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    Mar. 1, 2012

Registration, Reporting, Disclosure and Operational Consequences for Hedge Fund Managers of the SEC’s New “Regulatory Assets Under Management” Calculation

The SEC’s newly-adopted assets under management (AUM) calculation, known as an investment adviser’s “regulatory assets under management” (Regulatory AUM), will have numerous important regulatory implications for hedge fund managers.  Among other things, the calculation will govern whether the manager must or may register with the SEC as an investment adviser; whether the manager must file Form ADV; and which parts, if any, of Form PF the manager must complete and file.  See “Former SEC Commissioner Paul Atkins Discusses the Big Issues Raised by Form PF: Law, Operations, Confidentiality, Risk Management, Disclosure, Enforcement and Policy,” Hedge Fund Law Report, Vol. 5, No. 8 (Feb. 23, 2012).  Unfortunately for many hedge fund managers, the calculation of a firm’s Regulatory AUM is quite different from the calculation of the firm’s traditional AUM.  Also, in certain circumstances, large hedge fund managers may need to calculate their Regulatory AUM for each month.  Therefore, hedge fund managers must understand their Regulatory AUM and arrange to have it calculated in a timely fashion to ensure that they will comply with applicable registration and reporting requirements.  This article begins by defining Regulatory AUM and discussing how to calculate it.  The article then discusses the applicability of a firm’s Regulatory AUM with respect to the hedge fund adviser registration regime; the various exemptions from adviser registration; and the various new reporting obligations imposed on hedge fund advisers, including those relating to Form PF.  The article concludes with an analysis of some of the challenges associated with Regulatory AUM and specific guidance on navigating such challenges.

Applicability of New Disclosure Obligations Under ERISA to Hedge Fund Managers

More and more ERISA-covered benefit plans (especially defined benefit pension plans) are becoming interested in alternative investments, including hedge funds, and assets under management in the hedge fund industry are growing.  The U.S. Department of Labor (DOL) recently reported that the total amount of assets held by private pension plans increased to about $5.5 trillion by the end of the plans’ 2009 plan years (including about $2.2 trillion held by defined benefit pension plans).  Private Pension Plan Bulletin, DOL, Employee Benefits Security Administration (2011).  (The DOL’s numbers do not include the amount of assets in public pension plans and individual retirement accounts.)  And a recent survey conducted by Credit Suisse found that assets under management in hedge funds globally are on track to reach $2.13 trillion by the end of 2012.  Given these numbers and trends, hedge fund managers are increasingly likely to consider marketing their funds to benefit plans as investment opportunities.  However, if ERISA-covered benefit plans (and certain other tax-exempt retirement vehicles) own 25% or more of any class of equity interest in a hedge fund, an undivided portion of all of the underlying assets of the hedge fund becomes “plan assets” subject to ERISA, and the manager of the hedge fund becomes a fiduciary under ERISA to the ERISA-covered benefit plan investors.  See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part One of Three),” Hedge Fund Law Report, Vol. 3, No. 19 (May 14, 2010).  This raises a number of issues for such a “covered” hedge fund manager.  One of those issues that will arise this year for the first time is a final rule released by the DOL on February 2, 2012 under ERISA §408(b)(2) regarding fee disclosures by service providers to ERISA plans.  In a guest article, Fred Reish, Bruce Ashton and Gary Ammon, all Partners in the Employee Benefits & Executive Compensation Group at Drinker Biddle & Reath LLP, analyze, with respect to the final rule under ERISA §408(b)(2): covered plans; covered service providers; covered services; disclosure requirements; the effective date for compliance; the definition of compensation for purposes of the rule; how to handle changes in information or status; disclosure errors; and related topics.  This article is relevant to hedge fund managers that have ERISA investors or are considering marketing to such investors.

National Futures Association COO Dan Driscoll Discusses Registration, Reporting and Related Challenges Facing Hedge Fund Managers with Strategies Involving Commodities or Derivatives

Hedge fund managers with strategies that involve commodities or derivatives are facing complicated new registration and reporting requirements.  On the registration side, on February 9, 2012, the Commodity Futures Trading Commission (CFTC) adopted final rules that rescinded the CFTC Rule 4.13(a)(4) exemption from commodity pool operator (CPO) registration that has been heavily relied upon by many hedge fund managers and their affiliates.  See “CFTC Adopts Final Rules That Are Likely to Require Many Hedge Fund Managers to Register as Commodity Pool Operators,” Hedge Fund Law Report, Vol. 5, No. 7 (Feb. 16, 2012).  As a result, many hedge fund managers will either have to qualify for another exemption from CPO registration (most likely the Rule 4.13(a)(3) exemption for de minimis commodity interest trading activity), or register as a CPO.  See “Do You Need to Be a Registered Commodity Pool Operator Now and What Does It Mean If You Do? (Part One of Two),” Hedge Fund Law Report, Vol. 5, No. 8 (Feb. 23, 2012).  On the reporting side, with the adoption of new CFTC Rule 4.27(d), CPOs that manage private funds and that are dually registered with the SEC as investment advisers and with the CFTC as CPOs will need to complete Form PF, which requires detailed information about the private funds managed by the adviser/CPO.  See “Form PF: Operational Challenges and Strategic, Regulatory and Investor-Related Implications for Hedge Fund Managers,” Hedge Fund Law Report, Vol. 5, No. 4 (Jan. 26, 2012).  With these registration, reporting and related challenges in mind, a session at the Regulatory Compliance Association’s Spring 2012 Regulation & Risk Thought Leadership Symposium will identify and address critical issues and pitfalls with respect to Form PF.  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.  One of the anticipated speaking faculty members for the Form PF session at the RCA Symposium is Dan Driscoll, the Chief Operating Officer of the National Futures Association (NFA).  We recently interviewed Driscoll, who spoke with Hedge Fund Law Report about Form PF and other issues related to CFTC and NFA regulation of hedge fund managers.  Specifically, our interview covered topics including: interpretational and operational issues related to qualification for the Rule 4.13(a)(3) de minimis exemption from CPO registration; the applicability of the relief granted under Rule 4.7 to hedge fund managers; the NFA examination and enforcement paradigm, including questions about how registrants are targeted for examination, what are the focus areas for NFA audits and how audits can lead to NFA enforcement activity; prospective NFA regulation of swap dealers and major swap participants; and Form PF, including issues related to the use of Form PF data for NFA enforcement activity, interpretation and confidentiality.

Hedge Fund Investor Accuses Paulson & Co. of Gross Negligence and Breach of Fiduciary Duty Stemming from Losses on Sino-Forest Investment

Hugh F. Culverhouse, an investor in hedge fund Paulson Advantage Plus, L.P., has commenced a class action lawsuit against that fund’s general partners, Paulson & Co. Inc. and Paulson Advisers LLC.  Culverhouse alleges that those entities were grossly negligent in performing due diligence in connection with the fund’s investment in Sino-Forest Corporation, whose stock collapsed after an independent research firm cast serious doubt on the value of its assets and the viability of its business structure.  Culverhouse seeks monetary and punitive damages for alleged breach of fiduciary, gross negligence and unjust enrichment.  This article does two things.  First, it offers a comprehensive summary of the Complaint.  This summary, in turn, is useful because lawsuits by investors against hedge fund managers are rare, and particularly rare against a name as noteworthy as Paulson.  Disputes between investors and managers are almost always negotiated privately, but such negotiation occurs in the “shadow” of relevant law.  This article outlines what the relevant law may be.  Second, this article contains links to various governing documents of Paulson Advantage Plus, L.P., including the fund’s private offering memorandum, limited partnership agreement and subscription agreement.  Regardless of the merits of Culverhouse’s claim, Paulson remains a well-regarded name in the hedge fund industry.  According to LCH Investments NV, Paulson & Co. Inc. has earned its investors $22.6 billion since its founding in 1994.  Those kinds of earnings can – and have – purchased highly competent legal advice, which translates into workably crafted governing documents.  Accordingly, the governing documents of the Paulson fund are useful precedents for large or small hedge fund managers looking to assess the “market” for terms in such documents or best practices for drafting specific terms.  Thus, we provide links to the governing documents.  See also “Questions Hedge Fund Managers Need to Consider Prior to Making Investments in Chinese Companies,” Hedge Fund Law Report, Vol. 4, No. 21 (Jun. 23, 2011).

SEC Adopts Final Rules Governing the Payment of Performance Fees to Registered Hedge Fund Managers

On February 15, 2012, the SEC issued a final release in which it adopted rule amendments (final rule amendments) to Rule 205-3 under the Investment Advisers Act of 1940 (Advisers Act), which governs the payment of performance-based compensation to registered investment advisers by qualified clients.  On May 10, 2011, the SEC issued a notice of intent to issue order (May 10 Notice) to modify the assets under management and net worth dollar thresholds informing the qualified client definition and to make additional amendments to Rule 205-3.  On July 12, 2011, the SEC issued an order (July 12 Order) that raised the qualified client dollar thresholds.  For a discussion of the May 10 Notice and the July 12 Order, see “SEC Order Increasing the Dollar Threshold for ‘Qualified Client’ Status Further Chips Away at the Utility of the 3(c)(1) Fund Structure,” Hedge Fund Law Report, Vol. 4, No. 28 (Aug. 19, 2011).  The final rule amendments codified the change in the qualified client dollar thresholds by amending the definition of qualified client contained in Rule 205-3(d) and adopted rules that are substantially similar to those proposed in the May 10 Notice.  Nonetheless, there are some important differences between the final rule amendments and the rule proposals.  This article discusses the final rule amendments in detail as well as the implications for hedge fund managers, particularly those that operate hedge funds that rely on the exclusion from registration of the hedge fund as an investment company contained in Section 3(c)(1) of the Investment Company Act of 1940.

SEI and Greenwich Associates Survey Identifies Institutional Investors’ Expectations With Respect to Hedge Fund Performance, Transparency and Liquidity

On February 22, 2012, SEI Knowledge Partnership and Greenwich Associates released the second installment of a two-part report summarizing the results of their September and October 2011 survey of hedge fund investors.  For a detailed analysis of Part I, see “Survey by SEI and Greenwich Associates Highlights the Importance to Hedge Fund Investors of a Clearly Articulated, Comprehensible and Credible Value Proposition,” Hedge Fund Law Report, Vol. 5, No. 4 (Jan. 26, 2012).  The second installment, entitled “The Shifting Hedge Fund Landscape, Part II of II: The New Dynamics of Hedge Fund Competitiveness” (Report), details investors’ greatest concerns when investing in hedge funds as well as their hedge fund selection criteria and expectations.  This article summarizes the findings of the Report and outlines the Report’s five key recommendations for hedge fund managers.

Recent Federal Court Decision Outlines Approach to Determining When a Payment Received by a Service Provider Will Constitute a Fraudulent Transfer from Those Orchestrating a Ponzi Scheme

The Madoff scandal has demonstrated that receivers appointed on behalf of troubled funds that were actually or allegedly run as Ponzi schemes can aggressively pursue legal action to recover funds misappropriated from investors.  See “Two Recent Federal Court Decisions Clarify the Differing Treatment under SIPA of Returned Principal and Fictitious Profits,” Hedge Fund Law Report, Vol. 4, No. 34 (Sep. 29, 2011).  To date, receivers continue to aggressively pursue such actions.  This article outlines the approach recently taken by a federal court in determining when a fraudulent transfer has been made to a service provider from persons that have operated a Ponzi scheme.

Morgan Lewis Expands Existing Derivatives and Commodity Futures Platform with Addition of Leading Chicago-Based Partner

On February 6, 2012, Morgan Lewis announced that Michael M. Philipp, who has practiced in the derivatives field for 20 years, joined the firm as a Partner in its Financial Services, Investment Management and Securities Industry practice, resident in Chicago.  See “Do You Need to Be a Registered Commodity Pool Operator Now and What Does It Mean If You Do? (Part One of Two),” Hedge Fund Law Report, Vol. 5, No. 8 (Feb. 23, 2012).

Investment Funds Lawyer Matthew Judd Joins Ropes & Gray’s London Office

Ropes & Gray recently announced that Matthew Judd has joined its London office as a Partner in its Private Investment Funds Group.

John Budzyna and Maurice Holmes Join KPMG’s Alternative Investments Practice

On February 27, 2012, KPMG LLP named new leaders of market development for its Alternative Investments Practice: John Budzyna will be the National Leader for Market Development and Maurice Holmes will be Managing Director for Market Development.

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