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    Oct. 17, 2013

Six Critical Questions to Be Addressed by Hedge Fund Managers That Outsource Employee Background Checks (Part Three of Three)

This is the third installment in our three-part series on employee background checks in the hedge fund industry.  This article begins by weighing three factors favoring conducting background checks in-house against five factors favoring outsourcing of background checks.  The article then identifies and addresses six important questions to be answered by any hedge fund manager that outsources the employee background check process.  The first article in this series outlined the imperative of conducting background checks, cataloging the wide range of regulatory and other risks presented by employees.  See “Why and How Should Hedge Fund Managers Conduct Background Checks on Prospective Employees? (Part One of Three),” Hedge Fund Law Report, Vol. 6, No. 38 (Oct. 3, 2013).  And the second article in the series discussed the mechanics of conducting a background check, identified three common mistakes made by hedge fund managers in conducting background checks and detailed four legal risks in conducting background checks.  See “Why and How Should Hedge Fund Managers Conduct Background Checks on Prospective Employees? (Part Two of Three),” Hedge Fund Law Report, Vol. 6, No. 39 (Oct. 11, 2013).  The backdrop for our discussion of backgrounds is the growing competition for top talent in the hedge fund industry.  In brief, assets under management by hedge funds are growing rapidly; Citi Prime Finance, for example, forecasts that institutional investment in hedge funds will reach $2.314 trillion by 2017, up from $1.485 trillion in 2012.  Managers that can attract and retain the best and the brightest are more likely to capture a larger slice of a growing pie.  See “How Can Hedge Fund Managers Use Profits Interests, Capital Interests, Options and Phantom Income to Incentivize Top Portfolio Management and Other Talent?,” Hedge Fund Law Report, Vol. 6, No. 33 (Aug. 22, 2013).  Also, insightful investment talent can enable a manager to explore creative structuring options such as alternative mutual funds, funds of one and reinsurance vehicles.  The opportunities can cause a manager to rush headlong into the market for talent, and at least one of the purposes of this series is to suggest that managers pause to separate the peccadilloes from the fundamental problems.  Before you can know your customer, you need to know your employees.

What Do the CFTC Harmonization Rules Mean for Non-Mutual Fund Commodity Pools, Including Hedge Funds?

As a result of 2012 changes in the exemptions from registration as a commodity pool operator (CPO) available to operators of pooled investment vehicles, a large number of operators of unregistered investment companies – which may include hedge fund investment advisers, investment managers and/or boards of directors – were required to register with the Commodity Futures Trading Commission (CFTC) as CPOs, thus becoming subject to the Commodity Exchange Act (CEA) and the rules promulgated by the CFTC thereunder (CFTC Rules, and, together with the CEA, the Commodity Rules).  As a result, many investment advisers that were already subject to various federal securities laws and regulations, including the Investment Company Act of 1940 (Company Act), the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 and the rules under each of those Acts (collectively, Securities Rules), became subject to an additional regulatory regime.  Duplicative rules and regulations are nothing new to investment advisers or CPOs, and the public, press, politicians and regulators whose collective conscience had been scarred and greatly influenced by Madoff and other scandals and a debilitating financial crisis for which many scapegoated hedge funds were not particularly concerned with creating a larger regulatory and compliance burden for investment advisers.  Nevertheless, it was soon recognized that conflicting Commodity Rules and Securities Rules created an environment under which dual registrants (that is, those subject to both the Commodity Rules and Securities Rules) could not reasonably comply with certain of the conflicting requirements of both sets of rules.  Rather than permit this situation to drive certain types of pooled investment vehicles either to cease or materially alter their operations due to these conflicts, the CFTC adopted rules and rule interpretations designed to resolve them (Harmonization Rules).  Most of the Harmonization Rules pertain to “investment companies” registered under the Company Act (RICs), many of which are commonly referred to as mutual funds.  In a guest article, Steven M. Felsenthal and Stephanie T. Green focus on those Harmonization Rules that apply to CPOs whose pooled investment vehicles are not RICs, including hedge funds and other commodity pools, describing the implications of the Harmonization Rules for such commodity pools in the process.  Felsenthal is General Counsel and Chief Compliance Officer of Millburn Ridgefield Corporation, The Millburn Corporation and Millburn International, LLC; Green is a legal and compliance associate at The Millburn Corporation.

U.S. Tax Court Decision Considering “Investor” vs. “Trader” Status Could Impact the Tax Status of Hedge Funds and the Deductibility of Fund Expenses by Hedge Fund Investors

Whether a hedge fund is deemed to be an “investor fund” or a “trader fund” can have a significant financial impact on its investors because investors in trader funds are able to deduct a greater portion of the fund’s expenses on their personal income tax returns.  Expenses passed through to investors from an investor fund are capped at two percent of the investor’s adjusted gross income, while expenses passed through by a trader fund are fully deductible against hedge fund income.  See “What Critical Issues Must Hedge Fund Managers Understand to Inform Their Preparation of Schedules K-1 for Distribution to Their Investors?,” Hedge Fund Law Report, Vol. 6, No. 11 (Mar. 14, 2013).  A recent U.S. Tax Court decision involving an individual who traded stocks and call options provides an excellent overview of the criteria the Internal Revenue Service considers in determining whether an individual or entity is a “trader.”  Although the decision involves an individual, the criteria considered by the Court are likely to apply to the tax status of hedge funds.  This article summarizes the factual allegations as well as the Court’s legal analysis and holding in the case.

Daniel New, Executive Director of E&Y’s Asset Management Advisory Practice, Discusses Best Practices on “Hot Button” Hedge Fund Compliance Issues: Disclosure, Expense Allocations, Insider Trading, Political Intelligence, CCO Liability, Valuation and More

The task of serving as chief compliance officer (CCO) of a hedge fund manager is becoming progressively more challenging in light of ever-increasing regulatory obligations, heightened enforcement activity and resource constraints.  CCOs can benefit from understanding the best practices being employed by their peers, and customizing relevant practices to their businesses.  As Executive Director of Ernst & Young’s Asset Management Advisory Practice, Daniel New sees a cross-section of compliance practices at brand-name hedge fund managers.  He sees what works from a compliance perspective, and what needs work.  The Hedge Fund Law Report recently interviewed New on a range of issues regularly encountered by hedge fund manager CCOs.  The interview spanned topics including consistency of fund marketing and disclosure documents; a CCO’s role in preparing and completing Form PF and other regulatory filings; structuring and memorializing annual compliance reviews; allocating expenses between a manager and its funds; insider trading and political intelligence controls; social media use by manager personnel; a CCO’s risk management responsibilities; outsourcing of CCO functions in light of resource constraints; and mitigating rogue trading risks.  The breadth of topics covered reflects the expansiveness of a typical CCO’s portfolio.  The idea behind this interview is to enable CCOs to allocate their scarcest resource – time – more effectively.  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.  Subscribers to the Hedge Fund Law Report are eligible for a registration discount.

How Have Dodd-Frank and European Union Derivatives Trading Reforms Impacted Hedge Fund Managers That Trade Swaps?

The Practising Law Institute recently sponsored a panel highlighting the impact of derivatives reforms on managers of hedge funds that trade swaps.  Among other things, the panel addressed key product definitions, including whether certain instruments are considered “swaps”; CPO registration obligations, exemptions and other administrative relief; ongoing compliance requirements applicable to registered CPOs, including the Series 3 exam requirement; and amendments to swap trading documentation triggered by Dodd-Frank and European Union derivatives regulatory reforms.  See “Dechert Webinar Highlights Key Deal Points and Tactics in Negotiations between Hedge Fund Managers and Futures Commission Merchants regarding Cleared Derivative Agreements,” Hedge Fund Law Report, Vol. 6, No. 16 (Apr. 18, 2013); and “A Practical Guide to the Implications of Derivatives Reforms for Hedge Fund Managers,” Hedge Fund Law Report, Vol. 6, No. 29 (Jul. 25, 2013).  This article summarizes the key insights from the discussion.  The speakers were Michael J. Drayo, Senior Counsel at investment adviser The Vanguard Group, Inc., and Susan C. Ervin, a partner in the Financial Institutions group at Davis Polk & Wardwell LLP.  See “Do You Need to Be a Registered CPO Now and What Does It Mean If You Do? (Part Two of Two),” Hedge Fund Law Report, Vol. 5, No. 19 (May 10, 2012).

Criminal and Civil Actions against Purported Investment Adviser Underscore the Imperative of Candor during SEC Examinations

On September 13, 2013, the SEC charged Frederick D. Scott, owner of a New York-based investment advisory firm, with defrauding investors and falsely claiming he managed $3.7 billion in assets.  On the same day, in a parallel criminal action brought in the Eastern District of New York, Scott pled guilty to making materially false statements to the SEC during the course of an investigation and conspiring to commit wire fraud.  Scott, who will be sentenced later this year, faces up to five years’ imprisonment on the false statements charge alone.  The joint actions against Scott highlight the government’s commitment to civilly and criminally charging individuals who defraud investors and lie during the course of an SEC examination or investigation.  See “Is This an Inspection or an Investigation? The Blurring Line Between Examinations of and Enforcement Actions Against Private Fund Managers,” Hedge Fund Law Report, Vol. 5, No. 13 (Mar. 29, 2012).  In preparing for investigations, investment advisers must ensure that all personnel who communicate with the SEC are well versed in the potential repercussions of withholding material information or lying to examiners.  This article summarizes the civil and criminal charges against Scott and his subsequent plea deal, based on allegations contained in the SEC complaint, the criminal information and a Debevoise & Plimpton LLP Client Update describing the case and Scott’s plea deal.

Martin Haisch Joins Dechert as Partner in Frankfurt

On October 15, 2013, Dechert LLP announced that Dr. Martin Haisch, formerly of Linklaters, has joined as a partner in Dechert’s Frankfurt office.  See “Dechert Partners Aisha Hunt and Richard Horowitz Discuss Strategies and Challenges for Hedge Fund Managers Wishing to Enter the Alternative Mutual Fund Space,” Hedge Fund Law Report, Vol. 6, No. 20 (May 16, 2013).

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