Nov. 12, 2010

Key Elements of Electronic Communications Policies and Procedures for Hedge Fund Managers

Electronic communications technologies – phone, e-mail, instant messaging, social media and others described in this article – are essential to the efficient operations of hedge fund managers, but at the same time pose considerable regulatory and litigation, reputational and trading risks.  Hedge fund managers cannot live without electronic communications, but may not survive if such communications are not properly handled.  Moreover, electronic communications are among the most difficult categories of information to contain – they are indelible, pervasive and often determine the outcome of private and government litigation.  Yet more often than not, such communications are drafted under the mistaken impression that they are as easy to erase as they are to create.  Despite a lengthy list of cases illustrating the error in this view, hedge fund manager personnel continue to create and send electronic communications that would fail the commonly used litmus test: “If you wouldn’t want it on the cover of the Wall Street Journal, don’t send it.”  The intent of this article is to assist hedge fund managers in creating, refining and enforcing electronic communications policies and procedures.  To do so, this article first catalogues the various types of electronic communications technologies used by hedge fund manager personnel, as well as the categories of communications that may be made with such technologies.  Next, the article identifies specific risks arising out of the various communications and technologies.  Notably, the range of risks posed by electronic communications in the hedge fund context is significantly broader than the risk of embarrassment or bad evidence at trial – other risks relate to loss of trading advantages, insider trading charges, spoliation sanctions and more.  Incorporating the discussion of communications, technologies and risks, the article then discusses the key elements of electronic communications policies and procedures for hedge fund managers.

SEC and DOJ Commence, Respectively, Civil and Criminal Insider Trading Actions Against a Doctor Who Allegedly Tipped Off a Hedge Fund Manager to Impending Negative Information About a Drug Trial

The Securities and Exchange Commission (SEC) has commenced a civil insider trading action against Dr. Yves M. Benhamou (Benhamou) after a hedge fund allegedly traded on inside information provided by Benhamou about the prospects of Human Genome Sciences, Inc. (HGSI).  Benhamou is a doctor who was on a steering committee overseeing a clinical trial of HGSI’s drug Albumin Interferon Alfa 2-a (Albuferon).  An unnamed hedge fund manager, through six separate funds (Funds), owned over six million shares of HGSI.  One of its investment managers was a friend and business acquaintance of Benhamou.  According to the Complaint, Benhamou revealed material nonpublic information about the Albuferon trial to the investment manager from December 2007 through January 2008.  During that same period, the Funds sold all of their HGSI shares, including a block trade of the Funds’ remaining two million shares at the close of trading on January 22, 2008, the day before HGSI announced negative information about the Albuferon trial.  By selling prior to that announcement, the Funds avoided a $30 million loss on the HGSI shares.  The SEC charges that Benhamou violated the antifraud provisions of the Securities Act of 1933 and the Securities and Exchange Act of 1934.  The U.S. Attorney for the Southern District of New York has also brought criminal insider trading charges against him.  Benhamou was arrested in Boston on November 2, 2010.  We summarize the SEC’s civil complaint.

Municipal Securities Rulemaking Board Extends Its Regulatory Reach to Include Hedge Fund Placement Agents

On November 1, 2010, the Municipal Securities Rulemaking Board (MSRB) filed proposed rule changes with the Securities and Exchange Commission (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,” Hedge Fund Law Report, Vol. 3, No. 35 (Sep. 10, 2010).  Those proposed rule changes are of interest to the hedge fund community for five primary reasons.  First, they clarify the definition of a “municipal advisor” for purposes of Section 975 of Dodd-Frank.  That definition likely encompasses placement agents providing services to hedge funds and other entities that provide similar services to hedge funds but call themselves something else (such as “finders,” “solicitors” or “cash solicitors”).  Second, the proposed rule changes impose three procedural requirements on municipal advisors.  Third, they impose two substantive requirements on municipal advisors.  Fourth, the MSRB’s Notice 2010-47 (Notice), announcing the filing of the proposed rule changes, includes a roadmap of the MSRB’s rulemaking agenda for “the coming months and years,” including rules that will directly affect hedge fund placement agents.  Fifth, the Notice contains a portentous endnote relating to the “federal fiduciary duty” of municipal advisors, and the entities to whom that duty is owed.  This article discusses each of these five points – and identifies the questions that placement agents have to ask and answer today based on these points.

District Court Suggests That Prime Brokers May Have Expanded Due Diligence Obligations

On November 8, 2010, the U.S. District Court for the Southern District of New York denied a petition by Goldman Sachs Execution & Clearing, L.P. (GSEC) to vacate a Financial Industry Regulatory Authority (FINRA) arbitration award ordering it to pay $20.58 million to the Official Unsecured Creditors' Committee of Bayou Group, LLC and others (Bayou Estate).  The court also granted a cross-petition by the Bayou Estate to confirm the award.  Importantly, the court noted that final judgment would not be entered in the case until the court issues an opinion setting forth the reasons for its ruling.  We are monitoring the docket for that opinion, and – in light of the importance of this case to the hedge fund community – will report on the opinion shortly after it is issued.  The opinion may expand the range of circumstances in which a prime broker has a legal obligation to investigate red flags suggesting potential fraud at a hedge fund customer, and to act on its findings.  See “In Petition to Vacate FINRA Arbitration Award, Goldman Seeks to Define the Scope of a Prime Broker’s Duty (If Any) to Investors in a Hedge Fund that is a Customer of the Prime Broker,” Hedge Fund Law Report, Vol. 3, No. 30 (Jul. 30, 2010).

Sarah Davidoff Joins Ropes & Gray as Partner in Hedge Fund Practice

On November 8, 2010, Ropes & Gray announced that Sarah Davidoff joined the firm as a Partner in its hedge fund practice.  Davidoff is resident in Ropes & Gray’s New York office.

White Collar Defense Attorney Ike Sorkin Joins Lowenstein Sandler

Lowenstein Sandler is expanding its New York Litigation Department with the addition of white collar defense lawyer Ira Lee (Ike) Sorkin as a Member of the firm.  Sorkin represents hedge funds in Securities and Exchange Commission enforcement and other regulatory investigations and proceedings, internal investigations, corporate governance matters, New York Stock Exchange and Financial Industry Regulatory Authority (FINRA) matters, and criminal and civil litigation.  See “For Hedge Fund Managers in a Heightened Enforcement Environment, Internal Investigations Can Help Prevent or Mitigate Criminal and Civil Charges,” Hedge Fund Law Report, Vol. 2, No. 47 (Nov. 25, 2009).

Joseph Brenner Named Chief Counsel in SEC Division of Enforcement

On November 10, 2010, the Securities and Exchange Commission announced the selection of Joseph K. Brenner as Chief Counsel of the Division of Enforcement, where he will oversee the process of providing legal and policy advice on potential enforcement actions before they are recommended to the Commission for approval.