Recent high-profile prosecutions, including the Galleon and “expert network” criminal cases, have once again reminded the investment community of the perils of trading on material nonpublic information, or “MNPI.”  These cases have been sensational, but they have not made new law.  At the heart of each case was MNPI that unscrupulous traders allegedly knew had come from within the public companies whose shares they traded.  The focus on expert networks, however, has placed a spotlight on how hedge funds and other investment professionals conduct their investment research.  Many firms have reacted to this new reality by reconsidering how they use industry experts and by fashioning policies to address these latest concerns.  This is an important step, but investors must also anticipate new issues that will arise in the future from today’s heightened focus on investment research.  In a guest article, Michael A. Schwartz, a Partner at Willkie Farr & Gallagher LLP, starts by discussing “inside” versus “outside” information.  Schwartz then analyzes – via a hypothetical that can easily describe a real-world situation – the circumstances in which information obtained by a hedge fund manager from an expert about one company may prohibit trading by the manager’s funds in securities of another company in the same industry.  This article is important in understanding the implications of recent insider trading enforcement activity for day-to-day investment research by hedge fund managers. Read full article …

In late 2009, the SEC adopted amendments to Rule 206(4)-2 (Custody Rule) under the Investment Advisers Act of 1940, as amended (Advisers Act).  (The Hedge Fund Law Report has analyzed the implications of the amended Custody Rule for, among other things, compliance policies and procedures; the balance of power between hedge fund managers and accountants; structuring of managed accounts; internal control reporting; and hedge fund liquidations.)  As amended, the Custody Rule provides that any investment adviser deemed to have custody of client securities or assets – and most hedge fund managers would have deemed custody within the Custody Rule’s broad definition of custody – is required to undergo an annual surprise examination conducted by an independent public accountant.  However, an adviser to a pooled investment vehicle (such as a hedge fund) is excepted from the surprise examination requirement if its hedge fund is audited annually in accordance with GAAP by “an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board (PCAOB) in accordance with its rules” (Annual Audit Exception).  The exemption also requires a hedge fund manager to distribute the relevant fund’s audited financial statements to investors within 120 days (180 days for funds of funds) of the fund’s fiscal year-end.  For hedge fund managers, the Annual Audit Exception provided welcome relief from the annual surprise examination requirement of the Custody Rule.  However, two of the requirements of the Annual Audit Exception proved difficult for hedge fund managers to comply with in practice.  This article analyzes recent SEC guidance applicable to hedge fund managers relying on the Annual Audit Exception. Read full article …

In resolving a contentious lawsuit between a start-up hedge fund manager, Michelle Paige, and her seed investor, the Lerner family, the Delaware Chancery Court issued an opinion on August 8, 2011 that described the scope of a manager’s fiduciary duty to a seed investor, and the circumstances in which a manager viably may prohibit redemption by a seed investor by lowering a gate.  See “Is a Threatening Letter from a Hedge Fund Manager to a Seed Investor Admissible in Litigation between the Manager and the Investor as Evidence of the Manager’s Breach of Fiduciary Duty?,” Hedge Fund Law Report, Vo. 4, No. 17 (May 20, 2011).  This feature-length article details the background of the action and the Court’s legal analysis.  The opinion is one of the longer statements to date by the Delaware Chancery Court on a hedge fund dispute, and thus provides valuable insight into the Chancery Court’s view of fiduciary duty in the hedge fund context.  In addition, given the factual background, the opinion is particularly relevant to hedge fund managers that have or are seeking seed investors, and to entities that make seed investments in hedge fund managers and hedge funds.  See “Ten Issues That Hedge Fund Seed Investors Should Consider When Drafting Seed Investment Agreements,” Hedge Fund Law Report, Vo. 4, No. 12 (Apr. 11, 2011). Read full article …

A recent federal court judgment against the manager of hedge funds purporting to follow a socially responsible investment strategy yields a number of important lessons for hedge fund investors when conducting due diligence.  Among other things, the judgment highlights the relevance of the financial condition of the manager and its principals; how managers should account for organizational expenses; how managers should account for fund loans, if they are used at all; and the perils of guaranteed returns.  See “Twelve Operational Due Diligence Lessons from the SEC’s Recent Action against the Manager of a Commodities-Focused Hedge Fund,” Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011). Read full article …

From July 2006 through January 2008, the manager of Cayman Islands hedge fund Mercurius International Fund Limited (Fund) repeatedly violated the Fund’s investment guidelines by over-concentrating investments in thinly-traded companies.  When the values of those investments began to drop, the Fund’s director and chief executive officer, Michiel Visser (Visser), and its chief financial and compliance officer, Oluwole Modupe Fagbulu (Fagbulu), engaged in market manipulation to inflate artificially the Fund’s net asset value (NAV), engaged in sham trades to increase NAV and conceal money borrowed at exorbitant rates and concealed all these machinations, and the Fund’s perilous financial position, from existing and prospective investors.  The Fund collapsed in January 2008 and is now in liquidation.  The British Financial Services Authority (FSA) charged Visser and Fagbulu with market manipulation and other violations of the Financial Services and Markets Act of 2000.  It banned the defendants from the securities industry and imposed steep financial penalties on them.  Visser and Fagbulu appealed to the Upper Tribunal of the British Tax and Chancery Chamber.  We summarize the Tribunal’s decision. Read full article …

On August 22, 2011, The Commodity Futures Trading Commission (CFTC) announced the appointment of Gary Barnett to serve as the agency’s Director of the Division of Swap Dealer and Intermediary Oversight.  For more on the treatment of swaps in and around bankruptcies, see, “U.K. Supreme Court Rules That Change in Priority over Dante CDO Collateral Triggered by Lehman Bankruptcy Does Not Violate Britain’s Anti-Deprivation Bankruptcy Rule,” Hedge Fund Law Report, Vol. 4, No. 27 (Aug. 12, 2011); “Bankruptcy Court Holds That a Provision in a Derivative Contract Subordinating Payments to a Bankrupt Counterparty May Be an Unenforceable Ipso Facto Clause,” Hedge Fund Law Report, Vol. 4, No. 18 (Jun. 1, 2011); “Bankruptcy Court Finds Unenforceable CDO Provisions Subordinating Swap Termination Payments to Swap Counterparty Lehman Brothers as a Result of Its Bankruptcy,” Hedge Fund Law Report, Vol. 3, No. 5 (Feb. 4, 2011); “Treatment of a Hedge Fund’s Claims Against and Other Exposures To a Covered Financial Company Under the Orderly Liquidation Authority Created by the Dodd-Frank Act,” Hedge Fund Law Report, Vol. 4, No. 15 (May 6, 2011). Read full article …