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    Dec. 3, 2010

Repeal of Dodd-Frank Confidentiality Protection for SEC: What Investment Advisers Lost and What Remains

On October 5, 2010, President Obama signed Senate Bill 3717 (“Bill”) into law, amending the Investment Advisers Act of 1940 (the “IAA”) by repealing a broad exemption of the Securities and Exchange Commission (“SEC”) from the Freedom of Information Act (“FOIA”) and other disclosure obligations enacted only three months before by Section 929I of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”).  Section 929I, which added Section 210(d) to the IAA, exempted the SEC from being compelled through FOIA and non-FOIA litigation to disclose information obtained by the SEC in connection with reporting obligations of financial institutions, including in connection with the SEC’s surveillance, risk assessment, regulatory or oversight activities.  The SEC had requested the exemption to facilitate its enforcement activities.  According to the SEC, financial institutions resist providing the agency with non-public information on the grounds that the SEC might not be able to keep it confidential, particularly from competitors or other third parties seeking the information through discovery in connection with commercial litigation or otherwise.  After the SEC used Section 210(d) to avoid disclosing details of its failure to detect the Bernie Madoff Ponzi scheme, Congress determined that Section 210(d) was overbroad, and repealed the provision.  In a guest article, Hillel M. Bennett and Gary L. Granik, both Partners at Stroock & Stroock & Lavan LLP, and Alessandro J. Sacerdoti, an Associate at Stroock, discuss in detail: the reporting and filing requirements applicable to investment advisers, as established by Dodd-Frank; the new confidentiality protections for filed information included in Dodd-Frank; confidential treatment of information obtained by the SEC during examinations and investigations; Exemption 8 of FOIA; the Aguirre case; requests by investment advisers for confidential treatment of non-public information disclosed to the SEC during an examination or investigation; confidentiality of proprietary information under Dodd-Frank; and potential legislative action with respect to confidentiality of information filed with or obtained by the SEC.

Lessons for Hedge Fund Managers and Expert Network Firms from the Government’s Criminal Complaint against Don Chu, Formerly of Primary Global Research LLC

On Wednesday, November 24, 2010, agents of the Federal Bureau of Investigation arrested Don Chu, at the time, an employee of expert network firm Primary Global Research LLC (Primary Global).  (Primary Global fired Chu after his arrest.)  The arrest was based on probable cause established in a Complaint filed in the United States District Court for the Southern District of New York the day prior to the arrest.  This article offers a critical reading of the Complaint and its implications for hedge fund managers and expert network firms.  By “critical,” we do not mean to take issue with the allegations in the complaint or the sufficiency of the evidence; the evidence appears to have been carefully collected and is persuasively marshaled.  Rather, by “critical,” we mean to describe our purpose in writing about the Complaint.  Here, as in substantially every article in the Hedge Fund Law Report, our purpose in writing about a particular legal document is to extract the insights and lessons that may be more broadly applicable to hedge fund managers and other hedge fund industry participants.  Such articles are intended to assist our subscribers in updating their assumptions, revising their policies and procedures and tracking the concerns of regulators and prosecutors.  With those and related goals in mind, this article discusses the following issues, insights and ideas arising out of the Chu Complaint: the three ways in which expert networks can facilitate the movement of material, non-public information; the ways in which expert networks, properly structured and used, can inhibit the movement of material, non-public information; the categories and timing of information allegedly communicated in the Chu matter; an important compliance suggestion for hedge fund managers that use expert networks, based on the specifics of the allegations in the Chu Complaint; the role of soft dollars in the ongoing insider trading investigation; the jurisdictional issue raised by the Complaint; and the interaction between competition in the expert network business, insider trading and insider trading law.

A Prime Broker that Fails to Diligently Investigate the Sources of Funds in a Hedge Fund’s Margin Account May Be Jointly and Severally Liable, with the Fund and Its Manager, for Fraud by the Manager, to the Extent of Funds in the Account

In an Opinion dated November 30, 2010, Judge Jed Rakoff of the U.S. District Court for the Southern District of New York explained his rationale for denying a petition by Goldman Sachs Execution & Clearing, L.P. (GSEC) to vacate a Financial Industry Regulatory Authority (FINRA) arbitration award ordering GSEC to pay $20.58 million to the Official Unsecured Creditors’ Committee of Bayou Group, LLC (Committee).  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).  Judge Rakoff had denied GSEC’s petition to vacate the FINRA award, and had granted the Committee’s cross-petition to confirm the award, in a one-page Order issued on November 8, 2010.  See “District Court Suggests That Prime Brokers May Have Expanded Due Diligence Obligations,” Hedge Fund Law Report, Vol. 3, No. 44 (Nov. 12, 2010).  That one-page Order promised a fuller explanation, and this November 30 opinion is that explanation, delivered with Judge Rakoff’s typical sarcasm, intelligence and outspokenness.  (The objects of that sarcasm include not only GSEC, but also the Roberts Court, which Rakoff takes to task for its vapid and inconclusive prose; such are the free speech benefits of holding a federal judicial office during “good behavior,” broadly understood.)  The Opinion is important to the hedge fund community for various reasons.  Most notably, it suggests that a prime broker can be liable, jointly and severally with a hedge fund customer and its manager, for a fraud perpetrated by the manager, to the extent of funds deposited into the hedge fund’s margin account with the prime broker.  Accordingly, the Opinion suggests that prime brokers have an obligation to perform reasonable due diligence with respect to the sources of funds in hedge fund customer accounts, and to act on “red flags” suggesting that deposited funds come from illegal activities.  Moreover, the Opinion suggests that this due diligence obligation on the part of prime brokers cannot be waived or abridged by contract.  See, by way of background, “Bayou Creditors Sue Goldman Prime Brokerage Unit to Avoid Allegedly Fraudulent Transfers” Hedge Fund Law Report, Vol. 1, No. 13 (May 30, 2008).  Procedurally, the Opinion illustrates the “exceedingly heavy burden” that must be satisfied by a party seeking to vacate an arbitration award.  As detailed below, the grounds for vacating an arbitration award are so narrow that arbitration decisions are, in Rakoff’s phrase, “essentially unappealable.”  Hedge fund managers and prime brokers should keep this in mind before demanding or agreeing to mandatory arbitration provisions in prime brokerage agreements or other agreements.  This article discusses: the three factors a district court in the Second Circuit must consider in determining whether it can vacate an arbitration award based on a “manifest disregard of the law” by the arbitration panel; the factual background of GSEC’s relationship with the Bayou Group, LLC and hedge funds it managed; the inferred holdings of the arbitration panel with respect to fraudulent conveyance and fraudulent transfer (the panel’s holdings are inferred because the arbitration decision, as is customarily the case, did not include an explanation of the reasons for the decision); and GSEC’s argument for equitable credit for returned funds.

U.S. District Court Holds That Hedge Fund Investors Do Not Have Standing to Bring a Direct, As Opposed to Derivative, Claim against Hedge Fund Auditor PricewaterhouseCoopers LLP

The U.S. District Court for the Southern District of New York has granted hedge fund auditor PricewaterhouseCoopers LLP (PWC) summary judgment, dismissing the direct fraud claims brought by certain investors in hedge fund Lipper Convertibles, L.P. (Fund).  Following the Fund’s collapse in 2002, Andrew E. Lewin and other Fund investors commenced an action against PWC, the Fund, the Fund’s general partner and certain Fund affiliates and principals, alleging a variety of direct and derivative claims.  At the time of the subject decision, the only surviving claims were the investors’ direct claims against PWC for fraud in the inducement under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 under that Act, common law fraud and negligent misrepresentation.  The investors alleged that they were induced to invest in the Fund by PWC’s false and misleading auditor’s opinions that the Fund’s operations had been audited in accordance with generally accepted auditing standards and that its financial statements were prepared in accordance with generally accepted accounting principles.  The Court granted PWC’s motion for summary judgment, deciding that the investors’ claims were derivative in nature and could not be maintained in a direct action against PWC.  The investors offered no proof that they received less than they bargained for at the time of their respective investments in the Fund.  We summarize the key legal and factual provisions of the Court’s decision.

UBS Settles Claims that It Offered Hedge Fund Manager Customers of its Prime Brokerage Business Below-Market Office Rental Deals Without Adequate Disclosure

On November 18, 2010, the Massachusetts Securities Division (Division) entered into a Consent Order with UBS Securities LLC (UBS) settling allegations that UBS violated Massachusetts securities laws by failing to disclose deals for high-end office space offered at below-market rents in exchange for hedge fund prime brokerage business.  The Secretary of the Commonwealth of Massachusetts, William F. Galvin, released a statement confirming that UBS agreed to pay $100,000 to settle the eight-year investigation into the so-called “hedge fund hotels.”  In addition, UBS agreed to hire an independent consultant to review its disclosure policy and report to the Division with implementation recommendations that UBS must adopt.  This article reviews the (admitted) facts found in the Order regarding the office space arrangement; UBS’ disclosure policies regarding the arrangement over the relevant period; the sequence of events leading to the settlement; conclusions of law (not admitted by UBS) regarding alleged violations of Massachusetts law as well as the remedies agreed to under the terms of the settlement.

Dechert Adds Dr. Wolfgang Kissner to its Financial Services and Investment Management Group in Munich

Dechert, LLP has added Dr. Wolfgang Kissner to its financial services and investment management group as a national partner in Munich.  Kissner advises both German and international clients on capital markets, private funds, banking and structured finance matters, including on the tax and regulatory aspects of deals.

Financial Services Partner Grace Sucaldito Joins Grant Thornton LLP’s San Francisco Office

On December 2, 2010, Grant Thorton LLP announced that Grace Sucaldito joined its San Francisco office as Financial Services Audit Partner.  She specializes in real estate investment trusts and investment partnerships, including hedge funds and private equity funds.

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