Aug. 27, 2015

Tax Regulators Attack Hedge Fund Manager Efforts to Disguise Management Fees (Part One of Two)

Tax regulators in the United States and United Kingdom are attacking arrangements in which hedge fund managers and other private investment fund managers receive interests in funds in exchange for waiving management fees – or otherwise disguise fixed management fees – thereby deferring recognition of income and changing its character.  The IRS recently issued a notice of proposed rulemaking (Notice) that will treat such arrangements as “disguised payments for services,” resulting in immediate ordinary income for the manager or general partner that waives the fee.  Some fund sponsors will need to alter their current and future fee waivers to avoid this outcome, and they may need to act quickly because the Notice indicates that the IRS believes this reflects current law.  In a guest article, the first in a two-part series, George J. Schutzer and Timothy Jarvis of Squire Patton Boggs describe common management fee waiver provisions and explain how the U.S. proposals would limit fee waivers that would be respected for tax purposes.  The second article in the series will describe similar proposed actions in the U.K. and suggest steps for hedge fund managers and others to take in response to the rules in place and the proposed new rules in the U.S. and the U.K.  For more on tax proposals that could affect hedge fund managers and their employees, see “Tax Proposals and Tax Reforms May Affect Rates and Impose Liabilities on Hedge Fund Managers,” Hedge Fund Law Report, Vol. 8, No. 15 (Apr. 16, 2015); and “U.K. Disguised Fee Rules May Result in Increased U.K. Taxation of Investment Fees to Individuals Affiliated with Hedge Fund Managers (Part One of Two),” Hedge Fund Law Report, Vol. 8, No. 15 (Apr. 16, 2015).

Establishing a Hedge Fund Manager in Seventeen Steps

Wall Street traders often consider leaving large investment houses to launch their own hedge funds.  They have built solid track records; made money for their firms and clients; and figure it’s time to be their own bosses and take the show on the road.  What these emerging managers may not understand, however, is that running a hedge fund means overseeing a full-service business, not just a trading strategy.  While the trading strategy is very important and generating returns is paramount, there is much more to consider when establishing and sustaining a successful hedge fund operation.  In this guest article, Marni Pankin of Marcum provides a checklist for emerging managers to follow when launching a hedge fund in order to meet various operational, accounting, compliance and regulatory requirements.  In a companion article to be published in a forthcoming issue of the HFLR, Vinod Paul of Eze Castle Integration will discuss technology and infrastructure considerations applicable to emerging hedge fund managers.  For more insight from Marcum, see “Prime Broker Merlin Securities Develops Spectrum of Hedge Fund Investors; Event Hosted by Accounting Firm Marcum LLP Examines Marketing Implications of the Merlin Spectrum,” Hedge Fund Law Report, Vol. 3, No. 39 (Oct. 8, 2010).  For more on emerging managers, see “Key Accounting and Legal Hurdles in Starting a Hedge Fund Management Business, and How to Surmount Them,” Hedge Fund Law Report, Vol. 7, No. 18 (May 8, 2014).

U.K. Treasury Proposes Limited Partnership Reforms to Boost Competitiveness of Private Fund Structures

HM Treasury recently published proposals to reform partnership legislation to ensure that the U.K. limited partnership structure remains the vehicle of choice for European private equity, venture capital and other types of U.K.-domiciled private funds.  Technical changes to the partnership legislation applicable to private funds are proposed to be made by means of a legislative reform order, intended to remove unnecessary legal complexity and administrative burdens for both limited partnership managers and investors.  The reforms broadly address registration; ongoing notification requirements; capital contributions; limited partners’ rights and actions; wind-downs; and striking-off in relation to private fund limited partnerships.  This article reviews the reasons for the proposed reforms and sets out the specific amendments encapsulated in the draft order and accompanying consultation paper.  For more on private equity, see “Dechert Global Alternative Funds Symposium Highlights Portfolio Management and Global Trends for Private Equity and Real Estate Funds,” Hedge Fund Law Report, Vol. 8, No. 26 (Jul. 2, 2015); and “How to Mitigate Conflicts Arising Out of Simultaneous Management of Hedge Funds and Private Equity Funds (Part Three of Three),” Hedge Fund Law Report, Vol. 8, No. 20 (May 21, 2015).  For discussions regarding other European fund structures, see “Tax, Legal and Operational Advantages of the Irish Collective Asset-Management Vehicle Structure for Hedge Funds,” Hedge Fund Law Report, Vol. 8, No. 32 (Aug. 13, 2015); and “How Can Hedge Fund Managers Use Luxembourg Funds to Access Investors and Investments in Europe, Asia and Latin America?,” Hedge Fund Law Report, Vol. 5, No. 27 (Jul. 12, 2012). 

Failure to Regularly Audit Compliance and Surveillance Systems May Carry Significant Consequences

As hedge fund trading becomes more complex and reliant on technology, it is incumbent upon investment advisers and broker-dealers to ensure that their compliance systems are able to adequately and accurately monitor such technology and trading.  The SEC recently settled an enforcement action with a registered investment adviser and broker-dealer arising from compliance and surveillance failures involving technological errors that, in some cases, remained undetected for years.  As a result of these failures, the entity in question violated provisions of the federal securities laws relating to trade surveillance and its policies and procedures regarding principal transactions.  This article summarizes the SEC order against, and settlement with, the investment adviser and broker-dealer, including the violations alleged in, as well as the lessons to be learned from, the action.  For another recent SEC enforcement action relating to inaccurate reports resulting from persistent operational issues, see “SEC Settlement Suggests that Hedge Fund Managers Have Responsibility for Counterparties’ Reporting Obligations,” Hedge Fund Law Report, Vol. 8, No. 29 (Jul. 23, 2015).  For discussion of similar enforcement actions, see “SEC Summary Judgment Emphasizes the Importance of Disclosure of and Client Consent to Cross Trades and Principal Transactions,” Hedge Fund Law Report, Vol. 8, No. 15 (Apr. 16, 2015); and “Two Recent Enforcement Actions Elucidate the SEC’s Perspective on Principal Transactions,” Hedge Fund Law Report, Vol. 7, No. 40 (Oct. 24, 2014).

SEC Settlement with Investment Adviser Highlights Perils of Undisclosed Conflicts of Interest

As evidence of its continuing focus on conflicts of interest and their proper disclosure, the SEC recently settled an enforcement action with a registered investment adviser.  See “Conflicts Remain an Overarching Concern for the SEC’s Asset Management Unit,” Hedge Fund Law Report, Vol. 8, No. 10 (Mar. 12, 2015).  A client of the investment adviser made a significant loan to one of the adviser’s executives.  The investment adviser subsequently entered into several transactions that involved the client/lender and other advisory clients without disclosing the existence of that loan to the other clients.  This article summarizes the transactions that gave rise to the SEC’s enforcement action, the investment adviser’s alleged violations and the outcome of the action.  For an overview of the types of conflicts of interest faced by hedge fund managers, see “Identifying and Addressing the Primary Conflicts of Interest in the Hedge Fund Management Business,” Hedge Fund Law Report, Vol. 6, No. 3 (Jan. 17, 2013).  For discussion of a recent enforcement action involving potential conflicts of interests created by the private business interests of a portfolio manager, see “SEC Settlement Highlights Circumstances in Which Hedge Fund Managers Must Disclose Conflicts of Interest,” Hedge Fund Law Report, Vol. 8, No. 16 (Apr. 23, 2015).  Although this matter involved a loan from an adviser’s client to an executive of the adviser, a more common conflict of interest arises when a fund makes a loan to one of its principals; see, e.g., “Important Implications and Recommendations for Hedge Fund Managers in the Aftermath of the SEC’s Settlement with Philip A. Falcone and Harbinger Entities,” Hedge Fund Law Report, Vol. 6, No. 33 (Aug. 22, 2013).

Credit Suisse Survey Evaluates Investor Appetite for Alternative Investment Vehicles and Strategy Preferences

Credit Suisse Capital Services (CS) recently released the results of its 2015 “Mid-Year Survey of Hedge Fund Investor Sentiment” (Survey).  CS considers the Survey to be an extension of its more comprehensive annual survey.  The Survey gathered investor preferences for a variety of alternative investment vehicles in addition to the traditional master-feeder hedge fund structure, comparing investors allocations in the first half of 2014 with their allocation plans for the second half of the year.  It also analyzed investor appetite for various investment strategies.  This article summarizes the key takeaways from the Survey.  For coverage of prior surveys, see “Credit Suisse Hedge Fund Survey Considers Factors in Institutional Investors’ Investment and Redemption Decisions, Appetite for Alternative UCITS and Anticipated 2015 Hedge Fund Investments by Strategy and Region,” Hedge Fund Law Report, Vol. 8, No. 12 (Mar. 27, 2015); and “Credit Suisse Survey Reveals Allocation Preferences of Hedge Fund Investors, With Particular Attention on Preferences of Pension Funds and Insurance Companies,” Hedge Fund Law Report, Vol. 6, No. 11 (Mar. 14, 2013).

Reed Smith Financial Industry Group Adds Matthew J. Bromberg in New York

On August 25, 2015, Reed Smith announced the addition of Matthew J. Bromberg as a partner in its financial industry group.  A former managing director and senior managing counsel in the investment servicing division of The Bank of New York Mellon, Bromberg will practice out of the firm’s New York office.  Bromberg focuses his practice on advising mutual fund, exchange traded fund and private fund clients, as well as the investment advisers and sponsors to funds and managed account platforms.  See “Considerations for Hedge Fund Managers Looking to Join Managed Account Platforms (Part Two of Two),” Hedge Fund Law Report, Vol. 5, No. 31 (Aug. 9, 2012). 

Jennifer Parsons Joins Mourant Ozannes in the Cayman Islands

Mourant Ozannes recently announced that Jennifer Parsons has joined the firm as counsel.  Based in the Cayman Islands office, she will join the corporate and investment funds practices.  Parsons’ primary focus and experience has been in investment funds; securities investment business; and corporate and commercial work.  For insight from the firm, see “The Cayman Islands Weavering Decision One Year Later: Reflections by Weavering’s Counsel and One of the Joint Liquidators,” Hedge Fund Law Report, Vol. 5, No. 36 (Sep. 20, 2012); and “Cayman Islands Developments Impacting Fund Governance, Master Fund Registration and the Insolvency Regime: An Interview with Neal Lomax, Simon Dickson and Simon Thomas of Mourant Ozannes,” Hedge Fund Law Report, Vol. 5, No. 23 (Jun. 8, 2012).