The Hedge Fund Law Report

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

Recent Issue Headlines

Vol. 3, No. 3 (Jan. 20, 2010) Print IssuePrint This Issue

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

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

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  • IRS Issues Guidance on Compliance with Section 409A Requirements Applicable to Deferred Compensation Plans of Hedge Fund Managers

    In 2004, as part of the American Jobs Creation Act, Congress amended the Internal Revenue Code to include Section 409A, which generally requires recipients of deferred compensation to elect the time and form of deferred compensation payments in a manner that complies with Section 409A and Sec. 1.409A-1(c) of the Income Tax Regulations.  Failure to elect time and form properly, or utilizing an acceleration of deferred compensation payments, can subject the employee, director, independent contractor or other “service provider,” which may be an individual, corporation, partnership or limited liability company, to an additional 20 percent income tax, accelerated taxation of the deferred payments and heightened interest assessments.  Section 409A was enacted in response to the corporate scandals of the early Naughts, such as Enron, Tyco and WorldCom, and was intended to curb the practice of executives deferring large amounts of compensation and to eliminate the ability of executives to vary the payment schedule by which they received deferred compensation.  In attempting to curb these perceived “evils,” Congress, in enacting Section 409A, created a statute that is hyper-technical in its application, with harsh penalties for noncompliance.  Hedge fund managers, who may be considered “service providers” under the statute, should examine compensation plans that include any form of deferred compensation, including deferral of management or performance fees, for compliance with Section 409A.  Because the penalties for noncompliance are harsh, the Internal Revenue Service (IRS) has issued guidance on correcting plan failures.  In 2008, the IRS provided guidance on operational failures.  However, on January 5, 2010, the IRS issued Notice 2010-6, which provides guidance on correcting document failures.  Both notices provide guidance relevant to hedge fund managers and should be closely examined.  This article examines the scope of Section 409A and Notice 2010-6 and details the applicability of both to hedge funds and hedge fund managers.

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  • New IRS Audit Guidelines Target Equity Swaps with Non-U.S. Counterparties

    On January 14, 2010, the Large and Mid-Scale Business division of the IRS issued its “Industry Directive on Total Return Swaps Used to Avoid Dividend Withholding Tax” (Swap Audit Guidelines).  In addition to providing audit guidance to IRS field agents auditing U.S. financial institutions and U.S. branches of foreign financial institutions, the Swap Audit Guidelines contain six Information Document Requests for agents to use to solicit information from financial institutions that have equity swap operations.  The new guidance is substantially more detailed than the previous guidance.  As a result, IRS audits of financial institutions undertaken in accordance with the Swap Audit Guidelines are likely to impose a significant compliance burden on affected companies.  The purpose of the Swap Audit Guidelines is to assist IRS agents in “uncovering and developing cases related to total return swap transactions that may have been executed in order to avoid tax with respect to U.S. source dividend income” paid to non-U.S. persons.  The Swap Audit Guidelines posit four different transaction structures involving equity swaps.  If an IRS agent uncovers one of these fact patterns, he is encouraged to “develop facts supporting a legal conclusion that the Foreign Person retained ownership of the reference securities.”  In a guest article, Greenberg Traurig, LLP Shareholder Mark Leeds examines those four transaction structures in depth, and discusses the implications of the Swap Audit Guidelines for over-the-counter derivatives markets participants.

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  • New York Appellate Division, First Department, Affirms Dismissal of Breach of Employment Contract Claim Against Hedge Fund Manager Stanfield Capital Partners

    On December 22, 2009, the New York State Supreme Court, Appellate Division, First Department, affirmed the decision of a New York County trial court dismissing Richard Johnson’s complaint against his former employer, New York-based hedge fund manager Stanfield Capital Partners, LLC.  Johnson had sued Stanfield for allegedly breaching their employment agreement by failing to pay him millions in additional bonus compensation.  In support of his claims, Johnson represented that he had entered into an “oral” agreement with a member of the firm for an annual formulaic bonus arrangement.  Noting the existence of an “integrated” written employment agreement that called for only discretionary bonuses, the Appellate Division held that the parol evidence rule precluded Johnson from introducing evidence contradicting those terms.  We detail the background of the action, the court’s legal analysis and various additional arguments made by Stanfield (including a Statute of Frauds argument) on which the court did not have occasion to rule (because it found Stanfield’s parol evidence argument sufficient for dismissal).

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  • CFTC Proposes Position Limits for Four Energy Contracts in the Energy Futures and Options Markets to Curb Volatility

    On January 14, 2010, the Commodity Futures Trading Commission (CFTC) proposed limits for certain futures and option contracts in the major energy markets that may curtail the investments of large banks and swaps dealers in the markets for oil, natural gas, heating oil and gasoline.  The proposal aims to curb some of the significant price volatility that occurred in 2007 and 2008.  Under the proposal, speculators in the futures markets will no longer be grouped together with commodity-linked businesses like airlines and oil companies that may exceed limits on the number of energy futures one trader can hold.  In addition, the proposal establishes consistent, uniform exemptions for certain swap dealer risk management transactions while maintaining exemptions for bona fide hedging.  This article outlines the proposed rule, the exemptions and the rule’s implications for hedge fund participants in the futures markets.

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  • Federal District Court Denies Summary Judgment to J.P. Morgan Chase as to Whether Its Hedge Fund Accounting Business Employees Were Exempt from Fair Labor Standards Act Overtime Pay Requirements

    Plaintiff Damian Hendricks (Hendricks) was a “Fund Accounting Specialist” in the “Hedge Fund Services” business of defendant J.P. Morgan Chase Bank (JPMorgan).  Plaintiff Michael Minzie (Minzie) was a “Fund Accounting Analyst” in that business.  They performed various services in connection with JPMorgan’s preparation of financial statements for hedge fund clients.  Both were paid a weekly salary and were eligible for bonuses.  They claimed on behalf of themselves “and on behalf of other similarly situated individuals” that JPMorgan failed to pay them overtime in violation of the federal Fair Labor Standards Act (FLSA).  Following discovery and depositions, JPMorgan moved for summary judgment, claiming that Hendricks and Minzie were exempt from the FLSA overtime requirements because they were both employed in bona fide professional and administrative capacities.  In a decision that serves as an excellent primer on the applicability, in the hedge fund context, of exemptions from overtime pay under the FLSA and the analogous Connecticut law, the district court denied the motion, holding that there were significant issues of fact as to the nature of the employees’ duties.  We summarize the factual allegations and the court’s decision.

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  • SEC Names New Co-Chiefs of Enforcement Division Asset Management Unit and Other Specialized Unit Chiefs

    On January 13, 2010, the Enforcement Division of the Securities and Exchange Commission announced the appointment of the newest members of its national leadership team as the Division undertakes its most significant reorganization since its establishment in 1972.  The Division named leaders of units it has established in five priority areas dedicated to specialized and complex areas of securities law.  One of those new units is an asset management unit that will cover, among other things, hedge funds.  See “For Hedge Funds and Their Managers, the SEC’s New Enforcement Initiatives May Increase the Likelihood, Speed and Vigor of Inspections and Examinations,” The Hedge Fund Law Report, Vol. 2, No. 33 (Aug. 19, 2009).  The Division also has created a new Office of Market Intelligence that is responsible for the collection, analysis, and monitoring of the hundreds of thousands of tips, complaints and referrals that the SEC receives each year.

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  • Carol Hall to Head Walkers’ New Hong Kong Investment Funds Group

    On January 19, 2010, international financial center law firm Walkers announced the appointment of Carol Hall as head of its newly-formed Investment Funds Group in Hong Kong.

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  • Alan Swersky Joins Duff & Phelps as Head of Operational and Risk Due Diligence Group

    Alan Swersky has joined Duff & Phelps’ New York office as a Director in the Portfolio Valuation service line and head of the firm’s Operational and Risk Due Diligence group.

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