The Hedge Fund Law Report

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

Articles By Topic

By Topic: Background Checks

  • 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. 8 No.31 (Aug. 6, 2015)

    New York Appeals Court Rules on Applicability of New York Labor Law to Hedge Fund Incentive Compensation

    A recent decision by New York’s Appellate Division, First Department (Manhattan) is of great significance to hedge fund managers doing business in the state.  The ruling is important to hedge fund managers because it applies to the type of incentive-based compensation that is often made available to many financial industry employees – which typically depends on the overall success of the business or a team of employees – and determines whether such compensation merits the special protections provided by the Labor Law.  In a guest article, Sean R. O’Brien and Sara A. Welch, managing partner and counsel, respectively, at O’Brien LLP, discuss the Court’s decision in light of the Labor Law, as well as the ramifications of the ruling on the hedge fund industry.  For more from O’Brien and Welch, see also “Hedge Fund Incentive Compensation Not Subject to Wage Claim under New York Labor Law,” The Hedge Fund Law Report, Vol. 7, No. 14 (Apr. 11, 2014); and “How Can Hedge Fund Managers Protect Themselves Against Trade Secrets Claims?,” The Hedge Fund Law Report, Vol. 7, No. 19 (May 16, 2014).  For commentary on other rulings relating to hedge fund employee compensation, see “New York Court Assesses the Validity of a Former Portfolio Manager’s Claim against a Fund Management Company for Unvested Performance Compensation,” The Hedge Fund Law Report, Vol. 8, No. 18 (May 7, 2015); “New York Federal District Court, Applying ‘Faithless Servant’ Doctrine, Allows Morgan Stanley to Recoup Entire Compensation Paid to a Former Hedge Fund Portfolio Manager Who Admitted to Insider Trading,” The Hedge Fund Law Report, Vol. 7, No. 5 (Feb. 6, 2014); and “How Can Hedge Fund Managers Use Profits Interests, Capital Interests, Options and Phantom Income to Incentivize Top Portfolio Management and Other Talent?,” The Hedge Fund Law Report, Vol. 6, No. 33 (Aug. 22, 2013).

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  • From Vol. 7 No.31 (Aug. 21, 2014)

    The Role of Background Checks in Hedge Fund Investor Due Diligence and Hedge Fund Manager Hiring

    A thoroughgoing understanding of the backgrounds of principals and employees of a hedge fund management company has historically been a matter of prudence; increasingly, it is also a matter of regulatory compliance.  The “bad actor” disqualification provisions of the JOBS Act, Form ADV and the anti-fraud provisions of the Investment Advisers Act all require hedge fund managers to accurately understand the litigation, licensing, disciplinary, employment, educational, financial and other history of their actual and potential principals and employees.  For hedge fund investors, best operational due diligence practices involve examination of at least the foregoing categories of information for management company principals.  In addition, both managers and investors are well-advised to understand the backgrounds of decision-makers at service providers (such as prime brokers, law firms, administrators, accountants, companies that provide fund directors and others).  Importantly, background checks should not be a rote exercise: if they uncover red flags, those red flags should be pursued vigorously, and should, if serious and not subject to remedy, cause a change of plan (e.g., passing on an investment or a candidate, or terminating an employee).  In an effort to assess the market for important components of background checks as commissioned by investors and managers, The Hedge Fund Law Report recently interviewed Richard “Bo” Dietl, a former New York City police officer and decorated detective, and a seasoned veteran of the private fund background check business.  Dietl provided on-the-ground intelligence on specific goals and targets of background checks by investors and managers; coverage in background checks of nonpublic information; the top three “red flags” that investors are looking for in background checks on managers; best practices for managers in responding to identified red flags; background check pricing and resulting work product; state requirements for employee consent and disclosure to manager background checks; the interaction between background checks and the bad actor disqualification rule; frequency with which background checks should be updated; and whether background checks should be performed on fund directors.

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  • From Vol. 6 No.45 (Nov. 21, 2013)

    Citi Prime Finance Report Distills the Four Pillars of “People Alpha” at Hedge Fund Managers

    Most hedge fund managers believe that people are their primary resource and that absolute, uncorrelated returns are a function of top talent.  Citi Prime Finance has coined a new and pithy term for this view – “people alpha” – and, in a recent report, outlined the building blocks of a robust human capital infrastructure at hedge fund managers.  Specifically, Citi’s report distilled best practices among hedge fund managers (based on interviews) in four critical human resources areas: talent acquisition, talent retention, employee learning and development and performance measurement and management.  This article summarizes key insights from the Citi report.  See also “How Can Hedge Fund Managers Use Profits Interests, Capital Interests, Options and Phantom Income to Incentivize Top Portfolio Management and Other Talent?,” The Hedge Fund Law Report, Vol. 6, No. 33 (Aug. 22, 2013).

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  • From Vol. 6 No.40 (Oct. 17, 2013)

    Six Critical Questions to Be Addressed by Hedge Fund Managers That Outsource Employee Background Checks (Part Three of Three)

    This is the third installment in our three-part series on employee background checks in the hedge fund industry.  This article begins by weighing three factors favoring conducting background checks in-house against five factors favoring outsourcing of background checks.  The article then identifies and addresses six important questions to be answered by any hedge fund manager that outsources the employee background check process.  The first article in this series outlined the imperative of conducting background checks, cataloging the wide range of regulatory and other risks presented by employees.  See “Why and How Should Hedge Fund Managers Conduct Background Checks on Prospective Employees? (Part One of Three),” The Hedge Fund Law Report, Vol. 6, No. 38 (Oct. 3, 2013).  And the second article in the series discussed the mechanics of conducting a background check, identified three common mistakes made by hedge fund managers in conducting background checks and detailed four legal risks in conducting background checks.  See “Why and How Should Hedge Fund Managers Conduct Background Checks on Prospective Employees? (Part Two of Three),” The Hedge Fund Law Report, Vol. 6, No. 39 (Oct. 11, 2013).  The backdrop for our discussion of backgrounds is the growing competition for top talent in the hedge fund industry.  In brief, assets under management by hedge funds are growing rapidly; Citi Prime Finance, for example, forecasts that institutional investment in hedge funds will reach $2.314 trillion by 2017, up from $1.485 trillion in 2012.  Managers that can attract and retain the best and the brightest are more likely to capture a larger slice of a growing pie.  See “How Can Hedge Fund Managers Use Profits Interests, Capital Interests, Options and Phantom Income to Incentivize Top Portfolio Management and Other Talent?,” The Hedge Fund Law Report, Vol. 6, No. 33 (Aug. 22, 2013).  Also, insightful investment talent can enable a manager to explore creative structuring options such as alternative mutual funds, funds of one and reinsurance vehicles.  The opportunities can cause a manager to rush headlong into the market for talent, and at least one of the purposes of this series is to suggest that managers pause to separate the peccadilloes from the fundamental problems.  Before you can know your customer, you need to know your employees.

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  • From Vol. 6 No.39 (Oct. 11, 2013)

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

    This is the second article in our three-part series on employee background checks in the hedge fund industry.  The occasion for this series is a growing recognition in the industry that people can be either the best asset of a manager or a manager’s worst liability.  The potential value of people is implicit in the impressive returns of some managers; the road of good returns invariably leads back to human insight.  And – less pleasantly – the industry graveyard is littered with management companies laid low by human foibles rather than investment mistakes.  See, e.g., “Former Rajaratnam Prosecutor Reed Brodsky Discusses the Application of Insider Trading Doctrine to Hedge Fund Research and Trading Practices,” The Hedge Fund Law Report, Vol. 6, No. 13 (Mar. 28, 2013); and “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).  How can managers obtain the data necessary to identify aspects of a prospective employee’s background that are or may become problematic?  The high-level answer is: By conducting background checks.  But since a background check is a capacious concept – covering everything from a Google search to a private investigation – managers can benefit from more detail on the topic.  This series is designed to provide that detail.  In particular, the first article in this series outlined 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).  See “Why and How Should Hedge Fund Managers Conduct Background Checks on Prospective Employees? (Part One of Three),” The Hedge Fund Law Report, Vol. 6, No. 38 (Oct. 3, 2013).  This article discusses the mechanics of conducting a background check, including four specific activities that managers or their service providers should undertake; identifies three common mistakes made by hedge fund managers in conducting background checks; and details four legal risks in conducting background checks.  The final article in this series will weigh the benefits and burdens of outsourcing background checks versus conducting them in-house.

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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. 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. 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.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.22 (Jul. 1, 2011)

    What Hedge Fund Managers Need to Know About Information and Data Security

    While hedge fund executives are experts at identifying and managing the risks relating to their financial assets and portfolios, they generally do not have the time or expertise to focus on the security of their people and intellectual property assets.  However, all organizations – especially financial institutions – must be prepared for the inherent risks and responsibilities associated with doing business in an online world through a sound digital risk management strategy.  The appropriate approach to digital risk management varies from firm to firm based on unique business models and requirements.  However, all hedge fund managers should take a risk-based approach to security and ensure that the approach is aligned with the way executives manage other business issues.  While physical security and information security present different challenges, they are strongly related, are part of internal controls and should be managed using an integrated strategy.  In a guest article, Edward Stroz, Co-President of Stroz Friedberg, a digital risk management and investigations firm, and Steven Garfinkel, Vice President of Stroz Friedberg’s Business Intelligence & Investigations Division – and both former FBI Special Agents – outline the most critical aspects involved in implementing a digital risk management program for hedge fund managers.

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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.36 (Sep. 9, 2009)

    In Conducting Background Checks of Hedge Fund Managers, What Specific Categories of Information Should Investors Check, and How Frequently Should Checks be Performed?

    Background checks or investigations of managers of hedge funds, private equity funds and venture capital funds are in the spotlight with the recent frauds involving Bernard Madoff in New York and Stanford Financial in Houston.  For defrauded investors, the focus in the Madoff and Stanford contexts has shifted to litigation and asset recovery.  For those who still are invested in third-party managed funds or are considering investing in such vehicles, the Madoff, Stanford and other scandals have emphasized the importance of investigating the background of the individuals responsible for managing the funds.  No background investigation can prevent all fraud.  However, background investigations can indicate signs of a checkered past, which in turn can increase the risk profile of a potential investment.  In a guest article, Jack McCann and Daniel Weiss, both of investigation firm McCann Global, discuss the specific categories of information that investors should look into when conducting a background check on a hedge fund manager, the frequency with which background checks should be performed (and renewed) and the manner in which background checks should (and should not) be performed.

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