Apr. 21, 2011

How Can Hedge Fund Managers Structure the Compensation of Third-Party Marketers in Light of the Ban On “Contingent Compensation” Under New York City and California Lobbying Laws? (Part Two of Three)

An authoritative recent interpretation of New York City’s lobbying law and recent amendments to California’s lobbyist law likely will require placement agents and other third-party hedge fund marketers, in-house hedge fund marketers and, in some cases, hedge fund managers themselves, to register as lobbyists.  Such registration will impose new obligations and prohibitions on hedge fund marketers and managers.  See “Recent Developments in New York City and California Lobbying Laws May Impact the Activities and Compensation of In-House and Third-Party Hedge Fund Marketers (Part One of Three),” Hedge Fund Law Report, Vol. 4, No. 6 (Feb. 18, 2011).  Most dramatically, both California and New York City will prohibit a registered lobbyist from receiving contingent compensation, that is, compensation that is calculated by reference to the success of the lobbyist’s efforts in persuading a public pension fund to invest in a hedge fund.  Success-based compensation is the primary mechanism used to compensate and incentivize hedge fund marketers.  Accordingly, the legal change in California and the interpretive change in New York will fundamentally alter the economics of hedge fund marketing.  Or to set the stage in simpler terms: Hedge fund marketers will be required to register as lobbyists; hedge fund marketers are paid by commission; lobbying laws prohibit the payment of commissions to lobbyists; so how will hedge fund marketers be paid going forward?  This is the second article in a three-part series intended to address that question.  The first article included a comprehensive chart detailing the provisions relevant to hedge fund managers and marketers of the New York City and California lobbying laws.  This article examines how hedge fund managers can structure or restructure their arrangements with third-party hedge fund marketers in light of the ban on contingent compensation.  Specifically, this article discusses: the relevant provisions of the New York City Administrative Code and the California Code; trends in other states and municipalities; typical components, levels and structures of compensation of third-party hedge fund marketers (all of which were analyzed in depth in a prior article in the HFLR); four specific strategies that hedge fund managers can use to structure new arrangements with third-party marketers, and the benefits and burdens of each; three of the more challenging scenarios that hedge fund managers may face in restructuring existing agreements with third-party marketers, and the relevant legal considerations in each scenario; whether the New York City and California lobbying laws contain grandfathering provisions; special lobbying law considerations for funds of funds; and changes to representations, warranties, covenants and due diligence necessitated by the changes to the lobbying law.  The article concludes with a discussion of a “bigger issue” that has the potential to render the foregoing discussion largely moot.  (The third article in this series will examine related issues with respect to in-house hedge fund marketers.)

Ten Steps That Hedge Fund Managers Can Take to Avoid Improper Transfers among Funds and Accounts

On April 8, 2011, the SEC filed a complaint in the U.S. District Court for the Southern District of New York against Perry A. Gruss, the former chief financial officer of D.B. Zwirn & Co., L.P. (DBZ).  The complaint generally alleges that Gruss inappropriately authorized the transfer of cash from hedge funds and accounts managed by DBZ for four purposes: investments by the onshore fund with cash from the offshore fund; repayment of debt of the onshore fund with cash from the offshore fund; early payment of DBZ’s management fees by various funds and accounts; and purchase of an aircraft with funds from the onshore fund and a managed account.  The complaint relates a tale of meteoric growth at DBZ from October 2001 through October 2006.  By our reckoning based on figures in the complaint, DBZ’s AUM grew by $2.74 million per day during that five-year period.  However, the complaint also illustrates the fragility of even the most successful hedge fund management businesses.  DBZ was a great business that was laid low by alleged legal violations that in retrospect appear pedestrian and preventable.  This article relates the factual and legal allegations in the SEC’s complaint, then offers 10 detailed suggestions on how hedge fund managers can avoid the adverse consequences of violations such as those alleged against Gruss.

Former Portfolio Manager of Hedge Fund Manager FrontPoint Partners, Joseph F. “Chip” Skowron, Is Charged with Civil and Criminal Insider Trading Arising Out of Trading in Human Genome Sciences Stock

The Securities and Exchange Commission (SEC) has amended its complaint in its insider trading action against Dr. Yves M. Benhamou to name Joseph F. “Chip” Skowron III as an additional defendant.  Skowron allegedly traded on inside information provided by Benhamou about the results of a clinical trial of a hepatitis drug manufactured by Human Genome Sciences, Inc. (HGSI).  Skowron had served as portfolio manager for six funds sponsored by hedge fund manager FrontPoint Partners LLC.  Benhamou is a doctor who was on a steering committee overseeing a clinical trial of HGSI’s drug Albumin Interferon Alfa 2-a.  The U.S. Attorney for the Southern District of New York has brought parallel criminal insider trading charges against Skowron based in large part on the testimony of Benhamou, who has already pleaded guilty to similar charges and is now a cooperating witness.  We provide a detailed summary of the amended complaint.  For a summary of the SEC’s original complaint, which referred to Skowron only as “Co-Portfolio Manager 1,” see “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. 12, 2010).

For Registered Hedge Fund Managers, Inadequate Drafting or Enforcement of Privacy Policies and Procedures May Violate Regulation S-P, Even Absent Harm to Investors

Section 403 of the Dodd-Frank Act will repeal, as of July 21, 2011, the private adviser exemption in Section 203(b)(3) of the Advisers Act.  Thus, under the Advisers Act and the proposed rules thereunder with respect to registration, (1) hedge fund advisers with at least $150 million in AUM in the U.S. that manage solely private funds and (2) hedge fund managers with AUM in the U.S. between $100 million and $150 million that manage at least one private fund and at least one other type of investment vehicle will have to register with the SEC.  The compliance date for hedge fund adviser registration currently is July 21, 2011.  However, in a letter dated April 8, 2011, Robert Plaze, Associate Director of the SEC’s Division of Investment Management, indicated that the SEC may extend the registration compliance date until the first quarter of 2012.  See “SEC Anticipates Extension of Compliance Dates for Hedge Fund Adviser Registration and Mid-Sized Adviser Deregistration,” Hedge Fund Law Report, Vol. 4, No. 12 (Apr. 11, 2011).  As registered investment advisers, formerly unregistered hedge fund managers will face a range of new regulatory obligations.  Among other things, registered hedge fund managers will be subject to examination by the SEC – or by FINRA, depending on how regulatory turf wars play out – and will be required to 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.  On examinations, see Part 1, Part 2 and Part 3 of our three-part series on what hedge fund managers need to know to prepare for, handle and survive SEC examinations.  On Form ADV, see “Application of Brochure Delivery and Public Filing Requirements of New Form ADV to Offshore and Domestic Hedge Fund Managers,” Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011).  In addition, registered hedge fund managers will have to comply with certain provisions of Regulation S-P, the SEC rule governing privacy of consumer financial information.  Many of the provisions of Regulation S-P are substantially similar to Federal Trade Commission privacy rules that, even before Dodd-Frank, applied to unregistered hedge fund managers.  Also, as a practical matter, even unregistered hedge fund managers have in many cases operated as if they were registered (including with respect to privacy of investor information) in order to accommodate the infrastructure demands of institutional investors.  However, the direct application of Regulation S-P to registered hedge fund advisers will constitute a regulatory change, and will require managers to revisit and revise (even if marginally) their privacy policies and procedures.  As hedge fund managers undertake such a revision process, they would do well to keep in mind a recent settlement order in an SEC administrative proceeding against the former chief compliance officer of a defunct broker-dealer.  This article discusses the legal context of the order, summarizes the factual and legal findings in the order and highlights the more notable privacy points for hedge fund managers.

Recent U.S. Tax Court Decision Suggests That Partners of Hedge Fund Management Companies Organized As Limited Partnerships May Be Subject to Self-Employment Tax

The U.S. Tax Court has ruled against a law firm limited liability partnership that had taken the position that its partners were not subject to self-employment tax on their respective shares of partnership income.  The case is relevant to the hedge fund industry because some fund management companies are organized as limited partnerships whose individual limited partners also work for the partnership and render management services.  We summarize the Court’s decision, emphasizing the self-employment tax discussion.

Opus Trading Fund Accuses Former Trader That Joined Competitor of Breach of Contract and Misappropriation of Proprietary Information

In a complaint filed on March 28, 2011 in New York County Supreme Court, trading and investment firm Opus Trading Fund, LLC (plaintiff) accused a former Opus trader, David Kleinman (defendant), of violating the confidentiality and non-competition clauses of his employment agreement by accepting employment with a competitor that follows a similar trading strategy.  For more on the legal and practical issues relating to confidentiality and non-competition clauses in employment agreements for hedge fund investment talent, see “Key Legal Considerations in Connection with the Movement of Talent from Proprietary Trading Desks to Start-Up or Existing Hedge Fund Managers: The Talent Perspective (Part One of Three),” Vol. 3, No. 49 (Dec. 17, 2010).  In addition to illustrating the types of legal disputes that can arise when trading talent moves from one firm to another, this matter also illustrates the importance of protecting sensitive information with technology.  This article summarizes the factual and legal allegations in the complaint, with emphasis on the security measures Opus implemented to protect its digital property.  For discussions of other disputed talent moves and hedge fund employment disputes, see, e.g., “Broadly Defined Terms in a Term Sheet Covering Employment of a General Counsel May Render Hedge Fund Manager Principal Personally Liable for Unpaid Compensation,” Hedge Fund Law Report, Vol. 4, No. 12 (Apr. 11, 2011); “Dispute between Structured Portfolio Management and Jeffrey Kong Offers a Rare Glimpse into the Compensation Arrangements between a Top-Performing Hedge Fund Management Company and a Star Portfolio Manager,” Hedge Fund Law Report, Vol. 4, No. 8 (Mar. 4, 2011); “Hedge Fund Research and Advisory Firm Aksia LLC Sues Two Former Employees for Misappropriation and Destruction of Confidential Business Information,” Hedge Fund Law Report, Vol. 3, No. 4 (Jan. 27, 2010); “New York Trial Court Permits Action for Misappropriation of Hedge Fund Proprietary Software and Breach of Partnership Agreement To Proceed,” Hedge Fund Law Report, Vol. 2, No. 6 (Feb. 12, 2009); “Protecting Hedge Funds’ Trade Secrets: The Federal Government’s Enforcement of Criminal Laws Protecting Proprietary Trading Strategies,” Hedge Fund Law Report, Vol. 3, No. 48 (Dec. 10, 2010).

Cantor Fitzgerald & Co. Adds Equity Securities Lending Team Within Prime Services Group

On April 20, 2011, Cantor Fitzgerald & Co. announced the addition of a new Equity Securities Lending team within the Cantor Prime Services Group, with the hiring of Securities Lending veterans Allen Wolkow and Janah Angelou, who will co-manage the effort.

Julius Leiman-Carbia Named Head of SEC’s National Broker-Dealer Examination Program

On April 20, 2011, the Securities and Exchange Commission announced the appointment of Julius Leiman-Carbia as Associate Director to lead the National Broker-Dealer Examination Program in the SEC’s Office of Compliance Inspections and Examinations (OCIE).  For more on SEC examinations of hedge fund managers, see Part 1, Part 2 and Part 3 of our three-part series on what hedge fund managers need to know to prepare for, handle and survive SEC examinations.