Feb. 18, 2011

Recent Developments in New York City and California Lobbying Laws May Impact the Activities and Compensation of In-House and Third-Party Hedge Fund Marketers (Part One of Three)

Public pension funds represent approximately 16 percent of all institutional investor assets in hedge funds, according to alternative investment data provider Preqin.  However, not all assets invested in hedge funds are equally weighted.  To a hedge fund manager, a dollar invested by a public pension fund generally is more valuable than a dollar invested by a high net worth individual, or most funds of funds, for at least two reasons.  First, that pension fund is likely to stay invested longer, and thus to generate more fees over time.  Second, an investment by a public pension fund often increases the likelihood of other investments because subsequent investors assume, rightly or wrongly, that the public pension fund engaged in rigorous investment and operational due diligence before investing.  Accordingly, public pension funds have long been among the most coveted investors in hedge funds, and that 16 percent figure understates the attention such funds have garnered from in-house and third-party marketers.  However, at least three recent developments have complicated the process of marketing to public pension funds.  The first two of those three developments are discussed in this article.  The third such development is this: an authoritative recent interpretation of New York City’s lobbying law, and recent amendments to California’s lobbying law, likely will require placement agents and other third-party marketers, in-house hedge fund marketers and, in some cases, hedge fund managers themselves, to register as lobbyists.  Such registration will impose new obligations and prohibitions on hedge fund marketers.  Most dramatically, both California and New York City prohibit a registered lobbyist from receiving contingent compensation, that is, compensation that is calculated by reference to the success of the lobbyist’s efforts in persuading a public pension fund to invest in a hedge fund.  In other words, the lobbying laws of both jurisdictions appear to prohibit – or at least complicate – precisely the types of compensation structures most typically found in placement agent agreements and many in-house marketer agreements.  See “What Is the ‘Market’ for Fees and Other Key Terms in Agreements between Hedge Fund Managers and Placement Agents?,” Hedge Fund Law Report, Vol. 3, No. 35 (Sep. 10, 2010).  Of course, the lobbying laws only prohibit or complicate such compensation structures in connection with solicitation activities directed at public pension funds in California or New York City.  However, those jurisdictions contain public pension funds – notably including CalPERS – whose actions are widely followed by other public pension funds and other institutional investors.  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).  This article is the first installment in a three-part series intended to explore the implications of the New York City and California lobbying law developments for various hedge fund industry participants.  Specifically, this article provides the legal basis on which the analyses in parts two and three will be based.  The core of this article is a proprietary, 14-page chart summarizing the key provisions of the New York City and California lobbying laws, and comparing those provisions side-by-side.  For example, column one of the chart lists a provision (e.g., people and entities whose efforts to influence investment decisions may constitute “lobbying” under relevant law), column two describes the provision under New York City law, and column three describes the provision under California law.  The intent of this layout is to enable subscribers to easily compare the way in which the different jurisdictions handle the same concept.  The specific provisions covered by the chart include: primary legal, regulatory and interpretive resources, and links thereto; affected pension funds; definitions of “lobbyist”; definitions of “client” (NY), “external manager” (CA) and “lobbyist employer” (CA); definitions of “lobbying”; people and entities whose efforts to influence investment decisions may constitute “lobbying” under relevant law; exceptions from the definition of “placement agent”; people and entities, contacts with whom may constitute “lobbying” under relevant law; registration requirements for lobbyists; timing and frequency of required filings by lobbyists of statements of registration; filing requirements applicable to clients of lobbyists; periodic filing requirements applicable to lobbyists; prohibitions on contingent compensation; other prohibitions; recordkeeping requirements; the requirement to attend ethics training courses; penalties for violations of lobbying laws; and the public availability of reported data.  Part two of this article series will examine the implications of these lobbying law developments for the activities and compensation of third-party hedge fund marketers, and part three of this series will examine the implications for in-house marketers.

What Are Hybrid Gates, and Should You Consider Them When Launching Your Next Hedge Fund?

Gates are provisions in hedge fund governing documents that permit the fund manager to limit the volume of assets redeemed on a given redemption date.  The general purpose of gates is to slow the pace of redemptions in down markets and to enable managers to avoid selling assets at temporarily depressed prices.  The goal of such devices is to protect long-term fund investors who, in the absence of gates, might be left with a less liquid and less valuable portfolio.  Historically, for purposes of determining whether a gate was triggered, the volume of assets sought to be redeemed on a given redemption date was measured at the fund level (fund-level gate).  More recently, some hedge fund documents have provided for measurement at the capital account level, on an investor-by-investor basis (investor-level gate).  Even more recently – and, admittedly, in just a few cases of which we are aware – managers have launched hedge funds with a novel provision that combines elements of fund-level and investor-level gates.  The market has taken to calling such provisions “hybrid gates.”  This article explains the mechanics and goals of hybrid gates.  In particular, this article discusses: how redemptions are reduced above the gate threshold in the context of fund-level gates; how the pro rata reduction amount is calculated; current practice with respect to priority of carried-forward excess redemptions; whether carried-forward excess redemptions remain subject to fund profit and loss; discounts or penalties for redemptions above a gate threshold; operation of investor-level gates; and examples of hedge funds that have implemented investor-level gates.  With that background, the article explains (using a numerical example) how hybrid gates work and why managers may consider using them.

What Do Hedge Fund Managers Need to Know to Prepare For, Handle and Survive SEC Examinations?  (Part Three 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 feature an extended 1.5 hour 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 was included in our issue of February 3, 2011.  See “What Do Hedge Fund Managers Need to Know to Prepare For, Handle and Survive SEC Examinations?  (Part One of Three),” Hedge Fund Law Report, Vol. 4, No. 4 (Feb. 3, 2011).  And full text of our interview with Stephen McShea was included in our issue of February 10, 2011.  See “What Do Hedge Fund Managers Need to Know to Prepare For, Handle and Survive SEC Examinations?  (Part Two of Three),” Hedge Fund Law Report, Vol. 4, No. 5 (Feb. 10, 2011).  The full text of our interview with Matthew Eisenberg is included in this issue of the Hedge Fund Law Report, below.  The Eisenberg interview covered a wide range of relevant topics, including but not limited to: four principal areas in which the SEC has been focusing its enforcement activity of late; the relationship among SEC sweeps, examinations and enforcement actions; primary lessons for hedge fund managers from the SEC’s recent sweeps and enforcement actions; the impact of new leadership in key examination roles at the SEC (for example, Carlo di Florio as Director of OCIE) on examinations of hedge fund managers; the SEC’s goals in conducting examinations; suggested goals of hedge fund managers when undergoing examinations; lessons for both the SEC and hedge fund managers of the report by the SEC Inspector General on Westridge Capital Management and related matters; the likelihood that a self-regulatory organization (SRO) for investment advisers will be given authority to examine registered hedge fund managers; whether SRO examination authority over hedge fund managers would be better or worse than the current state of affairs; principal areas of focus of the CFTC and National Futures Association (NFA) in their enforcement efforts; authority of the CFTC and NFA to examine hedge fund managers; and specific steps that managers can take to create and demonstrate a commitment to compliance and to strike the right “tone at the top.”

Private Equity Investment Adviser Full Value Advisors, L.L.C., Loses Appeal to D.C. Circuit in Bid to Avoid Filing Disclosures of Stock Positions Under Section 13(f) of the Securities Exchange Act of 1934

Section 13(f) of the Securities Exchange Act of 1934 requires institutional investment managers to disclose their investment positions to the Securities and Exchange Commission (SEC).  That information is then made public unless an exemption from disclosure applies.  In applying for an exemption, the investment manager must submit detailed information to the SEC, including the information that the manager desires to avoid disclosing, to enable the SEC to consider the application.  Appellant investment adviser Full Value Advisors, L.L.C. (Full Value) submitted an incomplete Form 13F disclosure form to the SEC and requested an exemption from disclosure.  The SEC denied the application on the ground that Full Value had failed to provide sufficient information on which to base a decision.  Full Value appealed the SEC’s determination, claiming that the disclosure requirements constituted an impermissible regulatory taking of property under the Fifth Amendment and violated its free speech rights under the First Amendment.  The U.S. Court of Appeals for the D.C. Circuit held that mandatory disclosure to the SEC did not violate either Amendment.  It also dismissed the appeal as unripe for consideration in so far as it related to Full Value’s claims regarding the potential disclosure of its Form 13F information to the public.  We summarize the Court’s decision.

Drawbacks of Being a Lone Dissident on a Board of Directors, Starting an Activist Campaign and Targeting Retail Investors Are Themes at Activist Investor Conference

On January 27 and 28, 2011, DealFlow Media hosted The Activist Investor Conference 2011 in New York City.  Among the key topics discussed during the conference were: the key strategies and objectives of activist investors; how activists deal with being the lone dissident on a board of directors; whether and when to seek reimbursement for the costs of proxy contests; when to solicit retail investors for support in a proxy contest; how to contact objecting and non-objecting beneficial owners; and what budding activists should know about getting started.  This article offers a comprehensive summary of the key points raised and discussed at the conference, and relays insights from Frank LaGrange Johnson, Philip Goldstein and others.

Michael Pereira, Publisher of the Hedge Fund Law Report, Contributes Section on Hedge Funds to Definitive New Guide to Global Fund Industry 

On February 10, 2011, MFS Investment Management (MFS) and NICSA announced that The Fund Industry: How Your Money is Managed has been published by John Wiley & Sons.  This definitive guide to the worldwide fund industry is authored by Robert Pozen and Theresa Hamacher.  Bob is Chairman Emeritus of MFS and a senior lecturer at Harvard Business School; Theresa is President of NICSA and a former mutual fund chief investment officer.  Michael Pereira, Publisher of the Hedge Fund Law Report, contributed the section on hedge funds to the new book.  For more on Bob’s writing and thinking, see “The Case for Professional Boards of Public Companies,” Hedge Fund Law Report, Vol. 4, No. 1 (Jan. 7, 2011); and “Book Review: ‘Too Big To Save? How to Fix the U.S. Financial System,’ By Robert Pozen; Wiley, 480 Pages,” Hedge Fund Law Report, Vol. 2, No. 43 (Oct. 29, 2009).  For more on NICSA, see “NICSA’s ‘Trends in Hedge Fund Operations’ Seminar Focuses on Liquidity, Managed Accounts, Third-Party Administration, Due Diligence, GIPS Standards and Related Topics,” Hedge Fund Law Report, Vol. 3, No. 19 (May 14, 2010).

Department Of Labor Defers Until 2012 Effective Date of New ERISA Regulations on Fee Disclosure That Can Impact Hedge Funds That Have or Target Private Pension Funds and Other ERISA Investors

The exemption under Section 408(b)(2) of ERISA from ERISA’s prohibited transaction rules permits a service provider to an employee benefit plan (including a hedge fund manager) to receive “reasonable compensation” for “necessary” services under a “reasonable” arrangement.  Regulations of the U.S. Department of Labor (DOL) promulgated in 1977 elaborated on the circumstances in which the exemption would be available.  Much has happened since 1977, and there have been recent comprehensive legislative and regulatory proposals to address the level of fee-related disclosure available to fiduciaries and plan participants and beneficiaries.  On the regulatory side, the DOL recently made extensive revisions to the compensation-related information that plan administrators are required to report annually on the “Form 5500,” and has previously issued proposed regulations that would affect the disclosure of fees charged in connection with participant-directed “401(k)” and other plans.  On Form 5500, see “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA's More Onerous Prohibited Transaction Provisions? (Part Two of Three),” Hedge Fund Law Report, Vol. 3, No. 20 (May 21, 2010).  Following its 2007 release of a controversial set of proposed Section 408(b)(2) regulations, on July 16, 2010, the DOL issued long-awaited interim final regulations under Section 408(b)(2) requiring increased disclosure of compensation in the case of certain services to pension plans.  Under the new regulations, where they are applicable, an arrangement for providing services to a pension plan will be treated as “reasonable” only if the service provider discloses to the plan specified compensation-related information.  See “Is That Your (Interim) Final Answer? New Disclosure Rules Under ERISA To Impact Many Hedge Funds,” Hedge Fund Law Report, Vol. 3, No. 33 (Aug. 20, 2010).  The effective date of the new regulations was scheduled to be July 16, 2011.  However, on February 11, 2011, the DOL announced that it intends to extend the applicability date for the new disclosure rules under Section 408(b)(2) to January 1, 2012.

Ogier Cayman Announces Promotions in Litigation and Fiduciary Services

On February 8, 2011, Ogier Cayman announced promotions in its litigation and fiduciary services practices.

FDIC Appoints General Counsel and Key Leadership Staff for Newly Established Office of Complex Financial Institutions and Division of Consumer Protection

Federal Deposit Insurance Corporation (FDIC) Chairman Sheila C. Bair recently announced the appointment of Michael H. Krimminger as the agency's new General Counsel.  In addition, on February 11, the FDIC announced the hiring of additional key leadership staff for newly established organizations: Jason C. Cave and Mary Patricia Azevedo for the Office of Complex Financial Institutions (CFI) and Sylvia H. Plunkett, Jonathan N. Miller and Keith S. Ernst for the Division of Depositor and Consumer Protection (DCP).