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    Mar. 8, 2012

When and How Should Hedge Fund Managers Shadow Functions Performed by Their Fund Administrators?

In 2007, hedge fund managers administered roughly 75 percent of U.S.-based hedge funds in house.  Today – for reasons including the credit crisis, high profile frauds and the institutionalization of the hedge fund investor base – the majority of the hedge fund industry outsources to administrators in some capacity.  But outsourcing of administrative functions in the hedge fund industry is not like outsourcing in any other industry.  A typical outsourcing arrangement is a classic division of labor: Party A pays Party B to perform specific tasks because Party B can perform them more cheaply or efficiently, or because Party A’s time would be spent more productively on other tasks.  See “Primary Legal and Practical Considerations for Hedge Fund Managers Looking to Outsource Their Operational Functions,” Hedge Fund Law Report, Vol. 4, No. 33 (Sep. 22, 2011).  By contrast, outsourcing of administrative functions in the hedge fund industry is not so much a division of labor as a duplication of it.  To a degree that likely would surprise observers outside of the industry, hedge fund managers often continue to perform administrative functions even after those functions are outsourced to an administrator.  In hedge fund industry parlance, this duplication of administrative efforts is known as “shadowing.”  According to a recent Ernst & Young survey, shadowing is “expensive and unique to the hedge fund industry,” widespread and “a business model that might not make economic sense.”  See “Ernst & Young Survey Juxtaposes the Views of Hedge Fund Managers and Investors on Hedge Fund Succession Planning, Governance, Administration, Expense Pass-Throughs and Due Diligence,” Hedge Fund Law Report, Vol. 5, No. 1 (Jan. 5, 2012).  So why do hedge fund managers shadow their administrators?  That is the fundamental question that this article addresses.  In particular, this article discusses: what hedge fund administrators do; what administrator shadowing is; the functions most commonly shadowed by hedge fund managers; reasons why managers shadow their administrators; the benefits and costs of administrator shadowing; whether funds or managers typically bear the costs of shadowing; the circumstances that make shadowing of an administrator most attractive for managers; the different methods managers can use to shadow administrators; and the challenges managers face when shadowing their administrators.

Former SEC Commissioner Roel Campos Discusses Hedge Fund Governance with the Hedge Fund Law Report

While day-to-day control of a hedge fund is largely vested in the hedge fund’s manager, the relationship between manager and fund is marked by inherent conflicts of interest.  See, e.g., “When and How Can Hedge Fund Managers Engage in Transactions with Their Hedge Funds?,” Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).  Hedge fund investors generally look to three factors to mitigate those conflicts: law, practice and structuring.  Legally, fiduciary duty and regulatory and private enforcement of securities laws are intended to mitigate conflicts.  Practically, reputational considerations and basic canons of ethical behavior are expected to limit manager overreaching.  And structurally, the boards of directors of certain hedge funds are intended to serve as a check on manager conflicts and other manager behavior contrary to the interests of investors.  Prior to the credit crisis, investors looked primarily to the first two factors to police conflicts.  After the credit crisis and the concomitant exposure of notable frauds, investors and regulators are paying increasing attention to the role of hedge fund boards as the investor’s internal advocate.  In short, investors and regulators now expect directors to be informed, engaged and competent.  This view was resoundingly echoed by the Grand Court of the Cayman Islands in the August 2011 Weavering Macro Fixed Income Fund Limited (In Liquidation) decision, in which the Grand Court found hedge fund directors personally liable for losses caused by their willful failure to supervise fund operations.  See “Corporate Governance Best Practices for Cayman Islands Hedge Funds,” Hedge Fund Law Report, Vol. 5, No. 3 (Jan. 19, 2012).  It is one thing to say that hedge fund directors need to be more informed, engaged and competent.  It is another thing altogether to define with specificity what these concepts mean in practice.  In an effort to do so, a session at the Regulatory Compliance Association’s Spring 2012 Regulation & Risk Thought Leadership Symposium will focus on hedge fund governance.  That Symposium will be held on April 16, 2012 at the Pierre Hotel in New York.    Subscribers to the Hedge Fund Law Report are eligible for discounted registration.  As part and parcel of the RCA’s effort to define with specificity the role of hedge fund directors, the Hedge Fund Law Report recently interviewed Roel Campos, one of the anticipated participants in the fund governance session, a former SEC Commissioner and a current Partner at Locke Lord LLP.  Campos’ high-level SEC experience gives him particularly useful insight into regulatory expectations with respect to hedge fund directors; and his regulatory experience is complemented by private legal practice and corporate experience.  Campos, accordingly, has a uniquely well-rounded view of what hedge fund directors should do, and the practical constraints on what they can do.  Our interview focused on: the key purposes and goals of hedge fund boards; how hedge funds can make their boards more effective and accountable; what constitutes an “independent” director; the role to be played by hedge fund boards in the valuation of assets and implementation of risk management policies; the maximum number of boards on which one director can serve; whether investors should talk to hedge fund boards during the due diligence process; and whether hedge funds should conduct background checks on prospective directors.  This article contains the full transcript of our interview with Campos.

ACA Webcasts Detail Exempt Reporting Adviser Qualifications and Compliance Obligations

While the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) repealed the exemption from registration found in Section 203(b)(3) of the Investment Advisers Act of 1940 (Advisers Act) historically relied upon by most hedge fund managers with fewer than 15 clients, it created several more narrowly tailored adviser registration exemptions, including separate exemptions for advisers solely to venture capital funds and advisers solely to private funds with aggregate regulatory assets under management (Regulatory AUM) of less than $150 million (private fund adviser exemption).  See “Registration, Reporting, Disclosure and Operational Consequences for Hedge Fund Managers of the SEC’s New ‘Regulatory Assets Under Management’ Calculation,” Hedge Fund Law Report, Vol. 5, No. 9 (Mar. 1, 2012).  These advisers now fall into a newly created class of advisers called exempt reporting advisers.  Although exempt reporting advisers are exempt from SEC registration, they are nonetheless required to fulfill certain regulatory obligations not applicable to unregistered advisers, including completing certain items in Part 1A of Form ADV, maintaining certain books and records and submitting to SEC examinations.  Exempt reporting advisers are also subject to other compliance obligations imposed by the Advisers Act, including the pay-to-play restrictions contained in Rule 206(4)-5.  See “Key Elements of a Pay-to-Play Compliance Program for Hedge Fund Managers,” Hedge Fund Law Report, Vol. 3, No. 37 (Sep. 24, 2010).  With this in mind, the ACA Compliance Group (ACA) held two separate webcasts to highlight issues important to advisers that may qualify as exempt reporting advisers.  This article summarizes some of the highlights from both webcasts with relevance to hedge fund managers.

U.S. Releases Helpful FATCA Guidance, But the Law Still Remains

The United States announced an unprecedented multi-country agreement and published detailed proposed regulations addressing implementation of the Foreign Account Tax Compliance Act (FATCA) on February 8, 2012.  In a guest article, Michael Hirschfeld, a Partner at Dechert LLP, explains the details of the agreement and proposed regulations and their impact on hedge fund managers.

Federal Court Decision Addresses the Enforceability of an Earnout Provision in the Sale of a Hedge Fund Management Business

This article summarizes the factual background and legal analysis in a recent federal court decision on the enforceability of an earnout provision in the sale of a hedge fund management business.  The dispute described in this article and the Court’s analysis of the dispute will inform the drafting of earnout and related provisions in documents governing the purchase and sale of a hedge fund management business.  For more on structuring considerations in connection with acquisitions of hedge fund managers, see “Buying a Majority Interest in a Hedge Fund Manager: An Acquirer’s Primer on Key Structuring and Negotiating Issues,” Hedge Fund Law Report, Vol. 4, No. 17 (May 20, 2011).

Hong Kong Securities and Futures Commission Wins Appeal of Insider Trading Action Against New York-Based Hedge Fund Manager Tiger Asia Management

On February 23, 2012, the Hong Kong Court of Appeal ruled on a dispute between hedge fund manager Tiger Asia Management LLC and the Hong Kong Securities and Futures Commission.  This ruling adds to the total mix of considerations for any U.S.-based hedge fund manager considering entering the Hong Kong market.  See also “Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part Four of Four),” Hedge Fund Law Report, Vol. 5, No. 3 (Jan. 19, 2012).  For a discussion of another matter highlighting the asymmetry between U.S. and non-U.S. insider trading doctrine, see “FSA Imposes £7.2 Million Penalty on Hedge Fund Manager David Einhorn and Greenlight Capital for Unintentional Insider Dealing in Shares of British Pub Owner Punch Taverns Plc,” Hedge Fund Law Report, Vol. 5, No. 5 (Feb. 2, 2012).

Proskauer Expands Litigation Practice and Private Investment Funds Capabilities

On March 1, 2012, Proskauer announced that Timothy W. Mungovan joined the firm as a Partner in the Boston office.  Mungovan joins Proskauer from Nixon Peabody.

Clifford Chance Welcomes Timothy Bennett to Its Secondary Market Trading Practice

On March 1, 2012, Clifford Chance announced that Timothy Bennett joined its secondary market trading practice in New York.  Bennett’s practice focuses on, among other things, trading of distressed bank debt.  See “Should Hedge Funds Include Automatic Termination as a Term of Bank Debt Trades on the New Loan Market Association Forms?,” Hedge Fund Law Report, Vol. 3, No. 10 (Mar. 11, 2010).

Sadis & Goldberg Welcomes Yehuda M. Braunstein to its New York Office

As of March 12, 2012, Sadis & Goldberg LLP announced the addition of Yehuda Braunstein to its New York Office as a Partner in the Financial Services and Corporate Groups.  Braunstein formerly served as Special Counsel in the Investment Management Group at Schulte Roth & Zabel.  For analysis published in the Hedge Fund Law Report by other Sadis & Goldberg attorneys, see “Sullivan v. Harnisch and SEC Proposed Whistleblower Rules Bolster Internal Compliance Programs While Creating Catch-22 for Compliance Officers,” Hedge Fund Law Report, Vol. 4, No. 10 (Mar. 18, 2011).

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