Jun. 8, 2011

How Can Hedge Fund Managers Avoid Criminal Securities Fraud Charges When Allocating Trades Among Multiple Funds and Accounts?

All hedge fund managers that manage multiple funds and accounts – which is to say, the vast majority of hedge fund managers – have to draft, implement and enforce policies and procedures governing the allocation of trades among those funds and accounts.  Where those funds and accounts follow explicitly different strategies, the appropriate approach to allocations is relatively straightforward.  For example, if a manager manages an equity long/short fund and a credit fund, equities go to the equity fund and bonds go to the credit fund.  But where multiple funds and accounts may be eligible to invest in the same security, the appropriate approach to allocations is more challenging.  For example, if a manager manages an equity long/short fund and an activist fund and purchases a block of public equity, how and when should the manager determine how to allocate the block between the two funds?  While the specifics of an allocations policy will depend on the manager’s fund structures and strategies, some general principles and proscriptions apply.  As for principles, an allocations policy should be equitable, should take into account the size and strategies of various funds, should provide a mechanism for correcting allocation errors and should give the manager an appropriate degree of discretion in making allocation determinations.  As for proscriptions, the boundaries of “appropriate discretion” in this context generally are set by the anti-fraud provisions of the federal securities laws and principles of fiduciary duty.  In other words, you cannot allocate trades in a manner that constitutes securities fraud.  How might trade allocations constitute securities fraud?  A recent SEC order (Order) answers that question; and a prior criminal indictment (Indictment, and together with the Order, the Charging Documents) and plea arising out of the same facts raises the frightening prospect that in more egregious circumstances, fraudulent trade allocation practices may constitute criminal securities fraud.  This article explains the facts and legal violations that led to the Order, Indictment and plea, then discusses the implications of this matter for hedge fund managers in the areas of trade allocations, marketing, disclosure on Form ADV and creation and maintenance of books and records.  In particular, this article discusses: why the cherry-picking scheme at issue in this matter was not just a bad legal decision, but also a bad business decision; two types of cherry-picking; whether and in what circumstances cherry-picking may lead to criminal liability; how the sometimes purposeful vagary of criminal indictments can subtly expand the reach of white collar criminal liability; whether disclosure can cure trade allocation practices that are otherwise fraudulent; the compliance utility of technology; conflicts of interest inherent in one person serving as chief compliance officer and in other roles; whether post-trade allocations are ever permissible; how hedge fund managers can test the sufficiency of their trade allocation policies; how trade allocation policies interact with the transparency rights sometimes granted to larger hedge fund investors; and the idea of “cross-fund transparency.”

If a Hedge Fund Goes into Liquidation between the Time of an Investor’s Subscription and Issuance of Fund Shares to that Investor, Who Owns the Money Paid for the Fund Shares?

Although both an investor and a hedge fund manager have a common interest in completing the subscription process, intervening events – for example, a petition for the winding up and liquidation of the fund before the process is complete – necessarily require a determination of the point in time at which the investor’s subscription monies cease to be its own, and fall within the ambit of the fund’s own assets.  In particular, if the fund is placed into liquidation after receipt of the investor’s subscription monies, but before issuing and registering the shares subscribed for, the question becomes: Would the investor be entitled to the return of the subscription monies, or entitled only to a pro-rated distribution in the liquidation which may become payable to it either as a creditor or member?  In a guest article, Christopher Russell and Shaun Folpp, Partner and Managing Associate, respectively, at Ogier, Cayman Islands, address this question.  In the process, Russell and Folpp discuss “Quistclose” trusts, constructive trusts and the extensive case law relevant to the ownership of subscription monies after liquidation but before the issuance of shares.

Alternative Investment Management Association Publishes Institutional Investor Guide Covering Hedge Fund Governance, Risk, Liquidity, Performance Reporting, Investor Relations, Marketing, Operations, Valuation, Due Diligence and Other Topics

On May 31, 2011, the Alternative Investment Management Association (AIMA), published a guide aimed at communicating institutional investors’ views, expectations and preferences to the hedge fund industry.  As described by AIMA Chairman Todd Groome, the guide was published “[i]n light of the ongoing ‘institutionalisation’ of the hedge fund industry and the growth of institutional investor participation.”  The authors of the guide, members of the AIMA Investor Steering Committee, and “some of the most influential investors and advisors in the industry,” include Luke Dixon of Universities Superannuation Scheme, Andrea Gentilini of Union Bancaire Privée, Kurt Silberstein of the California Public Employees Retirement Scheme, Michelle McGregor-Smith of British Airways Pension Investment Management and Adrian Sales of Albourne.  See “CalPERS ‘Special Review’ Includes Details of Misconduct and Recommendations That May Fundamentally Alter the Hedge Fund Placement Agent Business,” Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011).  The guide covers a range of increasingly relevant operational and organizational issues that institutional investors consider in their due diligence reviews, including: hedge fund governance, constitutional documents, the role of the board of directors, performance reporting practices and transparency, counterparty risk, operations, fund liquidity, risk controls, ownership of the management company, sales and marketing, valuation, business continuity planning, compliance, service provider relationships and more.  This article offers a comprehensive discussion of the key principles, ideas and recommendations presented in the guide.

Houston Pension Fund Sues Hedge Fund Manager Highland Capital Management and JPMorgan for Breach of Fiduciary Duty, Alleging Self-Dealing and Conflicts of Interest

In 2006 and 2007, plaintiff Houston Municipal Employees Pension System (HMEPS) invested an aggregate $15 million with hedge fund Highland Crusader Fund, L.P. (Fund).  The Fund was sponsored by Highland Capital Management, L.P. (Highland), which also served as the Fund’s investment manager.  The Fund’s general partner was defendant Highland Crusader Fund GP, L.P. (General Partner).  Defendant J.P. Morgan Investor Services Co. (JPMorgan) provided administrative support to the Fund.  The Fund is now in liquidation.  In a lawsuit filed in the Delaware Court of Chancery on May 23, 2011, HMEPS generally claims that, during the credit crisis of 2008, the Highland defendants and their principals “looted” the Fund with the assistance of JPMorgan and engaged in self-dealing by selling themselves high-quality assets from the Fund and leaving the Fund with junk assets.  HMEPS relies in part on a whistleblower complaint filed by a JPMorgan employee who observed “questionable accounting and management practices” at the Fund.  HMEPS claims that Highland, the General Partner and their principals breached their fiduciary duties to the Fund and that JPMorgan aided and abetted that breach.  HMEPS is suing derivatively on behalf of the Fund.  We summarize HMEPS’ specific allegations and Highland’s recent press release in response.

The Supreme Court Rejects Loss Causation Requirement at Class Certification Stage

On June 6, 2011, in Erica P. John Fund, Inc. v. Halliburton Co., the Supreme Court unanimously held that private securities fraud plaintiffs do not need to prove loss causation in order to obtain class certification.  The high court drew a firm line between two separate elements of a private securities fraud claim: (1) reliance on alleged misrepresentations or omissions, and (2) loss causation.  In a guest article, Jonathan K. Youngwood and Joseph M. McLaughlin, litigation partners with Simpson Thacher & Bartlett LLP in New York, discuss the factual and procedural background of the decision, the Supreme Court’s legal analysis and the implications of the decision for private securities fraud litigation.

Venor Capital Management Hires John Roth, Formerly of Harbinger Capital Partners, As Counsel and Chief Compliance Officer

On June 7, 2011, Venor Capital Management LP, an asset manager focusing on event-driven investing, announced that John H. Roth joined the firm as Counsel and Chief Compliance Officer, a newly created position.

Davis Polk Welcomes Leading Futures, Commodities and Derivatives Lawyer, Susan C. Ervin

On June 8, 2011, Davis Polk & Wardwell LLP announced that Susan C. Ervin, a leading futures, commodities and derivatives lawyer, is joining the firm as a partner in its Washington, D.C. office.  Ervin's addition provides Davis Polk’s Financial Institutions Group with expanded expertise in futures, commodities and derivatives, including the soon-to-be regulated swaps market.

Castle Hall Alternatives Expands Its Operational Due Diligence Expertise with the Addition of Ben Sansoucy

On June 6, 2011, operational due diligence provider Castle Hall Alternatives announced that Ben Sansoucy has joined the firm’s senior management team.  Castle Hall assists leading institutional investors, fund of funds, advisers, family offices and endowments in identifying and managing hedge fund operational risk.