was introduced by Banking Committee Chairman Senator Christopher Dodd on November 10, 2009 (Dodd bill).  For more on the Dodd bill, see “Does the IOSCO Hedge Fund Disclosure Template Foreshadow the Content of Hedge Fund and Hedge Fund Adviser Disclosures to be Required by the SEC?,” above, in this issue of the Hedge Fund Law Report.  Also on March 26, 2009, the Obama Administration issued details on proposed legislation for a “resolution authority” that would give the President sweeping powers to dismantle or reorganize failing companies that pose a threat to the country’s financial system.  On April 8, 2010, White & Case LLP held a seminar entitled “Financial Regulatory Reform: Current Status and Developments,” with the goal of outlining and analyzing some of the more significant pieces of the pending financial regulatory reform legislation referenced above, and the ways in which various market participants may be impacted by such reforms.  This article outlines the most relevant topics discussed at the seminar, including: legislation relating to creation of a “resolution authority” to deal with pending failures of large, interconnected financial companies; ipso facto clauses in derivatives contracts; proposed central clearing requirements for derivatives; comparisons of the relevant provisions of the House and Dodd bills with respect to hedge fund manager registration; the issue of self-custody by hedge fund managers in light of the recent amendments to the custody rule; the proposed fiduciary standard for broker-dealers providing investment advice incidental to their brokerage activities; and the treatment of proprietary trading activities of broker-dealers under the Volcker Rule.

Canadian and U.S. Regulators Aggressively Pursue Hedge Funds for Overstatements of Securities’ Values: the OSC Revises Fraud Allegations against Sextant Capital Management While the SEC Accuses Morgan Keegan and Two Employees of Fraud Relating to Subprime Mortgages

On December 16, 2008, the Ontario Securities Commission (OSC) accused Otto Spork, the founding manager and “driving force” of Sextant Capital Management Inc. (SCMI), of perpetrating a complex investment fund fraud between July 2007 and December 2008.  On April 5, 2010, the OSC released a revised set of allegations against SCMI.  It alleges that SCMI, the investment fund adviser, Sextant Capital GP, manager of the Sextant Canadian Fund, and Spork engaged in fraud by: (1) selling investment fund units at falsely inflated values; (2) taking millions of dollars in fees based on the falsely inflated values; and (3) misappropriating money from the investment funds.  See In the Matter of Sextant Capital Management Inc., et al. (April 5, 2008).  Spork allegedly perpetrated the fraud through three investment funds: the Sextant Strategic Opportunities Hedge Fund L.P.; the Sextant Strategic Hybrid2Hedge Resource Fund Offshore Ltd.; and the Sextant Strategic Global Water Fund Offshore Ltd. (the Sextant Funds).  Together, the Sextant Funds raised in excess of $80 million from Canadian and offshore investors.  Two days later, on April 7, 2010, the SEC announced administrative proceedings against Morgan Keegan & Company and Morgan Asset Management (MAM) as well as two of its employees, accusing them of defrauding investors by deliberately inflating the value of risky securities backed by subprime mortgages.  The SEC accuses Morgan Keegan of failing to employ reasonable procedures to internally price the portfolio securities in five funds managed by MAM, thereby, miscalculating the net asset values of the funds.  We detail the background of both actions and their implications for the hedge fund industry.

State Claims Against Directors and Administrators of Hedge Funds Managed by Lancer Management Group Survive SLUSA Challenge

Investors sought to recover losses stemming from the liquidation of two British Virgin Islands-based hedge funds (Funds) in which they held shares.  In the most recent decision in the ongoing litigation involving the failed hedge funds managed by Lancer Management Group, LLC (Lancer), the United States District Court for the Southern District of New York ruled that the Securities Litigation Uniform Standards Act of 1998 (SLUSA) did not preempt state claims against the directors and administrators of the Funds for allegations of material misstatements in connection with the purchase or sale of a covered security.  This was because the court ruled that the shares issued by the Funds were not “covered securities” under the SLUSA. Rather, the securities were merely held in portfolios.  We detail the background of the allegations and the court’s legal analysis.  See also “Pension Committee Case Highlights Obligations of Hedge Fund Managers to Preserve Documents and Information in Anticipation of Litigation,” Hedge Fund Law Report, Vol. 3, No. 6 (Feb. 11, 2010).

Bingham Adds Former FINRA Enforcement Chief Susan Merrill to Broker-Dealer Practice

On April 12, 2010, Bingham McCutchen LLP announced that Susan Merrill, head of enforcement at the Financial Industry Regulatory Authority (FINRA), will join as a Partner to lead the firm’s Securities Enforcement Practice in its New York Broker-Dealer Group.