The Hedge Fund Law Report

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

Recent Issue Headlines

Vol. 5, No. 12 (Mar. 22, 2012) Print IssuePrint This Issue

  • How Hedge Fund Managers Should Approach Preparing For, Conducting and Documenting the Annual Compliance Review (Part One of Two)

    We’ve all received that dreaded job interview question: What are your biggest weaknesses?  As strange and superfluous as it may seem in context, that question has a kind of analogue in the hedge fund industry: the annual compliance review.  Rule 206(4)-7 under the Investment Advisers Act of 1940 (Advisers Act) generally requires registered hedge fund managers and other registered investment advisers to evaluate, at least annually, the adequacy of their compliance policies and procedures and the effectiveness of their implementation.  In effect, Rule 206(4)-7 poses a recurring regulatory question to registered advisers: What are your biggest compliance weaknesses?  But like savvy jobseekers faced with the weaknesses question, hedge fund managers can approach the annual compliance review as an opportunity to shine, not just an opportunity to mess up.  While there is scant regulatory guidance on how to prepare for, conduct and document an annual compliance review, considerable custom and practice has developed in this area; and managers who familiarize themselves with best practices – or who retain and closely monitor service providers conversant with best practices – can reconcile the competing goals of such a review.  On one hand, hedge fund managers want to communicate to the SEC that they take their compliance obligations seriously.  On the other hand, hedge fund managers do not want to provide the SEC with an open book revealing all weaknesses in their compliance programs for fear of SEC enforcement activity.  Complicating things is the increasing interest on the part of the SEC in holding investment advisers, and in some cases compliance officers, liable for compliance failings.  See “Three Recent SEC Orders Demonstrate a Renewed Emphasis on Investment Adviser Compliance Policies and Procedures by the Enforcement Division,” The Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).  Therefore, it is imperative for hedge fund managers to thoughtfully consider how to approach the annual compliance review process with the goal of mitigating weaknesses in their compliance programs.  This article – the first in a two-part series on the intricacies of the annual compliance review process – is intended to help hedge fund managers identify relevant questions and think through answers.  In particular, this article discusses: what the annual compliance review is; the enforcement actions that make conducting the annual compliance review imperative; how to prepare for the annual compliance review, including a discussion of information gathering and the three types of testing that should be performed prior to the review; and who should conduct the annual compliance review.  The second article will discuss: when the annual compliance review should be conducted; the annual compliance review process itself, including identifying the scope of the review, reviewing the policies and procedures, conducting a risk assessment for changed circumstances, identifying compliance weaknesses and taking appropriate remedial actions; how to document the annual compliance review; the most formidable challenges in conducting the review; and common mistakes made by hedge fund managers in conducting the review.

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  • IRS Introduces New Disclosure, Consent and Notice Procedures to Govern the Electronic Delivery of 2011 Schedules K-1 by Partnerships, Including Many Hedge Funds and Hedge Fund Managers

    On February 13, 2012, the Internal Revenue Service (IRS) issued new procedures for partnerships to provide Schedules K-1 to their partners electronically.  Among other things, the new procedures introduce rigorous consent and disclosure procedures that govern the electronic delivery of Schedules K-1 by partnerships, including limited partnerships, such as many hedge funds and hedge fund managers.  As such, hedge funds and hedge fund managers that wish to provide electronic delivery of their Schedules K-1 to fund investors or partners in the management company, respectively, should promptly and carefully evaluate the new procedures and their potential impact on the processes they are currently following to obtain consent to electronic delivery of such Schedules K-1.  In a guest article, Roger Wise and Kenneth Wear, Partner and Associate, respectively, at K&L Gates LLP, discuss the mechanics and implications of the new K-1 procedures.

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  • Speakers at Katten Seminar Outline ERISA Concerns for Managers of Plan Asset Hedge Funds

    On January 31, 2012, Katten Muchin Rosenman LLP (Katten) hosted a seminar entitled, “25% Solutions: How to Manage ERISA Plan Assets in a Hedge Fund” in New York City.  Speakers at this event addressed: the implications of the Employee Retirement Income Security Act of 1974 (ERISA) for alternative investment fund managers managing plan asset funds; the plan asset regulations and the exception for comingled investment funds with less than 25% ownership by benefit plan investors; how the 25% calculation should be performed; and special concerns for managers managing hedge funds offering different share classes, fund of funds and funds utilizing a master-feeder structure.  This feature-length article summarizes the key points discussed at the seminar on each of the foregoing topics, and provides a self-contained tutorial on ERISA considerations for hedge fund managers.

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  • To What Extent Can a Hedge Fund Manager Hold Back Redemption Proceeds for Contingent Liabilities?

    Contingent or unforeseen liabilities can present numerous problems for hedge fund managers because it can be extremely difficult to determine the amount of such liabilities as well as the timing of payments to cover any such liabilities.  This is why many hedge fund managers have historically built into their fund governing documents the right to “hold back” amounts that would otherwise be distributed to fund investors to account for such liabilities.  Unfortunately, although the fund documents may give a hedge fund manager unfettered discretion in exercising its right to hold back distributions, its fiduciary obligations may trump such rights, particularly if it is determined that the hedge fund manager is not acting in accord with its obligation of good faith and fair dealing owed to all fund investors in making distributions.  A hedge fund manager’s decisions as to how to address contingent liabilities can be particularly difficult when a fund is in liquidation, where there may be only limited resources to cover contingent or unforeseen liabilities.  A recently-filed complaint has initiated a lawsuit relating to the amount of discretion hedge fund or hedge fund of funds managers have to hold back distributions to a single investor where there are contingent liabilities arising out of such investor’s investment in a liquidating hedge fund.  This article summarizes the complaint in that case.

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  • Preqin/Global ARC Report Details Preferences of Asia-Pacific Institutional Hedge Fund Investors Regarding Manager Selection, Geography, Strategies, Fund Structures and Terms

    Hedge fund managers continue to face a challenging capital raising environment.  As such, many managers have extended their reach to find new sources of capital, with a particular focus on institutional investors.  At the same time, Asia-Pacific institutional investors are becoming increasingly educated about the global alternative investment fund industry and have begun to dip their toes into the alternative investment waters.  Yet, to procure investments from Asia-Pacific institutional investors, fund managers must understand these investors and their investment priorities.  With this in mind, Preqin, an alternative investment research firm, and the Global Absolute Return Congress (Global ARC), conducted a survey of Asia-Pacific institutional investors in hedge funds to better understand these investors’ attitudes towards alternative investment funds.  Preqin and Global ARC recently released a report of the study findings (Report).  Overall, the Report indicated that, although weak 2011 performance was a concern among Asia-Pacific institutional investors, confidence in hedge funds remains strong.  This article highlights the Report’s key findings and their implications for hedge fund managers targeting this investor class.

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  • Recent Bankruptcy Court Opinion Affirms That Safe Harbor Provision in Bankruptcy Code Provides Some Protection to Hedge Fund Investors Who Face Suits to Claw Back Redemption Proceeds from Trustees of Bankrupt Hedge Funds

    Hedge fund investors, including funds of funds, ultimately want certainty once they redeem their investments in hedge funds.  However, in recent years, this certainty has eroded (and therefore, investors’ confidence has been shaken) as proactive bankruptcy trustees have sought to claw back redemption proceeds from investors that redeemed their investments prior to the declaration of bankruptcy by hedge funds, particularly those funds that invested in Ponzi schemes.  See “Federal Court Affirms the Ability of a Bankruptcy Trustee to Claw Back Fictitious Profits from Investors in LPs or LLCs Operated as Ponzi Schemes,” The Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).  In such cases, trustees have pressed claims based on the theory that the redemption proceeds represent fraudulent transfers.  However, the Bankruptcy Code (Code) provides a safe harbor provision (Safe Harbor Provision), found in Sections 546(e) and 546(g) of the Code, that protects investors by effectively barring trustees from making such claims against certain persons that have been paid prior to the declaration of bankruptcy by an estate, such as a hedge fund.  A recent opinion issued by a federal Bankruptcy Court provides some welcome news for hedge fund investors with respect to the application of the Safe Harbor Provision, as it is applied in the hedge fund context.  This article describes the facts and legal analysis in that opinion.

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  • NASAA Report Identifies Most Commonly Cited Investment Adviser Deficiencies Found in Coordinated State Adviser Examinations and Recommends Compliance Best Practices for Mid-Sized Hedge Fund Managers

    The Dodd-Frank Wall Street Reform and Consumer Protection Act shifted a great deal of responsibility for regulating many mid-sized investment advisers with between $25 million and $100 million in assets under management (AUM) to state regulatory authorities.  See “Registration, Reporting, Disclosure and Operational Consequences for Hedge Fund Managers of the SEC’s New ‘Regulatory Assets Under Management’ Calculation,” The Hedge Fund Law Report, Vol. 5, No. 9 (Mar. 1, 2012).  Hedge fund managers within that AUM range must therefore become familiar with the state laws, rules and regulations that govern their activities because they will likely be subject to periodic examinations from state regulatory authorities.  While the SEC staff attempts to convey its adviser examination priorities to the advisory industry through various speeches and pronouncements, state regulatory authorities are generally silent with respect to their adviser examination priorities.  As such, state-regulated investment advisers have little guidance to inform their preparations for regulatory examinations.  Given this backdrop, at the end of 2011, the North American Securities Administrators Association (NASAA), the lobbying arm of the various state securities authorities, issued a report (Report) detailing the most common deficiencies found during state regulatory examinations of investment advisers conducted between January 1, 2011 and June 30, 2011.  The Report also contained a series of recommended best practices to assist mid-sized hedge fund managers and other investment advisers in mitigating risks of regulatory violations.  While state examinations priorities can vary from state to state, the Report nonetheless provides valuable insight into what state regulators, as a whole, are focusing on in their examinations of investment advisers.  This article details the 13 categories of cited deficiencies and the 15 best practice recommendations contained in the Report.

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  • Appleby Recruits Leading Cayman Litigator Christopher Russell from Ogier

    Appleby has announced that prominent Cayman litigator Christopher Russell will join its Cayman Islands office as a partner on May 1, 2012.  Russell joins Appleby from Ogier’s Cayman office where he led the firm’s litigation group.  Russell specializes in heavy insolvency and commercial and trust matters, and is a frequent contributor to The Hedge Fund Law Report.  See, e.g., “How Safe Is It to Ignore Foreign Tax Claims or Judgments Against Cayman Islands Hedge Funds in the Context of a Winding Up of the Fund?,” The Hedge Fund Law Report, Vol. 5, No. 5 (Feb. 2, 2012).

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  • Ernst & Young LLP Adds Four Senior Professionals to its West Coast Asset Management Tax Practice

    On March 21, 2012, Ernst & Young LLP (E&Y) announced that four new senior professionals have joined the firm to expand the West Coast sector of its Asset Management tax practice.  For a recent interview with the Co-Leader of E&Y’s Global Hedge Fund practice, see “Ernst & Young’s Arthur Tully Talks in Depth with The Hedge Fund Law Report About Hedge Fund Governance, Succession Planning, Valuation, Form PF and Administrator Shadowing,” The Hedge Fund Law Report, Vol. 5, No. 11 (Mar. 16, 2012).

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