The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

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By Topic: Accounting

  • From Vol. 10 No.16 (Apr. 20, 2017)

    Failure to Consider Relevant Market Inputs When Valuing Assets May Draw SEC Enforcement Action Against Fund Managers

    Valuation by private fund managers remains a focus of SEC attention for its effect on performance, the fees payable to managers and the price at which investors enter and exit a fund. As it relates to illiquid or thinly traded assets, this exercise is particularly nettlesome. In a recently settled enforcement proceeding, the SEC asserted that, in contravention of its funds’ governing documents and valuation policies, a registered investment adviser and one of its principals ignored for valuation purposes its own trades in certain assets. Instead, the adviser favored the higher valuations provided by a third-party pricing service that did not use actual market inputs, resulting in a significant overvaluation of those securities. For another recent action in which a manager improperly used pricing service marks instead of actual trades, see “SEC Settlement With PIMCO Highlights the Importance of Proper Valuation and Performance Disclosures” (Dec. 8, 2016). This article summarizes the valuation practices that the SEC challenged, the sanctions imposed and the other relevant terms of the settlement order. For additional coverage of the SEC’s recent attention to valuation of illiquid assets, see “Hedge Fund Platinum Partners and Principals Face Civil and Criminal Proceedings From SEC and DOJ Over Alleged Fraudulent Valuation Practices and Liquidity Misrepresentations” (Jan. 12, 2017); and “SEC Continues to Focus on Insider Trading and Fund Valuation” (Jun. 30, 2016).

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  • From Vol. 10 No.12 (Mar. 23, 2017)

    Avoiding Common Pitfalls Under the Custody Rule: Inadvertent Custody, Delivery Failures and GAAP Compliance (Part One of Two)

    Since its initial adoption in 1962, Rule 206(4)-2 of the Investment Advisers Act of 1940, commonly referred to as the “custody rule,” has undergone a number of revisions and has increasingly been the subject of SEC comments. The SEC’s Office of Compliance Inspections and Examinations has issued several risk alerts – in 2013 and, most recently, in February 2017 – identifying custody deficiencies as an area of concern. See “Top Five Compliance Deficiencies in OCIE Risk Alert Include Annual Compliance Reviews, Accurate Regulatory Filings and Custody Issues” (Feb. 23, 2017); and “SEC Risk Alert Reveals Significant Deficiencies in Custody Practices of Hedge Fund Managers and Other Investment Advisers” (Mar. 7, 2013). This latest risk alert prompted The Hedge Fund Law Report to investigate whether the staff commonly identifies deficiencies in custody rule compliance by investment advisers. Our research suggests that, while alternative asset managers of “plain vanilla” private funds tend to comply with the rule with minimal difficulty, weaknesses can and do occur when advisers are presented with nuanced circumstances. In this two-part series, we identify six common traps that can lead to a private fund adviser’s non-compliance with elements of the custody rule. This first article identifies options for private fund managers to comply with the rule; discusses the frequency with which custody is reviewed during SEC examinations; and identifies common weaknesses in the areas of inadvertent custody, preparing audited financial statements (AFS) and meeting the deadline for delivering AFS. The second article will discuss circumstances under which private fund advisers may fail to realize that they have custody, the auditor independence requirement and liquidation audits.

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  • From Vol. 10 No.8 (Feb. 23, 2017)

    What Role Should the GC or CCO Play in the Audit of a Fund’s Financial Statements? 

    The first quarter of the year marks the busy season for finance professionals at private funds. Once the investment manager (or its administrator) finalizes the prior year-end performance for its funds, the firm can officially commence auditing those funds’ financial statements, although preparations have likely been underway for several months. From a regulatory perspective, Rule 206(4)-2 (Custody Rule) of the Investment Advisers Act of 1940 is the driving force behind the flurry with which a hedge fund manager approaches the audit process. See “How Does the Custody Rule Apply to Special Purpose Vehicles Used by Private Equity Funds to Purchase, and Escrow Accounts Used to Sell, Portfolio Companies?” (Jul. 24, 2014); and “How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures in Light of Amendments to the Custody Rule?” (Jan. 20, 2010). Registered commodity pool operators must also adhere to CFTC Regulation 4.22(c), which requires that audited financial reports be delivered to the pool’s investors and filed with the NFA within 90 days of the pool’s fiscal year-end. See “NFA Workshop Details the Registration and Regulatory Obligations of Hedge Fund Managers That Trade Commodity Interests” (Dec. 13, 2012). Of course, even without these regulatory requirements, most institutional investors – particularly those that owe a fiduciary duty to their end-investors – insist that funds to which they allocate undergo an annual audit. To assist our subscribers that are currently engaged in the audit process, this article considers the audit from the perspectives of the fund manager’s chief compliance officer and general counsel. Specifically, we analyze the fund’s audit process and explore the extent to which legal and compliance personnel should be part of that process, or whether this is a purely financial function that is outside their purview. 

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  • From Vol. 9 No.33 (Aug. 25, 2016)

    Expense Allocation and Fee Practices Fund Managers Should Avoid to Reduce Risk of SEC Scrutiny (Part One of Three)

    There were no specific regulations – and minimal SEC guidance – for fund managers to reference prior to 2015 when allocating expenses between themselves and their funds. To fill this void and protect investors, the SEC announced in 2015 and 2016 that private fund fee and expense practices would be a priority of its Office of Compliance Inspections and Examinations. A flurry of enforcement actions followed, targeting practices often viewed as “market” by hedge fund managers at the time. Fund managers must study those actions to date to ensure they do not commit the same violations highlighted by the SEC. To illuminate best practices for fund managers to avoid expense allocation violations, The Hedge Fund Law Report spoke with top practitioners in the industry and examined SEC enforcement actions and statements by SEC staff. This article, the first in a three-part series, outlines trends in the types of expense allocations most aggressively scrutinized by the SEC. The second article will examine the flaws in disclosures to investors and the gaps in policies and procedures of managers that frequently result in expense allocation violations. The third article will describe best practices fund managers should adopt to prevent violations, as well as remedial actions to take upon discovering the improper allocation of an expense. For additional coverage of expense allocations, see “Battle-Tested Best Practices for Private Fund Expense Allocations” (Oct. 10, 2014); and our two-part series entitled “How Should Hedge Fund Managers Approach the Allocation of Expenses Among Their Firms and Their Funds?”: Part One (May 2, 2013); and Part Two (May 9, 2013).

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  • From Vol. 8 No.29 (Jul. 23, 2015)

    PwC White Paper Explores Hedge Fund Manager M&A Activity

    PwC recently issued a white paper on asset manager merger and acquisition activity.  The paper enumerates various factors that affect M&A activity; examines the types of acquisitions and investments asset managers are seeking; provides an overview of recent M&A and IPO activity; and discusses asset manager valuations and accounting rule changes that may affect certain elements of asset manager M&A transactions.  This article summarizes the key takeaways from the PwC paper.  For coverage of PwC’s 2012 study on this topic, see “PricewaterhouseCoopers Study Describes Recent Trends in and Outlook for Asset Manager Mergers and Acquisitions,” The Hedge Fund Law Report, Vol. 5, No. 11 (Mar. 16, 2012).  See also “Experts Offer Advice on Initiating and Structuring M&A Transactions in the Asset Management Industry (Part One of Two),” The Hedge Fund Law Report, Vol. 8, No. 18 (May 7, 2015).

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  • From Vol. 6 No.24 (Jun. 13, 2013)

    How Should Hedge Fund Managers Select Accountants, Prime Brokers, Independent Directors, Administrators, Legal Counsel, Compliance Consultants, Risk Consultants and Insurance Brokers for Their Funds?

    This article discusses what hedge fund managers should look for in the companies that provide accounting, brokerage, directorial, administration, legal, consulting, risk management and technology services to a fund.  To do so, this article focuses on questions that hedge fund managers should ask and issues they should address when retaining or changing service providers.

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  • From Vol. 5 No.29 (Jul. 26, 2012)

    Corgentum Survey Illustrates the Views of Hedge Fund Investors on the Roles, Duties, Risks and Performance of Service Providers

    Corgentum Consulting, LLC, a specialist consulting firm that performs operational due diligence reviews of fund managers, recently conducted a survey asking hedge fund investors five questions about their views on service providers, including questions concerning the functions provided by service providers and the risks associated with them.  This article describes the survey findings.

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  • From Vol. 5 No.13 (Mar. 29, 2012)

    SEC Enforcement Action Against Investment Adviser Highlights Importance of Conducting Due Diligence on a Hedge Fund’s Auditor to Avoid Fraud

    Although hedge fund investment decisions are based on numerous factors, information relating to a hedge fund’s financial condition and performance results remains a critical component of any such decision.  See “Legal and Operational Due Diligence Best Practices for Hedge Fund Investors,” The Hedge Fund Law Report, Vol. 5, No. 1 (Jan. 5, 2012).  Various parties have a hand in creating and confirming the information that goes into financial statements and performance reporting.  Those parties include the manager, the administrator and the auditor.  Many investors pay particularly close attention to reports from auditors because of the rigorous standards governing the accounting profession and the presumably uniform application of those standards across different contexts.  However, information about a hedge fund provided by an accountant is only as good as the accountant itself.  A good accountant can provide, directly or indirectly, good information to an investor – even though the accountant’s duty typically does not flow to the investor – while a bad accountant can provide a false sense of security or, worse, cover for a fraud.  Indeed, a recurring feature of frauds in the hedge fund industry is an accountant that does not exist, is much smaller or less experienced than claimed or that is affiliated with the manager.  An accounting firm that was both fictitious and affiliated with the manager was a notable feature of the Bayou fraud.  See “Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices,” The Hedge Fund Law Report, Vol. 4, No. 25 (Jul. 27, 2011).  A fraudulent auditor and fictitious financial statements also featured prominently in a recently filed SEC action against an investment adviser.  This article summarizes the SEC’s Complaint in that action and describes five techniques that hedge fund investors can use to confirm the existence, competence and reliability of hedge fund auditors.

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  • From Vol. 5 No.11 (Mar. 16, 2012)

    Use of SSAE 16 (SAS 70) Internal Control Reports by Hedge Fund Managers to Credibly Convey the Quality of Internal Controls, Raise Capital and Prepare for Audits

    An “institutional” quality infrastructure is becoming a prerequisite for hedge fund managers looking to raise capital from sophisticated investors.  But institutional is a difficult quality to define with precision in the hedge fund industry, a function of, among other things, the relative youth of the industry, asymmetry in the size and structure of management companies and the reluctance on the part of managers to disclose information.  As used by hedge fund investors, consultants, managers, regulators, service providers and others, institutional is more of a conclusion than a characteristic.  Managers are said to be institutional when they have fund directors with substance, gray hair in key operational roles, best-of-breed technology, brand name service providers, top tier investment talent and high caliber personnel focused on aspects of the business other than investing.  But a manager may be institutional without some of these elements, and even a manager with these elements can have holes in its processes that undermine the veneer of competence.  So how can investors reliably assess the institutional caliber of a manager, and how can managers credibly demonstrate their level of institutionalization?  Along similar lines, how can investors make institutional apples to apples comparisons when hedge fund management businesses are radically different in terms of size, structure, strategy and operations?  One method is to focus on the robustness of a manager’s internal controls, since robust internal controls are a necessary – though not sufficient – element of an institutional quality infrastructure.  Unlike other indicia of institutionalization, the robustness of internal controls can be measured at a single manager and compared across managers.  Such measurement can be accomplished by having an independent auditor conduct an internal control audit and issue an internal control report in accordance with Statement on Standards for Attestation Engagements No. 16 (SSAE 16), which replaced the long-standing Statement on Auditing Standards 70 (SAS 70).  While SSAE 16s have been in use in other industries for some time, they are a relatively new technique in the hedge fund industry.  However, in a climate of heightened regulator and investor scrutiny of non-investment aspects of the hedge fund business, SSAE 16s offer one of the most objective available barometers of institutionalization.  This article provides an introduction to the SSAE 16 audit process as applied to the hedge fund industry, including a description of the SSAE 16 audit and the corresponding internal control report; provides guidance regarding fund service providers a hedge fund manager should request an internal control report from and what should be covered in such internal control reports; outlines the reasons why hedge fund managers may consider obtaining an SSAE 16 audit on themselves, including a discussion of key benefits and costs of obtaining an internal control audit and report; describes the process for hedge fund managers to obtain an internal control audit and report; addresses who should pay for the internal control audit and report; addresses how often a hedge fund manager should obtain an internal control audit and report; identifies the challenges hedge fund managers face in obtaining an internal control audit and report; and explores whether there are any suitable alternatives to the internal control audit and report.

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  • From Vol. 5 No.6 (Feb. 9, 2012)

    Massachusetts Superior Court Dismisses Investors’ Claims Against Hedge Fund Manager Dutchess Capital, its Auditor, Administrator, Principals and Affiliate

    Plaintiffs in this action were investors in two hedge funds managed by Dutchess Capital Management, LLC (Dutchess Capital).  When those investments failed, plaintiffs commenced suit against Dutchess Capital, an affiliate, its principals, its outside auditor and its administrator.  They alleged breach of contract, breach of fiduciary duty, malpractice, fraud and similar claims.  The Court granted defendants’ motion to dismiss, holding that plaintiffs lacked standing to bring certain derivative claims, that the Court lacked jurisdiction over the fund administrator and that the remaining claims were barred by the applicable statutes of limitations.  This article summarizes the Court’s decision.

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  • From Vol. 4 No.29 (Aug. 25, 2011)

    The Hedge Fund Industry Narrowly Avoids a De Facto Auditor Rotation Requirement via SEC No-Action Relief

    In late 2009, the SEC adopted amendments to Rule 206(4)-2 (Custody Rule) under the Investment Advisers Act of 1940, as amended (Advisers Act).  (The Hedge Fund Law Report has analyzed the implications of the amended Custody Rule for, among other things, compliance policies and procedures; the balance of power between hedge fund managers and accountants; structuring of managed accounts; internal control reporting; and hedge fund liquidations.)  As amended, the Custody Rule provides that any investment adviser deemed to have custody of client securities or assets – and most hedge fund managers would have deemed custody within the Custody Rule’s broad definition of custody – is required to undergo an annual surprise examination conducted by an independent public accountant.  However, an adviser to a pooled investment vehicle (such as a hedge fund) is excepted from the surprise examination requirement if its hedge fund is audited annually in accordance with GAAP by “an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board (PCAOB) in accordance with its rules” (Annual Audit Exception).  The exemption also requires a hedge fund manager to distribute the relevant fund’s audited financial statements to investors within 120 days (180 days for funds of funds) of the fund’s fiscal year-end.  For hedge fund managers, the Annual Audit Exception provided welcome relief from the annual surprise examination requirement of the Custody Rule.  However, two of the requirements of the Annual Audit Exception proved difficult for hedge fund managers to comply with in practice.  This article analyzes recent SEC guidance applicable to hedge fund managers relying on the Annual Audit Exception.

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  • From Vol. 4 No.29 (Aug. 25, 2011)

    How Should Hedge Fund Managers Account for Organizational Expenses and Fund Loans, and What Role Should Such Accounting and Manager Solvency Play in Operational Due Diligence?

    A recent federal court judgment against the manager of hedge funds purporting to follow a socially responsible investment strategy yields a number of important lessons for hedge fund investors when conducting due diligence.  Among other things, the judgment highlights the relevance of the financial condition of the manager and its principals; how managers should account for organizational expenses; how managers should account for fund loans, if they are used at all; and the perils of guaranteed returns.  See “Twelve Operational Due Diligence Lessons from the SEC’s Recent Action against the Manager of a Commodities-Focused Hedge Fund,” The Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011).

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  • From Vol. 4 No.8 (Mar. 4, 2011)

    U.S. District Court Dismisses All Claims by Seattle City Employees’ Retirement System Against Hedge Fund Epsilon Global in Pension Fund’s Suit Seeking to Compel Epsilon to Produce Audited Financial Statements

    Plaintiff in this action is the Seattle City Employees’ Retirement System (SCERS) which, from December 2003 through December 2004, had invested $20 million in defendant hedge fund Epsilon Global Active Value Fund II, Ltd. (Epsilon or Fund).  Epsilon was a feeder fund that invested substantially all of its assets in defendant Epsilon Global Master Fund II, Ltd. (Master Fund).  The Fund’s offering documents required it to provide an annual report and an annual audited financial statement to each investor within 120 days after the end of its fiscal year.  Following the liquidity crises of 2008, Epsilon failed to produce an annual report or audited financial statements.  In January 2010, as Epsilon continued to fail to produce the requisite reports, SCERS notified Epsilon that it desired to redeem its entire investment.  Epsilon responded that it had suspended redemptions pending completion of its audit.  After negotiations for a partial redemption of SCERS’ position failed, SCERS commenced this action against the Master Fund, Epsilon, its general partner, its investment manager and one of the Fund’s principals.  SCERS sought a temporary restraining order and preliminary injunction directing the Fund to produce the requisite annual reports and prohibiting the Fund from paying fees to its manager pending redemption of SCERS’ interest in the Fund.  By the time of the Court’s hearing on the preliminary injunction request, Epsilon had provided SCERS with unaudited financial statements for 2008 and 2009 and other financial information for the Fund.  In May 2010, the Court ruled that, since completion of the audit was solely in the hands of the Fund’s auditor, it was impossible to order the Fund to complete the audit.  In addition, the Court noted that Epsilon had already provided SCERS with all available information in its possession.  Consequently, the Court denied SCERS’ request for a preliminary injunction.  The parties eventually agreed to dismiss the action without prejudice.  We summarize the claims in the suit and the Court’s decision.

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  • From Vol. 4 No.2 (Jan. 14, 2011)

    Accounting for Uncertain Income Tax Positions for Investment Funds

    FIN 48, now included in ASC Topic 740 (Income Taxes) under the Financial Accounting Standards Board’s Codification, was issued in 2006 and after two one-year deferrals became effective for all entities issuing financial statements under Generally Accepted Accounting Principles (GAAP) for years beginning after December 15, 2008.  FIN 48 was issued as an interpretation of FASB Statement 109, Accounting for Income Taxes, with the intent of reducing the diversity of practice in financial accounting for income taxes, including U.S. federal, state and local taxes as well as foreign taxes.  A major component of FIN 48 is that its reach includes all statutory open tax years, not just the accounting reporting year.  This requires that each year is looked at on a cumulative basis.  Entities that report on a non-GAAP basis, such as International Financial Reporting Standards (IFRS), are not subject to FIN 48.  FIN 48 has become a hot topic for fund managers and their auditors.  Given the complicated nature of fund structures, global investment strategies and the variety of financial products that managers invest in, it is an important area, and one to which managers should allocate sufficient resources.  In a guest article, Michael Laveman, a Partner at EisnerAmper LLP, discusses in detail the four-step process for adoption of and compliance with FIN 48.

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  • From Vol. 4 No.2 (Jan. 14, 2011)

    The Investment Funds Amendment Act 2010: Key Changes for Hedge Funds Established in Bermuda, and Their Managers

    The Bermuda Investment Funds Amendment Act 2010 (Amendment Act), which received the assent of the Governor General on December 22, 2010, amends the Investment Funds Act 2006 (Act) in making new provisions for the regulation of investment funds in Bermuda.  In a guest article, Neil Henderson, an Associate in the corporate department in the Bermuda office of Conyers Dill & Pearman, describes the changes introduced by the Amendment Act which have particular relevance for hedge funds established in Bermuda, and their managers.

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  • From Vol. 3 No.48 (Dec. 10, 2010)

    SEC Commences Civil Insider Trading Action Against Deloitte Mergers and Acquisitions Partner and Spouse Who Allegedly Tipped Off Relatives to Impending Acquisitions of Seven Public Companies

    On November 30, 2010, the Securities and Exchange Commission (SEC) commenced a civil insider trading action against Deloitte Tax LLP (Deloitte) partner Arnold A. McClellan and his wife, Annabel McClellan, after they allegedly passed to their London-based relatives material, non-public information about pending acquisitions by Deloitte clients.  Those relatives, and the brokerage through which they traded, made millions of dollars trading ahead of the announcements of those acquisitions.  Arnold McClellan allegedly told his wife about seven acquisition deals on which Deloitte had been retained as an adviser.  Annabel McClellan, in turn, passed those tips to her sister and brother-in-law, Miranda and James Sanders.  The Sanders then took equity positions in the target companies and made substantial profits when the deals were announced.  The SEC charges that the McClellans violated the antifraud provisions of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.  This article summarizes the SEC’s Complaint.

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  • From Vol. 3 No.43 (Nov. 5, 2010)

    Structuring, Valuation, Fee Calculation and Other Legal and Accounting Considerations in Connection with Hedge Fund General Redemption Provisions, Lock-Up Periods, Side Pockets, Gates, Redemption Suspensions and Special Purpose Vehicles

    Due to the recent financial crisis, the hedge fund industry has experienced significant investor redemptions along with reduced availability of credit and leverage from prime brokers and other financial institutions.  As a result, certain shortcomings have been revealed in the way hedge funds have been managed, including liquidity mismatches identified between investment portfolio assets and liabilities and redemption restriction provisions contained in fund offering documents.  The liquidity mismatch dilemma was quite a shock for many hedge fund investors who were unable to withdraw capital according to required redemption terms upon the freezing of the credit markets.  Redemption restriction provisions such as lock-ups and gates have become commonplace as hedge funds have evolved from traditional strategies which primarily invested in liquid securities.  Hedge fund offering documents generally contain multiple liquidity provisions that enable fund managers to manage the liquidity needs of investors without selling assets at distressed prices or disposing of liquid assets while leaving the most illiquid investments to remaining investors.  Financial statements of hedge funds prepared in accordance with accounting principles generally accepted in the United States (“US GAAP”) usually contain disclosures of liquidity provisions specified in the fund offering documents.  In a guest article, Fredric S. Burak and Cindy Shen, both partners at EisnerAmper LLP, generally discuss the various liquidity provisions contained in hedge fund offering documents as well as the relevant accounting and financial statement reporting requirements and practices related to such provisions.  Specifically, Burak and Shen describe market practice regarding structuring of redemption provisions, including discussions of Accounting Standards Codification Topic 480 (formerly FAS 150), frequency of permitted redemptions, holdback provisions and in-kind distributions; lock-up periods, including discussions of “hard” and “soft” lock-ups and the use of sub-accounts within capital accounts; investor-level and fund-level gates and related disclosure considerations; suspensions of redemptions; side pockets and designated investments (i.e., investments placed in side pockets); the interplay between valuation of designated investments, US GAAP and the Custody Rule; calculation of management and performance fees with respect to designated investments; reporting performance of designated investments; structuring, fees and books and records considerations in connection with special purpose vehicles; and market color with respect to: typical length of lock-up periods, the relationship between strategy and length of lock-up; investor receptivity to various lock-up period lengths, percentage of assets typically subject to a gate on any redemption date, the “market” for the number of successive redemption dates to which excess redemptions may be carried over, opt-out rights with respect to side-pockets and renewed SEC attention on disclosure relating to side pockets.

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  • From Vol. 3 No.34 (Aug. 27, 2010)

    Foundation for Accounting Education’s “2010 Hedge Funds and Alternative Investments” Conference Focuses on Taxation of Hedge Funds and Hedge Fund Managers, Structuring, Valuation, Risk Management, Due Diligence, Insurance and Regulatory Developments

    On July 29, 2010, the Foundation for Accounting Education (FAE) presented its 2010 Hedge Funds and Alternative Investments Conference in New York City.  Speakers at the one-day event focused on a range of issues impacting the hedge fund industry, including: FIN 48 (which relates to accounting for uncertain tax liabilities); ASU 2010-10 (which amends Statement of Financial Accounting Standards No. 167, which in turn requires nonpublic companies to publicly disclose their interests in variable interest entities in a similar manner to the disclosure provided by public entities); carried interest taxation developments; state and local tax developments relevant to hedge fund managers; tax implications of globalization of the hedge fund industry; special purpose vehicles; blockers; unrelated business taxable income and effectively connected income; mini-master funds; master-feeder and side-by-side structures; International Financial Reporting Standards; valuation trends; risk management; due diligence; insurance; and regulatory developments.  This article details the key points discussed during the conference.

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  • From Vol. 3 No.18 (May 7, 2010)

    Massachusetts Courts Approve of Accounting Firm Rothstein Kass’ Role as Award Arbiter in Hedge Fund Management Fee Dispute

    On April 21, 2010, the Appeals Court of Massachusetts affirmed the decision of the Suffolk County Superior Court of Massachusetts denying a hedge fund’s motion to remove Rothstein Kass & Company, P.C., as independent accountant and deemed arbiter in a management fee dispute.  The dispute, between Rajesh and Neelam Idnani (Plaintiffs) and Vikas Mehrotra and his hedge funds Venus Capital Management (VCM), Venus Investment Partners, LLC and Venus Series Trust (together Defendants) had landed in arbitration.  There, an arbitration panel had ordered Defendants to pay Plaintiffs either quarterly fees based on Defendants own internal financial report, or, if Plaintiffs’ rejected that report, based on an accounting by an independent third party.  As a result, the report of the third-party accountant became the arbitration award, and that firm effectively became the arbitrator for all future disputes.  Defendants challenged Plaintiffs’ decision to use Rothstein Kass as the third-party accountant because of perceived bias.  The Superior Court rejected this claim.  Also, the Appeals Court affirmed because Defendants failed to previously challenge the selection of Rothstein Kass in earlier litigation, and because the firm’s performance was free of “evident partiality,” as required to vacate an arbitrator’s award under the Massachusetts Uniform Arbitration Act.  This article summarizes the background and legal analysis of the courts below.

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  • From Vol. 3 No.5 (Feb. 4, 2010)

    Duff & Phelps Roundtable Focuses on Hedge Fund-Specific Valuation, Accounting and Regulatory Issues

    On January 28, 2010, Duff & Phelps Corp., the financial advisory and investment banking firm, hosted a roundtable discussion on the future of fair value accounting.  The panel consisted of Warren Hirschhorn, a Managing Director in the New York office of Duff & Phelps and the global head of its Portfolio Valuation practice, and David Larsen, Managing Director in the San Francisco office and a member of the Portfolio Valuation practice.  They reviewed the history of mark-to-market accounting, both before and since the promulgation of Standards of Financial Accounting Statement (FAS) 157 in September 2006, while seeking to correct mischaracterizations of that document; surveyed developments in accounting standards in late 2009 that may not yet have received sufficient attention from affected entities; outlined differences between the Financial Accounting Standards Board (FASB) and its London-based counterpart, the International Accounting Standards Board (IASB); discussed the degree to which the International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP) have or may converge; covered the question of “sensitivity analysis” (an analysis of the degree to which different assumptions about “inputs” may affect valuations), and whether such analysis should be mandated as part of either IFRS or GAAP; and briefly analyzed pending regulatory issues in Europe and the U.S.  This article summarizes the key points discussed at the conference on each of the foregoing topics.

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  • From Vol. 3 No.4 (Jan. 27, 2010)

    How Does the Amended Custody Rule Change the Balance of Power Between Hedge Fund Managers and Accountants?

    The bad news about the amended custody rule is the surprise examination requirement.  The good news, at least for many hedge fund managers, is the annual audit exception.  (That is, the amended custody rule contains an exception from the surprise examination requirement for advisers to pooled investment vehicles that are annually audited by a PCAOB-registered accountant and that distribute audited financial statements prepared in accordance with GAAP to fund investors within 120 days (180 days for funds of funds) of the fund’s fiscal year end.)  See “SEC Adopts Investment Adviser Custody Rule Amendments,” The Hedge Fund Law Report, Vol. 3, No. 1 (Jan. 6, 2010).  The qualified news is that while many hedge fund managers may avail themselves of the annual audit exception, an appreciable number may not.  For example, managers whose funds are audited by non-PCAOB-registered accountants, or that do not (or cannot) distribute audited financial statements to fund investors within 120 days of the fund’s fiscal year end, would not be eligible for the annual audit exception.  See “How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures in Light of Amendments to the Custody Rule?,” The Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010).  For such “ineligible” hedge fund managers, the surprise examination requirement may complicate operations for at least two reasons.  First, it creates a de facto annual audit requirement.  The substance of a surprise examination – explained in the SEC’s adopting release and a related interpretive release providing specific guidance for accountants – closely resembles the substance of an annual audit.  (The substance of a surprise examination is discussed in more detail in this article.)  Moreover, as the SEC pointed out in the adopting release accompanying the custody rule amendments, a hedge fund manager’s inability to predict which transactions an auditor will test in the course of an annual audit is analogous to the “surprise” element of the examination requirement.  Second – and perhaps more controversially – the surprise examination requirement may complicate operations for hedge fund managers that are not eligible for the annual audit exception because of various SEC reporting requirements imposed on accountants that conduct surprise examinations.  Those reporting requirements are described in more detail in this article, but in pertinent part would require an accountant to file with the SEC, within four business days of resignation, dismissal or other termination from an engagement to provide surprise examinations, Form ADV-E, along with an explanation of any problems that contributed to such resignation, dismissal or other termination.  Importantly, Form ADV-E, along with the accompanying explanation, would be publicly available.  According to the adopting release, the policy rationale for such public availability is to enable current and potential clients of an adviser to assess for themselves the importance of the explanation provided by the accountant for its resignation, dismissal or other termination.  The concern haunting the subset of hedge fund managers that are (or are concerned about becoming) subject to the annual surprise examination requirement is that the Form ADV-E filing requirement may – in cases where reasonable minds can differ on close accounting and valuation calls – further enhance the leverage of accountants over managers.  In other words, the concern is that revised Form ADV-E may increase the volume and specificity of an accountant’s “noisy withdrawal,” and in recognition of that, may increase risk aversion on the part of hedge fund managers in dealings with accountants.  The rejoinder to this argument is that accountants already have considerable leverage over hedge fund managers, as evidenced most starkly by the consequences flowing from withholding of an unqualified audit opinion letter.  See, e.g., “Former CFO of Highbridge/Zwirn Special Opportunity Fund Sues Ex-Partner Daniel B. Zwirn for Defamation and Breach of Contract,” The Hedge Fund Law Report, Vol. 2, No. 30 (Jul. 29, 2009).  In an effort to assess the extent to which the custody rule amendments may alter the balance of power between accountants and hedge fund managers, this article examines: how custody is defined in the amended custody rules (because custody is a condition precedent for application of the surprise examination requirement); the substance of the surprise examination requirement; the three exceptions from the surprise examination requirement; relevant SEC reporting requirements (on Form ADV-E); expert insight on whether and how the SEC reporting requirements may increase the leverage of accountants vis-à-vis hedge fund managers; existing accountant leverage (including a discussion of audit representation letters); who bears the cost of a surprise examination; and PCAOB resource limits.

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  • From Vol. 2 No.51 (Dec. 23, 2009)

    FASB Issues Proposed Accounting Standards Update to Defer Consolidation Reporting Requirements for Managers of Certain Hedge Funds

    On December 4, 2009, the Financial Accounting Standards Board (FASB) issued proposed guidance to allow certain entities that manage the assets of investment funds, including mutual, private equity and hedge funds, to avoid having to consolidate the assets and liabilities of such entities on their balance sheets under new consolidation rules that go into effect in January 2010.  The draft guidance, issued as an Accounting Standards Update (ASU) and entitled “Amendments to Statement 167 for Certain Investment Funds,” would affect the use of Accounting Standards Codification Topic 810 (formerly FASB No. 167, amending FASB Interpretation 46(R)).  As currently written, Accounting Statement 167 – which requires nonpublic companies to publicly disclose their interests in variable interest entities in a similar manner to public entities – may result in investment managers consolidating in their financial statements the assets and liabilities of many hedge funds, private equity funds and other investment funds that they manage.  The draft ASU would defer its application for investment managers’ interests that meet certain criteria.  This article details those criteria, the proposed amendments and the implications for hedge fund managers of the proposed guidance.

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  • From Vol. 1 No.16 (Jul. 22, 2008)

    New York Supreme Court Grants Summary Judgment to Auditor on Fund Liquidators’ Claim that Auditor Negligently Failed to Detect and Report Fraudulent Valuations by Fund Managers

    On June 19, 2008, the New York State Supreme Court in Manhattan granted summary judgment to the auditor of a failed Cayman Islands hedge fund on claims of negligence brought by the fund’s joint official liquidators. In the factual circumstances of the case, the court determined that the auditor’s failure to detect fraudulent valuations of portfolio securities by the fund’s managers, and the auditor’s resulting failure to alert the fund’s directors to the fraudulent valuations, did not constitute negligence. The case illustrates the standard of care to which US-based courts will hold auditors of Cayman Islands funds, and sheds light on the limits of the duties owed by auditors to fund investors and directors.

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  • From Vol. 1 No.15 (Jul. 8, 2008)

    FASB Proposes Changes to Hedge and Derivative Accounting Rules

    In an effort to simplify one of the most complex and criticized financial reporting regimes, the Financial Accounting Standards Board (FASB) is proposing changes to hedge and derivative accounting rules that, if approved, would (1) (according to FASB) greatly improve comparability of financial results for entities that apply hedge accounting, and (2) require application of the fair-value measurement approach to all transactions, a mark-to-market accounting method long favored by the Board.

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