Dec. 15, 2011

When and How Can Hedge Fund Managers Engage in Transactions with Their Hedge Funds?

Generally, investors hire hedge fund managers to make decisions – hopefully smart ones – with respect to their assets, rather than to serve as trading counterparties.  However, circumstances routinely arise in which transactions between a hedge fund manager and its funds can serve investors more effectively than transactions with third parties or the absence of a transaction.  The law does not prohibit such transactions, but it looks with suspicion on them based on the inherent conflicts of interest.  Hedge fund managers generally act exclusively as agents on behalf of their funds, but in such transactions, hedge fund managers are acting as both principals (with respect to themselves) and agents (with respect to their funds).  That is, hedge fund managers are on both sides of so-called “principal transactions,” which raises the question: how can hedge fund managers trade with their own funds without impairing the interests of fund investors?  There are practical and legal answers to this question.  The practical answer is that most principal transactions are not zero-sum trades.  One party does not gain in direct proportion to what the other party loses.  Rather, such transactions are more nuanced and involve other dimensions, such as time, fees and opportunity cost.  The legal answer is that the investment Advisers Act of 1940 (Advisers Act) and other authority provide disclosure and consent requirements that hedge fund managers must follow to legally effect a principal transaction.  The intent of the legal mechanics is investor protection, or in other words, to ensure that hedge fund managers only effect principal transactions where investor benefits are demonstrably present.  One of various challenges faced by hedge fund managers in this context is that the required legal process is ill-suited to the reality of most principal transactions.  Obtaining consent, for example, is slow and involved, and many investment opportunities are fast and fleeting.  Moreover, available legal guidance is limited and general.  Accordingly, hedge fund managers typically look to market practice when engaging in transactions with their funds.  This article explains market practice in this area in a thoroughgoing way and also details relevant law and regulation to the extent it exists.  In particular, this article begins by describing four categories of situations in which hedge fund managers may wish to engage in transactions with their funds (e.g., certain cross trades).  The article then discusses: the practical and legal risks of engaging in such transactions and the concomitant conflicts of interest involved; what types of transactions constitute a “principal transaction” as defined in Section 206(3) of the Advisers Act; the statutory disclosure and informed consent requirements applicable to principal transactions; specific methods used by hedge fund managers to streamline the process for obtaining informed consent; and required compliance policies and procedures.

Is the “Mosaic Theory” a Viable Defense to Insider Trading Charges Against Hedge Fund Managers Post-Galleon?

When a hedge fund manager pieces together what he or she reads in a recent article, blog or report with other inconsequential nonpublic information previously acquired in such a way that it reveals a material insight into an issuer or its prospects – and the manager trades based on the insight – should that manager be charged with insider trading?  Generally, such “Eureka” moments have been protected under the “mosaic theory,” which has been recognized explicitly both in caselaw and in pronouncements by the SEC.  For example, in October 2011, when SEC Chairman Mary Schapiro was asked for her views on the use of “expert network” firms by hedge fund managers, she noted that “[t]here is nothing wrong with doing tremendous due diligence” when it comes to stock research, and that there “is a . . . pretty bright line” between stock research and illegal insider trading.  See “How Can Hedge Fund Managers Avoid Insider Trading Violations When Using Expert Networks? (Part Two of Two),” Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011).  Recently, however, the SEC has brought a number of insider trading cases suggesting that the “line” separating research and conduct the SEC may seek to punish is far greyer and fainter than Chairman Schapiro indicated.  In a guest article, Perrie Weiner, Patrick Hunnius and Stephanie Smith, partner, senior counsel and associate, respectively, at DLA Piper, examine recent insider trading cases brought by the SEC based on investors having pieced together a mosaic of facts.  These cases provide valuable insight into important questions that should shape a hedge fund manager’s approach to the investment research process and what precautions the fund manager should take.  For example, what mosaic of activities has amounted to an inference of insider trading?  What actions should hedge fund managers take to ensure their conduct does not even give rise to the appearance of insider trading?

Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part Three of Four)

Any asset manager who chooses to open up an office in Singapore will have significant interaction with the Monetary Authority of Singapore (MAS), which acts as Singapore’s unified financial services regulator.  The MAS has confirmed that in the first half of 2012, it will implement a new regulatory structure over asset managers that maintain an investment management office in Singapore.  This article is the third in a four-part series by Maria Gabriela Bianchini, founder of Optionality Consulting.  The first article in this series identified factors that hedge fund managers should consider in determining whether to open an office in Asia and compared the relative merits of Hong Kong and Singapore as locations for an office.  See “Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part One of Four),” Hedge Fund Law Report, Vol. 4, No. 43 (Dec. 1, 2011).  The second article in this series discussed technical steps and considerations for the actual process of opening an office in either Hong Kong or Singapore.  See “Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part Two of Four),” Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011).  This article describes Singapore’s new regulatory structure for hedge fund managers, which is expected to take effect in the first half of 2012, and discusses the application of the new regulations with respect to staffing, compensation, taxation, compliance, regulatory filings and other matters.  Part four will conclude the series with a discussion of Hong Kong.

Three Recent SEC Orders Demonstrate a Renewed Emphasis on Investment Adviser Compliance Policies and Procedures by the Enforcement Division

A trio of consent orders recently issued by the Securities and Exchange Commission (SEC) highlights the importance of adoption by investment advisers of meaningful compliance policies and procedures and following through when SEC examinations reveal deficiencies.  The subjects of the SEC’s actions, Asset Advisors, LLC, Feltl & Company, Inc., and OMNI Investment Advisors Inc. (and its principal Gary R. Beynon), all failed to maintain and implement appropriate compliance and ethics policies.  Two of those respondents failed to implement SEC recommendations from earlier examinations.  All three respondents were censured, fined and ordered to cease and desist from future violations, although respondents neither admitted nor denied the SEC’s allegations.  Although none of the respondents was a hedge fund manager, the legal principles at issue in the three matters have direct relevance to adoption and implementation of compliance policies and procedures by registered hedge fund managers.  This article summarizes the key factual and legal points from the three orders.  For an overview of SEC examinations and likely areas of inquiry regarding compliance, see “SEC Exams of Hedge Fund Advisers: Focus Areas and Common Deficiencies in Compliance Policies and Procedures,” Hedge Fund Law Report, Vol. 4, No. 38 (Oct. 27, 2011).  For more on SEC examinations, disclosure of examinations and the consequences of ignoring the SEC’s recommendations following an examination, see “Are Hedge Fund Managers Required to Disclose the Existence or Outcome of Regulatory Examinations to Current or Potential Investors?,”  Hedge Fund Law Report, Vol. 4, No. 32 (Sep. 16, 2011).

Federal Court Affirms the Ability of a Bankruptcy Trustee to Claw Back Fictitious Profits from Investors in LPs or LLCs Operated As Ponzi Schemes

On October 27, 2011, the Federal Court of Appeals for the Eleventh Circuit issued an opinion upholding clawback protections for members of limited liability companies and partners of limited partnerships who are victims of a Ponzi scheme.  This decision reaffirmed the general rule that, in the case of a Ponzi scheme, the return of an investor’s principal cannot be avoided where the investor can prove that he took that money in good faith.  See “Two Recent Federal Court Decisions Clarify the Differing Treatment under SIPA of Returned Principal and Fictitious Profits,” Hedge Fund Law Report, Vol. 4, No. 34 (Sep. 29, 2011).  Procedurally, the decision affirmed the lower court’s ruling and resolved an issue of first impression in the Eleventh Circuit.  This article explains the factual background of the decision and the court’s legal analysis, and references relevant HFLR articles.  Much of what we publish is intended to help hedge fund investors avoid Ponzi schemes and similar bad investment calls.  See, e.g., “What Should Hedge Fund Investors Be Looking for in the Course of Operational Due Diligence and How Can They Find It?,” Hedge Fund Law Report, Vol. 4, No. 36 (Oct. 13, 2011).  However, despite best efforts, even savvy investors sometimes wind up in Ponzi schemes.  See “Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices,” Hedge Fund Law Report, Vol. 4, No. 25 (Jul. 27, 2011).  This article is intended to help clarify the rights and obligations of such investors.

CFTC Position Limit Rules Challenged in Lawsuit by ISDA and SIFMA

On Friday, December 2, 2011, the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (SIFMA) jointly filed a complaint in the U.S. District Court for the District of Columbia against the Commodity Futures Trading Commission (CFTC).  Their complaint challenges the final rules adopted by the CFTC at its October 18, 2011 meeting establishing speculative position limits on 28 commodity futures, option contracts and economically equivalent commodity swaps (the Position Limit Rules).  This article summarizes the Position Limit Rules and the lawsuit challenging them.  For hedge fund managers that trade covered commodities or derivatives based on them, the Position Limit Rules and the lawsuit can directly affect trading volumes and strategies.  See also “Recent CFTC Settlement with Former Moore Capital Trader Illustrates a Number of Best Compliance Practices for Hedge Fund Managers that Trade Commodity Futures Contracts,” Hedge Fund Law Report, Vol. 4, No. 30 (Sep. 1, 2011).

Mayer Brown Expands Private Investment Funds Group with Addition of Rory Cohen as Partner in New York

On December 7, 2011, Mayer Brown announced that Rory Cohen joined the firm as a partner in the Corporate & Securities practice and the Private Investment Funds group in New York.  Cohen has been quoted in the Hedge Fund Law Report.  See, e.g., “Investments by Hedge Fund Managers in Their Own Funds: Rationale, Amounts, Terms, Disclosure, Duty to Update and Verification,” Hedge Fund Law Report, Vol. 3, No. 21 (May 28, 2010).