Jan. 16, 2014

How Can Hedge Fund Managers Structure, Implement and Enforce Information Barriers to Mitigate Insider Trading Risk Without Impairing Securities Trading?  (Part One of Four)

Insider trading law is rife with counterintuitive presumptions.  Notable among them is the presumption that if one employee of a hedge fund management company receives material nonpublic information (MNPI), all employees of that management company are in possession of MNPI for insider trading purposes, and any trade in the subject security will be “on the basis of” that information.  See “Hedge Funds in the Crosshairs: The Law of Insider Trading in an Active Enforcement Environment,” Hedge Fund Law Report, Vol. 3, No. 7 (Feb. 17, 2010).  However, that presumption can be rebutted by the presence of well-designed information barriers.  An information barrier, in this context, is a set of physical, operational, legal and technological structures and processes used to prevent the flow of information from one part of a firm to another, thereby preserving the ability of one part of the firm to trade securities that another part of the firm may not trade.  For example, assume that a single manager has a distressed debt fund that trades bank debt and a separate high-yield credit fund that trades bonds.  If the investment team for the distressed debt fund receives nonpublic earnings projections of an issuer based on service on that issuer’s creditor committee, the investment team for the high-yield credit fund would be prohibited – as a default – from trading in the public bonds of the same issuer because the whole firm would be presumed to be in possession of MNPI of that issuer.  However, if the firm had implemented a legally sufficient information barrier between the distressed debt and high-yield credit fund teams prior to receipt by the distressed fund team of MNPI, the high-yield credit fund team would still be able to trade public bonds of the issuer, even after receipt by the distressed fund team of MNPI.  This legal issue matters to investment performance because a good and legitimate investment opportunity may arise anytime.  In the foregoing example, the high-yield credit fund team may wish to purchase bonds of the issuer based on immaterial or public information received after the receipt of MNPI by the distressed fund team.  In the presence of a legally sufficient information barrier, the high-yield credit fund team would be able to execute on the opportunity.  Absent such an information barrier, the high-yield credit fund team would have to forego the opportunity or assume heightened insider trading risk.  Implicit in the foregoing hypothetical is the notion that an information barrier is useful to the extent that it is legally, operationally and otherwise sufficient.  Which of course begs the question: How can a hedge fund manager structure, implement and enforce sufficient information barriers?  This is the first article in a four-part series that aims to answer this question, or at least provide the rudiments of an answer and direction for further analysis.  In particular, this article provides an overview of various insider trading controls, including restricted lists, watch lists and information barriers, explaining how they can work together; describes four principal benefits available from the use of robust information barriers; highlights the types of firms that can benefit most from the implementation of information barriers; and describes the types of firms that will find the implementation of robust information barriers most challenging.  The second article in this series will describe the regulatory environment surrounding the use of information barriers and discuss the building blocks of an effective information barrier control environment.  The third installment will describe how a firm can limit access to MNPI within the information barrier control environment and outline policies and procedures designed to bolster the effectiveness of information barriers.  The fourth installment will discuss the benefits of training and compliance surveillance related to information barriers and describe the four most significant challenges faced by hedge fund managers in structuring, implementing and enforcing robust information barriers.

Succession Planning Series: Selling a Hedge Fund Founder’s Interest to an Outside Investor (Part Two of Two)

When a veteran hedge fund founder begins to contemplate retirement, he or she has choices to make about the nature of the firm to be left behind.  The previous installment in this two-part series on succession planning explored the issues surrounding one such choice: bequeathing the management firm as an independent entity to be wholly owned and led by a successor generation of firm principals.  This second installment addresses a different decision that a founder nearing retirement might make: selling the founder’s stake in the firm to an outside investor.  More specifically, this article touches on the following topics: reasons for selling a firm, finding a buyer, valuation issues, franchise protection (including strategies for retaining key employees), control rights (including veto rights), future rights to increase or decrease ownership (including exit opportunities for the remaining principals), fund documentation issues, other legal issues and investor relations issues.  In certain respects, these alternative choices have similar consequences and raise similar issues because each path is a way to institutionalize the manager’s business in conjunction with the founder’s exit.  Valuation of the founder’s interest, for example, will be a central concern in each scenario.  Post-closing retention incentives for the manager’s remaining talent is also a common theme, as are investor relations and fund documentation issues.  In other respects, however, a sale transaction differs significantly from an internal succession.  In the sale context, grooming and making visible a new internal leadership generation may not be as important; valuation will be negotiated with a third party and may be AUM-centric; and arrangements regarding post-closing control and ownership rights between the buyer and the remaining principals will loom large.  The authors of this article series are Scott C. Budlong, William Q. Orbe and Kenneth E. Werner, all partners Richards Kibbe & Orbe LLP.

Hedge Fund Tax Experts Discuss Allocations of Gains and Losses, Contributions to and Distributions of Property from a Fund, Expense Pass-Throughs and K-1 Preparation at FRA/HFBOA Seminar (Part One of Four)

Most U.S.-domiciled hedge funds are organized as partnerships for tax purposes, which gives them flexibility in structuring the economic terms of investments in a fund, including through the allocation of gains and losses.  Fund income, expenses, gains and losses are allocated to investors periodically and passed through to them annually on Schedule K-1 of the fund’s partnership tax return.  Those allocations and contributions of property to, and distributions of property from, partnerships have important tax ramifications for fund investors.  Against this backdrop, three presentations during the 15th Annual Effective Hedge Fund Tax Practices seminar, co-hosted by Financial Research Associates and the Hedge Fund Business Operations Association, covered the fundamentals of the tax treatment of partnership contributions and distributions, special rules on deductibility of fund expenses and the allocation of fund gains and losses, as well as how those items will be reflected on the Form K-1 delivered by a fund to its investors.  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).  This article summarizes the key lessons from those three presentations.

Stroock Seminar Identifies Five Strategies for Mitigating the Risk of Supervisory Liability for Hedge Fund Manager CCOs

Law firm Stroock & Stroock & Lavan LLP (Stroock) recently hosted a seminar on liability risk confronting chief compliance officers (CCOs) at hedge fund management companies.  Panelists addressed lessons learned from recent enforcement actions involving CCO liability; the impact of the SEC’s recently-published frequently asked questions (FAQs) addressing supervisory liability of fund manager CCOs; and best practices that CCOs can implement to mitigate liability risk.  See “What Do the SEC’s Recently Released FAQs on Supervisory Liability Mean for Legal and Compliance Personnel at Broker-Dealers and Hedge Fund Managers?” Hedge Fund Law Report, Vol. 6, No. 41 (Oct. 25, 2013).  The panelists included Stroock partner Robert E. Plaze, who previously served as Deputy Director of the SEC’s Division of Investment Management; Stroock partner Tram N. Nguyen, who previously served as Branch Chief of the Private Funds Branch within the Division of Investment Management; William Braverman, general counsel (GC) of asset management and managing director at Neuberger Berman Group LLC; and Ronen Voloshin, associate general counsel and CCO at Monarch Alternative Capital LP.  This article discusses the salient points raised during the seminar and describes the five strategies identified by panelists for mitigating the risk of supervisory liability for manager CCOs.

Aksia’s 2014 Hedge Fund Manager Survey Reveals Manager Perspectives on Economic Conditions, Derivatives Trading, Counterparty Risk, Financing Trends, Capital Raising, Performance, Transparency and Fees

Aksia LLC (Aksia), a specialist hedge fund research and portfolio advisory firm, recently released the results of its 2014 Hedge Fund Manager Survey (Survey).  This third annual survey solicited hedge fund managers’ views on topics in three principal areas: The state of the economy and the broader market; the state of the hedge fund industry (particularly with respect to counterparty risk and central clearing, fund financing and capital raising); and hedge fund investor concerns with regard to performance, transparency and fees.  The Survey also drew insights on trends by comparing this year’s responses to those from Aksia’s first two surveys.  See “Aksia Survey Reveals Hedge Fund Managers’ Perspectives on AUM Composition, Fees, Liquidity, Advertising Practices, Transparency, Reporting and High-Frequency Trading,” Hedge Fund Law Report, Vol. 6, No. 3 (Jan. 17, 2013); and “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).

GLG Partners Settlement Illustrates SEC Views Regarding Valuation Controls at Hedge Fund Managers

On December 12, 2013, the SEC issued an order instituting settled administrative proceedings against publicly-traded investment firm GLG Partners, Inc. (GPI) and its investment adviser subsidiary GLG Partners, L.P. (GLG).  The SEC charged GLG with violating various provisions of the Securities Exchange Act of 1934 (Exchange Act) because, among other things, it allegedly had deficient internal controls relating to valuation of assets.  The settlement (which arose out of the SEC’s aberrational performance inquiry) is explicitly relevant to investment managers required to report under the Exchange Act, and implicitly relevant to other investment managers (whether or not they report under the Exchange Act) as an illustration of the SEC’s views regarding internal controls around valuation.  For a discussion of related recent enforcement activity, see “SEC’s Recent Settlement with a Hedge Fund Manager Highlights the Importance of Documented Internal Controls when Managing Conflicts of Interest Associated with Asset Valuation and Cross Trades,” Hedge Fund Law Report, Vol. 7, No. 1 (Jan. 9, 2014).  This article summarizes the SEC’s factual and legal allegations levied against GPI and GLG (including a discussion of the deficiencies in the firm’s valuation policies and procedures), as well as the sanctions levied against GPI and GLG.  The article also briefly outlines the potential ramifications of the settlement for hedge fund managers.  For a discussion of valuation best practices, see “DLA Piper Hedge Fund Valuation Webinar Covers Fair Value Methodologies, Valuation Services, Valuing Illiquid Positions and Handling Valuation Inquiries During SEC Examinations,” Hedge Fund Law Report, Vol. 6, No. 31 (Aug. 7, 2013); and “WilmerHale and Deloitte Identify Best Legal and Accounting Practices for Hedge Fund Valuation, Fees and Expenses,” Hedge Fund Law Report, Vol. 6, No. 28 (Jul. 18, 2013).

Jesse Kanach Adds Depth to Perkins Coie’s Investment Management Practice in D.C.

On January 15, 2014, Perkins Coie announced that Jesse P. Kanach has joined the firm’s Washington, D.C. office as partner in its Investment Management Group.  For insight from Kanach, see “How Much Are In-House Hedge Fund Marketers Paid, and How Will Recent Developments in New York City and California Lobbying Laws Impact the Compensation Levels and Structures of In-House Hedge Fund Marketers (Part Three of Three),” Hedge Fund Law Report, Vol. 4, No. 20 (Jun. 17, 2011).

William Campbell Joins I Squared Capital as General Counsel & Chief Compliance Officer

On January 14, 2014, independent global infrastructure investment platform I Squared Capital (ISQ) announced that William “Bill” Campbell, a partner in the New York office of Gibson Dunn & Crutcher and co-chair of the Energy and Infrastructure Practice Group, will be joining ISQ as General Counsel and Chief Compliance Officer, effective February 1, 2014.  See “Benefits, Challenges and Recommendations for Persons Simultaneously Serving as General Counsel and Chief Compliance Officer of a Hedge Fund Manager,” Hedge Fund Law Report, Vol. 5, No. 19 (May 10, 2012).