Financial industry scandals uncovered during the past year and a half have led to calls from regulators and institutional investors for the unbundling of services that, in some cases, have been performed under the roof of a single hedge fund manager.  On the regulatory side, the most salient example is the recently amended custody rule.  As the SEC said in its adopting release, although the amendments do not require the use of an independent custodian, the SEC “encourage[s] custodians independent of the adviser to maintain client assets as a best practice whenever feasible.”  (We covered the custody rule amendments last week, and will have significantly more to say about them in coming weeks.  See “SEC Adopts Investment Adviser Custody Rule Amendments,” Hedge Fund Law Report, Vol. 3, No. 1 (Jan. 6, 2010).)  On the institutional investor side, the most noteworthy development along these lines has been the increasing volume and frequency of calls for independent hedge fund administration.  See “Implications of Demands by Institutional Investors for Independent Hedge Fund Administrators,” Hedge Fund Law Report, Vol. 2, No. 3 (Jan. 21, 2009).  The basic idea underlying calls for such unbundling is that the provision of administration, custody and similar services by third parties will diminish the ability of hedge fund managers to engage in fraud and, in less extreme scenarios, will mitigate conflicts of interest.  For example, if Custodian X has custody of the assets of Fund Y and sends account statements to investors in Fund Y, the manager of Fund Y will have a difficult time persuading those investors that the fund contains assets that do not exist.  Similarly, if Administrator X calculates the net asset value (NAV) of Fund Y and shares that NAV with investors in Fund Y on a monthly basis, the manager of Fund Y will have a difficult time selling inflated NAV figures to investors.  While the case for third-party administration is plausible – and indeed various leading hedge fund managers have acceded to demands from institutional investors for third-party administration – there remain compelling counterarguments in favor of in-house administration.  Two of the most compelling such arguments involve cost and complexity.  That is, third-party administration generally is paid for by the fund, so in-house administration can save costs.  Also, some managers, especially those with more complex strategies, have invested significantly in the people, processes, technology and infrastructure that comprise their in-house administrative function.  From the perspective of such managers, converting to third-party administration would constitute a step down in terms of expertise and would undermine the value in a large, long-term investment.  (While some of that value can, in theory, be recouped by selling the in-house administrative unit as a separate entity, the unit may be so integrated into the manager’s operations that such a spin out is not practicable.)  Since money-raising remains challenging, and calls for third-party administration remain stentorian, this article aims to elucidate the pros and cons of third-party administration versus in-house administration for various categories of hedge fund managers.  Specifically, this article discusses: what specific services hedge fund administrators perform; typical fees for administrators; relevant considerations when selecting a third-party administrator; the case for in-house administration; the case against in-house administration; and the treatment of administration under the EU’s proposed AIFM Directive and in Luxembourg.  Perhaps most importantly, this article highlights a compromise solution that may enable hedge fund managers to perform in-house administration while addressing the underlying concerns that cause institutional investors to demand third-party administration. Read full article …

In response to demands from institutional investors for increased transparency with respect to hedge fund assets, and consistent with the renewed, post-crisis emphasis on liquidity, certain hedge fund managers are taking a novel approach to the presentation and use of net asset value (NAV).  See “Rolling Lock-Up Periods Enable Hedge Fund Managers to Pursue Less Liquid Strategies While Managing Investors’ Liquidity Expectations,” Hedge Fund Law Report, Vol. 3, No. 1 (Jan. 6, 2010).  Generally, the NAV of a hedge fund is its assets less its liabilities divided by the number of shares or units outstanding.  For example, if a hedge fund has $100 million in assets, $10 million in liabilities and one million shares outstanding, its NAV is $90.  NAV is used, among other things, to measure performance, calculate fees, determine the number of shares an investor will get for a certain amount of cash upon subscription or determine the amount of cash an investor will get for a certain number of shares upon redemption.  The new method – known as 3WayNAV – reflects a recognition that many of the assets held by hedge funds do not have a single value.  Rather, such assets, in particular the less liquid ones, have a range of potential values, including what a buyer would pay for the assets today (the bid price), what the fund would be willing to sell the assets for today (the ask or offer price) and the average of the bid and ask prices (the mid or average price).  See “How Can Hedge Fund of Funds Managers Manage a ‘Liquidity Mismatch’ Between Their Funds and Underlying Hedge Funds?,” Hedge Fund Law Report, Vol. 2, No. 40 (Oct. 7, 2009).  Under the 3WayNAV approach, the party that calculates the hedge fund’s NAV (usually the fund administrator or manager) measures NAV based on the bid, ask and average (or bid, offer and mid) prices of assets in the hedge fund’s portfolio.  Such a calculation offers investors significantly more insight into the current realizable value of a hedge fund portfolio than traditional approaches to calculating NAV.  In short, it enables investors to “discount” NAV by standardized measures of liquidity.  (Of course, if the fund does not offer investors actual liquidity, e.g., redemption rights, corresponding to their information rights, query what real purpose would be served for current investors by offering greater insight into portfolio liquidity.)  This article explores the new concept of 3WayNAV, detailing: how NAV traditionally has been defined and used; how NAV has been calculated in the context of illiquid assets; the definition of 3WayNAV, and how it differs from traditional NAV; disclosures required or recommended for funds that employ 3WayNAV; real-world examples of funds using 3WayNAV; types of funds that can use 3WayNAV; benefits of 3WayNAV; and burdens of 3WayNAV. Read full article …

On December 29, 2009, the Minnesota Court of Appeals affirmed that a hedge fund manager’s claim for overdue, unpaid bonuses was not barred by the statute of limitations because: (1) the owing party orally acknowledged, and thus extended, the due date for the bonuses; and (2) the owing party was equitably estopped from asserting this defense because the manager reasonably relied on those representations when he spent large sums to build a house.  However, the appellate court reversed a $126,352 award of fees and costs to the hedge fund manager, finding that the lower court abused its discretion in awarding those fees and costs.  This article offers extensive detail on the factual background of the case and the court’s legal analysis. Read full article …

On December 23, 2009, the United States District Court for the Southern District of New York refused to dismiss a derivative securities fraud putative class action against defendant Ambac Financial Group Inc. (Tolin v. Ambac Financial Group Inc., 08 Civ. 11241 (S.D.N.Y., filed Dec. 24, 2008)).  In so doing, the court answered a question of first impression: whether investors in mortgage-related derivatives had standing to pursue their claims where they had not purchased these securities directly from the issuer-defendant.  The court ruled that the holding in Ontario Pub. Serv. Employees Union Pension Trust Fund v. Nortel Networks Corp., 369 F.3d 27 (2d Cir. 2004), which stated that a shareholder has to purchase or sell the securities of the defendant company to have standing under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, did not prevent purchasers of a derivative securities products from bringing a Rule 10(b)(5) fraud action against an issuer of securities where an intermediary issuer had bundled those securities to create the derivative.  We detail the allegations in the complaint and the court’s legal analysis. Read full article …

A new Massachusetts state law establishes rigorous standards applicable to companies, including hedge fund managers, regarding safeguarding personal information of residents of the Commonwealth of Massachusetts.  In a guest article, Jayesh Punater, President & CEO of Gravitas Technology, a technology service provider to the alternative investment industry, suggests specific steps that affected hedge fund managers can take to comply with the new law. Read full article …

In a move that further evidences the growing importance of regulation in the hedge fund business, as well as the increasing clout of bona fide (and not merely rubber stamp) directors, Winton Capital Management has appointed two high-profile financial figures as directors of the Winton Futures Fund. Read full article …

Attorneys, compliance officers and regulatory professionals whose practice is or has been impacted by actions taken by institutional investors, such as funds of funds, pension plans, endowments, insurance companies, family offices and high net worth investors, may be interested in attending PLI’s Institutional Investor Forum 2010.  This full-day program is scheduled to take place live in PLI’s New York City Conference Center, via Live Webcast at www.pli.edu and via Groupcasts in Philadelphia and Pittsburgh on January 27, 2010. Read full article …

The Activist Investor Conference 2010 will take place at the Westin Times Square in New York from January 21-22, 2010.  Shareholder activism has intensified due to highly publicized corporate failures and controversy over executive compensation in light of poor corporate performance.  Newly proposed rules to facilitate shareholder participation in board decisions will ensure that the trend continues. Read full article …

Harneys has announced that Sarah Dobbyn and Jonathan Law have been made partners in its Cayman Islands office, effective January 1, 2010.  Dobbyn is head of the firm’s litigation and insolvency practice in the Cayman Islands and is a member of the firm’s distressed funds group.  Law is part of the firm’s growing Cayman Islands-based investment funds group. Read full article …