Perils of Side Letters for Hedge Fund Managers and Investors
Most investors contemplating investing in a hedge fund believe they are presented with a set of fixed terms for their investment. These terms are outlined in the private offering memorandum and appear to apply across the board to all investors. However, careful readers of the offering memo as well as the publicly available registration form (ADV) can ferret out what is often true — that some investors may be subject to more favorable terms. These terms are agreed upon in a “side letter” prior to investment and are usually granted to large or important investors, such as seed investors.
Once thought to be innocuous, if not actually beneficial to a hedge fund, side letters are turning out to be the bain of many managers’ operations. Raising issues ranging from the mundane (housekeeping) to headline-making (SEC regulatory actions), many managers are now thinking twice before granting special terms in a side letter.
Some of the more common issues with side letter usage include:
1. Inadequate disclosure of preferential treatment - This is the area in which regulators may get involved. The most recent example of this is the possible pending SEC case against Philip Falcone’s Harbinger Capital Partners ( http://online.wsj.com/article/SB10001424052970203413304577088440283592970.html) which appears to revolve around the granting of preferential redemption rights to certain investors under the terms of a side letter. Managers granting better treatment to side letter investors must, at a minimum, make adequate disclosure of these terms to all investors, particularly in certain sensitive areas like liquidity, information sharing and fees.
2. “Most Favored Nation” Provisions – This is not a reference to an international treaty of some sort… this is a very common side letter provision which allows an existing investor with an “MFN” clause to tag along with newer investors (usually investing less money than they did) who managed to negotiate a better side term than they did. As a simple example, the MFN clause might work like this: if Investor A invested $200 million in 2008 and signed a side letter with an MFN clause, and then Investor B invested $100m in 2011 and got better fee terms than Investor A has, Investor A would get the benefit of those better Investor B fee terms. Once thought to make perfect sense and to be somewhat innocuous, the MFN provisions can tend to pile up on managers. When faced with a situation where the manager thought just one investor would be invoking their side letter provision, all of a sudden there can be multiple parties invoking the same provision.
3. Housekeeping Issues - Side letters can impose obligations on a manager, for example, to provide certain information about the fund to the side letter investor by a certain date each year. These obligations need to be tracked by the manager to insure that they are fulfilled. In addition, some side letters appear to actually restate provisions of the offering documents. However, these restatements need to be carefully evaluated to determine whether there is in fact any deviation from the original terms.
In conclusion, hedge fund managers and investors alike both need to think carefully about side letters: careful drafting by both parties, followed by proper disclosure and housekeeping by the manager are imperatives.
State Investment Adviser Exams Reveal Significant Deficiencies
The results of coordinated state examinations of investment advisers in the first half of 2011 by the North American Securities Administrators Association (NASAA) reveal significant deficiencies in a broad range of areas. As investment advisers gear up nationally to register either with their state or the SEC in 2012, these results are important road maps of common pitfalls which investment advisers will need to address in their compliance programs going forward. Additionally, investors performing due diligence on advisers certainly should take note of these findings.
The NASAA report looked at 825 state-level adviser exams. While the NASAA has published a summary of findings (referenced below), we would like to highlight several significant areas:
1. Over half the exams had a deficiency in the “registration” category, meaning that their registration paperwork was not done correctly or was inconsistent. The registration process itself is complicated, and is getting more complicated as regulators add questions and requirements. A large number of deficiencies in this category is an indication that more care needs to be taken in completing the registration documents.
2. About a third of the advisers had deficiencies in the “supervisory” category, meaning that they had inadequate business continuity procedures or even no compliance procedures at all. While this can be a somewhat tricky area on the state level because some states may not technically require written procedures, the “best practice” clearly is to have written procedures.
3. About 20% of the advisers had deficiencies in the “financials” category, with violations such as inaccurate financials, non-GAAP financials, commingled accounts or poor financial condition. This is clearly an area for investors to watch out for.
4. Almost 20% of the advisers had deficiencies in the “fees” category, with violations such as inaccurate calculation of fees, billing errors, and inconsistencies between contracts/disclosure documents and amounts billed. While some of these deficiencies may be inadvertent or the result of failure to keep up with paperwork, advisers must be vigilant to maintain accurate billing.
The NASAA noted that “other areas in which investment advisers faced compliance challenges included privacy, fees, custody, investment activities, and solicitors. Among hedge fund advisers, the top deficiencies included valuation of holdings, cross trading, preferential treatment, registration-exemption issues, non-accredited investors issues and non-disclosed conflicts of interest…”
The link to the NASAA report and related documents can be found at http://www.nasaa.org/6156/coordinated-state-exams-identify-top-investment-adviser-deficiencies/
Hedge Fund Boards of Directors Play Vital Role
The role of directors on offshore hedge funds has often been, at best, a limited oversight role, with perfunctory annual meetings and limited interchange with the fund itself during the year.* This has been changing — slowly— as compliance moves to the top of the list of concerns for investors and managers alike. In addition, directors themselves are realizing that the status quo is no longer tenable.
Recent litigation has ensared directors, pushing them into playing a more active role. For example, in a recent Cayman Islands Grand Court decision in the Weavering fund fraud case**, two “independent” directors were ordered to pay $111 million for willful neglect and failing to carry out their duties. Even those these two directors may not have even been “independent” in a technical sense, the judgement was based on the fact that they “did nothing and carried on doing nothing for almost six years”, as the justice in the case noted.
What should managers and investors be looking for in a board of directors? Here are some areas to focus on:
-Is the board receiving relevant information on a timely basis? That is, do they have the information that they will need to perform their oversight role?
-Are the board meetings substantive, with a full agenda and detailed minutes? This indicates a board that is engaged, as opposed to playing a perfunctory role.
-Is the director a person or a company? While this type of set-up is becoming less common, it is still found occassionally and can be a red flag for a disengaged board.
-Is the board viewed as an integral part of a fund’s operations? Is the board utilized as a resource, and do the directors have the necessary experience and knowledge to be a resource? When a problem arises, the board can play an important role in providing guidance and decision-making.
-Are board fees significantly lower than industry standards? While it is important to keep operating expenses down, excessively low board fees may indicate a lack of engagement by the board members.
While no two boards will have completely similar procedures and levels of involvement, as the role of hedge fund boards move closer to the standard set by independent fund boards in the US, hedge fund advisers will need to add this area to their list of compliance and management concerns. Having the board act as a rubber-stamp is no longer an option.
* Hedge funds advised by US-based investment advisers will generally only have a board of directors if they are domiciled outside the US. That is, it is rare to see a board of directors on a US fund; but a non-US fund (i.e., Cayman Islands) will always have a board of directors.
**Weavering Macro Fixed Income Fund Limited v. Stefan Peterson and Hans Ekstrom, August 2011.
New Rules for Hedge Fund Adviser Registration Adopted — States to Assume More Responsibility
This past week, the SEC finalized rules requiring registration of most hedge fund investment advisers with either their state or the SEC. As mandated by the Dodd-Frank Act, a gaping regulatory hole has now been filled.
Whereas under prior rules, most hedge fund advisers could avoid registration, all but the very smallest advisers will now be subject to regulatory scrutiny. The new registration regime calls for hedge funds to establish a basic compliance program, make more public disclosure of critical items of importance to investors (such as conflicts of interest, key service providers, custody matters), as well as being subjected to the possibility of examination by regulators.
The attempt to require registration of hedge fund advisers failed before, when in 2006 the DC Circuit Court overturned a similar registration requirement in a case brought by hedge fund adviser, Phil Goldstein. Rescinded basically on a technicality, the decision allowed the majority of hedge fund advisers to avoid registration for the ensuing 5 years, until the passage of the Dodd-Frank Act. The new requirement, which goes into effect in March, 2012, closes this gap. There has been little on-the-record resistance to the new requirements by hedge funds.
In crafting the new rules, the federal government believes it has left a substantial portion of this registration burden to the states, as it has effectively raised the “assets under management” minimum for registration with the SEC (to over $100m in most cases), and left the smaller (over $25m, but under $100m) to the states. The SEC believes that as a result of the new rules, about 3,200 of its current 11,500 registered advisers will switch from registration with the SEC to registration with the states. What is left unknown is whether 3,200 or more new registrants will take their place, and, perhaps more importantly, whether the SEC actually has the muscle to oversee and examine these charges. Also left unknown is the extent to which the states themselves can handle an influx of registrants.
With the March 2012 deadline in sight, hedge fund advisers must now begin the paperwork process in earnest, and regulators are simultaneously gearing up their programs and personnel. In the meantime, as registrations begin to trickle in, savvy investors can access the information that the SEC has already gathered through its Investment Adviser Public Disclosure search engine, located at http://www.adviserinfo.sec.gov/(S(ftfawpf0g2kg30ld33pph0xz))/IAPD/Content/IapdMain/iapd_SiteMap.aspx . The website displays information on both state and SEC registered investment advisers.
New Whistleblower Rules Create Challenges and Opportunities for Hedge Funds
As part of the Dodd-Frank Act, the SEC has just adopted a rich bounty program which gives some serious incentives to whistleblowers to report first to the SEC (and to internal compliance later). The consequences for hedge funds in particular could be onerous.
The new whistleblower program makes it easier and more lucrative than ever to report a suspicion of wrong-doing to the SEC (first-hand knowledge isn’t even required). There’s a new office at the SEC to report to (the “Office of the Whistleblower”), and whistleblowers can even do so anonymously and online through the “Tips, Complaints and Referrals Questionnaire”. There could be a big reward too: if a person provides information that leads to a successful enforcement action in which the SEC recovers a total of at least $1 million in monetary sanctions, they could receive an award of between 10% -30% of the amount recovered. The program is topped off by strong anti-retaliatory provisions against the reporting employee. What a terrific opportunity for employees, where a big payday could be just an online form away!
For hedge funds, who run lean, this presents a particular challenge, putting even more pressure on a chief compliance officer who may already be filling multiple roles, ie, Chief Financial Officer/Chief Compliance Officer. The perverse outcome of this new program is that with no incentive to come to the CCO first if a violation is suspected, the CCO is essentially pitted against the employees, rather than working together to run a clean operation. In addition, the aftermath of a whistleblower filing will likely be costly and time-consuming investigations, which a light-infrastructure hedge fund is ill-equipped to handle.
The expectation by the SEC is that they will receive 30,000 tips a year through this program. That’s a large number, and implies that these tips would not all be related to major, serious infractions. The lesser ones might have been cleaned up by internal compliance before a tip was even necessary, but unfortunately, they may not get the chance.
The Office of the Whistleblower website is located at: http://sec.gov/complaint/info_whistleblowers.shtml
Hedge Funds and Advertising: “No advertising” rules more confusing than ever
In the category of “Laws that Haven’t Caught Up with the 21st Century”, the internet aspects of the rules that prohibit hedge fund advisers from “advertising” may come in first place. The SEC rules only allow hedge funds to be offered on a “private placement” basis. This means no general solicitations are allowed. While this is understandable in regard to some venues (think giant billboard in Times Square), when it comes to the internet, these rules may leave you scratching your head.
Consider this anomalous situation:
Beginning with new rules that came into effect in 2011, registered hedge fund advisers now post their ADV Part 2a (“brochure”) on the SEC website. This brochure contains a tremendous amount of information about an adviser’s strategy, fee structure,conflicts of interest and general fund structure. In conjunction with the ADV Part 1 (which has always been a publicly available document and contains more general information about an adviser), a complete picture of the adviser and the funds they manage emerges. This is the very information that most hedge funds now lock down on password-protected websites based on past regulatory interpretations of the private placement rules!
In issuing the new rules, the SEC recognized this issue and stated that the posting of the new ADV Part 2a on its website would not jeopardize the private offering status because there would be no performance information, financial statements or subscription instructions included in the new document.
However, what we see emerging is a new arm of what could be called “shopping information aggregators” taking information from the SEC website and offering it in database format for those “shopping” for hedge fund advisers. So, while we don’t see any of info the SEC seems concerned about, we see a form of advertising that is potentially even more powerful than a general solicitaion. By organizing massive amounts of information and putting it out there for the world to see, we see the ultimate hedge fund search engine emerge. Want to buy a toaster? Here is some basic info on toasters. Want a hedge fund investment adviser? Here is info on every single one of them (that have registered), complete with Google map on where to find them. The irony of this is that the investment adviser itself has no input into these databases, so, in effect, the “advertising” (if it is that) is being done for them.
We are hopeful that the SEC will clarify this confusing issue in the near future.
Rajaratnam Verdicts Send Message to Hedge Funds
Today’s guilty verdicts in the Rajaratnam insider trading case on 14 counts of securities fraud and conspiracy will send a strong message to hedge funds. The case explored the line between legitimate research and insider trading, striking at the very heart of hedge fund operations.
This case highlights the grey area that hedge fund managers must always be cognizant of — when does “research” cross over into “insider trading”. In the recent expert witness cases, for example, we see hedge funds supposedly doing “research” by interviewing former employees of companies that they are interested in, however, the type of information conveyed turned out to be actual material non-public information, leading to insider trading charges. The defense in the Rajaratnam case maintained that he was really only doing extensive research by interviewing his many sources, and that even if he did obtain material non-public information from them, that info was only minimally important to his overall research efforts.
We believe the operational effects at hedge funds of the Rajaratnam case and other recent insider trading cases will be palpable. There will be both more monitoring by compliance officers (such as email review, forensic trade review), more consideration and review of research sources, as well as a generally more timid atmosphere in terms of sharing ideas and conversation.
To view CNBC video announcing the verdict go to CNBC news, Rajaratnam verdict, May 11, 2011 .
Hedge Fund Compliance Blog Has Moved to FORBES.COM
Keep reading at “Hedge Rows” at http://blogs.forbes.com/judygross/
See you there!
Form PF Will Challenge Hedge Funds
The Securities and Exchange Commission, in conjunction with the Commodity Futures Trading Commission, has proposed a new “Form PF” reporting requirement, which, if implemented as proposed, represents a substantial increase in the amount of information required to be reported in to these regulators by hedge funds.
Form PF is a statutory mandate stemming from the Dodd-Frank Act’s goal of promoting the financial stability of the US by supervising non-bank financial companies that may pose systemic risks. The information gathered from the Form PF will be shared with the Financial Stability Oversight Council (FSOC). The SEC believes the Form PF is beneficial not only in monitoring systemic risks, but also in providing information that will enhance the SEC’s ability to formulate regulatory policies. The FSOC will use the data obtained from the Form PF to gain a broad view of the financial system and to gauge interconnectedness of financial players.
All SEC or CFTC registered investment advisers to private funds must file a Form PF. There are two types of proposed filers of the Form PF - those advisers with assets over $1billion, and those under $1billion.The under $1b group files annually, the over $1b group, quarterly. The annual filers have an abbreviated form, while the larger ones have an extended version to complete. Broadly speaking, the information requested falls into the categories of: amount of assets under management, use of leverage, counterparty credit risk exposure, and trading and investment positions/performance for each fund. The extended form includes additional information involving stress testing and exposure analyses.
We believe that the Form PF will present significant challenges to hedge funds in three areas:
1. Time/Cost Burden: The proposed rule estimates that the burden for the smaller advisers will be 10 hours to prepare an initial report, and 3 hours for each subsequent report. The estimated burden for the larger advisers is 75 hours for the initial report, and 35 hours for each subsequent quarterly report. The SEC notes that it believes some or all reporting will be outsourced, or, if not, will require both compliance and IT programmers to develop internal reporting systems. We believe that the time and cost burden may be even more significant than estimated by the SEC and that advisers need to begin to focus now on how they will address actually prepare the report.
2. Timetable: The implementation dates for the first filing are relatively soon. The first filing date for the large quarterly filers will be January 15, 2012, and for smaller annual filers (with a December 31 fiscal year end), March 31, 2012. The quarterly filers must file thereafter within 15 days of each quarter end. We believe that if this timetable is adopted as proposed, it is offering an extremely small window for quarterly filers, who will need to have expert systems in place very soon in order to fulfill these obligations.
3. Confidentiality: The proposal states that all information collected in Form PF will not be made public, although the information collected may be shared in an enforcement action or with Congress (upon agreement of confidentiality). The SEC may also share the information with other government agencies or SRO’s, most particularly the FSOC. While seemingly reasonable, we are concerned that the collected information, which is the cornerstone of a hedge fund’s business, may be made, through circuitous sharing within the government and Congress, unintentionally available publicly.
The proposed Form PF reporting regulation is available at http://www.sec.gov/rules/proposed/2011/ia-3145.pdf. Please consult us if you would like to discuss this proposal further.
US Sentencing Guidelines: A Cornerstone of Hedge Fund Compliance Practices
Compliance regulations couldn’t get any more press than they do today, given the almost daily raft of new SEC and Treasury rules. However, ever stop to wonder what the backbone of compliance law is? The answer is the US Sentencing Guidelines, which were enacted in 1991 and later amended in 2004. These Guidelines set forth sentencing recommendations for a variety of criminal offenses– including those for “organizations” (such as a hedge fund). Thus, if a hedge fund were to have been convicted of engaging in criminal conduct, the court would look to the Sentencing Guidelines for a recommendation on penalties.
An organization can become criminally liable for wrong-doing whenever an employee commits an offense within the scope of his/her employment, even if the act was contrary to company policy.The entire organization can be held criminally liable for that individual’s illegal actions. However — and this is a big “however”- the Guidelines have built into them the ability to mitigate a fine by up to 95% if the organization can demonstrate that it had an effective compliance program (assuming prompt reporting and non-involvement of high level employees).
So, what do the Guidelines tell us about compliance programs? They are actually quite specific, laying out 7 key aspects of a compliance program which would presumably qualify an organization for mitigation credit. These 7 criteria are:
1. Establish policies and procedures to protect and detect non-compliance with regulations;
2. Management must be proactive in overseeing the compliance program;
3. Not allowing employees who have engaged in some form of misconduct in the past from holding an authoritative position in the compliance program;
4. Effective communication of the compliance program to officers so that they can carry them through the organization;
5. Monitoring and auditing of the compliance program and maintenance of an effective reporting system;
6. Effective enforcement of the program (through incentives or disciplinary actions); and
7. Taking appropriate steps to prevent recurrence once non-compliance is discovered.
The Guidelines’ compliance concepts have been incorporated into regulations in a variety of areas, including those relating to the regulation of investment advisers by the SEC. Those in hedge fund management may not be aware of the derivation of many of the compliance concepts that are being implemented in their organization right now as they prepare to register with the SEC. An understanding of the importance of the compliance program that is derived from an understanding of these Sentencing Guidelines is a key tool for compliance officers.
The US Sentencing Commission has its website at: http://www.ussc.gov. A summary of the organization guidelines can be viewed at: http://www.ussc.gov/Guidelines/Organizational_Guidelines/ORGOVERVIEW.pdf.
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