May 2, 2013

How Should Hedge Fund Managers Approach the Allocation of Expenses Among Their Firms and Their Funds? (Part One of Two)

One of the categories of questions most frequently posed by hedge fund managers to outside counsel is: Who should bear the cost of this or that expense – the manager or one or more of its funds?  Generally, the answer is governed by the organizational documents of the manager and its funds, which in turn are drafted in the shadow of legal principles that provide, at best, indirect guidance on allocating expenses.  That is, the SEC and other regulators have not provided specific guidance to hedge fund managers on how to allocate expenses.  This is partly because such guidance would not be practicable – expense types are more various than routine rulemaking can accommodate – and partly so that agencies can reserve enforcement and examination discretion.  At the same time, the stakes of such questions have increased because the costs of operating a hedge fund management business have increased, thanks to Dodd-Frank, the presence examinations initiative and an evolving set of investor expectations more focused on infrastructure, compliance and risk management.  See “Citi Prime Finance Report Dissects the Expenses of Running a Hedge Fund Management Business, Identifying Components, Levels, Trends and Benchmarks,” Hedge Fund Law Report, Vol. 6, No. 1 (Jan. 3, 2013).  In short, hedge fund managers have a growing number and volume of expenses and little in the way of reliable guidance on allocating them.  Hence the frequency of calls to outside counsel on this topic.  In an effort to short-circuit, or at least shorten, some of those calls – to make our in-house counsel subscribers more informed purchasers of legal services; to enable our law firm partner subscribers to deliver lower-margin services more efficiently, the better to focus on higher-margin services; and to refine the due diligence practices of our institutional investor subscribers – the Hedge Fund Law Report is publishing a two-part series on allocation of expenses among hedge fund managers and their funds.  This article, the first in the series, provides an overview of the key issues and challenges inherent in allocation decisions, and outlines various regulatory and other concerns posed by allocation practices.  The second article in the series will provide an overview of approaches used by hedge fund managers in allocating expenses; describe challenges associated with disclosure of expense allocation practices; highlight approaches for addressing the allocation of expenses when disclosures are silent with respect to specific expenses; and discuss key controls designed to ensure that expenses are being allocated in accordance with the manager’s policies and procedures.

Three Recommendations to Help Hedge Fund Managers Avoid False GIPS Compliance Claims in Marketing Materials

Hedge fund managers engaged in raising capital are increasingly looking to present their performance results in compliance with the Global Investment Performance Standards (GIPS).  GIPS provide prospective investors with additional assurances about the integrity of such performance results.  At the same time, with the passage of the Jumpstart Our Business Startups Act, the SEC has become increasingly concerned about public advertising by private fund managers and has made it a priority to review performance advertising presentations during presence examinations of hedge fund managers.  See “OCIE Director Carlo di Florio and Asset Management Unit Chief Bruce Karpati Address Examination and Enforcement Priorities for Hedge Fund Managers at the RCA’s Compliance, Risk & Enforcement 2012 Symposium,” Hedge Fund Law Report, Vol. 6, No. 4 (Jan. 24, 2013); and “How Can Hedge Fund Managers Identify and Navigate Pitfalls Associated with the JOBS Act’s Rollback of the Ban on General Solicitation and Advertising?,” Hedge Fund Law Report, Vol. 6, No. 10 (Mar. 7, 2013).  In a development that may foreshadow heightened scrutiny in this area, the SEC has initiated administrative proceedings against an investment adviser and its principal for allegedly falsely claiming that the investment adviser’s performance results complied with advertising guidelines set forth in GIPS.  Although compliance with the GIPS standards are voluntary, the SEC has made clear that managers who advertise GIPS compliance, but whose advertisements and marketing materials do not actually provide all of the information required by GIPS, are subject to sanction under the anti-fraud provisions and advertising rules contained in the Investment Advisers Act of 1940.  This article summarizes the SEC’s factual and legal allegations in this case and provides three recommendations for hedge fund managers interested in reducing the risk of false GIPS compliance claims.  For an article that identifies some of the hedge fund specific issues related to GIPS-compliant performance presentations, see “A Step-By-Step Guide to GIPS Compliance for Hedge Fund Managers,” Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011).

Risk Management Survey Reveals Buy-Side Professionals’ Perspectives on Risk Management Approaches, Challenges and Concerns

A recently released report detailed findings from a survey of 375 buy-side professionals who were polled on their attitudes concerning risk management.  This article discusses salient points from that report.  For the SEC’s take on the issues addressed in the report, see “SEC Provides Recommendations for Establishing an Effective Risk Management Program for Hedge Fund Managers at Its Compliance Outreach Program National Seminar,” Hedge Fund Law Report, Vol. 5, No. 14 (Apr. 5, 2012).  For a discussion of operational risk management best practices, see “Top Ten Operational Risks Facing Hedge Fund Managers and What to Do about Them (Part Three of Three),” Hedge Fund Law Report, Vol. 6, No. 5 (Feb. 1, 2013).

When Can Hedge Fund Investors Bring Suit Against a Service Provider for Services Performed on Behalf of the Fund?

A federal district court recently considered whether claims brought by investors in a bankrupt hedge fund against a lender for allegedly aiding and abetting the fund manager’s breach of fiduciary duty and fraud against the hedge fund should be permitted to proceed.  The fundamental question at issue was whether the investors’ claims were direct claims that should be permitted to proceed or derivative claims that should have been brought by the hedge fund and therefore should be dismissed.  For another discussion of derivative suits in the hedge fund context, see “U.S. District Court Holds That Hedge Fund Investors Do Not Have Standing to Bring a Direct, As Opposed to Derivative, Claim against Hedge Fund Auditor PricewaterhouseCoopers LLP,” Hedge Fund Law Report, Vol. 3, No. 47 (Dec. 3, 2010).  This article summarizes the factual and procedural background of the case as well as the court’s legal analysis and decision.

SEC Commissioner Aguilar Discusses Insider Trading by Hedge Fund Managers, Valuation and Other Examination and Enforcement Pressure Points

In a speech at the Regulatory Compliance Association’s Regulation, Operations and Compliance Symposium, held on April 18, 2013, SEC Commissioner Luis Aguilar described the challenges to be tackled by hedge fund managers and regulators in serving investor interests.  In particular, Aguilar discussed the elements of a culture of compliance; how the SEC thinks about insider trading at hedge fund management companies; best practices in valuing assets; and internal dynamics at the SEC that may impact whether a hedge fund manager becomes an examination or enforcement target.  This article highlights the salient points from Aguilar’s speech.

Expert Network Firm GLG Hires SEC Veteran as Chief Compliance Counsel

Expert network firm Gerson Lehrman Group recently hired Michael King as Chief Compliance Counsel.  King was formerly an Assistant Director of Enforcement in the SEC’s Fort Worth regional office.  On expert networks, see “How Can Hedge Fund Managers Avoid Insider Trading Violations When Using Expert Networks in Connection with Leveraged Loan Market Transactions?,” Hedge Fund Law Report, Vol. 4, No. 32 (Sep. 16, 2011); and “How Can Hedge Fund Managers Avoid Insider Trading Violations When Using Expert Networks? (Part Two of Two),” Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011).  On compliance considerations when retaining expert network firms or other research providers or intermediaries, see “Best Practices for Due Diligence by Hedge Fund Managers on Research Providers,” Hedge Fund Law Report, Vol. 6, No. 11 (Mar. 14, 2013).

Private Equity Lawyer Marcia Ellis Rejoins Morrison & Foerster as a Partner

On April 22, 2013, Morrison & Foerster announced that Marcia Ellis has rejoined the firm as a corporate partner in its Hong Kong office.