Apr. 1, 2011

How Can Hedge Fund Managers Avoid Insider Trading Violations When Using Expert Networks? (Part Two of Two)

This is the second article in our two-part series intended to assist hedge fund managers in avoiding insider trading violations when using expert networks.  The first article in the series provided a detailed discussion of the law of insider trading.  See “How Can Hedge Fund Managers Avoid Insider Trading Violations When Using Expert Networks? (Part One of Two),” Hedge Fund Law Report, Vol. 4, No. 5 (Feb. 10, 2011).  This article – the second in our series – includes a detailed summary of the factual and legal allegations in the relevant civil and criminal complaints.  In light of the importance of the ongoing expert networks insider trading investigation to the hedge fund industry, and in light of the importance of the alleged facts in understanding the investigation, this article provides a comprehensive discussion of the alleged facts.  This article is long – over 25 pages – but is important reading for anyone who wants to understand the investigation, and its implications for hedge fund managers, at a granular level.  Specifically, this article provides: links to the primary civil complaint and the eight primary criminal complaints; a chart listing, with respect to the defendants and relevant uncharged parties: name, job category, background information, civil and criminal charges and plea status (where applicable); public companies about which experts in the network of Primary Global Research, LLC (PGR) allegedly passed inside information to PGR clients; language of selected public company compliance policies; PGR revenues during the relevant period and the sources of those revenues; compensation of PGR experts and employees; and the sources of information included in the criminal complaints.  The core of this article is a series of detailed summaries of the material civil and criminal allegations against the various defendants.  The allegations are organized by defendant, and for each defendant, are listed chronologically.  Also, for each allegation, we have included a citation to the specific paragraph of the specific complaint containing the allegation.  (For HFLR subscribers that wish to undertake a review of the original documents, these citations, along with our links to the relevant complaints, will save hours of research time.)  Our summaries of the factual allegations focus on the specific information allegedly conveyed by PGR experts to hedge fund managers, the timing of communications relative to public earnings announcements, the methods and channels through which information was communicated and the interconnections between the nine documents under analysis.  This article is a significantly expanded version of a prior article published in our March 11, 2011 issue.  See “The Hedge Fund Law Report Provides Due Diligence Roadmap for Institutional Investors Examining Use by Hedge Fund Managers of Expert Networks,” Hedge Fund Law Report, Vol. 4, No. 9 (Mar. 11, 2011).  For HFLR subscribers who have read that prior article, we have included in this article a redline highlighting the new information in this article.  Also, it should be noted that this article focuses on the civil and criminal allegations relating to trading in shares of public technology companies based on material nonpublic information allegedly obtained via one expert network firm or its employees or experts.  This article does not cover another category of complaints involving drug trials and alleged insider trading allegedly facilitated, directly or indirectly, by expert networks.  However, the HFLR has covered those other matters.  See “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,” Hedge Fund Law Report, Vol. 4, No. 10 (Mar. 18, 2011); “SEC and DOJ Commence, Respectively, Civil and Criminal Insider Trading Actions Against a Doctor Who Allegedly Tipped Off a Hedge Fund Manager to Impending Negative Information About a Drug Trial,” Hedge Fund Law Report, Vol. 3, No. 44 (Nov. 10, 2010).

Application of Brochure Delivery and Public Filing Requirements of New Form ADV to Offshore and Domestic Hedge Fund Managers

Many hedge fund managers that previously were not required to register with the SEC as investment advisers will be required to register by July 21, 2011 – that is, in just under four months – unless the SEC extends the registration deadline.  Rule 203-1 under the Investment Advisers Act of 1940 (Advisers Act) currently provides that to apply for registration with the SEC as an investment adviser, a hedge fund manager must complete Form ADV, file Part 1A of Form ADV and file the brochure(s) required by Part 2A of Form ADV electronically with the Investment Adviser Registration Depository (IARD).  Last July, the SEC finalized amendments to Part 2 of Form ADV and related rules under the Advisers Act.  Those amendments were long in the making – a decade, by some counts – and they have changed Part 2 significantly.  Most notably, Part 2 is now entirely narrative, publicly filed and deeper and broader in terms of the categories of required disclosure (including disciplinary history).  So, hedge fund managers will have to register as investment advisers and registered investment advisers must file Form ADV, Part 2.  Therefore, registered hedge fund managers will have to file Form ADV, Part 2.  For managers, this has been an expensive syllogism.  Many have hired compliance consultants with the goal of saying no more and no less than is required in their Part 2s.  Recently, the staff of the SEC’s Division of Investment Management (Division) offered assistance in this collective benchmarking effort by publishing “Staff Responses to Questions About Part 2 of Form ADV” (Staff Responses).  The Staff Responses include a series of commonly asked questions and answers to those questions.  But the questions are broad and the answers are terse, in some cases, limited to a single, oracular word.  While better than no statement from the Division, the Staff Responses raise as many questions as they answer.  In particular, the Staff Responses say nothing about the background and context of the answers; provide no guidance on the interaction among and application of the answers; and fail to highlight the extent to which certain answers render others largely moot.  This article seeks to fill in the blanks left by the Staff Responses.  It does so by discussing: the legal and regulatory authority supporting some of the more relevant answers; where those answers fit into the more general patchwork of hedge fund regulation; the interaction among the answers; and the application of the answers to offshore advisers to offshore hedge funds.  The article also offers guidance on implementing certain answers and highlights what certain of the answers do not cover.

Investments by Family Offices in Hedge Funds through Variable Insurance Policies: Tax-Advantaged Structures, Diversification and Investor Control Rules and Restructuring Strategies (Part One of Two)

Variable insurance policies are an often utilized structure through which family offices and other high net worth investors invest in hedge funds and other private investment funds.  One of the primary advantages of investing in hedge funds and other private investment funds through variable insurance policies is the deferral of income taxes.  However, policy holders must first satisfy two important tests – the “diversification rules” and the “investor control” rules – in order for the policies to qualify for favorable income tax treatment.  This article is the first in a two-part series of guest articles in the HFLR by James Schulwolf and Peter Bilfield, both Partners at Shipman & Goodwin LLP, and Lisa Zana, a Senior Associate at Shipman.  This article describes the mechanics of investing in an insurance dedicated fund through variable insurance policies and offers a roadmap for satisfying the two tests to ensure the variable insurance policies maintain their tax-advantaged status.  The second article in this series will describe in detail a recent restructuring transaction in which the authors participated and provide the key terms in the transaction documents applicable to the diversification and investor control rules.

Twelve Operational Due Diligence Lessons from the SEC’s Recent Action against the Manager of a Commodities-Focused Hedge Fund

On March 15, 2011, the SEC filed a complaint the U.S. District Court for the Southern District of New York against Juno Mother Earth Asset Management, LLC (Juno) and its principals, Arturo Rodriguez and Eugenio Verzili.  The complaint alleges that Juno and its principals started selling interests in the Juno Mother Earth Resources Fund, Ltd. (Resources Fund) in late 2006, and by the middle of 2008, substantially all of the Resources Fund's investors had requested redemptions.  The SEC alleges that during the short life of the Resources Fund, Rodriguez and Verzili engaged in a range of bad acts, including misappropriation of fund assets, inappropriate loans from the fund to the management company, misrepresentations of strategy and assets under management and disclosure violations.  Assuming for purposes of analysis that the allegations in the complaint are true, the complaint illuminates a variety of pitfalls for institutional investors to avoid.  This article describes the factual and legal allegations in the complaint, then details twelve important lessons to be derived from the complaint.  Similar to other articles we have published extracting due diligence lessons from SEC complaints, the intent of this article is to serve as a tool for institutional investors or their agents that can be used directly in performing due diligence, or can be used to update a due diligence questionnaire.  Our hope in publishing this article (and others of its type) is that at least one of the twelve lessons that we extract from the complaint enables an investor to identify a due diligence issue that it otherwise would have missed.  We think that there is no better way to identify future hedge fund frauds than to understand the mechanics and lessons of past frauds.

CalPERS “Special Review” Includes Details of Misconduct and Recommendations That May Fundamentally Alter the Hedge Fund Placement Agent Business

In 2009, the California Public Employees’ Retirement System (CalPERS) – the largest state pension fund in the country, with about $228 billion in assets held for the benefit of over 1.6 million California public employees, retirees and their families – discovered that exorbitant fees had been paid by certain of its external money managers to placement agents.  CalPERS retained the law firm of Steptoe & Johnson LLP to investigate whether the payment of these fees compromised the interests of its participants and beneficiaries.  The Steptoe investigation focused on placement agents that allegedly used their connections with certain members of CalPERS’ Board of Administration (Board), executive staff and senior officers to obtain excessive fees from money managers and others who wished to obtain access to CalPERS contracts.  As previously reported in the Hedge Fund Law Report, in December 2010, the law firm issued a series of twelve preliminary recommendations to CalPERS’ Board and its executive staff for its immediate consideration in remedying the harm to its beneficiaries and participants caused by the improper use of placement agents.  See “CalPERS Special Review Foreshadows Seismic Shift in Business Arrangements among Public Pension Funds, Hedge Fund Managers and Placement Agents,” Hedge Fund Law Report, Vol. 4, No. 1 (Jan. 7, 2011).  Since that time, CalPERS has effectively adopted each of these recommendations.  Then, on March 14, 2011, Steptoe & Johnson issued the “Report of the CalPERS Special Review.”  This Report detailed, subject to limitations requested by law enforcement agencies and allegations for which the law firm could not obtain sufficient corroboration, the apparent misconduct and ethical breaches committed by former CalPERS Board members and employees.  The Report also offered four additional recommendations to prevent a recurrence.  As a result of its size and experience with hedge funds, CalPERS is a trendsetter for other public pension funds and institutional investors with respect to hedge fund investment terms and governance, placement agent relationships and related matters.  Accordingly, the Report, like the previously issued recommendations, is of broad interest to hedge fund managers, investors and service providers.  See generally “Lessons for Hedge Fund Managers on Liquidity, Allocations, Marketing and More from Yale’s 2009 Endowment Report,” Hedge Fund Law Report, Vol. 3, No. 14 (Apr. 9, 2010).  Indeed, the Report acknowledges that CalPERS’ experience “was apparently no different . . . than that of a number of other public pension funds.”  This article summarizes: the findings of the Report; the four key recommendations made in the Report; and the terms of letter agreements entered into with respect to fees between CalPERS and some of its more prominent external money managers, including Apollo Global Management.

GM Bankruptcy Judge Rejects Distressed Debt Hedge Fund Investors’ Objections to Reorganization Plan

The U.S. Bankruptcy Court for the Southern District of New York has confirmed, subject to minor modifications, the proposed reorganization plan (Plan) of General Motors Corp., now known as Motors Liquidation Company (Old GM).  Although overwhelmingly approved by Old GM’s creditors, hedge funds (Funds) that held debt of one of Old GM’s subsidiaries objected to the Plan because their claims are disputed by Old GM’s creditors’ committee and the Plan does not require immediate distribution to holders of disputed claims.  The Funds claimed that the Plan was not proposed in good faith, that it unfairly discriminated between holders of disputed and undisputed unsecured claims, and that it failed to segregate a reserve for the Funds’ claims.  The Court rejected all of these contentions, holding that it was fair and reasonable for Old GM to delay even partial payment of disputed unsecured claims until such claims were resolved.  We summarize the Court’s decision, with an emphasis on the Funds’ objections.  See generally “Legal Considerations for Investors In and Around the General Motors Bankruptcy, And Similar Distressed Situations Involving Politically Important Stakeholders,” Hedge Fund Law Report, Vol. 2, No. 23 (Jun. 10, 2009); “Equities of Bankrupt Companies Offer Hedge Funds a High Risk, Potentially High Return Method of Investing in Restructurings,” Hedge Fund Law Report, Vol. 2, No. 27 (Jul. 8, 2009).

Survey by SEI and Greenwich Associates Identifies the Primary Decision Factors and Concerns of Institutional Investors When Investing in Hedge Funds

A survey of 97 institutional investors and 14 investment consultants conducted by SEI Knowledge Partnership in collaboration with Greenwich Associates last October, and released earlier this year, identifies the hierarchy of considerations and concerns of institutional investors when investing in hedge funds.  One notable finding of the survey – especially for a publication, like the HFLR, focused on regulation – is the view of most institutional investors with respect to regulation.  That view is discussed in this article.  In addition, this article discusses the survey’s findings on the following topics: statistics with respect to hedge fund returns, assets under management, launches and liquidations during the last three years; plans with respect to hedge fund allocations during 2011; objectives of institutional investors when investing in hedge funds; most significant challenges in hedge fund investing; experience with and perceptions of liquidity; the 16 factors that investors consider most important when selecting among managers; four key takeaways for hedge fund managers from the survey findings; breakdown of hedge fund allocations by institutional investor type; trends with respect to fees; the role of consultants; the success rate of negotiations on liquidity terms; and trends with respect to the resources dedicated by institutional investors and consultants to hedge fund due diligence and monitoring.

KKR’s Treasurer and IR Head, Jonathan Levin, to Join Grosvenor Capital Management

Jonathan R. Levin will be leaving Kohlberg Kravis Roberts & Co. to join Grosvenor Capital Management, L.P., a Chicago alternative asset manager, as Senior Vice President, Strategy and Corporate Development, a newly-created position.  Writing by Scott Lederman, Managing Director at Grosvenor, has been referenced in the Hedge Fund Law Report.  See, e.g., “Is the In-House Marketing Department of a Hedge Fund Manager Required to Register as a Broker?,” Hedge Fund Law Report, Vol. 4, No. 10 (Mar. 18, 2011).

SEC Names WilmerHale Partner Anne K. Small as Deputy General Counsel

On March 24, 2011, the SEC announced the appointment of Anne K. Small as Deputy General Counsel in the SEC’s Office of General Counsel.  See also “Mark Cahn Named SEC General Counsel,” Hedge Fund Law Report, Vol. 4, No. 5 (Feb. 10, 2011).