The Hedge Fund Law Report

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By Topic: Custody

  • From Vol. 10 No.14 (Apr. 6, 2017)

    Avoiding Common Pitfalls Under the Custody Rule: Custody Determination, Auditor Independence and Liquidation Audits (Part Two of Two)

    The crux of Rule 206(4)-2 under the Investment Advisers Act of 1940 (Advisers Act), commonly referred to as the “custody rule,” is the protection of client and investor assets. There are several areas, however, where an adviser can run afoul of the custody rule. In this second installment of a two-part series, we review the auditor-independence requirement and discuss two additional hazards that may result in non-compliance with the custody rule: failing to realize when the adviser has custody and liquidation audits. The first article detailed options for fund managers to comply with the rule; discussed the frequency with which custody is reviewed during SEC examinations; and identified common weaknesses relating to inadvertent custody, as well as preparation and delivery of audited financial statements. For a discussion of SEC enforcement actions and corresponding penalties involving violations of the custody rule, see “Failure by Investment Advisers to Ensure Accurate Client Billing May Lead to SEC Enforcement Action and Penalties” (Feb. 2, 2017); “Repeat Custody Rule Offenders Face Severe SEC Sanctions” (Dec. 10, 2015); and “SEC Sanctions Two Private Fund Managers for Custody Rule Violations, Including Imposing Statutory Bars on Their Chief Compliance Officers” (Nov. 8, 2013).

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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. 10 No.8 (Feb. 23, 2017)

    Top Five Compliance Deficiencies in OCIE Risk Alert Include Annual Compliance Reviews, Accurate Regulatory Filings and Custody Issues

    Each year, fund managers attempt to anticipate what new areas the SEC will focus on in its upcoming examinations. In their push to get ahead, however, those managers often fail to adequately perform many of the compliance requirements to which they have been subject for years. The SEC’s Office of Compliance Inspections and Examinations (OCIE) recently issued a risk alert (Risk Alert) which, in some respects, urges fund managers to return to the basics as it pertains to their compliance efforts. This is because the five most common compliance issues identified in deficiency letters to investment advisers by OCIE which were described in the Risk Alert include traditional duties such as maintaining proper books and records, conducting annual compliance reviews and making accurate regulatory filings. All investment advisers should review their compliance policies and procedures considering the Risk Alert to ensure they avoid the five deficiencies highlighted by OCIE. This article summarizes the compliance failures and other items covered by the Risk Alert. For a similar 2014 OCIE alert, see “OCIE Director Andrew Bowden Identifies the Top Three Deficiencies Found in Hedge Fund Manager Presence Exams and Outlines OCIE’s Examination Priorities” (Oct. 10, 2014).

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  • From Vol. 10 No.5 (Feb. 2, 2017)

    Failure by Investment Advisers to Ensure Accurate Client Billing May Lead to SEC Enforcement Action and Penalties

    The fee and expense practices of private fund managers and other investment advisers are a perennial target of SEC scrutiny. SeeSelf-Reporting and Remedying Improper Fee Allocations May Not Be Sufficient for Fund Managers to Avoid SEC Action” (Sep. 15, 2016); and Undisclosed Increase in Investment Advisers Fees Could Result in Significant Penalties” (Jun. 23, 2016). In two recent enforcement actions, the SEC alleged that Citigroup Global Markets, Inc. (CGMI) and Morgan Stanley Smith Barney, LLC (MSSB) overbilled advisory clients and failed to preserve customer records. MSSB was also charged with violating the custody rule under the Investment Advisers Act of 1940. While the operations of asset management behemoths MSSB and CGMI are infinitely more complicated than those of many hedge fund advisers, the settlements are a timely reminder that fund advisers must have adequate policies and procedures to ensure that the fees assessed against investors and clients adhere to the disclosures made in fund offering documents, investment management agreements and any side letters. Advisers are also encouraged to consider whether their own policies and procedures are designed to identify the sorts of deficiencies outlined by the SEC in MSSBs and CGMIs policies and procedures. This article summarizes the nature of the violations and the terms of both settlements. For more on fee and expense allocation practices, see our three-part series: Practices Fund Managers Should Avoid” (Aug. 25, 2016); “Flawed Disclosures to Avoid” (Sep. 8, 2016); and Preventing and Remedying Improper Allocations” (Sep. 15, 2016).  

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  • From Vol. 10 No.5 (Feb. 2, 2017)

    ACA 2016 Compliance Survey Addresses Custody; Fee Policies and Arrangements; Safeguarding of Assets; and Personal Trading (Part Two of Two)

    In its 2016 Alternative Fund Manager Compliance Survey, ACA Compliance Group (ACA) covered various issues pertinent to hedge fund and illiquid private fund managers. ACAs Brian Lattanzio, a senior compliance analyst and private equity associate, and Danielle Joseph, a senior principal consultant, discussed the survey results in a recent webinar. This article, the second in a two-part series, explores the survey findings concerning the custody of fund assets and certificated securities; procedures around and types of fees charged by illiquid fund managers; steps to safeguard assets; and personal trading. The first article summarized the surveys results pertaining to SEC examinations; compliance staffing and budgeting; compliance reviews, testing and training; and anti-money laundering and sanctions compliance. For additional insights from ACA experts, see Recommended Actions for Hedge Fund Managers in Light of SEC Enforcement Trends” (Oct. 22, 2015); and The SECs Broken Windows Approach: Compliance Resources, CCO Liability and Technology Concerns for Hedge Fund Managers (Part Two of Two)” (Oct. 1, 2015).

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  • From Vol. 9 No.48 (Dec. 8, 2016)

    How Fund Managers Can Mitigate Prime Broker Risk: Structural Considerations of Multi-Prime or Split Custodian-Broker Arrangements (Part Two of Three)

    To mitigate the risks arising from potential prime broker failure or malfeasance, fund managers have looked beyond individual arrangements with brokers to broader structural changes, such as reallocating some of the risk to third parties. This can be accomplished by using multiple prime brokers (multi-prime arrangements) or by engaging a third-party custodian to hold some or, in rare instances, all assets separate from the prime broker (split custodian-broker arrangements). While each approach varies in effectiveness with respect to mitigating prime brokerage risk, there are also various factors and potential downsides for fund managers to evaluate when considering any such arrangement. This article, the second in a three-part series, outlines the various nuances of multi-prime and split custodian-broker arrangements to enable fund managers to evaluate the ability of each to mitigate the risk posed by their prime brokers. The first article in this series detailed preliminary considerations for fund managers before engaging prime brokers, including the various types of services available and the ways that managers can perform diligence on the creditworthiness of prime brokers. The third article will examine various legal protections – including with respect to sub-custodians and cross-default provisions – that can be negotiated in prime brokerage agreements to mitigate risk from the arrangement. For more on mitigating risk from prime brokers, see “In Frozen Credit Markets, Enhanced Prime Brokerage Arrangements Offer a Rare Source of Hedge Fund Leverage, but Not Without Legal Risk” (Feb. 26, 2009); and “How Can Hedge Funds Structure Their Prime Brokerage Arrangements to Protect Themselves?” (Oct. 10, 2008). 

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  • From Vol. 9 No.47 (Dec. 1, 2016)

    How Fund Managers Can Mitigate Prime Broker Risk: Preliminary Considerations When Selecting Firms and Brokerage Arrangements (Part One of Three)

    The actions and potential failure of prime brokers pose sizable threats to the well-being of fund managers. In 2008, insolvencies by prominent prime brokers such as Bear Stearns and Lehman Brothers imperiled a number of hedge funds. See “Hedge Funds Turning to Prime Brokerage Trust Affiliates for Added Protection Against Prime Broker Insolvencies” (Jun. 24, 2009). In addition, as recently as July 2016, Merrill Lynch agreed to pay a $415 million settlement to the SEC in connection with actions that threatened its hedge fund clients. See “Merrill Lynch Settlement Reminds Hedge Fund Managers to Be Aware of How Brokers Are Handling Their Assets” (Jul. 7, 2016). In an effort to help our subscribers mitigate the risks posed by their prime brokers, this three-part series outlines steps that fund managers can take when engaging a prime broker. This first article details preliminary considerations when engaging prime brokers, including regulatory protections, several types of arrangements based on fund risk profiles and due diligence efforts managers can undertake. The second article will examine structural considerations to mitigate prime broker risk, including the viability of multi-prime and split broker-custodian arrangements. The third article will describe legal protections that can be included in prime brokerage agreements to mitigate risk, including with respect to rehypothecation limits and asset transfer restrictions. For more on prime broker selection, see “Factors to Be Considered by a Hedge Fund Manager When Selecting a Prime Broker” (Dec. 4, 2014); “How Should Hedge Fund Managers Select Accountants, Prime Brokers, Independent Directors, Administrators, Legal Counsel, Compliance Consultants, Risk Consultants and Insurance Brokers for Their Funds?” (Jun. 13, 2013); and “Prime Brokerage Arrangements From the Hedge Fund Manager Perspective: Financing Structures; Trends in Services; Counterparty Risk; and Negotiating Agreements” (Jan. 10, 2013).

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  • From Vol. 9 No.20 (May 19, 2016)

    SEC No-Action Letter Eliminates Surprise Examination Requirement Under Custody Rule for Certain Sub-Advisers

    In 2009, in the wake of the Madoff Ponzi scheme and other adviser frauds, the SEC revised Rule 206(4)-2 under the Investment Advisers Act of 1940, the so-called “custody rule.” See “SEC Adopts Investment Adviser Custody Rule Amendments” (Jan. 6, 2010). A critical element of the revised rule is that, absent an applicable exception, an adviser with custody of client funds or securities must undergo a surprise annual examination by an independent public accountant to verify custody. The revised custody rule requires both a sub-adviser and a related primary adviser to have a surprise annual exam when the primary adviser (or an affiliate) also serves as the qualified custodian. The SEC recently issued a no-action letter indicating that it would not take enforcement action against a sub-adviser in such circumstances if certain conditions are met. This article summarizes the terms of the relief provided by the SEC. For examples of the SEC’s severe treatment of custody rule violations, see “Repeat Custody Rule Offenders Face Severe SEC Sanctions” (Dec. 10, 2015); and “SEC Sanctions Two Private Fund Managers for Custody Rule Violations, Including Imposing Statutory Bars on Their Chief Compliance Officers” (Nov. 8, 2013).

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  • From Vol. 9 No.14 (Apr. 7, 2016)

    RCA Session Highlights Issues Pertaining to the Custody Rule, ERISA, Client Agreements, Fees, Codes of Ethics and Confidentiality

    The first session of the Regulatory Compliance Association’s (RCA) Compliance Program Transparency Series examined key provisions from the CFA Institute’s Asset Manager Code of Professional Conduct (AMCC) and the RCA’s Model Compliance Manual (Manual), which is intended to facilitate implementation of the AMCC. Among the topics covered by the panel were client and fiduciary relationships, including compliance with the custody rule and ERISA as well as best practices for entering into agreements with and charging fees to clients; codes of ethics; and confidentiality. Moderated by Jane Stafford, the RCA’s general counsel, the session featured James G. Jones, a founder and portfolio manager of Sterling Investment Advisors; Michelle Clayman, managing partner and chief investment officer of New Amsterdam Partners; Gerald Lins, general counsel of Voya Investment Management; and Tanya Kerrigan, general counsel and chief compliance officer of Boston Advisors. This article highlights the salient points made on the foregoing issues. For additional insight from RCA programs, see “Four Essential Elements of a Workable and Effective Hedge Fund Compliance Program” (Aug. 28, 2014); and our coverage of the most recent RCA Compliance, Risk and Enforcement Symposium: “Methods for Hedge Fund Managers to Upgrade Compliance Programs” (Jan. 14, 2016); and “Ways for Hedge Fund Managers to Mitigate Conflicts of Interest” (Jan. 21, 2016).

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  • From Vol. 8 No.48 (Dec. 10, 2015)

    Repeat Custody Rule Offenders Face Severe SEC Sanctions

    On November 19, 2015, the SEC announced that it had settled enforcement proceedings against registered investment adviser Sands Brothers Asset Management, LLC (SBAM) and its principals: Martin Sands, Steven Sands and Christopher Kelly, in connection with SBAM’s repeated violations of SEC Rule 206(4)-2, commonly referred to as the “custody rule.” The SEC alleged that, despite previously settling with the SEC for custody rule infractions, the respondents continued to violate the custody rule.  In the press release announcing the settlement, Andrew M. Calamari, the Director of the SEC’s New York office, cautioned, “There is no place for recidivism in the securities markets.  The Sands brothers missed their opportunity to right a previous wrong and instead merely repeated their custody rule violations, so now they face more severe consequences.”  This article summarizes the SEC’s allegations; the current and prior violations; and the details of those consequences, which include stiff penalties, suspensions and potential daily fines for custody rule violations.  For more on the custody rule, 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?,” The Hedge Fund Law Report, Vol. 7, No. 28 (Jul. 24, 2014); “Implications for Private Fund Managers of the SEC’s Recent Custody Rule Guidance and Relief Relating to ‘Privately Offered Securities’,” The Hedge Fund Law Report, Vol. 6, No. 32 (Aug. 15, 2013); and “How Does the SEC Approach Custody Issues in the Course of Examinations of Hedge Fund Managers?,” The Hedge Fund Law Report, Vol. 5, No. 18 (May 3, 2012).

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  • From Vol. 8 No.19 (May 14, 2015)

    Inadequate Disclosure of Expense Allocations May Carry Unintended Consequences

    The SEC recently settled two enforcement actions relating to a hedge fund adviser that allegedly failed to disclose payment of certain operational and administrative expenses to investors.  The first action – against the adviser, its CEO and its general counsel – alleged that the respondents violated the antifraud provisions of the Advisers Act and filed inaccurate Forms ADV.  The inadequate disclosures also allegedly violated the custody rule, because the funds’ financial statements failed to disclose adequately the related party transactions and, therefore, were not GAAP-compliant.  Inadequate disclosure of expense allocations remains a hot-button issue with the SEC.  See “Conflicts Remain an Overarching Concern for the SEC’s Asset Management Unit,” The Hedge Fund Law Report, Vol. 8, No. 10 (Mar. 12, 2015); and “Battle-Tested Best Practices for Private Fund Expense Allocations,” The Hedge Fund Law Report, Vol. 7, No. 38 (Oct. 10, 2014).  The second action, against the funds’ outside auditor, asserted that he aided and abetted the adviser’s violation of the custody rule and engaged in improper professional conduct.  For analysis of another enforcement action in which shortcomings in preparing and disseminating financial statements led to custody rule violations, see “SEC Charges Two Houston-Based Advisory Firms, Including a Hedge Fund Manager, with Principal Transaction, Custody Rule, Compliance Rule and Code of Ethics Violations,” The Hedge Fund Law Report, Vol. 7, No. 4 (Jan. 30, 2014).  This article details the facts surrounding the inadequate disclosures, the SEC’s charges and the settlement terms. 

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  • From Vol. 8 No.8 (Feb. 26, 2015)

    Alternative Mutual Fund Managers Have Two Custody Rules to Worry About

    A recent SEC administrative order serves as a stark reminder that, while the investment strategies of hedge funds and alternative mutual funds are similar, the legal regimes applicable to both are quite different.  Registered hedge fund advisers need to comply with Rule 206(4)-2 under the Investment Advisers Act of 1940, the so-called custody rule.  See “Implications for Private Fund Managers of the SEC’s Recent Custody Rule Guidance and Relief Relating to ‘Privately Offered Securities’,” The Hedge Fund Law Report, Vol. 6, No. 32 (Aug. 15, 2013).  Registered advisers to alternative mutual funds also need to comply with the Advisers Act custody rule, but in addition, need to comply with the custody provisions of the Investment Company Act of 1940.  A portfolio manager might reasonably expect the custody provisions to be mirror images of one another, but they are not.  For example, the Advisers Act custody rule would allow a hedge fund to post cash collateral to a broker-dealer, but the Investment Company Act custody provisions may only permit the posting of cash collateral to a bank – which could be problematic for an alternative mutual fund that wants to enter into a swap with a prime broker.  This article provides a detailed discussion of the order, then highlights the four most important lessons for alternative mutual fund managers arising out of the order.  See also “SEC Investment Management Division Director Norm Champ Details Disclosure Challenges Facing Hedge and Alternative Mutual Fund Managers,” The Hedge Fund Law Report, Vol. 7, No. 46 (Dec. 11, 2014).

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  • From Vol. 8 No.1 (Jan. 8, 2015)

    K&L Gates Partners Outline Six Compliance Requirements and Four Enforcement Themes for Private Fund Advisers (Part Three of Three)

    This article is the third in a three-part series discussing practical insights from a recent presentation on insider trading and compliance priorities by K&L Gates partners Michael W. McGrath, Carolyn A. Jayne and Nicholas S. Hodge.  This article summarizes six noteworthy compliance insights and four recent enforcement themes relevant to hedge fund managers.  The first article in this series provided background on critical aspects of insider trading doctrine (including entity liability and special considerations for CFA charter holders) and described four enforcement patterns bearing directly on hedge fund trading strategies and operations.  The second article detailed eight prophylactic measures that hedge fund managers can implement to avoid insider trading violations and also included a detailed discussion of what McGrath called “the next great undiscovered country for enforcement actions.”  On insider trading, see also “Second Circuit Overturns Newman and Chiasson Convictions, Raising Government’s Burden of Proof in Tippee Liability Insider Trading Cases,” The Hedge Fund Law Report, Vol. 7, No. 47 (Dec. 18, 2014).

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  • From Vol. 7 No.46 (Dec. 11, 2014)

    ACA 2014 Compliance Survey Covers SEC Exams, CCOs, Compliance Reviews, Custody, Fees and Personal Trading

    ACA Compliance Group (ACA) recently completed its 2014 Alternative Fund Manager Compliance Survey, which examined managers’ experience with recent SEC examination initiatives, the role of a manager’s chief compliance officer, compliance reviews and testing, custody and safeguarding of assets, fees and personal trading.  On November 14, 2014, Jack Rader and Danielle Joseph, both Senior Principal Consultants at ACA, discussed the survey results.  For coverage of prior ACA surveys, see “ACA Compliance Survey Covers Current Hedge Fund Practices on Marketing, Trading, Counterparties and Valuation,” The Hedge Fund Law Report, Vol. 7, No. 23 (Jun. 13, 2014); “ACA Compliance Report Facilitates Benchmarking of Private Fund Manager Compliance Practices (Part One of Two),” The Hedge Fund Law Report, Vol. 6, No. 38 (Oct. 3, 2013); “ACA Compliance Report Facilitates Benchmarking of Private Fund Manager Compliance Practices (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 39 (Oct. 11, 2013); and “ACA Compliance Group Survey Provides Benchmarks for a Range of Hedge Fund Manager Compliance Functions, Including Dual-Hatting, Annual Compliance Reviews, Forensic Testing, Custody, Fees and Signature Authority,” The Hedge Fund Law Report, Vol. 6, No. 19 (May 9, 2013).

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  • From Vol. 7 No.32 (Aug. 28, 2014)

    SEC Action Against Custodian to Fraudulent Hedge Fund Manager Limns the Spectrum of Service Provider Culpability

    The SEC recently charged a brokerage firm and its president (Defendants) with helping a hedge fund manager conceal trading losses from investors and misappropriate investor funds.  According to the SEC, the Defendants were necessary to the success of the fraud, and the Defendants received payments from the manager for participating in his scheme.  If the SEC’s factual allegations are accurate, then the Defendants were knowingly complicit in the underlying fraud, and thus effectively participants.  But what if the Defendants were not knowingly complicit but rather received “storm warnings” of the fraud, or identified red flags then did nothing, or not enough?  Or what if red flags could have been uncovered with reasonable investigation, but the Defendants failed to uncover them?  This article describes the factual and legal allegations in this matter, and briefly considers the foregoing questions.  For a stark illustration of the challenges facing a service provider to a fraudulent hedge fund manager, 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).

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  • From Vol. 7 No.28 (Jul. 24, 2014)

    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?

    In June 2014, the SEC’s Division of Investment Management issued a Guidance Update (Guidance) on certain obligations of advisers to pooled investment vehicles, particularly private equity funds, under Rule 206(4)-2 of the Investment Advisers Act (Custody Rule), when they invest in special purpose vehicles (SPVs) to purchase, or use escrow accounts to sell, portfolio companies.  The Guidance provides three scenarios under which advisers would be deemed to have indirect custody of the assets owned by the SPV and therefore should include the assets in the pooled investment vehicles’ financial statement audits.  The Guidance describes a fourth scenario under which advisers should treat the assets of an investment fund as a separate client for purposes of the Custody Rule, complying separately with its audited financial statement distribution requirements with respect to the investment fund.  Finally, the Guidance states that the SEC would allow advisers to maintain client funds in an escrow account with other client and non-client assets if five criteria are met.  See also “How Does the SEC Approach Custody Issues in the Course of Examinations of Hedge Fund Managers?,” The Hedge Fund Law Report, Vol. 5, No. 18 (May 3, 2012).

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  • From Vol. 7 No.22 (Jun. 6, 2014)

    RCA Enforcement, Compliance and Operations 2014 Symposium Offers Insight from Top SEC Officials on Custody, Conflicts, Broker Registration, Alternative Mutual Funds and the JOBS Act (Part One of Two)

    On May 1, 2014, the Regulatory Compliance Association held its Enforcement, Compliance and Operations (ECO) 2014 Symposium in New York City.  Top SEC officials and other panelists at the ECO 2014 Symposium offered detailed, current and candid insight on regulatory transparency, custody, conflicts raised by serving simultaneously as a broker and investment adviser, what the SEC’s Division of Trading and Markets does, interaction between the SEC’s Office of Compliance Inspections and Examinations and its Enforcement Division, broker registration of in-house marketing departments, alternative mutual funds, the JOBS Act, cybersecurity, Regulation M, examinations, expert networks and political intelligence.  This is the first article in a two-part series summarizing the key takeaways from the ECO 2014 Symposium.  See also “RCA Symposium Offers Perspectives from Regulators and Industry Experts on 2014 Examination and Enforcement Priorities, Fund Distribution Challenges, Conducting Risk Assessments, Compliance Best Practices and Administrator Shadowing (Part Three of Three),” The Hedge Fund Law Report, Vol. 7, No. 1 (Jan. 9, 2014).

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  • From Vol. 7 No.9 (Mar. 7, 2014)

    SEC Order Suggests That Private Fund Operating Expenses Should Be Allocated Based on Line-by-Line Determinations Rather Than an Across-the-Board Percentage Split

    On February 25, 2014, the SEC issued an administrative order (Order) against a private equity fund manager and one of its founders and principals accusing the respondents of securities fraud in misappropriating more that $3 million from the funds they managed through improper allocations of operating expenses.  See “How Should Hedge Fund Managers Approach the Allocation of Expenses Among Their Firms and Their Funds? (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 19 (May 9, 2013).  The SEC also claims that the respondents violated provisions of the Investment Advisers Act of 1940 that require securities to be held by a “qualified custodian,” prohibit principal transactions, require effective compliance policies and procedures and prohibit false filings with the SEC.  See “ACA Compliance Report Facilitates Benchmarking of Private Fund Manager Compliance Practices (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 39 (Oct. 11, 2013) (in particular, discussion under subheading Allocations by Private Equity Fund Managers).  This article describes the factual and legal allegations in the Order.

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  • From Vol. 7 No.4 (Jan. 30, 2014)

    SEC Charges Two Houston-Based Advisory Firms, Including a Hedge Fund Manager, with Principal Transaction, Custody Rule, Compliance Rule and Code of Ethics Violations

    On November 26, 2013, the SEC issued an order instituting administrative and cease-and-desist proceedings against hedge fund manager Parallax Investments, LLC (Parallax) and a second order against investment adviser Tri-Star Advisors, Inc. (TSA), and executives of each firm.  The orders charged respondents with, among other things, engaging in thousands of principal transactions through an affiliated brokerage firm without notifying their clients or obtaining the required consent beforehand as required by Section 206(3) of the Investment Advisers Act of 1940 (Advisers Act).  See “When and How Can Hedge Fund Managers Engage in Transactions with Their Hedge Funds?,” The Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).  The SEC also charged Parallax and its chief compliance officer with violating Rule 206(4)-2 of the Advisers Act (Custody Rule) for failing to comply with the exception from various Custody Rule requirements as a result of reliance on the pooled investment vehicle exception.  See “How Does the SEC Approach Custody Issues in the Course of Examinations of Hedge Fund Managers?, The Hedge Fund Law Report, Vol. 5, No. 18 (May 3, 2012); and “Recently Published SEC Risk Alert Reveals Significant Deficiencies in Custody Practices of Hedge Fund Managers and Other Investment Advisers,” The Hedge Fund Law Report, Vol. 6., No. 10 (Mar. 7, 2013).  The SEC also charged Parallax with failing to establish a tailored compliance manual and to conduct annual compliance reviews as required by Rule 206(4)-7 under the Advisers Act and for failing to establish and maintain a code of ethics as required by Rule 204A-1 under the Advisers Act.  See “How Hedge Fund Managers Should Approach Preparing For, Conducting and Documenting the Annual Compliance Review (Part Two of Two),” The Hedge Fund Law Report, Vol. 5, No. 13 (Mar. 29, 2012); and “Key Legal and Operational Considerations for Hedge Fund Managers in Establishing, Maintaining and Enforcing Effective Personal Trading Policies and Procedures (Part One of Three),” The Hedge Fund Law Report, Vol. 5, No. 3 (Jan. 19, 2012).  This article summarizes the SEC’s factual and legal allegations levied against Parallax, TSA and their executive officers.

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  • From Vol. 7 No.1 (Jan. 9, 2014)

    RCA Symposium Offers Perspectives from Regulators and Industry Experts on 2014 Examination and Enforcement Priorities, Fund Distribution Challenges, Conducting Risk Assessments, Compliance Best Practices and Administrator Shadowing (Part Three of Three)

    This is the third installment in our three-part series covering the RCA’s Compliance, Risk & Enforcement 2013 Symposium.  It summarizes key points from two sessions, one offering perspectives from regulators and industry participants on regulatory risks and compliance best practices relating to expert networks, valuation, custody and allocation of expenses; and another providing a detailed look into fund administrator shadowing.  The first installment covered highlights from two sessions, one addressing effective risk assessments for hedge fund managers and the other offering current and former government officials’ perspectives on expert networks, political intelligence, insider trading and valuation-related conflicts of interest.  The second installment summarized the most salient points from two sessions, including the keynote address by OCIE Director Andrew Bowden, and a session addressing fund distribution, the JOBS Act, broker registration, National Futures Association oversight of hedge fund marketing practices and the EU’s Alternative Investment Fund Managers Directive.

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  • From Vol. 6 No.43 (Nov. 8, 2013)

    SEC Sanctions Two Private Fund Managers for Custody Rule Violations, Including Imposing Statutory Bars on Their Chief Compliance Officers

    On October 28, 2013, the SEC entered into settlement orders with three registered investment advisers who were charged with violations of Rule 206(4)-2 (Custody Rule) under the Investment Advisers Act of 1940 (Advisers Act), and other Advisers Act provisions and rules.  These enforcement actions, spurred by high-profile scandals as well as deficiencies uncovered during presence examinations of newly registered advisers, is emblematic of the SEC’s increasingly aggressive approach to enforcement.  See “Recently Published SEC Risk Alert Reveals Significant Deficiencies In Custody Practices of Hedge Fund Managers and Other Investment Advisers,” The Hedge Fund Law Report, Vol. 6, No. 10 (Mar. 7, 2013).  This article summarizes the settlements entered into with two private fund managers that provide the most pertinent lessons for hedge fund managers.  See also “How Does the SEC Approach Custody Issues in the Course of Examinations of Hedge Fund Managers?,” The Hedge Fund Law Report, Vol. 5, No. 18 (May 3, 2012).  In addition to the Custody Rule violations, the SEC also cited the fund managers for other significant Advisers Act violations (including a violation of Section 206(3) (with respect to an undisclosed principal transaction), style drift, making material misrepresentations in Form ADV, compliance program violations, and making improper distributions to investors).  Importantly, in both settlement orders, the chief compliance officers (CCOs) of both firms agreed to statutory bars, demonstrating the SEC’s commitment to holding CCOs responsible for the compliance failures of their firms.  See “Simon Lorne, Chief Legal Officer of Millennium Management LLC, Discusses the Evolving Roles, Challenges and Risks Faced by Hedge Fund Manager General Counsels and Chief Compliance Officers,” The Hedge Fund Law Report, Vol. 6, No. 37 (Sep. 26, 2013).

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  • From Vol. 6 No.33 (Aug. 22, 2013)

    Recent SEC Settlement Clarifies the Scope of Supervisory Liability for Chief Compliance Officers of Hedge Fund Managers

    For hedge fund manager general counsels (GCs) or chief compliance officers (CCOs) – or persons serving in both roles simultaneously – the prospect of liability for supervisory failures is real and frightening.  Two factors in particular make this a perilous area for GCs and CCOs: ambiguities in the caselaw mixed with the limited decision-making authority typically associated with the roles – a state of affairs that some view as overweight on downside and underweight on upside.  One of the more productive prophylactic measures that professionals can take in the area of GC and CCO supervisory liability is developing a real command of the handful of cases addressing the topic – understanding the facts, and how regulators and courts have applied relevant law and regulation to the facts.  A recent SEC settlement is instructive in this regard, taking its place among the narrow but important group of matters focused on CCO supervisory liability.  In the matter, the SEC alleged that the CCO of an investment advisory firm failed reasonably to supervise a rogue employee – and thereby violated the Investment Advisers Act of 1940 – by failing reasonably to implement the firm’s policies relating to custody, transaction reviews, books and records, e-mail and annual office audits.  This article provides a deeper discussion of the facts of the matter, the SEC’s legal claims and the terms of the settlement.  For articles discussing other matters in this genre, see “Scope of Supervisory Liability of Senior Legal and Compliance Professionals at Hedge Fund Managers Remains Uncertain after SEC Dismissal of Urban Action,” The Hedge Fund Law Report, Vol. 5, No. 5 (Feb. 2, 2012); “FSA Imposes Fine and Statutory Ban on Compliance Officer of Investment Advisory Firm for Failure to Safeguard Client Assets,” The Hedge Fund Law Report, Vol. 5, No. 20 (May 17, 2012); and “SEC Administrative Law Judge Holds that a Broker-Dealer’s General Counsel Could Be Held Liable as a Supervisor of a Financial Adviser Over Whom He Had No Actual Supervisory Authority,” The Hedge Fund Law Report, Vol. 3, No. 42 (Oct. 29, 2010).

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  • From Vol. 6 No.32 (Aug. 15, 2013)

    Implications for Private Fund Managers of the SEC’s Recent Custody Rule Guidance and Relief Relating to “Privately Offered Securities”

    On August 1, 2013, the SEC’s Division of Investment Management issued a Guidance Update relating to Rule 206(4)-2 under the Investment Advisers Act of 1940 indicating that it would not object if certain non-transferrable stock certificates and certain other instruments evidencing privately placed securities were not maintained with a qualified custodian by advisers to pooled investment vehicles.  Among other things, the relief could result in lower costs having to be incurred by private funds and investors to custody such privately placed securities.  This article describes the SEC’s guidance, the conditions for the relief granted and the implications for private fund managers.  For a discussion of the SEC’s heightened focus on custody issues, as highlighted in deficiencies uncovered during recent presence examinations, see “Recently Published SEC Risk Alert Reveals Significant Deficiencies in Custody Practices of Hedge Fund Managers and Other Investment Advisers,” The Hedge Fund Law Report, Vol. 6, No. 10 (Mar. 7, 2013).  See also “How Does the SEC Approach Custody Issues in the Course of Examinations of Hedge Fund Managers?, The Hedge Fund Law Report, Vol. 5, No. 18 (May 3, 2012).

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  • From Vol. 6 No.24 (Jun. 13, 2013)

    PLI Panel Provides Regulator and Industry Perspectives on SEC and NFA Examinations, Allocation of Form PF Expenses, Annual Compliance Review Reporting and NFA Bylaw 1101 Compliance

    The Practising Law Institute recently sponsored a program entitled “Hedge Fund Compliance and Regulation 2013,” which included a segment entitled “Building an effective compliance program and strategies for dealing with regulators.”  During that segment, the expert panel – consisting of regulators and industry professionals – offered unique and detailed insight on how regulators and managers approach the SEC and NFA examination process.  Among other things, the panel offered a behind-the-scenes look at how the SEC and NFA approach regulatory examinations; practical guidance on how managers should approach the examination process; candid thoughts on hot-button issues, including the allocation of Form PF expenses, whether managers should document their annual compliance reviews and how regulators use such reports; challenges that hedge fund managers face in complying with NFA Bylaw 1101; and making disciplinary disclosures.

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  • From Vol. 6 No.23 (Jun. 6, 2013)

    TheCityUK Report Discusses Trends in Hedge Fund Manager Locations, Fund Domiciles, Performance, Strategies, Investors, Secondary Market Transactions and Service Providers

    TheCityUK (TCUK), an association of representatives from the U.K. financial services sector and other businesses, recently released a report providing an overview of recent trends in the global hedge fund industry, broken down by geography, with a focus on the role of managers and funds based in the U.K.  Specifically, the report provided a geographical breakdown of funds and managers; a snapshot of fund performance and investment strategies; a synopsis of fund manager concerns; recent information on secondary market transactions in hedge fund interests; and perspectives on the use of hedge fund service providers.  This article summarizes the primary insights from the report.

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  • From Vol. 6 No.19 (May 9, 2013)

    ACA Compliance Group Survey Provides Benchmarks for a Range of Hedge Fund Manager Compliance Functions, Including Dual-Hatting, Annual Compliance Reviews, Forensic Testing, Custody, Fees and Signature Authority

    On April 16, 2013, ACA Compliance Group hosted a webinar in which it discussed findings from its recent survey of hedge and private equity fund managers regarding annual compliance reviews, forensic testing, risk management, custody, safeguarding of client assets, fee calculations and resources dedicated to compliance.  This article summarizes the survey findings and the practical takeaways from those findings as communicated by ACA in the course of the webinar.

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  • From Vol. 6 No.19 (May 9, 2013)

    What Measures Can Hedge Fund Managers Take to Prevent Employees from Forging Checks to Steal Assets from Client Accounts?

    The SEC recently entered into a settlement order with a private fund manager that was accused of: failing to supervise an employee that forged checks to misappropriate assets from fund investors; engaging in violations of the custody rule (Rule 206(4)-2 under the Investment Advisers Act of 1940); and failing to have policies and procedures reasonably designed to prevent violations of the custody rule.  See “How Does the SEC Approach Custody Issues in the Course of Examinations of Hedge Fund Managers?,” The Hedge Fund Law Report, Vol. 5, No. 18 (May 3, 2012).  This settlement is important for several reasons.  First, it highlights the dangers of failing to implement proper controls with respect to signing authority over client accounts.  See also, on this topic, “Ten Steps That Hedge Fund Managers Can Take to Avoid Improper Transfers among Funds and Accounts,” The Hedge Fund Law Report, Vol. 4, No. 13 (Apr. 21, 2011).  Second, it represents one of the most prominent actions initiated against a private fund manager for a custody rule violation.  Additionally, the settlement sheds light on the SEC’s current approach to the imposition of sanctions against an investment adviser where the respondent self-reports violations to the staff and cooperates with the staff in its investigation.  For a discussion of another enforcement action in the private funds context involving self-reporting, see “SEC Enforcement Action Against a Private Equity Fund Manager Partner Calls into Question the Value of Self-Reporting in the Private Funds Context,” The Hedge Fund Law Report, Vol. 4, No. 36 (Oct. 13, 2011).  This article describes the factual background, legal violations and sanctions in this case.  This article also offers several recommendations to reduce the risk of employee misappropriation of fund assets in similar situations.

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  • From Vol. 6 No.10 (Mar. 7, 2013)

    Ropes & Gray Partners Share Insights Gleaned from Successfully Navigating Presence Examinations with Hedge Fund Manager Clients

    On October 9, 2012, the Office of Compliance Inspections and Examinations (OCIE) of the SEC announced that it was going to conduct “focused, risk-based examinations of investment advisers to private funds that recently registered with the [SEC]” (Presence Exams).  See “OCIE Warns Newly Registered Hedge Fund Advisers to Watch Out for ‘Presence Examinations,’” The Hedge Fund Law Report, Vol. 5, No. 39 (Oct. 11, 2012).  On February 12, 2013, three partners at Ropes & Gray LLP presented a webinar entitled “SEC Presence Exams – Issues for Hedge Fund Managers,” to share their experience on how OCIE has conducted Presence Exams; their perspectives on hot-button areas of SEC investigations; and their tips for navigating a Presence Exam successfully.  This article summarizes the key points from the webinar.  See also “SEC’s National Examination Program Publishes Official List of Priorities for 2013 Examinations of Hedge Fund Managers and Other Regulated Entities,” The Hedge Fund Law Report, Vol. 6, No. 9 (Feb. 28, 2013).

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  • From Vol. 6 No.10 (Mar. 7, 2013)

    Recently Published SEC Risk Alert Reveals Significant Deficiencies in Custody Practices of Hedge Fund Managers and Other Investment Advisers

    On March 4, 2013, the SEC staff published a Risk Alert addressing custody-related compliance gaps that the Office of Compliance Inspections and Examinations uncovered in numerous recent examinations of registered investment advisers, including hedge fund managers.  The SEC identified custody-related compliance issues in approximately one-third (approximately 140) of recently-conducted examinations of registered advisers, and some cases were referred to the Division of Enforcement for further action.  Hedge fund managers should pay close attention to the deficiencies highlighted in the Risk Alert as many directly impact on their businesses, operations and compliance practices.  This article highlights those deficiencies that are particularly relevant for hedge fund managers.  See also “How Does the SEC Approach Custody Issues in the Course of Examinations of Hedge Fund Managers?, The Hedge Fund Law Report, Vol. 5, No. 18 (May 3, 2012).

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  • From Vol. 5 No.38 (Oct. 4, 2012)

    Finadium White Paper Highlights Potential for Growth in Prime Custody Services for Hedge Funds

    Finadium LLC (Finadium), in conjunction with BNY Mellon, has released a white paper highlighting the potential for growth in the use of prime custody services by hedge funds (White Paper).  Since the 2008 financial crisis, hedge funds have used less leverage, which has led to increased demand for custodial services for holding unencumbered assets.  On recent trends in the use of leverage by hedge funds, see “Federal Reserve Credit Officer Survey Identifies Trends in Prime Broker Credit Terms, Hedge Fund Leverage and Counterparty Risk,” The Hedge Fund Law Report, Vol. 5, No. 17 (Apr. 26, 2012).  Finadium estimates that $684 billion in fund assets may be available for prime custody services.  Prime custody arrangements offer funds potential cost savings and protection from the risk of the bankruptcy of a prime broker or other counterparty.  This article summarizes the key findings from the White Paper.  See also “Hedge Funds Turning to Prime Brokerage Trust Affiliates For Added Protection Against Prime Broker Insolvencies,” The Hedge Fund Law Report, Vol. 2, No. 25 (Jun. 24, 2009).

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  • From Vol. 5 No.18 (May 3, 2012)

    How Does the SEC Approach Custody Issues in the Course of Examinations of Hedge Fund Managers?

    The regulatory scrutiny of custody issues has intensified in recent years due to high-profile scandals involving investment advisers, and the SEC is spending more time on the review of custody issues during examinations of registered investment advisers, including hedge fund managers.  On January 31, 2012, the SEC hosted its annual “Compliance Outreach Program National Seminar” (Seminar).  The Seminar included five sessions.  The fifth session – entitled “Safety and Soundness of Client Assets/Custody” (Session) – discussed the impact of Rule 206(4)-2 under the Advisers Act (Custody Rule) on registered investment advisers, such as hedge fund managers.  The Session began with a discussion of the Custody Rule’s requirements, including a discussion of the 2009 amendments to the Custody Rule.  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).  The Session also discussed the SEC’s approach to reviewing custody issues during examinations of investment advisers.  Specifically, the Session explained what an investment adviser should expect with respect to the review of custody issues during an SEC examination and how to prepare for custody reviews in the course of examinations.  This article discusses the foregoing topics and the other key takeaways from the Session.

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  • From Vol. 5 No.6 (Feb. 9, 2012)

    Hedge Fund Managers May Be Required to File TIC Form SHC by March 2, 2012

    Hedge fund managers should consider as soon as possible whether they are required to file Treasury International Capital (TIC) Form SHC, Report of U.S. Ownership of Foreign Securities, Including Selected Money Market Instruments.  Basically, Form SHC requires the reporting of information regarding foreign securities owned by U.S. residents.  A hedge fund manager is required to file Form SHC if it meets a $100 million threshold for “reportable securities” determined on an aggregate basis for all funds under management.  For 2011, Form SHC is due by March 2, 2012, and reporting is based on the fair value of assets determined as of December 31, 2011.  In a guest article, Philip Gross and Allison Bortnick, Member and Associate, respectively, at Kleinberg, Kaplan, Wolff & Cohen, P.C., discuss the parameters of Form SHC, including a discussion of who must file Form SHC and what securities are covered; the composition of Form SHC; and the approach that hedge fund managers may take to determine whether they must file Form SHC, and, if reporting is required, how to complete Form SHC.

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  • From Vol. 5 No.3 (Jan. 19, 2012)

    Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part Four of Four)

    This article is the fourth in a four-part series by Maria Gabriela Bianchini, founder of Optionality Consulting.  The first article in this series identified factors that hedge fund managers should consider in determining whether to open an office in Asia and compared the relative merits of Hong Kong and Singapore as locations for an office.  See “Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part One of Four),” The Hedge Fund Law Report, Vol. 4, No. 43 (Dec. 1, 2011).  The second article in this series discussed technical steps and considerations for the actual process of opening an office in either Hong Kong or Singapore.  See “Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part Two of Four),” The Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011).  The third article in this series described the practical impact of Singapore’s new regulatory regime on hedge fund managers.  See “Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part Three of Four),” The Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15 2012).  This article series concludes with a discussion of topical regulatory issues regarding opening an office in Hong Kong.

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  • From Vol. 4 No.40 (Nov. 10, 2011)

    Business Issues with Legal Consequences: A Wide-Ranging Interview with Dechert Partner George Mazin about the Most Important Challenges Facing Hedge Fund Managers

    The Hedge Fund Law Report recently had the privilege of interviewing George J. Mazin, a Partner at Dechert LLP, and a deservedly well-regarded member of the hedge fund bar.  As evidenced by the text of our interview, which is included in this issue of The Hedge Fund Law Report, George has an aptitude for identifying the legal consequences of business issues, and explaining them clearly.  He also has the kind of market color that only comes with years – decades – in the trenches, and experience across business cycles.  Our interview was wide-ranging, reflecting the diversity of George’s experience, which in turn reflects the range of legal issues relevant to hedge fund managers.  In particular, our interview covered: valuation considerations in connection with affiliate transactions; valuations based on fraudulent sales and rigged dealer bids; manager overrides of third-party valuations; whether side pockets remain viable in new hedge fund launches; how even non-ERISA hedge funds can analogize the ERISA model of independent pricing; effective valuation testing programs; the interaction between GAAP and the custody rule; GAAP exceptions to audit opinions; use of counterparty confirmations by the SEC; delayed audits; custody of derivatives and limited partnership interests; insider trading policies with respect to market chatter and channel checking; how to grant side letters in light of selective disclosure considerations; how algorithmic or high-speed trading firms can prepare for regulatory examinations; legal considerations in connection with loans from a hedge fund to a manager; best practices in connection with principal trades; and whether side-by-side investing by manager personnel can pass muster under fiduciary duty and related principles.  This interview was conducted in connection with the Regulatory Compliance Association’s Fall 2011 Asset Management Thought Leadership Symposium, which is taking place today at the Pierre Hotel in New York.

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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. 3 No.42 (Oct. 29, 2010)

    SEC Temporarily Permits Hedge Fund Managers to Avoid Surprise Examination Requirement with Audits by Auditors That Are Registered with, but Not Subject to Inspection by, the PCAOB

    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 creates a general rule that is bad for hedge fund managers, an exception to the general rule that is good for hedge fund managers, and parameters for applying the exception that are ambiguous for hedge fund managers.  In brief, the general rule is 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.  The exception is that advisers to pooled investment vehicles (such as hedge funds) are excepted from the surprise examination requirement if their funds are 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.”  Advisers Act Rule 206(4)-2(b)(4)(ii).  The exemption also requires a hedge fund to distribute its audited financial statements to investors within 120 days (180 days for funds of funds) of the fund’s fiscal year-end.  The ambiguity in application of the exception is essentially as follows: A hedge fund manager is only excepted from the surprise examination requirement if the independent public accountant that it retains to perform annual audits of its funds is (1) registered with the PCAOB and (2) subject to regular inspection by the PCAOB (3) as of the commencement of the professional engagement period and (4) as of each calendar year-end.  But many of the independent public accountants that routinely audit hedge funds are not subject to regular inspection by the PCAOB, and it is not yet clear what “as of the commencement of the professional engagement period” will mean for purposes of the Custody Rule.  In other words, many independent public accountants would not satisfy the second and third elements of the test for eligibility to provide annual audits that can except a hedge fund manager from the surprise examination requirement.  Therefore, to avoid the surprise examination requirement, many hedge fund managers would have to replace their current auditors with auditors that are subject to “regular inspection” by the PCAOB.  Only auditors to public companies currently are subject to regular inspection by the PCAOB.  In many cases, such public company auditors are larger and more expensive, and have less institutional knowledge (and in some cases less industry knowledge), than auditors focused specifically on the hedge fund industry.  In short, absent relief and clarification, the Custody Rule would require many hedge fund managers to replace their funds’ current auditors, which in turn could: raise funds’ costs; increase the length of audits; increase the time of hedge fund manager personnel and other manager resources committed to annual audits; diminish or eliminate the value of institutional knowledge; and sever by regulation professional engagements that in many cases have been long-standing and mutually productive.  Fortunately, in an October 12, 2010 no-action letter to the law firm Seward & Kissel LLP (Seward Letter), the Staff of the SEC’s Division of Investment Management provided such relief and clarification.  This article further describes the legal, accounting and operational problems created by the Custody Rule, and the relief offered by the Seward Letter with respect to those problems.

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  • From Vol. 3 No.13 (Apr. 2, 2010)

    KPMG Webcast Focuses on Implications of Revised Custody Rule for Hedge Fund Managers in the Areas of Operational Independence, Delivery of Financial Statements, Surprise Examinations and Internal Control Reports

    As the hedge fund industry continues to work on compliance with the amended custody rule, KPMG LLP hosted a webcast on March 23, 2010 focusing on specific compliance concerns and strategies.  The event was moderated by Sean McKee, Partner and Audit Sector Leader for KPMG LLP’s Investment Management Practice, and included presentations by Michael Barnes and Deborah Hynds, both of KPMG’s Advisory Services group, and John Crowley of Davis, Polk & Wardwell LLP.  The speakers addressed various issues raised by the revised custody rule, including: the changing definition of custody; the definitions of “related party” and “operational independence”; requirements concerning delivery of account statements; the “audited pool exemption”; the exemption from the annual surprise examination requirement; and the proper format for internal control reports.  This article summarizes the key points discussed with respect to each of the foregoing issues, and concludes with a discussion of how the SEC’s recent clarifications of the amended custody rule affect the scope of the audited pool exemption.  Prior issues of The Hedge Fund Law Report have included extensive coverage of the custody rule amendments and their implications for hedge funds and their managers.  See: (1) “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); (2) “How Does the Amended Custody Rule Change the Balance of Power Between Hedge Fund Managers and Accountants?,” The Hedge Fund Law Report, Vol. 3, No. 4 (Jan. 27, 2010); (3) “How Can Hedge Fund Managers Structure Managed Accounts to Remain Outside the Purview of the Amended Custody Rule’s Surprise Examination Requirement?,” The Hedge Fund Law Report, Vo. 3, No. 5 (Feb. 4, 2010); (4) “Application to Hedge Fund Managers of the Internal Control Report Requirement of the Amended Custody Rule,” The Hedge Fund Law Report, Vo. 3, No. 6 (Feb. 11, 2010); and (5) “SEC Adopts Investment Adviser Custody Rule Amendments,” The Hedge Fund Law Report, Vol. 3, No. 1 (Jan. 6, 2010).

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  • From Vol. 3 No.6 (Feb. 11, 2010)

    Application to Hedge Fund Managers of the Internal Control Report Requirement of the Amended Custody Rule

    Under the amended custody rule, registered hedge fund managers that are excepted from the surprise examination requirement still may be subject to the internal control report requirement.  That is, under the amended custody rule, a registered hedge fund manager with actual or deemed custody of client assets generally would be required to undergo an annual surprise examination.  However, the rule contains an exception to the surprise examination requirement for advisers to pooled investment vehicles that deliver annual audited financial statements (prepared by an independent, PCAOB-registered accountant) to investors in the pool within 120 days of the end of the pool’s fiscal year (180 days for funds of funds).  See “How Can Hedge Fund Managers Structure Managed Accounts to Remain Outside the Purview of the Amended Custody Rule’s Surprise Examination Requirement?,” The Hedge Fund Law Report, Vol. 3, No. 5 (Feb. 4, 2010).  Similarly, under the amended custody rule, a registered hedge fund manager that self-custodies client assets or uses a related person to custody client assets is required to obtain or receive from that related person, at least annually, a written report from a PCAOB-registered accountant describing (as discussed more fully in this article) the manager’s or the related person’s custody controls, tests of those controls performed by the accountant and the results of such tests.  The amended custody rule does not contain an exception to the internal control report requirement for advisers to pooled investment vehicles.  Accordingly, a hedge fund manager may avoid the surprise examination requirement while remaining subject to the internal control report requirement.  For example, a hedge fund manager controlled indirectly by a bank holding company that custodies client assets at a broker-dealer also indirectly controlled by that bank holding company would be subject to the internal control report requirement, but could avoid the surprise examination requirement.  While the so-called Volcker Rule would prohibit the foregoing scenario, even independent hedge fund managers that custody assets at affiliated broker-dealers would have to comply with the internal control report requirement.  See "Senate Banking Committee Hears Testimony from Hedge Fund Industry Experts and Academics on 'Volcker Rule,'" below, in this issue of The Hedge Fund Law Report.  Because commissioning an initial internal control report and subsequent reports is likely to be expensive, especially for smaller hedge fund managers, the internal control report requirement generated controversy when the custody rule amendments were originally proposed.  Nonetheless, the requirement made it into the final rule, and the SEC’s apparent disregard of industry comments on this point appears to contain an element of action-forcing: the SEC’s stated goal in amending the custody rule was to “encourage custodians independent of the adviser to maintain client assets as a best practice whenever feasible.”  A hedge fund manager that maintains custody at an independent custodian would not be subject to the internal control report requirement.  Therefore, the cost of preparing internal control reports may be understood as a penalty for self-custody or related-party custody.  In an effort to assess the real impact of the internal control report requirement on hedge fund managers, this article discusses: the specific elements required to be included in internal control reports; who may prepare such reports; the interaction of surprise examinations and internal control reports; potential use by the SEC of such reports in the course of inspections and examinations; whether or not such reports will be public; how such reports will factor into the institutional investor due diligence process; and fee levels and structures for preparation of internal control reports.

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  • From Vol. 3 No.5 (Feb. 4, 2010)

    How Can Hedge Fund Managers Structure Managed Accounts to Remain Outside the Purview of the Amended Custody Rule’s Surprise Examination Requirement?

    Under the amended custody rule, a registered hedge fund manager that has custody of client assets is required to undergo an annual surprise examination unless it is eligible for one or more of three exceptions from the surprise examination requirement.  Generally, an adviser is deemed to have custody under the amended rule in any of four circumstances: if (1) it maintains physical custody of client funds or securities; (2) it has the authority to obtain client funds or securities, for example, by deducting advisory fees from a client’s account or otherwise withdrawing funds from a client’s account; (3) it acts in a capacity that gives it legal ownership of or access to client funds or securities (for example, where it acts as general partner of a limited partnership); or (4) client funds or securities are held directly or indirectly by a “related person” of the adviser.  However, even if an adviser is deemed to have custody for any of the foregoing reasons, it would not be subject to the annual surprise examination requirement if it were eligible for any of the following three exceptions: (1) if it is deemed to have custody solely based on its fee deduction authority; (2) to the extent it advises pooled investment vehicles that deliver annual audited financial statements (prepared by an independent, PCAOB-registered accountant) to investors in the pool within 120 days of the end of the pool’s fiscal year (180 days for funds of funds); or (3) if it is deemed to have custody solely based on custody by a “related person” and that related person is “operationally independent” of the adviser.  For a thoroughgoing discussion of the mechanics of the amended custody rule, see “How Does the Amended Custody Rule Change the Balance of Power Between Hedge Fund Managers and Accountants?,” The Hedge Fund Law Report, Vol. 3, No. 4 (Jan. 27, 2010).  Accordingly, most registered hedge fund managers would not be subject to the surprise examination requirement, with respect to hedge funds under management, because they would be eligible for the “pooled investment vehicle” exception.  However, to the extent a hedge fund manager also manages managed accounts, the manager would not be eligible for the pooled investment vehicle exception with respect to those managed accounts.  There are at least two reasons for this: (1) the typical managed account only has one investor, and thus is not “pooled” within the meaning of the amended custody rule; and (2) generally, hedge fund managers do not distribute audited financial statements to managed account investors (though such investors often conduct their own audits of the account).  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).  Therefore, a hedge fund manager may only avoid the annual surprise examination requirement with respect to any managed accounts under management if: (1) it is not deemed to have custody of the funds or securities in the managed accounts; or (2) it is eligible for an exception from the surprise examination requirement other than the pooled investment vehicle exception.  The problem is, many managed accounts are structured and operated in ways that would cause their managers to be deemed to have custody and would render their managers ineligible for any exception.  For example, if a hedge fund manager has authority to deduct fees from the managed account and custodies the managed account assets at an affiliate of the manager that is not operationally independent of the manager, the manager would not be eligible for any exception.  See “SEC Adopts Investment Adviser Custody Rule Amendments,” The Hedge Fund Law Report, Vol. 3, No. 1 (Jan. 6, 2010).  Given the intrusiveness, expense and potential reputational harm arising out of surprise examinations, this article examines how managed accounts may be structured so that the manager will not be deemed to have custody of the assets in the account.  (The urgency of such avoidance is compounded by the growing chorus of calls from institutional investors for exposure to hedge fund strategies via managed accounts.)  In particular, the remainder of this article details: precisely what a managed account is (including the use of segregated portfolio companies in the Cayman Islands); the benefits of managed accounts; the drawbacks of managed accounts; how managed accounts can be structured and documented to avoid imputing custody of the assets in the account to the manager, or to ensure that the manager remains eligible for the fee deduction exception to the surprise examination requirement; the special case of private securities and illiquid assets; and special purpose vehicle considerations.

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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. 3 No.3 (Jan. 20, 2010)

    How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures in Light of Amendments to the Custody Rule?

    On December 30, 2009, the Securities and Exchange Commission (SEC) published final amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940 (Advisers Act).  The goal of the amendments, as stated by the SEC in its adopting release, is to strengthen controls over the custody of client assets and to “encourage custodians independent of the adviser to maintain client assets as a best practice whenever feasible.”  The context of the amendments is a climate of heightened enforcement activity by the SEC against hedge fund managers and other investment advisers, and exposure of significant fraudulent activity during the recent economic downturn.  The amendments generally require a registered investment adviser with custody of client assets to: (1) undergo an annual surprise examination conducted by an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB) (subject to a number of important exceptions outlined below); (2) if the adviser maintains physical custody of client assets or uses a related person as a qualified custodian, to obtain an annual report, prepared by an independent, PCAOB-registered accountant, on the internal controls of the adviser or related custodian; and (3) have a reasonable belief after due inquiry that a qualified custodian that maintains custody of client assets sends quarterly account statements directly to clients (rather than the adviser itself sending such account statements).  The amendments contain three exceptions from the annual surprise examination requirement.  Most importantly for hedge fund managers, the amendments provide that advisers to pooled investment vehicles (such as hedge fund managers) that deliver annual audited financial statements (prepared by an independent, PCAOB-registered accountant) to investors in the pool within 120 days of the end of the pool’s fiscal year (180 days for funds of funds) are deemed to have satisfied the surprise examination requirement.  In addition, the custody rule amendments may have important implications for the design of compliance policies and procedures of hedge fund managers.  Specifically, the SEC’s adopting release contains a variety of recommended compliance policies and procedures that registered investment advisers (RIAs) may implement to facilitate compliance with the custody rule amendments.  As explained more fully in this article, while many hedge fund managers remain unregistered, a legal registration requirement is considered imminent by many practitioners, and in any case, compliance practices of RIAs are considered (by institutional investors and others) persuasive of best practices for unregistered advisers.  This article analyzes the implications of the SEC’s compliance recommendations for hedge fund managers.  The article begins by exploring the impact of the custody rule amendments for hedge fund managers, unregistered advisers and advisers to separately managed accounts, then details the SEC’s specific compliance recommendations.  The article goes on to analyze whether the recommendations are mandatory or merely suggestive (legally and practically), and for some of the key recommendations, provides insight from leading practitioners on precisely how the recommendations can and should be implemented.  Finally, after discussing the absence of public notice and comment on the compliance recommendations (which, in light of the nature of the recommendations, likely will not raise constitutional issues), the article explores the likelihood and necessity of adoption of the various recommendations by hedge fund managers.

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  • From Vol. 3 No.1 (Jan. 6, 2010)

    SEC Adopts Investment Adviser Custody Rule Amendments

    At an open meeting held on December 16, 2009, the Securities and Exchange Commission (SEC) adopted amendments to the custody requirements under the Investment Advisers Act of 1940 (Advisers Act).  These amendments aim to strengthen controls over client assets held by registered investment advisers (RIAs) or their affiliates.  On December 30, 2009, the SEC published the adopting release for these amendments.  These amendments significantly modify the amendments previously proposed in May 2009 in response to about 1,300 comment letters.  For a more detailed analysis of the prior proposal, see “SEC Proposes Stricter Custody Rules for Investment Advisers,” The Hedge Fund Law Report, Vol. 2, No. 21 (May 27, 2009).  For an analysis of the impact of the proposed custody rule on hedge fund managers, see “The SEC’s Proposed Custody Rule Changes: An Analysis of the Impact on Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 2, No. 21 (May 27, 2009).  Rule 206(4)-2 under the Advisers Act, commonly referred to as the “custody rule,” protects assets managed by RIAs.  The rule requires RIAs to maintain client funds and securities with a “qualified custodian” in accounts that contain only client funds, and to segregate and identify client securities and hold them in a reasonably safe place.  Few RIAs maintain physical custody of client assets, however; the SEC deems many RIAs to have custody because an RIA affiliate – e.g., an affiliated prime broker – maintains the client assets or the RIA retains access to the accounts via fee arrangements, general partner relationships or powers of attorney, among others.  The amendments to Rule 206(4)-2 impose significant additional requirements on RIAs with “custody” of client assets, including an annual surprise examination by an independent public accountant, registered with the Public Company Accounting Oversight Board to verify client assets, as well as a report by the accountant of internal controls relating to the custody of those assets.  With the amendment, the SEC also published an interpretive release providing guidance to auditors regarding the surprise examination and internal controls report requirements.  This article summarizes the amendments and their implications for the investment adviser community generally, and hedge fund managers specifically.

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  • From Vol. 2 No.52 (Dec. 30, 2009)

    Why Are Most Hedge Fund Investors Reluctant to Sue Hedge Fund Managers, and What Are the Goals of Investors that Do Sue Managers? An Interview with Jason Papastavrou, Founder and Chief Investment Officer of Aris Capital Management, and Apostolos Peristeris, COO, CCO and GC of Aris

    An article in last week’s issue of The Hedge Fund Law Report detailed a ruling by the New York State Supreme Court permitting a lawsuit by funds managed by Aris Capital Management (Aris) to proceed against hedge funds in which the Aris funds had invested and the managers of those investee funds.  See “New York Supreme Court Rules that Aris Multi-Strategy Funds’ Suit against Hedge Funds for Fraud May Proceed, but Negligence Claims are Preempted under Martin Act,” The Hedge Fund Law Report, Vol. 2, No. 51 (Dec. 23, 2009).  That lawsuit is one of various suits brought by Aris and its managed funds against hedge funds or managers in which the Aris funds have invested.  The Aris suits allege a variety of claims in a variety of circumstances, but collectively are noteworthy for their mere existence.  In the hedge fund world, there has been a conspicuous absence during the past two years of legal actions by hedge fund investors against hedge fund managers, despite the coming-to-fruition of circumstances that industry participants thought, pre-credit crisis, would augur an uptick in litigation: the imposition of gates, suspensions of redemptions, mispricing of securities, large losses, etc.  Jason Papastavrou, Founder and Chief Investment Officer of Aris, appears to have broken ranks with what seems like an unspoken agreement in the hedge fund world to avoid the courthouse steps, and he has done so with a considerable degree of thoughtfulness, for specific reasons and with particularized goals.  In an interview with The Hedge Fund Law Report, Papastavrou and Apostolos Peristeris, COO, CCO and GC of Aris, discuss certain of their lawsuits, why they brought them, what they seek to gain from them and what the relevant managers might have done differently to have avoided the suits.  They also discuss: seven explanations for the reluctance on the part of most hedge fund investors to sue managers; the fund of funds redemption process; how their lawsuits have affected their due diligence process; in-house administration; background checks; the importance of face-to-face meetings; side letters; how Aris investors have reacted to the lawsuits; and Aris’ transition to a managed accounts model from a fund of funds model.

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  • From Vol. 2 No.35 (Sep. 2, 2009)

    How Will the Proposed Liquidation Audit Amendment to the Custody Rule Affect Hedge Funds?

    The recent proposal to amend the Custody Rule has occasioned a flurry of comment letters from hedge fund industry participants, lawyers and other interested parties.  The amendments to the Custody Rule were proposed in part in response to recent fraudulent activities involving investment advisers and affiliated custodians.  While the amendments as a whole are intended to make it more difficult for registered investment advisers to misuse funds for which they serve as custodian, some portions of the amendments, according to various comment letters, would present difficulties in practice.  In particular, one aspect of the proposed amendments about which hedge fund managers have significant questions is the proposed requirement that hedge fund managers relying on the so-called audit approach that liquidate a hedge fund prior to the fund’s fiscal year end prepare audited financial statements upon liquidation.  The Securities and Exchange Commission (SEC) alleges that this “at liquidation” audit requirement is simply a “clarification” of standard practice, but practitioners interviewed by The Hedge Fund Law Report did not uniformly agree.  Further, there are questions regarding the timing of the liquidation audit and whether an audit upon liquidation should be required if it would occur close in time to when the hedge fund’s annual audit would be performed.  Finally, the liquidation audit requirement begs the question of what, in this context, constitutes a liquidation, and whether a hedge fund that is merged into another hedge fund will be considered to have liquidated and thus need to perform a liquidation audit.  This article addresses these and related issues.

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  • From Vol. 2 No.25 (Jun. 24, 2009)

    The SEC’s Proposed Custody Rule Changes: An Analysis of the Impact on Hedge Fund Managers

    The SEC recently voted to propose changes to the Advisers Act custody rule.  The SEC initiated this action with the intention of providing additional safeguards when an adviser has custody of client assets.  The proposed changes follow a series of recent enforcement actions involving alleged misappropriation or other misuse of client assets.  The proposed changes would primarily impose two new requirements on registered advisers with custody of client assets.  First, those advisers would need to undergo an annual surprise examination by an independent public accountant to verify client assets.  Second, those advisers who are qualified custodians and self custody client assets or use a related person who is a qualified custodian (rather than an “independent” qualified custodian) would need to obtain a written report from an independent public accountant.  The report would include an opinion as to the qualified custodian’s controls regarding the custody of client assets.  While the proposed changes would impact all registered advisers with custody of client assets, the changes would also have unique application to hedge fund managers.  In a guest article, Terrance J. O’Malley and Jessica Forbes, both Partners at Fried, Frank, Harris, Shriver & Jacobson LLP, examine the proposed changes to the custody rule from the perspective of a hedge fund manager.  Their article begins with a brief review of the rule’s history, then examines the current requirements under the rule and finally describes the proposed changes, including those most relevant to hedge fund managers.

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  • From Vol. 2 No.21 (May 27, 2009)

    SEC Proposes Stricter Custody Rules for Investment Advisers

    On May 20, 2009, the Securities and Exchange Commission (SEC) published its proposed amendments to Rule 206(4)-2 of the Investment Advisers Act of 1940, as amended (the Advisers Act), relating to “Custody of Funds or Securities of Clients by Investment Advisers.”  The suggested amendments: substantially increase protections for investors who allow investment advisers to retain custody over their assets; promote independent custody; enable independent public accountants to act as third-party monitors; and provide the SEC with better information about the custodial practices of registered investment advisers.  The rules would impose surprise accounting examinations on investment advisers who have custody of client assets, and additional reporting requirements by independent accountants.  We describe the proposed amendments in detail.

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  • From Vol. 2 No.21 (May 27, 2009)

    What Does the Market Think of the SEC’s Proposed Amendments to the Custody Rule?

    Following a spate of alleged Ponzi schemes and two dozen recent enforcement actions involving the misuse of client funds, the SEC has proposed amendments to custody rules to increase scrutiny and accountability of money managers.  The most significant of the proposed changes would require all registered investment advisers who have any kind of custody of client assets to undergo a surprise examination by an independent public accountant once per year to verify the existence and proper treatment of the funds.  The rigor and reporting requirements would differ depending on whether investment advisers place client funds with affiliated or unaffiliated custodians.  As a companion piece to our article describing the proposed amendments to the custody rules (above, in this issue of The Hedge Fund Law Report), we offer reactions from industry participants to the proposed amendments, and discuss the potential impact of the amendments on unregistered hedge fund managers.

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