The Hedge Fund Law Report

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By Topic: Due Diligence

  • From Vol. 9 No.50 (Dec. 22, 2016)

    How Are Your Peers Responding to the Most Intrusive Requests From Hedge Fund Investors? (Part Two of Two)

    Faced with increasingly intrusive requests for information from current and prospective investors, a hedge fund manager must be prepared to tactfully respond by disclosing an appropriate amount of information while otherwise protecting its business. While a manager may be willing to disclose particular items, it is likely to find itself subject to a growing number of due diligence requests for sensitive information and documents. In an effort to determine industry best practices for responding to such requests, The Hedge Fund Law Report surveyed 20 general counsels and other “C-level” decision-makers at leading hedge fund managers. We present the results of that survey in this two-part article series. The first part described the types of information requests that hedge fund managers are encountering from investors, focusing on the most intrusive requests. This second article explores how managers have actually responded to those requests and what they did to mitigate the potential negative consequences of releasing sensitive information. For more on due diligence, see “Evolving Operational Due Diligence Trends and Best Practices for Due Diligence on Emerging Hedge Fund Managers” (Apr. 18, 2014). For analysis of the investor view of due diligence, see “What Should Hedge Fund Investors Be Looking for in the Course of Operational Due Diligence and How Can They Find It?” (Oct. 13, 2011); and “Legal, Operational and Risk Considerations for Institutional Investors When Performing Due Diligence on Hedge Fund Service Providers” (Jul. 8, 2010).

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  • From Vol. 9 No.49 (Dec. 15, 2016)

    Challenges Fund Managers Face Meeting the Growing Demands of Employees, Investors and Regulators: An Interview With EY Principal Samer Ojjeh

    In a recent interview with The Hedge Fund Law Report, Samer Ojjeh, principal at Ernst & Young LLP (EY), analyzed the current state of the private funds industry. Specifically, Ojjeh discussed the high expectations of investors, the strategies currently attracting capital, barriers to entry for emerging asset managers and ways managers can retain top talent. Ojjeh’s remarks provide valuable perspective to hedge fund managers on the numerous demands they face from diverse parties, including investors, regulators and the managers’ own employees. For further commentary from Ojjeh, see “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)” (Jan. 9, 2014); and “Certain Hedge Fund Managers Are Moving From Full to Partial Shadowing of Administrator Functions” (Sep. 12, 2013). For additional insights from EY professionals, see “Daniel New, Executive Director of EY’s Asset Management Advisory Practice, Discusses Best Practices on ‘Hot Button’ Hedge Fund Compliance Issues: Disclosure, Expense Allocations, Insider Trading, Political Intelligence, CCO Liability, Valuation and More” (Oct. 17, 2013); as well as our two-part series “Steps That Alternative Investment Fund Managers Need to Consider to Comply With the Global Trend Toward Tax Transparency”: Part One (Apr. 7, 2016); and Part Two (Apr. 14, 2016). 

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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.47 (Dec. 1, 2016)

    How Investment Managers Can Advertise Sub-Adviser Performance Without Violating SEC Rules 

    In a series of recent enforcement actions, the SEC has held investment advisers responsible for performance claims included in their marketing materials that they received from sub-advisers and that turned out to be false and misleading. Although the SEC acknowledged that the investment advisers may have been unaware that the performance information was false and misleading, the regulator concluded that they were nevertheless responsible for ensuring that the overall reported performance record from their sub-advisers was compliant with the Investment Advisers Act of 1940. To avoid running afoul of applicable law, investment advisers conveying third-party performance returns should obtain adequate documentation to verify their accuracy and establish policies and procedures that govern what due diligence they will conduct on the sub-advisers’ performance. In a guest article, Daniel G. Viola, partner at Sadis & Goldberg, and Antonella Puca, head of the investment performance attestation practice at RSM US, review the key aspects of the recent enforcement activity of the SEC on performance advertising and provide guidance on how to address some of the SEC’s concerns. For additional insight from Viola, see “Hedge Fund Managers Advised to Prepare for Imminent SEC Examination” (Jan. 28, 2016). For more on performance advertising, see “The SEC’s Recent Revisions to Form ADV and the Recordkeeping Rule: What Investment Advisers Need to Know About Retaining Performance Records (Part Two of Two)” (Nov. 17, 2016); and “Liquidity and Performance Representations Present Potential Pitfalls for Hedge Fund Managers” (Mar. 31, 2016).

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  • From Vol. 9 No.45 (Nov. 17, 2016)

    How Hedge Fund Managers Can Design an ESG Investing Policy (Part Two of Two)

    There is no one-size-fits-all approach for private fund advisers that incorporate environmental, social and governance (ESG) factors into their investment processes (ESG investing), in part because many early adopters of ESG investing in the hedge fund space have done so at the request of their investors. Consequently, managers have had to develop a variety of approaches to meet the diverse needs of investors without uniform requirements. Some large institutional investors with ESG investing criteria seek to bypass commingled funds and allocate to separately managed accounts, thereby allowing them to dictate the ESG parameters that apply to their accounts. A benefit to an ESG-sensitive investor of investing in a separately managed account is that it provides transparency into the portfolio to (1) ensure the investment manager adheres to the account’s ESG investment parameters; and (2) evaluate the efficacy of the investment from an ESG perspective. Not all investors, however, have sufficient assets to pursue their mandates through managed accounts, forcing them to allocate to managers applying ESG investing policies to commingled funds. This second article in our two-part series discusses various options available to hedge fund managers when adopting an ESG policy and outlines some of the due diligence inquiries managers with an ESG policy should expect to receive from investors. The first article explored the development of ESG investing and its prevalence in the hedge fund space.

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  • From Vol. 9 No.43 (Nov. 3, 2016)

    Current Trends in Operational Due Diligence and Background Checks

    Operational due diligence is an important part of the investment process. Investors are concerned not only with a manager’s performance but also with the security and stability of its operations. At the recent Third Party Marketers Association (3PM) 2016 Annual Conference, marketers and operational due diligence professionals offered insights into the types of operational due diligence they conduct and how hedge fund managers can prepare for due diligence inquiries. Although the presentation was geared toward third-party marketers, its lessons apply equally to investors because the process by which a third-party marketer investigates a potential client is analogous to how an investor evaluates a hedge fund manager with which it is considering investing. Introduced by Steven Jafarzadeh and moderated by Mark Sullivan, both managing directors and partners at alternative asset placement agent platform Stonehaven, LLC, the program featured Lauri Martin Haas, founder and principal of operational due diligence firm PRISM LLC, and Kenneth S. Springer, founder and president of business investigations firm Corporate Resolutions Inc. This article highlights the key takeaways from the panel. For coverage of another 3PM annual conference, see “Third Party Marketers Association 2011 Annual Conference Focuses on Hedge Fund Capital Raising Strategies, Manager Due Diligence, Structuring Hedge Fund Marketer Compensation and Marketing Regulation” (Dec. 1, 2011). For additional insight from Springer, see “Can Hedge Fund Managers Use Whistleblower Hotlines to Help Create and Demonstrate a Culture of Compliance?” (Jul. 23, 2010); and “Implications for Hedge Funds of New Whistleblower Initiatives by FINRA and the SEC: An Interview With Kenneth Springer of Corporate Resolutions Inc.” (Mar. 11, 2009).

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  • From Vol. 9 No.40 (Oct. 13, 2016)

    How Developments With California’s Pension Plan Disclosure Law, the SEC’s Rules and FINRA’s CAB License May Impact Hedge Fund Managers and Third-Party Marketers

    Hedge fund managers and many service providers have faced a wave of new regulatory requirements since the 2008 global financial crisis. This is particularly true for third-party marketers engaged by hedge fund managers to solicit clients and fund investors, which may be subject to a barrage of regulations at the federal, state and local level depending on the nature of their business. To explore some of the latest regulatory challenges faced by funds and their marketers, The Hedge Fund Law Report recently interviewed Susan E. Bryant, counsel at Verrill Dana LLP, and Richard M. Morris, partner at Herrick, Feinstein LLP. This article sets forth the participants’ thoughts on a host of issues, including new disclosure requirements for state pension plan investors; recent enforcement trends; and new rules adopted by the SEC, FINRA, Municipal Securities Rulemaking Board (MSRB) and state regulators. On Thursday, October 20, 2016, from 10:30 a.m. to 11:30 a.m. EDT, Morris and Bryant will expand on the topics in this article – as well as other issues that affect hedge fund managers and third-party marketers – during a panel moderated by Kara Bingham, Associate Editor of the HFLR, at the Third Party Marketers Association (3PM) 2016 Annual Conference. For more information on the conference, click here. To take advantage of the HFLR’s $300 discount when registering for the conference, click the link available in the article. For prior coverage of a conference sponsored by 3PM, see “Third Party Marketers Association 2011 Annual Conference Focuses on Hedge Fund Capital Raising Strategies, Manager Due Diligence, Structuring Hedge Fund Marketer Compensation and Marketing Regulation” (Dec. 1, 2011).

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  • From Vol. 9 No.40 (Oct. 13, 2016)

    How Hedge Fund Managers Can Accommodate Heightened Investor Demands for Bespoke Negative Consent, Liquidity, MFN and Other Provisions in Side Letters

    As investors increasingly demand tailored investment terms, fund managers find themselves forced to accommodate these requests in light of today’s difficult capital raising environment. See “How Emerging Hedge Fund Managers Can Raise Capital in a Challenging Market Without Overstepping Legal Bounds” (Aug. 4, 2016). Some fund managers are incorporating common investor demands into their standard side letters and fund documentation in order to limit negotiations. Many are also adopting side letter policies to accommodate investor demands while avoiding any appearance of preferential treatment and preventing friction among investors. These themes came across in the opening session of the Tenth Annual Hedge Fund General Counsel and Compliance Summit, hosted by Corporate Counsel and ALM on September 28, 2016. Moderated by Mark Proctor, a partner in the private funds group at Vinson & Elkins, the panel featured S. Dov Lando, managing director, general counsel and chief compliance officer at MKP Capital Management; Nicole M. Tortarolo, head of investment structuring at UBS Hedge Fund Solutions; Solomon Kuckelman, head of U.S. legal for Man Investments; and Marc Baum, general counsel and chief administrative officer at Serengeti Asset Management. This article presents the key takeaways from the panel discussion. For additional commentary from Baum, see “Participants at Eighth Annual Hedge Fund General Counsel Summit Discuss CFTC Compliance, Conflicting Regulatory Regimes and Best Marketing Practices (Part Two of Four)” (Jan. 29, 2015). For insight from Tortarolo, see “RCA Asset Manager Panel Offers Insights on Hedge Fund Due Diligence” (Apr. 2, 2015). For additional views from Lando, see “Four Essential Elements of a Workable and Effective Hedge Fund Compliance Program” (Aug. 28, 2014); and “Three Pillars of an Effective Hedge Fund Valuation Process” (Jun. 19, 2014).

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  • From Vol. 9 No.39 (Oct. 6, 2016)

    How Studying SEC Examinations Can Enhance Investor Due Diligence

    Investors who are performing or planning to undertake due diligence on hedge funds can glean practical guidance from SEC examinations of fund managers. This was the primary theme of a recent webinar presented by the Investment Management Due Diligence Association (IMDDA) featuring Kristina Staples, managing director of ACA Compliance Group. This article summarizes Staples’ primary insights from the webinar. For more on due diligence, see “RCA Asset Manager Panel Offers Insights on Hedge Fund Due Diligence” (Apr. 2, 2015); “Operational Due Diligence From the Hedge Fund Investor Perspective: Deal Breakers, Liquidity, Valuation, Consultants and On-Site Visits” (Apr. 25, 2014); and “Evolving Operational Due Diligence Trends and Best Practices for Due Diligence on Emerging Hedge Fund Managers” (Apr. 18, 2014). For additional commentary from Staples, see “Five Steps That CCOs Can Take to Avoid Supervisory Liability, and Other Hedge Fund Manager CCO Best Practices” (Mar. 27, 2015). For coverage of a previous IMDDA webinar, see “How Managers May Address Increasing Demands of Limited Partners for Standardized Reporting of Fund Fees and Expenses” (Sep. 1, 2016).

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  • From Vol. 9 No.13 (Mar. 31, 2016)

    How Are Your Peers Responding to the Most Intrusive Requests From Hedge Fund Investors? (Part Two of Two)

    Faced with increasingly intrusive requests for information from current and prospective investors, a hedge fund manager must be prepared to tactfully respond by disclosing an appropriate amount of information while otherwise protecting its business. While a manager may be willing to disclose particular items, it is likely to find itself subject to a growing number of due diligence requests for sensitive information and documents. In an effort to determine industry best practices for responding to such requests, The Hedge Fund Law Report surveyed 20 general counsels and other “C-level” decision-makers at leading hedge fund managers. We present the results of that survey in this two-part article series. The first part described the types of information requests that hedge fund managers are encountering from investors, focusing on the most intrusive requests. This second article explores how managers have actually responded to those requests and what they did to mitigate the potential negative consequences of releasing sensitive information. For more on due diligence, see “Evolving Operational Due Diligence Trends and Best Practices for Due Diligence on Emerging Hedge Fund Managers” (Apr. 18, 2014). For analysis of the investor view of due diligence, see “What Should Hedge Fund Investors Be Looking For in the Course of Operational Due Diligence and How Can They Find It?” (Oct. 13, 2011); and “Legal, Operational and Risk Considerations for Institutional Investors When Performing Due Diligence on Hedge Fund Service Providers” (Jul. 8, 2010).

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  • From Vol. 9 No.11 (Mar. 17, 2016)

    How Are Your Peers Responding to the Most Intrusive Requests From Hedge Fund Investors? (Part One of Two)

    Hedge fund investors have become increasingly savvy in recent years, and one sign of that growing sophistication is the level of scrutiny focused on managers of hedge funds in which they are considering investing. Far beyond the simple review process that it once was, due diligence of hedge fund managers and their funds has become an intrusive process, as prospective investors seek deeper looks into managers’ operations and access to sensitive documents. Consequently, a manager must be prepared to tactfully respond to these invasive requests for information, providing sufficient information to satisfy the investors’ requests while protecting the manager’s business and confidentiality. In an effort to determine industry best practices for responding to such requests from prospective investors, The Hedge Fund Law Report surveyed 20 general counsels and other “C-level” decision-makers at leading hedge fund managers. We are presenting the results of that survey in a two-part article series. This first part describes the types of information requests that hedge fund managers are encountering from investors, focusing on the most intrusive requests. The second article will explore how managers have responded to those requests while mitigating the potential negative consequences of releasing sensitive information. For more on due diligence, see “Why Should Hedge Fund Investors Perform Onsite Due Diligence in Addition to Remote Gathering of Information on Managers and Funds? (Part Three of Three)” (Feb. 12, 2015). For analysis of the investor view of due diligence, see “Operational Due Diligence From the Hedge Fund Investor Perspective: Deal Breakers, Liquidity, Valuation, Consultants and Onsite Visits” (Apr. 25, 2014). For another industry survey conducted by the HFLR, see our two-part series on how hedge fund managers: “Define and Handle Trade Errors” (Oct. 15, 2015); and “Detect and Bear Responsibility for Trade Errors” (Oct. 22, 2015).

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  • From Vol. 9 No.9 (Mar. 3, 2016)

    Hedge Fund Managers Are Advised to Build Robust Infrastructure

    As investors conduct deeper due diligence into infrastructure – such as compliance policies and procedures, technology systems and cybersecurity protections – hedge fund managers must ensure that their programs and systems are robust and able to withstand scrutiny. See “Legal, Operational and Risk Considerations for Institutional Investors When Performing Due Diligence on Hedge Fund Service Providers” (Jul. 8, 2010). Managers may choose to supplement their in-house infrastructure by outsourcing and delegating to third-party service providers, while monitoring those providers to ensure quality. At a recent seminar hosted by Backstop Solutions Group and ACA Compliance Group, panelists discussed the integration of technology and compliance, outsourcing of business functions to third parties, due diligence of service providers and investor scrutiny of hedge fund managers. This article highlights the salient points raised during the program. For additional insight from Backstop, see “Essential Tools for Hedge Fund Managers to Combat Escalating Cyber Threats” (Feb. 4, 2016). For coverage of a recent program jointly offered by the HFLR and ACA, see “Recommended Actions for Hedge Fund Managers in Light of SEC Enforcement Trends” (Oct. 22, 2015).

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  • From Vol. 9 No.8 (Feb. 25, 2016)

    FCA Report Enjoins Hedge Fund Managers to Improve Due Diligence

    In a recent report, the U.K. Financial Conduct Authority (FCA) noted that hedge fund managers and other financial advisory firms must improve due diligence of products and services they recommend for their clients. Firms must also appropriately manage conflicts of interest between themselves and their clients. This article details the key points raised in the FCA report. For more on due diligence conducted by hedge fund managers, see “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 “Best Practices for Due Diligence by Hedge Fund Managers on Research Providers” (Mar. 14, 2013).

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  • From Vol. 8 No.49 (Dec. 17, 2015)

    Distribution and Operational Due Diligence Considerations for Hedge Fund Managers Launching UCITS Funds (Part Two of Two)

    As a growing number of hedge fund managers look to Undertakings for Collective Investments in Transferable Securities (UCITS) funds as a means of accessing the European market, those managers must establish a framework for distributing UCITS funds.  While UCITS products are more regulated and transparent than private hedge funds, investors must still conduct thorough operational due diligence before investing in those funds.  At the recent Liquid Alternative Strategies Global conference held in London, speakers delved into these topics as part of a broader discussion about the rise of alternative UCITS as a global investment solution.  This article, the second in a two-part series, focuses on distribution of UCITS products and operational due diligence.  The first article addressed the drivers behind the recent growth in alternative UCITS funds and several key factors that managers should consider when assessing their ability to capitalize on demand for UCITS products.  For more on UCITS, see “U.K. Government Proposes to Implement UCITS V Measures Applicable to Fund Managers,” The Hedge Fund Law Report, Vol. 8, No. 43 (Nov. 5, 2015); and “FCA Consults on Implementation of UCITS V Provisions Applicable to Managers,” The Hedge Fund Law Report, Vol. 8, No. 36 (Sep. 17, 2015).  For more on operational due diligence, see “PLI ‘Hot Topics’ Panel Addresses Operational Due Diligence and Registered Alternative Funds,” The Hedge Fund Law Report, Vol. 8, No. 48 (Dec. 10, 2015); and “FRA Liquid Alts 2015 Conference Highlights Due Diligence Concerns with Alternative Mutual Funds (Part Three of Three),” The Hedge Fund Law Report, Vol. 8, No. 19 (May 14, 2015).

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  • From Vol. 8 No.48 (Dec. 10, 2015)

    PLI “Hot Topics” Panel Addresses Operational Due Diligence and Registered Alternative Funds

    A recent panel discussion at The Practising Law Institute’s Hedge Fund Management 2015 program, “Hot Topics for Hedge Fund Managers,” offered insight on current investor due diligence practices and a look at the challenges of starting a registered alternative fund, in addition to providing the perspective of an SEC counsel on cybersecurity and a summary of significant developments in swaps regulation.  Nora M. Jordan, a partner at Davis Polk & Wardwell, moderated the discussion, which featured Jessica A. Davis, chief operating officer and general counsel of investment adviser Lodge Hill Capital, LLC; Jennifer W. Han, associate general counsel at the Managed Funds Association; and Aaron Schlaphoff, an attorney fellow in the Rulemaking Office of the SEC Division of Investment Management.  This article summarizes the key takeaways from the program with respect to operational due diligence and registered alternative funds.  For additional coverage of PLI’s Hedge Fund Management 2015 program, see “PLI ‘Hot Topics’ Panel Addresses Cybersecurity and Swaps Regulation,” The Hedge Fund Law Report, Vol. 8, No. 43 (Nov. 5, 2015); and “SEC’s Rozenblit Discusses Operations and Priorities of the Private Funds Unit,” The Hedge Fund Law Report, Vol. 8, No. 37 (Sep. 24, 2015).

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  • From Vol. 8 No.42 (Oct. 29, 2015)

    European Hedge Fund Managers Must Incorporate New Guidelines on Risk Factors into Due Diligence Processes

    The E.U. Directive to prevent money laundering and terrorist financing via the financial system (AML Directive) became effective on June 26, 2015.  It seeks to bring Europe into alignment with the 2012 International Standards on Combating Money Laundering and the Financing of Terrorism and Proliferation (Standards).  Following the Standards, the AML Directive puts the onus on Member States, competent authorities and in-scope firms – including hedge fund and other investment managers – to assess and manage anti-money laundering risks and implement appropriate counter-terrorist financing measures.  Consequently, European hedge fund managers will be required to determine the extent of their customer due diligence (CDD) measures on a risk-sensitive basis, applying simplified CDD for low-risk relationships but enhanced CDD for higher-risk relationships.  To help firms identify, assess and manage money laundering and terrorist financing risk – as well as help national competent authorities measure the adequacy of such firms’ actions – the European Supervisory Authorities jointly issued draft risk factor Guidelines for risk assessments, outlining how firms may adjust their CDD commensurate with identified risks.  This article summarizes those sections of the Guidelines applicable to hedge fund managers; outlines the impact of the Guidelines on hedge fund managers; and sets out the timeframe for implementation and compliance.  For more on anti-money laundering, see “Do Hedge Funds Really Pose a Money Laundering Threat? A Decade of Regulatory False Starts Raises Questions,” The Hedge Fund Law Report, Vol. 5, No. 7 (Feb. 16, 2012); and “FinCEN Working on a Proposed Rule That Would Require Investment Advisers to Establish Anti-Money Laundering Programs and Report Suspicious Activity,” The Hedge Fund Law Report, Vol. 5, No. 4 (Jan. 26, 2012).

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  • From Vol. 8 No.19 (May 14, 2015)

    FRA Liquid Alts 2015 Conference Highlights Due Diligence Concerns with Alternative Mutual Funds (Part Three of Three)

    With the significant expansion of the liquid alternatives (or alternative mutual fund) space in recent years and the increase in offerings of alternative mutual funds by hedge fund managers, the importance of conducting proper due diligence has commensurately grown.  Investors looking to allocate funds to alternative mutual funds need to consider numerous factors when evaluating potential candidates for investments, and managers deciding to launch alternative mutual funds must also conduct thorough due diligence on service providers for their structures.  This topic was among those discussed at the recent Liquid Alts 2015 conference hosted by Financial Research Associates, LLC.  This article, the third in a three-part series, focuses on the panel discussions of issues investors should consider while conducting due diligence on an alternative mutual fund, as well as due diligence issues managers should consider while establishing a fund structure under the Investment Company Act of 1940 (the ’40 Act).  The first article discussed the keys to successfully launching and operating an alternative mutual fund.  The second article explored ’40 Act fund structures and regulatory concerns with liquid alternative funds.  For more on alternative mutual funds, see “Five Key Compliance Challenges for Alternative Mutual Funds: Valuation, Liquidity, Leverage, Disclosure and Director Oversight,” The Hedge Fund Law Report, Vol. 7, No. 28 (Jul. 24, 2014).

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  • From Vol. 8 No.13 (Apr. 2, 2015)

    RCA Asset Manager Panel Offers Insights on Hedge Fund Due Diligence

    As institutional investors seek better returns or mitigation of downside risk in their portfolios, they frequently turn to hedge funds.  A recent program sponsored by the Regulatory Compliance Association provided an overview of the basic due diligence steps that such investors take with regard to investments with hedge fund managers, and focused on alignment of interests, indemnification provisions, liquidity, investor consent and the issues raised when investing through or alongside separate accounts.  The program was moderated by Scott Sherman, a Managing Director at Blackstone and Senior RCA Fellow from Practice.  The other speakers were Maura Harris, a Senior Vice President at The Permal Group; Nicole M. Tortarolo, an Executive Director at UBS A.G.; and David Warsoff, Executive Director at J.P. Morgan Alternative Asset Management.  For more on investor due diligence, see “Operational Due Diligence from the Hedge Fund Investor Perspective: Deal Breakers, Liquidity, Valuation, Consultants and On-Site Visits,” The Hedge Fund Law Report, Vol. 7, No. 16 (Apr. 25, 2014).  For fund managers’ perspectives on investor due diligence, see “Evolving Operational Due Diligence Trends and Best Practices for Due Diligence on Emerging Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 7, No. 15 (Apr. 18, 2014).  For more on due diligence from the Regulatory Compliance Association, see “RCA Session Covers Transparency, Liquidity and Most Favored Nation Provisions in Hedge Fund Side Letters, and Due Diligence Best Practices,” The Hedge Fund Law Report, Vol. 6, No. 1 (Jan. 3, 2013).  This month, the RCA will be hosting its Regulation, Operations and Compliance (ROC) Symposium in Bermuda.  For more on ROC Bermuda 2015, click here; to register for it, click here.  For a discussion of another RCA program, see “Four Pay to Play Traps for Hedge Fund Managers, and How to Avoid Them,” The Hedge Fund Law Report, Vol. 8, No. 5 (Feb. 5, 2015).

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  • From Vol. 8 No.6 (Feb. 12, 2015)

    Why Should Hedge Fund Investors Perform On-Site Due Diligence in Addition to Remote Gathering of Information on Managers and Funds? (Part Three of Three)

    On-site visits have become de rigueur in operational due diligence, with many investors putting a high premium on face-to-face meetings with fund managers.  But the difference between a superficial and an effective on-site visit can be profound.  Merely showing up is not sufficient.  In fact, going on site without the right strategy can create the illusion of a “deep dive” without the substance.  Effective on-site due diligence is not just a matter of staying longer, asking more questions and reviewing more documents.  It is a discipline unto itself, with techniques that are proven to work.  Usually, those techniques can only be learned through trial and error.  This article, the third in a three-part series, aims to minimize the “error” part of that learning process by revealing best practices learned by long-time ODD practitioners.  Specifically, this article details: workable and effective on-site diligence procedures, including evaluating cybersecurity programs; red flags to identify; and an investor’s options following the on-site visit.  The first article focused on the rationale for the on-site visit and the mechanics of preparation.  The second article discussed how investors should conduct due diligence visits, and how managers can prepare for them effectively.  See also “Operational Due Diligence from the Hedge Fund Investor Perspective: Deal Breakers, Liquidity, Valuation, Consultants and On-Site Visits,” The Hedge Fund Law Report, Vol. 7, No. 16 (Apr. 25, 2014).

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  • From Vol. 8 No.5 (Feb. 5, 2015)

    Why Should Hedge Fund Investors Perform On-Site Due Diligence in Addition to Remote Gathering of Information on Managers and Funds? (Part Two of Three)

    An on-site visit has become an essential element of a hedge fund operational due diligence program.  As one allocator told the HFLR, “There are a few important questions that can only be asked while looking into the eyes of the COO or CFO.”  But what are those questions and, more generally, what practices, approaches and techniques can investors implement to extract maximum value from an on-site visit?  This article is the second in a three-part series detailing how and why investors should perform on-site due diligence visits.  Based on insight from operational due diligence veterans, this article describes how investors should conduct diligence visits, and how managers can prepare for them effectively.  The first article focused on the rationale for the on-site visit and the mechanics of preparation.  The third article will discuss further on-site procedures, including red flags to identify, and an investor’s options following the on-site visit.  See also “Evolving Operational Due Diligence Trends and Best Practices for Due Diligence on Emerging Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 7, No. 15 (Apr. 18, 2014).

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  • From Vol. 8 No.4 (Jan. 29, 2015)

    Why Should Hedge Fund Investors Perform On-Site Due Diligence in Addition to Remote Gathering of Information on Managers and Funds? (Part One of Three)

    Technology is an important adjunct to hedge fund investments and operations, but the human element continues to loom disproportionately large in operational due diligence.  Institutional investors review voluminous information in the course of due diligence, and a year-long courtship is not unusual before making an investment.  Much of that information is obtained and reviewed remotely, but according to the smart money, an operational due diligence process is not complete without an on-site visit.  What can institutional investors glean on-site that they cannot obtain remotely?  To answer that question, The Hedge Fund Law Report interviewed practitioners working in various phases of the hedge fund investment process.  This article – the first in a three-part series – conveys the key findings of our interviews on topics including: general goals of an on-site review; the four core benefits of an on-site review; how to prepare for an on-site visit; the role of background checks and confidentiality agreements; how to structure an on-site visit agenda to maximize productivity; and who should participate in an on-site visit and what materials participants should bring.  The second article in this series will address protocol for the on-site visit, and the third article will discuss an investor’s options following the on-site visit.  See also “Operational Due Diligence from the Hedge Fund Investor Perspective: Deal Breakers, Liquidity, Valuation, Consultants and On-Site Visits,” The Hedge Fund Law Report, Vol. 7, No. 16 (Apr. 25, 2014).

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  • From Vol. 7 No.23 (Jun. 13, 2014)

    Pension Plan Gatekeepers Increasingly Serving as Competitors to Alternative Investment Managers

    On May 21, 2014, Rep. George Miller, Senior Democratic Member of the House Committee on Education and the Workforce, sent a letter to Labor Department Secretary Thomas Perez expressing concerns about a “growing trend” in which pension consultants are “recommending” themselves to manage the assets of their pension plan clients.  See also “Getting to Know the Gatekeepers: How Hedge Fund Managers Can Interface with Investment Consultants to Access Institutional Capital (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 28 (Jul. 18, 2013).

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  • From Vol. 7 No.16 (Apr. 25, 2014)

    Operational Due Diligence from the Hedge Fund Investor Perspective: Deal Breakers, Liquidity, Valuation, Consultants and On-Site Visits

    On March 25 and 26, 2014, at the Princeton Club in New York, Financial Research Associates held the most recent edition of its annual Hedge Fund Due Diligence Master Class.  This article summarizes a series of panels at the event focusing on operational due diligence from the investor perspective.  In particular, this article covers seven categories of “deal breakers” that investors can discover in the course of operational due diligence (ODD); a three-part framework for thinking about manager liquidity; six categories of people that should serve on a hedge fund manager valuation committee; five best practices for institutional investors that elect to conduct due diligence on their own, without a dedicated ODD team; how investors can work with consultants to conduct ODD; and the three phases of on-site ODD visits.  Prior articles in the HFLR covered an overview presentation at the same event, and another series of panels focusing on operational due diligence from the manager perspective.  See “Evolving Operational Due Diligence Trends and Best Practices for Due Diligence on Emerging Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 7, No. 15 (Apr. 18, 2014).

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  • From Vol. 7 No.15 (Apr. 18, 2014)

    Evolving Operational Due Diligence Trends and Best Practices for Due Diligence on Emerging Hedge Fund Managers

    On March 25 and 26, 2014, at the Princeton Club in New York, Financial Research Associates held the most recent edition of its annual Hedge Fund Due Diligence Master Class.  This article summarizes a series of panels at the event focusing on operational due diligence from the manager perspective.  In particular, this article covers evolving operational due diligence trends, due diligence on emerging hedge fund managers, due diligence on service providers, corporate governance and cybersecurity considerations for hedge fund managers.  A prior article in the HFLR covered an overview presentation at the same event.  See “Seward & Kissel Partner Steven Nadel Identifies 29 Top-of-Mind Issues for Investors Conducting Due Diligence on Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 7, No. 13 (Apr. 4, 2014).  And a subsequent article will cover panels at the event focusing on operational due diligence from the investor perspective.

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  • From Vol. 7 No.13 (Apr. 4, 2014)

    Seward & Kissel Partner Steven Nadel Identifies 29 Top-of-Mind Issues for Investors Conducting Due Diligence on Hedge Fund Managers

    On March 25 and 26, 2014 at the Princeton Club in New York, Financial Research Associates held the most recent edition of its annual Hedge Fund Due Diligence Master Class.  During an opening “fireside chat,” Seward & Kissel LLP partner Steven Nadel identified 29 areas of concern for investors engaged in due diligence of hedge fund managers.  Many of these concerns overlap with concerns of regulators examining hedge fund managers.  This article lists the issues identified by Nadel and relays his market color on each.

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  • From Vol. 7 No.6 (Feb. 13, 2014)

    OCIE Risk Alert Identifies the Chief Concerns of Pension Fund Gatekeepers When Performing Hedge Fund Due Diligence

    The SEC’s Office of Compliance Inspections and Examinations (OCIE), in coordination with the Division of Investment Management and the Asset Management Unit of the Enforcement Division, recently issued a Risk Alert summarizing the due diligence procedures that certain investment advisers employ when considering hedge funds and other alternative investments for their clients.  This article summarizes the key findings of the Risk Alert.  See also “Legal and Operational Due Diligence Best Practices for Hedge Fund Investors,” The Hedge Fund Law Report, Vol. 5, No. 1 (Jan. 5, 2012).

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  • From Vol. 6 No.38 (Oct. 3, 2013)

    Why and How Should Hedge Fund Managers Conduct Background Checks on Prospective Employees? (Part One of Three)

    Hedge fund management is a human capital business, and employees are (or should be) the key asset of a manager.  See “Key Legal Considerations in Connection with the Movement of Talent from Proprietary Trading Desks to Start-Up or Existing Hedge Fund Managers: The Hedge Fund Manager Perspective (Part Three of Three),” The Hedge Fund Law Report, Vol. 4, No. 4 (Feb. 3, 2011).  However, employees can also be a manager’s most dangerous liability.  One rogue employee can destroy or seriously damage even the best hedge fund franchise by, among other things, inviting a presumption that the employee is not rogue but representative of a culture of permissiveness.  See “Rajaratnam Prosecutor and Dechert Partner Jonathan Streeter Discusses How the Government Builds and Prosecutes an Insider Trading Case against a Hedge Fund Manager,” The Hedge Fund Law Report, Vol. 5, No. 45 (Nov. 29, 2012).  Recognizing the risks of picking bad apples, hedge fund managers are increasingly using employee background checks as a downside mitigation strategy.  But the concept of a background check spans a wide range of activities – everything from a superficial online search to a deep, manual process.  Whether to conduct a background check in the first instance, and what kind of background check to conduct, depends on dynamics specific to the industry, firm and prospective employee.  To assist hedge fund managers in understanding the role of background checks in their hiring and “people” processes, The Hedge Fund Law Report is publishing a three-part series on the role of background checks in the hedge fund industry, with the three parts focusing on, respectively, three questions: Why, how and who.  More specifically, this article – the first in the series – outlines the case for conducting background checks, cataloging the wide range of regulatory and other risks presented by employees (including discussions of insider trading, Rule 506(d), pay to play, track record portability, restrictive covenants and other topics).  The second installment will describe the anatomy of an employee background check, highlighting mechanics, common mistakes and risks.  And the third part will weigh the benefits and burdens of outsourcing background checks versus conducting them in-house.

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  • From Vol. 6 No.32 (Aug. 15, 2013)

    How Can Hedge Fund Managers Apply the Law of Insider Trading to Address Hedge Fund Industry-Specific Insider Trading Risks? (Part Two of Two)

    This is the second article in a two-part series detailing the application of abstract insider trading principles to specific scenarios and challenges faced by hedge fund managers.  This article discusses the misappropriation theory of insider trading; recent caselaw on the element of scienter; channel checking and field research; insider trading issues raised when fund investors are affiliated with portfolio companies; special insider trading rules that apply to tender offers; and criminal and civil penalties for insider trading.  The first article in this series discussed the definition of nonpublic information; the scope of the concept of materiality; the limits of the concept of fiduciary duty as it relates to insider trading; and the mosaic theory of insider trading.  See “How Can Hedge Fund Managers Apply the Law of Insider Trading to Address Hedge Fund Industry-Specific Insider Trading Risks? (Part One of Two),” The Hedge Fund Law Report, Vol. 6, No. 31 (Aug. 7, 2013).  The author of this article series is Ralph Siciliano, head of the Governmental and Regulatory Investigations Practice at Tannenbaum Helpern Syracuse & Hirschtritt LLP.

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  • From Vol. 6 No.28 (Jul. 18, 2013)

    Deutsche Bank’s Hedge Fund Consulting Group Provides a Roadmap to Hedge Fund Managers in Navigating the Operational Due Diligence Process

    Deutsche Bank’s Hedge Fund Consulting Group recently released a report analyzing the results of a survey of institutional investors on operational due diligence (ODD).  Survey participants included 68 investors that collectively manage or advise $2.13 trillion in total assets, including $764 billion of assets invested in hedge funds.  Among other things, the report discussed the composition of ODD teams; the frequency and duration of ODD visits; how investors approach the ODD process; circumstances in which ODD teams have and use investment veto rights; priority focus areas for investor ODD reviews; operating and allocation preferences (including which expenses investors perceive as acceptable for charging to the fund); and recommendations to managers in preparing for ODD reviews.  The insights from investors captured in the Deutsche Bank report can help hedge fund managers refine their approach to the ODD process.  In turn, a well-informed, coherent and credible approach to ODD can pay dividends to hedge fund managers in the form of increased allocations and more effective marketing.  This article extracts insights from the report that managers can incorporate directly into their responses to due diligence inquiries.  For more on ODD, see “Legal and Operational Due Diligence Best Practices for Hedge Fund Investors,” The Hedge Fund Law Report, Vol. 5, No. 1 (Jan. 5, 2012); and “FRA Conference Juxtaposes Manager and Investor Perspectives on Hedge Fund Due Diligence (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 23 (Jun. 6, 2013).

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  • From Vol. 6 No.24 (Jun. 13, 2013)

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

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

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  • From Vol. 6 No.23 (Jun. 6, 2013)

    FRA Conference Juxtaposes Manager and Investor Perspectives on Hedge Fund Due Diligence (Part Two of Two)

    Financial Research Associates LLC recently hosted a two-day seminar entitled “Hedge Fund Due Diligence Master Class.”  This is the second article in a two-part series extracting and summarizing key lessons from the event.  Specifically, this article discusses counterparty risk and valuation issues, recent regulatory developments impacting due diligence, strategic planning for sustainable due diligence programs, evolution of the due diligence process and manager perspectives on due diligence.  The first installment discussed red flags that investors should look for during diligence, the tension between increased portfolio transparency and protection of a manager’s proprietary information and investor perspectives on enterprise risk management by managers.  See “FRA Conference Juxtaposes Manager and Investor Perspectives on Hedge Fund Due Diligence (Part One of Two),” The Hedge Fund Law Report, Vol. 6, No. 22 (May 30, 2013).

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  • From Vol. 6 No.22 (May 30, 2013)

    FRA Conference Juxtaposes Manager and Investor Perspectives on Hedge Fund Due Diligence (Part One of Two)

    Hedge fund managers and investors sometimes view the same topic very differently.  See, e.g., “Ernst & Young’s Sixth Annual Global Hedge Fund Survey Highlights Continued Divergence of Expectations between Managers and Investors,” The Hedge Fund Law Report, Vol. 5, No. 44 (Nov. 21, 2012).  The all-important topic of hedge fund due diligence is no exception to this industry truism.  This divergence of interests, experience and expectations was in evidence at a recent conference entitled “Hedge Fund Due Diligence Master Class,” and hosted by Financial Research Associates LLC (FRA).  But, equally if not more importantly, the FRA event also highlighted areas of shared concern among managers and investors, as well as specific due diligence techniques that benefit both constituencies.  Hedge fund due diligence has become a condition precedent of the initiation and continuation of a relationship between a manager and investor.  It is front and center in terms of importance.  Therefore, the concerns, best practices, due diligence approaches and stories from the trenches shared at the FRA event hold important lessons for investors as well as managers.  The Hedge Fund Law Report is memorializing the key lessons from the event in a two-part series of articles.  This article, the first in the series, addresses key priorities and red flags that investors should look for during the manager diligence process; the tension between increased portfolio transparency and protection of proprietary information; and investor perspectives on enterprise risk management by managers.  The second installment will discuss custody and valuation issues; strategic planning for sustainable due diligence programs; recent regulatory developments and how managers should respond; questions that investors should ask during diligence; and ways in which managers are improving their due diligence processes.

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  • From Vol. 6 No.17 (Apr. 25, 2013)

    Roundtable Addresses Trends in Hedge Fund Operational Due Diligence, Fund Expenses, Administrator Shadowing, Business Continuity Planning and Cloud Computing

    At a recent roundtable, hedge fund investor due diligence experts offered their perspectives on evolving hedge fund manager operations and investor due diligence practices.  The panelists addressed various specific topics, including: the impact of regulations on investor due diligence processes; investor responses to increased insider trading risks; scrutiny of fund expenses; administrator shadowing; business continuity planning for hedge fund managers; and the benefits and risks of cloud computing services.  These investor perspectives can provide useful information for hedge fund managers looking to refine their capital raising efforts.  This article highlights the salient points discussed on each of the foregoing topics.

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  • From Vol. 6 No.13 (Mar. 28, 2013)

    Former Rajaratnam Prosecutor Reed Brodsky Discusses the Application of Insider Trading Doctrine to Hedge Fund Research and Trading Practices

    For at least the last five years, Reed Brodsky has been at the epicenter of the evolution of insider trading law as it applies to hedge fund managers.  As an Assistant U.S. Attorney in the Southern District of New York, he was one of the three prosecutors who tried the largest criminal hedge fund insider trading trial in history, U.S. v. Raj Rajaratnam, which resulted in Rajaratnam’s conviction and sentence of 11 years.  See “Implications of the Rajaratnam Verdict for the ‘Mosaic Theory,’ the ‘Knowing Possession’ Standard of Insider Trading and Criminal Wire Fraud Liability in the Absence of a Trade,” The Hedge Fund Law Report, Vol. 4, No. 18 (Jun. 1, 2011).  Also, he was one of two prosecutors who tried the insider trading case against Rajat Gupta, the former McKinsey Chairman, which resulted in Gupta’s conviction; and he worked on the prosecution of former FrontPoint Partners portfolio manager Joseph Skowron for insider trading in connection with a drug trial.  See “Morgan Stanley Sues Former FrontPoint Partners Portfolio Manager Joseph F. ‘Chip’ Skowron III for Losses Allegedly Caused by Skowron’s Insider Trading and Subsequent Cover-Up,” The Hedge Fund Law Report, Vol. 5, No. 44 (Nov. 21, 2012).  Based on this experience, Brodsky’s command of insider trading doctrine as it applies to hedge fund managers is recent, relevant and deep.  The Hedge Fund Law Report recently had the opportunity to interview Brodsky in connection with the Regulatory Compliance Association’s upcoming Regulation, Operations & Compliance 2013 Symposium, at which Brodsky is scheduled to participate.  (The details of the Symposium are discussed below.)  Our interview did not focus on insider trading doctrine per se, although Brodsky is eminently equipped to discuss doctrine in depth.  Rather, our interview focused on the application of evolving insider trading doctrine to a range of research and trading practices commonly undertaken by hedge fund managers.  Specifically, we explored with Brodsky: how insider trading law should inform the efforts of hedge fund managers with respect to the use of expert network firms, channel checking firms and political intelligence firms; the application of insider trading law to commodities, derivatives and trades in private company stock; the practicability of “walling off” employees with material nonpublic information; trends in investigative methods and enforcement topics; how to generate goodwill from witness cooperation; and the value of self-reporting discovered insider trading violations.  In addition, we posed a number of challenging hypotheticals to Brodsky – which were hypothetical only in the sense that we did not name names, although the fact patterns are quite real.  Brodsky’s answers were insightful, business-minded and candid, and provide invaluable insight into how prosecutors think about the hedge fund industry.  The RCA Symposium will be held at the Pierre Hotel in New York City on April 18, 2013, and is scheduled to include a panel covering government investigations and prosecutions of hedge fund and private equity fund managers entitled “Post SAC Capital – Investigation, Enforcement & Prosecution of Hedge & PE Managers.”  For a fuller description of the Symposium, click here.  To register for the Symposium, click here.  Subscribers to The Hedge Fund Law Report are eligible for a registration discount.  Brodsky will soon join Gibson Dunn & Crutcher LLP as a partner.  See “Rajaratnam and Gupta Prosecutor Reed Brodsky to Join Gibson Dunn,” The Hedge Fund Law Report, Vol. 6, No. 5 (Feb. 1, 2013).

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  • From Vol. 6 No.12 (Mar. 21, 2013)

    How Can Hedge Fund Managers Wishing to Rely on the JOBS Act’s Advertising Relief Enhance Their Accredited Investor Due Diligence Procedures?

    The Jumpstart Our Business Startups (JOBS) Act provides relief from the ban on general solicitation and advertising contained in the Rule 506 securities registration safe harbor, as long as all purchasers of an issuer’s securities are accredited investors.  While the JOBS Act creates more opportunities for hedge fund managers to market their funds to the public, such opportunities are accompanied by an obligation on the part of managers to take “reasonable steps” to verify that all purchasers of fund securities are accredited investors.  However, the SEC has not yet adopted final rules to define when an adviser has taken such “reasonable steps.”  For a discussion of the SEC’s proposed rules, see “JOBS Act: Proposed SEC Rules Would Dramatically Change Marketing Landscape for Hedge Funds,” The Hedge Fund Law Report, Vol. 5, No. 34 (Sep. 6, 2012).  Despite the lack of definitive guidance from the SEC, hedge fund managers should nonetheless evaluate their investor due diligence procedures to ascertain whether they are sufficiently robust.  In a guest article, Philip Segal, founder of Charles Griffin Intelligence, provides recommendations to assist hedge fund managers in enhancing their investor due diligence practices.

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  • From Vol. 6 No.11 (Mar. 14, 2013)

    Best Practices for Due Diligence by Hedge Fund Managers on Research Providers

    Recent high-profile enforcement actions, including that involving Mathew Martoma and CR Intrinsic, an affiliate of SAC Capital, highlight the SEC Division of Enforcement’s continuing commitment to aggressively prosecuting hedge fund insider trading cases.  See “Fund Manager CR Intrinsic and Former SAC Portfolio Manager Are Civilly and Criminally Charged in Alleged ‘Record’ $276 Million Insider Trading Scheme,” The Hedge Fund Law Report, Vol. 5, No. 44 (Nov. 21, 2012).  While registered hedge fund managers are required by Rule 206(4)-7 under the Investment Advisers Act of 1940 to adopt policies and procedures reasonably designed to prevent and detect insider trading and other federal securities law violations, it behooves all hedge fund managers (even those that are not registered) to adopt such policies and procedures.  See “Three Recent SEC Orders Demonstrate a Renewed Emphasis on Investment Adviser Compliance Policies and Procedures by the Enforcement Division,” The Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).  Many hedge fund managers have recognized the insider trading risks posed by the use of expert network firms and have adopted policies and procedures designed to address these risks.  But other types of research firms also present insider trading and other regulatory risks.  Before using any investment research firm, it is imperative for hedge fund managers to conduct thorough due diligence to appropriately assess and address those risks.  In a guest article, Susan Mathews and Sanford Bragg describe the different types of research providers in the marketplace; the general approach to research provider due diligence; and some best practices for conducting due diligence on research providers.  Bragg is CEO of Integrity Research Associates, LLC, a consulting firm specializing in evaluating investment research providers, including their compliance platforms.  Mathews is Counsel and head of Integrity Research Compliance.

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  • From Vol. 6 No.1 (Jan. 3, 2013)

    RCA Session Covers Transparency, Liquidity and Most Favored Nation Provisions in Hedge Fund Side Letters, and Due Diligence Best Practices

    The Regulatory Compliance Association, in cooperation with major law firms and institutional investors, recently presented a Practice Readiness Series session entitled “Navigating the Side Letter and Due Diligence Process” (Session).  The Session focused on issues involved in negotiating hedge fund side letters from the perspectives of hedge fund managers and investors.  It also reviewed due diligence from both perspectives, highlighting the categories of due diligence performed by institutional investors and best practices for managers when responding to due diligence requests.  This article summarizes the key points made during the Session.

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  • From Vol. 6 No.1 (Jan. 3, 2013)

    How Can Hedge Fund Managers Identify, Mitigate and Insure Against Cyber Security Threats?

    On December 4, 2012, a webcast jointly sponsored by insurance brokerage firm Maloy Risk Services; insurer Chubb & Son; and Internet security software developer Trend Micro, provided an overview of the current cyber “threat landscape,” highlighted the critical need to vet the cyber defenses of third party service providers, and discussed insurance coverage available with respect to cyber attacks.  This article summarizes the key points from the webcast that are most relevant to hedge fund managers and includes a due diligence checklist for managers to verify cyber security measures taken by third party vendors.

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  • From Vol. 5 No.40 (Oct. 18, 2012)

    Top Ten Operational Risks Facing Hedge Fund Managers and What to Do about Them (Part One of Three)

    Operational risk has become a centerpiece of investor due diligence and a focal point of regulatory interest.  See “Legal and Operational Due Diligence Best Practices for Hedge Fund Investors,” The Hedge Fund Law Report, Vol. 5, No. 1 (Jan. 5, 2012).  Operational excellence is more difficult to discern than good performance; performance can be quantified and compared across managers while operations are often unique to a manager’s business practices and investment strategies.  At the same time, operational failures typically pose a greater threat than investment shortcomings.  Everyone understands that generating returns requires assuming risk, but it is often difficult to articulate a coherent explanation for operational shortcomings.  In short, in the area of hedge fund manager operations, best practices are critical, but challenging to identify.  Recognizing that the supply of best practices information on hedge fund manager operations generally falls short of the demand for it, SEI recently published the first of a series of papers entitled “Top 10 Operational Risks: A Survival Guide for Investment Management Firms.”  In a three-part series, The Hedge Fund Law Report is summarizing the key takeaways from the full Guide.  This first installment addresses a hedge fund manager’s attitude and approach towards operational risk; the need for effective oversight of firm functions; and the imperative of appropriate training and staffing to minimize operational risks.

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  • From Vol. 5 No.37 (Sep. 27, 2012)

    BNY Mellon Study Identifies Best Risk Management Practices for Hedge Fund Managers

    In the last few years, hedge fund managers, investors and regulators have identified a growing roster of risks facing hedge fund investments and operations.  See, “SEC Provides Recommendations for Establishing an Effective Risk Management Program for Hedge Fund Managers at Its Compliance Outreach Program Seminar,” The Hedge Fund Law Report, Vol. 5, No. 4 (Apr. 5, 2012).  As a consequence, investors and regulators are increasingly demanding effective, appropriately tailored risk management systems, and managers are making an ongoing effort to divine best practices.  Recognizing and reflecting this trend, BNY Mellon issued a research study in August 2012 that provides a roadmap of the state of risk management in the hedge fund industry, risk management trends and best practices.  This article summarizes the key points from the study, with particular emphasis on tools and practices hedge fund managers can implement to identify, monitor, mitigate and report on risk.  See also “Ernst & Young Survey Shows Risk Managers Possess Tremendous Influence and Face Substantial Challenges in the Asset Management Industry,” The Hedge Fund Law Report, Vol. 5, No. 23 (Jun. 8, 2012).

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  • From Vol. 5 No.29 (Jul. 26, 2012)

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

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

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  • From Vol. 5 No.29 (Jul. 26, 2012)

    Hedge Fund of Funds Manager Principal Charged with Securities Fraud and Wire Fraud over Misrepresentations Concerning Fund Performance and Investment Due Diligence

    The U.S. has filed a seven-count indictment against Chetan Kapur, the sole principal of hedge fund manager Lilaboc, LLC, d/b/a ThinkStrategy Capital Management, LLC (ThinkStrategy).  Kapur is charged with securities, investment adviser and wire fraud arising out of his alleged misrepresentations to investors regarding due diligence of fund investments and fund performance.  Kapur and ThinkStrategy have previously settled civil charges brought by the SEC in connection with the same matters.  See “Private Lawsuits Against Hedge Fund Managers Can Be Important Sources of Examination and Enforcement ‘Leads’ for the SEC,” The Hedge Fund Law Report, Vol. 4, No. 42 (Nov. 23, 2011).  This article summarizes the background in this case (including a discussion of the enforcement action initiated by the SEC and the private investor suit brought against Kapur and ThinkStrategy) and outlines the criminal charges levied against Kapur.  See also “Federal Court Decision Holds That a Fund of Funds Investor May Sue a Fund of Funds Manager That Fails to Perform Specific Due Diligence Actions Promised in Writing and Orally,” The Hedge Fund Law Report, Vol. 4, No. 27 (Aug. 12, 2011).

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  • From Vol. 5 No.28 (Jul. 19, 2012)

    Second Circuit Panel Upholds $20.6 Million FINRA Arbitration Award Against Prime Broker Goldman Sachs in Connection with Fraudulent Transfers Into and Among Bayou Fund Accounts

    The amount of due diligence that hedge fund prime brokers should conduct with respect to the source of funds deposited and maintained in brokerage accounts has been a topic of keen interest for hedge fund managers, investors and prime brokers, particularly in light of the ongoing litigation between the creditors of the defunct Bayou Group funds and the funds’ prime broker, Goldman Sachs Execution & Clearing, P.C. (GSEC).  See “Does a Prime Broker Have a Due Diligence or Monitoring Obligation When Paying With Soft Dollars for a Hedge Fund Customer’s Access to Expert Networks or Other Alternative Research?,” The Hedge Fund Law Report, Vol. 3, No. 49 (Dec. 17, 2010).  In the latest round of that litigation, a three-judge panel of the U.S. Court of Appeals for the Second Circuit denied GSEC’s appeal of a district court ruling that upheld a $20.6 million arbitration award against GSEC.  See “District Court Suggests That Prime Brokers May Have Expanded Due Diligence Obligations,” The Hedge Fund Law Report, Vol. 3, No. 44 (Nov. 12, 2010).  The arbitrators’ decision, seemingly based in part on the theory that GSEC should have identified red flags in connection with the Bayou fraud, was not rendered in “manifest disregard of the law,” suggesting that prime brokers are indeed at risk for such types of claims.  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).  This article analyzes the Second Circuit’s Summary Order.

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  • From Vol. 5 No.27 (Jul. 12, 2012)

    U.K. High Court of Justice Finds Magnus Peterson Liable for Fraud in Collapse of Hedge Fund Manager Weavering Capital and Weavering Macro Fixed Income Fund

    In 1998, defendant Magnus Peterson formed hedge fund manager Weavering Capital (UK) Limited (WCUK).  He served as a director, chief executive officer and investment manager.  One fund managed by WCUK, the open-end Weavering Macro Fixed Income Fund Limited (Fund), collapsed in the midst of the 2008 financial crisis.  Peterson was accused of disguising the Fund’s massive losses by entering into bogus forward rate agreements and interest rate swaps with another fund that he controlled.  In March 2009, the Fund suspended redemptions and went into liquidation when it could not meet investor redemption requests.  At that time, WCUK went into administration (bankruptcy).  WCUK’s official liquidators, on behalf of WCUK, brought suit against Peterson, his wife, certain WCUK employees and directors and others, seeking to recover damages for fraud, negligence and breach of fiduciary duty and seeking to recover certain allegedly improper transfers of funds by Peterson.  After a lengthy hearing, the U.K. High Court of Justice, Chancery Division (Court), has allowed virtually all of those claims, ruling that Peterson did indeed engage in fraud.  In a separate action, the Fund’s official liquidators recovered damages from Peterson’s brother, Stefan Peterson, and their stepfather, Hans Ekstrom, who served as Fund directors, based on their willful failure to perform their supervisory functions as directors.  See “Cayman Grand Court Holds Independent Directors of Failed Hedge Fund Weavering Macro Fixed Income Fund Personally Liable for Losses Due to their Willful Failure to Supervise Fund Operations,” The Hedge Fund Law Report, Vol. 4, No. 31 (Sep. 8, 2011).  This article summarizes the factual background and the Court’s legal analysis in the liquidators’ action against Peterson and others.

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  • From Vol. 5 No.26 (Jun. 28, 2012)

    Delaware Chancery Court Decision Highlights the Imperative of Thorough Due Diligence on Potential Hedge Fund Business Partners

    As a hedge fund manager, you are required as a legal matter to “know your customers,” that is, your investors.  In addition, you are required as a practical matter to know your partners.  In many cases, this imperative is beside the point: many hedge fund management businesses are founded by partners that have been working together for years.  In other cases, however, management companies are organized by partners that met only recently.  In such cases, the partners should perform thorough due diligence on one another.  It may seem contrary to the optimism, trust and team spirit required to scale the increasingly high barriers to beginning in the hedge fund business.  But a recent Delaware Chancery Court (Court) opinion highlights the fact that the stakes are too high to rely on gut feelings.  The stakes are even too high to rely on routine due diligence conducted by credible service providers.  The stakes are nothing less than your personal reputation, and in the investment management business, that is all you have or can have.  Diligence in this context should be deep, customized and cross-checked.  Once you get into bed with a bad actor in the investment management business, it is virtually impossible – from a reputation point of view – to get out.

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  • From Vol. 5 No.23 (Jun. 8, 2012)

    SEC Sanctions Quantek Asset Management and its Portfolio Manager for Misleading Investors About “Skin in the Game” and Related-Party Transactions

    Investments by hedge fund managers in their own funds and related party transactions (such as loans from a fund to a manager) exist at opposite sides of the incentive spectrum.  The former – so-called “skin in the game” – is typically thought to align the interests of investors and managers while the latter is seen as pitting the interests of investors and managers in direct conflict.  Investors want to know about both, for obviously different reasons.  A May 29, 2012 SEC Order Instituting Administrative and Cease-And-Desist Proceedings against Quantek Asset Management LLC (Quantek), Javier Guerra, Bulltick Capital Markets Holdings, LP (Bulltick) and Ralph Patino highlights these and other investor considerations.  This article summarizes the SEC’s factual and legal allegations against Quantek, Bulltick, Guerra and Patino, and the settlement among the parties.  The SEC’s action follows private actions against the same or similar parties.  See, e.g., “Fund of Hedge Funds Aris Multi-Strategy Fund Wins Arbitration Award against Underlying Manager Based on Allegations of Self-Dealing,” The Hedge Fund Law Report, Vol. 4, No. 39 (Nov. 3, 2011); “British Virgin Islands High Court of Justice Rules that Minority Shareholder in Feeder Hedge Fund that had Permanently Suspended Redemptions Was Not Entitled to Appointment of a Liquidator,” The Hedge Fund Law Report, Vol. 4, No. 9 (Mar. 11, 2011).

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  • From Vol. 5 No.20 (May 17, 2012)

    Amber Partners White Paper Highlights Key Due Diligence Points for Hedge Fund Investors Evaluating Hedge Fund Portfolio Composition and Valuation

    Valuation is one of the key focal areas for many hedge fund investors because a hedge fund manager that utilizes poor valuation practices can present significant investment and operational risks.  At the same time, assessing valuation risk is often one of the most difficult tasks that a hedge fund investor faces in conducting an operational due diligence review.  This is due, in part, to the myriad investment strategies employed by hedge fund managers and the differing levels of transparency provided by hedge fund managers, which, in turn, lead to varying approaches in the presentation of portfolio information.  In April 2012, Amber Partners published a White Paper (Amber White Paper) that supplies hedge fund investors with a roadmap for assessing the level of valuation risk posed by a hedge fund manager.  Specifically, the Amber White Paper provides guidance to investors on how to evaluate the composition of a hedge fund portfolio as well as the manager’s controls over the month-end valuation process.  In addition to providing guidance to hedge fund investors, managers can also glean important lessons from the Amber White Paper on how to avoid valuation pitfalls and institute best-of-breed valuation practices.  This article details the recommendations described in the Amber White Paper.  See also “Hedge Fund Valuation Pitfalls and Best Practices: An Interview with Arthur Tully, Co-Leader of Ernst & Young’s Global Hedge Fund Practice,” The Hedge Fund Law Report, Vol. 5, No. 2 (Jan. 12, 2012).

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  • From Vol. 5 No.16 (Apr. 19, 2012)

    Corgentum Webinar Highlights Trends, Challenges and Best Practices for Hedge Fund Investors in Conducting Operational Due Diligence

    We at The Hedge Fund Law Report have heard operational due diligence defined – persuasively but expansively – as the rigorous evaluation of all non-investment aspects of the business of a hedge fund manager.  A robust consensus has developed in the hedge fund industry around the importance of operational due diligence, but there is less consensus on precisely what operational due diligence entails or how to conduct it.  The absence of uniformity in implementation, in turn, is likely a function of the fact that no two managers are exactly alike.  The term “hedge fund manager” encompasses a wide range of businesses in terms of strategy, sophistication, staffing, size and other factors.  Therefore, operational due diligence is often driven by principles, experience and best practices rather than hard and fast rules.  See “Legal and Operational Due Diligence Best Practices for Hedge Fund Investors,” The Hedge Fund Law Report, Vol. 5, No. 1 (Jan. 5, 2012).  Hedge fund investors and managers must understand the operational due diligence process thoroughly, for different but related reasons.  Investors have to understand the process to make informed investments and avoid frauds, and managers have to understand the process to anticipate and accommodate due diligence requests from investors.  For parties in either category, the more you know, the better; you can never know enough; and what you think you know is constantly evolving.  To bring some clarity and coherence to this ambiguous but critical area, Corgentum Consulting, LLC (Corgentum), a firm that provides operational due diligence consulting services, recently hosted a webinar on trends, challenges and best practices in conducting operational due diligence on hedge fund managers.  Jason Scharfman, Managing Partner of Corgentum, conducted the webinar and covered, among other things: how to staff an operational due diligence team; trends and challenges that hedge fund investors face in conducting operational due diligence; and techniques that hedge fund investors can employ to maximize the effectiveness of their operational due diligence efforts.  This article summarizes the key points made during the webinar on each of these topics.

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  • From Vol. 5 No.15 (Apr. 12, 2012)

    Recent New York Court Decision Suggests That Hedge Funds Have a Due Diligence Obligation When Entering into Credit Default Swaps

    Domestic and foreign regulators have historically afforded differing levels of protection to retail investors as opposed to sophisticated investors, such as hedge funds, based on their presumptively differing levels of financial knowledge and abilities to conduct due diligence on prospective investments.  Sophisticated investors have been permitted to invest in more complicated financial products based on their presumed ability to understand and conduct due diligence on such investments.  However, the flip side of enhanced access is diminished investor protection, as evidenced by a recent court decision holding that sophisticated investors have a duty to investigate publicly available information in arms-length transactions.

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  • From Vol. 5 No.13 (Mar. 29, 2012)

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

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

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  • From Vol. 5 No.11 (Mar. 16, 2012)

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

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

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  • From Vol. 5 No.9 (Mar. 1, 2012)

    Hedge Fund Investor Accuses Paulson & Co. of Gross Negligence and Breach of Fiduciary Duty Stemming from Losses on Sino-Forest Investment

    Hugh F. Culverhouse, an investor in hedge fund Paulson Advantage Plus, L.P., has commenced a class action lawsuit against that fund’s general partners, Paulson & Co. Inc. and Paulson Advisers LLC.  Culverhouse alleges that those entities were grossly negligent in performing due diligence in connection with the fund’s investment in Sino-Forest Corporation, whose stock collapsed after an independent research firm cast serious doubt on the value of its assets and the viability of its business structure.  Culverhouse seeks monetary and punitive damages for alleged breach of fiduciary, gross negligence and unjust enrichment.  This article does two things.  First, it offers a comprehensive summary of the Complaint.  This summary, in turn, is useful because lawsuits by investors against hedge fund managers are rare, and particularly rare against a name as noteworthy as Paulson.  Disputes between investors and managers are almost always negotiated privately, but such negotiation occurs in the “shadow” of relevant law.  This article outlines what the relevant law may be.  Second, this article contains links to various governing documents of Paulson Advantage Plus, L.P., including the fund’s private offering memorandum, limited partnership agreement and subscription agreement.  Regardless of the merits of Culverhouse’s claim, Paulson remains a well-regarded name in the hedge fund industry.  According to LCH Investments NV, Paulson & Co. Inc. has earned its investors $22.6 billion since its founding in 1994.  Those kinds of earnings can – and have – purchased highly competent legal advice, which translates into workably crafted governing documents.  Accordingly, the governing documents of the Paulson fund are useful precedents for large or small hedge fund managers looking to assess the “market” for terms in such documents or best practices for drafting specific terms.  Thus, we provide links to the governing documents.  See also “Questions Hedge Fund Managers Need to Consider Prior to Making Investments in Chinese Companies,” The Hedge Fund Law Report, Vol. 4, No. 21 (Jun. 23, 2011).

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  • From Vol. 5 No.4 (Jan. 26, 2012)

    Recent SEC Enforcement Action Against Private Fund Manager Underscores Importance of Identifying and Understanding Money Transfers Between a Hedge Fund and the Hedge Fund Manager During the Investor Due Diligence Process

    On January 17, 2012, Judge Carol E. Jackson of the U.S. District Court, Eastern District of Missouri granted the SEC’s request for emergency injunctive relief (including an asset freeze and appointment of a receiver) against Burton Douglas Morriss as well as several investment management companies and private equity funds operated by Morriss in response to the SEC’s complaint alleging that Morriss misappropriated more than $9 million in investor assets from 2005 through 2011.  See generally “Key Legal Considerations in Connection with Loans from Hedge Funds to Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 3, No. 28 (Jul. 15, 2010).  This article describes the SEC action brought against Morriss and the investment management companies and private equity funds he operated.  The article also provides several recommendations to assist hedge fund investors in identifying and understanding asset transfers between a hedge fund manager and its hedge funds.  See also “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).

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  • From Vol. 5 No.1 (Jan. 5, 2012)

    Legal and Operational Due Diligence Best Practices for Hedge Fund Investors

    In the wake of the financial crisis in late 2008, many investors were left trapped in suspended, gated or otherwise illiquid hedge funds.  Unfortunately, for many investors who had historically taken a passive role with respect to their hedge fund investments, it took a painful lesson to learn that control over fundamental fund decisions was in the hands of hedge fund managers.  Decisions such as the power to suspend or side pocket holdings were vested in managers either directly or through their influence over the board of directors of the fund.  In these situations, which were not uncommon, leaving control in the hands of the manager rather than a more independent board gave rise to a conflict of interest.  Managers were in some cases perceived to be acting in their own self-interest at the expense, literally and figuratively, of the fund and, consequently, the investors.  The lessons from the financial crisis of 2008 reinforced the view that successful hedge fund investing requires investors to approach the manager selection process with a number of considerations in mind, including investment, risk, operational and legal considerations.  Ideally, a hedge fund investment opportunity will be structured to sufficiently protect the investor’s rights (i.e., appropriate controls and safeguards) while providing an operating environment designed to maximize investment returns.  Striking such a balance can be challenging, but as many investors learned during the financial crisis, it is a critical element of any successful hedge fund program.  The focus on hedge fund governance issues has intensified in the wake of the financial crisis, with buzz words such as “managed accounts,” “independent directors,” “tri-party custody solutions” and “transparency” now dominating the discourse.  Indeed, investor efforts to improve corporate governance and control have resulted in an altering of the old “take it or leave it” type of hedge fund documents, which have become more accommodative towards investors.  In short, in recent years investors have become more likely to negotiate with managers, and such negotiations have been more successful on average.  In a guest article, Charles Nightingale, a Legal and Regulatory Counsel for Pacific Alternative Asset Management Company, LLC (PAAMCO), and Marc Towers, a Director in PAAMCO’s Investment Operations Group, identify nine areas on which institutional investors should focus in the course of due diligence.  Within each area, Nightingale and Towers drill down on specific issues that hedge fund investors should address, questions that investors should ask and red flags of which investors should be aware.  The article is based not in theory, but in the authors’ on-the-ground experience conducting legal and operational due diligence on a wide range of hedge fund managers – across strategies, geographies and AUM sizes.  From this deep experience, the authors have extracted a series of best practices, and those practices are conveyed in this article.  One of the main themes of the article is that due diligence in the hedge fund arena is an interdisciplinary undertaking, incorporating law, regulation, operations, tax, accounting, structuring, finance and other disciplines, as well as – less tangibly – experience, judgment and a good sense of what motivates people.  Another of the themes of the article is that due diligence is a continuous process – it starts well before an investment and often lasts beyond a redemption.  This article, in short, highlights the due diligence considerations that matter to decision-makers at one of the most sophisticated allocators of capital to hedge funds.  For managers looking to raise capital or investors looking to deploy capital intelligently, the analysis in this article merits serious consideration.

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  • From Vol. 5 No.1 (Jan. 5, 2012)

    Ernst & Young Survey Juxtaposes the Views of Hedge Fund Managers and Investors on Hedge Fund Succession Planning, Governance, Administration, Expense Pass-Throughs and Due Diligence

    Ernst & Young (E&Y) recently released the 2011 edition of its annual hedge fund survey entitled, “Coming of Age: Global Hedge Fund Survey 2011” (Report).  The Report conveys and compares the views of hedge fund managers and investors on topics including succession, independent board oversight, use of administrators, expense pass-throughs and due diligence.  This article summarizes the more salient findings from the Report.  One of the Report’s many interesting insights is that managers frequently receive little in the way of feedback when a potential investor declines an investment.  The Report partially fills this “feedback gap” by offering generalized insight on what matters most to investors.  For example, managers may be surprised to learn that the absence of a robust and reliable succession plan may have played as much or more of a role in a lost investment as performance or even operational issues.  (The HFLR will be covering succession planning for hedge fund managers in an upcoming issue.)  More generally, the depth of the disparity in perception between managers and investors on a range of topics, as found by the Report, is at times startling.  The Report therefore offers a sobering reality check for both managers and investors.  Both sides need one another, albeit for different reasons, and the lifecycle of an investment can be significantly more productive if expectations and assumptions are better aligned.

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  • From Vol. 4 No.43 (Dec. 1, 2011)

    Third Party Marketers Association 2011 Annual Conference Focuses on Hedge Fund Capital Raising Strategies, Manager Due Diligence, Structuring Hedge Fund Marketer Compensation and Marketing Regulation

    Changing investor expectations and heightened regulation of hedge fund marketing has ushered in a new era for hedge fund managers seeking to raise capital.  Hedge fund managers must continuously keep abreast of the issues that will impact their ability to effectively raise capital, particularly from institutional investors.  Additionally, recent regulatory developments have created new challenges for fund managers that use third party marketers to assist in raising capital.  This “New Normal” was the backdrop of the 2011 annual conference of the Third Party Marketers Association (3PM) in Boston on October 26 and 27, 2011.  This article focuses on the most important points for hedge fund managers that were discussed during the conference.  The article begins with a discussion of how fund managers can enhance their marketing efforts to raise more capital by understanding various aspects of the capital raising cycle, including the changing request for proposal (RFP) process, product positioning, the investor due diligence process and the manager selection process.  The article then moves to a discussion of the regulatory challenges facing hedge fund managers using third party marketers, including a discussion of third party marketer due diligence of fund managers and appropriate compensation arrangements for third party marketers in light of lobbying law changes and pay to play regulations.  The final section discusses impending and existing rules that will have a significant impact on hedge fund marketing.

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  • From Vol. 4 No.42 (Nov. 23, 2011)

    Private Lawsuits Against Hedge Fund Managers Can Be Important Sources of Examination and Enforcement “Leads” for the SEC

    On November 10, 2011, the Securities and Exchange Commission (SEC) announced the simultaneous filing and settling of charges against investment adviser Lilaboc, LLC d/b/a ThinkStrategy Capital Management, LLC (ThinkStrategy) and its founder and managing director, Chetan Kapur (Kapur, and together with ThinkStrategy, Defendants).  The SEC’s Complaint in the action (Complaint) alleges that over nearly seven years the Defendants made false statements to investors in ThinkStrategy Capital Fund (Capital), a hedge fund managed by the Defendants, and TS Multi-Strategy Fund (Multi-Strategy, and together with Capital, Funds), a fund of funds managed by the Defendants.  Those allegedly false statements related to the Funds’ performance, longevity and assets under management (AUM), as well as the credentials of Kapur and his management team.  Moreover, with respect to Multi-Strategy, the Complaint alleges that the Defendants failed to perform due diligence commensurate with their representations to investors before investing with underlying managers.  As a result of such inadequate due diligence, Multi-Strategy invested in notorious Ponzi schemes such as Bayou, Valhalla/Victory Funds and Finvest Primer Fund.  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).  Allegations in the SEC action incorporate and expand upon allegations in a private civil action recently filed against the Defendants, and – as discussed more fully in this article – highlight the interaction between private claims and SEC enforcement actions.  See “Federal Court Decision Holds that a Fund of Funds Investor May Sue a Fund of Funds Manager That Fails to Perform Specific Due Diligence Actions Promised in Writing and Orally,” The Hedge Fund Law Report, Vol. 4, No. 27 (Aug. 12, 2011).

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  • From Vol. 4 No.41 (Nov. 17, 2011)

    SEC Commences Fraud Action against a Purported Hedge Fund Manager for Providing False Background Information and Including False Information on a Website

    On October 26, 2011, the Securities and Exchange Commission (SEC) filed suit against Andrey Hicks and the hedge fund manager he ran, Locust Offshore Management, LLC (LOM), alleging that they defrauded investors by fabricating the existence of a British Virgin Islands-incorporated pooled investment fund.  The SEC’s complaint (Complaint) also names the purported fund, Locust Offshore Fund, Ltd. (LOF), as a relief defendant.  The Complaint, among other things, sheds new light on an old due diligence verity – the imperative of thorough background checks.  See “In Conducting Background Checks of Hedge Fund Managers, What Specific Categories of Information Should Investors Check, and How Frequently Should Checks be Performed?,” The Hedge Fund Law Report, Vol. 2, No. 36 (Sep. 9, 2009).

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  • From Vol. 4 No.40 (Nov. 10, 2011)

    Principals of Paron Capital Management Sue Rothstein Kass for Negligence, Fraud and Breach of Contract Based on Alleged Failure to Obtain Third-Party Verification of Performance Results

    Plaintiffs Peter McConnon (McConnon) and Timothy Lyons (Lyons) are the current principals of plaintiff investment manager Paron Capital Management, LLC (Paron).  In April 2010, McConnon and Lyons were introduced to James Crombie (Crombie), who claimed to have run a successful commodity futures trading business and desired to form a new trading business with McConnon and Lyons.  McConnon and Lyons claim that Paron retained defendant accounting firm Rothstein, Kass & Company, LLP (Rothstein Kass) to verify Crombie’s claimed returns.  In particular, they asked Rothstein Kass to obtain third-party confirmation of data provided by Crombie.  According to the complaint, Rothstein Kass never did so.  It turned out that the historical performance data supplied by Crombie was a complete fabrication.  That false data formed the basis of Paron’s marketing materials.  Following investigations and enforcement actions by the National Futures Association and the U.S. Commodity Futures Trading Commission, Paron and Crombie were banned from futures trading and Paron’s business collapsed.  The plaintiffs seek damages from Rothstein Kass for negligence, fraud and breach of contract.  We detail the plaintiffs’ allegations and the allegations and findings in the enforcement actions.  Rothstein Kass told The Hedge Fund Law Report with respect to this matter: “We have no comment on these meritless claims.”

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  • From Vol. 4 No.39 (Nov. 3, 2011)

    Anti-Bribery Compliance for Private Fund Managers

    Managing the risks inherent in dealing with foreign officials should be a top priority for managers of hedge funds and private equity funds.  This is especially true in the current climate of expansive government interpretations of anti-bribery laws, new incentives for whistleblowers and the recent government scrutiny of the inner workings of fund managers.  It has become standard fare for fund managers to have regular interactions with foreign officials or their representatives in the ordinary course of raising capital and making investments.  There is nothing inherently wrong with such interactions.  Still, those dealings need to be informed by a heightened sensitivity to the possible appearance that something of value was given to a foreign official in connection with a particular investment or transaction.  The risk is that, regardless of the intent of the fund manager, certain conduct may be viewed in hindsight as an effort to improperly influence the actions of a foreign official.  As a result, a fund manager needs to focus on more than just the substance of the transaction and needs to consider both how the transaction might be perceived and the record that is being created.  As cross-border investments continue apace, fund managers can protect themselves by having adequate policies and procedures in place to identify potential bribery risks and to prevent violations from occurring.  Aggressive enforcement of the Foreign Corrupt Practices Act (FCPA) by U.S. authorities and the comprehensive overhaul of anti-corruption laws in the U.K., culminating in the new Bribery Act 2010 (Bribery Act), highlight the importance of implementing effective anti-corruption compliance policies and procedures.  In these circumstances, fund managers must do more than assure themselves that they are not acting with a corrupt intent; they also need to be alert to the risk of misunderstandings and to be diligent in creating a record of compliance.  In a guest article, Paul A. Leder and Sarah P. Swanz, partner and counsel, respectively, in the Washington D.C. office of Richards Kibbe & Orbe LLP, outline steps to take to identify and manage the compliance risks faced by fund managers both directly (through their own dealings with foreign officials) and indirectly (through investments in operating companies that operate overseas).  Specifically, Leder and Swanz identify conduct at the fund manager level that can put the manager at risk; discuss the importance of strong internal controls and compliance programs to mitigate corruption risks; and highlight categories of conduct at the portfolio company level that can put the manager at risk.  The authors then make specific suggestions for identifying potential bribery risks and managing such risks.  They conclude with a case study of a criminal prosecution that demonstrates the potential exposure for managers when making foreign investments.

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  • From Vol. 4 No.36 (Oct. 13, 2011)

    What Should Hedge Fund Investors Be Looking For in the Course of Operational Due Diligence and How Can They Find It?

    As previously reported in The Hedge Fund Law Report, on September 13, 2011, ALM Events hosted its fifth annual Hedge Fund General Counsel Summit at the Harvard Club in New York City.  See “Fifth Annual Hedge Fund General Counsel Summit Covers Insider Trading, Expert Networks, Whistleblowers, Exit Interviews, Due Diligence, Examinations, Pay to Play and More,” The Hedge Fund Law Report, Vol. 4, No. 33 (Sep. 22, 2011).  One of the panels at that Summit dealt with operational due diligence, an increasingly important topic in the hedge fund world.  See “Six Principles of Operational Due Diligence,” The Hedge Fund Law Report, Vol. 4, No. 34 (Sep. 29, 2011).  One of the participants on the due diligence panel was William Woolverton, Senior Managing Director and General Counsel at fund of funds manager Gottex Fund Management.  We reported on some of Woolverton’s insights in our article on the Summit.  Following the Summit, we had the privilege of digging deeper into Woolverton’s thinking on operational due diligence in the form of an interview.  Gottex is a major investor in underlying hedge funds, and Woolverton participates materially in the operational due diligence process.  He speaks, accordingly, with the authority of experience, and his insights are relevant to investors honing their approach to due diligence, managers refining their responses to due diligence and others concerned with the hedge fund due diligence process.  This issue of The Hedge Fund Law Report contains the full transcript of our interview with Woolverton, which covered the following topics, among others: the specific non-investment aspects of the hedge fund business covered by operational due diligence; how managers can maintain the consistency of answers across people and documents; how managers can address requests for proprietary or confidential information; whether a manager should disclose an important disciplinary event, even if an investor does not ask about it; what investors can get from on-site visits that they cannot get remotely; whether integration clauses in fund documents have any value in light of the apparent ability of investors to sue based on oral representations by managers; the interaction among side letters, disclosure and certain regulatory developments; and what specific items investors should be looking for in background checks of managers.

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  • From Vol. 4 No.34 (Sep. 29, 2011)

    Six Principles of Operational Due Diligence

    Hedge funds have progressively moved into the mainstream of institutional investing.  While even ten years ago, hedge funds were still largely the “secret club of the super rich,” sophisticated investors such as pension funds, sovereign wealth funds and large endowments now embrace the absolute return and diversification benefits available from hedge funds.  Retail investors are also exposed to hedge funds as never before: many corporate pension schemes have added hedge fund exposure, and more generally, the movements of both stock and bond markets are now heavily influenced by hedge fund investment decisions and capital flows.  Since the 2008 market crisis – thanks in part to Bernie Madoff, Lehman and numerous funds gating and suspending redemptions – operational due diligence has become much more significant to the hedge fund selection process.  See “What Are Hybrid Gates, and Should You Consider Them When Launching Your Next Hedge Fund?,” The Hedge Fund Law Report, Vol. 4, No. 6 (Feb. 18, 2011).  While performance and strategy remain central to every decision to allocate to a fund, investors large and small must also ensure that they have selected a manager with sufficient controls and infrastructure to safeguard assets.  In a guest article, Christopher J. Addy, President and CEO of Entreprise Castle Hall Alternatives Inc., focuses on several more qualitative aspects of the hedge fund due diligence process, highlighting six principles which can guide the development of an effective due diligence function.

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  • From Vol. 4 No.33 (Sep. 22, 2011)

    Fifth Annual Hedge Fund General Counsel Summit Covers Insider Trading, Expert Networks, Whistleblowers, Exit Interviews, Due Diligence, Examinations, Pay to Play and More

    On September 13, 2011, ALM Events hosted its fifth annual Hedge Fund General Counsel Summit at the Harvard Club in New York City.  Participants at the event discussed how the changing regulatory landscape is impacting the day-to-day policies, procedures and practices of hedge fund managers.  Of particular note, discussions focused on insider trading in the post-Galleon world; best compliance practices for engaging and using expert network firms; how to motivate employees to report wrongdoing internally rather than filing whistleblower complaints; the interaction between non-disparagement clauses in hedge fund manager exit agreements and the whistleblower rule; best practices for exit interviews; best practices for responding to initial and ongoing due diligence inquiries; consistency across DDQs and other documents; standardization of DDQs versus customized answers; whether to disclose the existence or outcome of regulatory actions; how to deal with government investigations and examinations; and strategies for complying with the pay to play rule.  This article summarizes the most noteworthy points made at the event.

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  • From Vol. 4 No.33 (Sep. 22, 2011)

    An Investment Adviser May Not Call Itself Independent If It Receives Fees from Underlying Managers

    The SEC recently commenced administrative proceedings against an investment adviser that allegedly received undisclosed fees for channeling over $80 million into SJK Investment Management, LLC (SJK).  As previously reported in The Hedge Fund Law Report, on January 6, 2011, the SEC filed an emergency civil injunctive action charging SJK and its principal, Stanley Kowalewski, with securities fraud, and obtained a temporary restraining order and asset freeze against SJK and Kowalewski.  See “Thirteen Important Due Diligence Lessons for Hedge Fund Investors Arising Out of the SEC’s Recent Action against a Fund of Funds Manager Alleging Misuse of Fund Assets,” The Hedge Fund Law Report, Vol. 4, No. 3 (Jan. 21, 2011).  The order in this administrative proceeding (Order) is interesting to hedge fund and hedge fund of funds managers primarily in helping clarify the circumstances in which managers may and may not claim to be “independent.”  The facts alleged by the SEC are rather egregious, and thus the Order itself does not make noteworthy new law.  However, the Order does raise close and interesting questions regarding the language of representations that hedge fund of fund managers and other investment advisers may make to investors with respect to independence; the channels through which such representations are made (including websites); how to approach disclosure with respect to conflicts and independence in Form ADV; and how to move client assets from one investment manager to another without breaching fiduciary duties or running afoul of the antifraud provisions of the federal securities laws.

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  • From Vol. 4 No.32 (Sep. 16, 2011)

    Are Hedge Fund Managers Required to Disclose the Existence or Outcome of Regulatory Examinations to Current or Potential Investors?

    Generally, two categories of hedge fund managers will be required to register with the SEC as investment advisers by March 30, 2012: (1) managers with assets under management (AUM) in the U.S. of at least $150 million that manage solely private funds; and (2) managers with AUM in the U.S. between $100 million and $150 million that manage at least one private fund and at least one other type of investment vehicle, such as a managed account.  See “Will Hedge Fund Managers That Do Not Have To Register with the SEC until March 30, 2012 Nonetheless Have To Register in New York, Connecticut, California or Other States by July 21, 2011?,” The Hedge Fund Law Report, Vol. 4, No. 24 (Jul. 14, 2011).  Registration will trigger a range of new obligations.  For example, registered hedge fund managers that do not already have a chief compliance officer (CCO) will have to hire one.  See “To Whom Should the Chief Compliance Officer of a Hedge Fund Manager Report?,” The Hedge Fund Law Report, Vol. 4, No. 22 (Jul. 1, 2011).  Also, registered hedge fund managers will have to complete, file and deliver, as appropriate, Form ADV.  See “Application of Brochure Delivery and Public Filing Requirements of New Form ADV to Offshore and Domestic Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011).  But perhaps the most onerous new obligation for newly registered hedge fund managers will be the duty to prepare for, manage and survive SEC examinations.  Most hedge fund managers facing a registration requirement for the first time have hired high-caliber people and completed complex forms.  Therefore, hiring a CCO and completing Form ADV will exercise existing skill sets.  But few such managers have experienced anything like an SEC examination.  On the contrary, many such managers have spent years behind a veil of permissible secrecy, disclosing little, rarely disseminating information beyond top employees and large investors and interacting with the government only indirectly.  Examinations will change all that.  The government will show up at your office, often with little or no notice; they will ask to review substantially everything; and a culture of transparency will have to replace a culture of secrecy, where the latter sorts of cultures still exist.  (The SEC does not appreciate secrecy and has any number of ways of demonstrating its lack of appreciation.)  Hedge fund managers facing the new examination reality will have to think about two sets of issues.  The first set of issues relates to examination preparedness, and The Hedge Fund Law Report has written in depth on this topic.  See, e.g., “Legal and Practical Considerations in Connection with Mock Examinations of Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 4, No. 26 (Aug. 4, 2011).  The second set of issues relates to examination management and survival, and that is the broad topic of this article.  Specifically, this article addresses a question that hedge fund managers inevitably face in connection with examinations: What should we tell investors and when and how?  To help hedge fund managers identify the relevant subquestions, think through the relevant issues and hopefully plan a disclosure strategy in advance of the commencement of an examination, this article discusses: the three types of SEC examinations and similar events that may trigger a disclosure examination; the five primary sources of a hedge fund manager’s potential disclosure obligation; whether and in what circumstances hedge fund managers must disclose the existence or outcome of the three types of SEC examinations; rules and expectations regarding responses to due diligence inquiries; selective and asymmetric disclosure issues; how hedge fund managers may reconcile the privileged information rights often granted to large investors in side letters with the fiduciary duty to make uniform disclosure to all investors; whether hedge fund managers must disclose deficiency letters in response to inquiries from current or potential investors, and whether such disclosure must be made even absent investor inquiries; whether managers that elect to disclose deficiency letters should disclose the letters themselves or only their contents; best practices with respect to the mechanics of disclosure (including how and when to use telephone and e-mail communications in this context); and whether deficiency letters may be obtained via a Freedom of Information Act request.

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  • From Vol. 4 No.32 (Sep. 16, 2011)

    Nine Due Diligence Lessons Arising Out of the SEC’s Recent Enforcement Action Against the Manager of a Purported Quantitative Hedge Fund

    On August 10, 2011, the SEC filed a complaint (Complaint) against a hedge fund management company and its principal, generally alleging that the defendants solicited a $1 million investment based on five categories of misrepresentations.  The management company purported to manage a hedge fund with a quantitative investment strategy, and the investment came from an individual bond fund portfolio manager at a prominent New York hedge fund management company.  The misrepresentations in this matter highlight a number of pitfalls that hedge fund investors should avoid.  More generally, the matter highlights a number of due diligence points for investors to add to their DDQs – if the points are not there already.  This article describes the factual and legal allegations in the Complaint, then discusses the nine key lessons from the Complaint.

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  • From Vol. 4 No.31 (Sep. 8, 2011)

    Spreadsheets Can Stunt a Hedge Fund Manager’s Growth

    Prime broker and technology provider Merlin Securities recently published a white paper entitled “The Importance of Business Process Maturity and Automation in Running a Hedge Fund.”  Broadly, the white paper does four things.  First, it identifies business process automation as fundamental to various aspects of the hedge fund management business, including growth (in assets, strategies, personnel, etc.), marketing and avoidance of major mistakes.  Second, it provides a framework for determining a manager’s level of business process automation.  Third, it offers a method for assessing whether a manager’s level of business process automation is too much, too little or just right in light of where the manager is in its lifecycle.  And fourth, for managers with too little or too much automation in light of their stage of growth, the white paper examines the three primary strategies for getting to what it terms the “automation sweet spot.”  The fundamental insights of the white paper are that the hedge fund management business is becoming more “institutional,” and that business process automation is an important element of institutionalization.  It is hard to say whether managers are becoming more institutional because more assets are coming from institutional investors (as opposed to, for example, high net worth individuals), or whether institutional investors are becoming more open to investments in hedge funds because managers are becoming more institutional.  The answer is probably a bit of both, but for practical purposes, the answer is moot: managers that seek assets from major institutional investors have to “act institutional.”  What this Merlin white paper adds to the discussion is a way of thinking about what it means to act institutional from a business process perspective.  This white paper is the latest in a series of white papers from Merlin Securities, and we at The Hedge Fund Law Report have reported on prior Merlin white papers.  See, e.g., “Eight Refinements of the Traditional ‘2 and 20’ Hedge Fund Fee Structure That Can Powerfully Impact Manager Compensation and Investor Returns,” The Hedge Fund Law Report, Vol. 4, No. 17 (May 20, 2011) (discussing, among other things, the Merlin white paper entitled “The Business of Running a Hedge Fund: Best Practices for Getting to the ‘Green Zone’”); and “Prime Broker Merlin Securities Develops Spectrum of Hedge Fund Investors; Event Hosted by Accounting Firm Marcum LLP Examines Marketing Implications of the Merlin Spectrum,” The Hedge Fund Law Report, Vol. 3, No. 39 (Oct. 8. 2010) (discussing, among other things, the Merlin white paper entitled “The Spectrum of Hedge Fund Investors and a Roadmap to Effective Marketing”).

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  • From Vol. 4 No.29 (Aug. 25, 2011)

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

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

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  • From Vol. 4 No.27 (Aug. 12, 2011)

    Federal Court Decision Holds That a Fund of Funds Investor May Sue a Fund of Funds Manager That Fails to Perform Specific Due Diligence Actions Promised in Writing and Orally

    A recent federal district court order (Order) described the range of legal claims available to an investor in a hedge fund of funds for alleged inconsistencies between the fund of funds manager’s representations and actions regarding due diligence and monitoring.  Read narrowly, the Order may merely stand for the proposition that a fund of funds manager may not promise to undertake specific actions in the course of due diligence and monitoring, accept investor money based on those representations then fail to take those actions.  Read more broadly, the Order may foreshadow a heightening of the legal standard to which hedge fund of funds managers are held when conducting due diligence and monitoring.  That is, the Order may presage a decision on the merits to the effect that fund of funds managers have a legal duty more or less consonant with industry best practices regarding due diligence.  That would constitute a significant increase in the level of legal obligations applicable to fund of funds managers, but would not enhance the commercial standard of care, which already demands best practices.

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  • From Vol. 4 No.26 (Aug. 4, 2011)

    SEC Wins Summary Judgment in Its Fraud Suit Against Investment Adviser Locke Capital and Its Principal, Leila C. Jenkins, Who Fabricated a Non-Existent “Massive Swiss Banking Client” to Attract Investors

    Defendant Leila C. Jenkins (Jenkins) was the founder and sole owner of investment adviser Locke Capital Management, Inc. (Locke).  In 2009, the Securities and Exchange Commission (SEC) brought a civil enforcement action against Locke and Jenkins, alleging that they had fabricated a “massive Swiss banking client” to trick potential investors into believing that they had more than a billion dollars under management, when in fact they did not.  The initial misstatement of assets under management by the defendants, along with Jenkins’ clumsy efforts to conceal the deception, supported fraud and other charges under the Securities Act of 1933, the Securities and Exchange Act of 1934 and the Investment Advisers Act of 1940.  The U.S. District Court for the District of Rhode Island granted the SEC’s motion for summary judgment on all charges, directed the defendants to disgorge profits, imposed penalties and enjoined them from future securities laws violations.  This article summarizes the decision, which has important implications for hedge fund operational due diligence.

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  • From Vol. 4 No.25 (Jul. 27, 2011)

    Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices

    The United States District Court for the Southern District of New York recently issued judgments in favor of three bankrupt hedge funds in fraudulent conveyance actions against investors that redeemed within two years of the funds’ bankruptcy filings.  The hedge funds were members of the Bayou group of hedge funds, which – as the hedge fund industry knows well – was a fraud that collapsed in August 2005, resulting in bankruptcy filings by the Bayou funds and related entities in May 2006.  These judgments are very important for hedge fund investors because they illustrate what appears to be a direct conflict between bankruptcy law and hedge fund due diligence best practices.  In short, hedge fund due diligence best practices currently counsel in favor of redemption at the first whiff of fraud on the part of a manager.  However, bankruptcy law appears to require a hedge fund investor to undertake a “diligent investigation” when it obtains facts that put it on inquiry notice of insolvency of the fund or a fraudulent purpose on the part of the manager.  The immediacy of a prompt redemption is directly at odds with the delay inherent in a diligent investigation.  How can hedge fund investors reconcile the practical goal of prompt self-help with the legal obligation of a diligent investigation?  To help answer that question, this feature length article surveys the factual and procedural history of the Bayou matters, then analyzes the arguments and outcome in the recent Bayou trial.  The primary question at the trial was whether certain investors that redeemed from the Bayou funds could keep their redemption proceeds based on “good faith” defenses to the Bayou estate’s fraudulent conveyance actions.  In the absence of a court opinion, The Hedge Fund Law Report analyzed the 142-page transcript of the closing arguments, as well as the motion papers filed by the parties and four prior bankruptcy court and district court opinions.  This article embodies the results of our analysis.  The article concludes by identifying five ways in which hedge fund investors may reconcile hedge fund due diligence best practices with the seemingly draconian outcome in these recent Bayou judgments.

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  • From Vol. 4 No.25 (Jul. 27, 2011)

    Fourteen Due Diligence Lessons to Be Derived from the SEC’s Recent Action against a Serial Practitioner of Hedge Fund Fraud

    On July 13, 2011, the SEC issued an Order making findings and imposing remedial sanctions against an individual hedge fund manager.  The Order describes a career involving modest and infrequent investment successes, and predominantly characterized by repeated, serial and egregious frauds.  The diversity and audacity of the frauds make for lurid reading, but the relevance of the Order for The Hedge Fund Law Report and our subscribers resides in the due diligence lessons to be derived from the factual findings.  This article details the factual findings in the Order, then extracts 14 distinct due diligence lessons from those facts.  Many of our institutional investor subscribers will read the factual findings and say, “This could never happen to me.”  And they may be right.  But we never cease to be amazed by the level of sophistication of investors caught up in even the most crude and simple frauds.  Perhaps this is because our industry is based on trust, and despite the salience of fraud, fraud remains (fortunately) the exception to the wider rule of ethical conduct.  Perhaps it is because frauds that look simple in retrospect were difficult to discover in the moment.  Regardless of the reason, hedge fund investors of all stripes and sizes can benefit from ongoing refinement of their due diligence practices.  And we continue to believe that the best way to refine due diligence practices is to look at what went wrong in actual cases and to revise your list of questions and techniques accordingly.  Here is a useful test for hedge fund investors: read the facts of this matter, as described in this article, then pause to ask yourself: Would our current due diligence practices have discovered all of these facts and caused us to pass on this investment or to redeem?  If the answer is yes, you can stop reading.  But if the answer is no – that is, if your due diligence practices may have missed any aspect of this fraud – we strongly encourage you to read and incorporate our fourteen lessons.  We would also note that we have undertaken similar exercises with respect to prior SEC actions.  That is, we have reviewed allegations of hedge fund manager fraud and detailed the due diligence steps that may have uncovered such frauds.  All of our thinking on this topic is available in the “Due Diligence” section of our Archive.

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  • From Vol. 4 No.19 (Jun. 8, 2011)

    Alternative Investment Management Association Publishes Institutional Investor Guide Covering Hedge Fund Governance, Risk, Liquidity, Performance Reporting, Investor Relations, Marketing, Operations, Valuation, Due Diligence and Other Topics

    On May 31, 2011, the Alternative Investment Management Association (AIMA), published a guide aimed at communicating institutional investors’ views, expectations and preferences to the hedge fund industry.  As described by AIMA Chairman Todd Groome, the guide was published “[i]n light of the ongoing ‘institutionalisation’ of the hedge fund industry and the growth of institutional investor participation.”  The authors of the guide, members of the AIMA Investor Steering Committee, and “some of the most influential investors and advisors in the industry,” include Luke Dixon of Universities Superannuation Scheme, Andrea Gentilini of Union Bancaire Privée, Kurt Silberstein of the California Public Employees Retirement Scheme, Michelle McGregor-Smith of British Airways Pension Investment Management and Adrian Sales of Albourne.  See “CalPERS ‘Special Review’ Includes Details of Misconduct and Recommendations That May Fundamentally Alter the Hedge Fund Placement Agent Business,” The Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011).  The guide covers a range of increasingly relevant operational and organizational issues that institutional investors consider in their due diligence reviews, including: hedge fund governance, constitutional documents, the role of the board of directors, performance reporting practices and transparency, counterparty risk, operations, fund liquidity, risk controls, ownership of the management company, sales and marketing, valuation, business continuity planning, compliance, service provider relationships and more.  This article offers a comprehensive discussion of the key principles, ideas and recommendations presented in the guide.

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  • From Vol. 4 No.18 (Jun. 1, 2011)

    Is a Hedge Fund Manager Required to Disclose the Existence or Substance of SEC Examination Deficiency Letters to Investors or Potential Investors?

    Following an examination of a registered hedge fund manager by the SEC staff, the staff typically issues a deficiency letter to the manager listing compliance shortcomings identified by the staff during the examination.  See “What Do Hedge Fund Managers Need to Know to Prepare For, Handle and Survive SEC Examinations?  (Part Three of Three),” The Hedge Fund Law Report, Vol. 4, No. 6 (Feb. 18, 2011).  Quickly, comprehensively and conclusively remedying compliance shortcomings identified in a deficiency letter should be a first order of business for any hedge fund manager – that is the easy part, a point that few would dispute.  However, considerably more ambiguity surrounds the question of whether and to what extent hedge fund managers must disclose to investors and potential investors various aspects of SEC examinations – including their existence, scope, focus and outcome.  More particularly, hedge fund managers that receive deficiency letters routinely ask: must we disclose the fact of receipt of this deficiency letter or its contents to investors or potential investors?  And does the answer depend on whether potential investors have requested information about or contained in a deficiency letter in due diligence or in a request for proposal (RFP)?  The answers to these questions generally have been governed by a “materiality” standard – the same standard that, at a certain level of generality, governs all disclosure questions.  The consensus guidance has been: disclose whatever is material.  But this is more of a reframing of the question than an answer.  The practical question in this context is how to assess materiality in the interest of disclosing adequately, avoiding anti-fraud or breach of fiduciary duty claims and ensuring best investor relations practices.  A recently issued SEC order (Order) settling administrative proceedings against a registered investment adviser provides limited guidance on the foregoing questions.  This article describes the facts recited in the Order, the SEC’s legal analysis and how that analysis can inform decision-making of hedge fund managers considering whether and to what extent to disclose the existence or substance of deficiency letters to investors or potential investors.  This analysis has particular relevance for hedge fund managers seeking to grow institutional assets under management by responding to RFPs.

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  • From Vol. 4 No.11 (Apr. 1, 2011)

    Twelve Operational Due Diligence Lessons from the SEC’s Recent Action against the Manager of a Commodities-Focused Hedge Fund

    On March 15, 2011, the SEC filed a complaint the U.S. District Court for the Southern District of New York against Juno Mother Earth Asset Management, LLC (Juno) and its principals, Arturo Rodriguez and Eugenio Verzili.  The complaint alleges that Juno and its principals started selling interests in the Juno Mother Earth Resources Fund, Ltd. (Resources Fund) in late 2006, and by the middle of 2008, substantially all of the Resources Fund's investors had requested redemptions.  The SEC alleges that during the short life of the Resources Fund, Rodriguez and Verzili engaged in a range of bad acts, including misappropriation of fund assets, inappropriate loans from the fund to the management company, misrepresentations of strategy and assets under management and disclosure violations.  Assuming for purposes of analysis that the allegations in the complaint are true, the complaint illuminates a variety of pitfalls for institutional investors to avoid.  This article describes the factual and legal allegations in the complaint, then details twelve important lessons to be derived from the complaint.  Similar to other articles we have published extracting due diligence lessons from SEC complaints, the intent of this article is to serve as a tool for institutional investors or their agents that can be used directly in performing due diligence, or can be used to update a due diligence questionnaire.  Our hope in publishing this article (and others of its type) is that at least one of the twelve lessons that we extract from the complaint enables an investor to identify a due diligence issue that it otherwise would have missed.  We think that there is no better way to identify future hedge fund frauds than to understand the mechanics and lessons of past frauds.

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  • From Vol. 4 No.11 (Apr. 1, 2011)

    Survey by SEI and Greenwich Associates Identifies the Primary Decision Factors and Concerns of Institutional Investors When Investing in Hedge Funds

    A survey of 97 institutional investors and 14 investment consultants conducted by SEI Knowledge Partnership in collaboration with Greenwich Associates last October, and released earlier this year, identifies the hierarchy of considerations and concerns of institutional investors when investing in hedge funds.  One notable finding of the survey – especially for a publication, like the HFLR, focused on regulation – is the view of most institutional investors with respect to regulation.  That view is discussed in this article.  In addition, this article discusses the survey’s findings on the following topics: statistics with respect to hedge fund returns, assets under management, launches and liquidations during the last three years; plans with respect to hedge fund allocations during 2011; objectives of institutional investors when investing in hedge funds; most significant challenges in hedge fund investing; experience with and perceptions of liquidity; the 16 factors that investors consider most important when selecting among managers; four key takeaways for hedge fund managers from the survey findings; breakdown of hedge fund allocations by institutional investor type; trends with respect to fees; the role of consultants; the success rate of negotiations on liquidity terms; and trends with respect to the resources dedicated by institutional investors and consultants to hedge fund due diligence and monitoring.

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  • From Vol. 4 No.4 (Feb. 3, 2011)

    Eight Important Due Diligence Lessons for Hedge Fund Investors Arising Out of the SEC’s Recent Action against a Hedge Fund Manager Alleging Misuse of Hedge Fund Assets to Make Personal Private Equity Investments

    On January 28, 2011, the SEC obtained a court order freezing the assets of Stamford, Connecticut-based, unregistered hedge fund manager Michael Kenwood Capital Management, LLC (MK Capital Management) and Francisco Illarramendi, who indirectly owns and controls MK Capital Management.  On January 14, 2011, the SEC had filed a complaint in the United States District Court for the District of Connecticut generally alleging that Illarramendi caused hedge funds managed by MK Capital Management to invest in private companies, with the shares of those private companies registered to advisory or investment entities indirectly owned and controlled by Illarramendi.  That is, the SEC essentially alleges that Illarramendi used fund assets to make personal private equity investments.  Moreover, the SEC alleges that a non-U.S. corporate pension fund was the source of approximately 90 percent of the assets in the two hedge funds involved in the matter.  The SEC’s allegations regarding misuse of fund assets shed light on the variety of things that can go wrong in a hedge fund investment, and how some of those wrong turns can be avoided.  Working from the allegations in the SEC’s complaint, we derive eight distinct due diligence lessons that investors can apply directly to their evaluation and monitoring of hedge fund managers.  This article details the eight lessons.  Before proceeding, a caveat is in order.  We have published a number of articles that analyze SEC complaints against hedge fund managers and extract due diligence lessons from the allegations in those complaints.  See “Thirteen Important Due Diligence Lessons for Hedge Fund Investors Arising Out Of the SEC’s Recent Action against a Fund of Funds Manager Alleging Misuse of Fund Assets,” The Hedge Fund Law Report, Vol. 4, No. 3 (Jan. 21, 2011); “Ten Due Diligence Questions that Might Have Helped Uncover the Fraud Described in the SEC's Recent Administrative Proceeding against Subprime Automobile Loan Hedge Fund Manager and Its Principals,” The Hedge Fund Law Report, Vol. 3, No. 50 (Dec. 29, 2010).  But it is important to note that our articles of this type do not and are not intended to endorse or support SEC’s allegations or positions in the various matters.  For purposes of these articles, we do not undertake an independent investigation into the veracity of the SEC’s allegations.  Rather, we assume for analytical purposes that the SEC’s allegations are true, and we aim to be explicit about the procedural posture of covered matters.  We do not believe that this approach undermines the relevance or applicability of the due diligence lessons we describe.  Quite the contrary: we believe that our due diligence lessons are based on expressed concerns of the SEC, and thus are valid, generalizable and useful.  At best, these lessons can help our subscribers avoid investment and operational missteps.  However, in fairness to the defendants in these matters, we consider it important to emphasize that our analysis is based on allegations that remain to be proven or disproven.

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  • From Vol. 4 No.3 (Jan. 21, 2011)

    Thirteen Important Due Diligence Lessons for Hedge Fund Investors Arising Out of the SEC’s Recent Action against a Fund of Funds Manager Alleging Misuse of Fund Assets

    The SEC recently obtained an emergency asset freeze and temporary restraining order against a hedge fund of funds manager, Stanley J. Kowalewski (Kowalewski), and his management entity, SJK Investment Management LLC (SJK).  The SEC’s complaint, filed in federal district court in Atlanta, generally alleges that Kowalewski and SJK engaged in two categories of conduct in violation of federal securities laws.  First, Kowalewski and SJK allegedly used fund assets to pay management company and personal expenses.  Second, Kowalewski allegedly launched a hedge fund in which his fund of funds invested, but failed to disclose to his fund of funds investors either the existence of the underlying hedge fund or the investment by his fund of funds in it.  Neither the dollar values nor the creativity in this matter are particularly noteworthy.  The alleged fraud itself was trite, brief and straightforward.  However, a close reading of the SEC’s complaint offers a veritable treasure trove of insight into how investors in hedge funds and funds of funds can sharpen their due diligence practices.  We have extracted 13 key lessons from the matter that investors can use to revise their approach to hedge fund due diligence – or, even better, to confirm that their approach reflects current best practices.  This article details the SEC’s factual and legal allegations against Kowalewski and SJK, briefly discusses the procedural posture of the matter, then discusses in detail the 13 key lessons.

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  • From Vol. 3 No.50 (Dec. 29, 2010)

    Ten Due Diligence Questions that Might Have Helped Uncover the Fraud Described in the SEC's Recent Administrative Proceeding against Subprime Automobile Loan Hedge Fund Manager and Its Principals

    On December 21, 2010, the SEC instituted and settled administrative proceedings against a San Francisco-based hedge fund management company and its principals.  A hedge fund managed by that company purported to invest almost exclusively in subprime auto loans, but in fact wound up "investing" largely in debt owed to the fund by entities controlled by principals of the management company and other hedge funds managed by the management company.  The SEC's Order in the matter is a study in conflicts of interest, strategy drift, material misstatements and omissions in offering documents and Form ADV and improper principal trades.  Working from the alleged facts of this matter, we derive ten due diligence questions that any investor should add to its questionnaire or incorporate into in-person meetings with managers.  Importantly, these are questions that should be asked periodically, not just prior to an initial investment.

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  • From Vol. 3 No.49 (Dec. 17, 2010)

    Settlement of SEC Fraud Charges by Small San Francisco-Based Hedge Fund Manager Highlights Importance of Valuation Checks and Balances

    On December 1, 2010, the SEC instituted and simultaneously settled fraud charges against an individual hedge fund manager based in San Francisco.  (This matter is further evidence of reinvigorated enforcement efforts by the SEC's San Francisco office.  For a discussion of another matter recently initiated by that office, see "SEC Commences Civil Insider Trading Action Against Deloitte Mergers and Acquisitions Partner and Spouse Who Allegedly Tipped Off Relatives to Impending Acquisitions of Seven Public Companies," The Hedge Fund Law Report, Vol. 3, No. 48 (Dec. 10, 2010).)  The allegations in the SEC's Order tell a familiar story: a young manager raises, at peak, $30 million; while the Order does not specify, the money likely came from friends and family.  The manager experiences losses in a relatively conservative investment strategy.  The manager, presumably embarrassed, tells his investors that everything is fine, while trying to make up those losses by taking on slightly more risk.  But instead, the manager loses more money, and his misrepresentations to investors depart to a greater extent from the facts.  Eventually, the manager comes clean, the fund is liquidated and the manager is charged by the SEC with civil fraud.  What is noteworthy about this matter are two statements in the SEC's order.

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  • From Vol. 3 No.27 (Jul. 8, 2010)

    Legal, Operational and Risk Considerations for Institutional Investors When Performing Due Diligence on Hedge Fund Service Providers

    The old paradigm of hedge fund due diligence focused on the hedge fund manager and the new paradigm focuses on hedge fund service providers.  That is, the purpose of hedge fund due diligence used to be (broadly, pre-2008) to ensure that the hedge fund manager itself had, internally, sufficient people, process and plant to maintain its return and risk profile.  However, the credit crisis that began in 2008, and the frauds it brought to the fore, highlighted the franchise risk posed by service providers to hedge funds and managers.  Consequently, post-crisis hedge fund due diligence has focused more squarely and thoroughly on service providers.  For example, in a June 2010 study, hedge fund operational due diligence consulting firm Corgentum Consulting analyzed data from over 200 hedge fund allocators and concluded that hedge fund “investors are focusing the bulk of their due diligence efforts on legal, compliance and regulatory risks.”  The primary reason for this shift in focus – from managers and performance (then), to service providers and operations (now) – relates to the estimated harm from adverse outcomes.  In relative terms, most investment losses are high probability, low magnitude events, while most operational failures are low probability, high magnitude events.  The chief goal of due diligence is to avoid low probability, high magnitude events; and, moreover, the credit crisis taught that the probability of some operational failures may not be so low after all.  Lehman Brothers provides the most sobering example.  Hedge funds that used Lehman’s U.S. or U.K. brokerage entities as their only prime brokers and that did not perform adequate due diligence on Lehman’s custody and cash management arrangements – or that did perform such diligence but did not incorporate its lessons – wound up with significant investor assets tied up for long periods in bankruptcy, SIPA or administration proceedings.  The purpose of service provider diligence is to identify operational issues that can have a material adverse effect on investment outcomes – issues such as the commingling of hedge fund customer assets by certain Lehman brokerage entities.  With the twin goals of providing guidance to investors conducting due diligence on hedge fund service providers, and to hedge fund managers and service providers anticipating such diligence, this article: identifies key hedge fund service providers; details ten specific areas on which investors should focus when conducting service provider diligence; highlights areas of diligence specific to certain service providers; discusses strategies for accessing the data necessary to perform adequate due diligence; and incorporates recommendations regarding the timing and frequency of service provider due diligence.

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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.50 (Dec. 17, 2009)

    Speakers at Walkers Fundamentals Hedge Fund Seminar Outline Hedge Fund Due Diligence and Financing Trends, as well as Predictions for 2010 and Beyond

    On December 2, 2009, international law firm Walkers Global held its Walkers Fundamentals Hedge Fund Seminar in New York City.  Speakers at this event addressed various current issues, including: the evolving nature, rigor and focus of hedge fund due diligence; renewed scrutiny of custody arrangements in the course of due diligence; post-investment due diligence and monitoring; financing for hedge funds and due diligence with respect to collateral; the regulatory outlook (with insight from Todd Groome, Non-Executive Chairman of AIMA); the duty of care applicable to hedge fund directors; Cayman Islands law with respect to indemnification of directors; and the outlook with respect to near-term fund-raising and a potential new government levy on hedge fund managers.  This article summarizes the key points discussed at the conference on each of the foregoing topics.

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  • From Vol. 2 No.44 (Nov. 5, 2009)

    How Can Hedge Fund Investors Hone Their Due Diligence in Light of Alarming Rate of “Verification Problems” Discovered in Recent Study of Hedge Fund Due Diligence Reports?

    In a draft paper dated October 16, 2009 and titled “Trust and Delegation,” four scholars analyzed the frequency of misrepresentations and inconsistencies on the part of hedge fund managers in the course of due diligence performed by institutional investors.  They did this by analyzing hundreds of due diligence (DD) reports prepared by a DD firm.  Most notably, they found that 21 percent of the hedge fund managers described in the reports they sampled misrepresented their past legal and regulatory history; 28 percent made incorrect or unverifiable representations about other topics; and 42 percent had had “verification problems” including either misrepresentations or inconsistencies.  This article describes in detail the more salient findings of the study and, more importantly, explores how hedge fund investors and managers can put those findings into practice.  For investors, this entails reviewing current approaches to DD to refocus on the most common categories of verification problems.  For managers, this involves focusing on knowledge management in order to avoid accidental or negligent misrepresentations, and recognizing the heightened importance of transparency and specificity in responding to DD inquiries.

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  • From Vol. 2 No.24 (Jun. 17, 2009)

    Interview with Duff & Phelps Director Eric S. Lazear on Operational Risk Due Diligence

    Amid the backdrop of recent high profile frauds, unprecedented market declines, poor hedge fund performance and resulting closures, hedge fund investors are placing heightened emphasis on due diligence.  In particular, investors are focusing in the course of due diligence on operational risks and business infrastructure.  Last month, independent financial advisory and investment banking firm Duff & Phelps Corporation created an Operational Risk Due Diligence (ORDD) practice to provide investors with an independent third-party assessment of their hedge fund managers’ operating policies and procedures.  The Hedge Fund Law Report spoke with Duff & Phelps Director Eric S. Lazear about the new ORDD practice; trends in operational risk due diligence; specific risks he has seen in the course of his practice (including risks relating to trading practices, valuation of illiquid assets, cash management, fund structuring and allocation of trades); and solutions recommended to institutional investor clients to address those risks.  The full text of the interview is available in this issue of The Hedge Fund Law Report.

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  • From Vol. 2 No.22 (Jun. 3, 2009)

    Protean Fraud Risk Appraisal Launches Hedge Fund Fraud Risk Certification

    On June 2, 2009, Protean Fraud Risk Appraisal announced that it had launched the investment industry’s first hedge fund fraud risk certification.  Protean Fraud Risk Appraisal is an independent risk certification firm specializing in the alternative investment sector.

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  • From Vol. 1 No.29 (Dec. 24, 2008)

    Involvement of Funds of Funds in Alleged Madoff Fraud Reemphasizes Importance of Due Diligence

    As Warren Buffett famously said in his 2001 Chairman’s Letter, “you only find out who is swimming naked when the tide goes out.”  According to a criminal complaint and press reports, the tide has clearly gone out on Bernard L. Madoff Investment Securities LLC and its founder Bernard Madoff, and a number of prominent funds of hedge funds have been caught swimming sans bathing trunks.  Specifically, a significant part of the value proposition of funds of funds is the ostensibly rigorous due diligence they perform on underlying managers.  Yet some of the biggest names in the fund of funds world appear to have invested in Madoff investment vehicles without performing adequate due diligence.  The anticipated losses of such names from the Madoff scandal emphasize the central importance of due diligence, especially for funds of funds, and the inadequacy of exclusive or near-exclusive reliance on personal relationships in making investment decisions.  We explore the implications of the Madoff scandal on the rigor and content of due diligence that should be performed by funds of funds prior to and after investing in underlying funds.

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  • From Vol. 1 No.24 (Nov. 12, 2008)

    Petters’ Fraud Underlines Need for Vigilant Due Diligence

    Several hedge funds have been caught in a large-scale fraud alleged against Tom Petters, former CEO of Petters Companies Inc.  Based on a review of court filings and interviews with managers and attorneys at or representing funds who declined investments in Petters Co., we offer specific suggestions on how hedge funds can approach pre- and post-investment due diligence to avoid getting caught in fraudulent situations.

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  • From Vol. 1 No.21 (Sep. 22, 2008)

    Interview with Kenneth Springer of Corporate Resolutions Inc. on Hedge Fund Manager Due Diligence

    An investment in a hedge fund is more than just an investment in assets or instruments in which the fund invests. It’s also an investment in the managers of the fund – and not just in the investment prowess of the managers, but also in their integrity, transparency and forthrightness. An analysis of these factors should figure prominently into initial investment due diligence and ongoing investment monitoring, yet many investors pay inadequate attention to managers’ backgrounds, or lack the tools or know-how to adequately gather and evaluate such information. In this exclusive interview, Kenneth S. Springer, a Wall Street private investigator, former FBI agent and founder of Corporate Resolutions Inc., discusses hedge fund manager due diligence with The Hedge Fund Law Report.

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