Oct. 3, 2013

Why and How Should Hedge Fund Managers Conduct Background Checks on Prospective Employees? (Part One of Three)

Hedge fund management is a human capital business, and employees are (or should be) the key asset of a manager.  See “Key Legal Considerations in Connection with the Movement of Talent from Proprietary Trading Desks to Start-Up or Existing Hedge Fund Managers: The Hedge Fund Manager Perspective (Part Three of Three),” Hedge Fund Law Report, Vol. 4, No. 4 (Feb. 3, 2011).  However, employees can also be a manager’s most dangerous liability.  One rogue employee can destroy or seriously damage even the best hedge fund franchise by, among other things, inviting a presumption that the employee is not rogue but representative of a culture of permissiveness.  See “Rajaratnam Prosecutor and Dechert Partner Jonathan Streeter Discusses How the Government Builds and Prosecutes an Insider Trading Case against a Hedge Fund Manager,” Hedge Fund Law Report, Vol. 5, No. 45 (Nov. 29, 2012).  Recognizing the risks of picking bad apples, hedge fund managers are increasingly using employee background checks as a downside mitigation strategy.  But the concept of a background check spans a wide range of activities – everything from a superficial online search to a deep, manual process.  Whether to conduct a background check in the first instance, and what kind of background check to conduct, depends on dynamics specific to the industry, firm and prospective employee.  To assist hedge fund managers in understanding the role of background checks in their hiring and “people” processes, the Hedge Fund Law Report is publishing a three-part series on the role of background checks in the hedge fund industry, with the three parts focusing on, respectively, three questions: Why, how and who.  More specifically, this article – the first in the series – outlines the case for conducting background checks, cataloging the wide range of regulatory and other risks presented by employees (including discussions of insider trading, Rule 506(d), pay to play, track record portability, restrictive covenants and other topics).  The second installment will describe the anatomy of an employee background check, highlighting mechanics, common mistakes and risks.  And the third part will weigh the benefits and burdens of outsourcing background checks versus conducting them in-house.

Guidepoint Global’s General Counsel, Catherine Smith, Discusses How Hedge Fund Managers Are Using Expert Networks to Conduct Investment Research and Mitigate Insider Trading Risks

SEC, FBI and other government officials have acknowledged that expert networks are a legitimate method for conducting primary investment research.  See “RCA Symposium Clarifies Current Market Practice on Side Letters, Conflicts of Interest, Insider Trading Investigations, Whistleblowers, FATCA and Use of Managed Accounts Versus Funds of One (Part Two of Two),” Hedge Fund Law Report, Vol. 6, No. 25 (Jun. 20, 2013) (“Commenting on the permissible use of expert networks, FBI Special Agent David Chaves observed, ‘I think a majority of expert networks serve a very legitimate function and have always acted responsibly.  We do not want to scare people into thinking this is not a valid resource because it is, and you can continue to use them.  You will know when conduct crosses the line.  I do not think people should overreact.’”).  Yet many of the recent civil and criminal insider trading actions against hedge fund professionals have involved expert networks, directly or indirectly.  See, e.g., “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).  Accordingly, hedge fund managers have struggled with capturing the research and investment advantages of expert networks while avoiding insider trading and other information risks.  To offer concrete guidance and specific best practices in this area, Hedge Fund Law Report recently interviewed Catherine Smith, former Senior Counsel of the SEC’s Division of Enforcement and current General Counsel of expert network firm Guidepoint Global.  Smith brought her regulatory and private practice experience to bear on topics including how the use by hedge fund managers of expert networks has evolved; whether managers impose restrictions or prohibitions on the experts that may be consulted; how managers conduct due diligence on expert networks; how expert networks screen prospective experts; whether expert networks restrict topics eligible for discussion by their experts; compliance controls implemented by expert network firms and hedge fund managers; and different surveillance methods for monitoring expert network consultations.  This interview was conducted in connection with the Regulatory Compliance Association’s upcoming Compliance, Risk & Enforcement 2013 Symposium, to be held at the Pierre Hotel in New York City on October 31, 2013.  For a fuller description of the Symposium, click here.  To register for the Symposium, click here.  Subscribers to Hedge Fund Law Report are eligible for a registration discount.

Chapter 15 of the Bankruptcy Code Presents Litigation Risks and Liability for Creditors, Counterparties, Service Providers and Others Doing Business with Bankrupt Offshore Hedge Funds

Chapter 15 of the United States Bankruptcy Code (Bankruptcy Code) provides certain protections and tools to offshore hedge funds in liquidation and opens up parties that do business with such funds to possible litigation risk.  That chapter was created to preserve, protect and maximize the recovery of a foreign debtor’s assets located in the United States so that all creditors of that debtor may share in their value.  It is available to foreign liquidators and trustees in foreign bankruptcies, such as those filed in the Cayman Islands, British Virgin Islands and Bermuda, three popular countries in which offshore hedge funds organize.  It allows these foreign liquidators to come to the United States and use its courts and laws to seek, through discovery and lawsuits, the return of assets purportedly belonging to the foreign estates.  It is not a well-known bankruptcy proceeding, and it can create uncertain and substantial legal costs and liability for uninformed persons and entities who have dealt with offshore funds.  To best protect information and assets when dealing with an offshore hedge fund, it is critical for parties dealing with such funds to understand the possible discovery and recovery rights that a foreign liquidator of a bankrupt hedge fund may have under Chapter 15.  In a guest article, Marc D. Powers and Natacha Carbajal, senior partner and associate, respectively, at BakerHostetler, describe Chapter 15 proceedings, including highlighting how such proceedings work and what types of relief are available to the petitioner.  Powers and Carbajal also provide practice tips to help those dealing with offshore hedge funds mitigate the risks associated with Chapter 15 proceedings.  For additional coverage of Chapter 15 proceedings, see “Cayman Islands Liquidations of Failed Bear Stearns Hedge Funds Denied Access to US Bankruptcy Court,” Hedge Fund Law Report, Vol. 1, No. 13 (May 30, 2008).

ACA Compliance Report Facilitates Benchmarking of Private Fund Manager Compliance Practices (Part One of Two)

ACA Compliance Group (ACA) recently released the second part of its three-part report describing the results of its surveys of hedge fund and private equity fund manager compliance practices, focusing on the completion and preparation of regulatory filings, various insider trading issues and expense practices.  ACA also presented a webcast explaining and expanding on the survey findings.  The report and webcast provided important market color and guidance enabling hedge fund and private equity fund managers to benchmark their compliance practices against those of their peers.  This article, the first of two installments covering the report and webcast, summarizes survey results relating to (1) the present status and focus areas of hedge fund and private equity fund manager presence examinations, and (2) fund managers’ preparation and completion of regulatory filings (e.g., Form ADV, Form PF and non-U.S. regulatory filings), including a discussion of how many managers are making various regulatory filings; what resources are being used to prepare such filings; how Form PF expenses are being allocated among a manager and its funds; and whether Form PF is being shared with fund investors.  The second installment will address insider trading issues (including discussions of information barriers, online data rooms, non-disclosure agreements, restricted and watch lists, political intelligence, expert networks and public company contacts); and expense practices (including the use of expense caps and the allocation of expenses among a manager and its funds).  For coverage of the first part of the ACA compliance report, conducted during the first quarter of this year, see “ACA Compliance Group Survey Provides Benchmarks for a Range of Hedge Fund Manager Compliance Functions, Including Dual-Hatting, Annual Compliance Reviews, Forensic Testing, Custody, Fees and Signature Authority,” Hedge Fund Law Report, Vol. 6, No. 19 (May 9, 2013).

How Can Hedge Fund Managers Managing Plan Asset Funds Comply with the QPAM and INHAM Exemption Requirements?

Hedge funds that accept investments from pension plans need to be cognizant of the requirements of the Employee Retirement Income Security Act of 1974 (ERISA) and its “plan asset” regulations.  Specifically, if a benefit plan investor owns more than 25 percent of any class of a fund’s equity securities, the fund could be deemed a “plan asset fund” subject to ERISA, including its prohibition against transactions with “parties in interest.”  As a result, many managers of plan asset funds rely on an exemption from ERISA’s prohibited transaction rules for “qualified professional asset managers” (QPAM).  A recent panel reviewed the requirements of the QPAM exemption and the related exemption for “in-house asset managers” (INHAM), emphasizing the requirement that INHAMs and certain QPAMs conduct an annual audit of their compliance with the exemptions.  This article summarizes the key take-aways from that discussion.  See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part Three of Three),” Hedge Fund Law Report, Vol. 3, No. 24 (Jun. 18, 2010).

SEC Sanctions Hedge Fund Manager Principal for Failing to Disclose and Obtain Consent to a Principal Transaction

Transactions between a hedge fund manager principal and a fund managed by that manager, while not prohibited, are potential minefields because of the inherent conflicts of interest they present: On one side of the transaction, the principal is acting as agent for the fund; on the other, the principal is acting in his or her own interest.  At a minimum, pursuant to Section 206(3) of the Investment Advisers Act of 1940, managers must provide advance written disclosure to fund investors of the proposed transaction and obtain consent.  See “When and How Can Hedge Fund Managers Engage in Transactions with Their Hedge Funds?,” Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).  A recently-settled SEC enforcement action is a reminder of the perils of proceeding in the absence of full disclosure and consent.  This article summarizes the details of the principal transaction, the SEC’s charges and the sanctions imposed on the principal by the SEC.  For a discussion of an action alleging violation of Section 206(3), see “How Can Hedge Fund Managers Structure Their Compliance, Reporting and Disclosure Systems to Avoid Allegations of Principal Trading Rule Violations Such As Those Recently Alleged by the DOJ Against Former Bear Stearns Hedge Fund Manager Ralph Cioffi?,” Hedge Fund Law Report, Vol. 2, No. 36 (Sep. 9, 2009).

Morrison & Foerster Adds Energy and Financial Services Regulatory Specialist and CFTC Veteran Julian Hammar in Washington, D.C.

On September 26, 2013, Morrison & Foerster announced that Julian E. Hammar has joined the firm’s Energy and Financial Service Regulatory Practices in Washington, D.C.  See “Merchant Power Regulatory Roulette,” Hedge Fund Law Report, Vol. 4, No. 33 (Sep. 22, 2011); “CPO Compliance Series: Registration Obligations of Principals and Associated Persons (Part Three of Three),” Hedge Fund Law Report, Vol. 6, No. 6 (Feb. 7, 2013); “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).