Jun. 14, 2012

Davis Polk “Hedge Funds in the Current Environment” Event Focuses on Establishing Registered Alternative Funds, Hedge Fund Manager M&A and SEC Examination Priorities

On May 11, 2012, the New York City Bar Association held its annual “Hedge Funds in the Current Environment” program co-hosted by law firm Davis Polk & Wardwell LLP.  Speakers at this event addressed various topics of current relevance to the hedge fund industry, including: SEC examination priorities, such as insider trading, trade reviews and asset verification; establishing registered alternative funds; trends in hedge fund manager mergers and acquisitions; and hedge fund advertising after passage of the Jumpstart Our Businesses Startups (JOBS) Act.  Notably, Norm Champ, Deputy Director of the Office of Compliance Inspections and Examinations with the SEC, provided an up-to-date view of the SEC’s examination priorities in relation to hedge funds and their managers.  This article summarizes the key points discussed at the conference relating to each of the foregoing topics.

How Can Hedge Fund Managers Both Advertise and Accept Investments from Non-Accredited Employees, Friends and Family Members?

The Jumpstart Our Business Startups (JOBS) Act has been received by the hedge fund industry with cautious optimism.  Most notably, the JOBS Act eliminates the long-standing and hard-to-justify gag order prohibiting hedge fund managers from “generally soliciting,” or, in plain English, advertising.  The business benefits of advertising are obvious: communicating a value proposition; solidifying a brand; correcting misperceptions; etc.  However, the JOBS Act does not give something for nothing.  In exchange for the ability to advertise, hedge fund managers may only accept accredited investors into their funds.  See “Implications for Hedge Fund Managers of the Rule Amendments Recently Adopted by the SEC to Raise Accredited Investor Standards,” Hedge Fund Law Report, Vol. 5, No. 1 (Jan. 5, 2012).  In the majority of circumstances, this is not an issue because the majority of investors are accredited.  But in an important minority of cases, this regime appears to require hedge fund managers to elect between advertising, on the one hand, and accepting non-accredited investors into their funds, on the other hand.  (Under Rule 506 of Regulation D, hedge fund managers may offer fund interests in a “private offering” – faster, cheaper and otherwise preferable to a “public offering” – to up to 35 non-accredited investors; and the JOBS Act does not change this part of the Rule.)  In turn, this matters because hedge fund managers sometimes have occasion to accept investments in their funds from non-accredited investors – persons such as family members, friends and lower-level employees.  While such “tickets” are typically small relative to institutional investments, they can be strategically important and even connected to institutional investments.  For example, many institutional investors like manager employees to have “skin in the game”; and this preference applies across the pecking order, to investments by star portfolio managers, operations and accounting professionals, compliance personnel, etc.  See “Investments by Hedge Fund Managers in Their Own Funds: Rationale, Amounts, Terms, Disclosure, Duty to Update and Verification,” Hedge Fund Law Report, Vol. 3, No. 21 (May 28, 2010).  From the perspective of institutional investors focused on operational due diligence, there are no unimportant employees at a hedge fund manager.  Everyone should be invested, figuratively and, ideally, literally.  See “Legal and Operational Due Diligence Best Practices for Hedge Fund Investors,” Hedge Fund Law Report, Vol. 5, No. 1 (Jan. 5, 2012).  So, the good news is that hedge fund managers can advertise.  The bad news appears to be that if managers advertise, they cannot accept investments from non-accredited friends, family members, employees and others, which can constitute a strategic impairment.  But hedge fund managers are not lawyers.  When confronted with two alternative options, lawyers – at least good ones – will do a thorough analysis and choose the better option.  Hedge fund managers will choose both.  Accordingly, to enable our hedge fund manager subscribers to get the best of both worlds, and to arm our attorney subscribers for conversations with managers, we have worked with sources to identify eight strategies for simultaneously advertising and accepting non-accredited investments.  Those strategies are detailed toward the end of this article.  To provide context for those strategies, this article also describes: Rule 506 and the mechanics of the JOBS Act; the impact of the JOBS Act on hedge funds and managers; the current accredited investor requirement; integration of securities offerings; and the status of SEC rulemaking under the JOBS Act.

Five Steps Hedge Fund Managers Should Take to Mitigate Avoidance and Disallowance Risks After Delaware Court Finds That Avoidance and Disallowance Risks Travel with Trade Claims

Distressed investors, such as hedge fund managers, purchasing trade claims against a debtor in the secondary market must now face the fact that certain disabilities may attach to and travel with claims following a May 4, 2012 decision by Judge Kevin J. Carey of the United States Bankruptcy Court for the District of Delaware (Court) in the KB Toys bankruptcy proceeding.  The Court held that a purchaser of a trade claim against a debtor takes such claim subject to the risk of disallowance of the claim under Bankruptcy Code Section 502(d) based on the original claimholder’s receipt of (and failure to pay) an avoidable transfer.  While Judge Carey specified that the decision was limited solely to trade claims purchased from the original holders of such claims, the Court’s reasoning could be extended to other circumstances, such as bank loans traded in the secondary market.  Therefore, it is essential that distressed investors perform the necessary diligence and negotiate sufficient protections in agreements to purchase distressed debt.  In a guest article, Steven F. Wasserman and Howard S. Steel, both Partners at Brown Rudnick, and Laura F. Weiss, an Associate at Brown Rudnick, provide an overview of the KB Toys decision and recommend five best practices to minimize risks to recoveries in light of this important decision.

FSA Bans Hedge Fund Firm Dynamic Decisions and Imposes Highest-Ever Fine on an Individual in a Non-Market Abuse Case Against CEO Alberto Micalizzi

On May 29, 2012, the UK Financial Services Authority (FSA) published a Decision Notice explaining the facts and rationale for the largest fine in a non-market abuse case, £3 million, against Alberto Micalizzi, Chief Executive Officer of Dynamic Decisions Capital Management Ltd (DDCM), a hedge fund management firm based in London and Milan. In a related case decided in November 2011, the FSA fined Dr. Sandradee Joseph, DDCM’s Compliance Officer, £14,000 (US $21,757), and banned her from performing any significant influence function in regulated financial services.  In that matter, the FSA found that Joseph failed to investigate or act on investors’ concerns over potentially improper activity at DDCM.  See “Recent FSA Settlement Helps Define the Scope of Potential Liability of the Chief Compliance Officer of a U.K. Hedge Fund Manager,” Hedge Fund Law Report, Vol. 4, No. 43 (Dec. 1, 2011).  The cases against Micalizzi and Joseph are part of a series of recent vigorous enforcement actions by the FSA, including significant fines levied for non-market abuse.  See “FSA Fines Former J.C. Flowers Europe CEO for Fraudulent Invoicing Scheme,” Hedge Fund Law Report, Vol. 5, No. 6 (Feb. 9, 2012).

Receiver’s Suit to Recover Over $500 Million for Defrauded Investors of Hedge Fund Manager Founding Partners Nears Settlement

In an unusual arrangement, the receiver for defunct hedge fund manager Founding Partners Capital Management Company is nearing settlement of a $500 million lawsuit against Sun Capital, Inc. and Sun Capital Healthcare, Inc.  This article provides relevant background and details the structure of the potential settlement. 

Ontario Securities Commission Sanctions Hedge Fund Manager Sextant Capital Management and its Principal for Breach of Fiduciary Duty

The Ontario Securities Commission recently handed down a decision against an investment fund manager that demonstrates its willingness to levy severe sanctions against managers engaged in fraud with respect to investors.  The decision is notable for its facts and legal analysis as well as its location.  Canada is an increasingly important jurisdiction for hedge fund managers and investors, and this matter provides useful color on the regulatory landscape there.

WilmerHale Expands Hedge Fund Practice with Addition of Drew Chapman

On June 12, 2012, WilmerHale announced that Drew G.L. Chapman is joining the firm’s New York office as a partner in the Securities Department and Investment Management Group and head of the Alternative Investment practice.

Schulte Roth & Zabel’s London Office Adds Transactional & Private Equity Funds Partner

On June 13, 2012, Schulte Roth & Zabel LLP (SRZ) announced the addition of James “Jim” McNally as a partner in its London office.  McNally was a part of Dewey & LeBoeuf’s global private equity team led by Joseph Smith, who joined SRZ in New York in May 2012.

Former SEC Official Joins Murphy & McGonigle

On June 7, 2012, Murphy & McGonigle, P.C. announced that Matthew B. Comstock has joined the firm as a partner in its Washington, D.C. office.