Oct. 17, 2014

Derivative Actions and Books and Records Demands Involving Hedge Funds

This article explores the use of derivative actions by investors in hedge funds, which investors may bring against hedge fund managers, and explains that where a fund is organized determines whether an investor can maintain a derivative action.  This article also discusses investor requests for books and records relating to a hedge fund, which typically precede an investor’s derivative action.  The authors of this article are Thomas K. Cauley, Jr. and Courtney A. Rosen, both litigation partners in the Chicago office of Sidley Austin LLP.  See also “Contractual Provisions That Matter in Litigation between a Fund Manager and an Investor,” Hedge Fund Law Report, Vol. 7, No. 37 (Oct. 2, 2014).

Identifying and Mitigating the Chief Legal, Regulatory and Operational Risks in Hedge Fund Manager Office Sharing Arrangements (Part One of Three)

Smaller hedge fund managers – those just starting up or accelerating; those courting or deploying seed capital; or those spun out of banks or other managers, for example – typically consider sharing office space with other hedge fund managers.  It’s an arrangement with ample precedent and identifiable business advantages, but with obvious and not-so-obvious legal, regulatory and operational risks.  This article is the first in a three-part series identifying those risks and outlining strategies for minimizing them.  This article defines office sharing, outlines its mechanics and catalogues the four primary business reasons for office sharing by hedge fund managers.  The subsequent articles in the series will focus on legal and regulatory risks, the compliance value of physical barriers, security of paper and electronic files, employee training, selection of office partners, confidentiality and nondisclosure agreements, cybersecurity, allocation of costs and risks, the role of prime brokers in office sharing arrangements and how managers sharing office space should negotiate on-site due diligence visits from institutional investors.  See “Operational Due Diligence from the Hedge Fund Investor Perspective: Deal Breakers, Liquidity, Valuation, Consultants and On-Site Visits,” Hedge Fund Law Report, Vol. 7, No. 16 (Apr. 25, 2014).  Taken together, the articles in this series are intended to provide an issue spotting checklist to smaller hedge fund managers so that such managers can capture the benefits of office sharing while avoiding the pitfalls.  For a related discussion, see “Six Privacy-Related Topics to Be Covered by a Hedge Fund Manager’s Compliance Policies and Procedures (Part Three of Three),” Hedge Fund Law Report, Vol. 7, No. 20 (May 23, 2014).

Ackman’s Pershing Square Public Offering Features Novel Performance Fee Mechanism

Following in the footsteps of other private fund managers who have sought permanent capital through public offerings, activist investor Bill Ackman’s Pershing Square Holdings, Ltd. has raised about $2.7 billion through a recent offering of its shares on Euronext Amsterdam.  Prior to the offering, the company converted into a closed-end investment vehicle; its shareholders will be able to achieve liquidity by selling their shares on that exchange.  This article focuses on the novel approach to the company’s calculation of performance fees and on the tax treatment of the entity and its investors in Guernsey, where it is organized, and the Netherlands, where its shares now trade.  For discussions of other fund managers who have gone to the public markets for permanent capital, see “Anatomy of a Blank Check IPO by a Hedge Fund Manager,” Hedge Fund Law Report, Vol. 7, No. 13 (Apr. 4, 2014); and “Prospectus for Suspended Ellington Financial IPO Details Mechanics of a Hedge Fund Permanent Capital Vehicle,” Hedge Fund Law Report, Vol. 2, No. 50 (Dec. 17, 2009).  Other managers have used public offerings to monetize the value of their businesses, to provide capital for expansion and to create liquidity for founders and employees.  See “Ares Management IPO Raises Permanent Capital and Creates Liquidity for Founders’ Interests,” Hedge Fund Law Report, Vol. 7, No. 14 (Apr. 11, 2014); and “Mechanics of a Hedge Fund Manager IPO,” Hedge Fund Law Report, Vol. 5, No. 16 (Apr. 19, 2012).

Best Practices for Ensuring That Only Accredited Investors Participate in Publicly Advertised Private Offerings by Hedge Funds (Part Two of Two)

In June 2013, under authority delegated to it by Congress in the JOBS Act, the SEC adopted Rule 506(c) under the Securities 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).  Rule 506(c) generally permits hedge fund managers to advertise a private offering while maintaining the offering’s Securities Act Section 4(a)(2) exemption from registration, so long as they, among other things, take reasonable steps to verify that investors in the offering are “accredited.”  See “SEC Provides Guidance on When the Bad Actor Rule Disqualifies Hedge Fund Managers from Generally Soliciting or Advertising,” Hedge Fund Law Report, Vol. 7, No. 9 (Mar. 7, 2014).  Recently, the CFTC issued guidance harmonizing its general solicitation rules with the SEC’s.  See “The Odyssey of Private Fund Advertising: From Great Expectations to Much Ado about Nothing,” Hedge Fund Law Report, Vol. 7, No. 36 (Sep. 25, 2014).  Hedge fund managers have been slow to access the expanded marketing rights under the JOBS Act rules.  See, e.g., “Dan Darchuck of Topturn Capital Discusses the Mechanics and Consequences of Video Advertising by Hedge Fund Managers,” Hedge Fund Law Report, Vol. 7, No 13 (Apr. 4, 2014).  One of the more frequently cited reasons for the industry-wide reluctance is the challenge of verifying the accredited status of investors.  Specifically, Rule 506(c)(2)(ii) contains four safe harbors pursuant to which a hedge fund issuer will be deemed to have taken reasonable steps to verify accredited investor status.  But those safe harbors entail practical obstacles.  To help the broker-dealer and investment management industries overcome those obstacles, the SEC and SIFMA issued guidance on complying with the safe harbors.  See “SEC and SIFMA Offer Additional Guidance on Rule 506(c) Accredited Investor Status,” Hedge Fund Law Report, Vol. 7, No. 30 (Aug. 7, 2014).  At PLI’s recent Hedge Fund Management 2014 program, Sidley Austin partner Thomas J. Kim and Davis Polk partner Nora M. Jordan – both principal drafters of the SIFMA guidance – explained the thinking behind the SIFMA guidance, how the guidance interacts with the Rule 506(c) safe harbors (in particular, the account method test and the investment amount test), how the guidance addresses privacy concerns, the rationale for the guidance’s focus on assets rather than liabilities and the utility of disclaimers in connection with 506(c) offerings.  This article summarizes the main points made by Kim and Jordan.  For the first article in our series covering the same PLI event, see “Davis Polk and Sidley Partners and MFA GC Address the Maze of Hedge Fund Marketing Regulation in the U.S. and E.U. (Part One of Two),” Hedge Fund Law Report, Vol. 7, No. 38 (Oct. 10, 2014).

Practical Guidance for Hedge Fund Managers on Preparing For and Handling NFA Audits

A hedge fund manager may be subject to CFTC jurisdiction and registration as a commodity pool operator (CPO) or commodity trading adviser (CTA) if it uses derivatives or trades in commodities.  See “Do You Need to Be a Registered Commodity Pool Operator Now and What Does It Mean If You Do (Part One of Two),” Hedge Fund Law Report, Vol. 5, No. 8 (Feb. 23, 2012); and Part Two of Two, Vol. 5, No. 19 (May 10, 2012).  A CPO or CTA is required to become a member of the National Futures Association (NFA) and, as such, is subject to NFA rules and regulations and to periodic audits.  In that regard, a recent program reviewed the nuts and bolts of an NFA audit, NFA compliance programs and common audit issues; offered strategies for preparing for and surviving an audit; and summarized recent CFTC guidance that affects CPOs and CTAs.  The program featured Robert V. Cornish, Jr., a partner at Phillips Lytle LLP; Dorothy D. Mehta, a special counsel at Cadwalader, Wickersham & Taft LLP; Deborah A. Monson, a partner at Ropes & Gray, LLP; and Heather Wyckoff, counsel at Haynes & Boone LLP.  See also “NFA Workshop Details the Registration and Regulatory Obligations of Hedge Fund Managers That Trade Commodity Interests,” Hedge Fund Law Report, Vol. 5, No. 47 (Dec. 13, 2012).

Ropes & Gray Enhances Derivatives Capabilities for Hedge Funds Clients with Addition of London Counsel

On October 14, 2014, the London office of Ropes & Gray announced the appointment of counsel Anna Lawry to the firm’s hedge funds group.  For insight from the firm, see “Ropes & Gray Attorneys Discuss Implications for U.S. Hedge Fund Managers of the European Market Infrastructure Regulation,” Hedge Fund Law Report, Vol. 7, No. 27 (Jul. 18, 2014); “Ropes & Gray Attorneys Discuss the Impact on Private Fund Managers of Final Regulations Under the Volcker Rule,” Hedge Fund Law Report, Vol. 7, No. 10 (Mar. 13, 2014).  Lawry will focus her practice on derivatives and will enhance the firm’s current capabilities in this area to serve clients in the U.S., London and across the globe.

Financial Regulatory Lawyer Anna Maleva-Otto Joins SRZ’s London Office

On October 13, 2014, Schulte Roth & Zabel announced the addition of Anna Maleva-Otto as a partner in the Investment Management Regulatory & Compliance Group, resident in the firm’s London office.  For HFLR articles authored by SRZ partners, see “Ten Recommendations to Help Hedge Fund Managers Conduct Successful Internal Investigations,” Hedge Fund Law Report, Vol. 6, No. 9 (Feb. 28, 2013); and “Hedge Fund Names: What a Hedge Fund Manager Should Do Before It Starts Using a Name,” Hedge Fund Law Report, Vol. 5, No. 11 (Mar. 16, 2012).  For additional insight from SRZ partners, see “Hedge Fund Industry Experts Discuss Presence Examinations Priorities, SEC Investigations and How an Admission in an SEC Settlement May Affect Insurance Coverage,” Hedge Fund Law Report, Vol. 7, No. 26 (Jul. 11, 2014); and “Can Activist Hedge Fund Managers Provide Special Compensation to Nominees That Are Elected to the Board of a Target? An Interview with Marc Weingarten, Co-Head of the Global Shareholder Activism Practice at Schulte Roth & Zabel,” Hedge Fund Law Report, Vol. 7, No. 16 (Apr. 25, 2014).  Maleva-Otto previously served as in-house counsel and compliance officer of a hedge fund manager.  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).