Placement agents, in-house marketers, data providers and others interviewed by the Hedge Fund Law Report have identified two salient trends in the current hedge fund capital raising environment: the “race to the top” and the growing importance of ERISA money.  As discussed below, both trends highlight the importance to the hedge fund industry of a provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank or the Act), enacted on July 21, 2010, relating to swaps with “special entities.”  On the first trend: The race to the top refers to the fact – good for larger managers, not so good for smaller and start-up managers – that the lion’s share of recent inflows have gone to the largest hedge funds.  According to data provider Hedge Fund Research, Inc., 93 percent of the $9.5 billion of net inflows into hedge funds in the second quarter of 2010 went to funds managed by managers with more than $5 billion in assets under management (AUM).  And that capital raising advantage is only enhancing the current distribution of assets in favor of larger managers.  According to HFR, as of June 30, 2010, managers with $5 billion or more in AUM managed approximately 60 percent of total industry assets of $1.6 trillion.  Moreover, HFR data as of June 30 showed that while 342 hedge funds with $1 billion or more in AUM comprised just 4.9 percent of the total number of hedge funds globally, they accounted for 76.1 percent of total industry AUM.  While a full analysis of the reasons for this race to the top is beyond the scope of this article, a few of the reasons are discussed herein.  However, investors racing to the top may miss many of the more interesting hedge fund investment opportunities.  According to research published by PerTrac Financial Solutions in February 2007 and updated to incorporate 2009 data, smaller, younger hedge funds appear to perform better, over longer periods, than larger, older funds.  And on the second trend: the Hedge Fund Law Report has and continues to analyze the growing importance of ERISA investors in hedge funds.  See, for example, the Hedge Fund Law Report’s three-part series on ERISA considerations for hedge fund managers and investors.  The story here is essentially as follows: private sector pension funds are the most important category of ERISA investor.  According to data provider Preqin, as of late 2009, private sector pension funds represented 14 percent of institutional investors in hedge funds and constituted the largest group of investors actively considering their first investment in hedge funds in 2010.  Moreover, survey data released by Preqin on August 10, 2010 indicates that 29 percent of institutional investors plan to allocate more capital to hedge funds in the next 12 months while just 15 percent are looking to redeem, meaning the balance of inflows into hedge funds over the next year is expected to be positive.  Preqin also found that 37 percent of institutional investors are planning to invest in new hedge funds in the next 12 months.  Many of those new investments, often with new managers, will come from private sector pension funds and other ERISA investors.  Accordingly, more hedge fund managers (by number and AUM) will become subject to ERISA in the near term.  In anticipation of that trend, we have provided managers with a roadmap for accepting ERISA money without materially undermining their investment and operational discretion.  See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part Three of Three),” Hedge Fund Law Report, Vol. 3, No. 24 (Jun. 18, 2010).  In light of the importance of the race to the top and ERISA money to hedge fund capital raising, any legal provision that directly impacts larger hedge funds and hedge funds subject to ERISA (Plan Asset Hedge Funds) is of central importance to the industry.  Dodd-Frank contains precisely such a provision.  Specifically, Dodd-Frank will require a “swap dealer” or “major swap participant” that enters into a swap with a “special entity” to: (1) have a reasonable basis to believe that the special entity has an independent representative that, among other things, has sufficient knowledge to evaluate the transaction and risks; and (2) comply with certain business conduct standards.  As explained more fully below, the definition of “major swap participant” in Dodd-Frank may include large hedge funds, and the definition of “special entity” in Dodd-Frank may include Plan Asset Hedge Funds.  See “Hedge Fund Industry Practice for Defining ‘Class of Equity Interests’ for Purposes of the 25 Percent Test under ERISA,” Hedge Fund Law Report, Vol. 3, No. 29 (Jul. 23, 2010).  To help explain the application of this “swaps and special entities” provision of Dodd-Frank to hedge fund managers, swap dealers and others, this article: defines the relevant terms, including a discussion of the extent to which those definitions may include hedge funds and hedge fund managers; offers examples of applications of the special entities provision in the hedge fund context; explains the mechanics of the “reasonable basis test” included in the statute; describes the business conduct standards; then analyzes the elements of the statutory reasonable basis test, including a potential “de facto best execution” standard included in the test. Read full article …

In 2009, the Securities and Exchange Commission (SEC) commenced a criminal enforcement action against Anthony Vassallo, Kenneth Kenitzer and their purported hedge fund, Equity Investment Management and Trading, Inc. (EIMT), claiming that the defendants had been running a $40 million Ponzi scheme.  A receiver was appointed to marshal EIMT’s assets.  In one branch of the receivership proceedings, the receiver sought disgorgement of a $2 million transfer from Veritas Investments, LLC (Veritas), a sub-fund of EIMT, to “parties in interest” Michael Callahan (Callahan) and Matthew Tucker (Tucker).  Callahan and Tucker had received, respectively, $125,000 and $1.875 million from Veritas in connection with a proposed collateralized mortgage obligation (CMO) deal.  Tucker and Callahan purportedly offered to arrange for Veritas to purchase Greenwich Capital CMOs for $2 million and re-sell those CMOs on the same day for $7 million.  Although Veritas wired the $2 million to Tucker and Callahan, and Tucker did acquire Greenwich Capital CMOs, the trade was never completed and Tucker eventually sold the CMOs at a huge loss.  The receiver sought an order forcing Tucker and Callahan to disgorge the $2 million received from Veritas.  Tucker did not oppose the motion, but Callahan did, claiming that he should only be responsible for the $125,000 he actually received.  The Magistrate Judge determined that Callahan knew or should have known that the CMO deal was a fraud and, consequently, was jointly and severally liable with Tucker to disgorge the full $2 million.  We outline the background facts and the court’s reasoning. Read full article …

The Massachusetts Supreme Judicial Court’s recent decision in the case Bulldog Investors General Partnership, et al. v. Secretary of the Commonwealth has significant implications for hedge fund managers and the scope of authority of the Massachusetts Securities Division of the Secretary of the Commonwealth.  In Bulldog, the SJC found that: (1) Bulldog Investors General Partnership, a hedge fund manager, and its principals violated Massachusetts securities laws by offering unregistered securities to a Massachusetts resident via a single e-mail after he registered with Bulldog’s publicly accessible website; and (2) the Securities Division could exercise personal jurisdiction over non-residents Bulldog and its principals in administrative enforcement proceedings.  See “Massachusetts High Court Rules that Website and Single E-Mail Communication to Massachusetts Resident Confer Personal Jurisdiction Over Philip Goldstein’s Hedge Fund Company in Administrative Proceeding,” Hedge Fund Law Report, Vol. 3, No. 28 (Jul. 15, 2010).  In a guest article, Michele Adelman and Catherine Karuga, Counsel and Associate, respectively, at Foley Hoag LLP, explain the factual background of the case and the court’s legal analysis, and offer several take-aways for hedge fund managers. Read full article …

On June 30, 2010, Michael Pasternak filed suit in the U.S. District Court for the Southern District of New York against his former employer Dow Kim, founder of failed hedge fund start-up Diamond Lake Investment Group.  Pasternak accuses Kim of fraud in the inducement and negligent misrepresentation because Kim allegedly provided false information to Pasternak regarding capital commitments to the fund in order to induce Pasternak to join – commitments which never materialized due in part to the ensuing global economic crisis.  Pasternak now seeks damages of over $6 million to reflect the opportunity cost of a simultaneous job offer he declined to pursue.  His complaint provides an insider’s look at the launch of a hedge fund on the eve of the crisis.  We summarize the details of the complaint and the relief sought. Read full article …

On August 4, 2010, Pardus Capital Management, L.P., a New York-based alternative investment manager, announced that industry veteran Ali Mostafavee joined the firm as Head of Portfolio Risk and a member of the firm’s Investment Committee. Read full article …

On August 4, 2010, Okapi Partners LLC, the proxy solicitation firm, announced the addition of Geoff Sorbello as a Managing Director.  Sorbello joins Okapi Partners from ISS, a division of RiskMetrics Group (now a subsidiary of MSCI Inc.).  For more of Okapi’s research and analysis, see “How Will Changes to Proxy Access and Broker Voting Rules Impact Activist Hedge Fund Investors?,” Hedge Fund Law Report, Vol. 2, No. 30 (Jul. 29, 2009). Read full article …