Nov. 10, 2011

Portability and Protection of Hedge Fund Investment Track Records

A hedge fund’s performance history, or track record, can be one of its most valuable assets.  A fund that has developed a successful track record will want to promote that track record as evidence of its own capabilities and protect that track record from being claimed or distorted by others.  On the other hand, a portfolio manager or other employee who has developed a successful track record will want to take that track record with him when he leaves the fund and use it to attract his own investors.  A fund or portfolio manager with a poor track record may want to avoid or limit the disclosure of past performance.  In a guest article, Sean R. O’Brien and Sara A. Welch, Managing Partner and Counsel, respectively, at O’Brien LLP, along with Joel A. Blanchet, a Partner at Kirkland & Ellis LLP, explore the manner in which the law affects investment funds, investment adviser firms and individuals when it comes to the portability of track records, and identify steps that funds and portfolio managers can take to protect their respective rights with respect to those track records.  At the outset, this article discusses who owns an investment track record and therefore, who can use such a track record.  The following sections detail regulatory guidance provided by the Securities and Exchange Commission (SEC), industry guidance provided by the CFA Institute and court decisions on the ownership and portability of track records.  The article concludes with a discussion of contractual provisions hedge fund managers can use to protect their investment track records from misappropriation and misuse.  For more on O’Brien LLP, see “Sean R. O’Brien Launches Boutique Law Firm Focused on Hedge Fund Litigation,” below, in this issue of the Hedge Fund Law Report.  For more by O’Brien LLP attorneys, see “Protecting Hedge Funds’ Trade Secrets: The Federal Government’s Enforcement of Criminal Laws Protecting Proprietary Trading Strategies,” Hedge Fund Law Report, Vol. 3, No. 48 (Dec. 10, 2010).

Key Legal and Operational Considerations in Connection with Preparing, Filing and Updating Form PF (Part Two of Two)

Form PF generally calls for voluminous disclosure by private fund managers to regulators of fund, investor, counterparty, credit and other information.  The form is legally complex and operationally challenging.  On the legal side, its novelty means that there is no direct market practice to assess the form’s application or to guide completion.  On the operational side, its novelty means that managers and service providers do not have dedicated systems in place to create, organize, scrub, update and secure the relevant data.  See “Technical and Operational Considerations for Hedge Fund Managers in Connection with Preparing, Filing and Updating Form PF,” Hedge Fund Law Report, Vol. 4, No. 37 (Oct. 21, 2011).  To bring some clarity to the complexity, on October 25, 2011, Advise Technologies and the Hedge Fund Law Report co-sponsored a seminar on Form PF.  The seminar consisted of two panels, the first focusing on legal questions raised by the form and the second focusing on operational considerations in connection with the form.  At an open meeting held on October 26, 2011, the SEC adopted Rule 204(b)-1 under the Investment Advisers Act of 1940, requiring periodic reporting by private fund managers on Form PF.  (The SEC and CFTC jointly issued the final rule release on October 31, 2011.)  Despite this chronology, the vast majority of the discussion at the seminar remains very relevant to a wide range of hedge fund industry participants; most of the changes from the proposed form to the final form involved thresholds and timing provisions, while the discussion at the seminar focused on market color, best practices, trends and precedent.  For the benefit of those that could not attend the seminar – and as a recap for those who did attend – this article summarizes and, as relevant, updates the discussion during the legal panel.  In particular, this article discusses: the four assets under management (AUM)-based categories that trigger the frequency and content of Form PF filing obligations for hedge fund managers; the definition of a “hedge fund” for purposes of Form PF; how to calculate “regulatory AUM” for purposes of Form PF; aggregating conventions with respect to managed accounts and assets of private funds advised by related persons; issues raised by leverage, funds of funds, non-U.S. advisers and sub-advised hedge funds; removal of the certification requirement from Form PF and the ability to rely on internal methodologies; how final Form PF handles disclosure of value at risk measurements and other risk metrics; and four concerns regarding confidentiality of data in Form PF.  This article is the second in a two-part series on Form PF.  The first article in this series included a line by line comparison of proposed Form PF and final Form PF.  See “Key Legal and Operational Considerations in Connection with Preparing, Filing and Updating Form PF (Part One of Two),” Hedge Fund Law Report, Vol. 4, No. 39 (Nov. 3, 2011).  Taken together, the two parts of this series are intended to help HFLR subscribers determine whether they have to file Form PF, what they have to file, how they can go about filing and how their obligations have changed from the proposed rule to the final rule.

Business Issues with Legal Consequences: A Wide-Ranging Interview with Dechert Partner George Mazin about the Most Important Challenges Facing Hedge Fund Managers

The Hedge Fund Law Report recently had the privilege of interviewing George J. Mazin, a Partner at Dechert LLP, and a deservedly well-regarded member of the hedge fund bar.  As evidenced by the text of our interview, which is included in this issue of the Hedge Fund Law Report, George has an aptitude for identifying the legal consequences of business issues, and explaining them clearly.  He also has the kind of market color that only comes with years – decades – in the trenches, and experience across business cycles.  Our interview was wide-ranging, reflecting the diversity of George’s experience, which in turn reflects the range of legal issues relevant to hedge fund managers.  In particular, our interview covered: valuation considerations in connection with affiliate transactions; valuations based on fraudulent sales and rigged dealer bids; manager overrides of third-party valuations; whether side pockets remain viable in new hedge fund launches; how even non-ERISA hedge funds can analogize the ERISA model of independent pricing; effective valuation testing programs; the interaction between GAAP and the custody rule; GAAP exceptions to audit opinions; use of counterparty confirmations by the SEC; delayed audits; custody of derivatives and limited partnership interests; insider trading policies with respect to market chatter and channel checking; how to grant side letters in light of selective disclosure considerations; how algorithmic or high-speed trading firms can prepare for regulatory examinations; legal considerations in connection with loans from a hedge fund to a manager; best practices in connection with principal trades; and whether side-by-side investing by manager personnel can pass muster under fiduciary duty and related principles.  This interview was conducted in connection with the Regulatory Compliance Association’s Fall 2011 Asset Management Thought Leadership Symposium, which is taking place today at the Pierre Hotel in New York.

Principals of Paron Capital Management Sue Rothstein Kass for Negligence, Fraud and Breach of Contract Based on Alleged Failure to Obtain Third-Party Verification of Performance Results

Plaintiffs Peter McConnon (McConnon) and Timothy Lyons (Lyons) are the current principals of plaintiff investment manager Paron Capital Management, LLC (Paron).  In April 2010, McConnon and Lyons were introduced to James Crombie (Crombie), who claimed to have run a successful commodity futures trading business and desired to form a new trading business with McConnon and Lyons.  McConnon and Lyons claim that Paron retained defendant accounting firm Rothstein, Kass & Company, LLP (Rothstein Kass) to verify Crombie’s claimed returns.  In particular, they asked Rothstein Kass to obtain third-party confirmation of data provided by Crombie.  According to the complaint, Rothstein Kass never did so.  It turned out that the historical performance data supplied by Crombie was a complete fabrication.  That false data formed the basis of Paron’s marketing materials.  Following investigations and enforcement actions by the National Futures Association and the U.S. Commodity Futures Trading Commission, Paron and Crombie were banned from futures trading and Paron’s business collapsed.  The plaintiffs seek damages from Rothstein Kass for negligence, fraud and breach of contract.  We detail the plaintiffs’ allegations and the allegations and findings in the enforcement actions.  Rothstein Kass told the Hedge Fund Law Report with respect to this matter: “We have no comment on these meritless claims.”

Impact of Regulation SHO on the Short Sale Activity of Hedge Fund Managers and Broker-Dealers

On October 25, 2011, The Financial Industry Regulatory Authority (FINRA) announced that it fined UBS Securities LLC (UBS) $12 million for violations of Regulation SHO (Reg SHO) and related failures in supervising short sales.  In general terms, FINRA found that, over a substantial period, UBS: (1) placed short sale orders to the market without the required “locates”; (2) mismarked sale orders including labeling short sales as “long”; and (3) misrepresented its aggregation units in a way that may have further produced failures to locate and mismarking.  Moreover, FINRA found that UBS had insufficient supervisory and monitoring procedures in place to either prevent or detect these violations.  FINRA’s charging document provides one of the most comprehensive recent analyses of Reg SHO in practice.  The document provides important insight into FINRA’s expectations with respect to a broker-dealers’ compliance obligations in connection with short sales.  And by extension, FINRA’s analysis is relevant to hedge funds because, as discussed in this article, Reg SHO affects hedge funds and hedge fund managers directly and indirectly (via their use of prime brokers).  Accordingly, the background and analysis in this article are important for hedge fund managers for whom short sales are part of an investment strategy.

SEC Charges Hedge Fund Founder and His Friends and Family with Insider Trading

On August 31, 2011, the United States Securities and Exchange Commission (SEC) continued its war on “family and friends” insider trading when it filed a civil complaint in the United States District Court for the District of New Jersey against Clay Capital Management, LLC; one of its founders, James F. Turner, II; his neighbor, Mark Durbin; and Mr. Turner’s alleged accomplices, Scott Vollmar and Scott Robarge (together, defendants).  The complaint accuses Turner of insider trading in early 2008 on information obtained from his brother-in-law Vollmar, a director of business development for Autodesk, Inc., and his college friend Robarge, a recruiting technology manager for, Inc.  It also accused Turner of passing that information to the Clay Capital Fund, LP (the Fund) and other family members and friends, and accuses Vollmar of doing the same for his neighbor Durbin.  The complaint does not accuse his unnamed associates, including his partners in the Clay Fund, of participating in or having any knowledge of the scheme.  The accusations again Robarge and Durbin have already resulted in settlements with the SEC.  We detail the allegations in the complaint, which provide further insight into what information flows among friends and family constitute insider trading in the view of the current SEC Enforcement Division.

Sean R. O’Brien Launches Boutique Law Firm Focused on Hedge Fund Litigation

Seasoned litigator Sean R. O’Brien recently launched O’Brien LLP, a litigation firm with extensive experience in, and a special focus on, the hedge fund industry and hedge fund related disputes.  O’Brien LLP’s attorneys prevailed this year in a jury trial in Texas State Court on behalf of an affiliate of Touradji Capital Management, LP, recovering over $3 million dollars in damages and attorneys’ fees, and obtaining a judgment of dismissal of all claims asserted against its client.  For a discussion of a related matter, see “New York State Supreme Court Dismisses Intentional Infliction of Emotional Distress Claim in Suit by Former Employees Against Hedge Fund Manager Touradji Capital,” Hedge Fund Law Report, Vol. 3, No. 23 (Jun. 11, 2010).  O’Brien LLP’s attorneys also recently resolved an insider trading lawsuit brought by the Securities Exchange Commission against Trivium Capital Management, LP, with a complete dismissal of the action.  In addition, the firm’s attorneys have represented firms in criminal and civil trade secret disputes, including the successful representation of the energy risk manager of Amaranth Advisors following its dissolution.  For analysis by O’Brien LLP attorneys, see “Portability and Protection of Hedge Fund Investment Track Records,” above, in this issue of Hedge Fund Law Report.

Boyd M. Johnson, III, Deputy U.S. Attorney for the Southern District of New York, Joins WilmerHale

Boyd M. Johnson III, who most recently served as Deputy U.S. Attorney for the Southern District of New York, recently joined WilmerHale.  As Deputy U.S. Attorney, Johnson managed multiple high-profile matters, including the largest crackdown on hedge fund insider trading in U.S. history; the criminal prosecutions and civil forfeiture proceedings related to the Bernard Madoff fraud; and the investigation and prosecution of individuals and entities responsible for structuring and promoting international tax shelters.  For more on tax shelters, see “IRS Enhancing Its Scrutiny of Tax Shelter Disclosures by Hedge Funds,” Hedge Fund Law Report, Vol. 4, No. 4 (Feb. 3, 2011).

Offshore Law Firm Bedell Cristin Expands Operations in BVI and Singapore and Launches Management Services in Mauritius

Offshore law firm Bedell Cristin recently announced that it is expanding operations in BVI and Singapore and that it has launched its Mauritius Management Services.  See “Hedging into Africa through Cayman and Mauritius,” Hedge Fund Law Report, Vol. 4, No. 7 (Feb. 25, 2011).