Jul. 26, 2012

Cayman Islands Segregated Portfolio Companies: New Case Law Highlights Attractions for Promoters and Hedge Fund Managers

Typically, hedge fund managers use exempted companies organized in a master-feeder structure or in an umbrella fund structure to organize their funds.  Presently in the Cayman Islands, approximately 70% of funds are organized using these structures.  However, with the introduction in 1998 of segregated portfolio companies (SPCs) (known in other jurisdictions as “single account” or “protected cell” companies), an opportunity was given to promoters to utilize a structure that was less expensive and more efficient than the traditional structures.  Although a seemingly attractive fund vehicle, SPCs have not gathered a great following in the Cayman Islands.  At present, only around 10% of Cayman registered funds are SPCs, and that proportion has been relatively constant in recent years.  Their use has been generally limited to single investor funds where there are a large number of participants and there is a need to have the ability to create new portfolios quickly and simply.  However, with the Cayman Islands Court of Appeal (Court) handing down its decision in ABC Company (SPC) v. J & Co Ltd in June 2012, it is opportune to revisit the option available to promoters and managers of using an SPC as an attractive alternative to the vehicles more commonly used to establish hedge funds in the Cayman Islands.  In a guest article, Christopher Russell and Jayson Wood, partner and counsel, respectively, in the litigation and insolvency department of Appleby (Cayman) Ltd., discuss: the purposes and the general advantages of SPCs; the reasons for the apparent unpopularity of SPCs; the facts and legal analysis of the ABC decision; and four key structuring lessons for hedge fund managers looking to use the SPC structure following the ABC decision.

The Nuts and Bolts of FATCA Compliance: An Interview with James Wall of J.H. Cohn Concerning Due Diligence, Document Collection, Reporting and Other Operational Challenges

The Foreign Account Tax Compliance Act (FATCA) has that unfortunate combination of qualities that strikes fear into the hearts of hedge fund managers and investors: ambiguity and significant penalties.  FATCA is set to become effective as of January 1, 2013, but final rules have not yet been promulgated by the U.S. Department of the Treasury.  At the same time, sizable financial penalties can be imposed for noncompliance.  Accordingly, the hedge fund industry is paying close attention to FATCA developments.  Given the serious ramifications of non-compliance with FATCA and the significant uncertainty regarding the details of final regulations, the Hedge Fund Law Report conducted an interview with James K. Wall, a Principal and International Tax Director at J.H. Cohn LLP, concerning FATCA and its implications for hedge fund managers and investors.  Our interview with Wall covered various topics, including key questions hedge fund managers still face relating to FATCA compliance; due diligence and compliance measures that hedge fund managers must take; operational challenges in becoming FATCA compliant; whether the hedge fund or the manager should be responsible for bearing costs and expenses in connection with FATCA compliance; dealing with recalcitrant investors; policies and procedures that hedge fund managers should consider adopting for FATCA compliance; what to communicate to fund investors about FATCA; and whether fund governing documents must be amended to include FATCA-related provisions.  This article contains the transcript of our interview with Wall.  See also “U.S. Releases Helpful FATCA Guidance, But the Law Still Remains,” Hedge Fund Law Report, Vol. 5, No. 10 (Mar. 8, 2012).

SEC Staff Provides Additional Guidance on Form PF Regarding Key Definitions, Reporting Obligations, Calculation Methodologies and Transitional Reporting Mechanics

On June 28, 2012 and July 19, 2012, the staff of the Securities and Exchange Commission (Staff) provided additional guidance on Form PF by updating its frequently asked questions on Form PF (FAQs).  The Staff has offered reporting entities some flexibility in how they respond to certain questions in Form PF, provided that such reporting is consistent with internal reporting and reporting to investors and provided further that reporting methodologies are explained in Question 4 of Form PF.  Among other things, the additional guidance: defines key terms in Form PF; clarifies the reporting obligations for specific questions; provides instructions for performing certain calculations necessary for reporting information on Form PF; and provides guidance on transitional mechanics for preparing and filing Form PF.  See also “How Should Hedge Fund Managers Allocate Form PF Expenses Between Their Hedge Funds and Their Management Entities?,” Hedge Fund Law Report, Vol. 5, No. 25 (Jun. 21, 2012).

Recent Cayman Grand Court Decision Demonstrates the Practical and Legal Challenges of Investing in Hedge Funds through Nominees

A recent decision of the Grand Court of the Cayman Islands (Court) addressed a range of relevant questions for hedge fund managers and investors, among them: Does a side letter survive a fund restructuring?  Does a side letter entered into between a hedge fund and a beneficial investor bind a nominee through which the beneficial investor subsequently invests?  Is a beneficial investor a party to a hedge fund’s governing documents where it invests through a nominee?  What is the legal status of a side letter entered into prior to (rather than simultaneously with) an investment in a hedge fund?  In short, the decision illustrates the myriad legal and practical challenges faced by investors that invest in hedge funds through nominees; the relevance of the identity of contracting parties; and the scrutiny to which governing documents are subject in the course of hedge fund restructurings.  This feature-length article describes the factual background and legal analysis in the decision, and extracts two key lessons for investors that wish to invest in hedge funds via nominees.  See also “Investing in Cayman Islands Hedge Funds Through a Nominee or Custodian: An Unforeseen Peril,” Hedge Fund Law Report, Vol. 5, No. 4 (Jan. 26, 2012).

U.S. Bankruptcy Court Rules on Whether Money Managers’ “Soft Dollar” Credits Are Entitled to “Customer” Priority in Lehman SIPA Liquidation

When Lehman Brothers collapsed in 2008, hundreds of money managers that used its brokerage arm, Lehman Brothers Inc. (Lehman), to execute trades were left with unspent “soft dollar” commission credits.  In the Lehman liquidation proceeding, a number of those managers claimed that they were “customers” of Lehman with respect to those soft dollar balances within the meaning of the Securities Investor Protection Act of 1970 (SIPA).  Brokerage “customers” are entitled to priority in a SIPA liquidation over the claims of unsecured creditors of the brokerage firm.  The U.S. Bankruptcy Court for the Southern District of New York (Bankruptcy Court) recently ruled on whether the money managers’ claims for “soft dollar” credit balances represent “customer” claims under SIPA or whether such claims must be treated as general unsecured claims.  This article summarizes the background in this case and the Bankruptcy Court’s decision and reasoning.

Corgentum Survey Illustrates the Views of Hedge Fund Investors on the Roles, Duties, Risks and Performance of Service Providers

Corgentum Consulting, LLC, a specialist consulting firm that performs operational due diligence reviews of fund managers, recently conducted a survey asking hedge fund investors five questions about their views on service providers, including questions concerning the functions provided by service providers and the risks associated with them.  This article describes the survey findings.

Hedge Fund of Funds Manager Principal Charged with Securities Fraud and Wire Fraud over Misrepresentations Concerning Fund Performance and Investment Due Diligence

The U.S. has filed a seven-count indictment against Chetan Kapur, the sole principal of hedge fund manager Lilaboc, LLC, d/b/a ThinkStrategy Capital Management, LLC (ThinkStrategy).  Kapur is charged with securities, investment adviser and wire fraud arising out of his alleged misrepresentations to investors regarding due diligence of fund investments and fund performance.  Kapur and ThinkStrategy have previously settled civil charges brought by the SEC in connection with the same matters.  See “Private Lawsuits Against Hedge Fund Managers Can Be Important Sources of Examination and Enforcement ‘Leads’ for the SEC,” Hedge Fund Law Report, Vol. 4, No. 42 (Nov. 23, 2011).  This article summarizes the background in this case (including a discussion of the enforcement action initiated by the SEC and the private investor suit brought against Kapur and ThinkStrategy) and outlines the criminal charges levied against Kapur.  See also “Federal Court Decision Holds That a Fund of Funds Investor May Sue a Fund of Funds Manager That Fails to Perform Specific Due Diligence Actions Promised in Writing and Orally,” Hedge Fund Law Report, Vol. 4, No. 27 (Aug. 12, 2011).