Mar. 4, 2011

Six Important Lessons for Hedge Fund Managers, Investors, Administrators and Others in Structuring Side Pockets and Monitoring Their Use

The SEC recently charged hedge fund manager Baystar Capital Management, LLC (BCM) and its principal, Lawrence Goldfarb, with fraud in connection with the use of side pockets in a hedge fund.  The alleged fraud in this case was unorthodox: rather than stashing a poor-performing investment in a side pocket in order to slow redemptions, BCM and Goldfarb allegedly placed a good-performing asset in a side pocket, but diverted the cash flows from the asset to improper uses and misrepresented to fund investors various facts relating to the side pocket.  See generally “SEC Brings Civil Securities Fraud Action Against Principals of Hedge Fund Palisades Master Fund, Alleging Fraud, Self-Dealing, Misuse of Fund Assets and Use of a ‘Side Pocket’ to Misrepresent the Fund’s Value to Its Investors,” Hedge Fund Law Report, Vol. 3, No. 42 (Oct. 29, 2010).  Despite these somewhat atypical facts, and despite the diminishing relevance of side pockets in hedge fund structuring (discussed in more detail below), the SEC’s complaint in the matter yields at least six important lessons for hedge fund managers, investors, administrators and others – lessons on topics including structuring, drafting, valuation, transparency and the appropriate role of administrators.  This article details the relevant factual and legal allegations in the matter, then discusses those six important lessons.

Dispute between Structured Portfolio Management and Jeffrey Kong Offers a Rare Glimpse into the Compensation Arrangements between a Top-Performing Hedge Fund Management Company and a Star Portfolio Manager

On December 20, 2010, one of the top performing hedge fund managers of 2010, Structured Portfolio Management, LLC (SPM), as well as its affiliates, sued their former Portfolio Manager, Jeffrey Kong, in the District of Stamford, Connecticut Superior Court.  SPM’s complaint, which painted Kong as a disgruntled former employee who merely had access to its confidential investment strategies, sought to enjoin Kong from joining and disclosing SPM trade secrets to Passport Capital LLC, a rival global macro hedge fund manager, and to recover over $10.8 million in distributions and bonuses given to Kong prior to his resignation.  On February 4, 2011, Kong filed counterclaims against SPM.  In his cross-complaint, he took credit for putting SPM “on the map,” hiring its top portfolio team members, and spearheading and adjusting its most successful investment strategies, including those that resulted in the notable returns generated by SPM funds in 2009 and 2010.  Kong also protested SPM’s failure to pay him the industry standard performance fee as a cash bonus, which for those two years, allegedly should have totaled $49 million more than he had received.  Kong also demanded an accounting of his remaining equity stake in SPM, which he believed had a value of more than $25 million.  While the matter has settled, the complaints provide unique insight into high-level compensation arrangements at a successful hedge fund management company, as well as the types of legal allegations that disputes over such compensation arrangements may involve.  As the pace of talent mobility in the hedge fund industry picks up, managers face compensation structuring decisions with increasing frequency, and the stakes of those decisions are considerable.  To get compensation decisions right, it is critical to understand what can go wrong.  Accordingly, this article provides extensive detail on the factual and legal allegations in the SPM and Kong complaints.

Redomiciling Offshore Investment Funds to Ireland, the European Gateway

Alternative investment managers have increasingly chosen to domicile their funds in European jurisdictions in recent years rather than the Caribbean islands which have traditionally been the home domiciles for hedge funds.  Ireland has been a particularly significant beneficiary of this trend and the percentage of global hedge fund assets domiciled in Ireland has more than doubled over the last 18 months alone so that it now exceeds that of both Bermuda and the BVI.   Furthermore, recent industry statistics showed that 63 percent of European hedge funds were domiciled in Ireland, and this position as the dominant jurisdiction in Europe is continuing to grow.  In a guest article, Mark Browne, a Partner in the Financial Services Department of Mason Hayes+Curran, explores the key drivers behind the movement of offshore funds to Ireland and details the practical steps involved where an asset manager decides to redomicile an existing fund to that jurisdiction.

Implications for Hedge Fund Managers of Recent Insider Trading Enforcement Initiatives (Part Two 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 may be redefining 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 LLC; 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 was included in last week’s issue of the Hedge Fund Law Report.  See “Implications for Hedge Fund Managers of Recent Insider Trading Enforcement Initiatives (Part One of Three),” Hedge Fund Law Report, Vol. 4, No. 7 (Feb. 25, 2011).  The full text of our interview with John Robbins is included in this issue, and our interview with Adam Wasserman will be published in next week’s issue.  Our interview with John Robbins, included in full below, covered a wide range of relevant topics, including but not limited to: typical ways in which a hedge fund manager might acquire material nonpublic information (MNPI) about an issuer that would inhibit trading; designing “wall crossing” policies and procedures; the possibility of automating analysis of wall-crossing inquiries; points that CCOs should keep in mind when designing and implementing effective information walls; what exactly inclusion of a name on the restricted list means; how managers can enforce the prohibition on trading names on the restricted list in funds and personal accounts; the utility of Big Boy letters in SEC and private actions (including a reference to an important SEC enforcement action involving Big Boy letters); the possibility of complying with SEC Rule 10b5-1 through the use of “information walls”; the difference between a restricted list and a watch list; who at a hedge fund management company should have access to a watch list; and how to determine when a name should be added to or removed from a restricted list.

U.S. District Court Dismisses All Claims by Seattle City Employees’ Retirement System Against Hedge Fund Epsilon Global in Pension Fund’s Suit Seeking to Compel Epsilon to Produce Audited Financial Statements

Plaintiff in this action is the Seattle City Employees’ Retirement System (SCERS) which, from December 2003 through December 2004, had invested $20 million in defendant hedge fund Epsilon Global Active Value Fund II, Ltd. (Epsilon or Fund).  Epsilon was a feeder fund that invested substantially all of its assets in defendant Epsilon Global Master Fund II, Ltd. (Master Fund).  The Fund’s offering documents required it to provide an annual report and an annual audited financial statement to each investor within 120 days after the end of its fiscal year.  Following the liquidity crises of 2008, Epsilon failed to produce an annual report or audited financial statements.  In January 2010, as Epsilon continued to fail to produce the requisite reports, SCERS notified Epsilon that it desired to redeem its entire investment.  Epsilon responded that it had suspended redemptions pending completion of its audit.  After negotiations for a partial redemption of SCERS’ position failed, SCERS commenced this action against the Master Fund, Epsilon, its general partner, its investment manager and one of the Fund’s principals.  SCERS sought a temporary restraining order and preliminary injunction directing the Fund to produce the requisite annual reports and prohibiting the Fund from paying fees to its manager pending redemption of SCERS’ interest in the Fund.  By the time of the Court’s hearing on the preliminary injunction request, Epsilon had provided SCERS with unaudited financial statements for 2008 and 2009 and other financial information for the Fund.  In May 2010, the Court ruled that, since completion of the audit was solely in the hands of the Fund’s auditor, it was impossible to order the Fund to complete the audit.  In addition, the Court noted that Epsilon had already provided SCERS with all available information in its possession.  Consequently, the Court denied SCERS’ request for a preliminary injunction.  The parties eventually agreed to dismiss the action without prejudice.  We summarize the claims in the suit and the Court’s decision.

Walkers Appoints Paul Farrell as Head of Investment Funds Group in Dublin

International law firm Walkers recently announced the appointment of Partner Paul Farrell in its new Dublin office, where he will head up Walkers’ Investment Funds Group in Ireland.

Morris, Manning & Martin Expands Newly Launched Funds & Alternative Investments Practice with New Partner Addition

On February 23, 2011, Morris, Manning & Martin, LLP announced the expansion of its Funds & Alternative Investments Practice with the addition of Margaret R. A. Paradis as Partner.

Jay Baris Joins Morrison & Foerster as Head of the Firm’s Investment Management Practice

On March 1, 2011, Morrison & Foerster LLP announced that Jay Baris joined the firm as a Partner in its New York office and will lead the firm’s Investment Management practice.