The Hedge Fund Law Report

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

Recent Issue Headlines

Vol. 3, No. 43 (Nov. 5, 2010) Print IssuePrint This Issue

  • Structuring, Valuation, Fee Calculation and Other Legal and Accounting Considerations in Connection with Hedge Fund General Redemption Provisions, Lock-Up Periods, Side Pockets, Gates, Redemption Suspensions and Special Purpose Vehicles

    Due to the recent financial crisis, the hedge fund industry has experienced significant investor redemptions along with reduced availability of credit and leverage from prime brokers and other financial institutions.  As a result, certain shortcomings have been revealed in the way hedge funds have been managed, including liquidity mismatches identified between investment portfolio assets and liabilities and redemption restriction provisions contained in fund offering documents.  The liquidity mismatch dilemma was quite a shock for many hedge fund investors who were unable to withdraw capital according to required redemption terms upon the freezing of the credit markets.  Redemption restriction provisions such as lock-ups and gates have become commonplace as hedge funds have evolved from traditional strategies which primarily invested in liquid securities.  Hedge fund offering documents generally contain multiple liquidity provisions that enable fund managers to manage the liquidity needs of investors without selling assets at distressed prices or disposing of liquid assets while leaving the most illiquid investments to remaining investors.  Financial statements of hedge funds prepared in accordance with accounting principles generally accepted in the United States (“US GAAP”) usually contain disclosures of liquidity provisions specified in the fund offering documents.  In a guest article, Fredric S. Burak and Cindy Shen, both partners at EisnerAmper LLP, generally discuss the various liquidity provisions contained in hedge fund offering documents as well as the relevant accounting and financial statement reporting requirements and practices related to such provisions.  Specifically, Burak and Shen describe market practice regarding structuring of redemption provisions, including discussions of Accounting Standards Codification Topic 480 (formerly FAS 150), frequency of permitted redemptions, holdback provisions and in-kind distributions; lock-up periods, including discussions of “hard” and “soft” lock-ups and the use of sub-accounts within capital accounts; investor-level and fund-level gates and related disclosure considerations; suspensions of redemptions; side pockets and designated investments (i.e., investments placed in side pockets); the interplay between valuation of designated investments, US GAAP and the Custody Rule; calculation of management and performance fees with respect to designated investments; reporting performance of designated investments; structuring, fees and books and records considerations in connection with special purpose vehicles; and market color with respect to: typical length of lock-up periods, the relationship between strategy and length of lock-up; investor receptivity to various lock-up period lengths, percentage of assets typically subject to a gate on any redemption date, the “market” for the number of successive redemption dates to which excess redemptions may be carried over, opt-out rights with respect to side-pockets and renewed SEC attention on disclosure relating to side pockets.

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  • Implications of the DOL’s Proposed Expanded Definition of “Fiduciary” for Hedge Fund Managers, Placement Agents, Valuation Firms and Pension Consultants

    On October 22, 2010, the Department of Labor’s Employee Benefits Security Administration proposed rule amendments that would considerably expand the definition of “fiduciary” for purposes of the Employee Retirement Income Security Act of 1974, as amended (ERISA).  Under current regulation, a person can be deemed a fiduciary for ERISA purposes by reason of rendering investment advice if the person meets a five-part test.  The proposed amendments would replace that five-part test with a two-part test.  Generally, the new two-part test would be easier to satisfy – that is, would capture a wider range of entities and activities – than the old five-part test.  Thus, under the new rule, more entities would qualify (often involuntarily) as ERISA fiduciaries and thereby become subject to a range of duties, at least one of which (the duty of prudence) has been characterized by courts as the “highest known to the law.”  According to the preamble to the proposed rule release in the Federal Register, the DOL proposed the new rule for two primary reasons: to address purported changes in relationships between investment advisers and employee benefit plan clients occasioned by the increasing complexity of investment products and services, and to more efficiently allocate its enforcement resources.  The investment management industry has already voiced skepticism with respect to both rationales.  Regarding the first, commentators have suggested that while investment products and services have become more complex, the fundamental nature of investment advisory relationships has not changed in the 35 years since the current regulation was put in place.  Regarding the second, commentators have suggested that the DOL’s enforcement efforts may be largely moot because if the amendments become effective in their proposed form, many financial services firms – notably, broker-dealers, valuation agents and placement agents – may cease offering services directly or indirectly to employee benefit plans.  Surprisingly, the DOL appears to be cognizant of the potential adverse business consequences of its proposed amendments.  In the rule release, the DOL noted that “plan service providers that fall within the Department’s rule might experience increased costs and liability exposure associated with ERISA fiduciary status.  Consequently, these service providers might charge higher fees to plan clients, or limit or discontinue the availability of their services or products to ERISA plans.”  However, the DOL apparently determined that the benefits of increased enforcement efficiency and a more pervasive fiduciary duty are worth increasing the costs and reducing the choices available to plans.  This article explores the implications of the proposed rule amendments for four categories of hedge fund industry participants: hedge fund managers, placement agents, valuation firms and pension consultants.  The article concludes that the amended rule would have a limited effect on most hedge fund managers, and a potentially direct and adverse effect on placement agents, valuation firms and pension consultants.  However, the proposed amendments also contain exceptions – and this article explains how various hedge fund industry participants may use those exceptions to avoid undesired characterization as an ERISA fiduciary.

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  • SEC and Connecticut Banking Commissioner Bring Civil Fraud Charges Against Stephen M. Hicks and the Southridge Hedge Fund Investment Advisers He Controls, Claiming that They Defrauded Investors by Failing to Follow Stated Investment Policies, Overstating the Fund’s Asset Values and Misappropriating Fund Property

    On October 25, 2010, the Securities and Exchange Commission (SEC) filed a civil securities fraud action in the U.S. District Court for the District of Connecticut against hedge fund manager Stephen M. Hicks (Hicks) and the two investment advisers he controls, Southridge Capital Management LLC and Southridge Advisors LLC (together, Southridge).  The SEC claims that Hicks and Southridge violated the antifraud provisions of the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 by (i) misleading fund investors as to the liquidity of the funds’ assets, (ii) improperly overvaluing the assets held by the funds, which resulted in their payment of inflated management fees and (iii) using one fund’s cash to pay the legal and other expenses of another fund they managed.  The SEC charges that the Defendants promised investors that at least 75 percent of the funds in question would be invested in cash or liquid securities when, in fact, almost half of the funds’ assets were held in extremely illiquid investments.  The SEC also claimed that the Defendants continued to value a position in one portfolio company, Fonix, at its $30 million acquisition cost, when they knew that the value of that position was worth only a fraction of that amount.  We summarize the SEC’s Complaint and give a brief overview of a Connecticut state court action that makes substantially similar claims.

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  • Office Depot Settles SEC Charges that It Violated Regulation FD by Indirectly Signaling Its Quarterly Estimates Privately to Analysts and Institutional Investors

    On October 21, 2010, the U.S. Securities and Exchange Commission (SEC) filed a Complaint in the Southern District of New York and simultaneously settled enforcement actions against Office Depot, Inc., its CEO, Stephen A. Odland, and its former CFO, Patricia A. McKay (collectively, the Defendants).  The SEC charged the Defendants with violating Section 13(a) of the Securities Exchange Act of 1934 (Exchange Act), and SEC Regulation FD, in 2007, for selectively communicating to analysts and institutional investors that Office Depot would not meet the analysts’ quarterly earnings estimates.  The settlement is noteworthy because Office Depot did not directly inform analysts that it would not meet expectations, a classic Regulation FD violation, but signaled that fact through references to recent public statements of comparable companies and its prior cautionary public statements.  This matter is of particular importance to the hedge fund community because it highlights the risks involved when hedge fund managers, analysts and traders gather information from corporate insiders in small group meetings or other private settings.  For more on situations in which hedge fund managers speak to corporate management, see “How Can Hedge Fund Managers Distinguish Between Market Color and Inside Information,” The Hedge Fund Law Report, Vol. 2, No. 46 (Nov. 19, 2009).  This article discusses the legal principles underlying Regulation FD, the background of the action and the settlement.

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  • Corporate Partner Joseph Chan Joins Sidley Austin in Shanghai

    On November 3, 2010, Sidley Austin LLP announced that Joseph Chan joined its Shanghai office as a Partner, effective November 1, 2010.  Chan’s practice encompasses the full life cycle of private equity funds, from offshore and RMB fund formation and portfolio investments to M&A and capital markets.  See “Interview with Timothy Spangler: Key Legal and Business Considerations when Launching Hedge Funds or Hedge Fund Managers in China,” The Hedge Fund Law Report, Vol. 3, No. 8 (Feb. 25, 2010).

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  • David Meister Appointed as Director of Enforcement at the CFTC

    On November 1, 2010, Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler announced the appointment of David Meister as Director of Enforcement.  Meister, a former federal criminal prosecutor, comes to the CFTC with nearly 25 years of experience in investigations, litigation and trials involving fraud and other complex schemes relating to U.S. financial markets.

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  • Susan Clark Joins Heritage International Fund Managers as Head of Fund Administration

    On October 27, 2010, Heritage Group announced the appointment of Susan Clark as Head of Fund Administration for its administration arm, Heritage International Fund Managers Limited.  The Heritage Group has offices in Guernsey, Malta, Bermuda, Gibraltar and London.

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