The Hedge Fund Law Report

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

Recent Issue Headlines

Vol. 3, No. 37 (Sep. 24, 2010) Print IssuePrint This Issue

  • Key Elements of a Pay-to-Play Compliance Program for Hedge Fund Managers

    New limits on political contributions and other political activity by advisers to hedge funds with public pension plan investors will become effective on March 14, 2011.   Many of the concepts in Rule 206(4)-5 (Rule) under the Investment Advisers Act of 1940 are grounded in campaign finance law, rather than the securities laws.  For this reason, compliance with the Rule may present challenges to many advisers.  At the same time, however, the penalties for failing to adhere to the strict requirements of the Rule will be severe – including a two-year ban on business, loss of revenues, and possible sanctions by regulators.  In a guest article, Edward L. Pittman, Counsel at Dechert LLP, provides a practical overview of a compliance program for hedge fund advisers.

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  • Legal and Investment Considerations in Connection with Closing Hedge Funds to New Investors or Investments

    What a difference two years make.  In late September 2008, Lehman Brothers Holdings Inc. had just filed a bankruptcy petition, and hedge fund redemptions were growing in size and speed.  Some even thought, at the time, that the viability of the hedge fund industry itself was in doubt.  But two years later, the industry is not only viable, but vibrant, and facing a very different set of challenges.  Whereas the problem in late 2008 was, generally, too little money, the problem today, at least for some managers, is too much money.  That is, a growing number of hedge funds are reaching a level of assets under management (AUM) above which it will be difficult for their managers to deliver performance consistent with target returns or expectations.  As a result, managers are closing such funds to new investors or new investments.  See “Primary Legal and Business Considerations in Structuring Hedge Fund Capacity Rights,” The Hedge Fund Law Report, Vol. 3, No. 22 (Jun. 3, 2010).  There are at least four reasons for this trend.  First, gross assets under management by hedge funds are growing.  See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part One of Three),” The Hedge Fund Law Report, Vol. 3, No. 19 (May 14, 2010).  Second, institutional investors are, with some notable exceptions, shifting away from funds of funds in favor of direct investments in hedge funds, for two primary reasons: increasing familiarity and comfort on the part of institutional investors with direct hedge fund investing, and skepticism regarding whether the due diligence and monitoring services performed by funds of funds justify the extra layer of fees.  This shift to direct hedge fund investing can strain capacity in various ways.  For example, in times past, a pension fund might have invested $10 million in a fund of funds that in turn invested $8 million in an underlying hedge fund and kept $2 million in cash.  Today, that same pension fund might invest the same $10 million directly in the underlying hedge fund, resulting in $2 million less capacity in the hedge fund.  See “Three Significant Legal Pitfalls for Hedge Fund Marketers, and How to Avoid Them,” The Hedge Fund Law Report, Vol. 3, No. 36 (Sep. 17, 2010).  Third, a disproportionate share of the capital recently invested in hedge funds and expected to be invested in the coming quarters has flowed into larger funds.  See “Dodd-Frank May Impose New Obligations on Managers of Large Hedge Funds and Plan Asset Hedge Funds that Enter into Swaps,” The Hedge Fund Law Report, Vol. 3, No. 32 (Aug. 13, 2010).  And fourth, some institutional investors are changing their approach to allocations in ways that, on balance, may result in larger percentages of their portfolios being allocated to hedge funds.  See “Implications for Hedge Funds of a Potential Paradigm Shift in Pension Fund Allocation Strategies,” The Hedge Fund Law Report, Vol. 3, No. 16 (Apr. 23, 2010); “Lessons for Hedge Fund Managers on Liquidity, Allocations, Marketing and More from Yale’s 2009 Endowment Report,” The Hedge Fund Law Report, Vol. 3, No. 14 (Apr. 9, 2010); “As Pension Funds Exceed Hedge Fund Allocation Guidelines as Other Asset Classes Decline More Precipitously, Hedge Fund Managers Ask: Will Pension Funds Redeem or Revise their Allocation Guidelines?,” The Hedge Fund Law Report, Vol. 2, No. 17 (Apr. 30, 2009).  The net effect of these four factors is that, in certain strategies, the demand for hedge fund capacity is starting to outstrip the perceived supply, or as Simon Ruddick, CEO of alternative investment consultant Albourne Partners, Ltd., put it in recent comments to Pensions & Investments, “Contingent institutional interest massively exceeds credible alpha supply.  This means capacity is bound to be an issue sooner or later.”  In order to help hedge fund managers think through whether, when and how to close their funds to new investors or investments, this article discusses: recent example of closings; the benefits of hedge fund size; the drawbacks of size, or in other words, the rationales for closing; hard versus soft closes; the overlay of capacity rights granted in side letters; using hedge fund closings to manage the composition of an investor base; disclosure with respect to closings and reopening in hedge fund governing documents; communicating with investors; side letters; managed accounts; and fiduciary duty.  Before proceeding, a caveat is in order.  We recognize that for every hedge fund manager running up against capacity constraints, there are one or probably many managers knocking themselves out to raise funds.  At the industry level, there may well be sufficient capacity to meet the investment demand.  However, implicit in our phrase “perceived supply” and Ruddick’s phrase “credible alpha supply” – and in the “race to the top” phenomenon discussed above – is a note of risk aversion: for many institutional investors, the issue is not hedge fund capacity overall, but capacity with the largest, most established managers.  Such risk aversion may be rational for the managers of many institutional investors in light of restrictive investment policies, considerable personal downside for investment losses and limited personal upside for returns in excess of modest targets.  However, the opportunity cost of that risk aversion includes the strong returns that, according to studies, can be generated over long periods from a portfolio of smaller hedge funds.  See “The Space between Alpha and Beta (and Why Hedge Fund Investors Should Care),” The Hedge Fund Law Report, Vol. 3, No. 24 (Jun. 18, 2010).  Also, industry participants expect Dodd-Frank in the U.S. and the AIFM Directive in Europe to increase the costs of launching and operating a hedge fund management company, and thus to diminish entry into the hedge fund business by potential new managers, increase exits by closure or sale and decrease the total capacity in smaller hedge funds.

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  • SEC Obtains Partial Victory in Securities Fraud Civil Action against Hedge Fund Manager Robert Berlacher and the Lancaster Hedge Funds for Insider Trading on Nonpublic “PIPE” Offering Information

    As part of a broader federal investigation into hedge funds that use non-private information obtained during Private Investment in Public Equity (PIPE) offerings in order to short-sell the stock of those companies – a technique that virtually guarantees profits since a PIPE typically drives down the price of public shares – the SEC recently accused hedge fund manager Robert A. Berlacher, and eight hedge funds he managed or advised (the Defendants), of insider trading and securities fraud in connection with four such transactions.  Specifically, it alleged that the Defendants unlawfully traded on non-public information obtained by Berlacher in a PIPE issued by Radyne ComStream, and made material misrepresentations in the PIPE stock purchase agreements (SPAs) Berlacher had signed with Radyne, Hollywood Media, International Display Works (IDWK), and SmithMicro.  On September 13, 2010, the U.S. District Court for the Eastern District of Pennsylvania concluded, following a bench trial, “The SEC has not sustained its burden of proof on the insider-trading count and two of the fraud claims” but “has met its burden on two separate fraud claims” in connection with the Radyne and IDWK transactions because the SPAs for those transactions had prohibited the types of trading in which Berlacher had engaged.  The court ordered Berlacher to disgorge net profits of $352,363.68, but refused to impose civil penalties, pre-judgment interest, or injunctive relief, as sought by the SEC.  We detail the background of the action and the court’s legal analysis.

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  • Second Circuit Upholds Connecticut’s Ban on Campaign Contributions by State Contractors and Contractors’ Principals and Family Members, But Invalidates “Pay to Play” Law on First Amendment Grounds to the Extent that it Bans Contributions by Lobbyists or the Solicitation of Contributions by Lobbyists or Contractors

    The United States Court of Appeals for the Second Circuit has handed Connecticut a partial victory in its efforts to address the potentially corrupting influence of campaign contributions by contractors and lobbyists in the state.  The Second Circuit has upheld Connecticut’s “pay to play” law insofar as it imposes a complete ban on campaign contributions both by contractors that have business pending with the State and by their principals and close family members.  On the other hand, the Second Circuit ruled that the portions of the law banning campaign contributions by lobbyists and prohibiting lobbyists and contractors from soliciting campaign contributions were so broad as to violate the First Amendment’s free speech protections.  We summarize the decision, which could provide valuable insight into how courts might address similar challenges to other “pay to play” laws, such as the SEC’s new Rule 206(4)-5, which affects investment advisers.  See “Key Elements of a Pay-to-Play Compliance Program for Hedge Fund Managers,” above, in this issue of The Hedge Fund Law Report.

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  • The Hedge Fund Industry: The Year in Review and What to Expect in 2011

    Please join Mesirow Financial Consulting, LLC, Rothstein Kass and Tannenbaum Helpern Syracuse & Hirschtritt, LLP for a Q&A session moderated by Mike Pereira, Publisher of The Hedge Fund Law Report.  Presenters: Stephen B. Darr, Senior Managing Director, Mesirow Financial Consulting and Mesirow Financial Consulting Capital; Howard Altman, Co-CEO and Co-Managing Principal of Rothstein Kass and Principal-in-Charge of the Financial Services Group; Ricardo W. Davidovich, Partner, Tannenbaum Helpern Syracuse & Hirschtritt LLP – Financial Services, Private Funds and Capital Markets.  Discussion Topics: US Regulation/Dodd-Frank, EU Directive, Best Practices/Internal Controls, Valuation, Litigation, Liquidation, New Products, Opportunities, Risks; Date, Time and Location: Thursday, September 30, 2010; 4:30 p.m. – 6:00 p.m. – Program and Q&A Session; 6:00 p.m. – 7:00 p.m. – Cocktail Reception; The Yale Club of New York City, 50 Vanderbilt Avenue, New York, NY 10017; To RSVP, please click here or contact Mike Pereira at mpereira@hflawreport.com.

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  • Sidley Expands in San Francisco with Hedge Fund Partners Mark Whatley and David Tang

    On September 21, 2010, Sidley Austin LLP announced that Mark Whatley and David Tang will be joining the firm later this month as partners in the hedge fund practice in its San Francisco office.

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  • James Mulholland Named New Partner at Carey Olsen’s London and Jersey Offices

    On September 16, 2010, Channel Islands law firm Carey Olsen LLP announced the appointment of James Mulholland as a new Partner.  He will be working in the firm’s Jersey and London offices in the corporate and funds practice areas.

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