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    Jul. 30, 2015

The Use of Benchmarks to Measure Hedge Fund Performance by Pension Funds and Institutional Investors (Part One of Two)

While mutual funds are required to identify a benchmark and state performance over certain timeframes and against certain indices, hedge funds are not legally required to do so.  As such, hedge fund managers typically do not benchmark their performance.  However, pension funds and other institutional investors may assess hedge fund returns, either explicitly or implicitly, in light of a benchmark.  This first article in our two-part series discusses the use of benchmarks as a performance measure, exploring if, and how, pension funds and institutional investors evaluate hedge fund performance against a benchmark.  The second article will discuss the practical consequences of subjecting hedge funds to performance benchmarks; consider whether such a practice could shift the performance emphasis of hedge funds away from absolute returns toward a focus on benchmarked results; and analyze the parameters surrounding the use of benchmarks for evaluating hedge funds.  For discussion of another method of performance measurement, see “Common Practices, Benefits and Drawbacks for Hedge Fund Managers of Using Target Returns (Part One of Two),” Hedge Fund Law Report, Vol. 8, No. 16 (Apr. 23, 2015).

Commissioner Gallagher’s Dissent in SEC Enforcement Action Against Hedge Fund Manager Misses the Mark

On June 18, 2015, SEC Commissioner Daniel Gallagher took the unusual step of publishing a statement explaining why he had voted against two proposed settlements for enforcement cases against investment advisers, each of which alleged fairly serious violations of the federal securities laws.  See “SEC Commissioner Speaks Out Against Trend Toward Strict Liability for Compliance Personnel,” Hedge Fund Law Report, Vol. 8, No. 25 (Jun. 25, 2015).  Gallagher did not seem to be moved by these violations.  He was, however, deeply troubled that the SEC’s Enforcement Division sought to hold both firms’ chief compliance officers responsible under Rule 206(4)-7, the so called “Compliance Rule” under the Investment Advisers Act of 1940.  In a guest article, Robert E. Plaze, a partner at Stroock & Stroock & Lavan, analyzes Gallagher’s statement; addresses the more interesting case of the two settlements Gallagher voted against; and discusses Gallagher’s criticisms of Rule 206(4)-7.  For additional insight from Plaze, see “Stroock Seminar Identifies Five Strategies for Mitigating the Risk of Supervisory Liability for Hedge Fund Manager CCOs,” Hedge Fund Law Report, Vol. 7, No. 2 (Jan. 16, 2014).  For more from Stroock, see “Aligning Employee and Investor Interests Under the Volcker Rule,” Hedge Fund Law Report, Vol. 7, No. 21 (Jun. 2, 2014); and “How Can Offshore Hedge Funds Ensure That Section 10(b) Will Apply to Their Transactions in Securities Not Listed on U.S. Exchanges?,” Hedge Fund Law Report, Vol. 5, No. 13 (Mar. 29, 2012).

Seward & Kissel Private Funds Forum Highlights Key Trends in Fund Structures (Part Two of Two)

As hedge fund managers adapt to changes in the marketplace, they are employing special fund vehicles, such as pledge funds, activist funds and alternative mutual funds, in order to take advantage of special opportunities.  During the recent Seward & Kissel Private Funds Forum, panelists discussed these and other hedge fund industry trends with respect to fund structuring and capital raising.  This article, the second of a two-part series, explores how hedge fund managers are employing such fund structures and strategies.  The first article highlighted current trends in seeding arrangements and fee terms, and examined the impact of ERISA and tax considerations on hedge fund structuring.  For additional insight from the firm, see “The First Steps to Take When Joining the Rush to Offer Registered Liquid Alternative Funds,” Hedge Fund Law Report, Vol. 7, No. 42 (Nov. 6, 2014); and “Private Investment Funds Investing in CLO Equity and CLO Warehouse Facilities,” Hedge Fund Law Report, Vol. 7, No. 18 (May 8, 2014).

Employees of Hedge Fund Managers May Be Liable for Failing to Prevent Fraud

An investment management firm, along with its affiliate, has filed a claim against its former chief financial officer (CFO), who unwittingly disclosed the firm’s online banking security details to a fraudulent caller, enabling illegitimate transfers from the firm’s bank accounts.  The investment management firm claims that the CFO acted negligently and in breach of his contractual, tortious and fiduciary duties in failing to protect assets in corporate bank accounts.  The CFO, who believed he was providing security details to a member of the anti-fraud team of the investment manager’s private bank, denies failing to uphold the required standard of care, asserting that he was acting honestly, in what he reasonably and genuinely believed to be the best interests of his employer.  This article examines the allegations in the claim, as well as the rebuttals raised by the CFO in his defense.  In addition, the claim raises a number of questions and brings to the fore various issues of relevance to hedge fund managers and their staff, which are discussed in this article.  For another case where employees of a hedge fund manager were held liable for fraudulent actions, see “U.K. Appellate Court Holds That Hedge Fund Manager Employees May Be Personally Liable for Unreasonably Relying on the Representations of a Hedge Fund Manager Principal Regarding Performance and Portfolio Composition,” Hedge Fund Law Report, Vol. 6, No. 9 (Feb. 28, 2013).

Second Circuit Rules on Whether Repo Clients of Broker-Dealers Are “Customers” Under SIPA

In 2008, Lehman Brothers, Inc. (Lehman) entered into a liquidation proceeding in the U.S. Bankruptcy Court for the Southern District of New York, in accordance with the Securities Investor Protection Act (SIPA).  A number of banks that had sold securities to Lehman under various repurchase agreements (repos) filed claims in the proceeding seeking to be treated as “customers” of Lehman, which would have given them priority claims in respect of the securities covered by the repos.  Lehman’s bankruptcy trustee determined that the banks were not “customers” within the meaning of SIPA.  Both the Bankruptcy Court and the U.S. District Court for the Southern District of New York affirmed the trustee’s determination.  See “U.S. District Court Rules on Whether a Party to a Repurchase Agreement with a Broker-Dealer That Enters Liquidation Is a ‘Customer’ of the Broker-Dealer under SIPA,” Hedge Fund Law Report, Vol. 7, No. 18 (May 8, 2014).  In what is likely to be the last judicial word on the subject, the U.S. Court of Appeals for the Second Circuit recently ruled on the District Court’s decision.  This article summarizes the facts and circumstances surrounding the Lehman repos; examines the Second Circuit’s legal reasoning; and discusses possible implications of the decision on the hedge fund industry as a whole.  For coverage of a dispute over “customer” status in a liquidation of a futures commission merchant, see “Bankruptcy Court Rules on Whether Funds Held by Bankrupt Futures Commission Merchant for Retail Forex and OTC Metals Trading Are ‘Customer Property’ Entitled to Priority Distribution,” Hedge Fund Law Report, Vol. 7, No. 20 (May 23, 2014).

Citi Survey Examines Evolution of Portfolio Construction and the Role of Hedge Funds in Institutional Portfolios (Part One of Three)

During the past 50 years, portfolio construction for institutional investors has evolved, growing from a basic split between equities and bonds to more complex allocations to a diverse group of investments.  In its sixth annual asset management Industry Evolution Report, Citi Business Advisory Services (Citi) tracks this evolution and examines the recent development of numerous “convergence products” available to investors and fund managers that, according to Citi, have “blurred the lines between distinct asset manager, hedge fund and private equity product sets.”  This article, the first in a three-part series, discusses the methodology employed by Citi in conducting its survey; explores the evolution of modern portfolio theory; examines portfolio weaknesses exposed by the global financial crisis; and reviews the alignment by investors of their portfolios to certain risk factors.  The second article will address Citi’s assessment of the adaptation of products by investment managers to investors’ needs and the evolution of hedge funds following the global financial crisis.  The third article will explore how asset managers may tailor their product offerings and marketing efforts to meet the evolving needs of institutional investors and how they may offer “institutional” portfolio construction to retail investors.  For coverage of Citi’s 2014 survey, see “Citi Survey Highlights Opportunities for Hedge Fund Managers as Institutional Investors Seek to Optimize Their Portfolios (Part One of Two),” Hedge Fund Law Report, Vol. 7, No. 22 (Jun. 6, 2014).

Investment Funds Partner to Rejoin O’Melveny in London

O’Melveny & Myers has announced that Eve Ellis will return to the firm’s London office as a partner in the investment funds practice group.  An O’Melveny alumna, Ellis regularly advises clients on AIFMD; the need for regulatory approval; compliance with regulators’ rules; anti-money laundering issues; and marketing of financial products.  For commentary from the firm, see “O’Melveny & Myers Partners Dean Collins and James Ford Discuss the Rationale, Mechanics and Common Terms for Secondary Market Sales of Private Equity Fund Interests,” Hedge Fund Law Report, Vol. 6, No. 15 (Apr. 11, 2013). 

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