Jul. 1, 2011

To Whom Should the Chief Compliance Officer of a Hedge Fund Manager Report?

As we and others reported, at an open meeting held on June 22, 2011, the SEC delayed the date by which many hedge fund managers will have to register as investment advisers.  The new registration deadline is March 30, 2012.  See “SEC Delays Registration Deadline for Hedge Fund Advisers, and Clarifies the Scope and Limits of Registration Exemptions for Private Fund Advisers, Foreign Private Advisers and Family Offices,” Hedge Fund Law Report, Vol. 4, No. 21 (Jun. 23, 2011).  One of the consequences of registration is that registered hedge fund managers will have to designate a chief compliance officer (CCO) to administer their compliance policies and procedures.  See “Who Should Newly Registered Hedge Fund Managers Designate as the Chief Compliance Officer and How Much Are Chief Compliance Officers Paid?,” Hedge Fund Law Report, Vol. 4, No. 7 (Feb. 25, 2011).  The rule requiring registered investment advisers to designate a CCO – SEC Rule 206(4)-7 – provides that the CCO of a registered hedge fund manager “should have a position of sufficient seniority and authority within the organization to compel others to adhere to the compliance policies and procedures.”  However, the rule does not prescribe any specific institutional designs that would be sufficient to confer the required “seniority and authority” on a CCO.  That is, the rule requires a CCO to have authority, but it does not tell hedge fund managers what specific steps to take to ensure that the CCO has such authority.  Accordingly, hedge fund managers confronted with a new registration requirement are facing the question that is the title of this article: to whom should the CCO of a hedge fund manager report?  The answer to this question has important consequences for the effectiveness of a CCO within a hedge fund management company and for the CCO’s professional security, and is by no means intuitive.  Industry practice varies considerably on the topic, though sources interviewed by the Hedge Fund Law Report voiced agreement on certain fundamental principles.  This article offers insight on the appropriate design of CCO reporting lines within a hedge fund management company.  At a general level, this article addresses two questions: How can CCO reporting lines be structured to protect the management company?  And: How can CCO reporting lines be structured to protect the CCO?  To address those general questions, this article analyzes: what “reporting” means in the hedge fund context; the benefits and burdens to a hedge fund management company of the typical CCO reporting lines; related industry precedents for CCO reporting; how reporting lines can be structured to protect the CCO; terms that should be included in CCO employment agreements, compliance manuals and codes of ethics to protect the CCO; and the pros and cons of whistleblowing under the recently finalized rule.  This article concludes with a ten-step roadmap for reporting that can serve as a template for hedge fund manager CCOs that discover violations or potential violations, regardless of how their reporting lines are structured.

In Case of First Impression, U.S. District Court Interprets Private Right of Action Under Whistleblower Provisions of Dodd-Frank Act, Limiting Claims of Dismissed Employee of Hedge Fund Technology Vendor

From August 2003 through August 2010, plaintiff Patrick Egan (Egan) was employed as a sales executive by TradingScreen, Inc. (TradingScreen), a company that sells online trading software to hedge funds and other investors.  In 2009, Egan learned that TradingScreen’s chief executive officer, defendant Philippe Buhannic (Buhannic), was diverting business from TradingScreen to two competing businesses that Buhannic controlled.  Egan reported his discovery to TradingScreen’s president who, in turn, alerted the company’s independent directors.  An internal investigation confirmed Egan’s suspicions, but Buhannic managed to outmaneuver the independent directors, gained control of TradingScreen’s board of directors and fired both Egan and the company president.  Egan sued TradingScreen, Buhannic and Buhannic’s competing entities, seeking relief under the whistleblower provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act and Securities Exchange Act Section 10(b)(5).  He also asserted various state law claims.  The defendants moved to dismiss the entire complaint.  We summarize the Court’s decision.

Enforcement in the Cayman Islands of U.S. and Other Foreign Judgments: How Safe Is It for Hedge Fund Managers to Allow Judgment to Be Entered by Default?

Cayman Islands hedge funds, their directors and service providers, are increasingly appearing as defendants in U.S. litigation, in particular in the aftermath of the Madoff fiasco.  These entities are facing a variety of claims, not always structured appropriately under Cayman Islands law, and not always structured with any particularity.  Broad, sweeping allegations of fraud, gross negligence, the existence of fiduciary and other duties, and clawback claims based on unjust enrichment are thrown in, not always with the application that should be displayed before launching such serious allegations.  Many of these claims face motions to dismiss, often on the basis of applicable Cayman Islands law, in particular, the existence of fiduciary and other duties under Cayman Islands law, derivative claims, reflective loss and exculpation and indemnity clauses.  See “Exculpation and Indemnity Clauses in the Hedge Fund Context: A Cayman Islands Perspective (Part Two of Two),” Hedge Fund Law Report, Vol. 4, No. 1 (Jan. 7, 2011).  It was not uncommon for Cayman Islands lawyers in the past to advise Cayman Islands funds, and other related Cayman entities facing U.S. proceedings, that since they were Cayman Islands entities, it was safe not to participate in the U.S. proceedings, even for the purpose of challenging the jurisdiction of the U.S. court – and to allow a judgment to be entered in the U.S. court, because the U.S. judgment would not be enforceable against them in the Cayman court.  Such advice, even if (rarely) appropriate in individual cases, could not be, and never was, of universal applicability.  There are very clear risks in advising a Cayman entity not to challenge the jurisdiction of a U.S. or other foreign court, where such a challenge can be mounted with a sufficient prospect of success, and, whether or not such an application is made, in allowing a judgment to be entered in default by not participating to defend the proceedings, on the premise that any such judgment would not be enforceable in the Cayman Islands court.  In a guest article, Chris Russell, a partner and head of the litigation and insolvency department of Ogier Cayman, and Michael Makridakis, a senior associate at Ogier, provide an overview of relevant law; identify the relevant common law rules and defenses; and discuss the enforcement of judgments in foreign insolvency proceedings.

What Hedge Fund Managers Need to Know About Information and Data Security

While hedge fund executives are experts at identifying and managing the risks relating to their financial assets and portfolios, they generally do not have the time or expertise to focus on the security of their people and intellectual property assets.  However, all organizations – especially financial institutions – must be prepared for the inherent risks and responsibilities associated with doing business in an online world through a sound digital risk management strategy.  The appropriate approach to digital risk management varies from firm to firm based on unique business models and requirements.  However, all hedge fund managers should take a risk-based approach to security and ensure that the approach is aligned with the way executives manage other business issues.  While physical security and information security present different challenges, they are strongly related, are part of internal controls and should be managed using an integrated strategy.  In a guest article, Edward Stroz, Co-President of Stroz Friedberg, a digital risk management and investigations firm, and Steven Garfinkel, Vice President of Stroz Friedberg’s Business Intelligence & Investigations Division – and both former FBI Special Agents – outline the most critical aspects involved in implementing a digital risk management program for hedge fund managers.

Brookside Settlement Suggests That in Calculating Disgorgement Based on a Rule 105 Violation, the SEC Will Look to the Number of Shares Purchased in a Secondary Offering Rather Than the Number of Shares Sold Short Prior to the Offering

In an order dated June 28, 2011 (Order), Brookside Capital, LLC (Brookside) settled SEC allegations that it violated Rule 105 of Regulation M of the Securities Exchange Act of 1934.  The SEC adopted Regulation M to foster secondary and follow-on offering prices that are determined by independent market dynamics.  For more on secondary offerings, see “Registered Direct Offerings Enable Hedge Funds to Make Advantageously-Structured Investments in Public Equity While Avoiding the Illiquidity and Other Downsides of PIPEs,” Hedge Fund Law Report, Vol. 3, No. 25 (Jun. 25, 2010).  For hedge fund managers, the Order is noteworthy for two primary reasons.

Ogier Cayman Appoints Counsel in Corporate and Investment Funds Practices

On June 27, 2011, Ogier Cayman announced the appointment of Colin Berryman to the role of Counsel in its corporate and investment funds practices.  For more from Ogier Cayman, see “What Is the Legal Effect of a Side Letter That Contains Specific Terms More Favorable Than a Hedge Fund’s General Offering Documentation?,” Hedge Fund Law Report, Vol. 4, No. 16 (May 13, 2011).