Jan. 17, 2013

How Can Hedge Fund Managers Use Reinsurance Businesses to Raise and Retain Assets and Achieve Uncorrelated Returns? (Part Two of Two)

Some well-known hedge fund managers have launched reinsurance businesses to address the twin challenges of raising capital and obtaining uncorrelated returns.  If properly structured and operated, reinsurance businesses offer hedge fund managers a steady stream of investable capital in the form of reinsurance premiums, which in turn can be invested in the manager’s other strategies.  However, few hedge fund managers start with the expertise or infrastructure necessary to launch and operate a reinsurance business effectively, and reinsurance businesses present unique challenges relating to people, risk management, structuring and regulation.  Moreover, running a reinsurance business alongside a hedge fund management business raises various compliance issues.  In short, launching a reinsurance business can help tackle some of the more elusive challenges facing hedge fund managers, but such launches entail risks to which managers typically are not accustomed.  To assist managers in capturing some of that upside while mitigating the risks, we are publishing this second article in a two-part series on the primary legal, business and risk considerations for hedge fund managers in launching reinsurance businesses.  In particular, this article discusses how hedge fund managers generally approach starting a reinsurance business; the best domiciles for reinsurers; a checklist of steps required to launch a reinsurance business; how hedge fund managers invest the “float” generated by such a business; conflicts of interest raised by a hedge fund manager’s side-by-side management of a reinsurance business and an investment management business, and how managers should address such conflicts; and policies and procedures that hedge fund managers should implement to accommodate the operation of a reinsurance business.  The first article in this series provided background on the reinsurance business; explained how reinsurers generate revenue; discussed how hedge fund managers can participate in the reinsurance business; and described some principal benefits and drawbacks of launching a reinsurance business.  See “How Can Hedge Fund Managers Use Reinsurance Businesses to Raise and Retain Assets and Achieve Uncorrelated Returns? (Part One of Two),” Hedge Fund Law Report, Vol. 6, No. 2 (Jan. 10, 2013).

In What Circumstances May Hedge Fund Investors Bring Proceedings in the Name of the Fund for a Wrong Committed Against the Fund, When Those in Control of It Refuse to Do So?

The evolution of the law relating to corporations, and in particular the doctrine of the company as a separate legal person, presented a risk from the earliest times that minority investors might be left without a remedy if those in control of the company breached their trusts or duties and destroyed the value of that investment through mismanagement, self-dealing or other misconduct.  The risk of losing one’s investment in circumstances where there has been corporate wrongdoing has not abated, and in today’s hedge fund universe, the likelihood is that the shareholder will have invested a very substantial amount of capital for a minority position in a fund, the majority of whose directors and whose investment manager and other service providers are based in another country.  There are over 10,000 registered Mutual Funds in the Cayman Islands alone, many of which are directed and managed out of New York or Delaware.  In response to the concern that there is no remedy for the shareholder for such wrongs, many jurisdictions have sought to implement the procedural device of the derivative action as a means of affording substantive relief to investors.  Wherever they are brought, derivative actions have a common theme and a universal aim: the theme is that shareholders are not being heard and cannot take action themselves; the aim is to restore value to the company in which they have invested.  The mechanics for providing this substantive relief vary across the different jurisdictions.  In a guest article, Christopher Russell, David Butler, Michael Swartz and Daniel Cohen compare the mechanics of how hedge fund investors may pursue derivative actions in three different jurisdictions: the Cayman Islands, Delaware and New York.  Russell is a Partner in the Litigation and Insolvency Department of Appleby Cayman, and Butler is a senior Associate in the Department; Swartz is a Partner and Cohen is an Associate at Schulte Roth & Zabel LLP.

Identifying and Addressing the Primary Conflicts of Interest in the Hedge Fund Management Business

Regulators are increasingly keen on scrutinizing how fund managers address conflicts of interest.  Norm Champ, then-Deputy Director of the SEC’s Office of Compliance Inspections and Examinations, spoke about conflicts at a May 2012 seminar held at the New York City Bar Association.  See “Davis Polk ‘Hedge Funds in the Current Environment’ Event Focuses on Establishing Registered Alternative Funds, Hedge Fund Manager M&A and SEC Examination Priorities,” Hedge Fund Law Report, Vol. 5, No. 24 (Jun. 14, 2012).  The SEC has indicated that it intends to scrutinize fund managers’ handling of conflicts of interest during “presence examinations” of newly registered managers to be conducted in the next two years.  See “Former SEC Asset Management Unit Co-Chief Robert Kaplan and Former NYS Insurance Superintendent Eric Dinallo, Both Current Debevoise Partners, Discuss the Purpose, Process and Consequences of Presence Examinations of Hedge Fund Managers,” Hedge Fund Law Report, Vol. 5, No. 48 (Dec. 20, 2012).  In addition, the FSA has expressed its own concerns with asset managers’ handling of conflicts of interest by penning a “Dear CEO” letter to asset managers identifying areas where it has particular concerns.  See “FSA Report Warns Investment Managers to Revise Their Compliance Policies and Procedures to Address Key Conflicts of Interest,” Hedge Fund Law Report, Vol. 5, No. 45 (Nov. 29, 2012).  Moreover, regulators have initiated enforcement actions to address conflicts of interest that were not appropriately managed, handled and documented.  The most notable of these actions was levied against Harbinger Capital Partners and its principal, Philip Falcone, in the summer of 2012.  See “SEC Charges Philip A. Falcone, Harbinger Capital Partners and Related Entities and Individuals with Misappropriation of Client Assets, Granting of Preferential Redemptions and Market Manipulation,” Hedge Fund Law Report, Vol. 5, No. 26 (Jun. 28, 2012).  Like regulators, hedge fund investors are concerned with conflicts of interest at managers.  See “Use of SSAE 16 (SAS 70) Internal Control Reports by Hedge Fund Managers to Credibly Convey the Quality of Internal Controls, Raise Capital and Prepare for Audits,” Hedge Fund Law Report, Vol. 5, No. 11 (Mar. 16, 2012).  Left unchecked, conflicts can ripen into legal violations and lost investments.  Accordingly, hedge fund managers must be vigilant in identifying and addressing conflicts.  While the details of conflicts may differ from firm to firm, certain general conflicts pervade the industry.  In a guest article, John Ackerley, a Director with Carne Global Financial Services in the Cayman Islands, provides a checklist of those pervasive conflicts, which are also those that matter most to regulators and investors.  In addition, Ackerley discusses specific measures that hedge fund managers can take to mitigate such conflicts.  Managers can expect questions from regulators and investors on each of the conflicts discussed herein.  Therefore, this article can be useful as a reference point in a mock examination, to prepare for marketing meetings and for other purposes.

Six Recommendations for Hedge Fund Managers Seeking to Protect Themselves from Waiver of Attorney-Client Privilege When Faced With SEC Document Requests

Receipt of subpoenas from the SEC can rattle even the most time-tested hedge fund managers, particularly where there is little time to respond.  The pressures created by an SEC investigation or enforcement action can lead to inadvertent disclosures of information or mistakes in judgment, which can result in a manager’s waiver of attorney-client privilege and other severe consequences.  See generally “Are Hedge Fund Managers Required to Disclose the Existence or Outcome of Regulatory Examinations to Current or Potential Investors?,” Hedge Fund Law Report, Vol. 4, No. 32 (Sep. 16, 2011).  A recent federal court decision illustrates these risks.  In that decision, the court held that a mutual fund adviser and another defendant waived their attorney-client privilege with respect to information inadvertently disclosed to the SEC in the course of an investigation and subsequent enforcement action.  The court also ruled on whether the defendants made a broader subject matter waiver of the attorney-client privilege (with respect to yet-undisclosed information) in disclosing information to bolster affirmative defenses (based on the reliance of counsel and other professionals) in the course of the enforcement action.  Although the case involves an adviser to a mutual fund, the risks, remedies and principles are equally applicable to hedge fund managers.  This article summarizes the factual background in this case as well as the court’s ruling on the SEC’s motion to confirm that the defendants waived attorney-client privilege with respect to their actions.  The article also outlines six recommendations for hedge fund managers seeking to preserve the attorney-client privilege when faced with SEC document requests.

Aksia Survey Reveals Hedge Fund Managers’ Perspectives on AUM Composition, Fees, Liquidity, Advertising Practices, Transparency, Reporting and High-Frequency Trading

Aksia LLC (Aksia), a specialist hedge fund research and portfolio advisory firm, recently released the results of its 2013 Hedge Fund Manager Survey (Survey), which covered two broad areas of inquiry: predictions for the world economy and the financial markets in 2013 and the state of the hedge fund industry.  More specifically, with respect to economic and financial market issues, the Survey revealed hedge fund managers’ predictions concerning U.S. economic growth, unemployment and inflation; Chinese economic growth; Euro zone concerns; sources of economic concern for 2013; and market liquidity.  With respect to hedge fund industry issues, the Survey revealed hedge fund managers’ perspectives on the composition of hedge fund assets under management; fund fees; fund liquidity; changes in advertising practices following passage of the Jumpstart Our Business Startups (JOBS) Act; fund transparency and reporting; and high-frequency trading.  This article summarizes key findings from the Survey and compares some of the findings against those from a similar study conducted by Aksia one year ago.  See “Aksia’s 2012 Hedge Fund Manager Survey Reveals Managers’ 2012 Predictions Regarding Tail Risk Hedges, Portfolio Transparency, Movement of Balances Away from Counterparties and More,” Hedge Fund Law Report, Vol. 5, No. 2 (Jan. 12, 2012).

When Can a Hedge Fund Shareholder Opt Out of a Class Action Settlement to Pursue Its Own Remedies When a Court Has Certified the Class as a Non-Opt-Out Class?

Companies are often reluctant to settle class action lawsuits with a group of shareholders unless they have some assurance that shareholders will not be permitted to opt out of the settlement to pursue their own remedies against the company.  As such, proposed settlements are sometimes conditioned upon the certification of a class by a court as a non-opt-out class, meaning that shareholders may not opt out of the class action settlement without court approval.  Nonetheless, in some circumstances, shareholders may object to a negotiated settlement for various reasons and may wish to opt out of the settlement to prosecute their own claims against the company.  The Delaware Supreme Court recently issued an opinion in a case in which it considered whether and when a shareholder (in this case a hedge fund) should be permitted to opt out of the class action settlement under these circumstances.  This article provides the factual and legal background of the case; discusses the court’s holding and analysis; and discusses the implications of the decision for hedge fund shareholders engaged in class action litigation.

Brynn Peltz Joins Goodwin Procter’s Private Investment Funds Practice in New York

On January 17, 2013, Goodwin Procter announced that Brynn D. Peltz has joined the firm’s Financial Institutions Group in New York as a partner in its Transactions and Investment Management & Regulation Practices, as well as the firm’s Private Investment Funds Practice.

David Grim Named Deputy Director of SEC’s Division of Investment Management

On January 15, 2013, the SEC announced that David Grim was appointed Deputy Director of its Division of Investment Management.