Jul. 30, 2010

Connecticut Welcomes You!  Federal Financial Regulatory Reform Restores Connecticut’s Authority over Hedge Fund Advisers

The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203) (the "Dodd-Frank Act") changes the federal framework for regulating investment advisers by amending provisions of the Investment Advisers Act of 1940, as amended (the "Advisers Act") regarding state and federal responsibilities and SEC investment adviser registration requirements.  These changes not only impact the scope of the federal regulation of investment advisers by the Securities and Exchange Commission ("SEC"), but also restore, in part, Connecticut's regulatory authority and enforcement responsibilities with respect to investment advisers previously preempted by the National Securities Markets Improvement Act of 1996 ("NSMIA").  More than 4,000 investment advisers are expected to land within the purview of state securities regulators when the Dodd-Frank Act amendments to the Advisers Act become effective on July 21, 2011.  The Securities Division of the Connecticut Department of Banking (the "Securities Division") is well-known in the securities industry for its aggressive approach to securities enforcement.  With a newly appointed U.S. Attorney whose first announcement was that he is creating a securities fraud task force focused on the financial services industry, it is clear that the stakes are going up significantly for private fund managers and other investment advisers with offices in Connecticut – as well as those out of state fund managers and other investment advisers with Connecticut clients.  Those advisers who have been able to escape the reach of the Securities Division, because they are either registered with the SEC or relying on a soon-to-be-lost exemption from SEC registration, must consider the application of Connecticut law to their advisory businesses.  Significantly, Connecticut, unlike most states, requires registration of investment advisers who have a place of business in Connecticut regardless of the number of Connecticut clients, as well as out-of-state investment advisers with more than five clients who are Connecticut residents.  For those investment advisers who would not otherwise land within the reach of the Securities Division, Connecticut Governor Jodi Rell is rolling out the red carpet in the hope of making Connecticut the haven for New York investment advisers looking to escape the proposed increase to the New York state non-resident income tax proposed by New York Governor David Patterson.  With so many variables now at play as a result of the passage of the Dodd-Frank Act, Genna N. Garver, an Associate at Bracewell & Giuliani LLP, and John A. Brunjes and Cheri L. Hoff, both Partners at Bracewell & Giuliani LLP, take this opportunity to survey, in a guest article, the changing federal framework and the interplay of these requirements with the current Connecticut investment adviser regulatory scheme.

How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures and Marketing Practices in Light of the SEC’s New “Pay to Play” Rule?

On July 1, 2010, the SEC adopted Rule 206(4)-5 (Rule) under the Investment Advisers Act of 1940 (Advisers Act).  See “SEC Adopts Pay to Play Rules for Investment Advisers; Total Placement Agency Ban Avoided,” Hedge Fund Law Report, Vol. 3, No. 28 (Jul. 15, 2010).  The Rule generally seeks to curtail pay to play practices in the selection by state investment funds, most notably public pension funds, of hedge fund managers and other investment advisers.  Broadly, the Rule does this in three ways: (1) by limiting donations by principals of investment advisers and others with an economic stake in winning public fund business to election campaigns of public officials who may directly or indirectly influence the selection of the adviser to manage a public fund; (2) by prohibiting payments by investment advisers to any person for soliciting government entities for advisory services unless that person is (a) a registered investment adviser subject to the Rule or a registered broker dealer subject to a similar rule to be promulgated by FINRA, or (b) a principal or employee of the adviser; and (3) by revising Advisers Act Rule 204-2 (the recordkeeping rule) to require investment advisers with government clients, or advisers to hedge funds with government entity investors, to maintain records regarding political contributions by the adviser and its covered associates.  According to private fund data provider Preqin, public pension funds represent approximately 17 percent of all institutional hedge fund investors, with an average allocation of six percent of total assets to hedge funds.  The Rule governs the process by which hedge fund managers seek advisory business from this important constituency.  Accordingly, the Rule is of fundamental importance to a wide range of hedge fund managers, for whom the Rule creates a range of new compliance and marketing challenges.  The purpose of this article is to identify and provide guidance with respect to many of those new challenges.  In particular, the descriptive section of this article provides an overview of the mechanics of the Rule.  The analytic section of this article addresses areas in which hedge fund managers should revisit their policies and procedures in light of the Rule, including policies and procedures relating to: political contributions; monitoring contributions; preclearance of contributions; due diligence on placement agents; compliance training with respect to contributions; prescreening of new employees; acquisitions of hedge fund management firms; state, local and fund-specific rules relating to pay to play arrangements; sub-advisers and funds of funds; and mandatory redemptions.  The analytic section also includes a discussion of the implications of the Rule for lobbying by hedge fund managers.  See “Hedge Funds Increasing Lobbying Efforts, Focusing On Shaping Regulations Rather Than Preventing Them,” Hedge Fund Law Report, Vol. 2, No. 28 (Jul. 16, 2009).  The article concludes with a note on potential constitutional challenges to the Rule.  One of the more important points made by this article is that while the Rule has garnered significant attention, it is just part of a patchwork of federal, state, local and fund-specific rules governing the process by which hedge fund managers solicit investment advisory business from government entities.

In Petition to Vacate FINRA Arbitration Award, Goldman Seeks to Define the Scope of a Prime Broker’s Duty (If Any) to Investors in a Hedge Fund that is a Customer of the Prime Broker

On July 23, 2010, Goldman Sachs petitioned the U.S. District Court for the Southern District of New York to vacate the June 24, 2010, Financial Industry Regulatory Authority (FINRA) arbitration award ordering it to pay $20.58 million to the bankruptcy estate of Bayou Group, LLC.  The Official Unsecured Creditors’ Committee of the estate (Committee) had filed a claim in arbitration against Goldman Sachs Execution & Clearing, L.P. (Goldman), claiming that, in its role as prime broker and clearing broker to the Bayou funds, Goldman failed to investigate the Ponzi scheme committed by the funds’ principals in the face of numerous red flags, and accepted fraudulent transfers and conveyances.  In its answer, Goldman argued that, as a matter of law, it could not be held accountable for the $20.58 million that the Bayou funds deposited in their own trading accounts and transferred among those accounts, because the Bayou funds never actually conveyed the money to Goldman as required for a fraudulent transfer, and because, as a clearing firm and prime broker, Goldman had no legal duty to monitor the suitability of transactions by or the finances of its account holders.  In its petition to vacate the award, Goldman stated that “the arbitration panel manifestly disregarded the law and exceeded its authority” for similar reasons.  We detail the background of the action, the claims for relief in the arbitration, and Goldman’s petition to vacate the award.  The case is of central importance in defining the scope of a prime broker’s duty to investors in a hedge fund that is a customer of the prime broker, in cases where the prime broker knows, should know or with reasonable diligence can discover information that may suggest fraud or other bad acts on the part of the manager of the customer hedge fund.  See, by way of background, “Bayou Creditors Sue Goldman Prime Brokerage Unit to Avoid Allegedly Fraudulent Transfers,” Hedge Fund Law Report, Vol. 1, No. 13 (May 30, 2008).

Heidrick & Struggles Report Details Compensation Numbers and Employment Contract Terms for Hedge Fund Marketing Professionals, Risk Managers and CCOs, and Outlines Industry Trends

On July 27, 2010, Heidrick & Struggles International, Inc. (Heidrick), a leadership advisory firm providing global executive search and leadership consulting services, released its Report on Hedge Fund Industry Trends for 2010.  “The hedge fund industry is turning on its head – with regulatory and distribution pattern changes having a big impact on talent in the sector,” said Daniel Edwards, co-author of the Report and newly appointed U.S. Hedge Fund Sector Leader for the firm.  (For this and other recent personnel changes at Heidrick, see the People Moves section of this issue of the Hedge Fund Law Report.)  The Report makes general market observations regarding the U.S., European and Asian hedge fund markers; outlines talent trends; reviews hedge fund manager employee contract terms and compensation numbers; and includes sections on launches and liquidations as well as the regulatory outlook.  This article reviews the key take-aways from the Heidrick Report.