Oct. 22, 2010

Indemnification Provisions in Agreements between Hedge Fund Managers and Placement Agents: Reciprocal, But Not Necessarily Symmetrical

In a recent article, we argued that the use of placement agents by hedge fund managers – especially smaller and start-up managers – is likely to continue and grow in the near term, for both macro and micro reasons.  At the macro level, we identified four rationales for this anticipated trend: (1) many new investments are going to larger managers; (2) many institutional investors plan to increase their hedge fund allocations in the next three to five years; (3) a noteworthy percentage of institutional investors plan to increase their allocations to new managers; and (4) manager reputation weighs heavily in the allocation decision-making of institutional investors.  And at the micro level, we suggested that the use of placement agents by hedge fund managers will continue and grow because placement agents provide a range of potentially valuable services to managers, including: marketing and sales expertise; division of labor between portfolio management and marketing; credibility; contacts and access; strategic and other services; geographic and cultural expertise; and the ability to avoid the question of whether the manager’s in-house marketing department must register with the SEC as a broker.  For a fuller discussion of each of these points, see “What Is the ‘Market’ for Fees and Other Key Terms in Agreements between Hedge Fund Managers and Placement Agents?,” Hedge Fund Law Report, Vol. 3, No. 35 (Sep. 10, 2010).  Another point we made in that article – and a large part of the reason why we have undertaken this article – is that while the business case for the use by hedge fund managers of placement agents is compelling, the recent regulatory attention focused on placement agent activities and hedge fund marketing more generally is unprecedented.  See, e.g., “Three Significant Legal Pitfalls for Hedge Fund Marketers, and How to Avoid Them,” Hedge Fund Law Report, Vol. 3, No. 36 (Sep. 17, 2010); “Third-Party Marketers that Solicit Public Pension Fund Investments on Behalf of Hedge Funds May Have to Register with the SEC within Three Weeks,” Hedge Fund Law Report, Vol. 3, No. 35 (Sep. 10, 2010); “Key Elements of a Pay-to-Play Compliance Program for Hedge Fund Managers,” Hedge Fund Law Report, Vol. 3, No. 37 (Sep. 24, 2010); “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).  Accordingly, hedge fund managers are increasingly sensitive to the prospect that retaining placement agents can involve burdens as well as benefits.  At best, placement agents can dramatically increase assets under management, revenues and profits.  But at worst, placement agents can materially expand the range and severity of liabilities to which hedge fund managers are exposed.  At the same time, marketing and selling hedge fund interests can expose placement agents to liability.  In short, the exposure created by the relationship is reciprocal, but not necessarily symmetrical: in most cases, and as explained more fully below, placement agents have more opportunities to harm managers than vice versa.  Sophisticated hedge fund managers and placement agents recognize that their relationships may create these reciprocal, asymmetrical liabilities, and, to the extent possible, seek to allocate the burden of such liabilities ex ante, by contract.  Specifically, the indemnification provisions included in agreements between hedge fund managers and placement agents theoretically aim to allocate a particular category of liability to the party best situated to avoid it.  (Practically, they often allocate more liabilities to the party with less bargaining power.)  By allocating (in theory) liabilities to the “least cost avoider,” indemnification provisions also seek to affect behavior in a manner that mitigates the likelihood of loss.  The idea is that a party is more likely to take precautions against a loss if it is required to internalize the cost of that loss; and the party best situated to take such precautions is the party that can do so at the lowest cost. This article explores a question that frequently arises in the negotiation of agreements between hedge fund managers and placement agents: who should indemnify whom?  Or more particularly – since the answer is not so absolute – for what categories of potential liability should placement agents indemnify managers, and vice versa?  To answer that question, this article discusses: the activities of placement agents that can give rise to claims (by regulators or investors) against or can otherwise adversely affect managers; the activities of managers that can give rise to claims against or can otherwise adversely affect placement agents; how indemnification provisions in placement agent agreements are drafted to incorporate the various categories of potential liability; other mechanics of indemnification provisions (including the relevant legal standard, term, advancement of attorneys fees and clawbacks); the inevitable insufficiency of indemnification; the consequent heightened importance of due diligence and monitoring (including a discussion of ten best compliance practices and procedures for broker-dealers); and the interaction in this context among indemnification, directors and officers (D&O) insurance and errors and omissions (E&O) insurance.

U.S. District Court Allows ERISA and Federal Securities Fraud Claims to Proceed Against Hedge Fund Manager Beacon Associates, Investment Adviser Ivy Asset Management and Pension Manager J.P. Jeanneret Associates

From 1995 through 2008, hedge fund Beacon Associates (Beacon) fed approximately 71 percent of its assets, or about $164 million, to Bernard L. Madoff Investment Securities LLC.  By the time Madoff’s scheme collapsed, Beacon had withdrawn only $26 million.  The Plaintiffs in this action are Beacon investors who claim that the Defendants violated various federal and state securities laws, state common law and the Employee Retirement Income Security Act (ERISA).  The Defendants include investment adviser Ivy Asset Management, LLC (Ivy) and its principals, Bank of New York, which acquired Ivy in 2000, Beacon and its principals, Beacon’s auditor, pension adviser J.P. Jeanneret Associates (JPJA) and JPJA’s principal.  The Defendants moved to dismiss all of the Plaintiffs’ claims.  The District Court permitted certain federal securities fraud claims to proceed against Ivy, Beacon, JPJA and their respective principals, permitted certain ERISA claims for breach of fiduciary duties of loyalty and prudence to proceed against those same Defendants and dismissed the remainder of the complaint.  We summarize the Court’s decision with emphasis on the Court’s ERISA analysis.

Decision in the Galleon Matter Illustrates Application of Wiretap Law in the Hedge Fund Context

On September 29, 2010, the U.S. Court of Appeals for the Second Circuit issued a writ of mandamus on behalf of Raj Rajaratnam, founder and general partner of Galleon Management, LP and Danielle Chiesi, former manager and consultant of New Castle Funds LLC (Defendants).  The writ vacated a discovery order of the U.S. District Court for the Southern District of New York that had required Defendants to disclose thousands of wiretaps to the Securities and Exchange Commission (SEC) as part of its civil enforcement action.  Defendants had obtained those wiretaps from the U.S. Attorney’s Office (USAO) in a parallel criminal action against them pursuant to Title III of the Omnibus Crime Control and Safe Streets Act of 1968 (18 U.S.C. §§2510-2522) (Title III or the Act).  Recognizing that the USAO had taken the position that the Act prohibits it from disclosing these wiretaps to the SEC, the Second Circuit held that the Act does not prohibit a federal court from ordering the Defendants to disclose that information during discovery in a civil action.  It reasoned that, in this instance, the district court clearly abused its discretion by issuing the order prior to a criminal court “ruling on the legality of the wiretaps and without limiting the disclosure to relevant considerations.”  We detail the background of the action and the Second Circuit’s legal analysis.

Participants at Fourth Annual Hedge Fund General Counsel Summit Outline Key Risks Facing Hedge Fund Managers and How to Address Them

On October 4, 2010, ALM Events hosted its fourth annual Hedge Fund General Counsel Summit in New York City.  The event brought together a number of industry thought leaders who identified key areas of risk facing hedge fund managers, and offered ideas on how to address those risks.  Specifically, participants at the Summit discussed: Dodd-Frank; insider trading; implementing and maintaining ethical walls; investors’ due diligence expectations; risk management trends; preparing for an SEC examination; and developing pay to play policies and procedures.  This article summarizes some of the key ideas discussed at the Summit.

The Regulatory Compliance Association to Host Annual Fall Asset Management Thought Leadership Symposium on November 3, 2010 at Marriott Marquis in New York City

A new paradigm is poised to emerge within the asset management industry – driven by the forces of worldwide financial regulatory reform (e.g., Dodd-Frank and the AIFM Directive), market turmoil, industry consolidation and escalating allocator demands.  Sections of Dodd-Frank will directly target hedge funds, private equity funds, investment advisers, investment companies and others, as well as impact various financial instruments, such as derivatives, and various markets.  More importantly, the breadth of the sweeping regulatory reform will affect prime brokers, administrators, auditors and other industry participants, which in turn will produce collateral implications for asset managers.

Incorrect Cite to Article Involving Philadelphia Alternative Asset Management Co. in Article on Pacific Alternative Asset Management Company

Last week's issue of the Hedge Fund Law Report included an article titled “District Court Requires Fund of Funds Manager PAAMCO to Pay 40 Percent of Annual Net Profits to Seed Investor.”  For a brief time following publication, that article contained a hyperlink to a prior article from the HFLR titled “Ex-Hedge Fund Manager Ordered to Pay Nearly $300 Million for Defrauding Clients.”  However, the first article – the one from last week’s issue – involved Pacific Alternative Asset Management Company, the independent fund of hedge funds firm, while the second article – the one involving a payment of $300 million to defrauded clients by an ex-hedge fund manager – involved Philadelphia Alternative Asset Management Co., a company that is separate from and not related to Pacific Alternative Asset Management Company.