Mar. 18, 2011

Is the In-House Marketing Department of a Hedge Fund Manager Required to Register as a Broker?

The hedge fund adviser registration provisions of Dodd-Frank have, deservedly, received considerable attention during the last year from hedge fund managers and other industry participants.  However, there is another big registration question in the hedge fund industry – a question that predates Dodd-Frank by years; that has been discussed in hushed tones, for fear that regulators will overhear; and that may have consequences at least as powerful as the new adviser registration rule.  The question is the title of this article: is the in-house marketing department of a hedge fund manager required to register as a broker?  A closely related question is whether the members of such a department must register as associated persons of a broker.  These questions do not lend themselves to conclusive answers, but this article seeks to provide a framework for analyzing the relevant issues.  In particular, this article discusses: the general broker-dealer registration regime; SEC staff and court interpretations of the term “broker”; registration relief available to issuers and “finders”; the non-exclusive registration safe harbor for associated persons of an issuer; consequences of not registering as a broker if a person or entity is required to do so; specific challenges for hedge fund managers in complying with the safe harbor; how to structure in-house marketer employment agreements to fit within the safe harbor; and structuring alternatives for managers who elect to live with the broker registration regime.  According to our research, while the SEC has brought enforcement actions against various types of entities for operating as unregistered brokers, the SEC has not, to date, brought an action against a hedge fund manager solely for operating its in-house marketing department as an unregistered broker.  However, the SEC’s enforcement division is newly invigorated, with an asset management unit focused specifically on regulating hedge funds via enforcement.  Moreover, the consequences for failing to register as a broker when required to do so can be dramatic.  Finally, the “hushed tones” referenced above have not been entirely successful – we at the Hedge Fund Law Report have anecdotal and written evidence that the issue of broker registration of in-house hedge fund marketing departments is on the SEC’s radar screen.  That is, this article is not alerting the SEC to an issue of which the agency is unaware.  Rather, it is letting hedge fund managers know that they should be prepared – and offering guidance on how to prepare.

Sullivan v. Harnisch and SEC Proposed Whistleblower Rules Bolster Internal Compliance Programs While Creating Catch-22 for Compliance Officers

Congress’s passage of the Dodd-Frank Act in July 2010 raised many concerns that its whistleblower program would harm hedge fund internal compliance programs by giving incentives for employees to bypass internal compliance and instead report wrongdoing directly to the SEC for a whistleblower award.  But the recent case Sullivan v. Harnisch has bolstered internal compliance programs by confirming that a hedge fund can require its compliance officer to internally report fraud, and even validly fire him in retaliation (under New York law).  See “Can the Chief Compliance Officer of a Hedge Fund Manager be Terminated for Investigating a Potential Compliance Violation by the Manager’s Principal, CEO or CIO?,” Hedge Fund Law Report, Vol. 4, No. 2 (Jan. 14, 2011).  Similarly, the SEC has proposed new rules making legal, audit and compliance employees effectively ineligible for a whistleblower award unless they first report internally and their employer fails to respond properly, without clarifying whether there is a federal remedy for retaliation.  These developments will certainly bolster hedge fund internal compliance programs, but leave key employees in a Catch-22 of being required to report wrongdoing internally while having no legal remedy for retaliatory firing.  In a guest article, Samuel J. Lieberman and Jennifer Rossan, Of Counsel and Partner, respectively, in the Litigation Group at Sadis & Goldberg LLP, detail: the facts, holding, context and implications of Sullivan v. Harnisch; the mechanics and consequences of the proposed whistleblower rule for hedge fund compliance, legal and audit employees; case law interpreting a relevant provision under the False Claims Act; the dynamics of the Catch-22 created by Sullivan and the proposed whistleblower rule; and how that Catch-22 will impact internal compliance programs at hedge fund managers.

Massachusetts Commences Civil Securities Fraud Enforcement Action against Hedge Fund Investment Adviser Risk Reward Capital Alleging that the Hedge Fund Traded on Inside Information Provided through an Expert Network

On March 9, 2011, the Enforcement Section of the Massachusetts Securities Division of the Office of the Secretary of the Commonwealth filed an administrative complaint against investment adviser Risk Reward Capital Management Corp., the hedge fund it advised, the fund’s general partner and their principal.  This article summarizes the Division’s allegations, which constitute the first state-level enforcement efforts in the unfolding investigation of alleged insider trading in connection with the use of expert networks by hedge fund managers.

IOSCO Report Discusses Appropriate Use and Disclosure of Hedge Fund Redemption Suspensions, Gates and Side Pockets

On March 8, 2011, the International Organization of Securities Commissions (IOSCO) Technical Committee issued a draft Consultation Report entitled “Principles on Suspensions of Redemptions in Collective Investment Schemes.”  The report focuses on all open-ended collective investment schemes (CIS), including hedge funds, which offer a continuous redemption right, without regard to the type of investor to which the CIS is offered (i.e., institutional or retail).  The report proposes general principles to inform regulatory regimes in their oversight of CIS, and to guide fund managers in deciding if, when and how to suspend investor redemptions.  The report addresses basic management of liquidity risk, permissible reasons for suspension and the actions a CIS should take following a decision to suspend.  It emphasizes three basic principles, and offers guidance relating to alternative liquidity tools available in certain jurisdictions.  This article discusses the most important points of the consultation report, focusing in particular on the points most relevant to hedge fund managers.