Oct. 29, 2010

2010 Developments in Family Office Regulation under Dodd Frank: Part Two

This is part two of a three-part series that addresses the regulation of family offices under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), signed into law by President Obama on July 21, 2010.  The Dodd-Frank Act provides that family offices are to be exempt from the definition of “investment adviser” in the Advisers Act, but left to the Securities and Exchange Commission (“SEC” or the “Commission”) the definitional details, requiring only that the SEC’s implementation of the new rule be consistent with its historic position as reflected in its exemptive orders.  In proposing its definition of family office, the SEC focuses on single family offices which have assets in excess of $100 million.  There are about 2,500 to 3,000 such family offices in the U.S.  In the aggregate, these family offices manage more than $1.2 trillion in assets.  Part one of this series presented the current SEC position as reflected by the exemptive orders.  See “Developments in Family Office Regulation: Part One,” Hedge Fund Law Report, Vol. 3, No. 38 (Oct. 1, 2010).  In this part two, Michael G. Tannenbaum and Christina Zervoudakis, Founding Partner and Associate, respectively, at Tannenbaum Helpern Syracuse & Hirschtritt LLP, discuss the proposed rules recently issued by the SEC.  Unless extended by the SEC, the comment period with regard to the proposals ends on November 18, 2010.  There will undoubtedly be comments for the SEC to consider and perhaps adopt.  The authors expect that part three of this series will deal with the state of affairs as made final after the comment period ends and the SEC issues its final rules.

SEC Temporarily Permits Hedge Fund Managers to Avoid Surprise Examination Requirement with Audits by Auditors That Are Registered with, but Not Subject to Inspection by, the PCAOB

In late 2009, the SEC adopted amendments to Rule 206(4)-2 (Custody Rule) under the Investment Advisers Act of 1940, as amended (Advisers Act).  (The Hedge Fund Law Report has analyzed the implications of the amended Custody Rule for, among other things, compliance policies and procedures; the balance of power between hedge fund managers and accountants; structuring of managed accounts; internal control reporting; and hedge fund liquidations.)  As amended, the Custody Rule creates a general rule that is bad for hedge fund managers, an exception to the general rule that is good for hedge fund managers, and parameters for applying the exception that are ambiguous for hedge fund managers.  In brief, the general rule is that any investment adviser deemed to have custody of client securities or assets – and most hedge fund managers would have deemed custody within the Custody Rule’s broad definition of custody – is required to undergo an annual surprise examination conducted by an independent public accountant.  The exception is that advisers to pooled investment vehicles (such as hedge funds) are excepted from the surprise examination requirement if their funds are audited annually in accordance with GAAP by “an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board (PCAOB) in accordance with its rules.”  Advisers Act Rule 206(4)-2(b)(4)(ii).  The exemption also requires a hedge fund to distribute its audited financial statements to investors within 120 days (180 days for funds of funds) of the fund’s fiscal year-end.  The ambiguity in application of the exception is essentially as follows: A hedge fund manager is only excepted from the surprise examination requirement if the independent public accountant that it retains to perform annual audits of its funds is (1) registered with the PCAOB and (2) subject to regular inspection by the PCAOB (3) as of the commencement of the professional engagement period and (4) as of each calendar year-end.  But many of the independent public accountants that routinely audit hedge funds are not subject to regular inspection by the PCAOB, and it is not yet clear what “as of the commencement of the professional engagement period” will mean for purposes of the Custody Rule.  In other words, many independent public accountants would not satisfy the second and third elements of the test for eligibility to provide annual audits that can except a hedge fund manager from the surprise examination requirement.  Therefore, to avoid the surprise examination requirement, many hedge fund managers would have to replace their current auditors with auditors that are subject to “regular inspection” by the PCAOB.  Only auditors to public companies currently are subject to regular inspection by the PCAOB.  In many cases, such public company auditors are larger and more expensive, and have less institutional knowledge (and in some cases less industry knowledge), than auditors focused specifically on the hedge fund industry.  In short, absent relief and clarification, the Custody Rule would require many hedge fund managers to replace their funds’ current auditors, which in turn could: raise funds’ costs; increase the length of audits; increase the time of hedge fund manager personnel and other manager resources committed to annual audits; diminish or eliminate the value of institutional knowledge; and sever by regulation professional engagements that in many cases have been long-standing and mutually productive.  Fortunately, in an October 12, 2010 no-action letter to the law firm Seward & Kissel LLP (Seward Letter), the Staff of the SEC’s Division of Investment Management provided such relief and clarification.  This article further describes the legal, accounting and operational problems created by the Custody Rule, and the relief offered by the Seward Letter with respect to those problems.

SEC Administrative Law Judge Holds that a Broker-Dealer’s General Counsel Could Be Held Liable as a Supervisor of a Financial Adviser Over Whom He Had No Actual Supervisory Authority

On September 8, 2010, Securities and Exchange Commission (SEC) Administrative Law Judge (ALJ) Brenda P. Murray held that Theodore W. Urban, as former general counsel of brokerage firm Ferris, Baker Watts, Inc. (FBW), had the requisite degree of responsibility, ability or authority to affect the conduct of a rogue broker at the firm, Thomas Glantz, for purposes of Section 15(b) of the Securities Exchange Act of 1934 (Exchange Act), notwithstanding that Urban lacked any authority normally associated with such supervision.  The ALJ found, however, that as Glantz’s “supervisor,” Urban had acted reasonably in following up on warning signs and in relying on other executives at FBW who actively lied to or kept information from him.  As a result, it dismissed the case brought by the SEC’s Enforcement Division against him.  The ALJ’s conclusion that Urban acted as Glantz’s supervisor for purposes of federal securities laws is important, as it could expose in-house counsel at broker-dealers and potentially at hedge fund managers to such supervisory liability or analogous liability.  We discuss the background of the SEC’s administrative proceeding against Urban and the ALJ’s legal analysis.

SEC Brings Civil Securities Fraud Action Against Principals of Hedge Fund Palisades Master Fund, Alleging Fraud, Self-Dealing, Misuse of Fund Assets and Use of a “Side Pocket” to Misrepresent the Fund’s Value to Its Investors

According to a complaint filed by the Securities and Exchange Commission (SEC) in the U.S. District Court for the Northern District of Georgia, Defendants Paul T. Mannion, Jr. (Mannion), and Andrew S. Reckles (Reckles), through the investment advisers they controlled, defrauded investors in hedge fund Palisades Master Fund, L.P. (Fund), by misstating the value of certain Fund assets, stealing from the Fund and failing to disclose material information about Fund assets.  In reports to Fund investors, Mannion and Reckles reported that the Fund’s investment in World Health Alternatives, Inc. (WHA), a medical staffing company, was worth over $19 million, even though they knew that the investment was worth millions less than the reported value.  The Defendants also allegedly stole and exercised WHA warrants owned by the Fund and failed to disclose their private sales of WHA stock.  Finally, in a transaction unrelated to WHA, Mannion and Reckles are alleged to have concealed their short position in Radyne Corporation at the time that they invested in that corporation’s PIPE offering.  The SEC seeks an injunction barring future securities law violations, disgorgement of unlawful profits and civil penalties.  This article summarizes the SEC’s Complaint.

“Overhaul: An Insider’s Account of the Obama Administration’s Emergency Rescue of the Auto Industry,” By Steven Rattner; Houghton Mifflin Harcourt, 336 Pages

In early 2009, Steven Rattner found himself appointed as the nation’s “auto czar” by President Barack Obama, with a mandate to rescue General Motors and Chrysler.  Rattner, a former Lazard investment banker, ran the private equity firm Quadrangle Group LLC, which was known for media and telecom deals, and for managing New York City Mayor Michael Bloomberg’s fortune, but he had little experience with the manufacturing sector.  Although he may have seemed an unlikely savior, Rattner has written a memoir claiming that he and his handpicked “Team Auto” should be credited with one of the most important successes of the Obama administration.  Rattner gives a detailed account of the rapid restructuring of the companies through accelerated bankruptcy proceedings.  He asserts that his handiwork has left GM and Chrysler viable and competitive, giving taxpayers a reasonable chance of recovering most of the $82 billion in federal aid received by the carmakers.  While that judgment may be premature, with initial public offerings still pending, there have been some encouraging signs of progress.  Our book reviewer, Joshua A. Lustig, offers a comprehensive review of Rattner’s new memoir.

New York State Court Dismisses Suit to Force Buy-Back of Reduced Mortgages, Finding that Plaintiffs Failed to Follow “No-Action Clause” Procedures

A New York State Court has dismissed a lawsuit brought by hedge funds and other investors seeking to force Countrywide Financial Corp. and two of its subsidiaries to buy back the full balance of mortgages that had been sold to investor trusts, but had been subsequently reduced pursuant to a settlement agreement.  In throwing out the Complaint, New York State Supreme Court Justice Barbara Kapnick ruled that the Plaintiffs, Greenwich Financial Services Distressed Mortgage Fund LLC, et al., failed to meet the required procedural preconditions for bringing a suit under the trusts’ pooling and service agreements, including the support of 25 percent of certificateholders.  This article details the key facts and the court’s legal analysis in a case that provides important insight into and background for the growing trend of mortgage “put-back” litigation.

Bingham Bolsters Hong Kong Office with Addition of Three Partners

Bingham McCutchen LLP has launched its Structured Finance Practice, augmented its Financial Services division with the addition of debt capital markets capacity and added to its Global Financial Restructuring practice by adding three new partners to its Hong Kong office: Laurence Issacson, Vincent Sum and Mark Fucci.

FINRA Names Brad Bennett as New Head of Enforcement Division

The Financial Industry Regulatory Authority (FINRA) announced on October 21, 2010 that it has selected J. Bradley Bennett, a Partner at the law firm Baker Botts in Washington, DC, as its new head of Enforcement.  Bennett will start at FINRA on January 1, 2011 and will take over from James Shorris, who has been acting Chief of Enforcement since Susan Merrill departed the organization in March 2010.

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.