Oct. 1, 2010

Developments in Family Office Regulation: Part One

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), signed into law on July 21, 2010, contains sweeping changes that will impact the U.S. regulatory landscape for years to come.  It is comprised of a number of separate titles – Title IV, the “Private Fund Investment Advisers Registration Act of 2010,” amends the U.S. Investment Advisers Act of 1940, as amended (the “Advisers Act”).  The Dodd-Frank Act requires, inter alia, that the U.S. Securities and Exchange Commission (“SEC”) issue rules relating to family offices.  Historically, family offices and their investment officers (and investment affiliates) have been granted exemptions from investment adviser registration under the Advisers Act on the basis that such persons (or entities) were not within the intent of Section 202(a)(11) of the Advisers Act, which contains the definition of “investment adviser.”  The relief came in the form of exemptive orders issued by the SEC.  The Dodd-Frank Act has codified this rationale by specifically excluding “family offices” from the definition of “investment adviser” under the Advisers Act and requiring the SEC to define the term “family office.”  Until the SEC issues its proposed rules, the exemptive orders and other relevant guidance reflect the current family office framework.  In a guest article, Michael G. Tannenbaum and Christina Zervoudakis, Founding Partner and Associate, respectively, at Tannenbaum Helpern Syracuse & Hirschtritt LLP, address those exemptive orders and other relevant guidance.  In a follow-up article in the HFLR, the authors will address the proposed rules shortly after they are issued by the SEC.

SEC’s Insider Trading Case Against Nelson Obus of Hedge Fund Wynnefield Capital Thrown Out on Summary Judgment Motion Because SEC Failed to Prove that GE Capital Tipper Acted Deceitfully or in Violation of a Confidentiality Duty

The U.S. District Court for the Southern District of New York has thrown out the SEC’s insider trading case against three individuals, the “tipper,” the “tippee” and the tippee’s superior, who allegedly traded in the securities of SunSource, Inc. (SunSource) after receiving inside information about the potential sale of SunSource.  In early 2001, Allied Capital Corporation (Allied) began exploring the possibility of acquiring SunSource and spinning off one of SunSource’s subsidiaries.  GE Capital was one of several lenders that were approached about the possibility of financing the transaction.  Defendant Thomas Strickland worked for the commercial finance group of GE Capital and was assigned to the SunSource deal team.  Strickland noticed that hedge fund Wynnefield Capital, Inc. (Wynnefield) owned SunSource stock.  In May 2001, Strickland had a conversation about SunSource with defendant Peter Black, an analyst at Wynnefield who happened to have been a college classmate of his.  Black advised his boss, defendant Nelson Obus, of Strickland’s interest in SunSource.  Obus then purchased additional shares of SunSource stock.  After Allied merged with SunSource, the Securities and Exchange Commission (SEC) brought civil insider trading charges against Strickland, Black and Obus.  On the defendants’ motion for summary judgment, the District Court dismissed the case against them.  It reasoned that, in mentioning the SunSource financing to Black, Strickland had not violated any fiduciary duty to GE Capital or SunSource, had not breached any duty of confidentiality to either company and had not acted deceptively.  Therefore, Strickland’s tip did not give rise to liability.  We outline the facts of the case and the Court’s reasoning.

SEC Settlement with Carlson Capital Suggests that Most Hedge Fund Managers with Multiple Strategies or Funds Will Not Be Able to Rely on the “Separate Accounts” Exception to Rule 105 Under Regulation M

Rule 105 of Regulation M under the Securities Exchange Act of 1934 generally prohibits a person from purchasing securities of an issuer in a public offering from an underwriter, broker or dealer if the person sold short securities of the same issuer within five days prior to the pricing of the public offering.  However, Rule 105 generally does not prohibit a person from purchasing securities of an issuer in a public offering, even if the person sold short securities of the same issuer within five days prior to the pricing of the public offering, if the short sale and subsequent purchase are made in “separate accounts.”  According to the SEC’s October 9, 2007 Adopting Release for Rule 105, the intent of Rule 105 is to prevent manipulative short selling prior to a public offering, and therefore “to foster secondary and follow-on offering prices that are determined by independent market dynamics.”  A September 23, 2010 SEC Order involving hedge fund manager Carlson Capital, L.P. (Carlson) illustrates the limits of the “separate accounts” exception to Rule 105 in the hedge fund context.  As explained more fully below, in one of the four transactions at issue, the short sale and purchase occurred in different “strategies.”  However, in the SEC’s view, these strategies did not have sufficient indicia of “separateness” to fall outside of the purview of Rule 105.  This finding is of note to the hedge fund community because the portfolio management structure employed by Carlson is not atypical.  The Order also highlights the ironic proposition that a hedge fund manager can “willfully” violate Rule 105 without having any “intent” to do so.  This is because: (1) as the Adopting Release confirms, Rule 105 applies “irrespective of a short seller’s intent”; and (2) the definition of “willful” for securities law purposes departs from the common understanding of the term.  Under D.C. Circuit precedent, to “willfully” violate securities laws or rules, a person need only know “what he is doing” – he need not know that such conduct violates any securities law or rule.  And this appears to have been the case here.  The Order does not allege that Carlson or any of its personnel intended to violate any securities law or rule.  Rather, the Order suggests that the relevant investment personnel at Carlson either misunderstood or were unaware of Rule 105’s requirements during the relevant period, and that Carlson had inadequate compliance policies and procedures in place.  Notably, the Order also indicates that Carlson promptly remedied its alleged compliance shortcomings during the SEC staff’s investigation, and the SEC took this remedial action into consideration in determining to accept Carlson’s offer of settlement of the SEC’s proceedings.  This article explains the facts alleged in the Order (which Carlson neither admitted nor denied), and the SEC’s legal analysis.

Fifth Circuit Holds that SEC’s Allegations Against Mark Cuban Provide a Plausible Basis for Finding that Cuban Traded in Violation of an Agreement Not to Trade

On September 21, 2010, the SEC won a significant victory in the United States Court of Appeals for the Fifth Circuit.  The Circuit Court reversed the SEC’s loss in its insider trading civil action against entrepreneur and Dallas Mavericks owner Mark Cuban.  The real question, however, and one highlighted by the Circuit Court, remains whether the SEC has sufficient facts to survive summary judgment or win at trial.  We summarize the background of the action, the Court’s legal analysis and Cuban’s related Freedom of Information Act request.

Fifth Street No-Action Letter Outlines Factors the SEC May Consider in Approving Joint Participation in a Restructuring by Registered and Private Funds Managed by the Same Manager

In February of this year, the SEC issued a no-action letter to Fifth Street Finance Corp. (Fifth Street), a registered investment company (RIC) that sought to participate jointly in a restructuring transaction with a private fund managed by the same management company.  While the letter is explicitly limited to its unique facts, it nonetheless provides insight into the factors the SEC may consider when determining whether a RIC is getting a worse deal than a private fund where both funds are under common control and participate jointly in the same transaction.  The letter is relevant to the hedge fund community because a growing number of hedge fund managers are launching RICs, UCITS and other registered products.  See “Hedge Fund Managers Launching Mutual Funds in an Effort to Stay a Step Ahead of Regulatory Convergence,” Hedge Fund Law Report, Vol. 2, No. 15 (Apr. 16, 2009); “New Study Offers Surprising Findings on the Incentives Created by Concurrent Management of Hedge and Mutual Funds,” Hedge Fund Law Report, Vol. 2, No. 23 (Jun. 10, 2009).  To the extent the investment strategies of hedge funds and RICs overlap, managers may have occasion to allocate the same deals to both categories of funds.  In such circumstances, at least in the U.S., beyond the fiduciary duty and anti-fraud considerations always lurking in the background of allocation decisions, managers also must consider Rule 17d-1 under the Investment Company Act of 1940 (Investment Company Act).  See “Can Mutual Funds Rely on the Recent T. Rowe Price No-Action Letter to Invest in Hedge Funds?,” The Hedge Fund Law Review, Vol. 2, No. 49 (Dec. 10, 2009).  That Rule, its operation in concurrent management scenarios and its implications for hedge fund managers that also manage RICs are explored in this article.

Movie Review: Wall Street: Money Never Sleeps (Directed by Oliver Stone; Released Sep. 24, 2010)

The return of Michael Douglas as Gordon Gekko, in Oliver Stone’s sequel to his 1987 classic, Wall Street, is a cinematic event so highly anticipated in the financial community that it has occasioned the Hedge Fund Law Report’s inaugural movie review. The pre-release hype was inescapable; the business press has been all abuzz with nostalgia for the original. Testimonials from numerous Street denizens confirm that Stone’s moralizing vision, which meant to condemn Gekko’s amoral corporate raiding and greed-celebrating philosophy, inadvertently inspired a generation to direct its career path toward the trading floor in emulation of this extraordinarily seductive villain.  Regretfully, it must be reported that anyone hoping to experience that old thrill again is bound to be somewhat disappointed with the sequel; but, that being said, it still merits close attention, as perhaps the first serious attempt by Hollywood to come to terms with the financial crisis of 2008.

Greenberg Traurig Expands Hedge Fund Practice with Addition of John A. Brunjes and Genna N. Garver

On September 28, 2010, Greenberg Traurig, LLP announced that hedge fund lawyers John A. Brunjes and Genna N. Garver have joined its Corporate and Securities Practice.  Both Brunjes and Garver have published articles in the Hedge Fund Law Report.  See “Implications of the Volcker Rule – Managing Hedge Fund Affiliations with Banks,” Hedge Fund Law Report, Vol. 3, No. 10 (Mar. 11, 2010); “Connecticut Welcomes You!  Federal Financial Regulatory Reform Restores Connecticut’s Authority over Hedge Fund Advisers,” Vol. 3, No. 30, (Jul. 30, 2010).

Titan Capital Group Names Keith Danko as Partner

On September 22, 2010, Titan Capital Group announced that hedge fund industry veteran Keith Danko has joined the firm as a Partner in Titan’s New York headquarters.