Regulatory Changes: Impact on Energy and Financial Service Companies

Regulatory Changes

 

Please join me for a special event that I organized and am moderating for the New York Society of Security Analysts (NYSSA) in my role as Chair of the Regulation and Market Integrity Leadership Group.

As Founder and Principal of Yarden Law Firm, it is important to me to work with NYSSA, a leading forum for the investment community whose membership consists of portfolio managers and investment analysts. The focus on regulations and their impact on different sectors from an investment perspective is a new initiative that I’m spearheading at NYSSA.

I hope you can join me for two panel discussions that will explore how current and anticipated regulatory changes will impact two critical investment sectors: energy and financial services. Details, including speakers, are listed below.

WHEN & WHERE

Regulatory Changes: Impact on Energy and Financial Service Companies
June 6, 5-8pm (registration opens at 4:30pm)
NYSSA Conference Center | 1540 Broadway #1010

 

SPEAKERS

Nir Yarden
Founder & Principal, Yarden Law Firm, LLC

Bradley Ball
Financial Sector Strategist, UBS

Brian Golob
Principal, Conduct & Regulatory Risk Management, Greenwich Associates; Former Global General Counsel & Chief Compliance Officer, Russell Investments (2009-2017)

Adam Gilbert
Risk and Regulatory Co-Leader, PwC Financial Services Advisory

Mark Menting
Partner, Financial Services Group, Sullivan & Cromwell LLP

Avi Garbow
Partner, Gibson, Dunn & Crutcher; Former General Counsel, U.S. Environmental Protection Agency (2013-2017)

Diana Liebmann
Partner, Haynes & Boone, LLP (Power & Utilities)

George Hopkins
Partner, Vinson & Elkins LLP (Oil & Gas)

 

NYSSA

New Proposed IRS Regulations: Investor + Manager Considerations

Selective focus on the watch on the hand of busy man wearing white shirt tie and blue jacket

In late July, the IRS released new proposed regulations related to certain manager fee waiver and profits interest arrangements. The release has important implications for both managers and investors. To date, little attention  has been paid to how the proposed IRS regulations impact investors. In this video, Nir Yarden and David Spencer, a tax lawyer, discuss the IRS release and practical issues that both managers and investors should consider.

The topics in this video include:

0:00 – Background
2:51 – Investment Fund Fee Waiver Arrangements
4:25 – Aggressive Approach Example
6:07 – Conservative Approach Example
7:09 – New Direction? Potential IRS Audit Concerns
9:20 – Profits Interest
10:42 – Manager Considerations: Economic Risk
13:27 – Investor Considerations: Notices, Operating Agreements and Risk Management

Alternative Fund Investing: Not a Spectator Sport

Why do large investors like pension plans and university endowments use lawyers to assist them with their investments in things like hedge funds, private equity funds, real estate, and commodity funds?

Beyond just reviewing legal terms, lawyers assist alternative asset investors in 4 important ways:

  1. Lawyers play an important risk management role. They assess legal and regulatory factors associated with an investment fund or manager that could lead to potential investment loss.
  1. Lawyers help investment professionals and advisers meet the fiduciary duties they owe to their clients.
  1. Lawyers help investors better position their investment relative to the initial terms that a manager may offer. They put in place certain agreements between an investor and manager to supplement the terms of an investment.
  1. Because an alternative investment fund is often made up of many investors, each of which is looking out for their own interest, a good lawyer can help an investor better position its investment relative to other fund investors in the fund.

And a lawyer should be able to do all that in a way that’s affordable to an investor.

To many people, including investors and their investment advisers, the concept of working with a lawyer on their alternative fund investments is new.

It shouldn’t be. Many investors are doing it now.

Or they may not think that they’re big enough relative to other private fund investors that they would derive any benefit from this legal service.

They shouldn’t. The same four concepts that were discussed earlier can be used by a lawyer to benefit an investor regardless of the amount of money that they’re allocating to a fund.

Or they may think they can’t afford these legal services.

In fact, legal services in these areas typically are scaled up or down depending on things like the nature of the investment being made and a client’s preferences, making use of such legal services accessible to most private fund investors and their investment advisors.

According to the SEC, as of May, 2015, there were roughly 4,400 investment managers registered with the SEC that provide advice on approximately $10 trillion dollars in assets to 28,500 private fund clients, made up of different individuals and entities.

In my opinion, every one of those 28,500 private fund investors and their investment advisors deserves an advocate who can help navigate and negotiate these investments in an affordable and efficient way. They need a lawyer who strives to empower them.

Alternative fund investing is an involvement sport — not a spectator sport.

Investors and their investment advisors need to be proactive in considering the risks associated with a particular investment and how best to position that investment regardless of size.

My goal at Yarden Law Firm is to help and to empower you in that critical task.

8 Reasons Why Legal Due Diligence is Critical

Due diligence on an alternative investment fund or manager to identify legal and regulatory risk issues is critical to making well-informed investment decisions.

By alternative investment funds, I’m referring to things like hedge funds, private equity funds, real estate and commodities funds.

Here are eight reasons why this due diligence is so important:

  1. Legal and regulatory issues associated with an investment fund or manager can sink an investment.
  1. Legal and regulatory due diligence can reveal something on the background of the folks who will be managing your money or your client’s money — and that really matters.
  1. Uncovering legal and regulatory issues associated with a manager or investment can strengthen an investor’s bargaining position if they decide to move forward with an investment.
  1. Legal and regulatory issues associated with a manager of a fund have a way of winding up as news stories – we call that “headline risk” and that’s not fun for any investor or adviser.
  1. Once an alternative fund investment is made and problems emerge, investor money can be stuck in a fund longer than an investor anticipates when it comes to things like hedge funds. Doing the due diligence work before an investment is made to anticipate problems and address them pre-investment is therefore important.
  1. Mangers that knowingly make false statements in their registration statements that they file with the SEC can be held liable. Due diligence on these regulatory documents is an excellent way to cross check the veracity of certain information in a fund’s selling documents.
  1. Conducting legal and regulatory due diligence on a fund and manager both before and after an investment is made can help address fiduciary duties that investment professionals may owe to their clients.
  1. The last place you want to be stuck in is in a herd of investors stampeding out the door if some material issue emerges that could have been flagged prior to an investment being made. That’s when things like gates start kicking in with hedge funds.

21 Notices that Matter in Private Fund Investments

In alternative investment funds, the act of managers providing investors with notice of certain events is an important but often overlooked area that governing manager-investor relationships.

The notice mechanism is essential to make investors aware of certain situations to protect their investment interests.

It’s usually up to each investor and their lawyer to determine whether the notice provisions provided in a fund’s selling documents are sufficient or whether there are other areas not covered that warrant notice by a manager.

So here are 21 notice situations to consider with private fund investing, including hedge funds, private equity, real estate, and commodity funds.

  1. Side Letters: A manager enters into existing or future “side letters” with preferential terms granted to other fund investors.
  1. Fund Terms: Changes to fund terms including fees, expenses, liquidity, and reporting requirements
  1. Breaches: Breaches of fund documents or fiduciary duties by a fund’s manager or general partner
  1. Regulatory: Non-routine investigations of a fund, its general partner or manager
  1. Legal Matters: Regulatory claims brought against a manager or its personnel, findings of securities law violations or convictions
  1. Tax Audits: IRS or foreign tax audits performed on a fund
  1. Key Person: Key person events are triggered.
  1. Investments: In the case of hedge funds, “side pocket” investment is made or contemplated.
  1. Redemption: In the case of hedge funds, managers suspend redemption rights or payments, “gate” or otherwise restrict redemption or suspend determination of fund net asset value.
  1. Changes to Fund Policies: Changes to a fund’s policies that impact investors. For example, changes to expense, valuation or allocation policies.
  1. Amendments: Amendments to fund documents are proposed or made or amendments are made to Form ADV filed with SEC.
  1. Board/Advisory Committee-Related: Board or advisory committee meetings are scheduled or board or advisory committee members are appointed or leave.
  1. Service Providers: Changes to service providers occur including changes to accountants, custodians or prime brokers
  1. Changes to Fund’s Manager or General Partner: Changes to a fund’s general partner or manager including change of control, insolvency or bankruptcy or material adverse changes to the business of a fund’s general partner or manager.
  1. Insider Withdrawals: Withdrawals of investment by fund “insiders” or affiliates beyond a specified amount
  1. Fund Reorganizations: This one is self-explanatory.
  1. Distribution In-Kind: Fund distributions in-kind occur or proposed to occur.
  1. Personnel Changes: Changes to a manager’s or general partner’s personnel including investment and operation staff
  1. Changes in Net Asset Value: With hedge funds, a material decline in a fund’s net asset value.
  1. Indemnification: Indemnification claims are made.
  1. Tax: Miscellaneous tax-related notices specific to an investor

 

SEC Proposes Manager Disclosure: Investor Considerations

There are currently 4,364 SEC-registered investment managers that provide advice on $10.1 trillion in assets to 28,532 private fund clients. (1) Late Wednesday, May 20th, the SEC released proposed changes to Form ADV — the form that managers use to register with the SEC, along with amendments to the Investment Advisers Act.

What are material changes that the SEC is proposing that you should keep an eye on? If you’re one of those 28,532 investors, an investment adviser or a manager, here are some suggestions and thoughts:

1. Separate Managed Account Businesses are Now in Focus
To date, the SEC has collected “detailed information about pooled investment vehicles, but little specific information regarding separately managed accounts.” (2) The proposed changes to Form ADV seek to fill this gap: New proposed disclosure would require a manager to list certain aggregate information on their separate account business including 1) regulatory assets under management, 2) types of assets held in separate accounts and 3) the use of separate account derivatives and borrowings.

2. Greater Visibility on Manager’s Overall Business Mix and Capabilities
Investors allocating money to a manager typically fall into one of three categories. Their money is managed in 1) registered and/or unregistered pooled investment vehicles, 2) separate managed accounts, or 3) some combination of both. The proposed SEC changes, in my opinion, provide investors and their gatekeepers with greater insight on a manager’s overall business mix, product capability, and limitations when considering an investment allocation.

3. Specific Numerical Client Count
A manager’s overall client mix in terms of investor category is currently listed in Form ADV, pursuant to a range. A proposed SEC change would require managers to list out the specific number of clients whose money they manage, pursuant to different investor categories. For certain investors that are sensitive as to whether a manager’s composite mix of clients is reflective of their own status, this change may be useful.

4. All Written Performance Calculations Must be Retained
A regulatory record retention rule will be modified to provide that managers must now keep documentation that “demonstrates performance calculations or rates of return in any written communications that the adviser circulates or distributes, directly or indirectly, to any person.” (3) For managers that are currently not abiding by this standard (the current rule requires retention at a higher threshold), this is an important change. This change may provide investors with additional due diligence data points related to a manager’s investment performance both before and after an investment is made.

5. Comparable Analysis Across Different Managers
The overall thrust of the SEC changes, in my opinion, is to make comparable manager analysis across different products and capabilities easier. The proposed SEC changes are now subject to a public comment period after which the proposed changes may become effective subject to any SEC changes.

Here’s the release: http://www.sec.gov/rules/proposed/2015/ia-4091.pdf (PDF)

(1) Amendments to Form ADV and Investment Advisers Act Rules, May 20, 2015, p. 27.
(2) Ibid, p. 6.
(3) Ibid, p. 7.

Confidentiality Agreements: 10 Issues

A manager may require a potential investor to sign a confidentiality agreement prior to making any investment.

Managers do this for two important reasons:

First, they’re subject to private placement rules associated with the sale of hedge fund interests. They want to ensure compliance with those rules.

Second, they don’t want sensitive information about their operations or investment program to be leaked.

The typical agreement that an investor will be asked to sign may be short, perhaps seven or eight pages.

These contracts are typical “off the-shelf” agreements that a manager will look to use with many prospective investors.

As an investor, it’s tempting to sign these agreements as is.

However, it’s important to recognize that these agreements are contracts that can bind a potential investors to significant restrictions even if they ultimately decide not to move forward with an investment.

So here are 10 issues to consider in connection with pre-investment hedge fund confidentiality agreements:

  1. The definition of confidential information is overly broad.
  1. The agreement is open-ended with no termination date.
  1. Contract terms conflict with the confidentiality provisions in fund documents.
  1. Limitations are present on an investor’s ability to share information with advisors.
  1. Exceptions to confidential information are too limited.
  1. Manager exculpation clauses on information provide don’t account for anti-fraud concerns.
  1. Contract terms interfere with an investor’s ability to respond to legal matters unencumbered.
  1. Onerous choice of law provisions are present.
  1. Onerous ongoing expense requirements are present.
  1. Agreements lack basic contractual clauses (for example, clauses related to the validity of amendments).

Investors are in the business of making investments — not running confidentiality agreement programs that go beyond legitimate manager concerns.

So beware.

Hedge Fund Defined: 7 Structural Features

When people define what a hedge fund is, they often focus on a fund’s investment strategy. I think any hedge fund definition should also incorporate structural features that may be present.In this talk, we’ll focus on seven hedge fund features that you may not find in other hedge fund definitions. I’ll provide a brief commentary on each one.

First some basics: A hedge fund is a private investment vehicle that is usually managed by an investment adviser for fees.

Hedge funds are not registered under the Investment Company Act of 1940, the federal statute that governs registered investment funds like mutual funds.

Their interests are sold in the U.S. to high-net worth individuals and institutions pursuant to private placement rules.

In the U.S., hedge funds are often organized as limited partnerships.

Now let’s turn to some not so obvious features that are often present in hedge funds.

These features are embedded in a fund’s legal terms.

1. A hedge fund is an economic bargain.
A hedge fund is an economic bargain.

An investor pays fees and expenses and, in turn, a manager provides investment management services.

Within those broad parameters, fund investment terms are often negotiated between a manager and one or more of its investors.

These negotiated terms can include fund fees, fund reporting obligations and an investor’s liquidity rights to redeem out of a fund.

 2. A hedge fund is a contract.
A really big contract with many investor obligations.

How big? In my experience, a hedge fund’s limited partnership agreement can run 40 or 50 pages. A subscription agreement which is also a contract can run 10 or 15 pages taking out the administrative pages.

Add to those 50 or 60 pages of contractual terms a fund’s private placement memorandum that contains terms that have a material impact on manager-investor relations and you can add another 100 pages to the contract pile.

3. A hedge fund is often part of multi-tiered, multi-jurisdictional ecosystem.
The use of the term “hedge fund” in the singular in many cases is only partially descriptive.

An investor may be investing into one fund but often that one fund acts as a “feeder” fund that, in turn, invests into a much larger overall fund structure.

Those fund structures often involve multiple interconnected funds and span multiple international jurisdictions with different rules and regulations than the U.S.

Here’s an example: In this case, a US limited partnership is investing into a Cayman Islands fund that acts as the structure’s overall “master fund” pooling different investment vehicles together.

4. Many hedge funds continuously sell fund interests.
Hedge funds can be continuously open to new investors. These funds are constantly selling their fund interests.

Contrast that with private equity funds that usually have a finite length of time that they are open to new investors.

If you’re an investor in such a hedge fund, how have you accounted for this?

What pressure, for example, is a manager under to change a fund’s investment terms for investors coming into the fund later?

5. Hedge funds are not self-liquidating.
Hedge funds typically are under no obligation to make distributions of fund interest.

The onus is on investors to redeem their interest out of a fund so the ability to monitor a fund’s performance and a manager over the course of an investment becomes critical.

6. Hedge fund structures are not static.
The pressure on a manager to grow overall assets under management means that managers can often form new funds with similar investment objectives and change existing structures to bring in new assets under management.

How are investors interests impacted by these changes?

 7. Hedge fund disclosure standards vary.
Hedge fund interests are sold pursuant to selling documents such as private placement memorandums.

Generally, the disclosure standard used is that there should not be “a material misstatement or omission” in these selling documents material to an investor’s decision on whether to invest in a fund or not.

But what one lawyer’s interpretation of this standard is when it comes to actually drafting hedge fund selling documents may be different from another.

Investors and their investment advisers should be cautious when picking up different hedge fund selling documents such as a private placement memorandums and assuming that the disclosure across these different fund products is the same.

Technique for Assessing Manager Information

How does an investor assess the accuracy of marketing material provided by a hedge fund manager to make a properly informed investment decision? Factors like whether a manager’s past performance numbers or track record is accurate and isn’t cherry-picked to reflect just positive results?

The issue is critically important for investors and its solution isn’t as simple as it may seem.

Hedge fund interests are sold in the U.S. pursuant to a private placement rules.

Hedge fund investors are often required to sign extensive confidentiality agreements by managers during the investment process.

Once executed, these confidentiality agreements can limit an investor’s ability to share specific manager or fund information with third parties.

Also, certain advisors to investors who may have access to manager-specific information under these confidentiality agreements may have limited information related to a particular manager.

Being an investor in a hedge fund can be a lonely experience.

The good news is that the area of marketing and advertising by investment managers is something that has gotten a lot of attention by the SEC over the years.

The SEC has issued extensive rules and interpretations designed to prevent activities by managers that might be deemed fraudulent, deceptive or manipulative related to the sale of their fund interests.

Hedge fund marketing and advertising material, whether it’s included in a manager’s PowerPoint presentation, letters or other communication with existing or prospective investors, is subject these antifraud rules.

These SEC rules and guidance provide important guide posts for how managers are supposed to present their marketing material. For example, these rules and guidance generally

  1. Limit a manager’s use of testimonials;
  1. Limit a manager’s ability to cite past specific recommendations without properly qualifying the information; and
  1. Require the presentation of manager performance data net of fees.

Now whether a manager follows the rules or not is obviously important.

The consequence of an investor relying on marketing material that is misleading or deceptive related to such things as a manager’s track record, can be disastrous.

Investors can never be too careful when their hard earned money is at stake.

In my opinion, the anti-fraud rules are an important filter that can be used by investors and their investment advisors to critically analyze a manager’s marketing material to ensure its compliance with SEC guidance.

The Game is Four Quarters

You’ll often hear NFL coaches’ breakdown the regular 16 game season into four quarterly parts.

By breaking down the football season into four parts, NFL coaches believe that they’re better able to assess their teams play over measurable chunks to implement the inevitable changes that will have to be made as the season goes through its different phases.

For those coaches, breaking down the football season into separate parts helps improve the process of managing a football team.

I think the NFL approach is a good one to emulate when thinking about the hedge fund investment process.

The hedge fund investment process can be also be broken down into four distinct parts.

First: Due Diligence
The first phase of the hedge fund investment process usually consists of investor due diligence on a manager and their fund product.

Second: Negotiation
Assuming that an investor decides to move forward, the second phase is the negotiation phase of an investment.

It’s usually during this second phase that final deal documents are executed, a side letter agreement between a manager and an investor is struck and money is wired into a fund.

Third: Monitoring
Once an investment has been made into a hedge fund, we enter into the monitoring phase of the investment process.

A manager is investing a fund’s proceeds, while investors and their advisors are monitoring the results of that investment program.

This phase can be relatively long or short depending on the results of fund and other factors impacting an investor or manager.

Fourth: Exit
Fourth is the investment exist phase when an investor looks to pull their money out of a hedge fund for a variety of reasons. Like the investment monitoring phase, the fund exit phase can be relatively long or short depending on the circumstances.

Now in reality, many times the hedge fund investment process is not so clear cut and different phases can blur together. The process of due diligence on a manager or their fund product can continue long after an investment is made.

However, I do think that breaking down the overall hedge fund investment process into these four distinct phases is productive by helping investors isolate risk over the entire investment cycle.

By breaking down the overall investment process into these distinct phases, an investor is better able to isolate hedge fund term risk and where it may spring to life.

This helps answer a critical question: Can an investor live with a particular hedge fund term, seek to modify it, or simply not make the investment?