Mar. 21, 2013

How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part Three of Three)

Trade errors can cause substantial harm to hedge fund managers and their investors.  Such errors can, among other adverse consequences, undermine investors’ confidence in a manager’s trade execution capability; cause a manager to miss investment opportunities; and divert investment and operating resources in the course of correcting errors.  As such, managers, investors and regulators are theoretically aligned in their shared interest in avoiding trade errors.  As a practical matter, however, there is no regulatory roadmap to best practices for trade error prevention, detection and remediation.  SEC guidance has been sparse on this topic; and industry practice has largely filled the vacuum left by the dearth of authority.  Accordingly, in the area of trade errors (as in other areas, such as principal transactions), hedge fund managers are left to divine industry practice – and, further, to conform relevant practice to the specifics of their businesses.  How can hedge fund managers do this?  To begin to answer this hard and multifaceted question, the Hedge Fund Law Report has been publishing a three-part series on preventing, detecting, resolving and documenting trade errors.  This third installment in the series discusses the allocation of losses and gains resulting from trade errors among a manager and its clients; limitations on the allocation of trade error losses; documentation of trade errors; whether managers can obtain insurance to cover losses resulting from trade errors; and common mistakes managers make in handling trade errors.  The first article in the series discussed the challenge of defining a trade error; a manager’s legal obligations relating to the handling of trade errors; and the policies and procedures that managers should consider to prevent, detect, resolve and document trade errors.  See “How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part One of Three),” Hedge Fund Law Report, Vol. 6, No. 10 (Mar. 7, 2013).  The second article in the series outlined various measures to prevent trade errors; detect trade errors after execution; report trade errors once identified; resolve trade errors; and calculate losses resulting from trade errors.  See “How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part Two of Three),” Hedge Fund Law Report, Vol. 6, No. 11 (Mar. 14, 2013).

Five Takeaways for Other Hedge Fund Managers from the SEC’s Record $602 Million Insider Trading Settlement with CR Intrinsic

On March 15, 2013, the SEC issued a press release announcing a landmark $602 million civil insider trading settlement with hedge fund adviser CR Intrinsic Investors, LLC (CR Intrinsic) and affiliated entities arising out of alleged insider trading engaged in by Mathew Martoma, a co-defendant in the SEC enforcement action and formerly a portfolio manager at CR Intrinsic.  Martoma allegedly caused hedge funds managed by CR Intrinsic and S.A.C. Capital Advisors, LLC (S.A.C. Capital) to trade based on inside information relating to a drug trial conducted by pharmaceutical companies Wyeth and Elan.  See “Fund Manager CR Intrinsic and Former SAC Portfolio Manager Are Civilly and Criminally Charged in Alleged ‘Record’ $276 Million Insider Trading Scheme,” Hedge Fund Law Report, Vol. 5, No. 44 (Nov. 21, 2012).  S.A.C. Capital and various funds managed by CR Intrinsic and S.A.C. Capital are also named as relief defendants in the settlement, although they are not charged with any securities law violations.  On the same day, the SEC also announced a $14 million insider trading settlement with Sigma Capital Management, LLC (Sigma), an affiliate of S.A.C. Capital, relating to trading in the shares of Dell, Inc. and Nvidia Corporation.  This article summarizes the background and terms of the settlements in both actions and offers five important takeaways for other hedge fund managers from the CR Intrinsic matter.  In addition, this article highlights the compliance lessons of the Sigma matter, particularly as those lessons relate to conversations between investment analysts employed by different hedge fund managers.

BVI Court of Appeal Rules on Priority of Redeemed Investors Versus Remaining Investors in a Hedge Fund Liquidation

The Court of Appeal of the Eastern Caribbean Supreme Court recently ruled on whether investors in a hedge fund, who had given notice of redemption but who had not been paid in full at the time the fund went into liquidation, have priority in the liquidation over fund investors who had not redeemed their shares prior to the liquidation.  This article recounts the relevant facts of the case and summarizes the Court’s decision and reasoning.  For a discussion of the trial court’s decision, see “British Virgin Islands High Court Issues Landmark Decision Affecting the Distribution Rights of Redeemed Versus Continuing Investors in a Liquidating Hedge Fund,” Hedge Fund Law Report, Vol. 5, No. 47 (Dec. 13, 2012).

SEC Provides Guidance in Frequently Asked Questions on Form PF Concerning Reporting of Related Persons; Disregarded Entities; Derivatives Positions and Volumes; Master-Feeder Structures; and Calculation of Gross Asset Value and Regulatory Assets Under Management

As filers continue to confront challenges in providing accurate and complete reporting on Form PF, the SEC has at various times during the past year provided answers to its Form PF Frequently Asked Questions (FAQs).  The most recent of these updates were provided on March 8, 2013 and November 20, 2012, and addressed issues such as how to report various related persons; report certain disregarded investments; calculate derivatives position exposures and trading volumes; report private funds that are part of a master-feeder structure; and calculate the gross asset value and regulatory assets under management of a reporting fund.  This article summarizes highlights from these most recent updates to the SEC’s Form PF FAQs.  For coverage of previous updates to the FAQs, see “SEC Staff Publishes Answers to Frequently Asked Questions Concerning Form PF,” Hedge Fund Law Report, Vol. 5, No. 26 (Jun. 28, 2012).

Recent District Court Decision in Mark Cuban’s Ongoing Insider Trading Case Clarifies the Application of the Misappropriation Theory to Interactions between Investment Professionals and Corporate Insiders

On March 5, 2013, the U.S. District Court for the Northern District of Texas (Court) allowed the SEC to proceed to trial in its civil enforcement action against Dallas Mavericks owner Mark Cuban for insider trading.  The SEC accused Cuban of selling his shares in after learning material nonpublic information about the company’s planned private investment in public equity (PIPE) offering, thereby avoiding a $750,000 loss.  The Court held that the SEC presented enough evidence to convince a reasonable jury that Cuban could be held liable on the misappropriation theory of insider trading because he agreed, “at least implicitly, to maintain the confidentiality of’s material nonpublic information and not to trade on it or otherwise use it.”  See “When Does Talking to Corporate Insiders or Advisors Cross the Line into Tipper or Tippee Liability under the Misappropriation Theory of Insider Trading?,” Hedge Fund Law Report, Vol. 6, No. 2 (Jan. 10, 2013).  For reasons described in more detail in this article, this decision helps to further clarify what hedge fund investment professionals should and should not say and do when talking to corporate insiders.  This article summarizes the factual background in the matter and the Court’s legal analysis, and enumerates some of the salient implications of this decision for the investment research process.

How Can Hedge Fund Managers Wishing to Rely on the JOBS Act’s Advertising Relief Enhance Their Accredited Investor Due Diligence Procedures?

The Jumpstart Our Business Startups (JOBS) Act provides relief from the ban on general solicitation and advertising contained in the Rule 506 securities registration safe harbor, as long as all purchasers of an issuer’s securities are accredited investors.  While the JOBS Act creates more opportunities for hedge fund managers to market their funds to the public, such opportunities are accompanied by an obligation on the part of managers to take “reasonable steps” to verify that all purchasers of fund securities are accredited investors.  However, the SEC has not yet adopted final rules to define when an adviser has taken such “reasonable steps.”  For a discussion of the SEC’s proposed rules, see “JOBS Act: Proposed SEC Rules Would Dramatically Change Marketing Landscape for Hedge Funds,” Hedge Fund Law Report, Vol. 5, No. 34 (Sep. 6, 2012).  Despite the lack of definitive guidance from the SEC, hedge fund managers should nonetheless evaluate their investor due diligence procedures to ascertain whether they are sufficiently robust.  In a guest article, Philip Segal, founder of Charles Griffin Intelligence, provides recommendations to assist hedge fund managers in enhancing their investor due diligence practices.

Prominent Investment Funds Lawyer Han Ming Ho First to Join Sidley Austin LLP Since Its Receipt of QFLP License

On March 21, 2013, Sidley Austin LLP announced that Han Ming Ho, who is recognized as one of Asia’s leading international funds lawyers, will join the firm’s Singapore office as a partner.  For more on regulation of hedge funds managers in Singapore, see “Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part Three of Four),” Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).

Robert W. Cook, Former Director of SEC Division of Trading and Markets, Returns to Cleary Gottlieb

On March 18, 2013, Cleary Gottlieb Steen & Hamilton LLP announced that Robert W. Cook, former Director of the Division of Trading and Markets of the U.S. Securities and Exchange Commission, will return to the firm as a partner this spring.  He will be based in the firm’s Washington, D.C. office and will focus on securities, derivatives and market regulation.