Feb. 3, 2011

Key Legal Considerations in Connection with the Movement of Talent from Proprietary Trading Desks to Start-Up or Existing Hedge Fund Managers: The Hedge Fund Manager Perspective (Part Three of Three)

This is the third installment in our three-part series on the movement of talent from bank proprietary (prop) trading desks to hedge fund managers.  The series focuses on the legal and business considerations raised by such moves, and highlights the different considerations faced by the different constituencies.  The first article in the series focused on the talent perspective, that is, the considerations that investment and non-investment personnel should address when moving from a bank to a hedge fund manager.  See “Key Legal Considerations in Connection with the Movement of Talent from Proprietary Trading Desks to Start-Up or Existing Hedge Fund Managers: The Talent Perspective (Part One of Three),” Hedge Fund Law Report, Vol. 3, No. 49 (Dec. 17, 2010).  The second article in the series focused on the bank perspective, and demonstrated that while banks face many of the same issues as talent in this context, banks often face those issues from a different perspective, and weight those issues differently.  See “Key Legal Considerations in Connection with the Movement of Talent from Proprietary Trading Desks to Start-Up or Existing Hedge Fund Managers: The Bank Perspective (Part Two of Three),” Hedge Fund Law Report, Vol. 4, No. 2 (Jan. 14, 2011).  This article focuses on the perspective of the hedge fund manager to which talent moves.  While the legal and business issues faced by such recipient managers are complex, at a broad level, they can be broken down into a simple binary question: Are your hiring decisions motivated by the goal of buying talent or access?  Generally, if you are looking to buy talent, you are okay, but if you are looking to buy access, you are in trouble.  Put slightly differently, while a variety of legal disciplines govern the relationships between hedge fund managers and their employees, the unifying theme among those disciplines is ensuring that business success or failure is based on merit commercialized on a level playing field.  If this sounds too pious to be plausible, read on – and also read some of our cautionary tales of recent access-buying in the hedge fund arena.  To illustrate this general idea, this article discusses the following categories of considerations for hedge fund managers receiving talent: avoiding insider trading violations based on material, non-public information possessed by incoming talent; the three-step process for avoiding liability for aiding and abetting a breach by a new employee of that employee’s employment or post-employment covenants with his or her former bank employer, including non-competition agreements (non-competes), non-solicitation agreements (non-solicits), termination, severance and option agreements; special considerations in connection with the movement of teams (as opposed to individuals); avoiding liability for unauthorized use by an incoming employee of trade secrets or other intellectual property owned by a former bank employer; use of data regarding employee performance at a prior bank employer; avoiding pay-to-play violations; and what to look for when performing background checks.

What Do Hedge Fund Managers Need to Know to Prepare For, Handle and Survive SEC Examinations?  (Part One of Three)

By July 21, 2011, many hedge fund managers that previously were not required to register with the SEC as investment advisers will be required to register.  Specifically, two categories of hedge fund managers will be required to register with the SEC as investment advisers: (1) hedge fund managers with assets under management in the U.S. of at least $150 million that manage solely private funds; and (2) hedge fund managers with assets under management in the U.S. between $100 million and $150 million that manage at least one private fund and at least one other type of investment vehicle (for example, a managed account).  Registration will subject previously unregistered hedge fund managers to a range of new regulatory obligations and burdens.  One of the most notable new burdens is that registered hedge fund managers will be subject to SEC examinations.  (Generally, unregistered hedge fund managers are not subject to examinations, though they may be subject to subpoenas or information requests from the SEC where the agency suspects fraud or violation of the federal securities laws.)  To assist newly registered (or soon to be registered) hedge fund managers and other registered investment advisers in preparing for, handling and surviving SEC examinations, the Regulatory Compliance Association’s 2011 Spring Asset Management Thought Leadership Symposium will include a session entitled “Regulatory Examinations – Briefing on Latest Inquiries from SEC and NFA Staff.”  That RCA Symposium will take place on April 7, 2011 at the Marriott Marquis in Times Square in New York.  The Hedge Fund Law Report recently conducted detailed interviews with three of the thought leaders scheduled to participate in the Regulatory Examinations session at the RCA’s April Symposium: Steven A. Yadegari, Senior Vice President & General Counsel at Cramer Rosenthal McGlynn, LLC; Stephen A. McShea, General Counsel & Chief Compliance Officer at Larch Lane Advisors LLC; and Matthew Eisenberg, Partner at Finn Dixon & Herling LLP.  Those interviews provide a preview of the topics to be discussed at the RCA Symposium, and offer detailed insights, practical strategies and actionable recommendations for newly registered hedge fund managers facing the prospect of regulatory examinations – in many cases, for the first time.  We are publishing these interviews as a three-part series.  The full text of our interview with Steven Yadegari is included in this issue of the Hedge Fund Law Report; our interview with Stephen McShea will be published in next week’s issue; and our interview with Matthew Eisenberg will be published in the following week’s issue.  Our interview with Steven Yadegari, included in full below, covered a wide range of relevant topics, including but not limited to: the statutory authority upon which the SEC relies in conducting examinations; the SEC’s authority to examine unregistered hedge fund managers; the three primary types of inspections and examinations; when to disclose examinations to hedge fund investors, and what to avoid in the course of disclosure; how the presence of multiple SEC divisions with authority over hedge fund managers impacts the examination process; the goals and objectives that hedge fund managers should aspire to when under examination; the average length of time between notification and initiation of an exam; grounds (if any) upon which the SEC may grant a delayed exam start date; the advisability of creating a regulatory exam preparation group; the SEC’s move to so-called “risk-based” exams, and the import of that move for hedge fund managers; how exams have evolved in terms of length or duration; the interaction between interviews of key personnel and presentations to SEC staff; whether presentations should be written or only oral; the utility of mock examinations; books and records rules as applied to mock examinations; and steps hedge fund managers can take to strike the right “tone at the top.”

The SEC’s Investigation of FCPA Violations and Sovereign Wealth Funds – Implications for Hedge Funds

Although the Securities and Exchange Commission has said little publicly about its recent inquiry into potential Foreign Corrupt Practices Act (FCPA) violations involving the financial services industry and sovereign wealth funds, this sweep – which began earlier this month – has critical implications for U.S. private equity and hedge funds.  In a guest article, Michael J. Gilbert and Joshua W.B. Richards, Partner and Associate, respectively, at Dechert LLP, detail the background of the SEC’s investigation; outline the relevant provisions of the FCPA; provide examples of scenarios in which hedge funds may be exposed to FCPA risks; and offer guidance on how to mitigate those risks.

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

On January 28, 2011, the SEC obtained a court order freezing the assets of Stamford, Connecticut-based, unregistered hedge fund manager Michael Kenwood Capital Management, LLC (MK Capital Management) and Francisco Illarramendi, who indirectly owns and controls MK Capital Management.  On January 14, 2011, the SEC had filed a complaint in the United States District Court for the District of Connecticut generally alleging that Illarramendi caused hedge funds managed by MK Capital Management to invest in private companies, with the shares of those private companies registered to advisory or investment entities indirectly owned and controlled by Illarramendi.  That is, the SEC essentially alleges that Illarramendi used fund assets to make personal private equity investments.  Moreover, the SEC alleges that a non-U.S. corporate pension fund was the source of approximately 90 percent of the assets in the two hedge funds involved in the matter.  The SEC’s allegations regarding misuse of fund assets shed light on the variety of things that can go wrong in a hedge fund investment, and how some of those wrong turns can be avoided.  Working from the allegations in the SEC’s complaint, we derive eight distinct due diligence lessons that investors can apply directly to their evaluation and monitoring of hedge fund managers.  This article details the eight lessons.  Before proceeding, a caveat is in order.  We have published a number of articles that analyze SEC complaints against hedge fund managers and extract due diligence lessons from the allegations in those complaints.  See “Thirteen Important Due Diligence Lessons for Hedge Fund Investors Arising Out Of the SEC’s Recent Action against a Fund of Funds Manager Alleging Misuse of Fund Assets,” Hedge Fund Law Report, Vol. 4, No. 3 (Jan. 21, 2011); “Ten Due Diligence Questions that Might Have Helped Uncover the Fraud Described in the SEC's Recent Administrative Proceeding against Subprime Automobile Loan Hedge Fund Manager and Its Principals,” Hedge Fund Law Report, Vol. 3, No. 50 (Dec. 29, 2010).  But it is important to note that our articles of this type do not and are not intended to endorse or support SEC’s allegations or positions in the various matters.  For purposes of these articles, we do not undertake an independent investigation into the veracity of the SEC’s allegations.  Rather, we assume for analytical purposes that the SEC’s allegations are true, and we aim to be explicit about the procedural posture of covered matters.  We do not believe that this approach undermines the relevance or applicability of the due diligence lessons we describe.  Quite the contrary: we believe that our due diligence lessons are based on expressed concerns of the SEC, and thus are valid, generalizable and useful.  At best, these lessons can help our subscribers avoid investment and operational missteps.  However, in fairness to the defendants in these matters, we consider it important to emphasize that our analysis is based on allegations that remain to be proven or disproven.

IRS Enhancing Its Scrutiny of Tax Shelter Disclosures by Hedge Funds

In late 2010, the IRS Office of Chief Counsel issued a memorandum indicating that some common “protective” disclosures that are made by hedge funds and other investment partnerships are inadequate.  This could result in significant penalties for a fund as well as its investors.  In a guest article, Joseph Pacello, a Tax Partner at Rothstein Kass, discusses: the legal and accounting background of the IRS memorandum, including relevant tax disclosure requirements; the IRS Office of Chief Counsel’s analysis in the memorandum; penalties for failure to properly disclose a reportable transaction; and the likely impact of the IRS memorandum for both funds of funds and direct trading funds.

How Can Liquid Hedge Funds Be Structured to Accommodate Investments in Illiquid Assets?

During the past decade, an increasing volume of hedge fund dollars has poured into traditional liquid strategies.  As a result, market inefficiencies have narrowed or vanished, and opportunities for arbitrage – and the alpha it can generate – have grown fewer and farther between.  In response, some hedge fund managers that traditionally focused on liquid strategies started investing at least part of their funds’ capital in private equity and other illiquid securities and assets.  However, using liquid fund vehicles to invest in illiquid assets has presented a variety of problems, including those relating to: taxation, liquidity, valuation, manager compensation, strategy drift, due diligence, expectations regarding returns and regulatory scrutiny.  While there has been considerable discussion regarding the convergence of hedge funds and private equity funds, the experience and aftermath of the credit crisis indicate that the convergence discussion should be more refined.  Convergence at the fund level is problematic because illiquids do not fit naturally into a liquid fund.  Convergence at the manager level – for example, the same manager managing both private equity funds and hedge funds – is marginally more palatable, but by and large, institutional investors have demonstrated a preference for managers who stick to their knitting.  In a guest article, Philippe Simoens, Senior Manager in Tax and Strategic Business Services for Weaver, an independent certified public accounting firm, addresses some of the reasons why illiquid assets present problems when housed in liquid funds – even liquid funds purportedly structured to accommodate illiquid investments via mechanisms such as side pockets.  In the course of doing so, this article explains traditional liquid fund structuring and taxation; characteristics and taxation of marketable securities versus private equity; and structures employed by liquid funds to accommodate illiquid assets (including side pockets, lock-ups, gates and redemption suspensions).  The article concludes with thoughts on structuring for managers who traditionally have focused on liquid strategies, but who are exploring illiquid opportunities.

Askari Foy Named Associate Regional Director for Examinations in SEC’s Atlanta Regional Office

On January 27, 2011, the Securities and Exchange Commission announced the promotion of Askari Foy to Associate Regional Director for Examinations in the agency’s Atlanta Regional Office.  For recent coverage of an SEC complaint filed in federal district court in Atlanta, see “Thirteen Important Due Diligence Lessons for Hedge Fund Investors Arising Out Of the SEC’s Recent Action against a Fund of Funds Manager Alleging Misuse of Fund Assets,” Hedge Fund Law Report, Vol. 4, No. 3 (Jan. 21, 2011).  For more on examinations, see “What Do Hedge Fund Managers Need to Know to Prepare For, Handle and Survive SEC Examinations?  (Part One of Three),” above, in this issue of the Hedge Fund Law Report.

Alternative Investment Secondaries Specialist Jeff Bollerman Joins Houlihan Lokey’s Secondary Advisory Group in New York

On February 2, 2011, international investment bank Houlihan Lokey announced that Jeff Bollerman joined the firm’s Secondary Advisory Group to support transaction execution and business development in an area that continues to thrive in current market conditions.  For more on secondary market transactions in the hedge fund context, see “Valuation and Confidentiality Concerns in Secondary Market Trading of Hedge Fund Interests,” Hedge Fund Law Report, Vol. 1, No. 27 (Dec. 9, 2008).

Man Group Names Former BlackRock Executive as Head of U.S. Consultant Relations

On January 27, 2011, Man Group announced that it hired Miriam Tai as Head of U.S. Consultant Relations.  For more on consultants, see “Implications of the DOL’s Proposed Expanded Definition of ‘Fiduciary’ for Hedge Fund Managers, Placement Agents, Valuation Firms and Pension Consultants,” Hedge Fund Law Report, Vol. 3, No. 43 (Nov. 5, 2010).  For more on pension funds, see “CalPERS Special Review Foreshadows Seismic Shift in Business Arrangements among Public Pension Funds, Hedge Fund Managers and Placement Agents,” Hedge Fund Law Report, Vol. 4, No. 1 (Jan. 7, 2011).

Hedge Fund Manager Finisterre Capital Appoints Ursula Newman as General Counsel

On January 31, 2011, emerging markets debt specialist Finisterre Capital announced that it appointed Ursula Newman as general counsel.