Aug. 19, 2011

How Can Hedge Fund Managers Update Their Insider Trading Compliance Programs to Reflect the SEC’s Focus on Systemic Violators, Gatekeepers, Trading Patterns, Profitable Trades and Expert Networks?

Insider trading enforcement remains a top priority for regulators and prosecutors.  For example, just this month to date: (1) Joseph F. “Chip” Skowron III, a former healthcare portfolio manager at FrontPoint Partners LLC, pleaded guilty to conspiracy to engage in insider trading and obstruction of justice; (2) the DOJ brought conspiracy to commit securities fraud and wire fraud charges against Stanley Ng, the former SEC Reporting Manager at Marvell Technology Group, Ltd., for allegedly providing material nonpublic information to Winifred Jiau; (3) the SEC charged a former professional baseball player and three others with insider trading ahead of the early 2009 buyout by Abbott Laboratories Inc. of Advanced Medical Optics Inc.; and (4) the SEC charged a California man with purchasing Marvel Entertainment call options while in possession of material nonpublic information obtained from his girlfriend (who worked at the Walt Disney Company) regarding Disney’s acquisition of Marvel.  In this still-heightened insider trading enforcement climate, hedge fund managers remain a prime target for civil and criminal insider trading charges.  This is so for at least five reasons.  First, regulators and prosecutors have been emboldened by the May 11, 2011 conviction of Galleon Group founder Raj Rajaratnam on 14 counts of conspiracy and securities fraud.  See “Implications of the Rajaratnam Verdict for the ‘Mosaic Theory,’ the ‘Knowing Possession’ Standard of Insider Trading and Criminal Wire Fraud Liability in the Absence of a Trade,” Hedge Fund Law Report, Vol. 4, No. 18 (Jun. 1, 2011).  Second, wiretapping has become a viable tool for investigating insider trading by hedge fund manager personnel, and a source of persuasive evidence.  See “Will a Criminal Court Admit into Evidence a Recorded Telephone Conversation Between a Hedge Fund Manager Charged with Insider Trading and an Alleged Co-Conspirator?,” Hedge Fund Law Report, Vol. 4, No. 24 (Jul. 14, 2011).  Third, in the course of examinations of hedge fund managers, SEC examination personnel are looking for (among other things) evidence of insider trading that can serve as the basis of referrals to the SEC’s Enforcement Division.  See “Is a Hedge Fund Manager Required to Disclose the Existence or Substance of SEC Examination Deficiency Letters to Investors or Potential Investors?,” Hedge Fund Law Report, Vol. 4, No. 18 (Jun. 1, 2011).  Fourth, the staff of the SEC’s Enforcement Division can now use tools developed in the criminal context in bringing, negotiating and settling insider trading charges against hedge fund managers.  See “Entry by SEC into a Non-Prosecution Agreement with Clothing Marketer Illustrates How Hedge Fund Managers May Survive Discovery of Certain Insider Trading Violations,” Hedge Fund Law Report, Vol. 3, No. 50 (Dec. 29, 2010).  And fifth, budgetary constraints have led the SEC to place a higher priority on deterrence, and insider trading actions against hedge fund managers are thought to have a powerful deterrent effect.  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 (Feb. 10, 2011).  In light of the vigor with which civil and criminal authorities are pursuing insider trading actions – and the ongoing susceptibility of hedge fund managers to insider trading charges – the Regulatory Compliance Association’s Fall 2011 Asset Management Thought Leadership Symposium will feature a session entitled “Insider Trading – The New Enforcement Paradigm.”  That RCA Symposium will take place on November 10, 2011 at the Pierre Hotel in New York. (Subscribers to the Hedge Fund Law Report are eligible for a registration discount.)  Scott Pomfret – Regulatory Counsel for a Boston-based institutional money manager and a former branch chief in the SEC’s Division of Enforcement – participated in the insider trading session during the RCA’s Spring 2011 Symposium and is expected to participate in the RCA’s Fall 2011 Symposium.  As a former regulator and current in-house counsel, Pomfret has a unique, and uniquely relevant, perspective on insider trading enforcement trends as they relate to hedge fund managers.  By way of revisiting some of the topics that Pomfret discussed during the last RCA Symposium, and by way of preview of some of the topics that he may discuss at the next RCA Symposium, the Hedge Fund Law Report recently conducted an interview with Pomfret.  Our interview covered: Pomfret’s background; a shift in the focus of the SEC’s insider trading enforcement efforts; the rationale for and implications of the SEC’s focus on “gatekeepers”; how the SEC collects and uses hedge fund trading data; the role of trade profitability in allocating SEC enforcement resources; how hedge fund managers can answer investor questions about SEC inquiries; specific steps hedge fund managers can take to mitigate insider trading risk when using expert networks; three specific ways in which hedge fund managers are revising their insider trading compliance policies and procedures; and insider trading concerns for hedge fund managers that typically invest in “private” securities and assets.  The full text of our interview with Pomfret is included in this issue of the Hedge Fund Law Report.

U.S. District Court Rules on Whether Attorney Interview Notes and Summaries Produced in Connection with Hedge Fund Manager D.B. Zwirn’s Internal Investigation of Financial Irregularities Are Protected from Disclosure by Attorney-Client Privilege

In early 2006, now-defunct hedge fund managers D.B. Zwirn & Co., L.P. and D.B. Zwirn Partners, LLC (Zwirn) learned of certain financial irregularities in their operations, including unauthorized early payment of management fees and the purchase of a Gulfstream jet for use by their founder and principal, Daniel B. Zwirn.  See “Ten Steps That Hedge Fund Managers Can Take to Avoid Improper Transfers among Funds and Accounts,” Hedge Fund Law Report, Vol. 4, No. 13 (April 21, 2011).  The Zwirn companies retained the services of three different law firms – Schulte, Roth & Zabel, LLP (SRZ); Gibson, Dunn & Crutcher, LLP (GDC); and Fried, Frank, Harris, Shriver & Jacobson LLP – to investigate the irregularities and defend any legal actions arising from them.  The investigations placed blame on plaintiff Perry A. Gruss (Gruss), who was Chief Financial Officer and a partner of certain Zwirn entities.  Gruss resigned.  Zwirn then communicated its attorneys’ findings to its investors and to the Securities and Exchange Commission (SEC).  In response, Gruss sued Zwirn for defamation in U.S. District Court.  During discovery, Gruss moved to compel disclosure of the interview notes and summaries prepared by SRZ and GDC attorneys in the course of their investigations.  This article discusses the District Court’s ruling on Gruss’ motion, as well as the Court’s analysis of the attorney-client privilege and the related work product doctrine in the hedge fund context.  For a summary of Gruss’ complaint, see “Former CFO of Highbridge/Zwirn Special Opportunity Fund Sues Ex-Partner Daniel B. Zwirn for Defamation and Breach of Contract,” Hedge Fund Law Report, Vol. 2, No. 30 (July 29, 2009).

SEC Order Increasing the Dollar Threshold for “Qualified Client” Status Further Chips Away at the Utility of the 3(c)(1) Fund Structure

On July 12, 2011, the SEC issued an order increasing for inflation the dollar thresholds for eligibility for qualified client status.  However, the SEC has not adjusted and has not expressed any intent to adjust the qualified purchaser threshold for inflation.  Therefore, the gap between the eligibility thresholds for qualified client status and qualified purchaser status is narrowing – and, accordingly, so is the scope of utility of the 3(c)(1) hedge fund structure.

Arbitration Award in Connection with an Unceremonious Departure from Oaktree Capital Management Precludes Legal Malpractice Claim Against Attorney Retained to Advise on Departure

The partnership agreements and similar governing documents of many hedge fund management companies provide that disputes among partners will be subject to mandatory arbitration, sometimes with a potential appeal to court.  But that potential appeal often turns out to be a right with little force: arbitration awards are rarely overturned on direct appeal, and – as this article discusses – can even have preclusive effect in collateral litigation.  See, on the former point, “A Prime Broker that Fails to Diligently Investigate the Sources of Funds in a Hedge Fund’s Margin Account May Be Jointly and Severally Liable, with the Fund and Its Manager, for Fraud by the Manager, to the Extent of Funds in the Account,” Hedge Fund Law Report, Vol. 3, No. 47 (Dec. 3, 2010).

Leading ERISA Lawyer, Jeffrey Crandall, Joins Davis Polk

On August 15, 2011, Davis Polk & Wardwell LLP announced that Jeffrey P. Crandall will be joining the firm in New York as a Partner in its Executive Compensation and Employee Benefits practice.  Crandall has expertise in, among other things, compensation and ERISA matters relating to financial institution, private equity and hedge fund clients.