Jan. 28, 2016

Going Private: Operational Considerations When Closing a Hedge Fund to Outside Investors (Part Two of Three)

Hedge fund managers weigh the decision to return outside capital and transition to a family office or other private investment structure in order to free themselves from investor burdens, gain performance advantages or reduce regulatory obligations. However, taking a hedge fund private may not be the panacea that it first appears, as ongoing regulatory obligations persist despite the lack of outside investors in the converted vehicle. See “Benefits and Burdens for Hedge Fund Managers in Establishing or Converting to a Family Office” (Jun. 6, 2014); and “Staff of SEC Division of Investment Management Clarifies the Scope of the Family Office Rule” (Feb. 9, 2012). This article, the second in a three-part series, examines the operational considerations a hedge fund manager faces when converting its hedge fund, including ongoing regulatory obligations and staffing concerns. The first article explored the “going private” trend and the factors a hedge fund manager should consider when deciding whether to convert a hedge fund, as well as the options available once that decision has been made. The third article will detail the mechanics for taking a hedge fund private, including redemption of outside investors and costs of conversion.

The New Section 871(m) Regulations: Issues With the Expanding Scope of Withholding Law Applicable to Non-U.S. Hedge Funds (Part Two of Two)

Most non-U.S. hedge funds take precautions to avoid engaging in a U.S. trade or business; otherwise, they are subject to U.S. federal income tax on net income that is effectively connected with that U.S. trade or business. However, all funds that invest in U.S. debt and equity – as well as in derivatives that reference U.S. debt and equity – may be subject to a 30% withholding tax on gross payments of U.S.-sourced fixed, determinable, annual or periodic income (FDAP). In this two-part series, John Kaufmann of Greenberg Traurig discusses certain ways in which final and temporary regulations recently promulgated under Internal Revenue Code Section 871(m) increase the scope of FDAP withholding, and lists traps for the unwary created by these regulations. This second article explains the scope of the new regulations and the potential complications that they have created. The first article discussed the current law and the issues that the new regulations are intended to address. For additional commentary from the firm, see our series on “Investment Opt-Out Rights for Hedge Fund Investors”: Part One (Nov. 8, 2013); Part Two (Nov. 14, 2013); and Part Three (Nov. 21, 2013).

Hedge Fund Managers Advised to Prepare for Imminent SEC Examination

As it pursues its “broken windows” approach to enforcement, the SEC has filed a record number of actions against hedge fund managers and investment advisers. Faced with this increased regulatory scrutiny, managers – both emerging and established – need to be cognizant of and prepared for aggressive inspection by regulators, as well as possible enforcement action. Among other topics, speakers at the annual Sadis & Goldberg Alternative Investment Seminar addressed the issue of increased regulatory scrutiny and how hedge fund managers can prepare for SEC examinations and investigations. This article summarizes the salient points made during the discussion. For more from Sadis & Goldberg, see “Practitioners Discuss U.S. and Canadian Shareholder Activism and Activist Tools” (Dec. 4, 2014); and “Tax Efficient Hedge Fund Structuring in Anticipation of the New 3.8% Surtax on Net Investment Income and Proposals to Limit Individuals’ Tax Deductions” (Oct. 18, 2012).

Adhering to Disclosed Fee and Valuation Methodologies Is Crucial for Hedge Fund Managers to Avert Enforcement Action

The SEC continues to focus on the fee and valuation practices of investment advisers. See “Current and Former SEC, DOJ and NY State Attorney General Practitioners Discuss Regulatory and Enforcement Priorities” (Jan. 14, 2016). Although disclosure does not necessarily cure all potential issues, adherence to disclosed practices is essential. See “Explicit Disclosure of Changes in Hedge Fund Investment Strategy to Investors and Regulators Is Vital to Reduce Risk of Enforcement Action” (Oct. 29, 2015). The SEC recently took forceful action against an adviser that manages several publicly traded funds, alleging that the adviser disregarded fund disclosures regarding calculation of management fees and valuation of fund assets. In the press release announcing the settlement, Marshall S. Sprung, Co-Chief of the Asset Management Unit of the SEC Division of Enforcement, cautioned, “Fund managers can’t tell investors one thing and do another when assessing fees and valuing assets.” This article summarizes the adviser’s alleged misconduct and federal securities laws violations, as well as the outcome of the settlement. For more on enforcement actions involving fee disclosures and practices, see “Full Disclosure of Portfolio Company Fee and Payment Arrangements May Reduce Risk of Conflicts and Enforcement Action” (Nov. 12, 2015); “Blackstone Settles SEC Charges Over Undisclosed Fee Practices” (Oct. 22, 2015); and “SEC Enforcement Action Involving ‘Broken Deal’ Expenses Emphasizes the Importance of Proper Allocation and Disclosure” (Jul. 9, 2015). Management fees and valuation practices are inextricably intertwined. See “SEC Fraud Charges Against Lynn Tilton, So-Called ‘Diva of Distressed,’ Confirm the Agency’s Focus on Valuation and Conflicts of Interest” (Apr. 9, 2015).

ESMA Chair Calls for Increased Transparency and Regulatory Convergence As Interest Rates Rise

In a recent speech delivered at the Asian Financial Forum in Hong Kong, Steven Maijoor, Chair of the European Securities and Markets Authority (ESMA), discussed several effects that current low interest rates have had on financial markets, including increasing investor demand for leverage and higher-yield investments, as well as impacting market liquidity. He also explained anticipated developments in the financial sector and recommended strategies to improve transparency for investors. Maijoor’s remarks offer valuable insight for hedge fund managers and other players in the European and Asian markets into ESMA’s focus and priorities, as he stressed the development of the Capital Markets Union and the need for regulatory cooperation. This article summarizes Maijoor’s speech. For additional insight from Maijoor, see “ESMA Chair Highlights Upcoming Focus on Supervisory Convergence” (Oct. 1, 2015).

SEC Starts Year With Pay to Play Penalties

A wide variety of both specific and general rules prohibit the making of political contributions in exchange for government business. See “Four Pay to Play Traps for Hedge Fund Managers, and How to Avoid Them” (Feb. 5, 2015). In the hedge fund space, pay to play schemes often involve making political contributions to secure investment allocations from public pensions or other public funds. Rule 206(4)-5 under the Investment Advisers Act of 1940 was adopted to prevent precisely such misconduct by investment advisers. See “The SEC’s Pay to Play Rule Is Here to Stay: Tips for Hedge Fund Managers to Avoid Liability” (Oct. 8, 2015). Pay to play charges can also be brought under the general antifraud provisions of the federal securities laws. The SEC recently charged State Street Bank and Trust (SSBT), along with a senior executive and others, with violating the antifraud provisions of the securities laws in connection with a scheme to win lucrative pension business from the State of Ohio by allegedly funneling cash to the Ohio Deputy Treasurer and campaign contributions to the Ohio State Treasurer. This article summarizes the alleged pay to play scheme and the outcomes of the SEC enforcement actions, as well as the SEC’s determination on SSBT’s parent’s no-action request for confirmation that it would not be deemed an “ineligible issuer” under Rule 405 of the Securities Act of 1933 by reason of the enforcement action.

Kirkland Announces Addition of Former SEC Director Norm Champ in New York

Kirkland & Ellis has announced that Norm Champ will join the firm’s New York office as a partner in the private funds group on February 1, 2016. Champ is the former Director of the SEC’s Division of Investment Management and a lecturer on investment management law at Harvard Law School. For insight from Champ, see “Top 10 Regulatory and Enforcement Lessons Learned During 2014” (Jan. 29, 2015); Disclosure Challenges Facing Hedge and Alternative Mutual Fund Managers (Dec. 11, 2014); and “Key Compliance Challenges in Hedge Fund and Alternative Mutual Fund Management” (Sep. 18, 2014).

Elizabeth Roberts Joins Goodwin Procter in D.C.

Goodwin Procter recently announced that Elizabeth Roberts has joined the firm as a partner in its financial institutions group in Washington, D.C. Roberts’ practice involves work across a variety of funds, and she advises on fund formation, maintenance and governance matters, including issues arising under the Investment Company Act, the Advisers Act and the Alternative Investment Fund Managers Directive. For insight from Goodwin practitioners, see “Critical Components of a Hedge Fund Manager Cybersecurity Program: Resources, Preparation, Coordination, Response and Mitigation” (Jan. 15, 2015); and “SEC Sanctions Dual-Registered Investment Adviser/Broker Dealer for Disclosure Failures and Breaches of Rules Regarding Best Execution, Compliance Policies and Principal Transactions” (Sep. 4, 2014).