Nov. 1, 2013

Can Hedge Fund Managers Use Gross (Rather Than Net) Results in Performance Advertising? (Part Two of Two)

Hedge fund managers work long and hard for every basis point of return they achieve.  Therefore, it often comes as a surprise to managers to learn that they do not have plenary rights in their performance information.  Such information is not fully portable.  See “Portability and Protection of Hedge Fund Investment Track Records,” Hedge Fund Law Report, Vol. 4, No. 40 (Nov. 10, 2011).  Investors often require performance information to be presented in a composite, while managers often think about performance per fund or per strategy.  See “A Step-By-Step Guide to GIPS Compliance for Hedge Fund Managers,” Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011).  And, as a default rule, regulators require performance to be presented net of fees, which, among other things, complicates apples-to-apples comparisons among funds with different fee structures.  See “Can Hedge Fund Managers Use Gross (Rather Than Net) Results in Performance Advertising? (Part One of Two),” Hedge Fund Law Report, Vol. 6, No. 41 (Oct. 25, 2013).  However, there are exceptions to that default rule – circumstances in which regulators permit managers to present performance information gross of fees.  It is important for hedge fund managers to understand the existence and limits of situations in which they can present performance information gross of fees, for at least two reasons.  First, as managers hardly need to be reminded, performance remains central to marketing and capital raising.  See “Why and How Do Corporate and Government Pension Plans, Endowments and Foundations Invest in Hedge Funds?,” Hedge Fund Law Report, Vol. 6, No. 14 (Apr. 4, 2013); “Why and How Do Family Offices and Foundations Invest in Hedge Funds?,” Hedge Fund Law Report, Vol. 6, No. 1 (Jan. 3, 2013); “Why and How Do Sovereign Wealth Funds Invest in Hedge Funds?,” Hedge Fund Law Report, Vol. 6, No. 13 (Mar. 28, 2013).  Second, regulators are taking a harder look at performance information in private fund marketing materials and activities, as Norm Champ, Director of the SEC’s Division of Investment Management, explicitly stated in a September 12, 2013 speech at the Practising Law Institute.  Accordingly, this article – the second in a two-part series – describes three circumstances in which hedge fund managers may present performance information gross of fees; analyzes four “hard cases” involving presentation of hedge fund performance information that do not fall neatly within the scope of no-action letters or other guidance; and discusses two categories of best practices that all managers should consider when presenting performance information.  The first article in this series provided an overview of relevant law, rules and SEC authority and offered practical guidance on calculating and presenting net performance results.

What Should Hedge Fund Managers Understand About Transfer Pricing and How to Manage the Related Risks?

Hedge fund firms with multinational operations should understand the implications of transfer pricing for their operations.  Transfer pricing establishes the price charged between controlled parties involved in cross-border transfers of goods, intangibles and services, as well as financial transactions (e.g., loans).  While transfer pricing is most often applicable to international transactions involving distinct legal entities within a global group, the concept of “controlled parties” can extend to entities involved in domestic transactions, as well as partnerships and individuals.  Taxing authorities around the world have enacted transfer pricing rules to ensure that income is not arbitrarily shifted to other taxpayers or jurisdictions, and that reported profits are aligned with functions, assets and risks.  The arm’s length standard is the fundamental basis of most transfer pricing law, and seeks to price a transaction between controlled parties as if it occurred between two unrelated parties.  Many countries require taxpayers to maintain documentation to demonstrate that intercompany transactions comply with the arm’s length standard and can impose significant penalties absent this documentation.  As a matter of course, many taxing authorities (including the Internal Revenue Service in the U.S.) request this documentation at the outset of an audit.  In a guest article, Jessica Joy, Stefanie Perrella and Matt Rappaport – Managing Director, Vice President and Analyst, respectively, at Duff & Phelps – present an overview of transfer pricing and relevant U.S. laws.  Further, the authors discuss current events that may be indicative of how lawmakers and regulators will approach transfer pricing for hedge fund firms going forward, and present illustrative transfer pricing issues of particular relevance to hedge fund firms.

K&L Gates Seminar Discusses Impact of CFTC Harmonization Rules on Alternative Mutual Funds and Other Registered Investment Companies

In the absence of an exemption, a manager of a fund that trades in “commodity interests” (including swaps) may be required to register with the U.S. Commodity Futures Trading Commission (CFTC) as a commodity pool operator (CPO) and become subject to the Commodity Exchange Act and the CFTC’s “Part 4” regulations (which specify a CPO’s disclosure, financial reporting and recordkeeping obligations).  See “Do You Need to Be a Registered Commodity Pool Operator Now and What Does It Mean If You Do? (Part Two of Two),” Hedge Fund Law Report, Vol. 5, No. 19 (May 10, 2012).  For managers of alternative mutual funds or other registered investment companies (RICs), the CFTC regime is yet another set of rules to navigate; such managers are already subject to the Securities Act of 1933 (Securities Act), the Securities Exchange Act of 1934, the Investment Company Act of 1940 (Company Act), the Investment Advisers Act of 1940, and rules under those statutes.  See “How Can Hedge Fund Managers Organize and Operate Alternative Mutual Funds to Access Retail Capital (Part Two of Two),” Hedge Fund Law Report, Vol. 6, No. 6 (Feb. 7, 2013).  To mitigate administrative and coordination challenges associated with duplicative or conflicting CFTC and SEC obligations impacting registered CPOs, on August 13, 2013, the CFTC issued an Adopting Release (Adopting Release) in which it amended existing CFTC rules to create a “substituted compliance” regime (harmonization rules).  Through these harmonization rules, compliance with designated SEC rules will be deemed to satisfy obligations imposed under corresponding CFTC rules.  A recent K&L Gates LLP seminar reviewed the Adopting Release, the harmonization rules and their impact on RICs.  As an increasing number of hedge fund managers have launched or are contemplating launching registered funds, this relief is welcome news in the hedge fund industry.  This article summarizes the key insights from that seminar.  For a discussion of the substituted compliance regime and its impact on managers of hedge funds and other entities not registered pursuant to the Company Act, see “What Do the CFTC Harmonization Rules Mean for Non-Mutual Fund Commodity Pools, Including Hedge Funds?,” Hedge Fund Law Report, Vol. 6, No. 40 (Oct. 17, 2013).

Hedge Funds Realize Material Return by Funding Litigation Over a Tax Refund in a Bank Holding Company Bankruptcy

Litigation funding – generally, debt, equity or other investments in third-party legal cases – can offer absolute and uncorrelated returns.  See “In Turbulent Markets, Hedge Fund Managers Turn to Litigation Funding for Absolute, Uncorrelated Returns,” Hedge Fund Law Report, Vol. 2, No. 25 (Jun. 24, 2009).  In a recent example of a successful execution of such a strategy, several hedge funds funded litigation on behalf of a bankrupt bank holding company involving a tax refund dispute with the Federal Deposit Insurance Corporation (FDIC).  Those funds are poised to profit handsomely following a decision by the U.S. Bankruptcy Court for the District of Delaware (Court) in favor of the bank holding company.  The four hedge funds financed the tax refund litigation on behalf of the bank holding company after the bankruptcy trustee ran out of money to finance continuing litigation.  The hedge funds also held notes issued by the bank holding company.  At issue was whether a huge tax refund was owned by the bank holding company or by a bank subsidiary.  If the bank subsidiary owned the refund, its receiver, the FDIC, would take it all.  However, if the bank holding company owned the refund, the FDIC would have to share it with other creditors of the bank holding company, including the hedge funds and other noteholders.  This article summarizes the facts of the case, the Court’s legal analysis and the anticipated distribution of the tax refund.  This article also identifies an ongoing bankruptcy that is factually similar (i.e., a bank holding company bankruptcy involving a dispute over a sizable tax refund) and may therefore lend itself to a similar litigation funding strategy.

Proprietary Trading Firm Sues Former Chief Operating Officer for Allegedly Misappropriating Confidential Information to Benefit His New Hedge Fund Manager Employer

A proprietary trading firm and its management company (Plaintiffs) recently filed a complaint in New York State Court charging their former chief operating officer (COO) with misappropriating the Plaintiffs’ confidential and proprietary information and using such information to benefit his new employer, a hedge fund manager.  This article summarizes the factual and legal allegations as well as the remedies requested in the complaint.  For a discussion of protection of trade secrets by hedge fund managers, see “Measures Hedge Fund Managers Can Implement to Maximize Protection of Their Trade Secrets,” Hedge Fund Law Report, Vol. 5, No. 46 (Dec. 6, 2012); “Eight Measures That Hedge Fund Managers Can Take to Mitigate the Risk of Theft of Their Trade Secrets,” Hedge Fund Law Report, Vol. 5, No. 21 (May 24, 2012).  For a discussion of the interaction between trade secret protection and hiring, 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. 38 (Oct. 3, 2013).

Deutsche Bank Survey Finds That, Based on AIFMD, Nearly Half of U.S. Hedge Fund Managers Will Only Market “Passively” to EU Investors

Deutsche Bank’s Hedge Fund Consulting group (Deutsche Bank) recently conducted a survey of 44 U.S. and European hedge fund managers with approximately $325 billion in aggregate assets under management.  Deutsche Bank asked the managers questions relating to whether and how their costs and infrastructure changed as a result of new regulatory requirements, as well as questions relating to their plans to market their funds into the European Union (EU) in light of the recent rollout of the EU Alternative Investment Fund Managers Directive (AIFMD).  See “Application of the AIFMD to Non-EU Alternative Investment Fund Managers (Part Two of Two),” Hedge Fund Law Report, Vol. 6, No. 24 (Jun. 13, 2013).  This article summarizes key takeaways from the survey.

Sam V. Tabar Joins Schulte Roth & Zabel in New York