The Hedge Fund Law Report

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

Recent Issue Headlines

Vol. 2, No. 43 (Oct. 29, 2009) Print IssuePrint This Issue

  • How Can Hedge Fund Managers Talk to Corporate Insiders Without Violating Applicable Insider Trading Laws?

    The recent insider trading allegations against Raj Rajaratnam, founder of Galleon Group, and others highlight a predicament faced by many in the hedge fund industry: absent a seer-like insight (a la Buffett) or superior computers (a la Renaissance Technologies and others), the only way to consistently generate alpha is to consistently obtain information that is not available to others, or to apply information that is available to others in unique ways.  See “Billionaire Founder of Hedge Fund Manager Galleon Group, Raj Rajaratnam, Charged in Alleged Insider Trading Conspiracy,” The Hedge Fund Law Report, Vol. 2, No. 42 (Oct. 21, 2009).  Especially after promulgation of Regulation Fair Disclosure (Reg FD), everyone can read and internalize the same disclosure documents at roughly the same time.  Therefore, hedge fund managers – especially those that invest in public equity or debt – have to talk to corporate insiders to stay competitive; to stay ahead, they have to talk to a lot of corporate insiders.  And hence the predicament: how to talk to corporate insiders without violating the insider trading laws?  Those laws generally prohibit trading while in possession of material, nonpublic information.  But what constitutes “materiality” for insider trading purposes, and what information is considered “nonpublic”?  For a hedge fund manager, analyst or trader who spends a good portion of each work day talking to corporate insiders, the line can often be blurry, and the consequences can be dire.  Galleon, for example, liquidated in record time in response to as yet unproven allegations of insider trading by its principal.  In recognition of the importance to hedge fund managers of avoiding insider trading allegations, this article examines the facts and allegations of the Galleon case; the statutory and regulatory bases for the prohibition of insider trading; 10b5-1 plans; the categories of financial instruments to which the prohibition applies; insider trading policies and procedures at hedge fund managers; specific best practices that hedge fund managers can employ to prevent insider trading or mitigate its impact; the “mosaic theory” of information gathering and use; and the utility and limitations of expert networks.

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  • Key Elements of a Hedge Fund Manager’s Insider Trading Policies and Procedures

    While the insider trading allegations against Raj Rajaratnam of Galleon Group and others remain to be proved or disproved, the case has already confirmed the fundamental importance to hedge fund managers of having, enforcing and training personnel with respect to comprehensive and strategy-specific insider trading policies and procedures.  See “Billionaire Founder of Hedge Fund Manager Galleon Group, Raj Rajaratnam, Charged in Alleged Insider Trading Conspiracy,” The Hedge Fund Law Report, Vol. 2, No. 42 (Oct. 21, 2009).  The SEC requires registered investment advisers to have written compliance policies and procedures and written codes of ethics – either may contain the adviser’s written policies and procedures regarding insider trading (or the code of ethics may be part of the compliance manual).  However, the prohibition against insider trading – a broad legal framework based in caselaw, regulatory pronouncements and statutory provisions – applies to all investment advisers and all hedge fund managers, not just registered managers.  Therefore, most hedge fund managers have written insider trading policies and procedures, those that do not should and even those that do should revisit them.  The importance and urgency of focusing or refocusing on written insider trading policies and procedures is based on at least two trends.  First, the allegations against Galleon are part of a renewed enforcement effort on the part of the SEC and DOJ against hedge funds specifically and insider trading generally.  See “For Hedge Funds and Their Managers, the SEC’s New Enforcement Initiatives May Increase the Likelihood, Speed and Vigor of Inspections and Examinations,” The Hedge Fund Law Report, Vol. 2, No. 33 (Aug. 19, 2009).  Second, most hedge fund managers likely will be required to register with the SEC within a relatively short time.  On Tuesday, October 27, 2009, the Private Fund Investment Advisers Registration Act, which generally would require registration by most hedge fund managers, passed the House Financial Services Committee.  See “U.S. House of Representatives Holds Hearing on Hedge Fund Adviser Registration,” The Hedge Fund Law Report, Vol. 2, No. 42 (Oct. 21, 2009); “Hedge Fund Association Hosts Capitol Hill Symposium Focused on Hedge Fund Adviser Registration and Hedge Fund Industry Regulation,” The Hedge Fund Law Report, Vol. 2, No. 42 (Oct. 21, 2009).  In light of the fundamental importance to hedge fund managers of having apt and thorough written insider trading policies and procedures, and making such policies part of the firm’s “culture of compliance,” this article examines the nuts and bolts of what should be in such policies and procedures and why.  In particular, we examine the statutory, regulatory and practical requirements for having an insider trading policy; certain key definitions typically included in an insider trading policy, including the definitions of “insider,” “nonpublic information,” “materiality” and “security”; remedies and penalties for violations of insider trading laws and insider trading policies; guidelines for avoiding violations, including watch lists and ethical walls; related categories of market manipulation; personal trading policies and procedures; the critical importance of training; and the utility of filtering information through the Chief Compliance Officer.

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  • What Happens to High Water Marks When Managers Restructure Hedge Funds?

    In July 2009, in response to requests for $4.7 billion in redemptions in Cerberus Partners, L.P. and Cerberus International, Ltd., hedge and private equity fund manager Cerberus Capital Management, L.P. established a restructuring plan.  The plan offered investors the opportunity to move their assets into one of two new funds: Cerberus Partners II LP and Cerberus International II Ltd.  Both are expected to have lower fees than the older funds, but a longer, three-year lock-up.  Cerberus also indicated that it would create special purpose vehicles (SPVs) for investors in each of the older funds who do not elect to participate in the new funds; interests in the SPVs are not expected to be transferable.  Cerberus expects to charge investors who stay in the SPV a 0.5 percent annual management fee, and it has not yet announced a specific timeline for the liquidation of the SPVs.  Rather, Cerberus has indicated that it intends to sell the assets in the SPVs as expeditiously as practicable and that it will distribute liquidation proceeds when such proceeds become available.  This article focuses on a provision of the Cerberus restructuring plan that would allow investors in the old funds to carry their high water marks (HWMs) over into the new funds.  Specifically, for two years after the HWM is reached, Cerberus plans to waive 60 percent of its usual performance fee.  Cerberus has not stated what the “usual performance fee” is, except to indicate that it is less than the typical – or formerly typical – 20 percent.  More generally, in light of a significant volume of fund restructurings currently occurring and anticipated in the coming months, this article examines the rationale for and incentive effects of HWMs; the barriers preventing managers below high water marks from simply closing up shop and reopening in a different corporate form and potentially under a different brand; how managers under HWMs have been renegotiating performance fees; and the clout of institutional investors in negotiations with respect to carrying over old HWMs to new or restructured funds.

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  • New Heidrick & Struggles Report Reveals Significant Uptick in Hedge Fund Hiring and Provides Salary Numbers

    Despite a troubled economy, demand for hedge fund professionals has bounced back.  According to a recent report published by Heidrick & Struggles International Inc. (HSII) titled “Hedge Fund Industry Trends,” hedge fund firms dramatically increased their hiring efforts in late August and September 2009 as they sought to rebuild assets under management after the industry’s worst year on record.  Much of that demand centered on hiring sales and marketing executives who can help hedge funds attract new investors.  This article summarizes the most salient findings from the report and focuses largely on the findings as they relate to hedge funds’ increased hiring and marketing efforts.  In particular, our coverage includes details from the HSII report on the “market” for salaries for specific hedge fund positions.

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  • Federal District Court Holds that Investor in Hedge Fund that Invested in Madoff Operation Must Arbitrate His Claims against the Financial Adviser Who Recommended Investment in the Hedge Fund

    Plaintiff Larry Wald (Wald) had a long business relationship with defendants 1 Financial Marketplace Securities, LLC (1 Financial Securities), and its Chief Executive Officer, Kevin M. Ross (Ross).  In 2002, in connection with the opening of an IRA account, Wald signed client account forms required by 1 Financial Securities.  The agreement contained a provision that called for any dispute “arising out of or relating to your business or this agreement” to be submitted to arbitration.  From 2007 through February 2008, Ross solicited investments by Wald in a hedge fund run by affiliates of the defendants.  The fund turned out to be a Madoff feeder fund and Wald’s entire investment was lost.  Wald sued the defendants in federal court, alleging various counts of federal and state securities fraud, breach of fiduciary duty, breach of contract and similar claims.  Defendants, pointing to the arbitration clause in the client agreement, moved to compel arbitration.  On October 5, 2009, the district court agreed that the arbitration clause was applicable to Wald’s claims, even though the investment was not made through 1 Financial Securities, and directed the parties to arbitrate the dispute.  This article examines the relevant facts and explains the court’s reasoning.

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  • “Too Big To Save? How to Fix the U.S. Financial System,” By Robert Pozen; Wiley, 480 Pages

    Robert Pozen, Chairman of MFS Investment Management, offers an insightful examination of the causes of the current global financial crisis in his new book “Too Big To Save? How to Fix the U.S. Financial System.”  Pozen’s text provides a detailed framework to analyze the abundance of information about the financial crisis, to avoid repeating the mistakes of the past and to create an effective plan for fixing the financial system in the future.  In part one of his book, Pozen lays blame for the collapse of the financial system on the bursting of the U.S. housing bubble.  The bubble, he explains, resulted from excessive debt spread globally by mortgage securitization, which allowed lenders to easily obtain cash to make more loans.  When the mortgages underlying these securities began to default and later reached record highs, even the most conservative investors in mortgage-backed securities suffered heavy losses.  After describing the origins of the financial crisis, Pozen’s book explains in parts two through four: (1) the government’s correct and incorrect decisions in responding to this financial crisis; and (2) the actions it still must take to resolve the financial crisis and prevent its recurrence.  With regard to the latter, he recommends that the least burdensome regulatory strategy would be the government’s best chance of success.  In particular, he suggests that Congress should focus on encouraging financial innovation and on coping with systemic risks, specifically with regard to regulating hedge funds.  We offer a detailed summary and review of Pozen’s book.

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