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    Mar. 29, 2012

How Hedge Fund Managers Should Approach Preparing For, Conducting and Documenting the Annual Compliance Review (Part Two of Two)

For newly registered hedge fund managers, one of the many newfound challenges of registered status is the obligation to conduct an annual compliance review.  This obligation is imposed by Rule 206(4)-7 under the Investment Advisers Act of 1940 (Advisers Act).  But neither Rule 206(4)-7 nor any other statute, rule or SEC pronouncement provides clear and authoritative guidance to hedge fund managers on how to prepare for, conduct and document the annual compliance review.  In the absence of such guidance, hedge fund managers typically seek to follow custom and practice in the market.  But custom and practice can be infamously difficult to discern with accuracy.  This article aims to alleviate that difficulty by detailing the mechanics of best practices for annual compliance reviews.  Specifically, this article is the second in a two-part series discussing, step by step, why and how hedge fund managers should approach, execute and follow up on the annual compliance review.  The first article discussed: what the annual compliance review is; enforcement actions demonstrating the imperative of a thorough annual compliance review; how to prepare for the annual compliance review, including a discussion of information gathering and the various types of testing that should be performed prior to the review; and who should conduct the annual compliance review.  See “How Hedge Fund Managers Should Approach Preparing For, Conducting and Documenting the Annual Compliance Review (Part One of Two),” Hedge Fund Law Report, Vol. 5, No. 12 (Mar. 22, 2012).  This article discusses: when the annual compliance review should be conducted; the annual compliance review process itself, including how a hedge fund manager can define the scope of the review, appropriately review its policies and procedures, conduct a risk assessment for changed circumstances, identify compliance weaknesses and take appropriate remedial actions; how to document the annual compliance review; the biggest challenges in conducting the review; and common mistakes made by hedge fund managers in conducting the review.

Is This an Inspection or an Investigation? The Blurring Line Between Examinations of and Enforcement Actions Against Private Fund Managers

The most significant impact of SEC registration on a private fund adviser is that the adviser becomes subject to inspection by the SEC’s Office of Compliance Inspections and Examinations (OCIE).  The greatest risk arising from an examination is that the inspection staff decides to refer a finding from an inspection to the Division of Enforcement (Enforcement) for an investigation.  Despite the severe collateral consequences that can befall a fund manager simply from the initiation of an investigation, divining whether the staff is contemplating an Enforcement referral is a surprisingly elusive proposition.  With numerous newly registered hedge fund managers about to undergo their first inspection, the risk of investigations has never been higher.  In a guest article, Mark K. Schonfeld and Kenneth J. Burke, Partner and Associate, respectively, at Gibson Dunn & Crutcher LLP, discuss the increasing risks of compliance examinations becoming enforcement investigations and practical strategies for hedge fund managers for anticipating and mitigating those risks.

Managing Risk in a Changing Environment: An Interview with Proskauer Partner Christopher Wells on Hedge Fund Governance, Liquidity Management, Transparency, Tax and Risk Management

The Hedge Fund Law Report recently interviewed Christopher M. Wells, a Partner at Proskauer Rose LLP and head of the firm’s Hedge Funds Group.  Wells has decades of experience advising hedge funds and their managers, and a broad-based practice that touches on substantially every aspect of the hedge fund business.  Our interview with Wells was similarly wide-ranging, covering topics including: hedge fund governance; investor demands for heightened transparency; co-investment opportunities; liquidity management issues; side pocketing policies and procedures; holdbacks of redemption proceeds; tax issues, including preparations for compliance with the Foreign Account Tax Compliance Act (FATCA) and the electronic delivery of Schedules K-1; and risk management, including practical steps to prevent style drift and unauthorized trading.  This interview was conducted in conjunction with the Regulatory Compliance Association’s Spring 2012 Regulation & Risk Thought Leadership Symposium.  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.  Wells is expected to participate in a session at that Symposium focusing on hedge fund governance and related issues.

Insurer Initiates Action to Recover Defense Costs Advanced to Hedge Fund Manager Level Global, Claiming Level Global Made False Statements in its D&O/E&O Liability Insurance Application

Hedge fund liability insurance in the form of errors and omissions (E&O) professional liability insurance and directors and officers (D&O) insurance can afford protection to hedge fund managers and their hedge funds as well as their respective officers, directors and employees, against claims for alleged errors, omissions, negligent acts, misstatements, misrepresentations and breaches of duties.  For an overview of D&O policies as they relate to hedge funds, see “Hedge Fund D&O Insurance: Purpose, Structure, Pricing, Covered Claims and Allocation of Premiums Among Funds and Management Entities,” Hedge Fund Law Report, Vol. 4, No. 41 (Nov. 17, 2011).  However, with increasing regulatory scrutiny resulting in heightened criminal prosecutions and enforcement activity affecting hedge fund managers and their employees, insurers are raising premiums with respect to such liability coverage and carefully examining policies to determine whether hedge fund manager insureds have breached terms or misrepresented facts.  Identified breaches or misrepresentations, in turn, may allow insurers to claw back defense costs previously advanced, or avoid or reduce payouts.  Historically, insurers have been reluctant to bring such breach of contract suits against their insureds for fear of alienating existing customers and diminishing new business.  However, a recent declaratory judgment action initiated by insurer XL Specialty Insurance Company (XL) – a well-known underwriter in the hedge fund D&O space – may portend a trend towards more aggressive litigation by insurers.  The litigation is also a timely reminder that D&O insurance agreements are not adhesion contracts.  Underwriters are typically amenable to negotiating at least certain provisions, and managers are well advised to negotiate because form agreements often reflect the experience of underwriters in avoiding or excluding claims.  See “Regulatory Compliance Association Hosts Program on Increased Risk for Hedge Fund Directors and Officers in the New Era of Heightened Regulation and Enforcement,” Hedge Fund Law Report, Vol. 2, No. 50 (Dec. 17, 2009).  This article summarizes XL’s Complaint and highlights the relevant provisions from the insurance application and policy.

How Can Offshore Hedge Funds Ensure That Section 10(b) Will Apply to Their Transactions in Securities Not Listed on U.S. Exchanges?

The recent decision by the United States Court of Appeals for the Second Circuit in Absolute Activist Value Master Fund Limited v. Ficeto has clarified the criteria for application of §10(b) of the Securities Exchange Act of 1934 to transnational transactions involving securities not listed on U.S. domestic exchanges.  See “Second Circuit Clarifies When Offshore Hedge Funds Can Make Section 10(b) Securities Fraud Claims in Connection with ‘Domestic Transactions’ with Conduct and Effects in the United States,” Hedge Fund Law Report, Vol. 5, No. 11 (Mar. 16, 2012).  Although in Absolute Activist the Second Circuit did not discuss what facts in any particular case would be sufficient to satisfy their subject matter jurisdiction test for application of Rule 10b-5, this ruling has practical implications for offshore hedge funds (and other non-U.S. purchasers) who acquire privately placed securities directly from U.S. issuers or on the secondary market.  In a guest article, Bradley Kulman and Bruce Schneider, both Partners at Stroock & Stroock & Lavan LLP, discuss the factual background and legal analysis in the case as well as some of the practical implications stemming from the decision for offshore hedge funds.

SEC Enforcement Action Against Investment Adviser Highlights Importance of Conducting Due Diligence on a Hedge Fund’s Auditor to Avoid Fraud

Although hedge fund investment decisions are based on numerous factors, information relating to a hedge fund’s financial condition and performance results remains a critical component of any such decision.  See “Legal and Operational Due Diligence Best Practices for Hedge Fund Investors,” Hedge Fund Law Report, Vol. 5, No. 1 (Jan. 5, 2012).  Various parties have a hand in creating and confirming the information that goes into financial statements and performance reporting.  Those parties include the manager, the administrator and the auditor.  Many investors pay particularly close attention to reports from auditors because of the rigorous standards governing the accounting profession and the presumably uniform application of those standards across different contexts.  However, information about a hedge fund provided by an accountant is only as good as the accountant itself.  A good accountant can provide, directly or indirectly, good information to an investor – even though the accountant’s duty typically does not flow to the investor – while a bad accountant can provide a false sense of security or, worse, cover for a fraud.  Indeed, a recurring feature of frauds in the hedge fund industry is an accountant that does not exist, is much smaller or less experienced than claimed or that is affiliated with the manager.  An accounting firm that was both fictitious and affiliated with the manager was a notable feature of the Bayou fraud.  See “Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices,” Hedge Fund Law Report, Vol. 4, No. 25 (Jul. 27, 2011).  A fraudulent auditor and fictitious financial statements also featured prominently in a recently filed SEC action against an investment adviser.  This article summarizes the SEC’s Complaint in that action and describes five techniques that hedge fund investors can use to confirm the existence, competence and reliability of hedge fund auditors.

Recently-Filed SEC Action Demonstrates the Potential Risks of Insider Trading by Investment Consultants Hired by Private Fund Managers

Private fund managers, including hedge fund managers, often hire investment consultants to help evaluate investments; analyze an investment target company’s operations, management and financial condition; offer strategic and structuring advice; and provide related services.  To provide value, such consultants typically request and receive deep access to confidential target company data.  The company typically grants such access under the terms of a confidentiality agreement between the company and the consultant, or among the company, the consultant and the private fund manager.  Typically, the primary purpose of such confidentiality agreements is to prevent confidential company information from reaching a competitor or from being used by the consultant on behalf of a competitor.  A secondary purpose of such agreements is to prevent insider trading by “temporary insiders” or their tippees, or Regulation FD violations by the company.  However, an enforcement action recently filed by the SEC suggests that confidentiality agreements, standing alone, may not be sufficient to prohibit insider trading by investment consultants.  While the private fund manager involved was not charged, the charges against the manager’s consultant reflect adversely on the manager.  The charges suggest, for example, that the manager did not take adequate precautions to control the conduct of the consultant.  Given the radioactivity of insider trading charges in the current enforcement environment, risk aversion with respect to insider trading is prudent business.  This article discusses the SEC’s factual and legal allegations in the matter, as well as the consultant’s proposed settlement agreement.  This article also details four steps that private fund managers may take to prevent insider trading by their investment consultants.

Finn Dixon & Herling Expands White Collar, Investment Management and Litigation Practices With Additions of Jeffrey Plotkin and Michael Q. English

On March 20, 2012, Finn Dixon & Herling LLP announced that Jeffrey Plotkin and Michael Q. English have joined the firm as Partners.  Plotkin is a former SEC enforcement attorney and English joins the firm from the criminal division of the U.S. Attorney’s Office for the Southern District of New York.  The moves are part of a trend of white collar defense lawyers, SEC veterans and former prosecutors moving to firms with notable investment management practices.  This trend, in turn, is a function of the heightened enforcement activity focused on hedge fund managers and other investment management industry participants.

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