The Hedge Fund Law Report

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

Recent Issue Headlines

Vol. 6, No. 5 (Feb. 1, 2013) Print IssuePrint This Issue

  • How Can Hedge Fund Managers Organize and Operate Alternative Mutual Funds to Access Retail Capital? (Part One of Two)

    The continuing quest for new sources of capital as well as the heightened regulation of hedge fund managers and their funds has prompted managers to explore launching alternative mutual funds.  Simultaneously, the desire for innovative investment strategies and uncorrelated returns has heightened retail investor demand for such products, according to a June 2012 report from McKinsey & Company.  See “McKinsey Analyzes Trends in the Mainstreaming of Alternative Investments and Outlines Strategic Imperatives for Traditional Asset Managers,” The Hedge Fund Law Report, Vol. 5, No. 31 (Aug. 9, 2012).  However, the organization and operation of alternative mutual funds present numerous challenges and risks for hedge fund managers – in particular, challenges and risks different from those typically encountered in the hedge fund world.  Retail is not necessarily simple, especially if you are starting with a non-retail orientation.  This two-part article series is designed to enable hedge fund managers to weigh the more salient pros and cons of launching alternative mutual funds.  This first installment discusses the structure of alternative mutual funds; the investment strategies typically employed by alternative mutual funds; why hedge fund managers consider launching alternative mutual funds; some drawbacks of launching alternative mutual funds; and the various ways in which hedge fund managers can participate in the alternative mutual fund business.  The second article will detail specific steps necessary to launch an alternative mutual fund; costs and fees associated with launching and operating an alternative mutual fund; how such funds are typically distributed; investment restrictions applicable to alternative mutual funds; and some common conflicts of interest hedge fund managers face when operating alternative mutual funds and traditional hedge funds side by side.  For analysis of an analogous side-by-side management scenario that raises its own conflicts of interest, see “How Can Hedge Fund Managers Use Reinsurance Businesses to Raise and Retain Assets and Achieve Uncorrelated Returns? (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 3 (Jan. 17, 2013) (in particular, the discussion under the heading “Compliance Policies and Procedures to Address Conflicts Raised by Side-By-Side Management”).

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  • What Impact Will FATCA Have on Offshore Hedge Funds and How Should Such Funds Prepare for FATCA Compliance?

    The Foreign Account Tax Compliance Act (FATCA) will begin to impact the offshore investment fund industry in 2013, requiring a “foreign financial institution” (FFI) to enter into an agreement with the Internal Revenue Service (IRS) and disclose certain information regarding its U.S. account holders on an annual basis.  FFIs are broadly defined to include offshore hedge funds or other offshore private investment funds, and compliance with FATCA may be difficult for many of these funds.  The principal goal of FATCA is to prevent U.S. taxpayers from using foreign accounts and investments to hide income from the IRS and evade payment of U.S. tax.  As the penalties for failure to comply with FATCA are harsh – including the imposition of a 30 percent withholding tax on certain U.S. source payments – managers of offshore hedge funds should begin to prepare for FATCA and its due diligence reporting requirements.  On January 17, 2013, the IRS issued long-awaited final regulations under FATCA, clarifying many of the items left open by the proposed regulations released in February of 2012 and previously issued IRS guidance.  In a guest article, Michele Gibbs Itri, a partner at Tannenbaum Helpern Syracuse & Hirschtritt, LLP, discusses the impact that current FATCA rules will have on offshore investment funds and describes the steps that fund managers can take now to comply with these rules to avoid any FATCA tax on the funds’ U.S. investments.

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  • Proskauer Partner Christopher Wells Discusses Challenges and Concerns in Negotiating and Administering Side Letters

    Hedge fund managers intent on attracting institutional capital often feel compelled to entertain requests for preferential treatment via side letters from institutional investors.  But the “cost of capital,” as it were, may increase materially where a side letter is involved.  Such instruments raise regulatory concerns, present business challenges and create operational issues.  See “RCA Session Covers Transparency, Liquidity and Most Favored Nation Provisions in Hedge Fund Side Letters, and Due Diligence,” The Hedge Fund Law Report, Vol. 6, No. 1 (Jan. 3, 2013).  In an effort to identify some of the chief regulatory concerns raised by side letters – and to offer suggestions on how to address those concerns in a way that makes business sense – The Hedge Fund Law Report recently interviewed Christopher Wells, a partner and head of the hedge fund practice at international law firm Proskauer Rose LLP.  Our interview with Wells covered selective disclosure, the role of advisory committees, most favored nation provisions, allocation of costs of administering side letters, ERISA considerations, the role of state “sunshine” laws, considerations specific to sovereign wealth funds and much else.  For additional insight from Wells, see “Managing Risk in a Changing Environment: An Interview with Proskauer Partner Christopher Wells on Hedge Fund Governance, Liquidity Management, Transparency, Tax and Risk Management,” The Hedge Fund Law Report, Vol. 5, No. 13 (Mar. 29, 2012).  This interview was conducted in connection with the Regulatory Compliance Association’s upcoming Regulation, Operations & Compliance 2013 Symposium, to be held at the Pierre Hotel in New York City on April 18, 2013.  That Symposium is scheduled to include a panel on side letters entitled “Navigating the Side Letter Negotiation & Due Diligence Process.”  For a fuller description of the Symposium, click here.  To register for the Symposium, click here.

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  • Top Ten Operational Risks Facing Hedge Fund Managers and What to Do about Them (Part Three of Three)

    The failure by a hedge fund manager to appropriately plan for, detect and address operational risks can lead to economic and other costs (e.g., the loss of valuable business or investor information and data) and reputational harm.  Yet the challenges associated with a quickly evolving hedge fund industry, the proliferation of operational risks and resource and personnel constraints make it difficult for hedge fund managers to identify and effectively address operational risks.  A recent guide published by SEI, entitled “Top 10 Operational Risks: A Survival Guide for Investment Management Firms” (Guide), speaks directly to the lacuna in best practices in this area.  The Guide identifies some of the recurring operational risks in the hedge fund industry and offers practicable ideas for handling such risks.  This is the third and final installment in a three part HFLR series summarizing the key takeaways from the Guide.  The first installment discussed a hedge fund manager’s attitude and approach towards operational risk; the need for effective oversight of firm functions; and the imperative of appropriate training and staffing to minimize operational risks.  See “Top Ten Operational Risks Facing Hedge fund managers and What to Do about Them (Part One of Three),” The Hedge Fund Law Report, Vol. 5, No. 40 (Oct. 18, 2012).  The second installment addressed information hand-offs; pitfalls in automating processes; and workflow documentation.  See “Top Ten Operational Risks Facing Hedge Fund Managers and What to Do about Them (Part Two of Three),” The Hedge Fund Law Report, Vol. 5, No. 42 (Nov. 9, 2012).  This installment discusses segregation of duties; reconciliation gaps; care in entering into agreements; and planning within the rapidly evolving regulatory and competitive landscape of the hedge fund industry.

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  • Under What Conditions Can a Hedge Fund Manager Present Hypothetical Backtested Performance Results?

    Hedge fund managers (particularly early-stage managers) that lack a robust track record to demonstrate their investment prowess may use hypothetical backtested performance results to show how their investment strategies would have performed on an historical basis.  However, the SEC and investors strictly scrutinize the use of hypothetical backtested performance results by hedge fund managers because such results do not represent actual performance data.  The concern is that hypothetical results may reflect rosy assumptions as opposed to real results, and potential investors may not be sufficiently apprised of the difference.  In an expression of such concern, the SEC recently entered into a consent order with an investment adviser and its principal to settle an enforcement action in connection with the misleading use of hypothetical backtested performance results.  The results at issue purported to show how the performance of the manager’s investment portfolios would have compared to designated benchmarks.  This article summarizes the factual background, legal violations and settlement terms in this case.  The article also describes prior SEC enforcement actions that were based on other impermissible practices in connection with the use of hypothetical backtested performance results.  For another example of an SEC action premised on the use of misleading performance advertising, see “SEC Charges Hedge Fund Manager and Its Founder with Securities and Investment Adviser Fraud Based on ‘Cherry Picking’ of Trades,” The Hedge Fund Law Report, Vol. 6, No. 1 (Jan. 3, 2013).

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  • What Happens to a Claims Trade If a U.S. Bankruptcy Court and a Foreign Court Disagree on the Validity of the Trade?

    Hedge funds that purchase bankruptcy claims assume numerous risks, including uncertainty relating to the timing and amount of distributions to be received in bankruptcy proceedings.  In particular, claims purchasers run the risk that the purchased claim will be disallowed, reduced, or subordinated altogether.  See “Five Steps Hedge Fund Managers Should Take to Mitigate Avoidance and Disallowance Risks After Delaware Court Finds that Avoidance and Disallowance Risks Travel with Trade Claims,” The Hedge Fund Law Report, Vol. 5, No. 24 (Jun. 14, 2012).  A recent bankruptcy court opinion highlights another risk associated with bankruptcy claims trading – a risk relating to seller’s remorse where a seller “forum shops” among courts in different jurisdictions in an attempt to undo a trade.  In this case, the seller’s representative brought the matter to the U.S. Bankruptcy Court (U.S. Court) following an adverse decision in a “foreign main proceeding” in which a foreign court upheld a bankruptcy claim transaction entered into with a hedge fund purchaser.  In evaluating whether it would contravene the foreign court’s judgment, the U.S. Court considered: whether it was appropriate for the U.S. Court to conduct a plenary review under Section 363 of the U.S Bankruptcy Code (Code) to determine whether the transaction involved a transfer of property in the U.S., as mandated by Chapter 15 of the Code; and whether undoing the foreign court’s ruling would offend the principle of comity integral to Chapter 15 of the Code.  This article summarizes the factual background, legal analysis and decision in the case, including a discussion of the mechanics of Section 363; the requirement under Chapter 15 of a transfer of interest in property within the U.S.; and the doctrine of comity as applied in bankruptcy situations.

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  • Rajaratnam and Gupta Prosecutor Reed Brodsky to Join Gibson Dunn

    Gibson Dunn & Crutcher LLP is expected to announce that Reed Brodsky will leave the United States Attorney’s Office in Manhattan to join the law firm as a partner in its white-collar criminal defense practice.  Brodsky is best known for his lead role in the criminal insider trading trial of Galleon Group founder Raj Rajaratnam.  See “Competing Briefs in Rajaratnam Appeal Outline the Application of Wiretap Law to Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 5, No. 42 (Nov. 9, 2012).

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  • Duane Morris Adds Investment Management Partner David A. Sussman

    On January 18, 2013, Duane Morris announced that David A. Sussman has joined the firm’s Corporate Practice Group as a partner in its Newark office.  He joins Duane Morris from Day Pitney LLP, where he was co-chair of that firm’s private equity and investment funds practice group.

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