Jul. 23, 2010

Can Hedge Fund Managers Use Whistleblower Hotlines to Help Create and Demonstrate a Culture of Compliance?

The January 2009 Report of the Asset Managers’ Committee to the President’s Working Group on Financial Markets remains one of the most eloquent and credible statements of best practices in the hedge fund industry.  That Report emphasized the importance of a culture of compliance to the success of any hedge fund management business.  It stated: “Critical to the success of [a hedge fund manager’s] compliance and business practices framework is a culture of compliance, grounded in the commitment and active involvement of the most senior leaders of the firm and fostered throughout the organization.  Particularly important to creating a culture of compliance are the following: (a) [e]ncouragement by senior management to personnel to raise any concerns or questions (facilitated by an environment that is free from fear of retribution); (b) [a]bility to communicate concerns to senior management; [and (c) s]enior management should consult regularly and encourage employees to consult regularly with the Chief Compliance Officer and his or her delegates whenever issues arise that could raise compliance issues.”  See “President’s Working Group Releases Final Best Practices Reports for Hedge Fund Managers and Investors,” Hedge Fund Law Report, Vol. 2, No. 5 (Feb. 4, 2009).  With growing frequency, hedge fund managers are implementing whistleblower hotlines to help create and demonstrate a culture of compliance.  Whistleblower hotlines are telephone numbers (and similar communication channels) that an employee or even a principal of a hedge fund manager or service provider can call to anonymously report violations of law or internal policy by another employee or principal of the hedge fund manager.  Such hotlines can help effectuate the goals identified by the Asset Managers’ Committee: encouraging voicing of concerns; minimizing fear of retribution; facilitating communication with senior management; and encouraging consultation with the CCO and his or her delegates.  While public companies are required under the Sarbanes-Oxley Act of 2002 to have whistleblower hotlines, hedge fund managers are not legally required to have such hotlines and they traditionally have not.  Nonetheless, a growing number of managers are looking to such hotlines as part of a coordinated response to a heightened enforcement environment.  See, e.g., “The SEC’s New Focus on Insider Trading by Hedge Funds,” Hedge Fund Law Report, Vol. 3, No. 22 (Jun. 3, 2010); “Regulatory Compliance Association Hosts Program on Increased Risk for Hedge Fund Directors and Officers in the New Era of Heightened Regulation and Enforcement,” Hedge Fund Law Report, Vol. 2, No. 50 (Dec. 17, 2009).  To assist hedge fund managers in evaluating the appropriateness of a whistleblower hotline to their businesses, this article details: the general goals and purposes of whistleblower hotlines; how such hotlines work in the public company context; the use by private equity fund advisers of such hotlines at their portfolio companies; the mechanics of whistleblower hotlines in the hedge fund context (including who reports, to whom, what is reported, and what actions should be taken in response to reports); advantages and disadvantages to hedge fund managers of implementing hotlines; attorney-client privilege issues as applied to hedge fund managers generally; and attorney-client privilege issues raised by hedge fund manager whistleblower hotlines specifically.  Also, this article includes a discussion of the potentially perverse incentives created by Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  A fuller discussion is below, but in brief, that section creates a system of financial incentives and protections for whistleblowers who disclose “original information” about securities or commodities law violations that leads to successful SEC or CFTC enforcement actions.  Therefore, Section 922 may give employees of hedge fund managers (and others) a financial incentive not to report misconduct through a hotline established by the manager so as to preserve the originality of the information and the potential for a financial bounty if that information is reported to and used by an agency in a successful enforcement action.

Hedge Fund Industry Practice for Defining “Class of Equity Interests” for Purposes of the 25 Percent Test under ERISA

The Hedge Fund Law Report recently published a three-part series on ERISA considerations for hedge fund managers and investors.  The first part of that series explained how hedge funds and their managers can become subject to ERISA; the second part of the series detailed consequences to hedge funds and their managers of becoming subject to ERISA; and the third part provided a roadmap to the prohibited transaction exemptions that enable hedge fund managers to both accept significant ERISA investors in their funds, and operate and invest without many of the constraints imposed by ERISA.  The first article in the series noted that the general rule under ERISA is that when a “benefit plan investor” acquires an equity interest in an entity, other than a public operating company or a registered investment company, all the assets of that entity are deemed to be “plan assets” subject to ERISA, unless an exception applies.  ERISA generally provides three exceptions, one of which – the 25 percent test – is typically relied on by hedge funds.  Under the 25 percent test, if benefit plan investors own less than 25 percent of any class of equity interests issued by a hedge fund, that hedge fund and its manager will not be subject to ERISA.  Accordingly, a threshold question to be addressed by any hedge fund manager that currently has ERISA investors in its funds or is considering accepting investments from ERISA investors is: What constitutes a “class of equity interests” for ERISA purposes?  ERISA does not define the phrase, and the Department of Labor has only defined an “equity interest” as an interest other than debt.  Therefore, like many questions under ERISA, the working definition of class of equity interests is a function of market practice.  The first article in our ERISA series included a survey of market practice on this point as part of a broader discussion.  But in light of the importance of the definition to any ERISA analysis, and in light of the importance of ERISA analysis to hedge fund capital-raising, this article drills down even further on market practice in this area.  Specifically, this article first examines the approaches, concerns and frameworks used by practitioners to define a class of equity interests.  We describe the “conservative” and “broad” views, and identify specific factors relied on by practitioners.  The article then examines whether certain nonintuitive arrangements may constitute a class of equity interests for ERISA purposes, including side letters, side pockets, managed accounts, single investor hedge funds (or “funds of one”), investments (directly or via IRAs) by manager principals and employees and seeding arrangements.  See “Single Investor Hedge Funds Offer the Benefits of Managed Accounts and Additional Tax and Other Advantages for Hedge Fund Managers and Investors,” Hedge Fund Law Report, Vol. 3, No. 16 (Apr. 23, 2010).

Sixth Circuit Rules that a Hedge Fund Adviser Can Owe a Fiduciary Duty Not Only to the Fund, But Also to Fund Investors

On July 14, 2010, the United States Court of Appeals for the Sixth Circuit upheld a conviction against Mark D. Lay for investment adviser fraud, mail and wire fraud, and for engaging in deceptive and manipulative practices relating to the Ohio Bureau of Workers’ Compensation (OBWC), which was an investor in a hedge fund he managed.  The government accused Lay of ignoring a leverage cap in the OBWC advisory agreement, of failing to disclose how he exceeded that cap to OBWC, and of causing OBWC to lose $212 million as a result.  For his part, Lay argued in the district court and on appeal that in his role as hedge fund adviser, he had a fiduciary duty to the hedge fund, but not to the OBWC, thereby rendering certain jury instructions at his trial improper, and invalidating his conviction on the grounds of insufficient evidence.  On May 13, 2008, the United States District Court for the Northern District of Ohio rejected his motion for judgment of acquittal.  The Court of Appeals affirmed that decision, holding that “Because a hedge fund adviser can, in some circumstances, have a fiduciary relationship with an investor, the jury instructions were correct and sufficient evidence supports Lay’s conviction” for investment adviser fraud.  Concurring in that judgment, one judge dissented in part on the grounds that the government had failed, as a factual matter, to prove mail and wire fraud.  This article summarizes the background of the action, the Court’s legal analysis, and the implications for the scope of a hedge fund manager’s fiduciary duties.

David W. Blass Named SEC Associate General Counsel for Legal Policy

On July 21, 2010, The Securities and Exchange Commission announced that David W. Blass has been named an Associate General Counsel for Legal Policy in the agency’s Office of the General Counsel.  Blass, who has prior experience both at the SEC and in private practice, will provide legal and policy advice to the Commission on a wide range of matters, with particular emphasis on investment management, trading and markets and international matters.