Feb. 25, 2011

Who Should Newly Registered Hedge Fund Managers Designate as the Chief Compliance Officer and How Much Are Chief Compliance Officers Paid?

The Dodd-Frank Act (Dodd-Frank) will require hedge fund managers to appoint a chief compliance officer (CCO) for two reasons – an explicit reason and an implicit reason.  Explicitly, Dodd-Frank will require registration (by July 21, 2011) by hedge fund managers with assets under management in the U.S.: (1) of at least $150 million that manage solely private funds; or (2) 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).  Registered hedge fund managers will be subject to SEC Rule 206(4)-7, which requires, among other things, registered investment advisers to “designate” (note: not “hire”) a CCO to administer their compliance policies and procedures.  Implicitly, Dodd-Frank is not only the cause of major regulatory change, but also the effect of a changed regulatory mindset.  Post-Dodd-Frank, there is more regulation – considerably more – and more vigorous enforcement of new and existing regulation.  Much of that regulation applies with equal force to registered and unregistered hedge fund managers.  Most notably, insider trading and anti-fraud rules apply to hedge fund managers regardless of their registration status.  See “How Can Hedge Fund Managers Avoid Insider Trading Violations When Using Expert Networks?  (Part One of Three),” Hedge Fund Law Report, Vol. 4, No. 5 (Feb. 10, 2011).  Recognizing this, even hedge fund managers beneath the relevant AUM thresholds are considering the appointment of a CCO (if they do not already have one).  For hedge fund managers considering the appointment of a CCO – and even for managers that currently have a CCO but are reevaluating how they staff the role – there are three basic approaches: (1) hire a new internal person to serve exclusively as CCO; (2) add the CCO title and duties to the existing portfolio of a current internal person, such as the general counsel (GC), chief operating officer (COO) or chief financial officer (CFO); or (3) outsource the role to a third-party compliance consulting or similar firm.  Which of these approaches makes sense, individually or in combination, depends on the size, strategy, complexity, resources, history and culture of the management company, among other factors.  In short, deciding who to designate as your CCO is a complex decision, and an increasingly important one.  The CCO is often the last bastion before a major compliance or operational failure, and as recent events demonstrate, those sorts of failures typically pose more franchise risk than bad investment calls.  See “Can the Chief Compliance Officer of a Hedge Fund Manager be Terminated for Investigating a Potential Compliance Violation by the Manager's Principal, CEO or CIO?,” Hedge Fund Law Report, Vol. 4, No. 2 (Jan. 14, 2011).  The basic purpose of this article is to identify the pros and cons of each of the three foregoing approaches to designating a CCO.  To do so, this article discusses: what Rule 206(4)-7 specifically requires and does not require; the relative benefits and burdens of hiring a dedicated CCO, assigning the role to an existing person and outsourcing the role; hybrid approaches that incorporate the best elements of outsourcing and internal work; counterintuitive insights with respect to the demand for compliance professionals in the current environment; and – perhaps most importantly to anyone in, considering or hiring for a CCO role – specific compensation numbers for compliance professionals at hedge fund managers, employees at hedge fund managers who add a CCO role to other roles and dedicated CCOs, and the “market” for fees payable to outsourced CCO firms.  (We thank David Claypoole, Founder and President of Parks Legal Placement LLC, for providing this detailed insight on CCO compensation numbers.)

Cayman Hedge Funds, Soft Wind-Downs and Disclosure

The expression “soft wind-down” is used in the corporate hedge fund context to describe the operating state where a fund is still under the control of its directors and where the investment manager is conducting an orderly realisation of the portfolio with a view to redeeming out all remaining investors.  The fund is not formally in liquidation – a specific statutory process in Cayman where the directors’ powers cease and liquidators assume control with a view to shutting the company down.  Over the past several years, a number of hedge funds have been faced with large numbers of redemption requests with the consequence that the economic viability of those funds has come into question.  Faced with little alternative, those funds have imposed suspensions and instituted soft wind-downs.  For some funds, the duration and conduct of the soft wind-down procedures has proved unsatisfactory to investors with the result that a number have ended up in court.  In recent decisions, the Cayman court has indicated that it will grant an order to place a corporate hedge fund into formal liquidation on the statutory grounds of it being “just and equitable” if the fund has lost its sub-stratum.  Put another way, an open ended hedge fund which has represented to investors that they will get periodic liquidity should not be implementing an indefinite suspension of redemptions coupled with a long term soft wind-down in the absence of proper disclosure.  In a guest article, Tim Frawley, a Partner at Maples and Calder, offers a detailed discussion of: the definition of “disclosure” in the hedge fund context; the rationale for disclosure; the evolution of the purpose of hedge fund offering documents; Cayman Islands statutory and common law with respect to misrepresentation and disclosure; considerations in connection with disclosing the possibility of a soft wind-down; and recent Cayman and BVI caselaw bearing on disclosure considerations.

Implications for Hedge Fund Managers of Recent Insider Trading Enforcement Initiatives (Part One of Three)

Recent criminal and civil enforcement actions allege that hedge fund manager personnel obtained material nonpublic information from employees and experts of at least one expert network firm.  See “How Can Hedge Fund Managers Avoid Insider Trading Violations When Using Expert Networks?  (Part One of Two),” Hedge Fund Law Report, Vol. 4, No. 5 (Feb. 10, 2011).  While the merits of these actions remain to be determined, the impact of these actions on the hedge fund industry has already been considerable.  At least one hedge fund management firm that was raided by the FBI has announced that it will wind down, and other firms that were raided by the FBI have sustained sizable redemptions.  Even for managers that have not been directly involved, the renewed focus of the SEC, DOJ and FBI on insider trading has caused hedge fund managers to revisit their insider trading compliance policies and procedures.  See “The SEC’s New Focus on Insider Trading by Hedge Funds,” Hedge Fund Law Report, Vol. 3, No. 22 (Jun. 3, 2010).  While the legal principles and theories of insider trading have not changed, the application of those principles and theories to new methods of investment research has redefined the scope of permitted activity.  To assist hedge fund managers in understanding what is permitted and what is prohibited in the current environment, how to conduct investment research without violating insider trading law and how to design compliance policies and procedures that reflect the new enforcement reality, the Regulatory Compliance Association’s 2011 Spring Asset Management Thought Leadership Symposium will feature a session entitled “Insider Trading – Analyzing and Addressing the Latest Enforcement Initiatives.”  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 Insider Trading Enforcement session at the RCA’s April Symposium: Robert B. Van Grover, Partner at Seward & Kissel LLP; John Robbins, Managing Director and Global Head of Compliance at Babson Capital Management; and Adam J. Wasserman, Partner at Dechert LLP.  The goal of these interviews is to enable hedge fund managers to continue performing rigorous and productive research while avoiding insider trading violations.  We are publishing these interviews as a three-part series.  The full text of our interview with Robert Van Grover is included in this issue of the Hedge Fund Law Report; our interview with John Robbins will be published in next week’s issue; and our interview with Adam Wasserman will be published in the following week’s issue.  Our interview with Robert Van Grover, included in full below, covered a wide range of relevant topics, including but not limited to: steps that hedge fund analysts, traders or portfolio managers should take when talking to corporate insiders in order to avoid insider trading violations; whether hedge fund analysts, traders or portfolio managers may be charged with aiding and abetting a breach of Regulation FD by a corporate insider; the definition of “market color,” and how it differs from material nonpublic information; how to handle rumors; what a CCO should do upon discovery of insider trading by junior or senior personnel; what a hedge fund manager should do if the FBI comes knocking; what managers should do about the increasing use of wiretaps in insider trading investigations; trends with respect to banning the use of expert networks outright; terms that managers are negotiating in their engagement letters with expert networks; how to mitigate improper informal communications; best practices with respect to electronic communications; implications of increased flexibility in the SEC’s Enforcement Division with respect to issuing subpoenas; interaction between the SEC examination and enforcement processes; and considerations for hedge fund manager personnel considering entering into immunity agreements with the SEC under the new cooperation initiative.  Notably, Van Grover recently sought and obtained no-action relief under the amended custody rule.  See “SEC Temporarily Permits Hedge Fund Managers to Avoid Surprise Examination Requirement with Audits by Auditors That Are Registered with, but Not Subject to Inspection by, the PCAOB,” Hedge Fund Law Report, Vol. 3, No. 42 (Oct. 29, 2010).

Irish High Court Rules that Hedge Fund Investor Is Entitled to Seek a Report of Fund’s Operations Directly from Fund’s Depository Bank When the Fund Fails to Make That Report Available Per Applicable EC Disclosure Rules

Plaintiffs in this action, Aforge Finance SAS and Aforge Gestion SAS (together, Aforge) were investors in non-party hedge fund Thema International Fund PLC (Thema or Fund).  Defendant HSBC Institutional Trust Services (Ireland) Limited (HSBC or Depository) served as the Fund’s depository.  The Fund apparently had a significant portion of its assets invested with Bernard Madoff.  After Madoff’s fraud was revealed, the Fund collapsed, losing substantially all of its assets.  HSBC, as one of the Fund’s depositories, was responsible for holding the Fund’s investments.  This action arose out of Aforge’s efforts to seek information about the Fund and its assets from HSBC.  Aforge claimed that it was entitled to obtain Fund information directly from HSBC.  A substantial part of Aforge’s argument rested on the theory that HSBC owed a fiduciary duty, and a corresponding duty to account, directly to the Fund’s investors.  Because it was organized in Ireland, the Fund was subject to the European Union’s Undertakings for Collective Investment in Transferable Securities Directive and the corresponding Irish implementing regulations (together, UCITS), which govern, among other things, disclosure by investment funds organized in the European Union.  UCITS requires a depository to make an annual report to the fund for which it holds assets.  In turn, the fund is required to make periodic financial disclosure to its investors, including the information contained in the depository’s report.  The Irish High Court, relying on the disclosure scheme mandated by UCITS, did not rule on whether a fiduciary relationship existed between HSBC and Aforge.  Instead, it determined that, because Thema failed to make the disclosures mandated by UCITS and, specifically, failed to provide HSBC’s requisite annual report, Aforge was entitled to seek that report directly from HSBC.  The Irish High Court refused to grant Aforge the right to seek any information beyond the information that HSBC was required to provide pursuant to UCITS.  We summarize the Court’s decision and its reasoning.

Hedging into Africa through Cayman and Mauritius

For decades, much of the African continent has been afflicted by political instability, war, famine and poverty.  Although these problems still remain for many in Africa, a number of African countries are beginning to see real economic growth and development.  Whilst it is uncertain whether events such as the current political upheaval along much of the Mediterranean coast of northern Africa or the vote for an independent state of South Sudan will hinder or spur economic growth in these particular areas, many African countries are nevertheless enjoying real economic growth and development.  As investors look to invest into Africa, they want to do so in a secure and tax efficient manner and are likely to seek out and rely on investment routes structured through reputable and internationally recognised jurisdictions.  The Cayman Islands and Mauritius tick these boxes, with both jurisdictions playing an important role in the investment process.  In a guest article, Kieran Loughran and Sonia Xavier, Partner and Associate, respectively, at Conyers Dill & Pearman, discuss, among other topics: the Cayman Islands as an efficient choice of domicile for hedge funds; Mauritius as a treaty-based jurisdiction; structuring and substance for Mauritius entities; tax advantages of Mauritius entities; and investment protection provided by Mauritius.

Federal Reserve Board Proposes Rule Defining Covered Nonbank Financial Companies That May Capture the Largest Hedge Funds

On February 8, 2011, the Federal Reserve Board (Board) issued a proposed rule (Proposed Rule) that implements two provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).  The Dodd-Frank Act requires the Board to issue regulations that establish criteria for determining whether a company is “predominately engaged in financial activities” and to define the terms “significant nonbank financial company” and “significant bank holding company” for purposes of designation by the Financial Stability Oversight Council (FSOC) of systemically important nonbank financial companies that may become subject to Board supervision.  The Proposed Rule defines a company as “predominately engaged in financial activities” if it, or its subsidiaries, derives 85 percent or more of its gross revenues or assets from activities defined as “financial in nature” under the Bank Holding Company Act of 1956 (BHCA), as amended by the Gramm-Leach-Bliley Act of 1999 and Board regulations.  The Proposed Rule also addresses how to treat the revenues and assets attributable to equity investments in other organizations that are not consolidated with the company.  The Proposed Rule would also deem a firm a “significant nonbank financial company” or “significant bank holding company” if it controls $50 billion or more in total consolidated assets, or the FSOC has designated it as “systemically important.”  We summarize the most pertinent parts of the Proposed Rule.

Sean McKessy Named Head of SEC Whistleblower Office

On February 18, 2011, the Securities and Exchange Commission (SEC) announced that Sean McKessy will oversee the new Whistleblower Office in the SEC’s Division of Enforcement.  The Office will consolidate existing resources to administer the whistleblower provisions mandated by the Dodd-Frank Act.

HedgeMark Names George Arnett, III as Executive Vice President and General Counsel

On February 8, 2011, managed accounts platform provider HedgeMark International, LLC announced that George “Tres” Arnett, III has joined the company as Executive Vice President and General Counsel.