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    Dec. 10, 2010

Protecting Hedge Funds’ Trade Secrets: The Federal Government’s Enforcement of Criminal Laws Protecting Proprietary Trading Strategies

On December 10, 2010, the trial of Sergey Aleynikov, a former Goldman, Sachs & Co. employee accused of stealing the computer code underlying Goldman’s high-frequency trading system, ended in a guilty verdict.  The Aleynikov trial follows close on the heels of the trial of Samarth Agrawal, a former employee of Société Générale who was convicted last month of theft of trade secrets, also in connection with misappropriation of high frequency trading code.  These cases reflect a new emphasis by the federal government on high-technology and intellectual property-related crimes, and should be of great interest to hedge funds, many of which rely upon trade secrets or proprietary trading strategies to some degree.  In a guest article, Sean O’Brien and Sara Welch, Partner and Associate, respectively, at Arkin Kaplan Rice LLP, focus upon the key legal issues presented and resolved in the Aleynikov prosecution, and the implications of those issues for hedge fund managers.

Participants at Hedge Fund Compliance Summit Detail Best Practices with Respect to Insider Trading, SEC Examinations, Risk Mitigation, Marketing Materials, Valuation and Avoiding Investor Lawsuits: Part Two of Two

On November 15 and 16, 2010, Financial Research Associates, LLC and the Hedge Fund Business Operations Association presented a Hedge Fund Compliance Summit at the Princeton Club in New York City.  In our issue of November 24, 2010, we detailed the key insights of Summit participants on topics including insider trading; the use by hedge fund managers of consultants and expert networks; sharing of information among personnel at different hedge fund managers; market rumors; insider trading considerations in connection with bank debt trading; and how to prepare for, handle and follow up on SEC examinations.  See “Participants at Hedge Fund Compliance Summit Detail Best Practices with Respect to Insider Trading, SEC Examinations, Risk Mitigation, Marketing Materials, Valuation and Avoiding Investor Lawsuits: Part One of Two,” Hedge Fund Law Report, Vol. 3, No. 46 (Nov. 24, 2010).  As we observed in that article, the timing of the Summit was fortuitous because two weeks after it, The Wall Street Journal and other sources disclosed a wide-ranging, inter-agency insider trading investigation focusing on hedge fund managers, expert networks and other alternative research providers, investment banks and others.  See “Lessons for Hedge Fund Managers and Expert Network Firms from the Government’s Criminal Complaint against Don Chu, Formerly of Primary Global Research LLC,” Hedge Fund Law Report, Vol. 3, No. 47 (Dec. 3, 2010).  This article finalizes our coverage of the Summit.  Specifically, this article summarizes the most relevant points made by Summit participants with respect to: the revised “accredited investor” definition in Dodd-Frank; the consequences of violating Regulation D, and how to mitigate those consequences; how to negotiate the apparent conflict between the prohibition on general solicitation of Regulation D and the expanded disclosures required by revised Form ADV, Part 2; the importance of consistency between marketing materials and fund documents; recordkeeping with respect to hedge fund manager websites; the distinction between specific representations in and collective impressions created by marketing materials; rules with respect to presentation of performance information; four specific items that the SEC looks for in valuation policies and procedures of hedge fund managers; six specific red flags that the SEC looks for with respect to valuation in the course of inspections and examinations of hedge fund managers; big boy letters; what provisions in side letters may, in the view of the SEC, need to be disclosed to hedge fund investors; and why the fraud exclusion in D&O and E&O insurance policies may often be moot.

Federal District Court Upholds the Government’s Right to Use Wiretaps to Investigate Suspected Insider Trading by Hedge Fund Manager Personnel

On November 24, 2010, the United States District Court for the Southern District of New York handed the United States Attorney’s Office (USAO) and the FBI (together, the government) a major victory in their ongoing criminal prosecution of Raj Rajaratnam, founder of Galleon Management, LP, and Danielle Chiesi, a former manager of New Castle Funds, LLC (defendants), for their alleged participation in a massive insider trading conspiracy.  In a precedential decision, the court upheld the government’s authority to secretly record phone calls under Title III of the Omnibus Crime Control and Safe Streets Act of 1968 (Title III or the Act) to investigate insider trading schemes using interstate wires, even though the Act does not specifically authorize wiretaps to investigate insider trading alone.  It also rejected defendants’ specific challenges to the government’s underlying search warrant applications, notwithstanding what it considered a “troubling” lack of government candor, because disclosure of the details “the government recklessly omitted would ultimately have shown that a wiretap was necessary and appropriate.”  As a result of its decision, the government may now present these recordings – likely the most persuasive evidence it will offer – at the trials of Rajaratnam and Chiesi, now tentatively scheduled to start on January 17, 2011.  We detail the background of the action and the Southern District’s legal analysis, primarily as it pertains to Rajaratnam’s claims, because the opinion heavily redacted the facts relating to Chiesi’s prosecution.  See also “Decision in the Galleon Matter Illustrates Application of Wiretap Law in the Hedge Fund Context,” Hedge Fund Law Report, Vol. 3, No. 41 (Oct. 22, 2010).

SEC Commences Civil Insider Trading Action Against Deloitte Mergers and Acquisitions Partner and Spouse Who Allegedly Tipped Off Relatives to Impending Acquisitions of Seven Public Companies

On November 30, 2010, the Securities and Exchange Commission (SEC) commenced a civil insider trading action against Deloitte Tax LLP (Deloitte) partner Arnold A. McClellan and his wife, Annabel McClellan, after they allegedly passed to their London-based relatives material, non-public information about pending acquisitions by Deloitte clients.  Those relatives, and the brokerage through which they traded, made millions of dollars trading ahead of the announcements of those acquisitions.  Arnold McClellan allegedly told his wife about seven acquisition deals on which Deloitte had been retained as an adviser.  Annabel McClellan, in turn, passed those tips to her sister and brother-in-law, Miranda and James Sanders.  The Sanders then took equity positions in the target companies and made substantial profits when the deals were announced.  The SEC charges that the McClellans violated the antifraud provisions of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.  This article summarizes the SEC’s Complaint.

Peak Ridge Hedge Fund Alleges that Morgan Stanley Breached its Prime Brokerage Agreement with the Fund by, Among Other Things, Tripling Margin Requirements over Ten Months

On November 8, 2010, Morgan Stanley & Co. Incorporated (Morgan Stanley) filed suit against commodities hedge fund Peak Ridge Master SPC LTD, claiming $40.6 million in damages resulting from losses stemming from bad bets on natural gas.  See “Morgan Stanley Sues Commodities Hedge Fund Peak Ridge for Alleged Failure to Satisfy Margin Calls,” Hedge Fund Law Report, Vol. 3, No. 45 (Nov. 19, 2010).  On November 29, 2010, Peak Ridge Master SPC Ltd. (obo The Peak Ridge Commodities Volatility Master Fund Segregated Portfolio (CVF)), brought counterclaims against Morgan Stanley, alleging that Morgan Stanley acted in a commercially unreasonable manner by, among other things: (1) tripling CVF’s margin requirements over a period of ten months; (2) giving notice of default and seizing the account without making a margin call or allowing any opportunity to cure; (3) assigning the fund’s management to a conflicted trader who mismanaged the fund, causing significant losses; and (4) selling its remaining open positions to a competitor, a Morgan Stanley affiliate, that recognized an immediate $23 million gain from the acquisition.  Morgan Stanley’s suit claimed $40.6 million in damages for losses caused by CVF’s failure to meet contractually required margin calls.  CVF’s Counterclaim seeks at least $30 million in damages.  In its Counterclaim, CVF accuses Morgan Stanley of terminating the fund's account to further Morgan Stanley’s own interests.  This article reviews CVF’s presentation of the sequence of events from the inception of the relationship between the parties through the disputed seizure and subsequent liquidation, and details CVF’s breach of contract counterclaim.

Dewey & LeBoeuf Hires Financial Regulation Expert Robert Finney to Head London Team

On November 11, 2010, Dewey & LeBoeuf hired Robert Finney as a Financial Regulation Partner to lead and expand its provision of regulatory advice to financial institution clients across Europe, the Middle East and Africa.

Eric R. Dinallo, Former New York State Superintendent of Insurance, Joins Debevoise

Debevoise announced on December 6, 2010 that Eric R. Dinallo, former New York State Superintendent of Insurance, has joined the firm as a Partner in the firm’s New York office and a member of the Financial Institutions Group.  For past HFLR articles referencing Dinallo, see “Regulating Credit Default Swaps as Insurance: Gone, But Not Forgotten,” Hedge Fund Law Report, Vol. 1, No. 27 (Dec. 9, 2008) (noting that Dinallo was reportedly among the first supervisors to push for regulation of the derivatives markets); “New York Insurance Regulator Suggests that Core Credit Default Swaps Might be Ripe for Regulation as Insurance Contracts,” Hedge Fund Law Report, Vol. 1, No. 11 (May 13, 2008); “Do Credit Defaults Swaps Need to be Regulated as Insurance?,” Hedge Fund Law Report, Vol. 1, No. 13 (May 30, 2008).

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