Oct. 15, 2015

How Hedge Fund Managers Define and Handle Trade Errors in Practice (Part One of Two)

The intricacies of hedge fund trading are rife with opportunities for trade errors to arise.  Hedge fund managers must remain vigilant for situations such as purchases of incorrect amounts of a particular security, inaccurate asset allocations and missed or delayed trades.  Registered investment advisers must also establish a compliance program that includes policies and procedures for addressing trade errors under the Investment Advisers Act of 1940, and the SEC remains interested in trade errors and their resolution when examining hedge fund managers.  However, crafting and executing policies and procedures to address trade errors requires a hedge fund manager to choose from many options.  What should the scope of the policy be?  Who bears responsibility for trade errors and operational procedures under the policy?  These and other questions must be dealt with consistently by the manager.  In an effort to determine industry best practices for addressing trade errors, the Hedge Fund Law Report conducted a survey of hedge fund managers.  This first article in a two-part series presents the results of that survey with respect to the fundamentals of trade error policies and handling trade errors.  The second article will discuss detection of and responsibility for trade errors, as well as other operational considerations.  For more on trade errors, see “Katten Forum Identifies Best Practices for Hedge Fund Managers Regarding Best Execution, Soft Dollars, Principal Trades, Agency Cross Trades, Cross Trades and Trade Errors,” Hedge Fund Law Report, Vol. 7, No. 10 (Mar. 13, 2014); and “How Should Hedge Fund Managers Approach the Identification, Prevention, Detection, Handling and Correction of Trade Errors? (Part One of Three),” Hedge Fund Law Report, Vol. 6, No. 10 (Mar. 7, 2013).

What Hedge Fund Managers Need to Know About Recent SEC Guidance on Substantive, Pre-Existing Relationships and Internet Use

On August 6, 2015, the staff of the SEC’s Corporation Finance Division issued Compliance and Disclosure Interpretations regarding general solicitations under Rule 506 of Regulation D under the Securities Act of 1933.  That guidance may change, endorse or liberalize certain hedge fund practices.  Separately, the SEC granted no-action relief to a firm using online qualification to establish a substantive, pre-existing relationship with an offeree.  Together, the guidance and no-action letter may alter some of the principles within which hedge funds and other private investment funds operate, potentially signifying a liberalization of how the SEC interprets the rules governing private offerings.  In a guest article, Steven M. Felsenthal, general counsel and chief compliance officer of Millburn Ridgefield Corporation, discusses the potential implications of the guidance and the no-action letter on the private investment fund industry.  Felsenthal will speak about marketing and compliance at the Ninth Annual Hedge Fund General Counsel and Compliance Officer Summit, hosted by Corporate Counsel and ALM.  For more information about the Summit, click here.  To register for the Summit, click here, using the HFLR’s promotional code available in this article for a discount of $500 off the registration price.  For additional insight from Felsenthal, see “Further CFTC Harmonization of Rules for Hedge Funds: A Welcome and Continuing Trend,” Hedge Fund Law Report, Vol. 7, No. 35 (Sep. 18, 2014); “What Do the CFTC Harmonization Rules Mean for Non-Mutual Fund Commodity Pools, Including Hedge Funds?,” Hedge Fund Law Report, Vol. 6, No. 40 (Oct. 17, 2013); and “CFTC and SEC Propose Rules to Further Define the Term ‘Eligible Contract Participant’: Why Should Commodity Pool and Hedge Fund Managers Care?,” Hedge Fund Law Report, Vol. 4, No. 21 (Jun. 23, 2011).

Investor Lawsuit Against Lynn Tilton Alleges Misrepresentations and Excessive Fees

A German bank and its affiliate that invested in two collateralized debt obligations (CDOs) sponsored and managed by Lynn Tilton’s firm, Patriarch Partners, have sued Tilton and the collateral managers of those CDOs in New York State Supreme Court for fraud and negligent misrepresentation.  The investors allege that the defendants improperly invested the CDOs’ assets in controlling equity positions in portfolio companies, enabling them to extract “excessive management fees” from those companies and benefit themselves at the expense of their investors.  The plaintiffs, who are seeking damages of more than $45 million, claim that the CDOs were in fact “poorly run and incredibly risky private equity ventures,” rather than traditional CDOs that invested in portfolios of debt.  This article summarizes the factual background of the dispute, the defendants’ alleged misconduct and the investors’ specific claims.  The suit follows the March 2015 SEC enforcement action against Tilton and the collateral managers of three CDOs sponsored by Patriarch Partners.  See “SEC Fraud Charges Against Lynn Tilton, So-Called ‘Diva of Distressed,’ Confirm the Agency’s Focus on Valuation and Conflicts of Interest,” Hedge Fund Law Report, Vol. 8, No. 14 (Apr. 9, 2015).

ESMA Work Programme Provides Hedge Fund Managers with Key Guidance About E.U. Financial Services Legislation

The European Securities and Markets Authority (ESMA) has published its 2016 Work Programme (Program), setting out for hedge fund managers and other market players its key priorities and planned activities in the E.U. financial services arena for next year.  The Program represents the first phase of ESMA’s Strategic Orientation 2016-2020 and sees the supervisory body shift its attention away from rulemaking, toward implementation of the single rulebook and enhancement of supervisory convergence among the various national financial services regulators across Europe.  The Program also highlights for hedge fund managers areas where ESMA will work with international organizations, European regulators and third-country supervisory authorities.  It affords hedge fund managers and other market participants more granular insight into the supervisor’s work plans.  See also “ESMA Chair Highlights Upcoming Focus on Supervisory Convergence,” Hedge Fund Law Report, Vol. 8, No. 38 (Oct. 1, 2015).  In particular, it identifies specific guidance, advice and measures that will be promulgated in the upcoming year under the European financial markets regime that will affect hedge fund managers’ operations, in areas including reporting requirements, clearing obligations and European investment fund legislation.  This article summarizes the key provisions of the Program.  For more on European supervisory initiatives, see “European Regulator Issues Guidance to Market Participants on Penalties for Settlement Failures,” Hedge Fund Law Report, Vol. 8, No. 38 (Oct. 1, 2015); and “European Commissioner Calls for Economic and Regulatory Coordination,” Hedge Fund Law Report, Vol. 8, No. 39 (Oct. 8, 2015).

Appropriately Crafted Disclosure of Conflicts of Interest Can Mitigate the Likelihood of an Enforcement Action Against an Investment Adviser

The SEC recently filed an enforcement action against an investment adviser and its owner for fraud, self-dealing, conflicts of interest and other violations.  Conflicts of interest remain near the top of the SEC’s enforcement agenda.  See, e.g., “SEC’s Rozenblit Discusses Operations and Priorities of the Private Funds Unit,” Hedge Fund Law Report, Vol. 8, No. 37 (Sep. 24, 2015); and “Conflicts Remain an Overarching Concern for the SEC’s Asset Management Unit,” Hedge Fund Law Report, Vol. 8, No. 10 (Mar. 12, 2015).  The SEC charges that the defendants caused clients and funds they managed to invest in companies in which the owner had a financial interest without revealing the interest or the owner’s receipt of compensation from those companies.  It also charges that they engaged in undisclosed principal transactions, diverted client income, ignored investment guidelines, violated the custody rule and failed to update Form ADV.  The SEC seeks an injunction against the defendants, disgorgement of ill-gotten gains and civil penalties.  This article summarizes the SEC’s allegations and claims for relief.  For more on disclosure, see “RCA Panel Discusses Pay to Play Rules, GIPS Compliance, Disclosures, Risk Assessments and ERISA Proposals,” Hedge Fund Law Report, Vol. 8, No. 27 (Jul. 9, 2015).

PwC Benchmarks Alternative Asset Manager Governance Practices

PwC recently completed its 2015 Alternative Asset Manager Benchmarking Survey, which explores key industry metrics in the areas of governance, valuation and fund administration.  As noted by Mike Greenstein, PwC’s U.S. and global alternative asset management leader, “Investor expectations and regulatory requirements have put governance squarely on the agenda of alternative asset managers.”  This article summarizes the results of the governance portion of the survey.  For more on governance, see “DMS Review Highlights Issues with Regulation, Institutionalization and Customization of Hedge Funds,” Hedge Fund Law Report, Vol. 8, No. 20 (May 21, 2015).  For additional commentary from PwC, see “PwC White Paper Explores Hedge Fund Manager M&A Activity,” Hedge Fund Law Report, Vol. 8, No. 29 (Jul. 23, 2015).

K. Susan Grafton Joins Dechert as a Partner in D.C.

Dechert recently announced the expansion of its broker-dealer and investment management practice with the addition of K. Susan Grafton as a partner in Washington, D.C.  Her practice focuses on advising hedge fund managers, broker-dealers and other investment advisers on compliance, regulatory and business issues.  For insight from the firm, see “Dechert Global Alternative Funds Symposium Highlights Trends in Hedge Fund Expense Allocations, Fees, Redemptions and Gates,” Hedge Fund Law Report, Vol. 8, No. 20 (May 21, 2015); and our series from Dechert partner Andrew Oringer: “Happily Ever After? – Investment Funds that Live with ERISA, For Better and For Worse,” Part One, Vol. 7, No. 33 (Sep. 4, 2014); Part Two, Vol. 7, No. 34 (Sep. 11, 2014); Part Three, Vol. 7, No. 35 (Sep. 18, 2014); Part Four, Vol. 7, No. 36 (Sep. 25, 2014); and Part Five, Vol. 7, No. 37 (Oct. 2, 2014).