Feb. 17, 2010

Hedge Funds in the Crosshairs: The Law of Insider Trading in an Active Enforcement Environment

As the Securities Exchange Commission and federal prosecutors continue their crackdown on what they perceive to be “systemic” insider trading within the hedge fund industry, now more than ever it is critical for all industry participants to be aware of the line between good research, including entirely lawful information-gathering, and impermissible insider trading.  In a guest article that should be required reading for investment, legal, compliance, marketing, operational and other professionals at hedge fund managers and their service providers – in short, for everyone in the hedge fund industry – Harry S. Davis and Richard Morvillo, both partners at Schulte Roth & Zabel LLP, and Justin Mendelsohn, an associate at Schulte, examine some of the commonly misunderstood areas of the law of insider trading in the context of the current, unprecedented regulatory environment.  Understanding the subtleties in the statutory framework is fundamental to protecting hedge fund management firms because, as we have all observed, mere allegations of insider trading can wipe out a multi-billion dollar hedge fund operation through massive investor redemptions.  In particular, this article discusses: the current regulatory environment; the definition of an “insider”; the broad scope of what constitutes a “trade in securities”; the meaning of a trade which is “on the basis of” material, non-public information; determining whether information is “material”; and the “mosaic theory” and its relationship to “materiality”.  Three among many critical points highlighted by this article are: (1) the definitions of “insider” and “security” for insider trading purposes are broader than you may think; (2) you do not have to actually use the information you receive in trading for a trade to be “on the basis of” that information; and (3) the “mosaic theory” does not permit a firm to trade in the securities of an issuer while a person at that firm is in possession of material, non-public information about that issuer.

Key Elements of a Hedge Fund Adviser Business Continuity Plan

The credit crisis changed the nature of institutional investor due diligence of hedge fund managers.  While performance remains a critical diligence point, aspects of the hedge fund advisory business other than performance now play a more prominent role in the investment decision-making process of institutional investors.  See “How Can Start-Up Hedge Fund Managers Use Past Performance Information to Market New Funds?,” Hedge Fund Law Report, Vol. 2, No. 50 (Dec. 17, 2009).  The idea is that even hedge fund managers with years of competitive fund performance and deep benches of investment talent can be laid low by inadequate risk management, compliance and controls.  Galleon is the paradigmatic example.  See “Best Practices for a Hedge Fund Manager General Counsel or Chief Compliance Officer that Suspects or Discovers Insider Trading by Manager Employees or Principals,” Hedge Fund Law Report, Vol. 2, No. 48 (Dec. 3, 2009).  One element of hedge fund adviser infrastructure that has received significant attention of late from institutional investors (as well as regulators) is the business continuity plan (BCP).  Broadly, as the name implies, a BCP is a written plan (often included in the compliance manual) in which a hedge fund manager identifies the range of events and risks that can interrupt business operations and investment activities, and details the steps that the manager will take if those events or risks come to fruition.  Events that may trigger the procedures in a BCP can be natural (e.g., hurricanes, earthquakes, pandemics), man-made (e.g., terrorism, theft, other crimes) or technological (e.g., power outages, disruption of exchanges, computer viruses).  And the procedures used to address those risks must be tailored to the manager’s strategy, technology, network of service providers and geographic location.  Moreover, the BCP has to be a living document – something that is tested, communicated to employees and other constituents, and updated as relevant.  It cannot be boilerplate: at this point, institutional investors have seen a healthy number of BCPs, and they will know when they see a BCP that reflects inadequate customization – and that can make the difference between investment and non-investment.  This article offers a comprehensive analysis of BCPs in the hedge fund context, as well as reporting from a recent webinar on the topic hosted by hedge fund technology firm Eze Castle Integration and prime broker Pershing Prime Services.  In particular, this article: defines a BCP more particularly; enumerates key elements of a hedge fund manager BCP (including, among others, development of an impact analysis, communications plans, backup facilities, coordination with third-party service providers and succession planning); and discusses: the impact of a hedge fund’s strategy on its manager’s BCP; regulatory requirements, including what the SEC looks for with respect to BPCs in the course of inspections and examinations; institutional investor expectations; disclosure considerations; communicating a BCP to hedge fund manager employees; and the frequency with which a BCP should be reviewed and updated.  This article is the first in a two-part series.  The second article in the series will deal with disaster recovery plans, which are close cousins of BCPs and are outlined in this article.

New York State Supreme Court Dismisses Hedge Funds of Funds’ Complaint against Accipiter Hedge Funds Based on Exculpatory Language in Accipiter Fund Documents and Absence of Fiduciary Duty “Among Constituent Limited Partners”

Plaintiffs Aris Multi-Strategy Fund, L.P., and Aris Multi-Strategy Offshore Fund Ltd. (together, Aris) are two funds of funds that invested in Accipiter Life Sciences Fund II (QP), L.P., Accipiter Life Sciences Fund II, L.P., and Accipiter Life Sciences Fund II (Offshore), Ltd. (collectively, Accipiter).  During the summer of 2008, about 60 percent of Accipiter’s investors – excluding Aris – requested redemptions of their interests in Accipiter as of the September 30, 2008 redemption date.  In October, Aris submitted a request to redeem its Accipiter interests effective as of the December 31, 2008 redemption date.  Shortly after Aris’ request, Accipiter announced that it would only honor the September 30, 2008 redemption requests, and that it was suspending all future redemptions so that Accipiter’s funds could liquidate in an orderly fashion.  In a relatively rare move in the hedge fund world, Aris sued Accipiter, its management companies and one of its principals for, among other things, negligence, breach of contract, breach of fiduciary duty and injunctive relief.  The defendants moved to dismiss the complaint for failure to state a cause of action.  The New York State Supreme Court dismissed the entire complaint, determining that the exculpatory language contained in the governing documents was sufficient to bar Aris’ claims.  We summarize the background of the action, Aris’ allegations and the court’s decision.  See also “Why Are Most Hedge Fund Investors Reluctant to Sue Hedge Fund Managers, and What Are the Goals of Investors that Do Sue Managers? An Interview with Jason Papastavrou, Founder and Chief Investment Officer of Aris Capital Management, and Apostolos Peristeris, COO, CCO and GC of Aris,” Hedge Fund Law Report, Vol. 2, No. 52 (Dec. 30, 2009).

Federal Judge Approves Settlement Agreements Arising out of Marc Dreier’s Criminal Fraud; Hedge Fund Victims “Squabble” Over Proposed Recovery

On February 5, 2010, the United States District Court for the Southern District of New York approved proposed settlement agreements and reconfirmed a restitution order for the distribution of assets from the estates of convicted swindler Marc Dreier and his law firm, Dreier LLP.  The court order responded to objections by certain hedge fund victims to those agreements, which had been reached between the United States Attorney’s Office for the Southern District of New York, the Securities and Exchange Commission, the Trustees in Bankruptcy overseeing the estates of Dreier and his firm, and two entities that had obtained proceeds and suffered losses from investing in Dreier’s fictitious notes: hedge funds GSO Capital Partners and its affiliates, and Fortress Investment Group LLC and its affiliates.  See “Affiliates of Hedge Fund Manager Fortress Investment Group Sue Dechert Over Opinion Letter Endorsing Marc Dreier,” Hedge Fund Law Report, Vol. 2, No. 52 (Dec. 30, 2009).  We discuss the background of the various related actions – including the dispute over the disposition of Dreier’s art collection – and the court’s legal analysis.

Barclays Capital Report Says Mid-Sized Hedge Funds Attract the Most Money from Investors and Hedge Funds Saw $150 Billion Inflows in First Nine Months of 2009

A December 2009, Barclays Capital’s Prime Services Division report on the hedge fund industry, entitled “Raising the Game,” found that hedge funds attracted $150 billion in new assets in the first nine months of this year.  Despite that inflow, the report stated that assets under management (AUM) remain an average of 32 percent below peak levels two years ago.  Even so, hedge fund managers surveyed for the report representing a combined total of $387 billion of AUM, or approximately one third of the industry, expressed optimism regarding future inflows.  Notably, the survey also found that hedge funds are devoting more resources to differentiate themselves as a result of the financial crisis.  See also “The Four P’s of Marketing by Hedge Fund Managers to Pension Fund Managers in the Post-Placement Agent Era: Philosophy, Process, People and Performance,” Hedge Fund Law Report, Vol. 2, No. 45 (Nov. 11, 2009).  This article details the most salient findings of the report and their implications.

Arbitration Panel Awards Bear Stearns Hedge Fund Investor Racetrac $3.4 million for Claims of Misrepresentation, Negligence and Failure to Supervise

On December 23, 2009, an arbitration panel awarded $3.4 million to Racetrac Petroleum Inc., an Atlanta-based chain of more than 525 gas stations and convenience stores across the U.S. Southeast.  Racetrac lost its $5 million investment in a former Bear Stearns hedge fund that collapsed in July 2007.  See “How Can Hedge Fund Managers Structure Their Compliance, Reporting and Disclosure Systems to Avoid Allegations of Principal Trading Rule Violations Such As Those Recently Alleged by the DOJ Against Former Bear Stearns Hedge Fund Manager Ralph Cioffi?,” Hedge Fund Law Report, Vol. 2, No. 36 (Sep. 9, 2009).  The award amount represents only 70 percent of Racetrac’s investment, but is significant because it is the first ruling in favor of an investor in one of two now defunct Bear Stearns hedge funds since a jury acquitted the funds’ former managers of criminal charges in November 2009.  We describe Racetrac’s specific claims and the panel’s decision.

SEC Enhances its Investigative Capabilities with Powerful New Document Review Software

In January 2010, the Securities and Exchange Commission (SEC) announced that Nuix Pty Ltd had won a five-year contract to provide the agency with corporate investigations software to assist in the detection of fraud and white-collar crime.  In non-technical language, the purpose of the Nuix software is to enable to SEC to review very large quantities of documents and data in a short time.  In other words, the software is intended to speed up the investigation process, or to dramatically expand the number of investigations the SEC can pursue in the same amount of time, without additional personnel.  In the conviction that hedge fund managers can benefit from a richer understanding of the SEC investigative process and technology, the Hedge Fund Law Report recently spoke with Nuix CEO Eddie Sheehy about how the Nuix software works and how the SEC will use the software in its fraud and insider trading investigations.  The transcript of that interview is included in this issue of the Hedge Fund Law Report.