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    Jan. 23, 2014

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

This is the second article in the Hedge Fund Law Report’s four-part series on information barriers in the hedge fund context.  Generally, the series explores why hedge fund managers might wish to implement information barriers and identifies best practices for doing so.  Specifically, this second article discusses the legal and regulatory basis for information barriers and describes the building blocks of effective information barriers (including the key players, physical components and technological processes).  The first article provided an overview of various insider trading controls, including restricted lists, watch lists and information barriers, explaining how they can work together; described four principal benefits available from the use of robust information barriers; highlighted the types of firms that can benefit most from the implementation of information barriers; and described the types of firms that will find the implementation of robust information barriers most challenging.  See “How Can Hedge Fund Managers Structure, Implement and Enforce Information Barriers to Mitigate Insider Trading Risk Without Impairing Securities Trading?  (Part One of Four),” Hedge Fund Law Report, Vol. 7, No. 2 (Jan. 16, 2014).  The third article will describe how a firm can limit access to material nonpublic information within the information barrier control environment and outline policies and procedures designed to bolster the effectiveness of information barriers.  And the fourth article 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.

Tax Experts Discuss Provisions Impacting Foreign Investors in Foreign Hedge Funds During FRA/HFBOA Seminar (Part Two of Four)

Offshore hedge funds, whether structured as corporations or partnerships, are subject to the provisions of the U.S. Internal Revenue Code (IRC) that govern taxation of nonresident aliens and foreign entities.  Generally, a foreign person is subject to U.S. taxation on its U.S.-source income.  Taxable U.S.-source income generally falls into two categories: (1) effectively connected income (ECI), which is income earned in connection with a U.S. trade or business, and (2) “fixed or determinable annual or periodic gains, profits, or income” (FDAPI).  ECI is subject to U.S. taxation in the same manner as income earned by U.S. citizens and residents: recipients are required to file U.S. tax returns.  In contrast, IRC Sections 1441, 1442 and 1443 provide for taxation of FDAPI that is not ECI, and that is payable to foreign individuals, corporations and tax-exempt entities, at the flat rate of 30% of the gross amount payable (or lower treaty rate, if applicable).  The 30% tax must be withheld at the source (i.e., by the payer).  This second installment in our series covering the 15th Annual Effective Hedge Fund Tax Practices seminar, sponsored by Financial Research Associates and the Hedge Fund Business Operations Association, summarizes key lessons learned from a session entitled “Handling Issues Relative to Inbound Tax Matters.”  That session outlined the basics of withholding with respect to FDAPI; the portfolio interest exemption from FDAPI withholding; the pitfalls of ECI for offshore hedge funds; and the sources of ECI.  The speakers included Jill E. Darrow, Partner and head of the New York tax practice of Katten Muchin Rosenman LLP.  The first installment covered three sessions addressing the contribution and distribution of property to fund investors, the allocation of investment gains and losses to fund investors and the preparation of Forms K-1.  See “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),” Hedge Fund Law Report, Vol. 7, No. 2 (Jan. 16, 2014).

Federal Court Decision Narrows the Scope of Attorney-Client Privilege Available to Hedge Fund Managers in Internal Investigations

A recent federal court decision limited the application of the “selective waiver” doctrine of attorney-client privilege and work product protection in internal investigations conducted by hedge fund managers.  See “Six Recommendations for Hedge Fund Managers Seeking to Protect Themselves from Waiver of Attorney-Client Privilege When Faced With SEC Document Requests,” Hedge Fund Law Report, Vol. 6, No. 3 (Jan. 17, 2013).  This article discusses the factual background of the case, related court decisions and the court’s legal analysis.  This article also restates the salient points from a law firm memorandum on how the decision should inform the approach of hedge fund managers to internal investigations and interactions with regulators.  For more on preserving privilege during internal investigations, see “Ten Recommendations to Help Hedge Fund Managers Conduct Successful Internal Investigations,” Hedge Fund Law Report, Vol. 6, No. 9 (Feb. 28, 2013).

SEC Excuses a Hedge Fund Manager’s Inadvertent Violation of the Pay to Play Rule

The SEC recently issued an exemptive order pursuant to Section 206A of the Investment Advisers Act of 1940 (Advisers Act) and Rule 206(4)-5(e) thereunder in response to an application by a hedge fund manager to excuse its inadvertent violation of the so-called “pay to play” rule, codified as Rule 206(4)-5 under the Advisers Act.  See “How Can Hedge Fund Managers Participate in the Political Process without Violating Pay to Play Regulations at the Federal, State, Municipal or Fund Level?,” Hedge Fund Law Report, Vol. 4, No. 35 (Oct. 6, 2011).  This article covers the legal and factual background of the firm’s application, as well as the SEC’s rationale for granting an exemptive order.  The exemptive order and application provide guidance for similarly-situated hedge fund managers on addressing inadvertent violations of the pay to play rule via SEC relief.  The order also clarifies the application of the pay to play rule to donations to state officials running for federal office.  See “Five Best Practices for Avoidance of Pay to Play Violations by Hedge Fund Managers or Their Covered Associates,” Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011).

Deutsche Bank Survey Describes the Contours of the Nontraditional Hedge Fund Product Market: Investor Appetite, Performance, Marketing, Fees and More

Deutsche Bank Markets Prime Finance (DB) recently released a report detailing the results of its fall 2013 survey of hedge fund managers and investors on the market for non-traditional hedge fund products (NTPs) offered by hedge fund managers, including long-only products, alternative mutual funds and UCITS funds.  The report offered a glimpse into how many hedge fund managers are offering such products; sources of investors and their rationale for investing; relative performance; investor demand; and fee structures and levels.  With NTPs capturing a growing proportion of the assets generally committed to “alternative” strategies, an appreciation of the evolving dynamics of the NTP market can be important to hedge fund managers as they innovate, market and grow.  This article summarizes the key takeaways from the survey.  See also “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); “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).

Understanding U.S. Public Pension Plan Delegation of Investment Decision-Making to Internal and External Investment Managers (Part One of Three)

As U.S. pension plans increasingly represent an important and sticky source of assets for hedge fund managers, it is imperative for managers to understand the evolution of pension plan organization and management as well as the legal obligations borne by pension plan trustees when delegating investment decision-making to, among others, hedge fund managers.  Understanding these parameters of prudent delegation can help managers respond more effectively to the needs of pension plans and their trustees, which will be essential in their quest to raise and retain capital from such pension plans.  To aid in this understanding, we are publishing this three-part series addressing the evolution of U.S. pension plan management and governance.  Part one highlights how growth of public pension plans and fundamental legal or regulatory change, when combined with increasing pension portfolio complexity and the current underfunded status of most U.S. public pension plans, will be the forces defining pension evolution in the twenty-first century.  For the reader’s reference, part one also includes, as Appendix A, an explanation of why the growth of public pension plans and fundamental legal or regulatory change impacted pension plan evolution through the twentieth century.  Part two will describe the current governance structures of today’s public pension, focusing on the board of trustees and pension staff; briefly review current governance research about public pension trustees, and the importance of both adequate staff infrastructure and effective delegation as features of good governance; and explain the new delegation rule and why it should be a key element of long-term organizational change within the U.S. pension system.  Part three will focus on what the next phase of pension evolution may look like and also highlight at least how, in one area, governance research can be developed to be a true value-added tool for public pension plans and their trustees, potentially guiding the design of their governance structures and investment infrastructures.  The author of this series is Von M. Hughes, a Managing Director at Pacific Alternative Asset Management Company, LLC.

Official from SEC’s Asset Management Unit Joins Latham & Watkins in Chicago

On January 21, 2014, Latham & Watkins LLP announced that John Sikora has joined the firm’s Chicago office as a partner in the Litigation Department.  Sikora joins Latham from the SEC, where his tenure included service in the Asset Management Unit of the Enforcement Division, a national specialized unit that focuses on misconduct by investment advisers, investment companies and private funds.

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