May 24, 2012

CFTC and SEC Adopt Long-Awaited Rules Excluding Most Hedge Funds from Swap Dealer Registration Requirements

The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) recently adopted final rules defining the types of entities that will be required to register as swap dealers, security-based swap dealers, major swap participants (MSPs) and major security-based swap participants (MSSPs) under the Dodd-Frank Wall Street Reform and Consumer Protection Act.  These entities will be required to register with the CFTC or the SEC and adhere to a wide variety of new requirements with respect to their derivatives trading, including capital, margin, reporting and business conduct requirements.  The CFTC and the SEC defined “swap dealer” and “security-based swap dealer” narrowly, thereby including for the most part only traditional dealers in the over-the-counter derivatives market and excluding most hedge funds and other buy-side participants who are not undertaking traditional dealing activities.  The final rules also set a high bar for the MSP and MSSP categories, excluding most hedge funds and hedge fund advisers from the requirement to register as an MSP or an MSSP.  The CFTC also adopted a revised definition of “eligible contract participant” (ECP).  The final rule exempts most hedge funds from the requirement that each investor in the fund be an ECP in order for the fund to be able to enter into off-exchange foreign currency transactions without satisfying certain requirements under the CFTC’s retail foreign exchange rules.  In a guest article, Leigh Fraser and Molly Moore, Partner and Associate, respectively, in the Hedge Funds group of Ropes & Gray LLP, provide a detailed analysis of the final rules and their application to hedge funds and hedge fund managers.

New York Court of Appeals Holds that the Chief Compliance Officer of a Hedge Fund Manager May be Fired for Internal Reporting

Even in the best of circumstances, administering the compliance program of a hedge fund manager presents intellectual, logistical and personal challenges for chief compliance officers (CCOs).  However, the inherent difficulties of the job are compounded when senior management of a manager is not committed to a culture of compliance.  Specifically, CCOs that discover conduct that merits reporting may be disinclined to report internally where they fear retaliation.  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).  This disinclination may be compounded by a recent New York Court of Appeals decision generally holding that CCOs of New York-based hedge fund managers are not exempt from the “employment-at-will” doctrine and can be dismissed for internal reporting of suspected wrongdoing.  Among other ramifications, this decision may further incentivize external reporting and whistleblowing – precisely the sort of incentives that the industry and individual managers have been working to mitigate.  See “How Can Hedge Fund Managers Incentivize Employees to Report Compliance Issues Internally in Light of the SEC’s Whistleblower Bounty Program?,” Hedge Fund Law Report, Vol. 5, No. 20 (May 17, 2012).

SEC and FSA Impose Heavy Fines on Investment Manager for Failing to Address Conflicts of Interest Associated with Side by Side Management of a Registered Fund and a Hedge Fund

Hedge fund managers are increasingly managing multiple products with different investment strategies and fee structures, and global regulators have enhanced their scrutiny of such arrangements.  Among other things, regulators are concerned about managers favoring one fund over other funds.  For instance, regulators have scrutinized arrangements in which managers allocate more attractive investment opportunities (e.g., initial public offerings) to funds that pay higher fees to the manager.  See, e.g., “How Can Hedge Fund Managers Collect the Investor Information Required to Comply with the Prohibition on ‘Spinning’ in FINRA Rule 5131?,” Hedge Fund Law Report, Vol. 4, No. 23 (Jul. 8, 2011).  Regulators are also concerned about investments by different funds at different levels of the capital structure of the same issuer and the conflicts managers face in simultaneously managing such investments to ensure fair treatment for all affected funds.  See, e.g., “Identifying and Resolving Conflicts Arising out of Simultaneous Management of Debt and Equity Hedge Funds,” Hedge Fund Law Report, Vol. 3, No. 10 (Mar. 11, 2010).  With this in mind, the U.S. Securities and Exchange Commission and the U.K. Financial Services Authority recently announced the settlement of charges brought by those regulatory agencies against two affiliated institutional investment managers for failing to appropriately address conflict raised by the side by side management of a mutual fund and hedge fund.  For more on the SEC’s view on such side by side management arrangements, see “Fifth Street No-Action Letter Outlines Factors the SEC May Consider in Approving Joint Participation in a Restructuring by Registered and Private Funds Managed by the Same Manager,” Hedge Fund Law Report, Vol. 3, No. 38 (Oct. 1, 2010).

Eight Measures That Hedge Fund Managers Can Take to Mitigate the Risk of Theft of Their Trade Secrets

Technology has made it increasingly easy for firm personnel and unauthorized third parties to steal proprietary information from hedge fund managers.  Managers that fail to adopt effective safeguards may face theft of their “secret sauce,” which could jeopardize their businesses.  A spate of high-profile alleged trade secret thefts emphasizes the need for managers to take such protective steps.  See “Protecting Hedge Fund Trade Secrets: What a Difference a Year Makes,” Hedge Fund Law Report, Vol. 5, No. 16 (Apr. 19, 2012).  On May 11, 2012, Yihao (Ben) Pu, a computer programmer, was indicted in the United States District Court for the Northern District of Illinois on 13 counts of theft of trade secrets and computer fraud in connection with the alleged misappropriation of proprietary software from two financial services firms, including hedge fund manager, Citadel LLC (Citadel).  The indictment (Indictment) comes on the heels of a civil lawsuit filed by Citadel against Pu, alleging that Pu misappropriated Citadel trade secrets in breach of a non-disclosure agreement executed by Pu and in violation of the Illinois Trade Secrets Act.  For a discussion of the civil action, see “Citadel Commences Action Against a Former Employee for Misappropriation of Confidential Information with the Intent to Aid a Competitor,” Hedge Fund Law Report, Vol. 4, No. 31 (Sep. 8, 2011).  The Indictment is instructive in that it offers a glimpse into some of the measures that Citadel instituted to prevent theft of its trade secrets.  This article summarizes the factual allegations and causes of action in the Indictment and recommends eight specific steps that hedge fund managers can take to mitigate the risk of trade secret theft.

Survey by AIMA and KPMG Identifies the Key Drivers of the Bifurcation of the Hedge Fund Industry Between Larger and Smaller Managers

Life is very different these days for larger and smaller hedge fund managers.  As a general matter, larger managers can afford to be institutional.  They have the resources (derived from fees) to invest in the people and process required to attract institutional capital, which generate more fees, which increase the manager’s ability to invest in infrastructure – a seemingly virtuous cycle for larger managers.  Smaller managers, on the other hand, face roughly similar infrastructure expectations from potential institutional investors, but typically do not have the resources to invest in people and process at a level commensurate with their larger competitors.  Or are they competitors?  This is a fundamental question animating a recent report (Report) from the Alternative Investment Management Association and KPMG.  The Report echoes the oft-cited sentiment that the hedge fund industry is institutionalizing.  But the Report takes the discussion a step further by addressing the elements of institutionalization and the disparate impact of that process on managers of different sizes (measured by assets under management and headcount).  The Report also discusses transparency, due diligence, sources of capital by geography, FATCA, competition among managers and collaboration among them.  It is important for managers and investors to understand the drivers and consequences of institutionalization, and the Report advances the industry’s understanding on these topics.  But the most novel and provocative findings of the Report relate to smaller managers.  In particular, the Report identifies: an effective method whereby smaller managers can compete with larger managers via collaboration and emphasis on their competitive advantages; a specific channel of fund flows to smaller managers; and the geographic regions that smaller managers should be targeting in their capital raising.

SEC Sues Investment Adviser for “Marking the Close” and Other Tactics Designed to Fraudulently Inflate Assets Under Management

Valuation risk is a key focal point for hedge fund investors and regulators because manager compensation flows directly from the value of portfolio assets and managers typically control or at least significantly influence the valuation process.  In short, managers often hold significant sway over the primary input into their compensation – an arrangement rife with opportunities for conflicts of interest.  As such, hedge fund investors typically dedicate material due diligence time to understanding a manager’s valuation policies and procedures and identifying valuation risk.  See “Amber Partners White Paper Highlights Key Due Diligence Points for Hedge Fund Investors Evaluating Hedge Fund Portfolio Composition and Valuation,” Hedge Fund Law Report, Vol. 5, No. 20 (May 17, 2012).  Similarly, the Securities and Exchange Commission (SEC) considers asset valuation a key enforcement priority and has targeted market manipulation and other tactics used to artificially inflate asset values.  Recently, the SEC charged two investment advisers and their sole owner for allegedly engaging in practices designed to artificially inflate the value of a large position in the hedge fund they managed.  This article summarizes the factual allegations, causes of action and requested remedies as outlined in the SEC’s complaint.

Kelli L. Moll to Lead Akin Gump’s New York Hedge Fund Practice

On May 21, 2012, Akin Gump Strauss Hauer & Feld LLP announced that Kelli L. Moll has joined the firm as a partner and will lead Akin Gump’s hedge fund practice in New York.

Former Federal Securities and Commodities Fraud Prosecutor Joins Gibson Dunn’s New York Office

On May 21, 2012, Gibson, Dunn & Crutcher LLP announced that Avi Weitzman has joined the firm’s New York office as of counsel.  For relevant analysis from the Gibson Dunn team, see “Is This an Inspection or an Investigation? The Blurring Line Between Examinations of and Enforcement Actions Against Private Fund Managers,” Hedge Fund Law Report, Vol. 5, No. 13 (Mar. 29, 2012).