On April 16, 2025, the U.S. Tax Court ruled (Decision) against hedge fund manager GWA LLC (GWA) in its challenge of an IRS judgment finding that basket options it had purchased from Royal Bank of Canada (RBC) and Deutsche Bank were taxable on an annual basis and that GWA was, for tax purposes, the owner of the basket securities. GWA, which filed for bankruptcy in April 2024, had made large profits by trading on the securities. It had unsuccessfully argued before the IRS that those profits were long-term capital gains, and hence it was appropriate to defer taxes on them at least until the exercise or termination of the options. The Tax Court rejected that argument, along with the manager’s claims to have relied on legal counsel regarding its trading activities.

Given how common it is for hedge funds to use leverage, and to make use of basket option contracts, the ruling against GWA has implications for the private funds space and the direction of tax policy and enforcement. This article presents a summary of the Decision as well as analysis from legal experts.

See “Hedge Funds Are Required to Disclose Basket Option Contracts and Basket Contracts” (Aug. 6, 2015).

Relevant Entities and Activities

GWA, which operated as GWA LLC and Weiss Multi-Strategy Advisers LLC (WMSA), began in 1978 as Weiss Associates under the leadership of founder George Weiss, with a focus on securities trading and brokerage, the Decision relates. In 1986, Weiss began to offer investors an opportunity to invest in a hedge fund, framing the pitch in terms of a “relative value long/short strategy,” according to the Tax Court. That strategy involved buying and selling stocks from a given industry in approximately equal dollar amounts.

The hedge fund grew rapidly and, by the middle of the 1990s, had $1.7 billion in assets under management (AUM). Riding on that success, Weiss and his colleagues began to invest their own money in the hedge fund, and, in 1996, Weiss registered it as GWA LLC. Using a selective process with high income thresholds, he offered key employees of Weiss Associates a stake in GWA, but total membership in the vehicle never exceeded 50, according to the Decision.

GWA made use of the common “2 and 20” compensation model, whereby its principal took home profits consisting of two percent of AUM and 20 percent of annual gains. In the view of the Tax Court, the fairly conservative long-short investment strategy that Weiss put to use brought in relatively small, although consistent, gains over time, prompting the manager to turn to leverage in the hope of building exposure and returns. As part of this strategy, GWA made extensive use of affiliates, including:

• George Weiss & Co. LLC, in which GWA held a controlling interest in 1997 and 1998; and
• OGI Associates LLC (OGI), which was launched in 1994 to use GWA’s proprietary capital to trade securities. According to the Decision, GWA was OGI’s sole member and Weiss its only manager as of May 28, 1998.

The Role of OGI

As a single-member limited liability company under GWA’s ownership, OGI sought not to be classified as a corporation and to be disregarded as an entity separate from its owner. Hence, under Treasury Regulation 301.7701‑2, OGI’s activities would be “treated in the same manner as a sole proprietorship, branch, or division of the owner,” the Decision explains.

OGI and Weiss Associates made an investment banking services agreement in 1998 giving the latter the right to “perform investment operations and investment banking functions” for OGI, the Tax Court alleged. With this arrangement in place, GWA pursued a strategy making extensive use of specially tailored financial instruments (SFTIs), ultimately investing hundreds of millions of dollars in what it judged to be “call options” with the RBC and then with Deutsche Bank.

According to the Decision, the call options had expiration dates ranging from five years to as long as 12 years in the future, and their underlying asset was a basket holding hundreds or thousands of different stocks, potentially varying from one hour to the next. Although, in theory, the bank was the owner of the basket, GWA was able to make trades using the securities as it pleased and relying on the long/short strategies that were its modus operandi.

GWA traded heavily in RBC and Deutsche Bank basket options, generating very high profits, cross-trading extensively with OGI and then attempting to escape tax consequences by passing off OGI as the entity that had made mark-to-market elections. In terms of profitability, the strategy worked out well for GWA, enabling it to make significant gains on the trades of securities that the baskets held, while retaining the choice of not exercising the option on the securities until maturity and thus deferring taxation on the trading profits for the foreseeable future. If and when taxes were finally levied, they would be long-term, capital gains taxes and thus less than taxes on trading profits.

In the Tax Court’s view, OGI operated effectively as little more than a shell company or a front designed to deflect tax liability from GWA. “Because OGI’s securities trading activities are regarded as being conducted by GWA, OGI cannot be regarded as the ‘trader in securities’ for purposes of section 475(f)(1),” states the Decision.

See “FRA Program Analyzes the Tax Implications of Common Hedge Fund Investment Strategies” (Aug. 5, 2021).

Relations With Deutsche Bank

When GWA’s first three RBC contracts were set to expire in six months, Weiss’s associate Frederick Doucette undertook negotiations with Deutsche Bank, which offered more competitive terms than those of the GWA-RBC arrangement. According to the Decision, RBC charged a financing fee on 100 percent of the investment capital funneled through the prime brokerage account. In contrast, Deutsche Bank applied such a fee only on the portion of capital invested in the reference basket. From GWA’s point of view, those terms were more consistent with its preference for keeping 20 percent of the account’s value uninvested.

On March 6, 2003, Deutsche Bank unveiled a pricing proposal setting forth financing fees for capital it would supply to the barrier contracts. Those fees were exactly the same as fees that Deutsche Bank took from ordinary customers for leverage in prime brokerage accounts, notes the Decision. With Doucette’s blessing, GWA’s executive committee approved GWA’s taking part in the barrier contracts.

On April 15, 2003, a “cross trade” gave Deutsche Bank the portfolio securities in the securities baskets underlying the RBC contracts that were set to terminate that very day. GWA made use of “cash events” to roll over its other RBC contracts and reported $59,439,344 worth of long-term capital gains arising from the closure of six RBC contracts, the Decision details.

That same day, GWA and Deutsche Bank entered into their first barrier contract. Although Deutsche Bank held title to the securities in the reference basket, GWA or one of its affiliates made use of a right to tell Deutsche Bank how voting rights for the shares in question would be exercised.

Reports that the bank put together stating the performance of the securities in the reference basket and the cash settlement that would come into play if the barrier contract were to end on that date were very similar to the monthly statements that prime brokerage customers received from Deutsche Bank, states the Decision. As in the case of the RBC options, GWA was entitled to receive settlement payments from shareholder-derivative and class-action lawsuits brought by companies whose stock the reference baskets held. In fact, on its 2009 tax return, GWA reported as long-term capital gains $127,925 that it had received from class-action settlement proceeds related to basket securities.

The Decision details how Weiss Associates directed trading in the reference basket, making use of strategies that “precisely mirrored” the long/short investment strategies that GWA and affiliates relied on in other contexts. On a nightly basis, Weiss Associates sent Deutsche Bank trade files that went straight into the bank’s order management system for execution the next day. Weiss Associates made trades of 268 various securities in the reference basket on a typical day and, in 2005, initiated 89,075 trades involving more than two billion units of stock, the Decision states.

The Launch of WMSA

The investment strategy worked out so well for GWA that, in 2005, it launched hedge fund WMSA, which would invest “outside” money as opposed to the “inside” money that principals of the firm had made available. From 2006 through 2010, Weiss acted as chairman and CEO of WMSA and Doucette as president, COO and head of risk management.

According to the Decision, Weiss Associates undertook a gradual transfer of its investment operations to WMSA, until the former entity was “a shell” by the end of 2006. WMSA investment teams, consisting of a portfolio manager, a trader and quantitative analysts, operated directly under Weiss, who also chaired an “allocation committee” figuring out what portion of funds under management would go to a given strategy, including the barrier contracts. GWA reaped huge payouts from the termination of certain barrier contracts and, in an April 20, 2006, addendum to its May 2001 private placement memorandum stated that its total capital stood at $149,558,658 and that “substantially all” those assets were “devoted to SFTIs, in particular the barrier options.”

The IRS’ Clarification of Ownership

On November 12, 2010, the IRS published Generic Legal Advice Memorandum No. AM2010‑005 (Memo), which addressed hedge fund basket option contracts and described the hypothetical case of a contract between a hedge fund and a foreign bank. The contract in that hypothetical closely resembled the actual barrier contracts in place between GWA and Deutsche Bank. The Memo clearly set forth the IRS’ view that such a contract was not an option and that the hedge fund owned the basket securities.

Just a day later, Deutsche Bank emailed Doucette a copy of the Memo. In a January 14, 2011, meeting, an unnamed Deutsche Bank official directly expressed concerns to Doucette about the implications of the Memo. Thus, the Tax Court concluded that Weiss understood that his hedge fund was operating outside stated law.

Fraudulent Tax Returns

In spite of knowing about the Memo and what it meant for GWA’s basket securities trading, Weiss and his associates filed a Form 1065 for the 2010 tax year on September 11, 2011, following the same approach as prior tax returns that had classified profits from six earlier basket contracts as long-term capital gains. GWA reported $182,678,910 as long-term capital gains arising from the termination of the seventh through tenth barrier contracts.

GWA’s tax return methodology, in its federal tax returns for 1997 and 1998, also made extensive use of mark-to-marketing, the Tax Court detailed. Under that methodology, GWA reported a gain or loss on a security held at the close of the taxable year as if parties had sold that security on the last business day of the year in question for its fair market value. The IRS did not agree with the methodology that GWA had used either in its classifications of long-term capital gains or its mark-to-marketing.

GWA filed its 1998 tax return approximately one year after executing its initial RBC options, the Tax Court noted. Had GWA sought to elect mark-to-market treatment for all its securities positions, it would have had to mark the RBC options to market at year-end 1998, it added. Instead, GWA reported $319,821 of “unrealized gains on investments.”

Failing to represent GWA’s direct holding of securities in its 1990 tax return, and indicating that such securities were held by OGI, was an act of knowing and deliberate tax fraud on the part of GWA, the Tax Court contended.

In the tax return, the Decision charges, GWA attempted to make use of an election that it did not legally have the right to employ, keeping from its mark-to-market election securities that it held directly rather than through OGI. “And here the evidence that appeared in GWA’s tax return was consistent with its intent,” the Decision states. “GWA could not possibly have intended to elect mark-to-market treatment for securities it held directly because that would have eviscerated the tax-deferential objective of the RBC ‘options.’”

The Decision takes particular exception to GWA’s practice of trading on Deutsche Bank’s “Trade Restricted List” by shifting the trades to OGI’s account and transferring securities positions from the managed accounts to the OGI account by cross-trading or position journaling, “free of transaction costs and without tax consequences.”

The Question of Ownership

In making a determination as to ownership of the basket securities – with all that such ownership implied for tax purposes – the IRS found it necessary to go far beyond nominal ownership (i.e., the bank’s) and look at a broad array of facts and circumstances, observed Mark Leeds, partner at Pillsbury. The ability of GWA to trade the securities or refrain from exercising the option until maturity – for potentially as long as 12 years – and thereby defer any tax obligations or liabilities for a commensurate period of time were critical considerations here.

In challenging the IRS, GWA tried to pursue a defense somewhat more limited in scope than the consideration of all relevant facts and circumstances might have warranted and, in particular, to emphasize the role of the banks with which GWA had entered into business, Leeds noted. “Beneficial ownership, or tax ownership, is based on the totality of the facts and circumstances,” he commented. “In this particular case, GWA exercised so much power over the securities within the basket that it would have been anomalous for the court to conclude that it wasn’t the owner.”

“The basis on which GWA took the position that it was not the beneficial owner related to creditor rights. In other words, the bank that wrote the derivatives was the nominal owner,” Leeds observed. “If the bank had gone bankrupt during the period in question, its creditors would have been able to foreclose on the securities held in the basket, because they weren’t held in a custody arrangement; they were owned by the bank.” It appeared that this contingent credit risk was the basis upon which GWA concluded it was not the owner of the basket components.

Unfortunately for GWA, the IRS had precedent to fall back on in making its case that GWA was, for all intents and purposes, the owner, Leeds noted. A February 1977 Tax Court ruling considered the question of whether Data Lease, with which Miami National Bank had filed a joint tax return, was the direct owner of shares in a subordinated securities account whose holder was First Devonshire. The tax commissioner concluded that, regardless of what rights the creditors may have held, the direct owner was not Data Lease but an individual named Samuel Cohen, even though the shares were held in the subordinated account. That conclusion has implications for subsequent matters in which courts must decide questions of beneficial ownership and attendant tax liabilities.

See “Hot Tax Topics for Private Fund Investors and Managers” (Jan. 21, 2021).

The Knockout Feature

A further consideration in determining beneficial ownership of the basket securities was the so-called “knockout feature” under which a decline in the value of the basket below a certain point would trigger termination of the contract and liquidation of the securities. From GWA’s viewpoint, that feature might have supported the notion that its ownership of the basket was limited and contingent. But that argument does not hold up to scrutiny, Leeds pointed out, because GWA could have defeated the knock-out by posting additional collateral.

As the Decision acknowledges, Deutsche Bank itself put in place a mechanism that GWA could use to preempt the knockout and avoid cancellation of the contract. In anticipation of circumstances in which the basket’s value appeared on course to fall below the threshold that would trigger the knockout, the bank gave GWA the right to pay it an additional premium to keep the contract active.

The IRS, in guidance set forth in 2024 and 2025, established that the ability to pay an additional premium to defeat a knockout was an indicator of ownership, pointed out Leeds. “The bank wasn’t in the business of taking an actual view on the underlying securities. The bank was acting as a dealer – just attempting to earn a dealer’s income from the writing of the option,” he noted. “So, if the value of the underlier fell below the amount by which the option was ‘in the money,’ and the bank had hedged itself under the option by buying the securities, it would have started to experience a loss itself.”

“It wasn’t as if these securities started off on the bank’s own balance sheet. The bank didn’t hold the securities. It just wanted to buy from X and sell to Y,” continued Leeds. “So if the value started to experience a loss, that’s not a dealer transaction.”

The existence of certain barrier options ultimately did not go far toward helping GWA prove its case, concurred Chaim Stern, special counsel at McDermott Will & Schulte. “The court disregarded the so-called barrier options and treated GWA as the tax owner of the underlying position. Given the facts of the case, it wasn’t a shocking decision,” he said.

It is understandable that some people might try to argue that the knockout feature of the arrangement was more indicative of a lending-type arrangement than an option, Stern acknowledged. “It goes back to the fact that the bank can effectively trigger a margin call. That is a feature that might lead some to view it more as a loan than an option,” he conceded.

But that argument does not really square with the common understanding of what barrier options are and how they function. Far from conferring beneficial ownership of the underlier to the optionee, barrier options are often tailored to protect the bank’s interests if prices rise too high. In that scenario, the bank relies on the “capped” feature of the options, Stern noted.

“Barrier options generally have features that protect the bank, and people still respect those as options,” said Stern. “The fact that they knock out when certain price points are hit doesn’t necessarily change that conclusion. That, itself, shouldn’t change the character of the option or the ownership of the underlier.”

In the end, GWA could not successfully downplay the rights it enjoyed with respect to the underlying assets or prove to the Tax Court that the bank was the beneficial owner. “If you have the right to trade and dispose of the underlier in the manner that you see fit, that is a feature of ownership – even more so than the fact that the bank has the right to unwind the contract if the collateral price falls,” Stern observed.

Accounting Method Change

An obvious potential hurdle to the IRS in its action against GWA is the sheer amount of time that had passed since the filing of the faulty tax returns. In theory, the IRS commits to limiting the scope of audits to the prior three years, or six years if it believes it has identified a significant error, although it reserves the right to go back further.

In Stern’s view, an unusual and significant aspect of the case is the reasoning the Tax Court used to get around the statute of limitations that otherwise might have protected GWA. “The biggest novelty is that the court considered its own position to be an accounting method change, which is how it effectively extended the statute of limitations,” he said. “You wouldn’t normally consider a change that is forced on the taxpayer – a court ruling – to be an accounting method change for purposes of extending a statute of limitations, but that is what the court decided.”

“The only reason for the technical classification of the IRS’ adjustment as an accounting method change is because the IRS has gotten so far outside the statute of limitations,” Stern posited. “It had to make the adjustment into an accounting method change because it wanted to extend the statute.”

See “Navigating the Uncertain U.S. Tax Landscape” (Jan. 13, 2022); and “Key Tax Issues Fund Managers Must Consider” (Jun. 10, 2021).

Attorney-Client Privilege

In the Tax Court’s view, GWA sought to escape responsibility for its fraudulent dealings by claiming to have exercised due diligence by getting expert opinions from tax lawyers in 2009 and 2011. During the discovery process, the Decision explains, GWA relied on attorney-client privilege, however, to avoid having to share with the IRS the content of its communications with the tax attorneys in question.

Although it does not challenge the claim that GWA did seek out expert tax advice in the two years in question, the Tax Court maintained that, without those legal opinions in the official record, “we are unable to ascertain the extent (if any) to which they could reasonably support GWA’s tax return positions.”

In Stern’s view, it would be a mistake to assume that, had GWA not invoked attorney-client privilege, it could have made a successful “reliance on professional advice” defense. “The court was concerned that the taxpayer had asserted attorney-client privilege inconsistently for some things and not for others. We cannot know exactly what it would have done if the taxpayer had been more open about its tax advice,” he said.

See “Understanding the Fiduciary Exception to Attorney-Client Privilege” (Aug. 17, 2023).

Takeaways

According to Stern, the terms of GWA’s arrangements are not favorable to its case. The prospect of challenging the Decision on the grounds of the statute of limitations offers slightly more hope than trying to defend the characterization of the arrangements as options in accordance with their form. As for potential tax law complications, it makes sense for registered entities to steer clear of certain types of arrangements altogether, in keeping with repeated IRS guidance.

“In my practice, I counsel people to stay away from arrangements that give the taxpayer the right to trade the underlier. I tell people that that doesn’t work,” Stern shared. “It has been the focus of the IRS in its guidance in 2010 and then again in 2015. The closer you are to a traditional option, the better off you are. You really want to have something that has the economic characteristics of an option, rather than a lending arrangement.”

Moreover, from an operational standpoint, GWA made some serious mistakes that could not have helped its legal position in the matter, Stern suggested. “There were unhelpful background details here, such as cross-netting against GWA’s other accounts. It wasn’t done on a form that was fit for purpose. There were various disclosures that were not helpful to their fact pattern,” he said. “Basically, the evidence suggested that the substance of the arrangement was inconsistent with its reported form – it suggested that the petitioner was simply borrowing on margin to finance its own trading positions.”

See our two-part series: “Synopsis of the IRS Partnership Audit Process and How It Can Be Addressed in Fund Documents” (Jun. 16, 2022); and “Modifications, Amended Returns and Push-Out Elections as Cures for Imputed Underpayments From IRS Partnership Audits” (Jun. 23, 2022).

Many investment fund managers are run as “benevolent dictatorships,” while others are more democratic, according to a Practising Law Institute (PLI) program on governance and succession planning for fund managers’ upper-tier entities. In either case, having a clear, documented governance structure and plans for both anticipated and unanticipated departures of founders and other key personnel are essential to ensuring smooth operations and an eventual transition to a new generation of leaders. They are also important considerations for institutional investors. The program covered governance and decision-making; founders’ retirement; business divorces; withdrawal of key personnel; succession planning; and sales of stakes in the fund manager’s general partners (GP stakes). Joshua Cohen, partner at Norton Rose Fullbright, moderated the discussion, which also included Jennifer M. Dunn, partner at Proskauer; Elizabeth Shea Fries, partner at Sidley Austin LLP; and Colin S. Kelly, partner at Fried Frank. This article synthesizes their remarks.

For coverage of other PLI programs, see “To Work Effectively, CCOs Need Authority, Autonomy and Information” (May 22, 2025); and “Answers to Six Key Questions About How Enforcers View Gatekeepers” (Nov. 21, 2024).

Governance and Decision-Making

Benevolent Dictatorship vs. Democracy

Decision-making varies widely across asset managers, said Dunn. They run the gamut, from a single founder running a “benevolent dictatorship” to shops with a management committee or democratic rule. In some instances, a founder or a supermajority may have to consent to certain specified actions. When there is a benevolent dictatorship, it is critical to have a succession plan as a backup in the event the founder becomes temporarily or permanently unavailable.

There is a tendency to think that a benevolent dictatorship is easier to run, added Cohen. That model, however, presents problems if that person becomes unreachable. Many such firms lack any documentation about what should happen in that event.

Hedge fund founders are more likely to run their firms as benevolent dictatorships because they are typically paid every year and can come and go relatively easily. In contrast, in a private equity (PE) or venture capital firm, where compensation is tied to long-term carry, “you tend to have a little bit more consensus around some of the decision-making power, and that can change from vintage to vintage,” said Fries.

The most common vehicles for management companies are limited partnerships (LPs) and limited liability companies (LLCs). Both offer governance flexibility, explained Fries. They can have boards, committees, and different majority and supermajority voting provisions. With so many choices, there is a tendency to include many different provisions, which increases complexity and cost. Founders should avoid being “the kid in the candy shop,” she advised.

See “SEC Cites Adviser, Whose Founder and CCO Had Died, for Multiple Compliance Failures” (Oct. 26, 2023).

Elections and Decision-Making

Founders should consider the mechanism for electing firm boards and committees, including which founders and/or other individuals will have a vote and whether the body will be self-perpetuating, said Fries. For example, imposing term limits and requiring elections every two years could be disruptive. “Do you really want all of your people to be in a political race all the time campaigning for their next position?” she asked.

Dunn noted that firms typically require a supermajority vote for major decisions, which may include:

• a change in business strategy;
• sale of some or all of the business;
• borrowing above a specified dollar amount; or
• admitting new partners – especially if that will be dilutive to the existing partners.

When setting up a firm, founders must consider not only how they will run it but also what happens if things go wrong, advised Fries. A key consideration in situations in which multiple individuals are involved in decision-making is how to break a tie. If the founders of a firm are unable to agree, they might not be able to carry the business forward. There are many approaches for handling those situations, including:

• giving one person a “super” vote;
• deferring to a trusted third party;
• giving other equity holders in the firm a vote, which can create challenging political dynamics within the firm; or
• requiring mediation or another process after a specified period of deadlock.

These are considerations that must be addressed both at the founding of a firm and then periodically as the business develops, added Dunn. For example, over time, a firm founded by a single individual may begin to make decisions by consensus – but that process may not be reflected in the fund documents. Similarly, when a closely held firm brings an institutional investor into the structure, it is likely that the investor will require a change in the governance structure. “But even if you have no transaction, the business is just going to change and you have to be willing to change with it,” she cautioned. For example, it is common for a portfolio manager who has had strong investment performance for a long time to want a seat at the table, added Fries.

Significant decisions depend on how a firm’s governance aligns with its economics, noted Fries. Although many firms try to make governance more democratic, in many cases ownership rests primarily in the founders, while other key personnel share primarily in carried interest. That affects governance and voting. Additionally, seeders and investors that purchase GP stakes typically have certain consent and other rights to protect their minority interests.

See our two-part series “Establishing a Best‑in‑Class Governance Framework for Cayman Funds”: Part One (Nov. 19, 2020); and Part Two (Dec. 10, 2020).

Choice of Domicile

The choice to domicile a firm in a state like Texas rather that Delaware is probably driven more by concerns about governance and fiduciary duty than tax because management companies are typically formed as LLCs or LPs and are not subject to entity-level tax, explained Kelly. It often makes sense for a small manager to organize the management company in the state where the firm is based to reduce complexity, said Fries. On the other hand, if a founder expects to have outside investors, “they’re probably going to want to be in Delaware,” she continued. Although Nevada has been in the headlines lately based on its governance and tax regime, she has not seen a shift away from Delaware.

Most managers still organize their firms in Delaware, Dunn agreed. The firm principals, however, may relocate to a different jurisdiction – often for tax reasons. “It’s usually Florida and Texas – and it’s moving the GP more than the manager because you want the carry elsewhere,” noted Fries. There are advantages to increasing apportionments to states with no or low income tax but there are also business considerations, added Kelly. For example, employees may not want to move to Florida.

See “Common Mistakes to Avoid When Launching a Hedge Fund” (May 8, 2025).

Founder’s Retirement

Founders generally do not withdraw from their firms and generally cannot be forced to withdraw, observed Dunn. In some firms, it is impossible to remove a founder. In limited circumstances, they may be forced to withdraw for cause, but the definition of “cause” for founders is usually much more restrictive than the definition applied to other firm personnel. For example, “cause” for a founder may be limited to illegal conduct or creating catastrophic reputational harm. In such cases, a founder is not likely to leave quietly. “It’s going to get ugly,” she observed. If the business will fail if the founder remains in the picture, the firm may have to negotiate an exit regardless of whether it has the right to force out the founder.

If a founder leaves at retirement or voluntarily at another time, the founder’s continuing rights will depend on the ongoing economics, said Dunn. If the founder retains a large economic stake in the business, the founder may also retain consent rights over major decisions similar to a GP stake investor. Such provisions are not usually included in the firm’s original documents. They are typically added as the founder approaches departure. Departure preparation includes informing investors, determining whether there will be a change of control and introducing successors to the investors. Ideally, planning should start several years in advance of the departure to ensure a seamless transition, she advised. Additionally, the firm will have to plan to amass sufficient liquidity to acquire the founder’s interest, noted Kelly.

Founders rarely want to retire and “sit on the beach and play golf,” according to Fries. They also sometimes change their plans during the transition process or must stay after a market event because only they can save the firm’s portfolio. In any transition, communication is one of the most critical elements. At one firm, after investors were told that the founder was going to retire and that firm leadership was deciding what to do next, “all of the investors promptly left because there was no plan,” she recounted. Investors should not suddenly be “stuck without a founder.”

See “Succession Planning Series: A Blueprint for Hedge Fund Founders Seeking to Pass Along the Firm to the Next Generation of Leaders (Part One of Two)” (Nov. 21, 2013).

Business Divorces

Often, “best friends for life” form a successful business – but 10 years later are no longer friends and have no buy-sell agreement or other mandatory process for separating, said Cohen. In those instances, it comes down to “maybe you leave, maybe I leave.” Business divorces can be even more challenging than matrimonial divorces, observed Dunn. There is often a lot more money at stake and both sides are equally wealthy. When that happens, “it just gets uglier [and] people are just fighting because they can.”

If there is no mandatory mechanism and the firm has a third-party GP stake investor, the investor may be able to serve as “the adult at the table” who is not part of the acrimonious relationship, noted Fries. Additionally, the investor may have certain rights if a founder leaves, which could help the parties reach a resolution.

See “Brevan Howard Co-Founder Sues Firm to Invalidate Non-Compete Provisions in Partnership Agreement” (Aug. 21, 2014); and “Hedge Fund Manager Business Divorce Highlights Need to Properly Document Significant Money Transfers Between Principals” (Aug. 15, 2013).

Withdrawal of Key Personnel

Some key personnel may have the right to resign with “good reason” and still retain carry and/or an interest in the management company or GP, noted Cohen. Such rights are increasingly common but “pretty narrow,” said Dunn. Triggers may include:

• a relocation of the firm beyond a specified area;
• a change of the employee’s role; or
• a change of reporting lines.

At a minimum, such provisions typically enable employees to retain their vested equity.

Two factors are driving use of such provisions, explained Fries. First, if institutional players take a large stake in a firm, employees may be concerned about arbitrary termination decisions. Second, more managers are diversifying and offering both open- and closed-end funds. Traditionally, employees leaving closed-end funds were able to keep their carry, whereas departing hedge fund employees were more likely to lose their economic stakes. Thus, retention of vested interests is becoming more common among managers that offer both types of funds.

See our two-part series on key person provisions: “Drafting Effective Key Person Provisions” (May 8, 2025); and “Grappling With a Key Person Event” (May 22, 2025).

Succession Planning

Bake Provisions Into Fund Documents

Institutional investors may ask a firm for its plans for disaster recovery or key person issues, observed Fries. In many cases, firms may have those arrangements in a letter or memo rather than in the firm’s governing documents. Worse, in some firms, the arrangements may only be reflected in the founder’s will or estate plan. In such cases, in the event the founder dies or becomes incapacitated, the founder’s family will not be able to step in immediately, and the firm’s other personnel may lack authority to make decisions.

To ensure a smooth process for someone to acquire an interest in an asset management firm, fund and separate account documents should specify what consent is required for a change of control and assignment of the advisory contract, said Dunn. Fund managers should consider including alternatives and multiple mechanisms, suggested Fries. For example, a PE fund might require consent from the limited partner advisory committee or permit the committee to retain an independent fiduciary to make the decision.

See “Anatomy of a Private Equity Fund Startup” (Jun. 22, 2017).

Consolidate Operations

It is increasingly common for managers to have a separate GP for each fund structure, even though the funds usually all have the same investment manager, according to Dunn. They create separate GPs for liability protection and to facilitate compensation of investment professionals who work for different funds.

However, managers may want to consolidate certain operations in fewer entities for both tax and acquisition purposes, continued Dunn. For example, a GP stake investor will want a piece of each of the managers’ entities but may not necessarily want to own a direct interest in every entity. It would much rather own an interest in a holding company. A founder can hold all the founder’s interests in a holding company or companies that are disregarded entities for tax purposes. Usually, fund managers have one holding company for management entities and another for GP entities. Additionally, if some of the manager’s funds generate U.S. effectively connected income, the manager may have a separate holding company for the GPs of such funds.

Anticipate Estate Taxes

If a founder dies suddenly, the founder’s estate may have to come up with funds to pay a substantial estate tax within nine months, noted Kelly. To avoid such an event, the founder may decide to sell a portion of the business to ensure sufficient liquidity, said Fries. In the event of the founder’s untimely demise, the founder is also likely to have a significant interest in the funds, which may be relatively liquid. Those interests might also be sold in a secondary transaction, added Dunn.

See our three-part succession planning series: “Why Fund Managers Must Review Their Positions on Succession Planning and CCO Outsourcing” (Jun. 7, 2018); “What Fund Managers Should Consider When Hiring and Onboarding CCOs; Determining CCO Governance Structures; and Evaluating Risks of CCO Turnover” (Jun. 14, 2018); and “A Succession-Planning Roadmap for Fund Managers” (Jun. 21, 2018).

Sales of GP Stakes

Key Drivers

A founder may decide to sell a stake in the founder’s business for both economic reasons and generational planning, according to Fries. For example, the founder may have an acquisition opportunity or need capital for a new line of business, but existing employee stakeholders may not be interested in reinvesting in the business. Alternatively, sale of a GP stake can provide a firm with liquidity to buy out older employees and allow younger employees to advance. In that event, however, the GP stake investor will not want the firm to buy out older individuals right away. Sale of a GP stake could also present an opportunity to address open governance issues.

See “Succession Planning Series: Selling a Hedge Fund Founder’s Interest to an Outside Investor (Part Two of Two)” (Jan. 16, 2014).

Structuring

In some staking transactions, the investor may both invest in the business and buy a portion of the founder’s interest, noted Fries. Such transactions usually progress in stages. The investments may include both working capital for the management company and GP capital for the funds.

A founder taking money off the table through a sale should expect to recognize gain on the sale, advised Kelly. The structures of some primary sales enable the founder to defer a portion of the gain for a period of time. The tax consequences of a sale also depend on the reason for the transaction and the use of the proceeds.

Employment Considerations

A GP stake investor will want to ensure the manager’s key employees will remain with the firm for some time, said Cohen. Often, they require all key employees, including founders, to sign a new employment or services agreement, noted Dunn. Individuals who previously were not subject to a non-compete or non-solicitation agreement may be required to sign one. Additionally, GP stake investors usually require the seller to reinvest a “fairly large chunk” of the sale price in either the business or the manager’s funds for a specified minimum period.

See “What Fund Managers Should Know About the FTC’s Ban on Non‑Competes” (Jun. 6, 2024); as well as our two-part series on internal compensation arrangements for investment professionals: “Carried Interest and Deferred Compensation” (Mar. 15, 2018); and “Hedge Fund Compensation and Non-Competes” (Mar. 22, 2018).

Impact on Governance

Regardless of whether a stake investor is acquiring a minority or majority interest, “they’re kicking the tires on that manager like you would not believe, which is part of the reason [limited partners] love to give money to people who have a GP staker,” said Dunn. “They know the diligence that the GP staker has done to buy that stake.” Part of that diligence involves understanding the manager’s governance. If the stake investor does not like the existing arrangements, it may insist on changes.

The purchaser of a minority GP stake will want certain protections, which usually include consent rights over specified important decisions, continued Dunn. In certain cases, including when the minority stake investor cannot be diluted on an issuance of new equity to employees, the investor may only have the right to notice of specified transactions. Every transaction is unique. The consent rights and protections given to the staker will depend on the nature of the deal, she said.

Many GP staker investors are simply interested in a portion of the business’ revenue stream, noted Kelly. Others are more strategic. For example, an insurance company that is going to invest several billion with a manager may also purchase a stake in the manager. Some managers are pairing with insurance companies, noted Dunn. Others, especially credit managers, have joint ventures with banks. Such joint ventures are entirely new businesses, typically with equal ownership. Those types of deals differ significantly from purchases of a plain-vanilla GP stake. Many traditional GP stakes are also strategic – because the investor is committing to the manager’s strategy, said Dunn. The GP stake investor may provide the GP with access to other potential investors or operational support.

Managers selling stakes to banks or insurance companies that manage other people’s money face additional fiduciary concerns, said Fries. For example, the stake investor may be putting one type of capital into the manager and another into the manager’s funds, which can affect governance and what protections the stake investor receives. There also might be different people within the stake investor managing different elements of the relationship with the manager.

When an investor is acquiring a controlling GP stake, the parties will have to address treatment of the remaining minority interests, said Fries. This is especially important when trying to facilitate a transition from one generation to the next. A majority stakeholder also must address fiduciary and accounting consolidation issues.

Mitigating Conflicts

A GP stake investor might learn about discord between founders, imminent departure of key personnel or a significant impairment of an investment, which can give rise to conflicts of interest, said Cohen. When a GP stake investor has a separately managed account (SMA), the potential for conflict is even greater, because of the right to terminate the SMA, noted Fries. Termination of the SMA could adversely affect funds that hold the same assets. Managers must be aware of such conflicts, seek ways to mitigate them and make appropriate disclosures to investors, advised Dunn.

For example, one fund manager had a strategic investor with a substantial investment in a liquid fund that agreed to a lockup but negotiated the right to withdraw before the end of the lockup upon the occurrence of specified events, recounted Dunn. The manager did not want to give the same rights to all other investors. Instead, the manager gave all the investors side letters providing that, if the strategic investor did decide to withdraw, all investors could withdraw. The approach was workable because the fund pursued a highly liquid strategy.

See “SEC Penalizes Adviser for Preferential Redemptions and Undisclosed Conflicts” (Sep. 26, 2024); and “Identifying and Managing Common Conflicts of Interest” (May 9, 2024).

 

“At the close of 2024, both limited partners (LPs) and general partners (GPs) were broadly enthusiastic about investment opportunities following a difficult few years,” according to the Barnes & Thornburg LLP 2025 Investment Funds Outlook report (Report). The Report, the firm’s third annual industry outlook report, covers the most pressing issues facing LPs and GPs; compliance focus areas; key fund terms; succession plans; and respondents’ positive outlook for the economy in general and hedge funds, private credit and the cryptocurrency market in particular.

The biggest takeaway from the Report is the “positivity and optimism” of both managers and investors, Barnes & Thornburg partner Scott L. Beal told the Hedge Fund Law Report. “Despite some volatility and turmoil in the markets earlier in the year, the majority of respondents view the general economic outlook (72%), availability of capital (66%) and regulatory environment (64%) as investment opportunities. That is consistent with what we’ve seen in our practice as well,” he said, adding that “it was notable to see that optimism with respect to some sectors or industries that have had challenges in the last few years, including hedge fund and cryptocurrency markets.” This article synthesizes the Report’s key fundings, with additional commentary from Beal.

See “Investment Fund Survey Finds Growing Investor Bargaining Power” (Aug. 17, 2023).

Survey Demographics

Barnes & Thornburg conducted the survey in March and April 2025. The 121 respondents included LPs (40%), GPs (37%) and service providers (23%). Investors participating in the survey represented:

• private credit (31%);
• private equity (23%);
• hedge funds (20%);
• investment banks (18%); and
• venture capital (8%).

The survey included firms of all sizes, including one-third with less than $500 million in assets under management; nearly half with between $500 million and $5 billion; and one-fifth with more than $5 billion. Two-thirds of respondents have between 101 and 1,000 employees. Of the rest, half have less than 100, and half have more than 1,000.

Most Pressing LP Issues

Barnes & Thornburg asked LPs to identify which, out of nine choices, were the most pressing issues they currently face. Two-thirds of LPs cited financing terms and/or increase in co-investing, up from half and one-third, respectively, in 2024. Half also cited transparency, up from just over one-third in 2024. Nearly half (44%) cited environmental, social and governance (ESG) considerations, up from just 14% last year. That increase could be attributable to ongoing anti-ESG efforts and associated responses by pro-ESG stakeholders, Barnes & Thornburg opined. In contrast, there were notable year-over-year declines in the proportions of LPs that cited returns (40%, down from 54%) and/or demand for data governance (27%, down from 43%).

“Co-investment has continued to rise in importance. This is a continuation of a trend that we’ve seen in recent years, as allocators look to co-investment opportunities as a key part of their allocation decisions,” explained Beal. Co-investments enable allocators to bring down the average fees they pay and to have a level of portfolio customization that is not available in blind-pool vehicles. “We’ve seen investors push for co-investment opportunities in structures in which you would not typically expect to see such opportunities being made available,” he added.

See “Evolving Practices Regarding Hybrid Structures, Co‑Investments, Separate Accounts, ESG Challenges and Expense Allocations” (May 19, 2022).

Most Pressing GP Issues

Barnes & Thornburg also asked GPs to identify their most pressing current issues out of 10 choices that were similar – but not identical – to the LP choices. With respect to each issue, there was a year-over-year increase in the proportion of GPs who cited such issue. The most common concerns, cited by just over half of GPs, are fundraising and returns, up significantly from 40% and 31%, respectively, in 2024. More than two-fifths of GPs cited regulatory risk, staffing and transparency. Nearly two-fifths cited ESG, succession and/or fee compression. One-third identified valuations. Concern over fundraising was not surprising in light of the fact that U.S. private equity fundraising declined for the third consecutive year, according to the Report.

“The top two issues cited by managers were fundraising and performance. Clearly the two are linked,” noted Beal. “Although we have seen increased optimism with respect to fundraising, it’s still a challenging environment for many managers that are faced with competition from a host of products in the market and LPs being constrained in making new allocations due to lack of exits and the denominator effect.” In light of those fundraising challenges, managers must “put up differentiated performance in order to attract capital,” he added.

Anticipated Compliance Focus

Forty-eight percent of GP and service provider respondents expect compliance with regulation and policy to be easier under the new Trump administration, while 36% expect compliance to be more difficult. Those who anticipate a lighter burden expect the administration to ease regulation. Those who expect more difficulty cited weakened enforcement, deregulation, tariffs, unclear guidelines and challenges implementing new rules.

Barnes & Thornburg asked both LPs and GPs which of the following should be key compliance focus areas in the coming year:

• cybersecurity and data management;
• artificial intelligence (AI);
• valuation;
• liquidity management;
• tax;
• ESG;
• national security/foreign investment requirements;
• conflicts of interest;
• anti-money laundering;
• transparency; and
• antitrust.

There was significant alignment between LPs and GPs on most of the top focus areas including, for example, cybersecurity (LPs – 63%, GPs – 62%); AI (60%/56%); valuation (50%/49%); liquidity management (38%/44%); and tax (44%/41%). On the other hand, there was a significant divergence regarding ESG (LPs – 63%, GPs – 33%), national security (54%/32%) and transparency (44%/22%). “This push for stronger governance frameworks, geopolitical protections, and greater insight into fund activity may reflect LPs’ uncertainty about the Trump administration’s enforcement priorities in 2025,” states the Report. Additionally, the proportions of GPs citing valuation, liquidity management and tax as key compliance focus areas grew significantly from 2024 to 2025.

Cybersecurity and data management was respondents’ most common compliance concern. “There have been a number of cybersecurity incidents that have impacted the asset management industry, involving managers and service providers. We’ve had clients who’ve been impacted by one of their vendors experiencing a data breach, requiring them to scramble to respond,” shared Beal. When a data breach compromises – or potentially compromises – investor information, managers must notify not just the investors but also multiple regulators. Consequently, firms “are doing more diligence across the board with their service providers.” he said.

Additionally, LPs are focusing more closely on cybersecurity in the diligence process than in previous years. “As more managers are accessing high-net-worth individuals and similar channels, they are coming into possession of more personally identifiable information, which increases the importance of having robust cybersecurity and data protection in place,” Beal observed.

See “Considerations for Managing Third-Party Cyber Risks” (Dec. 21, 2023); as well as our two-part series “Eleven Lessons From Cyber Hack That Forced an Australian Hedge Fund to Close”: Part One (Feb. 4, 2021); and Part Two (Feb. 11, 2021).

Fund Terms

There was a significant year-over-year increase in investment restrictions, according to the Report. Barnes & Thornburg asked respondents how they expected the frequency of use of the following 11 fund provisions and features to change in the coming year, compared with the prior 12 months:

1. change in GP commitments;
2. investment period extensions;
3. LP-led use of securitization techniques;
4. change in distribution of fund proceeds;
5. term extensions;
6. GP-led use of securitization techniques;
7. key-person clauses;
8. investment restrictions;
9. hurdle rates;
10. fundraise extensions; and
11. no-fault divorce clauses.

A majority of respondents said they expect an increase in the use of each, from a high of 76% for changes in GP commitments to a low of 56% for no-fault divorce clauses.

Additionally, with respect to each category, a significantly higher proportion of respondents in 2025 anticipate an increase than in 2024.

Sixty-four percent of respondents expect an increase in use of hurdle rates, up from just 27% last year. “This is something that we’ve seen being raised more frequently by LPs,” according to Beal. “Although most managers have held the line on this in our experience, there have been some notable funds that have added or modified hurdle rates.”

See our two-part series on cash hurdles for fund manager incentive fees: “Advantages and Challenges” (Mar. 13, 2025); and “Implementation” (Mar. 27, 2025).

Succession Plans

Virtually all LPs (96%) believe it is important for a manager to have a succession plan, including 77% who believe it is very important. That sentiment is considerably stronger than in Barnes & Thornburg’s 2024 study, when LPs were more evenly divided over whether a succession plan was very important (36%), important (30%) or “neutral” (30%).

On the GP side, 47% have a succession plan in place, up from 41% last year, and 49% are currently implementing or considering a plan, versus 51% last year. The most commonly cited reasons for having a plan include:

• fund leader legacy (67%);
• governance priorities (53%); and
• as a hedge against disruption (51%).

Just 30% of GPs cited pressure from LPs.

“One of the factors driving [investor interest in succession planning] is the well-publicized war for investment talent. There have been a number of high-profile departures from top funds, whether it has been individuals joining a competitor or looking to launch their own independent manager,” explained Beal. A succession plan can provide the next generation of talent certainty and security with respect to their future at the firm, which can make them less likely to leave. “So, from an investor standpoint, succession planning not only helps ensure continuity when a founder departs but also provides comfort that the team will remain in place in the near term,” he observed.

See our two-part series: “Drafting Effective Key Person Provisions for Hedge Funds” (May 8, 2025); and “Grappling With a Key Person Event at a Hedge Fund” (May 22, 2025).

Respondents Are Optimistic

“Despite emerging compliance headwinds, investment professionals are broadly optimistic about the year to come,” notes the Report. In that regard, most respondents identified the following as opportunities in the coming year:

• economic outlook (72%);
• availability of capital (66%);
• regulatory environment (64%);
• availability of assets (63%); and
• valuations (61%).

Most of the remaining respondents identified each of those subjects as challenges. Respondents were closely divided as to whether the geopolitical environment, the interest rate environment and/or exit opportunities presented opportunities or challenges.

Barnes & Thornburg asked respondents whether they expected an increase or decrease in private investment activity in each of 14 different sectors in the coming year, when compared to the last year. In all but one case, at least half of respondents said they expect an increase in private investment activity. More than 70% of respondents expect increases in financial services, technology, energy, automotive, real estate/construction and manufacturing. At the other end of the spectrum, just 41% expect an increase in the cannabis industry.

In addition to respondents’ general optimism, they expressed optimism about the performance of hedge funds, private credit and the cryptocurrency market in particular.

Hedge Funds

Three-quarters of hedge fund respondents are either very optimistic (42%) or somewhat optimistic (33%) about the outlook for hedge fund performance in the coming year, compared with the last 12 months. Just 8% are pessimistic. Additionally, 83% expect either an increase in invested capital of more than 20% (46%) or up to 20% (37%). None expect a decrease.

Half or more of hedge fund respondents said they are most optimistic about the following strategies:

• fixed income;
• long/short equity;
• event-driven;
• long-biased equity; and
• market neutral/absolute return.

In contrast, one-quarter or fewer are optimistic about convertible arbitrage, global macro, merger arbitrage, short-only and/or distressed debt.

Forty-two percent of respondents believe single-manager funds will gain a greater share of hedge fund investments this year. Many cited greater accountability, more targeted strategies and lower fees as key drivers. On the other hand, half expect multi-manager funds to gain a greater share, driven in part by risk management, diversification, performance and reduced key-person risk.

Barnes & Thornburg asked hedge fund respondents about the anticipated use of various redemption and liquidity terms in the coming year, compared to the past 12 months. They differed widely on whether use of such terms would increase, stay the same or decrease. At one end of the spectrum, more than half of hedge fund respondents (54%) expect an increase in lockups, versus just 13% who expect a decrease. At the other end, a plurality expect investor-level gates (46%) and/or suspension of redemptions (38%) to decrease, versus 38% and 33%, respectively, who expect them to increase. One-third expect fund-level gates to decrease, versus just 21% who expect an increase.

See our three-part series on suspending withdrawal or redemption requests: “The 2008 Crisis Versus the 2020 Pandemic” (May 21, 2020); “Key Steps in the Process” (May 28, 2020); and “When and How to Lift the Suspension” (Jun. 4, 2020). 

Private Credit

Four-fifths of respondents expect the private credit market to be stronger in 2025 than in 2024, including 35% who believe it will be significantly stronger. More than half expect small and mid-cap firms to target larger deals, which is consistent with ongoing consolidation in the industry, according to the Report. Of the respondents that are not private credit firms, 63% have a private credit strategy in place, and an additional 34% are either implementing or discussing such a strategy.

See “SEC Asset Management Conference Panel Addresses Private Fund Regulation, Private Credit and Responsible Investing” (Oct. 12, 2023); and “Interest in Private Credit Remains Strong, According to ACC/PCFI Survey” (Sep. 16, 2021).

Digital Assets

Eighty-four percent of respondents are optimistic about cryptocurrency investments, including 54% who are very optimistic. Consistent with that optimism, a similar proportion of respondents are either more likely (41%) or significantly more likely (44%) to invest in cryptocurrency funds than they were a year ago, versus just 4% who are less likely to do so. The top factors driving cryptocurrency investments, cited by about 60% of respondents, include regulatory clarity, growth of the market and/or innovative investment products. A significant proportion also cited institutional acceptance (55%), public acceptance (47%) and general economic conditions (42%).

See our two-part series on an SEC Crypto Roundtable on custody of digital assets: “Custody Challenges” (Jun. 5, 2025); and “Custody Models” (Jun. 19, 2025); as well as “Study Finds Increasing Hedge Fund Interest in Digital Assets” (Mar. 13, 2025).

Private sector firms have made modest progress in recent years when it comes to adopting cybersecurity best practices, according to then-CFTC Commissioner Kristin N. Johnson. In remarks delivered on July 14, 2025, at the Regulators Roundtable on Financial Markets Innovation and Supervision of Emergent Technology, Johnson discussed international cybersecurity defenses and protocols, highlighting acute dangers in a heavily interdependent business world in which a contagion of breaches, or “domino effect,” is all too likely. She noted that the expertise and technology that firms leverage in the hope of shielding their own data and systems often fail to take account of the dangers that a breach might occur at the nexuses of interaction between a firm and a central counterparty or other vendor or service provider.

The dangers of third-party exposure; failures of counterparty risk management; cross-border attacks and breaches; and the growing use of IT infiltrators and artificial intelligence (AI) on the part of rogue states, hackers and other bad actors are all issues of grave concern and call for improving third-party risk management; bolstering cross-border regulatory and enforcement efforts; and sharing of actionable threat intelligence among firms, Johnson argued. This article covers key takeaways from Johnson’s remarks with practical commentary on insider threats, third-party risk mitigation and incident preparation and response from cybersecurity experts at Debevoise & Plimpton and Otterbourg.

See “CFTC Advisory Cautions Firms to Remain Compliant When Deploying AI” (Aug. 14, 2025).

Encouraging Steps

Not all of Johnson’s assessment of the state of cyber preparedness in the United States and abroad was negative. On the contrary, her remarks cited evidence of significant progress in recent years toward achieving higher levels of operational resilience.

Some of the initiatives Johnson alluded to have come directly from her own agency. For example, in December 2023, the CFTC issued a proposed rule, which quickly met with unanimous approval, aiming to establish an operational resilience framework that would help future commission merchants, swap dealers and major swap participants “identify, monitor, manage, and assess risks relating to information and technology security, third-party relationships, and emergencies or other significant disruptions to normal business operations,” she noted.

The operational resilience framework approach can help bolster preparedness in a market in which cyber resilience “is only as strong as its weakest link,” Johnson argued. She went on to enumerate a number of concerning gaps in the defenses of firms both within and outside the CFTC’s regulatory purview.

See “CFTC Commissioner Shares Five Pillars of Cyber Resilience” (Aug. 3, 2023).

Continuing Vulnerability Highlights Need to Improve Key Defenses

For all the positive signs, Johnson noted that the Market Risk Advisory Committee (MRAC) she sponsors at the CFTC found cyber-resilience issues that the CFTC’s December 2023 proposal did not sufficiently address. In particular, the risks facing CFTC-regulated central counterparties – and, by extension, firms that do business with them and become vulnerable to potential contagion – did not get enough attention.

The Central Counterparty Risk and Governance Subcommittee (of the MRAC) identified a need to “improve upon the existing framework and require derivatives clearing organizations to establish, implement and maintain a third-party relationship management program,” Johnson noted. “Once again, this highlights the importance of international collaboration, in setting the standard for best practices, and for developing policies that are familiar to global market participants.”

Johnson’s comments align with a broad shift in perceptions about how the nature of cyber threats have evolved in recent years, Debevoise & Plimpton partner Luke Dembosky told the Hedge Fund Law Report. The antiquated view that cybersecurity was an issue only a discrete division within a firm – typically an IT or information security team with limited resources and capabilities – had to worry about has given way to a far broader view of cyber risks and how to respond to them, he observed. A growing number of private sector players are urging senior management, from CEOs and boards of directors on down, to be more cognizant of the risks of doing business in an interconnected world and to develop and implement plans that involve more proactive testing along with up-to-the-minute plans and playbooks, he added.

“We’re seeing threat actors penetrate email, penetrate chats and get into communications about the response – both the plans to try to eradicate their access and, potentially, any plan to negotiate with them over a ransom,” Dembosky observed. Firms have to identify alternative communications platforms, “so that you’re not left trying to figure out how your board, your response team and your negotiators are all going to communicate with you in the crisis.” Out-of-band communications methods are key if a firm suspects a threat actor may be able to eavesdrop on its usual systems, he advised.

See “‘Risk to Resilience’: CFTC Commissioner Romero Discusses Climate and Cybercrime Risk” (May 25, 2023).

Understanding Infiltration by North Korea’s IT Workers

If effective defenses, which Johnson calls for, are to be implemented, the most prevalent cybersecurity threats need to be more widely understood, Dembosky urged.

Evolution of a Calculated Threat

Although the dangers of bad actors gaining access to systems and data under a pretense of carrying out legitimate IT roles are not new, the specific provenance of one of the most serious threats is only starting to get the attention it warrants, Dembosky opined. That threat is a program that North Korea undertook shortly before the coronavirus pandemic and has pursued vigorously since then, he observed. The program involves surreptitiously inserting remote IT workers into the workforces of the U.S. and other powers, with a view to collecting salaries and sometimes stealing data to support regime objectives.

“Either as full-time employees or as contractors, thousands of North Korean IT workers have been placed inside hundreds if not thousands of Western companies,” Dembosky stated. “The FBI and [Cybersecurity and Infrastructure Security Agency (CISA)] have warned industries that if you’re of any size and scale and you outsource IT functions and allow remote work, you may well have North Korean workers passing themselves off as someone else.”

In the last few years, continued Dembosky, he and his colleagues have advised clients that fell victim to this scheme in dozens of cases. All too often, firms may have been lulled by the sense that they were paying for wholly legitimate (and, of course, legal) outsourcing. In some cases, they may even have made use of a placement agency, unaware of the dangers they courted by establishing a nexus of interaction between their systems and data and a third-party service provider that had not undergone proper screening, he reported.

The threat has evolved considerably over time, Dembosky observed. Originally, some of the North Korean IT workers may have simply collected a salary, just like their counterparts from other countries. Then, they started to steal, or attempt to steal, data. “In the current iteration of the scheme – in some cases – they are threatening to dump the data on a public site unless they are paid the equivalent of a ‘severance,’” he said.

See “Navigating Ransomware’s Challenges” (Sep. 26, 2024).

Legality of Ransom Payments

Firms that discover infiltration and data theft by a fraudulent worker are caught in something of a double bind, because they want to protect the integrity of their data but do not want to break the law by making payments to bad actors, Dembosky noted. When a fraudulent worker is caught and terminated, the last bit of leverage he or she has is to extract some monetary penalty. But “it’s illegal to pay them” pursuant to U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) regulations, he noted.

Even if a firm feels that paying a “severance” and preventing the dumping of its data on a public site will protect against further exposure of the data, the law applies, Dembosky said. OFAC sanctions can seriously complicate efforts to resolve the situation. A firm could apply to the Treasury Department for an emergency license, “but it’s certainly not the norm.” Thus, a firm can be stuck in a situation in which it is unable to legally pay, “and the penalties for paying illegally are criminal,” he added.

See “Dual Resolutions Demonstrate Full Spectrum of Sanctions-Related Enforcement Against Investment Firms” (Jul. 31, 2025).

Risk Mitigation Steps

Firms can minimize the risk of infiltration by fraudulent workers by investing in screening of prospective remote workers and outside service providers, even if they have made their services available through a reputable placement agency or otherwise act under the imprimatur of a respected source, Dembosky suggested.

Fortunately, the issue is very much on the radar of law enforcement, advisory bodies and tech firms. “There are patterns to the way that North Koreans carry out the scheme that one could learn about,” Dembosky said. “Speak with a trusted vendor in the space, consult with the FBI.”

Firms can consult with their local FBI office through InfraGard, for example, which makes such consultations between business and federal law enforcement possible, continued Dembosky. Another source is the Financial Services Information Sharing and Analysis Center. On the tech side, many resources are available, including sophisticated endpoint detection and recovery tools, he added.

Firms that may not “have the resources to do a full vetting of everybody” can prioritize vetting certain people, such as those who will work on their AI development program and/or the coding of the software that assesses lending and development risk, or who have access to the full trove of their investor data, Dembosky suggested.

Coordinating International Cybersecurity Efforts in Public and Private Sectors

Johnson repeatedly emphasized the degree to which the digitization of commerce has made jurisdictional and national boundaries immaterial in considering the scope and severity of cyber risk. “The threats or risks born in one nation may quickly ripple across continents,” Johnson stated.

A weakness in a third-party service provider can cripple many financial institutions across jurisdictions in one fell swoop, Johnson warned. The severity of the danger underscores the need for a number of changes and protocols to foster a more united, holistic approach, she urged.

Johnson’s acknowledgement of the need for a cross-jurisdictional approach on the part of regulators, and their proactive stance toward registered entities’ adherence to cybersecurity standards and systems, is in line with current realities in the private sector, Dembosky affirmed. She recognizes that there is “intra-company dependence not just geographically but across different functions within a company,” he observed. “And she emphasizes third-party issues because most businesses are far too complex just to rely on their own operations. They’ve got external people processing transactions, handling pieces of their data, doing certain clearing functions or performing other critical steps. And the diligence on that, historically, has been pretty static.”

See “Considerations for Managing Third-Party Cyber Risks” (Dec. 21, 2023).

Cross-Border Regulatory Efforts

The scope of the threat calls for aligning supervisory approaches across borders, with a view to countering cyber risk in a coordinated manner, Johnson opined. Although some regulators, such as the Financial Stability Board (FSB) and CPMI-IOSCO, have set forth the principles they intend to pursue, Johnson warned that a fragmented approach will not be sufficient and instead called for global implementation. Among the standards that Johnson argued should be part of regulators’ shared expectations are ISO 27001, the National Institute of Standards and Technology’s guidance and the FSB’s cyber incident response guidance.

“It is worth exploring mutual recognition of cyber audits and certifications for third-party providers, especially cloud platforms,” Johnson added.

The reality is that the experience and sophistication of regulators in different territories and jurisdictions vary widely, Dembosky noted. “Sometimes, it isn’t well-understood how long it takes to get answers and how much of a crush the first days of an incident response are,” he commented. There is now generally “a high level of incident response maturity in the West, but we do encounter regulators, especially in other parts of the world, who think that their 30 questions need to be answered immediately in the midst of a breach,” he explained. “And that often reflects a lack of understanding and experience with how incidents go and what the company has to prioritize in the immediate response.”

Evolving Third-Party Diligence Standards

Johnson urged firms to change how they supervise the cyber readiness and trustworthiness of entities and resources on which they rely. “We need a coordinated approach to supervising these critical third parties – through shared resilience testing, pooled audits, and transparent incident reporting,” she stated.

Dembosky said that proper third-party supervision includes “sending counterparties a questionnaire before you contract with them,” which asks, “Do you have cyber insurance? Do you have a response plan? Have you had an incident in the past year or two?” The questionnaire is “important, but it’s not enough. You need to understand how [counterparties] are going to interact with you, if there is a gray area for you or for them, what they’re going to share with you and vice versa, and how you’re going to communicate,” he noted. “And you need to monitor this going forward – it can’t be one-and-done on diligence.”

See “Checklist for Framing and Assessing Third-Party Privacy and Information Security Risk” (Sep. 28, 2023).

Disclosure of Breaches

Sharing Actionable Intel

It is imperative for not only government regulators but also private sector players to take a more proactive role in sharing information about cyber threats and incidents with others in the market, Johnson stressed. There is a role for private firms in building mutually accessible, real-time alert systems and threat-sharing protocols, she said.

“Silence, in the cyber domain, is a vulnerability,” she added, advocating for “transparent incident reporting” as a means to bolster critical awareness across industries and jurisdictions.

Johnson’s emphasis on transparent reporting signals certain problems with the manner in which some firms have disclosed, or failed to disclose, breaches in the past, limiting the ability of cyber experts to respond and adapt to the breaches by devising and implementing better defenses, Dembosky observed.

“Historically, there has been an impression that companies have underreported incidents, or, when they have reported them, they have not shared the story in a ‘fulsome’ manner. Certainly, the Biden Justice Department suggested that it wanted more fulsome reporting of cyber incidents,” Dembosky shared.

“The SEC, of course, under its last Chair, Gary Gensler, was quite aggressive about the level of detail that it required,” added Dembosky. “CISA has promulgated highly detailed reporting requirements, but we’ll have to see whether they eventually come into effect as written or whether they will be amended or set aside by the new administration.”

See “A Practical Approach to Navigating the New Cybersecurity Legal and Regulatory Landscape” (May 11, 2023).

Timing Issue

“A lot of the new rulemaking is designed to get more information out of companies. That is a wholesome objective, but there’s a sweet spot in terms of the timing for incident reporting,” Dembosky noted.

Right after a cyber breach occurs or is detected, a firm’s personnel will understandably have extremely urgent tasks to handle that supersede information sharing. Any proposed amendments to disclosure protocols must take into account that reality.

“In the scramble of musical chairs to try to regain control of your network in the first 48 to 72 hours, it’s the wrong time to be stopping to draft detailed regulatory reports,” Dembosky clarified. “You may have to get word out to the market, but to require a firm to write up a detailed report for the regulators in that time period is a mistake.”

See “Navigating the Interplay of Breach Response and Breach Notification” (Jun. 22, 2023).

Incident Response Plans

The longstanding focus, on the part of regulators and companies, on preventing cyber breaches is all well and good, but, in Johnson’s view, present realities necessitate anticipating that attacks will happen and investing in effective responses. Understanding that reality has numerous implications for firms’ budgets, operations and internal and external compliance cultures.

The investment “means building interoperable incident response plans,” which include “conducting joint cyber drills and tabletop exercise simulations and establishing trusted communications channels” that can be activated instantly in the event of a cross-border incident, stated Johnson.

Johnson’s sense that it is necessary to treat cyber breaches as a question of “when, not if” is in line with the views of most professionals in the cybersecurity realm, affirmed Erik Weinick, a member at Otterbourg. “We focus on prevention, but in today’s threat landscape, we must assume that breaches will occur and focus on how we will respond,” he stated.

Delegation of Communications Authority

Johnson could have gone into more detail on the designation of personnel within a firm who will be ready and available to respond when a breach occurs, Dembosky opined. Although it might seem an obvious step, not all firms have delegated responsibility for handling the response to a breach and making statements to the media, if that course is deemed prudent. All too often, the assumption is that the most senior executive will be the first and last port of call. Unless there is a plan in place for the CEO to speak publicly, it would be a mistake to wake the company leader, perhaps in a different time zone, with a call in the small hours of the morning, he cautioned.

“There will always be some scramble, because there will be differing facts in every instance. But you want to focus on what the strategic issues are and make sure everyone knows their role and responsibility,” Dembosky advised. “Where and when will information make its way up to the senior leadership? How will we make sure they’re not overwhelmed at a senior level with all the blocking and tackling? Those work streams can be addressed down in the war room. If you dump everything on the CEO’s desk, the response will break down.”

When formulating an incident response plan, and determining who will be responsible for what, it is crucial to anticipate how a potential incident could affect the form in which such information will be accessible. If available only in electronic form – in a system that has been shut down – a contact list for employees designated to handle incident response will be inaccessible when most needed. “Those simple things don’t always seem like big issues. But you can’t really even get off the launch pad unless you can communicate effectively as part of your response plan,” Dembosky noted.

See “New Pressures Shift Best Practices for Ransomware Crisis Communications” (Nov. 10, 2022).

Addressing Overconcentration Risk and Supply Chain Gaps

Johnson stressed the dangers inherent in overconcentration of resources and reliance on a narrow range of counterparties and vendors. She identified three categories of counterparties that firms tend to rely on excessively, fostering opportunities for bad actors:

1. cloud providers;
2. FinTech APIs; and
3. software stacks.

Johnson’s perspective aligns with private sector cybersecurity professionals’ views, affirmed Weinick. “In some instances, there is an overreliance on a small number of vendors and outside service providers,” he summarized, which can be efficient, “but it also leaves us highly vulnerable.”

See “Key Considerations for Fund Managers When Selecting and Negotiating With a Cloud Service Provider” (Sep. 21, 2017).

Making Due Investments

Even in the face of a severe threat, some private sector players are simply not directing enough of their operating budgets to cyber defenses, Weinick observed.

Part of the issue here, he posited, is psychological in nature. To marshal the resources and exercise the discipline needed to invest huge sums of money on programs and protocols that are preventive or reactive in nature – i.e., addressing threats that a firm has, so far, been lucky enough to avoid – can be challenging, he elaborated, illustrating his point with an analogy. “It’s kind of like asbestos removal for the construction industry. It’s costly, and there’s no immediate, obvious benefit to the bottom line. You spend all this time and money, and the room still looks the same once the asbestos is removed,” he said.

That example may help people understand why some firms are dragging their feet when it comes to what is obviously one of the gravest, fastest-evolving threats they are likely to face. “When it comes to cybersecurity, you often don’t notice the issue until there’s a problem, and that’s why it is very easy to deprioritize it when it comes to budgeting, allocating resources and making sure that people are trained properly,” Weinick observed.

Cybersecurity must “be something that everybody in the organization takes seriously, because people represent the greatest vulnerabilities. They are the avenues that threat actors use to blow an organization wide open, what they view as the easiest way in,” Weinick instructed.

See “Go Phish: Employee Training Key to Fighting Social Engineering Attacks” (Feb. 29, 2024).

In August 2019, the SEC filed a civil enforcement complaint (Complaint) against Commonwealth Equity Services, LLC d/b/a Commonwealth Financial Network (Commonwealth) in the U.S. District Court for the District of Massachusetts (District Court). The SEC alleged that Commonwealth failed to adequately disclose potential conflicts of interest arising out of receipt of revenue from National Financial Services, LLC (NFS), in connection with its sales of mutual funds. In April 2023, the District Court granted the SEC’s motion for summary judgment as to liability, ruling that omissions from Commonwealth’s conflicts disclosures were material as a matter of law. In March 2024, it entered a judgment (Final Judgment) against Commonwealth for more than $93 million.

On April 1, 2025, however, the U.S. Court of Appeals for the First Circuit (Court) issued an opinion (Opinion) vacating the District Court’s liability judgment and the Final Judgment, ruling that whether Commonwealth’s omissions were material was a question for a jury. This article discusses the facts underlying the litigation and the Opinion, which may have implications for how the SEC handles future conflicts disclosure-related litigation, including cases involving hedge fund managers.

See “Despite End of Share Class Selection Disclosure Initiative, SEC Continues Pursuit of Violators” (Jul. 16, 2020).

Commonwealth’s Business

Commonwealth is dually registered with the SEC as an investment adviser and broker-dealer. It provides advisory services through a network of about 2,300 investment adviser representatives (IARs), who are affiliated with Commonwealth but operate independent advisory businesses under their own names. They offer only products approved by Commonwealth. Commonwealth charges each client an annual advisory fee based on a percentage of the client’s assets under management. It shares between 50% and 98% of that advisory fee with the client’s IAR, according to the Opinion.

IARs use NFS, a clearing broker affiliated with Fidelity Investments, to buy and sell mutual funds for clients through Fidelity’s FundsNetwork platform. IARs can purchase funds on FundsNetwork through either a transaction fee (TF), no transaction fee (NTF) or institutional no transaction fee program. Funds in the TF program incur sales charges in addition to ongoing distribution and service fees. An IAR can decide whether to absorb some or all of the transaction fees or pass them on to clients.

Some mutual funds companies that offer their shares through FundsNetwork pay certain fees to NFS, including fees associated with particular classes of a fund’s shares. Since at least 2009, NFS and Commonwealth had a revenue sharing arrangement pursuant to which NFS paid a portion of such fees to Commonwealth. Commencing in 2014, NFC began paying Commonwealth 80% of its gross revenue from funds in the TF and NTF programs. However, IARs did not know which share classes were covered by the fee sharing arrangement nor was their compensation dependent on whether the funds they selected for clients provided Commonwealth with any fee sharing revenue from NFS, noted the Court.

According to the Opinion, Commonwealth provides IARs with:

• model portfolios through its Preferred Portfolio Services (PPS) program;
• a Mutual Fund Resource Guide with information on available mutual funds and share classes; and
• a list of recommended funds vetted by Commonwealth.

Prior SEC Settlement

In February 2018, the SEC initiated its share class selection disclosure initiative, which focused on disclosures by investment advisers that directly or indirectly received so-called “12b‑1” marketing and distribution fees from mutual fund share classes sold to clients who were eligible to invest in share classes that did not bear such fees. Pursuant to that initiative, Commonwealth self-reported to the SEC and, in March 2019, was ordered to disgorge $1,426,700.16 and pay prejudgment interest of $210,603.29. The SEC brought this action after that settlement.

See “SEC Settles With 16 Additional Advisers Under SCSD Initiative, Severely Penalizes One That Did Not Self‑Report” (Nov. 21, 2019); and “SEC Settles With 79 Investment Advisers Under Its Share Class Selection Disclosure Initiative” (Apr. 4, 2019).

Alleged Inadequate Conflicts Disclosures

The Complaint alleged that, from at least July 2014 through December 2018, Commonwealth made materially misleading disclosures regarding the conflicts of interest associated with its revenue sharing arrangements with NFS. Investment advisers must disclose all material conflicts of interest, with sufficiently detailed facts regarding each conflict, in their Form ADV, Part 2A brochures. From 2014 through 2018, Commonwealth disclosed its fee sharing arrangement with NFS and the associated conflict of interest with increasing detail. For example, in 2014, it disclosed generally that its receipt of compensation for recommending certain products or programs “may present a potential conflict of interest” by giving it an incentive to recommend investments that provide revenue sharing. By 2017, it had amended its disclosure to provide that its fee sharing arrangement with NFS “creates a conflict of interest” regarding mutual fund recommendations.

See “SEC Continues Crackdown on Use of ‘May’ in Disclosures” (Nov. 14, 2019).

In December 2018, it further amended its disclosure to provide that it had a conflict because it had an incentive to recommend investments “that provide additional compensation to Commonwealth that cost clients more than other available share classes in the same fund that cost you less.” The SEC did not challenge the December 2018 disclosure.

The SEC claimed that, by reason of the allegedly inadequate disclosures, Commonwealth violated Section 206(2) of the Investment Advisers Act of 1940 (Advisers Act), which makes it unlawful to engage in any transaction, practice or course of business that operates as a fraud or deceit on clients. It also claimed Commonwealth violated Section 206(4) of the Advisers Act and Rule 206(4)‑7 thereunder, known as the Compliance Rule, which requires advisers to adopt and implement policies and procedures reasonably designed to prevent violations by the adviser and its supervised persons of the Advisers Act and its rules.

The District Court granted partial summary judgment to the SEC as to Commonwealth’s liability on both claims. With regard to its violation of Section 206(2), the District Court held:

[T]o the extent that Commonwealth did not disclose that (i) Commonwealth may have a potential conflict of interest where it receives revenue sharing payments on mutual fund class shares that have higher expenses as compared to other mutual fund class shares or (ii) class shares of the same fund existed with lower internal expenses, such disclosure is inadequate under the Advisers Act.

Commonwealth moved for reconsideration of the decision, arguing that the District Court erred in holding that the alleged deficiencies in Commonwealth’s conflicts of interest disclosures were material. The District Court denied that motion and, after further motion practice over the SEC’s proposed sanctions, entered the Final Judgment, which ordered Commonwealth to pay:

• disgorgement of $65,588,906;
• prejudgment interest of $21,185,162; and
• a civil penalty of $6,500,000.

See “Identifying and Managing Common Conflicts of Interest” (May 9, 2024); and “SEC Reiterates Standards of Conduct for Advisers and Broker‑Dealers As to Conflicts” (Sep. 29, 2022).

Legal Analysis

Commonwealth appealed the summary judgment and Final Judgment to the Court. The Court vacated the judgments, ruling that the question of whether the alleged omissions from Commonwealth’s conflicts of interest disclosures were material was a jury question.

Materiality

Summary judgment on a cause of action is appropriate only when there are no material issues of fact and the court can decide the issue as a matter of law, the Court explained. It reviews an appeal from summary judgment de novo and draws all reasonable inferences in favor of the appellant – in this case, Commonwealth.

The District Court had determined that Commonwealth’s disclosures were inadequate as a matter of law, reasoning that it is “well-settled that potential conflicts of interest are material facts that investors would consider important in making investment decisions,” according to the Opinion. Commonwealth’s disclosures regarding its conflicts were inadequate in several respects, including:

• stating only that it “may” receive revenue from NFS when it was, in fact, receiving revenue;
• mentioning only revenue from the NTF program, not the TF program; and
• omitting the availability of lower-cost classes of a mutual fund’s shares.

On appeal, Commonwealth argued that whether the alleged omissions were material was an issue that should have been decided by a jury. The Court agreed. An adviser’s fiduciary duty, which arises under Section 206 of the Advisers Act, requires the adviser to provide clients with a full and fair disclosure of all material facts. The Supreme Court has held that an omission is material if a reasonable investor would consider the omitted facts as significantly altering the “total mix” of available information, explains the Opinion. In the First Circuit, materiality of an omission can be decided as a matter of law on summary judgment only if it is “so obviously important to an investor that reasonable minds cannot differ,” noted the Court.

“[T]he usual rule that materiality is to be decided by the jury applies in this case,” concluded the Court. “The district court did not engage in the required ‘fact-specific inquiry’ and instead rested on a generalized per se conclusion that ‘[i]t is indisputable that potential conflicts of interest are ‘material’ facts with respect to clients.’” The two cases relied on by the District Court involved reviews of administrative orders, which are reviewed only to determine whether they are supported by “substantial evidence.” Neither was a decision on a motion for summary judgment. Moreover, neither involved determining whether an omission was material, added the Court.

The District Court improperly reasoned that, “since all potential conflicts are material, the omissions at issue were material as a matter of law,” explained the Court. “Applying the correct test of materiality, we hold that a reasonable jury could conclude, on the facts of this case, that additional disclosures with more precise descriptions, added to the already-disclosed conflicts of interest, would not have [significantly altered the total mix of available information].”

First, at relevant times, Commonwealth had 2,300 IARs serving about 319,000 investors – who presumably had diverse investments and investment goals and received different advice from their IARs. The SEC “in many ways assumed that these investors were identically situated,” noted the Opinion. A reasonable jury could find the SEC’s assumptions to be unsubstantiated.

Second, the SEC provided no testimony from any investors or IARs as to how they viewed the significance of the omitted information. The testimony of the IARs who were deposed in the action suggested that share class was only one factor they considered. Several said they were not looking for the absolute lowest-cost class of shares. “And it does not follow that, simply because a share class was the lowest available cost, this was significant in the materiality sense to these representatives and their clients,” according to the Court.

Third, Commonwealth was able to influence the choice of a share class primarily through its model portfolios and Mutual Fund Resource Guide. However, clients did not use those materials; they made investment decisions through the independent IARs – who are “sophisticated and independent members of the financial industry who recommended to their clients the funds and share classes to be purchased,” said the Court. Indeed, four of the IARs who testified said they conducted independent research to determine the best share classes for clients. “There are material issues of fact as to the importance of price, Commonwealth's influence over the funds selected, and about the significance of the allegedly deficient disclosures, themselves. It is the role of a jury to determine those questions,” the Court concluded.

Finally, the Court distinguished its July 2024 decision in SEC v. Navellier & Associates, Inc., which held that failure to disclose that the performance of the “AlphaSector” strategy presented in the defendant’s marketing materials was backtested was material as a matter of law. “The established omissions here are obviously important to an investor because whether the AlphaSector strategy’s performance figures are back-tested or based on actual trades speaks to the potential risk that an investor will take if they decide to invest in the strategy,” the Court reasoned in Navellier. In contrast, “it is not obvious that the omitted facts from Commonwealth’s conflict of interest [disclosures] would have changed the investors’ perceptions, given their use of the investment advice of sophisticated intermediaries in the form of Commonwealth’s representatives,” reasoned the Court.

For more on Navellier, see “SEC Continues Its Pursuit of Firms That Licensed F‑Squared Indices” (Sep. 28, 2017).

Disgorgement

Because the Court vacated the judgment as to Commonwealth’s liability, it also vacated the Final Judgment. Additionally, the Court took issue with the SEC’s calculation of disgorgement, which the District Court had accepted. A disgorgement award must be a reasonable approximation of profits causally connected to the defendant’s violation, explained the Court. The SEC, which had the burden of proof, had not established either that its estimate was reasonable or that the estimated profit was properly attributable to the alleged wrongdoing.

For example, the District Court used the entire $65.6 million of Commonwealth’s estimated profits because, had Commonwealth made appropriate disclosures, “at least some” clients would have moved to lower-cost funds. The jump from “at least some” to “every” client was not supported by the evidence. Other concerns regarding the calculation included:

• whether the sample used to calculate lower-cost share classes was appropriate and representative;
• countervailing evidence of causation provided by IARs’ testimony regarding recommendations of mutual funds and share classes for clients; and
• inadequately supported assumptions.

Additionally, although a party’s legitimate expenses may be deducted from a disgorgement award, the District Court improperly declined to deduct Commonwealth’s expenses on the basis that the entire disgorgement award was based on ill-gotten gains. The District Court should have analyzed whether Commonwealth’s claimed expenses were legitimate business expenses or “merely wrongful gains ‘under another name,’” explained the Court.

See “Liu Is Dead, Long Live Liu: Spartan and Disgorgement After the NDAA” (Oct. 20, 2022); and “The SEC’s New Disgorgement Powers: Questions and Consequences” (Apr. 8, 2021).

K&L Gates welcomed Robert G. Leonard as a partner in its asset management and investment funds practice in the firm’s New York office. Leonard advises clients on the structuring and organization of various master-feeder, side-by-side and mini-master-feeder funds, catering to hedge fund managers implementing various strategies. 

For insights from Leonard, see “Credit Suisse Survey Finds Greater Satisfaction With Hedge Fund Investments, Strong Demand for Equity Strategies and Growing Flexibility on Fee Structures” (Apr. 5, 2018). 

Leonard concentrates his practice on the formation, structuring and representation of domestic and offshore hedge funds, funds of funds and other private investment vehicles for emerging and established managers. He also has substantial experience with seed deals, anchor investments and assisting managers that are joining and spinning out of platforms. He works closely with family offices, institutional investors and investment managers that pursue a wide range of investment strategies, including:

• long/short equity; 
• multi-strategy; 
• credit; 
• distressed credit; 
• mortgage-backed securities; 
• risk arbitrage; 
• quantitative; 
• emerging markets; 
• global macro; 
• statistical arbitrage; 
• relative value; 
• event-driven; and 
• direct lending. 

With more than three decades of experience, Leonard has helped clients navigate complex regulatory and compliance matters, representing them in examinations, investigations and disputes involving investors and third parties. 

See “SEC Regulatory and Examination Priorities in 2025” (Aug. 14, 2025). 

In addition, Leonard is at the forefront of legal developments in matters related to alternative data and generative artificial intelligence, advising clients on governance frameworks, due diligence, risk management and contract negotiations. 

See “Survey Finds Investment Managers Increasing Use of Alternative Data” (May 8, 2025); and “Dos and Don’ts for Employee Use of Generative AI” (Oct. 24, 2024).