Aug. 4, 2011

Legal and Practical Considerations in Connection with Mock Examinations of Hedge Fund Managers

SEC rulemaking implementing the Dodd-Frank Act will require many previously unregistered hedge fund managers to register by 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 more onerous consequences of registration is that registered hedge fund managers are subject to routine SEC examinations.  See “Key Insights for Registered Hedge Fund Managers from the SEC’s Recently Released Study on Investment Adviser Examinations,” Hedge Fund Law Report, Vol. 4, No. 5 (Jun. 23, 2011).  (While unregistered hedge fund managers typically are not subject to routine SEC examinations, the SEC has authority to issue subpoenas even to unregistered hedge fund managers in cases where the agency suspects fraud on the part of the manager or any of its employees.)  Earlier this year, we conducted a series of interviews with experienced veterans of hedge fund manager examinations.  See Part 1, Part 2 and Part 3 of our examinations series.  One of the key themes that emerged from those interviews is that a large part of the examination “battle” is won or lost before an examination begins.  In other words, preparation is paramount in surviving an examination.  And preparation cannot start upon receipt of notification of an examination.  According to Part 1 of our examinations series, the longest lead time that a hedge fund manager realistically can expect between notification and commencement of an examination is one week.  However, as discussed more fully below, one week is typically the minimum duration of a mock examination – and that is not counting preparation for the mock examination and responding to any findings, which together would lengthen that one-week period considerably.  In sum, preparation is key and notice is short.  The implication is that the time to prepare for an examination is as soon as possible, ideally, now.  While there are few certainties in law, one proposition that is reasonably close to certain is that you do not want the SEC to discover any compliance, operational or similar shortcoming for the first time in the course of an examination.  Rather, you want to know about any such shortcoming well in advance of an SEC visit, so that you can correct the shortcoming before the SEC shows up.  In turn, the most effective way to determine what the SEC would uncover is to go through an SEC exam without having the SEC present.  How can managers do that?  Through mock examinations – in essence, an exercise in which a third party (often a compliance consultant or law firm) goes through many of the same motions as the SEC examination staff, but with different goals and consequences.  The goal of a mock exam is to prepare a hedge fund manager for an SEC exam, whereas the goal of an SEC exam is to protect the investing public through enforcement of the federal securities laws.  The consequence of discovery of a bad fact in the course of a mock examination is an opportunity to correct, whereas the consequence of discovery of a bad fact in the course of an SEC examination could be a referral to the SEC’s Enforcement Division or, worse, to the DOJ.  To maximize the value and effectiveness of our subscribers’ preparation for SEC and other regulatory examinations, we have undertaken an analysis of many of the most important considerations for hedge fund managers in connection with mock examinations.  This article embodies our analysis.  In particular, this article discusses: the seven overlapping goals of mock examinations of hedge fund managers; the types of entities that provide mock examinations; four areas of expertise that a hedge fund manager should look for in a mock examination provider; the market for the costs of a mock examination, including cost levels and inputs that determine costs; the substance and process of a mock examination, that is, what exactly goes on during the course of one; 13 topics that are currently of interest to SEC examiners, and that therefore play a large role in determining the scope and substance of a mock examination; whether or not a mock examination report should be written, or delivered exclusively orally; contractual and legal strategies for maintaining the confidentiality of mock examinations; and considerations with respect to the timing and level of disclosure to hedge fund investors of the fact or findings of a mock examination.

Hedge Fund-Specific Issues in Portfolio Management Software Agreements and Other Vendor Agreements

Hedge fund managers require various third party vendor-provided products and services to manage their daily operations.  Typical agreements entered into by hedge fund managers for such products and services include trading system agreements, license agreements for investment analysis tools, risk management and portfolio valuation software, market data license agreements, software development agreements, hardware purchase agreements, website design agreements, consulting agreements and administration agreements.  All vendor agreements cover a common set of issues, including vendor performance obligations, indemnification and limitations on liability.  In addition to these common issues, vendor agreements entered into by hedge fund managers contain a few distinctive issues arising from the unique structure and the private nature of hedge fund groups.  In a guest article, Robert R. Kiesel, a Partner at Schulte Roth & Zabel LLP and chair of the firm’s Intellectual Property, Sourcing & Technology Group, and David L. Cummings, an Associate in Schulte’s Intellectual Property, Sourcing & Technology Group, discuss: selection of vendors and vendor breach; hedge fund structuring as it relates to vendor agreements; party selection; IT agreement standard scope restrictions; liability for trades; use of output and results; issues related to hedge fund secrecy; confidentiality; in-house systems versus third-party systems; privacy; arbitration; and publicity.

Loose Corporate Formalities of Former Hedge Fund Management Partners Result in a Messy Business Divorce

On July 8, 2011, the U.S. District Court for the District of Connecticut issued an opinion that partially ruled on summary judgment motions involving a highly “unusual set of circumstances” in a contentious dissolution involving former hedge fund partners Scott Stagg and Gary Katcher.  The action, part of three separate lawsuits that arose out of Stagg’s creation of a new hedge fund and Katcher’s sale of a company for a sizeable personal fortune, involved allegedly fraudulent and otherwise improper transfers by and among two families of hedge funds, their investment adviser and broker.  The plaintiffs, 3V Capital Master Fund, Ltd. (3V), and its purported successor-in-interest, SV Special Situations Master Fund, Ltd. (SV), which Stagg formed independently of Katcher, filed a complaint against his former partner Katcher and Katcher’s brokerage firms, Libertas Holdings, LLC and Libertas Partners, LLC, as well as a subsequent purchaser of the Libertas entities, in order to recover millions in allegedly improper financial transfers to those firms.  These defendants, in turn, filed a third-party complaint against Stagg, the Chief Operating Officer (COO) Mark Focht they had hired, and 3V Capital Management, LLC (3V Management), their investment adviser, in order to obtain, among other things, indemnification for the third-party defendants’ part in the alleged wrongdoing.  We detail the background of the action and the Court’s legal analysis.

SEC Wins Summary Judgment in Its Fraud Suit Against Investment Adviser Locke Capital and Its Principal, Leila C. Jenkins, Who Fabricated a Non-Existent “Massive Swiss Banking Client” to Attract Investors

Defendant Leila C. Jenkins (Jenkins) was the founder and sole owner of investment adviser Locke Capital Management, Inc. (Locke).  In 2009, the Securities and Exchange Commission (SEC) brought a civil enforcement action against Locke and Jenkins, alleging that they had fabricated a “massive Swiss banking client” to trick potential investors into believing that they had more than a billion dollars under management, when in fact they did not.  The initial misstatement of assets under management by the defendants, along with Jenkins’ clumsy efforts to conceal the deception, supported fraud and other charges under the Securities Act of 1933, the Securities and Exchange Act of 1934 and the Investment Advisers Act of 1940.  The U.S. District Court for the District of Rhode Island granted the SEC’s motion for summary judgment on all charges, directed the defendants to disgorge profits, imposed penalties and enjoined them from future securities laws violations.  This article summarizes the decision, which has important implications for hedge fund operational due diligence.

SEC Order against Pegasus Investment Management Suggests That a Hedge Fund Manager Cannot Keep the Proceeds of an Undisclosed “Rental” of Its Trading Volume

A recent SEC order instituting administrative and cease-and-desist proceedings against a small hedge fund manager confirms the principle that hedge fund investors – not managers – own the assets in funds and any assets generated with those assets, subject to specific exceptions.  The matter also addresses, albeit indirectly and inconclusively, the question of whether hedge funds may agree by contract to permit conduct by the manager that, absent such agreement, would constitute fraud or a breach of fiduciary duty.

Proskauer Adds Three Partners to Global Private Investment Funds Group in London

On July 28, 2011, Proskauer announced the expansion of its global Private Investment Funds Group and London office with the addition of Nigel van Zyl, Kate Simpson and Oliver Rochman as Partners.  Mr. van Zyl and Mr. Rochman join the firm from SJ Berwin, and Ms. Simpson joins from Kirkland & Ellis.

Brian V.S. McKenna Joins Merlin Institutional Group as Partner

On August 1, 2011, Merlin Securities, a prime brokerage services and technology provider offering integrated solutions to the alternative investment industry, announced that it has hired Brian V.S. McKenna as a Partner in the Merlin Institutional Group.  For more on Merlin Securities, see “Eight Refinements of the Traditional ‘2 and 20’ Hedge Fund Fee Structure That Can Powerfully Impact Manager Compensation and Investor Returns,” Hedge Fund Law Report, Vol. 4, No. 17 (May 20, 2011).