Sep. 13, 2012

Are the General Counsel and Chief Compliance Officer of a Hedge Fund Manager Considered “Knowledgeable Employees” of the Manager?

Allowing employees to invest in a hedge fund manager’s funds can have both direct and indirect benefits for the manager and the employees, including aligning the interests of the employees with those of the manager and fund investors.  However, because most hedge funds elect not to register as investment companies pursuant to the Investment Company Act of 1940 (Company Act), they typically must comply with the requirements of the exclusions from investment company registration found in Section 3(c)(1) (which basically prohibits more than 100 beneficial owners in the fund) and Section 3(c)(7) (which limits investors in the fund to “qualified purchasers”) of the Company Act.  These exclusions can restrict employee investments in the manager’s funds.  However, Rule 3c-5 under the Company Act permits “knowledgeable employees” of a fund and certain of its affiliates to acquire securities issued by the fund without being counted towards the 100-beneficial owner threshold for Section 3(c)(1) funds and without having to qualify as qualified purchasers with respect to Section 3(c)(7) funds.  Investment and business personnel – portfolio managers, directors, officers and other senior business employees – typically fall squarely within the definition of knowledgeable employee, and in any case are often qualified purchasers as well.  However, a recurring question at hedge fund managers – particularly in the so-called “back office” – is whether the general counsel (GC) and chief compliance officer (CCO) of the manager constitute knowledgeable employees of the manager.  This question arises for at least three reasons.  First, GCs and CCOs – at least those who believe in what they are doing and where they are doing it – often want to invest in the funds of their manager-employers.  Second, investments by GCs and CCOs are good for the manager – they align employee incentives and fund investment goals.  (Some argue that fund investments by the GC and CCO can result in lax compliance, for example, that a GC or CCO invested in the fund would be more inclined to permit insider trading to increase fund returns.  We do not find that argument credible.  Smart GCs and CCOs know that lax compliance diminishes long-term returns.)  Third, many GCs and CCOs are close to being qualified purchasers, but are not quite there.  Such GCs and CCOs would not be able to invest in 3(c)(7) funds unless they fit within the knowledgeable employee definition.  In short, hedge fund investments by GCs and CCOs are usually a win-win.  But do the federal securities laws and rules permit such investments?  That is the fundamental question that this article seeks to answer.  More specifically, this article discusses: the benefits to a hedge fund manager of employee investments in manager funds; the interaction between Sections 3(c)(1) and 3(c)(7) of the Company Act and the knowledgeable employee definition; the operation of Rule 3c-5 of the Company Act and who generally qualifies as a knowledgeable employee; categories of hedge fund manager employees that are typically considered knowledgeable employees; consequences of making an incorrect knowledgeable employee determination; whether in-house counsel and compliance staff constitute knowledgeable employees; whether “dual-hatted” GCs/CCOs constitute knowledgeable employees; factors bearing on the analysis; and how the size of the firm impacts the knowledgeable employee calculus.

Fund Misrepresentations Inducing Investment: Claims and Remedies Available to Fund Investors and Protections Available to Promoters, Fund Managers and Directors

False statements inducing initial or continued investment in Cayman funds are relatively rare, but if they do occur, the financial consequences are often catastrophic for the misled investor and present him with a dilemma – whether to pull out and try to recoup the investment, or to stay in, try to recover what losses are retrievable and take whatever benefits there may be down the line.  Although the decision may be easy enough as a matter of choice in principle, a number of thorny legal issues may arise, such as the right to rescind an allotment of shares, derivative claims and the bar on recovery of reflective loss.  For promoters, managers and directors seeking to avoid such claims, the issue is how to protect themselves from accusations of misleading statements about the fund, and from consequent liability for such statements.  In a guest article, Christopher Russell and Jeremy Snead of Appleby (Cayman) discuss the claims and remedies available to misled fund investors and the protections available to promoters, fund managers and directors that seek to protect themselves from allegations of misrepresentation.

SEC Commences Administrative and Cease and Desist Proceedings against Hedge Fund Adviser for Failing to File Form ADV Updates and Maintain Required Books and Records

The Securities and Exchange Commission (SEC) has issued an order commencing administrative and cease and desist proceedings against a registered investment adviser and its principal.  The SEC alleges various violations of the Investment Company Act of 1940 and the Investment Advisers Act of 1940 arising out of, among other things, the adviser’s failure to maintain required books and records relating to its service as a registered investment adviser to a registered investment company (Fund); failure to file Form ADV updates; failure to file Form ADV-W when its client ceased to be a registered investment company; and failure to supply information to the Fund’s board of directors.  This article summarizes the relevant terms of the SEC’s order, with emphasis on the violations of the Form ADV filing requirements and the books and records requirement.

Hedge Fund Manager Anthion Wins Dismissal of Silvercorp Metals’ Defamation Suit over Fraud Allegations

In continued sparring over the negative information disseminated by defendant hedge fund manager and short seller Anthion Management LLC, a/k/a (Anthion), about plaintiff Silvercorp Metals Inc. (Silvercorp), the New York State Supreme Court (Court) has dismissed in its entirety Silvercorp’s defamation and trade libel complaint.  Anthion and certain of the other defendants, who were affiliated with or had republished its reports (Alfred Little), had taken short positions in Silvercorp stock.  After taking those positions, Anthion and Alfred Little had disseminated information suggesting that Silvercorp was engaged in accounting fraud.  In response, Silvercorp sued Anthion and Alfred Little for defamation and other alleged misconduct, arguing that they were engaged in a scheme to drive down the price of Silvercorp’s stock.  Anthion responded with a counterclaim under New York’s anti-SLAPP law, alleging that Silvercorp was improperly retaliating against it for exposing its alleged misconduct.  In July, the Court threw out Anthion’s anti-SLAPP counterclaim.  See “How Far Can Hedge Fund Managers Go in Criticizing Public Companies?,” Hedge Fund Law Report, Vol. 5, No. 30 (Aug. 2, 2012).  Barring reversal on appeal, this case is now effectively over.  This article provides details not available at the time of the previous decision and summarizes the Court’s reasoning in dismissing Silvercorp’s complaint.  The matter is illustrative of how far a hedge fund manager can go in publicly criticizing a company in which it holds a short position.

AIMA Canada Handbook Provides Roadmap for Hedge Fund Managers Doing Business in Canada

Pershing Square’s successful proxy contest for control of Canadian Pacific Railway is the most prominent recent example, but by no means the only example, of the increasing importance of Canada for hedge fund managers.  See also “Ontario Securities Commission Sanctions Hedge Fund Manager Sextant Capital Management and its Principal for Breach of Fiduciary Duty,” Hedge Fund Law Report, Vol. 5, No. 24 (Jun. 14, 2012).  Specifically, Canada is growing in importance as a place where hedge fund managers may invest, raise capital and recruit talent.  In an effort to assist hedge fund managers in navigating the Canadian tax and regulatory landscape, AIMA Canada, a chapter of the Alternative Investment Management Association (AIMA), recently published the AIMA Canada Handbook (Handbook).  This article summarizes the key topics covered in the Handbook, including a background discussion of the Canadian securities industry; registration requirements for fund managers operating in Canada; regulations applicable to registrants; exemptions from fund manager registration; tax consequences for hedge funds and investors; structuring Canadian hedge funds; and the outlook for the Canadian hedge fund industry, including an update on the capital raising environment.

Greenwich Associates Report Shows Hedge Funds “Reasserting Themselves” in Trading in U.S. Fixed Income Markets

Greenwich Associates, LLC (Greenwich), has issued a report on trading volumes in the U.S. fixed income markets and the growing role that hedge funds play in those markets.

SEC Obtains Consent Judgment against Fund of Funds Manager Gary R. Marks Based on Charges that He Made Unsuitable Investment Recommendations; Misrepresented Fund Investment Diversification; and Failed to Disclose Material Fund Information

The Securities and Exchange Commission (SEC) has charged Gary R. Marks, who managed four funds of funds through Sky Bell Asset Management, LLC (Sky Bell), with violating various provisions of the Investment Advisers Act of 1940 and the Securities Act of 1933 by recommending unsuitable investments to his clients; misrepresenting that those funds’ returns were not correlated with each other; and failing to disclose material financial information about those funds.  Marks has consented to the entry of a judgment against him that enjoins him from future securities laws violations and requires him to disgorge profits and pay a civil penalty.  This article summarizes the events that led to the SEC’s enforcement action; the SEC’s specific charges; and the resolution of those charges.

Sharon M. Davison Joins Seward & Kissel LLP’s Investment Management Practice

On September 12, 2012, Seward & Kissel LLP announced that Sharon M. Davison has joined the firm as Counsel in its New York office.

Simon Compliance Expands to Provide Futures and Broker-Dealer Compliance Services

On September 12, 2012, Simon Compliance announced it has hired Mary M. McDonnell and UnBo (Bob) Chung as senior consultants tasked with expanding the firm’s service offerings to include futures and broker-dealer compliance services.