Jul. 8, 2011

How Can Hedge Fund Managers Collect the Investor Information Required to Comply with the Prohibition on “Spinning” in FINRA Rule 5131?

FINRA Rule 5131 seeks to ensure public confidence in the initial public offering (IPO) process by prohibiting allocations by broker-dealers of new issues to accounts (including hedge funds) in which a past, current or prospective investment banking client of the broker-dealer holds a beneficial interest – a practice known as “spinning.”  Rule 5131 imposes direct prohibitions on broker-dealers and indirect obligations on hedge fund managers.  That is, to avoid violations of Rule 5131 when allocating new issues to a hedge fund, broker-dealers need information about investors in the hedge fund.  Specifically, broker-dealers need to know whether any investor in the hedge fund is an executive officer or director of a public company or covered non-public company, or if any investor is materially supported by such an executive officer or director.  (All of these terms are discussed in detail in this article.)  However, such information is typically only available to the hedge fund manager.  Therefore, to comply with Rule 5131, broker-dealers – including prime brokers – will ask hedge fund managers for relevant investor information.  In order to provide broker-dealers with sufficient responses, hedge fund managers will have to collect such information from their existing and new investors.  The primary administrative and compliance issue here is that the information required to comply with Rule 5131 is not information that hedge fund managers typically have collected from investors.  As a result, hedge fund managers and other industry participants have been wondering what the scope of required information is, how to collect it, how frequently and what to do with it.  See “New FINRA IPO Allocation Rule Will Require Hedge Funds That Invest in ‘New Issues’ to Revisit Their Compliance Policies and Procedures and Fund Structures,” Hedge Fund Law Report, Vol. 4, No. 5 (Feb. 10, 2011).  With the goal of addressing these questions and more generally helping hedge fund managers comply with their obligations under Rule 5131, this article discusses: the mechanics of Rule 5131, including a discussion of the various defined terms in the rule; the relevance of hedge fund size and strategy in the application of Rule 5131; remedies that may be imposed on hedge fund managers for violations of Rule 5131; how hedge fund managers may revise their subscription documents, questionnaires and annual certifications; the viability and advisability of a negative consent process; the extent to which hedge fund managers are required to investigate investor representations regarding corporate affiliations; an investor’s duty to update representations regarding corporate affiliations; how beneficial ownership is measured for Rule 5131 purposes; the categories of relationships between a broker-dealer and a company that may implicate Rule 5131; and how to calculate the beneficial ownership of a fund of funds in an underlying hedge fund where an investor in the fund of funds is a restricted person under Rule 5131.  This article concludes with an analysis of the elements of two sets of questionnaires and annual certifications provided to the Hedge Fund Law Report by two leading law firm hedge fund practice groups.  We provide a step-by-step analysis of what is included in these forms.  The purpose of this analysis is to enable hedge fund managers to draft new questionnaires and certifications or to revise existing questionnaires and certifications to reflect best practices.

Developments in Family Office Regulation: Part Three

On June 22, 2011, the Securities and Exchange Commission (“SEC” or the “Commission”) issued Release No. IA-3220  (the “Final Release”), adopting rule 202(a)(11)(G)-1 (the “Final Rule”) which defines “family offices” that would be excluded from the definition of “investment adviser” under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).  The SEC received and considered approximately 90 comment letters on the proposed rule (the “Proposed Rule”) issued on October 12, 2010 and, as a result, modified the Proposed Rule in certain respects, as detailed in this article.  While family offices generally meet the Advisers Act’s definition of “investment adviser,” in that they provide investment advice for compensation, they have historically avoided registration by availing themselves of the private adviser exemption found in section 203(b)(3) of the Advisers Act or by seeking and obtaining exemptive relief from the Commission.  Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama on July 21, 2010 (the “Dodd-Frank Act”), Congress eliminated the private adviser exemption and directed the Commission to adopt a definition of single family offices that would be “consistent with previous exemptive policy” and recognize “the range of organizational, management, and employment structures and arrangements employed by family offices.”  The Final Rule contains three general conditions: that (1) the family office has only family clients; (2) the family office is wholly owned and exclusively controlled by family members and/or family entities; and (3) the family office does not hold itself out to the public as an investment adviser.  Each of the foregoing is subject to definitions and as usual, the “devil is in the details.”  In a guest article, Michael G. Tannenbaum and Christina Zervoudakis, Founding Partner and Associate, respectively, at Tannenbaum Helpern Syracuse & Hirschtritt LLP, provide a thorough analysis of the Final Rule.  This is the final installation of a three-part series by Tannenbaum and Zervoudakis in Hedge Fund Law Report addressing the regulation of family offices under the Advisers Act, by the Dodd-Frank Act and the Final Rule.  Part One of this series, entitled Developments in Family Office Regulation: Part One, presented the SEC’s position on the regulation of family offices prior to the Dodd-Frank Act as reflected by SEC exemptive orders, and Part Two, entitled 2010 Developments in Family Office Regulation: Part Two, discussed the Proposed Rule.

Federal District Court Opinions Address the Mechanics of Repatriating Offshore Hedge Fund Assets Connected to a Fraud and When Private Parties May Intervene in an SEC Action against a Hedge Fund Manager

On June 28, 2011, the United States Securities and Exchange Commission (SEC) announced that Highview Point Partners LLC (Highview) and its affiliated hedge funds had abided by a court order and returned $230 million from an offshore account to the United States.  The announcement followed in the wake of the SEC civil enforcement action in the U.S. District Court for the District of Connecticut (District Court) against Francisco Illarramendi, his unregistered investment advisory firm, Michael Kenwood Capital Management LLC (MK Capital), and Highview, an affiliated registered advisory firm.  See “Eight Important Due Diligence Lessons for Hedge Fund Investors Arising Out of the SEC’s Recent Action against a Hedge Fund Manager Alleging Misuse of Hedge Fund Assets to Make Personal Private Equity Investments,” Hedge Fund Law Report, Vol. 4, No. 4 (Feb. 3, 2011).  The ongoing action, in which the SEC has accused these entities of misappropriating investor assets and engaging in a Ponzi scheme, had named their affiliated hedge funds as relief defendants and had sought to freeze their assets and repatriate assets from overseas.  Investors in these affiliated hedge funds had also sought to intervene as of right or permissively in the SEC’s action to protect their financial interests.  In two opinions issued on June 16, 2011, the District Court addressed the investors’ request for intervention and the SEC motion to repatriate funds.  This article details the background of the litigation and the court’s legal analysis of the repatriation and intervention issues.

Recent No-Action Letter Suggests That the SEC Will Not Require Registration by a U.S. “Captive” Investment Advisory Subsidiary of a Foreign Insurance Company

In a letter dated June 30, 2011, the SEC’s Division of Investment Management (Division) confirmed that it would not recommend enforcement action to the SEC if the wholly-owned U.S. asset management subsidiary of a Japanese insurance company did not register with the SEC as an investment adviser.  For hedge fund managers, there are two potentially interesting aspects of this no-action letter, and one aspect of the no-action letter that limits its application.  The two potentially interesting aspects of the no-action letter are: First, it is one of the few pieces of authority, outside of rule releases, dealing with the real world implications of the elimination of the private adviser exemption by the Dodd-Frank Act.  (This elimination will happen automatically as of July 21, 2011, though the registration due date has been delayed to March 30, 2012.)  Second, at a broad level, it deals with registration questions in the context of global affiliate relationships – an area fraught with ambiguity, and one on which hedge fund industry participants are eager for more SEC guidance.  See “Impact of the Foreign Private Adviser Exemption and the Private Fund Adviser Exemption on the U.S. Activities of Non-U.S. Hedge Fund Managers,” Hedge Fund Law Report, Vol. 4, No. 16 (May 13, 2011).  However, unfortunately for those seeking guidance, the SEC did not focus on either of the foregoing two topics in its analysis.  Rather, the primary basis for the SEC’s grant of no-action relief, and the focus of its analysis, was more straightforward and less generalizable.

SEC Division of Investment Management Names Robert Plaze as Deputy Director and Diane Blizzard as Managing Executive

On July 1, 2011, the Securities and Exchange Commission announced that Robert E. Plaze has been named Deputy Director in the Division of Investment Management and Diane C. Blizzard has been named Managing Executive of the Division.