Sep. 10, 2010

What Is the “Market” for Fees and Other Key Terms in Agreements between Hedge Fund Managers and Placement Agents?

Historically, hedge fund managers have retained placement agents and other third-party intermediaries to identify investors, obtain investments and for related purposes.  Hedge fund managers’ use of placement agents is likely to continue and even increase for two simple reasons: because such use is permitted, and because it can add value.  On the first point, the fact that hedge fund managers can use placement agents is only news because between August 2009 and June 2010, the continued viability of that use was in doubt.  In short, in August 2009, the SEC proposed a pay to play rule that would have prohibited hedge fund managers from using placement agents (or “third-party solicitors,” “solicitors,” “finders” or “pension consultants”) to obtain investments from public pension funds.  Given the importance of public pension funds in the hedge fund investor base – according to Preqin, public pension funds comprise approximately 17 percent of all institutional hedge fund investors – many in the hedge fund industry thought that the proposed ban marked the beginning of the end of the use by hedge fund managers of placement agents.  See, e.g., “The Four P’s of Marketing by Hedge Fund Managers to Pension Fund Managers in the Post-Placement Agent Era: Philosophy, Process, People and Performance,” Hedge Fund Law Report, Vol. 2, No. 45 (Nov. 11, 2009).  However, the final pay to play rule, adopted by the SEC on June 30, 2010, did not prohibit hedge fund managers from using placement agents to solicit investments from public pension funds, but rather permitted such use so long as the relevant placement agent is a registered investment adviser or registered broker-dealer.  See “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?,” Hedge Fund Law Report, Vol. 3, No. 30 (Jul. 30, 2010).  Along similar lines, on September 2, 2010, the SEC adopted a temporary rule (Rule 15Ba2-6T under the Securities Exchange Act of 1934) requiring municipal advisors to register with the SEC by October 1, 2010 (i.e., within three weeks).  This rule does not prohibit the use by hedge fund managers of “finders,” “solicitors” or other previously unregistered entities to obtain investments from public pension funds, but it may require such entities to register with the SEC.  See “Third-Party Marketers that Solicit Public Pension Fund Investments on Behalf of Hedge Funds May Have to Register with the SEC within Three Weeks,” below, in this issue of Hedge Fund Law Report.  In short, while the legal and regulatory environment for placement agents has become more complex, their activities are, in general, still legally permitted.  And on the second point – the idea that placement agents can add value – there are two categories of rationales for this idea: micro rationales and macro rationales.  The micro rationales – the specific categories of services that placement agents are well-positioned to provide to hedge fund managers – are detailed below.  As for the macro rationales, four trends suggest that placement agents will play an increasingly important role in the allocation of capital to hedge funds.  First, a disproportionate volume of recent inflows have gone to larger managers.  Second, according to Preqin, 29 percent of institutional investors plan to invest more capital in hedge funds over the next 12 months than they did during the previous 12 months, and 46 percent of investors plan to increase their hedge fund allocations in the next three to five years.  Third, according to Preqin, 37 percent of institutional investors plan to direct any hedge fund allocations in the short to medium term to a mixture of new and existing managers, and 23 percent of institutional investors plan to invest in new managers only (that is, new to the investor, though not necessarily new to the market, i.e., not necessarily startup managers).  Fourth, according to Preqin, “firm reputation” is tied with “track record” as the second most important factor for institutional investors when making hedge fund allocations.  The point: capital is likely to flow into hedge funds over the next five years, but if you are anything other than a large, established manager, the competition for capital is likely to remain fierce.  And importantly in an industry where performance is easily measured, readily comparable and frequently updated, even “large, established managers” can stumble in terms of size and stature, and find themselves pounding the proverbial fundraising pavement once again.  In light of the anticipated importance of placement agents in steering capital into hedge funds over the next (at least) five years, this article seeks to shed light on a relatively obscure topic: the “market” for fees and other terms in agreements between hedge fund managers and placement agents.  Specifically, this article first identifies seven distinct reasons why a manager may hire a placement agent, then details the most important terms of, and issues in connection with, placement agent agreements, including the following: fee structures and levels; declining fees; duration of engagements and sunset provisions; carve-outs for the manager’s pre-existing relationships; exclusivity; licensing, registration and representations with respect to both; indemnification; insurance; and the pay to play overlay.

Hedge Fund Manager Elliott Management Withdraws Petition Seeking Discovery from Absolute Return + Alpha Regarding Identity of Source of Leaked Investor Letter

On August 31, 2010, hedge fund manager Elliott Management Corporation, along with its managed hedge funds Elliott Associates, L.P. and Elliott International, L.P. (collectively, Elliott), withdrew their petition seeking pre-litigation discovery from hedge fund industry publication Absolute Return + Alpha (Publisher).  Elliott had sought discovery regarding, among other things, the identity of a source that provided Elliott’s June 30, 2010 investor letter to the Publisher.  That copyrighted investor letter contained confidential information regarding Elliott’s investments, trading positions and performance, and Elliott argued in court papers that public disclosure of the information would undermine its negotiations with trading counterparties.  Accordingly, when the Publisher told Elliott that it was going to publish the letter, Elliott sought an emergency order permitting it to take a deposition of the Publisher and conduct other pre-action discovery to find the source of the disclosure.  In an unfiled affidavit, the Publisher argued, among other things, that the New York Reporter’s Shield Law provided it with an absolute privilege to report information obtained from a confidential source without revealing the identity of the source, even if the information was copyrighted and confidential. Although Elliott withdrew its petition before the court had an opportunity to issue a substantive opinion, the petition itself is noteworthy for various reasons.  First, it details five measures taken by a sophisticated hedge fund manager to protect the confidentiality of position and performance information in an investor letter.  (Those five measures are detailed in this article.)  Second, it illustrates the challenge faced by a manager in the event of an unauthorized disclosure of an investor letter.  Had the matter proceeded and had Elliott obtained the identity of the source, Elliott presumably would have faced the unpalatable option of suing one of its own investors for damages arising out of this disclosure (though any such damages would be hard to quantify) or an injunction against further disclosures of information in the June 30 letter or future letters.  Alternatively, or in addition, Elliott might have brought an action against the Publisher, though in the absence of a confidentiality agreement or any other relevant contract between Elliott and the Publisher, the basis of any such claim is not immediately apparent.  This article details the thorough and rigorous process that Elliott used to ensure the confidentiality of its investor letters, and the legal steps it undertook to maintain that confidentiality when, despite those efforts, the content of one of those letters leaked.

The Hedge Fund Industry: The Year in Review and What to Expect in 2011

Please join Mesirow Financial Consulting, LLC, Rothstein Kass and Tannenbaum Helpern Syracuse & Hirschtritt, LLP for a Q&A session moderated by Mike Pereira, Publisher of the Hedge Fund Law Report.  Presenters: Stephen B. Darr, Senior Managing Director, Mesirow Financial Consulting and Mesirow Financial Consulting Capital; Howard Altman, Co-CEO and Co-Managing Principal of Rothstein Kass and Principal-in-Charge of the Financial Services Group; Ricardo W. Davidovich, Partner, Tannenbaum Helpern Syracuse & Hirschtritt LLP – Financial Services, Private Funds and Capital Markets.  Discussion Topics: US Regulation/Dodd-Frank, EU Directive, Best Practices/Internal Controls, Valuation, Litigation, Liquidation, New Products, Opportunities, Risks; Date, Time and Location: Thursday, September 30, 2010; 4:30 p.m. – 6:00 p.m. – Program and Q&A Session; 6:00 p.m. – 7:00 p.m. – Cocktail Reception; The Yale Club of New York City, 50 Vanderbilt Avenue, New York, NY 10017.

Third-Party Marketers that Solicit Public Pension Fund Investments on Behalf of Hedge Funds May Have to Register with the SEC within Three Weeks

While prudence has for some time dictated that hedge fund managers only use registered broker-dealers to solicit investments from public pension funds, the law has not entirely kept pace with prudence.  That is, the term “broker” is defined in Section 3(a)(4) of the Securities Exchange Act of 1934 (Exchange Act) to mean a “person engaged in the business of effecting transactions in securities for the account of others.”  In a series of no-action letters, the SEC has adopted a broad understanding of the term “broker.”  Generally, absent an exemption, any entity that receives commissions or other transaction-based compensation in connection with securities-based activities is required, in the SEC’s view, to register as a broker-dealer.  However, the SEC has recognized a narrow exception to the broker-dealer registration requirement for so-called “finders” (although it is the activities of such entities, rather than their name, that determines the presence or absence of a registration obligation).  Generally, finders are entities that are compensated via a flat or hourly fee for bringing parties together for a potential securities transaction, but that do not receive commissions or other transaction-based compensation for such match-making.  Many of the intermediaries embroiled in the 2009 pay to play scandals styled themselves “finders” or “solicitors” whose activities did not require registration as a broker-dealer.  See “What Do the Regulatory and Industry Responses to the New York Pension Fund ‘Pay to Play’ Scandal Mean for the Future of Hedge Fund Marketing?,” Hedge Fund Law Report, Vol. 2, No. 30 (Jul. 29, 2009).  In part in response to those scandals – or more specifically, to the unregistered status of many of the participants in those scandals – the Dodd-Frank Wall Street Reform and Consumer Protection Act amended Section 15B of the Securities Exchange Act of 1934 to require registration with the SEC by “municipal advisors.”  On September 2, 2010, the SEC adopted temporary Rule 15Ba2-6T under the Exchange Act, which will require registration with the SEC by municipal advisors on Form MA-T by October 1, 2010 (i.e., within three weeks).  Notably, Dodd-Frank explicitly exempts from the municipal advisor registration requirement registered broker-dealers, registered investment advisers and Commodity Trading Advisers registered with the CFTC.

New York State Supreme Court Rules that Liquidating Trustee of Defunct Hedge Fund Lipper Convertibles, L.P. has Right to Claw Back Withdrawals Made to Sylvester Stallone and Other Investors Who Withdrew Their Interests in the Fund at a Time When the Fund’s Assets Were Grossly Overvalued Due to Fraud

Defendants Sylvester Stallone and other individuals and institutional investors invested in Lipper Convertibles, L.P. (Fund), a hedge fund formed by Lipper & Company, L.P.  From January 2001 through January 2002 the defendants withdrew as limited partners from the Fund and received payouts based on the net asset value of the Fund as of the time of their respective withdrawals, as calculated by the Fund’s general partner.  In March 2002, an internal review by the Fund revealed that the Fund’s assets had been dramatically overstated due to the fraudulent actions of its portfolio manager and the apparent neglect or complicity of the Fund’s auditor.  The Fund’s assets were then written down to about 53 percent of their prior values.  The write-downs prompted the Fund’s collapse and its subsequent Court-monitored liquidation.  The Court eventually appointed Richard A. Williamson (Williamson) to act as the Fund’s liquidating trustee in place of the Fund’s general partner.  Among the many lawsuits spawned by the Fund’s collapse were those by Williamson against about sixty Fund investors who had withdrawn prior to the Fund’s collapse and who had received distributions based on the Fund’s fraudulently inflated net asset values.  Williamson sought to claw back distributions made to those investors on the theory that the withdrawing investors had been unjustly enriched at the expense of other innocent investors who had not withdrawn from the Fund.  The eight investors in this action countered by alleging, among other things, that Williamson stood in the shoes of the Fund and that, because the Fund was at fault by virtue of its own fraud, the Fund was not entitled to claw back investor distributions.  The Court ruled that the claw backs were proper.  We outline the background of the lawsuit and summarize the parties’ arguments and the Court’s reasoning.

Senior SEC Enforcement Official Christopher Conte to Join Steptoe & Johnson to Represent Hedge Funds and Others in Regulatory Enforcement Actions and Investigations

On August 30, 2010, Steptoe & Johnson LLP announced that Christopher Conte, Associate Director of the Division of Enforcement of the Securities and Exchange Commission, will join the firm following a 17-year career in government.  Conte will be a Partner in Steptoe’s Washington, D.C. office.