The Hedge Fund Law Report

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

Recent Issue Headlines

Vol. 3, No. 6 (Feb. 11, 2010) Print IssuePrint This Issue

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

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

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  • Video Interview with Mark Dalton, Alex Sorokin and Neil Wessan of Halsey Lane Holdings: Key Considerations for Distressed Debt Hedge Funds that become “Unnatural Owners” of Equity Following a Reorganization

    When a hedge fund is set up – in terms of structure, strategy and managerial experience – to invest in secured debt, and the issuer of that debt defaults, the hedge fund and its manager often wind up in the unnatural position of owning equity or assets.  See “Hedge Funds Employing Loan-to-Own Strategies Face (and Resolve) Ownership Dilemmas,” The Hedge Fund Law Report, Vol. 2, No. 35 (Sep. 2, 2009).  How can such “unnatural owners” maximize the value of their post-reorganization investments?  In our inaugural video interview, The Hedge Fund Law Report discussed this and related questions with Mark Dalton, Alex Sorokin and Neil Wessan, founding principals of Halsey Lane Holdings.  In particular, we discussed issues including: circumstances in which hedge funds become unnatural owners; why such unnatural owners may be ill-equipped to maximize value following a restructuring; how Halsey Lane manages concerns relating to material, non-public information when advising unnatural owners; how hedge fund managers can negotiate the potential liquidity mismatch between their fund lock-ups and the time required to implement a strategic plan at a restructured company; how hedge funds with a debt strategy can remain faithful to that strategy while owning and managing post-reorganization equity; and more.

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  • Pension Committee Case Highlights Obligations of Hedge Fund Managers to Preserve Documents and Information in Anticipation of Litigation

    In the most recent decision in the ongoing litigation involving failed hedge funds managed by Lancer Management Group, Judge Shira Scheindlin of the U.S. District Court for the Southern District of New York detailed the obligations of hedge fund managers and investors with respect to preservation of evidence in anticipation of litigation.  See Pension Committee of the University of Montreal Pension Plan v. Banc of America Securities, LLC (No. 05-CV-9016 (S.D.N.Y. Jan. 15, 2010)).  More generally, since litigation is a reasonably foreseeable fact of life for hedge fund managers, the Pension Committee decision offers authoritative guidance to hedge fund managers on structuring policies and procedures with respect to data collection, preservation and destruction.  In other words, the key take-away from the Pension Committee decision is that by the time a hedge fund files or receives a complaint, it is too late to start thinking about data management issues.  Rather, data management has to be integrated into the compliance culture and processes at a hedge fund manager, and anything less than best of breed data management may result in draconian spoliation sanctions and reputational harm.  In an effort to assist hedge fund managers in translating the principles of the Pension Committee decision into actual policies, procedures and practices, this article discusses: the facts and legal analysis of the Pension Committee case; the practical considerations from the case most relevant to hedge fund managers (including tips relating to the irrelevance of organizational size to discovery obligations, interdepartmental cooperation, data mapping and document destruction); considerations with respect to departed or terminated employees (including provisions to include in severance agreements); back-up tapes; and cross-border data preservation and access issues (with a focus on the interaction of European privacy regulations and U.S. discovery rules).  The Hedge Fund Law Report has covered the Lancer litigation extensively.  See, e.g., “Second Circuit Revives Hedge Fund Fraud Claims Against Banc of America Securities,” The Hedge Fund Law Report, Vol. 2, No. 26, (Jul. 2, 2009); “Federal Court Permits Suit Concerning Collapsed Lancer Funds to Proceed in Part,” The Hedge Fund Law Report, Vol. 2, No. 5 (Feb. 4, 2009); “Federal Court Bars Investors’ Claims Against Hedge Fund Administrator,” The Hedge Fund Law Report, Vol. 1, No. 28 (Dec. 16, 2008).)

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  • Senate Banking Committee Hears Testimony from Hedge Fund Industry Experts and Academics on “Volcker Rule”

    On February 4, 2010, the U.S. Senate Committee on Banking, Housing and Urban Affairs held a hearing entitled “Implications of the ‘Volcker Rule’ for Financial Stability.”  The hearing followed on the heels of the February 2, 2010 hearing in which Former Federal Reserve Chairman Paul Volcker testified on behalf of the his eponymous rule, which President Barack Obama proposed on January 21, 2010 as a means of curbing commercial banks’ proprietary trading if they also benefit from federal protection of consumer deposits and have access to the Federal Reserve’s discount window.  The proposal would also prevent those institutions from owning, sponsoring or investing in hedge or private equity funds.  For more on the February 2, 2010 hearing, see “Senate Banking Committee Holds Hearing on ‘Volcker Rule’ Designed to Limit Banks’ Ability to Own, Invest In or Sponsor Hedge or Private Equity Funds,” The Hedge Fund Law Report, Vol. 3, No. 5 (Feb. 4, 2010).  At the February 4, 2010 hearing, witnesses included Gerald Corrigan, a Managing Director at Goldman Sachs; Professor Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship, Sloan School of Management, Massachusetts Institute of Technology; John Reed, former Chairman and Chief Executive at Citigroup; Professor Hal Scott, Nomura Professor of International Financial Systems, Harvard Law School; and Barry Zubrow, Chief Risk Officer and Executive Vice President at JPMorgan Chase.  Panelists at the hearing expressed concern regarding the feasibility of enforcing the Volcker Rule as well as its potential impact.  This article details the testimony of lawmakers and panelists at the February 4, 2010 hearing.

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  • Federal District Court Dismisses Hedge Funds’ Complaint Against PXRE Group for Federal Securities Laws Violations in Private Placement Offering

    On January 26, 2010, the U.S. District Court for the Southern District of New York dismissed without prejudice a lawsuit brought by 19 hedge funds against PXRE Group, Ltd. (PXRE), a reinsurance corporation, Argo Group International Holdings, Ltd., its successor in interest, and Jeffrey L. Radke, Guy D. Hengesbaugh and John M. Modin, three PXRE officers (collectively, Defendants), alleging violations of Section 12(a)(2) of the Securities Act of 1933 (Securities Act).  The court also declined to exercise supplemental jurisdiction over the hedge funds’ state law claims for fraud and negligent misrepresentation.  In examining the details of this action, this article addresses: (1) the mechanics of the Rule 144 sale, (2) the standard by which courts evaluate misrepresentations in a prospectus for a private offering of securities; and (3) how the applicable standard in securities fraud actions differs for Qualified Institutional Buyers (i.e., those entities which own and invest on a discretionary basis at least $100 million in securities) from others.

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  • Paul Hastings Hosts Program on Securities Litigation and Enforcement in Light of New SEC Initiatives to Enhance Enforcement Efforts and Encourage Witness Cooperation

    On February 2, 2010, law firm Paul, Hastings, Janofsky & Walker LLP hosted a Securities Litigation & Enforcement Roundtable focusing on key current enforcement and witness cooperation initiatives at the Securities and Exchange Commission (SEC).  The SEC Enforcement Division, led by Director Robert Khuzami, recently introduced new investigative units designed to enhance and revamp its investigation efforts, as well as to encourage witness cooperation in investigations.  See “SEC Names New Co-Chiefs of Enforcement Division Asset Management Unit and Other Specialized Unit Chiefs,” The Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010).  The speakers also discussed the implications of these initiatives and current enforcement trends for financial institutions and alternative investment vehicles, such as hedge funds.  One of the key points of the discussion was the SEC’s increased emphasis on insider trading enforcement, in particular in the hedge fund context.  The SEC has increased the number of insider trading enforcement actions recently initiated, and the techniques used by the regulator to investigate suspected insider trading have become increasingly aggressive and sophisticated.  For a comprehensive discussion of practice points that can help hedge fund managers avoid insider trading allegations, including links to relevant articles from The Hedge Fund Law Report, see “Regulatory Compliance Association Hosts Program on Increased Risk for Hedge Fund Directors and Officers in the New Era of Heightened Regulation and Enforcement,” The Hedge Fund Law Report, Vol. 2, No. 50 (Dec. 17, 2009).  This article summarizes the most relevant topics discussed at the Paul Hastings Roundtable, focusing on the SEC’s new enforcement initiatives and cooperation measures (including cooperation agreements, deferred prosecution agreements and non-prosecution agreements), and emphasizing the potential impact of those measures on hedge funds and their managers.

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  • Delaware Bankruptcy Court Recognizes Cayman Islands Proceeding as “Foreign Main Proceeding” Under Chapter 15 of the U.S. Bankruptcy Code

    On December 17, 2010, the U.S. Bankruptcy Court for the District of Delaware granted protection over U.S. assets in a Cayman Islands exempted company in liquidation, finding it to be a foreign main proceeding under Chapter 15 of the U.S. Bankruptcy Code (Code).  This case diverges from other courts that have denied or limited Chapter 15 protection for liquidating Cayman Islands exempted companies in recent years.  See, e.g., “Cayman Islands Liquidations of Failed Bear Stearns Hedge Funds Denied Access to US Bankruptcy Court,” The Hedge Fund Law Report, Vol. 1, No. 13 (May 30, 2008).  The petitioners were duly authorized foreign representatives and joint official liquidators in the debtors’ liquidation and winding up proceeding before the Grand Court of the Cayman Islands.  In granting the petition for recognition and protection under the Code, the Delaware Bankruptcy Court specifically found that the debtor, Saad Investments Finance Company (No. 5) Limited, had its “center of main interests” in the Cayman Islands.  This article summarizes the background of the case and the petitioners’ arguments, and examines how this case is distinguishable from foreign proceedings that were refused similar protection under the Code.  The case has particular relevance for hedge funds that are organized in the Cayman Islands, face winding up proceedings there and have U.S. investors.

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  • Bankruptcy Court Denies Philadelphia Newspapers’ Motion to Force Disclosure from Steering Group Pursuant to Rule 2019

    On February 3, 2010, Judge Stephen Raslavich of the U.S. Bankruptcy Court for the Eastern District of Pennsylvania denied a motion by Chapter 11 debtors Philadelphia Newspapers LLC, et al., seeking to compel the company’s largest creditors, who had formed a Steering Group, to disclose the value and amount of the debt each owns pursuant to Federal Rule of Bankruptcy Procedure 2019.  Its decision that Rule 2019 does not apply to ad hoc committees deepens the case law split on that issue.  At present, a battle exists between Chapter 11 debtors and the hedge fund industry over the scope and application of Rule 2019.  Debtors advocate applying the rule to ad hoc committees to promote transparency in the reorganization process.  Hedge funds, guarded from disclosing their trading secrets in reorganizations, argue that compelling disclosure will adversely affect their business, and may deter non-traditional lender participation in reorganization cases.  Yet, recently, the debtors in many cases appear to be filing the motions to compel as litigation tactics to intimidate and divide their hedge fund creditors, and to gain leverage in disputes among different classes of creditors or between debtors and certain of its creditors.  For instance, in this action, the Steering Group maintained that the debtors did not file their motion until right before the U.S. Court of Appeals for the Third Circuit appeared ready to decide an important issue in this case having to do with the right of these lenders to “credit bid” at a forthcoming auction of the debtors’ assets.

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  • Harvard Management Company Hires 20-Year Banking and Hedge Fund Industry Veteran Neil Mason as Chief Risk Officer

    On January 14, 2010, Harvard Management Company (HMC) announced that Neil Mason would join the company as its Chief Risk Officer as of March 2010.  See “What Is a Chief Risk Officer, and Should Hedge Fund Managers Have One?,” The Hedge Fund Law Report, Vol. 2, No. 31 (Aug. 5, 2009).

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  • Somer Hatano Joins FletcherBennett as Director of Investor Coverage for Japan

    On February 9, 2010, FletcherBennett Capital LLC announced the appointment of Somer Hatano as Director of Investor Coverage for Japan.

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