Mar. 11, 2011

The Hedge Fund Law Report Provides Due Diligence Roadmap for Institutional Investors Examining Use by Hedge Fund Managers of Expert Networks

Hedge fund managers have responded to the ongoing expert networks investigation by revisiting their insider trading compliance policies and procedures generally, and their expert networks policies specifically.  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).  Institutional investors have responded by updating their due diligence questionnaires and approaches.  At a minimum, investors are asking their current or prospective managers: whether they use expert networks and if so which; what compliance policies and procedures they have in place with respect to the use of expert networks; and whether they are under investigation for insider trading in connection with expert networks.  But investor due diligence on this topic can get significantly more granular.  According to one well-regarded industry source with whom we spoke, some institutional investors, or their third-party due diligence service providers, are asking their current or prospective managers for records of trades (in hedge funds and personal accounts) in securities of companies mentioned in the primary civil and criminal expert network complaints, around the dates mentioned in those complaints.  The goals of this exercise are to uncover trading patterns that resemble the patterns described in the complaints, to discover spikes in advance of earnings releases mentioned in the complaints and to find other fund or personal trading that is suspicious in light of the allegations in the complaints.  Regulators have undertaken similar analyses of trading patterns for some time, usually with the goal of identifying evidence of insider trading or market manipulation; and those efforts have improved in speed and effectiveness as the relevant technology has improved.  But institutional investors generally have not undertaken due diligence of this sort because it has been considered too attenuated – too much of a search for a needle in a haystack.  The key difference here is that the expert networks insider trading complaints provide a roadmap to potentially problematic issuers, dates and events.  The practical problem is that those issuers, dates and events are buried in hundreds of pages of legal papers.  We at the Hedge Fund Law Report have solved this problem by: analyzing the primary civil and criminal complaints alleging the use of expert networks to facilitate insider trading in technology company shares (as distinct from the biotechnology-related matters); extracting the salient facts; and organizing them in a manner that can serve as a due diligence roadmap for institutional investors.  This article contains the results of that analysis.  This article is long – close to 20 pages – but shorter than the source documents, and a ready-made framework for hedge fund due diligence.  Specifically, this article contains: a chart listing the names of the key civil and criminal defendants, their employers and job descriptions during the relevant periods and the charges brought against them; a list of the public companies about which Primary Global Research, LLC (PGR) experts allegedly passed material nonpublic information (MNPI) to PGR clients; the language of PGR and relevant public company compliance policies; PGR revenues and revenue sources; compensation numbers of PGR experts and employees; and sources of the data and information underlying the allegations in the criminal complaints.  In addition, this article contains a detailed summary of the allegations in the primary civil and criminal complaints against various categories of defendants, including: employees or former employees of PGR; experts in PGR’s network who also worked at technology companies; and employees or principals of hedge fund management companies that were also clients of PGR.  To enhance the utility of this article, we have listed the allegations chronologically in each category and emphasized the specific types of information alleged to have been improperly communicated.  Also, for each material allegation mentioned in this article, we have included references to the specific paragraphs of the relevant complaint containing the allegation, and we have included links to the relevant complaints.  Finally, it should be emphasized that this article is intended for use not only by institutional investors, but also by hedge fund managers.  That is, just as institutional investors can use this article as a framework for performing due diligence, managers can use this article to prepare for due diligence requests that may be in the offing.  While such preparation likely would not rise to the level of an “internal investigation,” managers may consider an internal review of fund and employee trading based on the issuers, dates and events mentioned in the complaints in this article.  Just as it is preferable for a manager to uncover bad facts before the SEC does so in an examination, it is better for a manager to uncover bad facts before an investor does so in due diligence.

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

Recent criminal and civil enforcement actions allege that hedge fund manager personnel obtained material nonpublic information from employees and experts of expert network firms.  See “The Hedge Fund Law Report Provides Due Diligence Roadmap for Institutional Investors Examining Use by Hedge Fund Managers of Expert Networks,” above, in this issue of the Hedge Fund Law Report.  While the merits of these actions largely 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 “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 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 the February 25, 2011 issue of the Hedge Fund Law Report, and our interview with John Robbins was included in last week’s issue.  Our interview with Adam Wasserman, included in full below, covered a wide range of relevant topics, including but not limited to: a taxonomy of the categories of potentially problematic information as revealed in the current criminal and civil complaints alleging insider trading in connection with expert networks; the government’s evolving view of what constitutes improper information; the definition of channel checking and how it is performed; the level of risk associated with various types of channel checks; whether hedge fund managers have been prohibiting their personnel outright from using expert networks; which categories of experts, consultants or entities should be covered by a hedge fund manager’s expert networks compliance policy; whether compliance policies should prohibit the use of an expert employed by a company in which the hedge fund has an investment, or within a certain period of the expert’s employment by the company; whether hedge fund investment personnel should be limited in the number of experts with whom they can consult in a certain period; the use of scripts or certifications; when to obtain certifications; how to prevent improper communications in informal settings; next steps in the ongoing insider trading investigation; potential RICO charges; how to talk to corporate insiders; and what to do when the FBI comes knocking.

British Virgin Islands High Court of Justice Rules that Minority Shareholder in Feeder Hedge Fund that had Permanently Suspended Redemptions Was Not Entitled to Appointment of a Liquidator

In a break with Cayman Islands jurisprudence on the availability of court-supervised fund liquidations, the British Virgin Islands High Court of Justice has refused to appoint liquidators for a hedge fund that has permanently suspended redemptions and is in the process of liquidating in a soft wind-down, ruling that the fund had not lost its “substratum” for purposes of the Business Companies Act of 2004.  Plaintiff Aris Multi-Strategy Lending Fund, Ltd. (Aris), a fund of funds, had invested about $11 million with defendant Quantek Opportunity Fund, Ltd. (Fund).  The Fund was a feeder fund that invested all of its assets in non-party Quantek Master Fund SPC (Master Fund).  Following the liquidity crisis of 2008, the Fund and the Master Fund suspended all redemptions and the calculation of net asset value.  The Fund adopted a reorganization plan pursuant to which it planned to distribute the proceeds from the liquidation of the Master Fund’s portfolio in three installments over a period of three years.  Apparently dissatisfied with the pace of liquidation, Aris commenced an action seeking court-supervised liquidation of the Fund.  The only substantial issue before the Court was whether Aris was entitled to the appointment of liquidators for the Fund on the grounds that the Fund had “lost its substratum.”  Aris has been aggressive in taking fund managers to task through litigation.  For summaries of litigation by Aris against domestic funds, see “New York State Supreme Court Dismisses Hedge Funds of Funds’ Complaint against Accipiter Hedge Funds Based on Exculpatory Language in Accipiter Fund Documents and Absence of Fiduciary Duty ‘Among Constituent Limited Partners,’” Hedge Fund Law Report, Vol. 3, No. 7 (Feb. 17, 2010); “New York Supreme Court Rules that Aris Multi-Strategy Funds’ Suit against Hedge Funds for Fraud May Proceed, but Negligence Claims are Preempted under Martin Act,” Hedge Fund Law Report, Vol. 2, No. 51 (Dec. 23, 2009).  Aris’ founder has previously discussed with the Hedge Fund Law Report the issues raised in contemplating litigation against fund managers.  See “Why Are Most Hedge Fund Investors Reluctant to Sue Hedge Fund Managers, and What Are the Goals of Investors that Do Sue Managers? An Interview with Jason Papastavrou, Founder and Chief Investment Officer of Aris Capital Management, and Apostolos Peristeris, COO, CCO and GC of Aris,” Hedge Fund Law Report, Vol. 2, No. 52 (Dec. 30, 2009).

First Department Decision May Give Aggrieved Hedge Fund Investors an Unexpected and Powerful Avenue of Redress

The Martin Act (New York General Business Law §§ 352-359) prohibits various fraudulent and deceitful practices in the distribution, exchange, sale and purchase of securities.  It authorizes the New York Attorney General to investigate these activities and seek relief against sellers of securities engaged in dishonest or deceptive activities.  For more on the Martin Act in the hedge fund context, see “New York Supreme Court Rules that Aris Multi-Strategy Funds’ Suit against Hedge Funds for Fraud May Proceed, but Negligence Claims are Preempted under Martin Act,” Hedge Fund Law Report, Vol. 2, No. 51 (Dec. 23, 2009); “Federal Court Dismisses Breach of Fiduciary Duty Claim, but Permits Securities Fraud Claim, Against Alternative Investment Fund and Its Manager and Principals,” Hedge Fund Law Report, Vol. 2, No. 3 (Jan. 21, 2009).  The Martin Act does not create a private right of action for such violations, however.  See CPC Int’l v. McKesson Corp., 70 N.Y.2d 268 (1987).  Enterprising defendants have used that proposition to argue not only that no private right of action exists, but also that the Martin Act preempts certain private common law claims arising from the conduct covered by the statute.  To date, New York State and a majority of federal courts have found this argument persuasive, and applied it to non-fraud-based common law claims, such as breach of fiduciary duty and negligent misrepresentation.  Hence, many defendants have succeeded in having these claims dismissed.  This has been especially true in the federal courts’ construction of New York law.  However, a recent and notable decision of the Appellate Division, First Department repudiates this trend.

Mesirow Financial Consulting Welcomes FCIC Senior Investigator Thomas R. Borgers as Managing Director

On March 7, 2011, Mesirow Financial Consulting, LLC (MFC) announced that Thomas R. Borgers, former senior investigator of the Financial Crisis Inquiry Commission (FCIC) and contributor to The Financial Crisis Inquiry Report, has joined the firm as a managing director.

Michael Callahan to Focus on U.S. Institutional and Family Office Relationships as Part of Man Group’s North American Sales Team

On March 9, 2011, Man Group announced the addition of Michael Callahan, previously a Vice President at The Blackstone Group, to its North American Sales team.  Callahan will focus on U.S. institutional and family office relationships.  For more on family offices as hedge fund investors, see “Developments in Family Office Regulation: Part One,” Hedge Fund Law Report, Vol. 3, No. 38 (Oct. 1, 2010); “2010 Developments in Family Office Regulation under Dodd Frank: Part Two,” Hedge Fund Law Report, Vol. 3, No.42 (Oct. 29, 2010).