Dec. 29, 2010

Entry by SEC into a Non-Prosecution Agreement with Clothing Marketer Illustrates How Hedge Fund Managers May Survive Discovery of Certain Insider Trading Violations

By and large, and subject to the inequities of resources and circumstances, individuals in the U.S. are still innocent until proven guilty.  Not so entity defendants, for whom that time-honored axiom is reversed.  In practice, entity defendants are guilty until proven innocent; the law moves deliberately, but markets and investors move quickly.  And in the rare circumstances where the law vindicates an entity defendant (Andersen comes prominently to mind), it is often too late.  Hedge funds and their managers are uniquely susceptible to this guilty until proven innocent phenomenon.  Raj Rajaratnam and Galleon, and Art Samburg and Pequot, are exhibits A and B.  Granted, Rajaratnam, Samberg and their respective management companies have not been "proven innocent" of the insider trading with which they were charged.  But nor have they been proven guilty or liable.  Yet the reputations of the individual defendants have been irrevocably tarnished, and both of those seafaring management companies have sailed into the hedge fund graveyard.  Indeed, it has effectively become a truism in the hedge fund industry that an accusation of insider trading by the SEC or DOJ against a hedge fund management company or any of its personnel constitutes a "death knell" for that management company and its funds.  However, a recent development suggests that an insider trading charge need not be fatal to hedge fund managers that appropriately prepare for and respond to discovered or suspected insider trading.  On December 20, 2010, the SEC entered into a non-prosecution agreement with Carter's Inc., a publicly traded clothing marketer, based on the company's response to discovery of accounting fraud and insider trading by one of its sales executives.  In doing so, the SEC exercised for the first time one of the tools added to its enforcement arsenal as part of its cooperation initiative announced in January 2010.  See "Katten Muchin Rosenman Hosts Program on 'Infected Hedge Funds' Highlighting Rights and Remedies of Investors in Hedge Funds Whose Managers are Accused of Insider Trading or of Operating Ponzi Schemes," Hedge Fund Law Report, Vol. 3, No. 12 (Mar. 25, 2010); "Paul Hastings Hosts Program on Securities Litigation and Enforcement in Light of New SEC Initiatives to Enhance Enforcement Efforts and Encourage Witness Cooperation," Hedge Fund Law Report, Vol. 3, No. 6 (Feb. 11, 2010).  Although the Carter's matter arose in the public company context, the SEC's stated rationale for entering into a non-prosecution agreement with Carter's − as opposed to initiating an enforcement action against Carter's (as it did against the sales executive) − would apply with equal strength to a scenario where a hedge fund manager discovers, responds vigorously to and had prepared for an isolated instance of insider trading by one of its employees.  Accordingly, this article examines the Carter's matter as a precedent for how hedge fund managers can discover an insider trading violation by one of their employees, yet live to fight another day.  Specifically, this article: briefly reviews the relevant facts and legal allegations of the Carter's matter; discusses the SEC's stated rationale for entering into the non-prosecution agreement with Carter's; details four important lessons for hedge fund managers to be drawn from that rationale; then details the relevant provisions of the non-prosecution agreement (which are quite rigorous; the SEC does not give up good enforcement facts for a peppercorn).

Ten Due Diligence Questions that Might Have Helped Uncover the Fraud Described in the SEC's Recent Administrative Proceeding against Subprime Automobile Loan Hedge Fund Manager and Its Principals

On December 21, 2010, the SEC instituted and settled administrative proceedings against a San Francisco-based hedge fund management company and its principals.  A hedge fund managed by that company purported to invest almost exclusively in subprime auto loans, but in fact wound up "investing" largely in debt owed to the fund by entities controlled by principals of the management company and other hedge funds managed by the management company.  The SEC's Order in the matter is a study in conflicts of interest, strategy drift, material misstatements and omissions in offering documents and Form ADV and improper principal trades.  Working from the alleged facts of this matter, we derive ten due diligence questions that any investor should add to its questionnaire or incorporate into in-person meetings with managers.  Importantly, these are questions that should be asked periodically, not just prior to an initial investment.

Seventh Circuit Approves Federal Receiver’s Hedge Fund Liquidation Plan Subordinating Priority Rights of Redeeming Investors; Agrees That Equity Mandates That All Investors, Redeeming and Not, Be Treated Equally Where Fund Lacks Sufficient Assets to Make Them Whole

On December 1, 2010, the U.S. Court of Appeals for the Seventh Circuit affirmed a pro rata distribution plan for the liquidation of a family of investment vehicles, akin to hedge funds, over the objections of investors who claimed that their pre-receivership redemption requests gave them creditor-priority over non-redeeming investors.  The appeal arose out of an enforcement action by the U.S. Securities and Exchange Commission (SEC) against the collapsed management firm, Wealth Management LLC, and its six investment vehicles.  The U.S. District Court for the Eastern District of Wisconsin had appointed a receiver to take over and liquidate the defendants.  The objectors, non-parties to that action, claimed that the receiver’s liquidation plan illegally failed to recognize their rights, as equity investors who sought to redeem their shares prior to the funds’ collapse, to have their interests converted into corporate debt with liquidation priority over other non-redeeming equity investors.  The Circuit Court agreed with the District Court, ruling that the liquidation plan, which subordinated their interests in order to treat all investors equally, only needed to allocate receivership property in a manner that is “fair and reasonable” to all investors, and that state law did not govern the distribution.  We detail the background of the action and the Court’s pertinent legal analysis.

The Case In Favor of Non-Executive Directors of Offshore Hedge Funds with Investment Expertise, Fewer Directorships and Independence from the Manager

In a white paper dated November 2010, HedgeDirector generally argues that: (1) boards of offshore hedge funds, especially the non-executive directors, have an important role to play in making sure that hedge funds appropriately pursue their investment goals and avoid undue investment, regulatory and other risks; (2) offshore boards generally perform that role inadequately because directors typically lack investment expertise, serve on too many boards and are inappropriately influenced by the hedge fund manager; (3) the governance and investor protection roles of offshore boards can be better effectuated by directors with alternative investment experience, fewer directorships and more independence from the manager; and (4) stronger offshore boards would help persuade supervisors that the hedge fund industry can adequately regulate itself, and thus would diminish the likelihood of further hedge fund regulation.  This article outlines the argument of the white paper in greater detail, and critiques that argument.

Exculpation and Indemnity Clauses in the Hedge Fund Context: A Cayman Islands Perspective (Part One of Two)

In an increasingly litigious world, and a world of increasing commercial failures, those sustaining losses look for others to sue.  In the hedge fund context, this will typically take the form of funds, their liquidators or their shareholders derivatively suing service providers such as the investment manager, the investment adviser and the auditors, or the fund’s former directors.  Frequently, there will be clauses in the Articles of Association or other constituent documents of the fund, or in contracts with directors or service providers, for exculpation or indemnity, or both, of which potential defendants will seek to avail themselves.  If effective, these clauses will halt a claim in its tracks against those entitled to the benefit of them, but the ambit of such clauses, and the meaning of terms contained in them, are not always clear; and even if they are clear, they are not always clearly understood.  In a guest article, the first of a two-part series, Christopher Russell and Rachael Reynolds, Partner and Senior Associate, respectively, at Ogier, Cayman Islands, provide an overview of exculpation and indemnity clauses in Cayman Islands hedge fund documents, then offer a detailed discussion of the relevant global caselaw with respect to carve-out terms including actual fraud, personal dishonesty, fraud, wilful fraud or dishonesty, wilful default, wilful neglect, wilful misconduct and gross negligence.

Terms of Gartmore Settlement with SEC Suggest that in Calculating Disgorgement for Reg M Violations, SEC Will Use a First-In, First-Out Approach

On December 8, 2010, Gartmore Investment Limited (Gartmore), an SEC-registered, U.K.-based hedge fund manager, settled SEC charges that it violated Rule 105 of Regulation M of the Securities Exchange Act of 1934.  The SEC's Order in the matter is brief, but contains at least three important insights for hedge fund managers that, as part of their investment strategy, engage in short sales of public equity and invest in secondary stock offerings.  For background on Rule 105 of Reg M, see "SEC Settlement with Carlson Capital Suggests that Most Hedge Fund Managers with Multiple Strategies or Funds Will Not Be Able to Rely on the 'Separate Accounts' Exception to Rule 105 Under Regulation M," Hedge Fund Law Report, Vol. 3, No. 38 (Oct. 1, 2010); "Appaloosa Management L.P. Settles SEC Allegations of Reg M Violations in Connection with Short Sales," Hedge Fund Law Report, Vol. 3, No. 28 (Jul. 15, 2010); "SEC Obtains Permanent Injunction Against Hedge Fund Colonial Fund LLC for Illegal Short Sales; Opinion Addresses Fund Manager's Faulty Internal Compliance and Accounting Systems," Hedge Fund Law Report, Vol. 2, No. 29 (Jul. 23, 2009).