Nov. 8, 2013

Investment Opt-Out Rights for Hedge Fund Investors: Rationales, Mechanics, Regulatory Risks and Operational Challenges (Part One of Three)

Investment products and services exist along a spectrum of customization, and, as a general matter, the bigger the investment ticket, the more customized the investment experience.  At the least customized end of the spectrum are mutual funds, effectively adhesion contracts in which investors typically have discretion over price, quantity and timing, but little else.  See “PLI Panel Addresses Recent Developments with Respect to Prime Brokerage Arrangements, Alternative Registered Funds and Hedge Fund Manager Mergers and Acquisitions,” Hedge Fund Law Report, Vol. 6, No. 41 (Oct. 25, 2013).  At the most customized end of the spectrum are family offices, and, just short of that, individual hedge fund style investment vehicles such as “funds of one” and managed accounts.  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 One of Two),” Hedge Fund Law Report, Vol. 6, No. 24 (Jun. 13, 2013).  Even within commingled hedge funds, the rights and obligations of investors are typically not uniform.  Smaller investors generally get the default terms of the PPM, while larger investors sometimes customize their deal by side letter or otherwise.  Side letters often modify default fund terms relating to liquidity and transparency.  Liquidity relates to the right to redeem from a fund, in whole or in part, and transparency relates to the right to know what’s going on in a fund.  But sometimes investors will wish to avoid a specific investment while not redeeming from the fund, in whole or even in part.  That is, investors sometimes want (or need) investment-specific liquidity rather than fund-level liquidity.  In practice, managers can grant investment-specific liquidity by offering investors the right to opt out of designated investments.  The concept of investment opt outs originated (at least within the private fund space) in private equity and still looms larger in private equity funds than hedge funds.  However, as hedge funds pursue an ever-expanding range of investment strategies – some of which resemble classic private equity – more and more managers are being confronted with requests from investors for investment opt-out rights.  Accordingly, the Hedge Fund Law Report is undertaking a three-part series analyzing the rationales for opt-out rights in the hedge fund context, and the legal and operational challenges involved in granting and implementing such rights.  This article, the first in the series, explores eight reasons why investors may demand and managers may grant opt-out rights.  The second installment will address the structure and exercise of opt-out rights, as well as regulatory risks associated with offering such rights.  The third installment will continue the discussion of risks associated with opt-out rights, focusing on regulatory and other risks, and will conclude with a discussion of best practices for implementing such rights.

Sidley Austin Private Funds Conference Addresses Recent Developments Relating to Fund Structuring and Terms; SEC Examinations and Enforcement Initiatives; Seeding Arrangements; Fund Mergers and Acquisitions; CPO Regulation; JOBS Act Implementation and Compliance; and Derivatives Reforms (Part Two of Three)

Sidley Austin LLP recently presented a conference entitled “Private Funds 2013: Developments and Opportunities.”  At the conference, Sidley partners offered updates, market color and practice recommendations on hedge and private equity fund structuring, regulation, operations and transactions.  The Hedge Fund Law Report is covering the conference in a three-part article series.  The first article covered the sections of the conference addressing fund structuring developments, single-investor funds, first loss capital arrangements, side letter terms, hard wiring of feeder funds for ERISA purposes, liquidity terms, fee terms, founder share classes and expense allocations and caps.  See “Sidley Austin Private Funds Conference Addresses Recent Developments Relating to Fund Structuring and Terms; SEC Examinations and Enforcement Initiatives; Seeding Arrangements; Fund Mergers and Acquisitions; CPO Regulation; JOBS Act Implementation and Compliance; and Derivatives Reforms (Part One of Three),” Hedge Fund Law Report, Vol. 6, No. 41 (Oct. 25, 2013).  This second installment addresses recent developments in SEC examinations and enforcement (including a discussion of compliance policy violations, valuation practices and allocation of investment opportunities); insider trading issues (including the use of political intelligence firms, expert networks and deputized directors); the SEC’s new policy requiring admissions of wrongdoing and best practices for compliance; seeding arrangements; and fund manager mergers and acquisitions (including a discussion of key terms and negotiating points for such transactions).  The third article in this series will describe regulatory developments impacting fund managers, including commodity pool operator registration and regulation, implementation and compliance with the JOBS Act and derivatives reforms.

In a Total Return Swap to Which a Hedge Fund Is a Party, Which Governs: The ISDA Master Confirmation or the Credit Support Annex?

The New York State Supreme Court, Appellate Division, First Department (Court), recently awarded a hedge fund an important victory in its suit to unwind a total return swap with a counterparty and to recover collateral being held by the counterparty.  The Court ruled that the counterparty had defaulted on the swap when it failed to pay in full a $40 million collateral call by the hedge fund pursuant to the ISDA documents governing the swap.  See “How Have Dodd-Frank and European Union Derivatives Trading Reforms Impacted Hedge Fund Managers That Trade Swaps?,” Hedge Fund Law Report, Vol. 6, No. 40 (Oct. 17, 2013).  A critical issue in the suit was whether language contained in the ISDA Master Confirmation negotiated by the parties modified and trumped the mechanism for disputing a collateral call contained in the credit support annex.  For a discussion of another action involving swap counterparty risk, see “British High Court Interprets ISDA Master Agreement to Suspend Non-Defaulting Party’s Payment Obligations Until Defaulting Party Has Cured the Default,” Hedge Fund Law Report, Vol. 5, No. 20 (May 17, 2013).

Katten Seminar Provides Hedge Fund Managers with a Roadmap for JOBS Act Compliance

Law firm Katten Muchin Rosenman LLP (Katten) recently hosted a seminar entitled “General Solicitation and Advertising Under the JOBS Act: Practical Considerations for Private Funds,” intended to help hedge fund managers navigate the challenges associated with understanding and complying with new rules proposed and adopted by the SEC to implement the JOBS Act.  See “A Compilation of Important Insights from Leading Law Firm Memoranda on the Implications of the JOBS Act Rulemaking for Hedge Fund Managers,” Hedge Fund Law Report, Vol. 6, No. 30 (Aug. 1, 2013).  Given the continuing rulemaking and interpretational challenges raised by the SEC’s JOBS Act implementing rules, hedge fund managers should proceed cautiously when considering general solicitation and advertising; and the Katten seminar provided useful guidance in this regard.  This article summarizes highlights from the seminar, focusing on, among other things, the accredited investor due diligence process; numerous interpretational challenges posed by the new “bad actor” disqualification provision; proposed rules addressing new filing and disclosure requirements; and pitfalls raised by the unresolved interaction between the JOBS Act and other federal securities laws.

SEC Sanctions Two Private Fund Managers for Custody Rule Violations, Including Imposing Statutory Bars on Their Chief Compliance Officers

On October 28, 2013, the SEC entered into settlement orders with three registered investment advisers who were charged with violations of Rule 206(4)-2 (Custody Rule) under the Investment Advisers Act of 1940 (Advisers Act), and other Advisers Act provisions and rules.  These enforcement actions, spurred by high-profile scandals as well as deficiencies uncovered during presence examinations of newly registered advisers, is emblematic of the SEC’s increasingly aggressive approach to enforcement.  See “Recently Published SEC Risk Alert Reveals Significant Deficiencies In Custody Practices of Hedge Fund Managers and Other Investment Advisers,” Hedge Fund Law Report, Vol. 6, No. 10 (Mar. 7, 2013).  This article summarizes the settlements entered into with two private fund managers that provide the most pertinent lessons for hedge fund managers.  See also “How Does the SEC Approach Custody Issues in the Course of Examinations of Hedge Fund Managers?,” Hedge Fund Law Report, Vol. 5, No. 18 (May 3, 2012).  In addition to the Custody Rule violations, the SEC also cited the fund managers for other significant Advisers Act violations (including a violation of Section 206(3) (with respect to an undisclosed principal transaction), style drift, making material misrepresentations in Form ADV, compliance program violations, and making improper distributions to investors).  Importantly, in both settlement orders, the chief compliance officers (CCOs) of both firms agreed to statutory bars, demonstrating the SEC’s commitment to holding CCOs responsible for the compliance failures of their firms.  See “Simon Lorne, Chief Legal Officer of Millennium Management LLC, Discusses the Evolving Roles, Challenges and Risks Faced by Hedge Fund Manager General Counsels and Chief Compliance Officers,” Hedge Fund Law Report, Vol. 6, No. 37 (Sep. 26, 2013).

KPMG/AIMA/MFA Survey Quantifies the Impact of the AIFMD, FATCA, Form PF and Adviser/CPO Registration on Hedge Fund Manager Compliance Budgets

KPMG International, in cooperation with the Alternative Investment Management Association and the Managed Funds Association, recently published a report detailing findings from its survey of 200 hedge fund managers around the world who have, in the aggregate, approximately $910 billion in assets under management.  The survey generally covered the impact of recent regulatory changes on managers’ compliance expenditures, operations and product offerings.  Specifically, the survey analyzed how size and geography impact manager compliance costs; key regulatory drivers of recent increases in manager compliance expenditures; manager projections for expenditures on outside service providers; impact of regulatory developments on manager operations (including whether regulatory changes would cause a manager to stop doing business or move from a jurisdiction); and manager predictions about future offerings of registered products such as funds organized pursuant to the EU’s Undertakings for Collective Investment in Transferable Securities (UCITS) Directive, or funds registered pursuant to the U.S. Investment Company Act of 1940 (mutual funds).  See “Are Alternative Investment Strategies Within the Spirit of UCITS?,” Hedge Fund Law Report, Vol. 5, No. 23 (Jun. 8, 2012); “Citi Prime Finance Report on Liquid Alternatives Describes a Massive Capital Raising Opportunity for Hedge Fund Managers Willing to Go Retail (Part One of Two),” Hedge Fund Law Report, Vol. 6, No. 21 (May 23, 2013).  This article summarizes key findings of the survey.

Sidley Expands Los Angeles Office with Addition of Investment Funds Partner

On November 4, 2013, Sidley Austin LLP announced that Timothy A. Spangler has joined the firm in Los Angeles as a partner and member of Sidley’s global Investment Funds, Advisers and Derivatives practice.  See “Sidley Austin Private Funds Conference (Part One of Three),” Hedge Fund Law Report, Vol. 6, No. 41 (Oct. 25, 2013); “Interview with Timothy Spangler: Key Legal and Business Considerations when Launching Hedge Funds or Hedge Fund Managers in China,” Hedge Fund Law Report, Vol. 3, No. 8 (Feb. 25, 2010).