Feb. 4, 2010

How Can Hedge Fund Managers Structure Managed Accounts to Remain Outside the Purview of the Amended Custody Rule’s Surprise Examination Requirement?

Under the amended custody rule, a registered hedge fund manager that has custody of client assets is required to undergo an annual surprise examination unless it is eligible for one or more of three exceptions from the surprise examination requirement.  Generally, an adviser is deemed to have custody under the amended rule in any of four circumstances: if (1) it maintains physical custody of client funds or securities; (2) it has the authority to obtain client funds or securities, for example, by deducting advisory fees from a client’s account or otherwise withdrawing funds from a client’s account; (3) it acts in a capacity that gives it legal ownership of or access to client funds or securities (for example, where it acts as general partner of a limited partnership); or (4) client funds or securities are held directly or indirectly by a “related person” of the adviser.  However, even if an adviser is deemed to have custody for any of the foregoing reasons, it would not be subject to the annual surprise examination requirement if it were eligible for any of the following three exceptions: (1) if it is deemed to have custody solely based on its fee deduction authority; (2) to the extent it advises pooled investment vehicles that deliver annual audited financial statements (prepared by an independent, PCAOB-registered accountant) to investors in the pool within 120 days of the end of the pool’s fiscal year (180 days for funds of funds); or (3) if it is deemed to have custody solely based on custody by a “related person” and that related person is “operationally independent” of the adviser.  For a thoroughgoing discussion of the mechanics of the amended custody rule, see “How Does the Amended Custody Rule Change the Balance of Power Between Hedge Fund Managers and Accountants?,” Hedge Fund Law Report, Vol. 3, No. 4 (Jan. 27, 2010).  Accordingly, most registered hedge fund managers would not be subject to the surprise examination requirement, with respect to hedge funds under management, because they would be eligible for the “pooled investment vehicle” exception.  However, to the extent a hedge fund manager also manages managed accounts, the manager would not be eligible for the pooled investment vehicle exception with respect to those managed accounts.  There are at least two reasons for this: (1) the typical managed account only has one investor, and thus is not “pooled” within the meaning of the amended custody rule; and (2) generally, hedge fund managers do not distribute audited financial statements to managed account investors (though such investors often conduct their own audits of the account).  See “How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures in Light of Amendments to the Custody Rule?,” Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010).  Therefore, a hedge fund manager may only avoid the annual surprise examination requirement with respect to any managed accounts under management if: (1) it is not deemed to have custody of the funds or securities in the managed accounts; or (2) it is eligible for an exception from the surprise examination requirement other than the pooled investment vehicle exception.  The problem is, many managed accounts are structured and operated in ways that would cause their managers to be deemed to have custody and would render their managers ineligible for any exception.  For example, if a hedge fund manager has authority to deduct fees from the managed account and custodies the managed account assets at an affiliate of the manager that is not operationally independent of the manager, the manager would not be eligible for any exception.  See “SEC Adopts Investment Adviser Custody Rule Amendments,” Hedge Fund Law Report, Vol. 3, No. 1 (Jan. 6, 2010).  Given the intrusiveness, expense and potential reputational harm arising out of surprise examinations, this article examines how managed accounts may be structured so that the manager will not be deemed to have custody of the assets in the account.  (The urgency of such avoidance is compounded by the growing chorus of calls from institutional investors for exposure to hedge fund strategies via managed accounts.)  In particular, the remainder of this article details: precisely what a managed account is (including the use of segregated portfolio companies in the Cayman Islands); the benefits of managed accounts; the drawbacks of managed accounts; how managed accounts can be structured and documented to avoid imputing custody of the assets in the account to the manager, or to ensure that the manager remains eligible for the fee deduction exception to the surprise examination requirement; the special case of private securities and illiquid assets; and special purpose vehicle considerations.

Offshore Fund Vehicles: Do U.S. Investment Managers Need Them?

With the green shoots of recovery beginning to emerge in the U.S. and significant amounts of capital withdrawn during the last twelve months beginning to be redeployed back into fund structures, should U.S. investment managers now be looking to establish offshore fund vehicles?  If so, what sources of capital should U.S. investments managers be looking to attract to invest into these offshore fund vehicles?  Additionally, with offshore jurisdictions subjected to more scrutiny than ever before, which jurisdictions should U.S. investment managers be looking to go to in order to domicile their offshore fund vehicles?  These are all important questions which U.S. investment managers and their advisors are frequently asking and which are worthy of consideration and analysis.  In a guest article, Ogier Partner Simon Schilder addresses these questions and discusses: the rationale for organizing offshore investment vehicles; potential changes to the unrelated business taxable income rules; the Alternative Investment Fund Manager Directive in the European Union; and considerations when selecting an offshore jurisdiction for organization of a hedge fund.

Hedge Fund Holders of Short Positions in Volkswagen Sue Porsche and Two Top Executives for Fraud for Allegedly Lying about Porsche’s Intention to Take over Volkswagen and Allegedly Manipulating the Supply of Porsche Stock

On October 26, 2008, Porsche Automobil Holding SE (Porsche), a European public company and German automobile manufacturer, announced that it owned directly, or had the right under cash-settled options to purchase, 74.1% of Volkswagen’s stock.  Plaintiffs are a group of hedge funds that held short positions in Volkswagen AG (VW) stock on that date.  VW’s stock price immediately rose on the Porsche announcement.  By the time Porsche went public with its VW holdings, plaintiffs’ short positions equaled more than 13% of VW’s outstanding shares.  Because the German State of Lower Saxony controlled more than 20% of VW, only about 6% of VW shares were available for purchase on the open market to cover the plaintiffs’ short positions.  A dramatic “short squeeze” ensued as plaintiffs scrambled to cover their short positions.  VW’s stock price soared from around 200 Euros per share prior to the Porsche announcement to over 1,000 Euros per share at the height of the squeeze on October 28, 2008.  Plaintiffs allege that, from as early as February 2008, Porsche lied and manipulated the market in a covert effort to accumulate sufficient options to take control of VW without paying a premium for control.  They claim that, had Porsche revealed its true intentions in the months prior to October 26, 2008, the price of VW stock would have begun to rise sooner and they would not have shorted VW stock at all or would have done so at higher prices.  They also allege that Porsche made billions in illicit profits by releasing some of its own VW shares for sale at the peak of the squeeze.  We summarize the hedge funds’ allegations and the events leading up to the dramatic October 2008 short squeeze.

Institutional Investor Forum Focuses on Hedge Fund Manager Fiduciary Duty, SEC Subpoena Power, Hybrid Hedge Fund Structures, Managed Account Platforms, Codes of Ethics and More

On January 27, 2010, the Practising Law Institute hosted the Institutional Investor Forum 2010 in New York City.  Among the key topics discussed during the conference were: fiduciary duty and the duties of good faith and fair dealing under Delaware law; exculpation and indemnification concerns in the context of Delaware limited partnerships and limited liability companies; various proposed and current federal and state regulations of hedge fund managers and placement agents; SEC staffing and budgeting; the SEC’s subpoena power when conducting examinations; hybrid fund structures and terms; managed accounts and managed account platforms; and what fraud prevention practices investors look for in hedge fund adviser Codes of Ethics.  This article offers a comprehensive summary of the key points raised and discussed at the conference.

Senate Banking Committee Holds Hearing on “Volcker Rule” Designed to Limit Banks’ Ability to Own, Invest In or Sponsor Hedge or Private Equity Funds

On February 2, 2010, Former Federal Reserve Chairman Paul Volcker testified before the U.S. Senate Committee on Banking, Housing and Urban Affairs on a key effort of the Obama Administration: to restrict commercial banking organizations from certain proprietary and speculative activities.  On January 21, 2010, the White House issued a press release endorsing the so-called Volcker Rule, which would seek to restrict the size and scope of financial institutions with the goals of reining in excessive risk-taking and protecting taxpayers.  With respect to scope, the proposal would seek to “ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.”  And with respect to size, the proposal would seek to “place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.”  At the hearing, Senate Banking Committee Chairman Christopher Dodd (D-CT) announced his support for the proposal, saying that the proposal was “borne out of fear that a failure to act would leave us vulnerable to another crisis, and of frustration at the refusal of financial firms to rein in their reckless behavior.”  We detail the key points from testimony at the hearing.

Duff & Phelps Roundtable Focuses on Hedge Fund-Specific Valuation, Accounting and Regulatory Issues

On January 28, 2010, Duff & Phelps Corp., the financial advisory and investment banking firm, hosted a roundtable discussion on the future of fair value accounting.  The panel consisted of Warren Hirschhorn, a Managing Director in the New York office of Duff & Phelps and the global head of its Portfolio Valuation practice, and David Larsen, Managing Director in the San Francisco office and a member of the Portfolio Valuation practice.  They reviewed the history of mark-to-market accounting, both before and since the promulgation of Standards of Financial Accounting Statement (FAS) 157 in September 2006, while seeking to correct mischaracterizations of that document; surveyed developments in accounting standards in late 2009 that may not yet have received sufficient attention from affected entities; outlined differences between the Financial Accounting Standards Board (FASB) and its London-based counterpart, the International Accounting Standards Board (IASB); discussed the degree to which the International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP) have or may converge; covered the question of “sensitivity analysis” (an analysis of the degree to which different assumptions about “inputs” may affect valuations), and whether such analysis should be mandated as part of either IFRS or GAAP; and briefly analyzed pending regulatory issues in Europe and the U.S.  This article summarizes the key points discussed at the conference on each of the foregoing topics.

Nicholas Plowman Named Partner at Ogier Hong Kong

Effective February 1, 2010, Nicholas Plowman was appointed Partner by Ogier in its Hong Kong office.  Plowman focuses on, among other things, private investment funds based in Asia.

Hedge Fund-Focused Channel Islands Law Firms Mourant and Ozannes to Merge

On February 3, 2010, Mourant du Feu & Jeune and Ozannes, two law firms in the Channel Islands, announced their intention to merge.  The deal, which is subject to regulatory approval, will be structured as a full economic merger of the existing businesses, effective May 1, 2010.