Dec. 17, 2010

Key Legal Considerations in Connection with the Movement of Talent from Proprietary Trading Desks to Start-Up or Existing Hedge Fund Managers: The Talent Perspective (Part One of Three)

Talent has always been mobile in the hedge fund industry.  But at least seven factors are increasing the pace with which hedge fund talent − investment talent (portfolio managers, analysts, traders) as well as non-investment talent (professionals focusing on marketing, operations, law, accounting, compliance and technology) − is moving from proprietary trading desks at investment or commercial banks (prop desks) to a range of other entities, most notably, start-up and existing hedge fund managers.  First, the Volcker Rule generally prohibits U.S. banking institutions and non-U.S. banking institutions with U.S. banking operations from: (1) proprietary trading unrelated to customer-driven business; and (2) sponsoring or investing in hedge funds or private equity funds, or engaging in certain covered transactions with advised or managed hedge funds or private equity funds.  See "Implications of the Volcker Rule – Managing Hedge Fund Affiliations with Banks," Hedge Fund Law Report, Vol. 3, No. 10 (Mar. 11, 2010).  Second, many of the investment and commercial banks that house proprietary trading desks have been subject to explicit or implicit restrictions on or reviews of compensation of key personnel.  Third, the availability of hedge fund seed funding has increased.  For example, a December 2010 survey conducted by private fund data provider Preqin found that the number of hedge fund investors expressing an interest in seed investments has almost doubled, from 11 percent in 2009 to 21 percent in 2010.  See also "How to Structure Exit Provisions in Hedge Fund Seeding Arrangements," Hedge Fund Law Report, Vol. 3, No. 40 (Oct. 15, 2010).  Fourth, many existing hedge fund managers have renegotiated, reset or regained their high water marks.  See "How Are Hedge Fund Managers with Funds Under their High Water Marks Renegotiating Performance Fees or Allocations?," Hedge Fund Law Report, Vol. 2, No. 33 (Aug. 19, 2009).  Fifth, many hedge fund industry professionals have no choice: they have been fired from prop desks, and plying their trade at a new institution is their highest value opportunity.  Sixth, according to a Fall 2010 Institutional Investor Survey conducted by Bank of America Merrill Lynch Capital Introductions, institutional investors are considerably more “bullish” on alternative investments than they are about traditional equities and fixed income investments.  Seventh, and finally, there is a considerable volume of dormant savings, particularly in the developing world (especially the so-called BRIC countries) and parts of developed Asia; many of the new funds being launched (by new or existing managers) are intended to tap this well of savings.  See "Local Currency Hedge Funds Expand Marketing and Investment Opportunities, but Involve Currency Hedging and Other Challenges," Hedge Fund Law Report, Vol. 3, No. 1 (Jan. 6, 2010).  Despite these seven factors (and there are likely others) motivating and hastening the movement of talent into and within the hedge fund industry, talent does not move in an entirely free market.  Rather, the mobility of talent is bound up in a web of legal and practical restrictions.  The basic purpose of this article − the first in a three-part series − is to identify relevant legal issues and offer practical suggestions to help talent negotiate the transition from a prop desk to the next hedge fund opportunity.  (The second article in this series will look at talent moves from the bank perspective, and a third article will look at talent moves from the perspective of the hedge fund management company to which the talent moves.)  To serve its purpose, this article discusses the following: the definition of "talent" (we are using the word as shorthand for a variety of typical job descriptions); the working definition of proprietary trading; the various types of entities from which and to which talent may move; which types of entities are likely to be the biggest winners in the movement of talent away from prop desks, and why; examples of recent talent moves from prop desks to other institutions; key legal considerations applicable to all moving hedge fund talent, whether such talent is moving to an existing hedge fund manager or starting its own shop (this discussion includes subtopics such as non-competition agreements, non-solicitation agreements, ownership of performance data and intellectual property, etc.); the key legal considerations specific to talent leaving a prop desk to start a new hedge fund management company; and the chief practical and cultural issues faced by talent that departs a prop desk to start or participate in running a hedge fund management company.

Does a Prime Broker Have a Due Diligence or Monitoring Obligation When Paying With Soft Dollars for a Hedge Fund Customer's Access to Expert Networks or Other Alternative Research?

A recent court opinion, a recent criminal complaint and certain bedrock principles of investment advisory law may be understood in concert to suggest a new category of potential liability for prime brokers, and thus a new or heightened due diligence obligation on the part of prime brokers.

Pair of District Court Opinions Illustrates the Difficulty of Enforcing a Purported Oral Agreement Between a Third-Party Marketer and a Hedge Fund Manager

On October 20, 2009 and November 9, 2010, the U.S. District Court for the Northern District of Illinois issued two opinions benefiting hedge fund manager Whitecap Advisors, LLC, in breach of contract litigation brought by third-party hedge fund marketer Coburn Group, LLC.  In the lawsuit, Coburn Group had accused Whitecap of breaching its oral agreement to continue to pay its commission for so long as the investors it introduced to Whitecap maintained investments with it.  Whitecap, in turn, had challenged Coburn Group’s claim that such an agreement existed, and claimed, alternatively, that they had entered a “pay-as-you-go” arrangement that it terminated following repeated unsuccessful attempts by both parties to reach a memorialized contract.  When Coburn Group moved for summary judgment, the District Court found that material issues of fact existed that necessitated a jury trial.  When Whitecap moved, days later, to preclude Coburn Group from introducing evidence at that trial of damages to Coburn Group that may arise in the future, the District Court agreed that such evidence would be inappropriate given the speculative nature of such damages, and granted Whitecap’s motion.  This action is particularly significant because not many legal opinions address the relationship between hedge fund managers and placement agents or third-party marketers.  This article details the background of the instant action and the court’s pertinent legal analysis.  For more on the relationships between hedge fund managers and placement agents or third-party marketers, 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); “Indemnification Provisions in Agreements between Hedge Fund Managers and Placement Agents: Reciprocal, But Not Necessarily Symmetrical,” Hedge Fund Law Report, Vol. 3, No. 41 (Oct. 22, 2010).

In Blow to Opponents of “Stranger-Owned Life Insurance,” New York’s High Court Rules that New York Law Did Not Prohibit a Person from Purchasing a Life Insurance Policy and Immediately Transferring that Policy to an Individual Who Does Not Have a Traditional Insurable Interest in the Purchaser’s Life

The New York Court of Appeals, the state's highest court, has upheld the practice of “stranger-owned life insurance” (SOLI) transactions under New York’s Insurance Law as it existed in 2005.  In 2005, attorney Arthur Kramer (Kramer) purchased life insurance policies on his own life with aggregate death benefits of more than $56 million.  The policies were purchased through newly-established insurance trusts that named three of his children as beneficiaries.  The trusts then sold the policies to investors, and the children assigned their interests as beneficiaries to other investors.  After Kramer’s death, his wife refused to provide certified death certificates to the investors who were trying to collect the policy proceeds.  Litigation ensued in U.S. District Court for the Southern District of New York.  Appeals were taken to the Second Circuit, which determined that the validity of Kramer’s SOLI transactions turned on the interpretation of New York Insurance Law §3205(b), which governs purchases of life insurance policies by persons who have no insurable interest in the life of the original policy holder.  Kramer’s insurers claimed that the SOLI arrangement violated both common law and §3205(b).  The Second Circuit certified the question of the interpretation of §3205(b) to the New York Court of Appeals, which ruled that, under §3205(b), a person may purchase life insurance on his own life and immediately assign that policy to a stranger with no insurable interest in the insured.  This year, New York made SOLI deals illegal.  We summarize the Court of Appeals’ ruling.  For an overview of “life settlement” investments by hedge funds, see “Life Settlement Securitizations Offer Hedge Funds Efficient Access to an Inefficient Market,” Hedge Fund Law Report, Vol. 2, No. 44 (Nov. 5, 2009); “Key Tax Considerations for Hedge Funds When Investing in Life Settlements,” Hedge Fund Law Report, Vol. 2, No. 40 (Oct. 7, 2009); “Hedge Funds Turning to Life Settlements for Absolute, Uncorrelated Returns,” Hedge Fund Law Report, Vol. 2, No. 39 (Oct. 1, 2009).

Settlement of SEC Fraud Charges by Small San Francisco-Based Hedge Fund Manager Highlights Importance of Valuation Checks and Balances

On December 1, 2010, the SEC instituted and simultaneously settled fraud charges against an individual hedge fund manager based in San Francisco.  (This matter is further evidence of reinvigorated enforcement efforts by the SEC's San Francisco office.  For a discussion of another matter recently initiated by that office, see "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," Hedge Fund Law Report, Vol. 3, No. 48 (Dec. 10, 2010).)  The allegations in the SEC's Order tell a familiar story: a young manager raises, at peak, $30 million; while the Order does not specify, the money likely came from friends and family.  The manager experiences losses in a relatively conservative investment strategy.  The manager, presumably embarrassed, tells his investors that everything is fine, while trying to make up those losses by taking on slightly more risk.  But instead, the manager loses more money, and his misrepresentations to investors depart to a greater extent from the facts.  Eventually, the manager comes clean, the fund is liquidated and the manager is charged by the SEC with civil fraud.  What is noteworthy about this matter are two statements in the SEC's order.

FRM Hires George Yepes to Head North American Business Development

On December 14, 2010, Financial Risk Management (FRM), a global hedge fund investment specialist with offices in Europe, Asia, North America and Australia, announced that it had hired George Yepes as Managing Director, Head of North American Business Development.

Highbridge Capital Management Appoints Mark D’Andrea as Head of Global Institutional Business Development

On December 9, 2010, Highbridge Capital Management announced that Mark D’Andrea will join the firm as Head of Global Institutional Business Development, effective January 3, 2011.