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As we have previously discussed here, the Securities and Exchange Commission’s Asset Management Unit has been investigating whether hedge fund managers overvalue illiquid assets so as to generate higher management fees. Most recently, on October 25, 2010, the SEC charged hedge fund manager Stephen M. Hicks and his investment advisory businesses with defrauding investors in funds managed by Southridge Capital Management LLC and Southridge Advisors LLC by overvaluing the largest position held by the funds.

According to the SEC’s complaint, the largest holding of the Southridge funds was an investment in Fonix Corporation, which was valued at $30 million. The Southridge funds had acquired Fonix securities in exchange for securities of two telecommunications companies owned by the Southridge funds – LecStar Telecom, Inc. and LecStar DataNet, Inc. (collectively, “LecStar”). Southridge and Hicks valued the Fonix securities at their cost of acquisition, which they determined to be equal to the appraised value of the LecStar securities at the time of the exchange. The SEC alleges that the defendants knew or should have known that this appraisal did not reflect the “real” acquisition cost of the Fonix securities because it was based on erroneous information indicating that LecStar was profitable and assumed that an earlier transaction in LecStar securities had been negotiated at arm’s length when in fact it was a transaction between affiliates.

Even if Southridge and Hicks had properly calculated the acquisition cost of the Fonix securities, they would not have been permitted to use this as the basis of a valuation. The offering materials for the Southridge funds indicated that such investments would be valued based on a valuation provided by a clearing broker or independent pricing service rather than acquisition cost.

The SEC is seeking injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.

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The Investment Fund Law Blog has been selected as one of the LexisNexis Top 25 Business Law Blogs for 2010. You can read the full announcement and list of honorees here. We are in very good company in the Top 25, which includes such highly regarded blogs as thecorporatecounsel.net, the Harvard Law School Forum on Corporate Governance, and the M&A Law Prof Blog.

As you’ll note, voting for the top blog begins today and will last one week so please feel free to visit the site and vote to show your support. Thanks to all our readers who supported our nomination for this award.

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The Securities and Exchange Commission’s Asset Management Unit has been investigating whether hedge fund managers have overvalued assets in “side pockets” and then charged investors higher fees based on those inflated values. A side pocket is a type of account that hedge funds use to separate certain illiquid investments from the rest of their portfolio. Investors are typically not permitted to redeem their interest in a fund with respect to assets allocated to a side pocket until such assets have been liquidated or reallocated to the general portfolio by the investment manager.

Recent charges brought by the SEC highlight the need for hedge fund managers to establish reasonable policies for the valuation of illiquid assets and carefully adhere to such policies when valuing assets allocated to a side pocket. On October 19, 2010, the SEC charged two hedge fund managers and their investment advisory businesses with defrauding investors by overvaluing illiquid fund assets they placed in a side pocket. According to the SEC complaint, Paul T. Mannion, Jr and Andrews S. Reckles, through their investment adviser entities PEF Advisors Ltd. and PEF Advisors LLC, caused certain investments made by Palisades Master Fund, L.P. to be overvalued by millions of dollars.

Beginning in August 2004, the fund, at the direction of Mannion and Reckles, invested millions of dollars in World Health Alternatives, Inc. By July 2005, World Health was the fund’s largest single position and constituted at least 20% of the fund’s assets. As World Health (now bankrupt) began to experience financial difficulties, Mannion and Reckles became concerned about the value of the fund’s World Health assets and the potential for any report of substantial losses in relation to such assets to cause investors to redeem their interests in the fund. Recognizing the risk of large scale redemptions, Mannion and Reckles decided to place the World Health assets in a side pocket.

Palisades had adopted specific policies on how it would value different categories of securities and communicated those policies to prospective investors in its offering memorandum and financial statements. Mannion and Reckles allegedly valued the World Health assets contrary to the disclosed valuation policies, which resulted in such assets being significantly overvalued. Mannion and Reckles then charged management fees that were improperly inflated by their overvaluation of fund assets.

Robert B. Kaplan, Co-Chief of the SEC’s Asset Management Unit, commented:

Side pockets are not supposed to be a dumping ground for hedge fund managers to conceal overvalued assets. Mannion and Reckles deceived investors about the fund’s performance and extracted excessive management fees based on the inflated asset values in a side pocket.

The SEC is seeking injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.

 

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Under Secretary for International Affairs Lael Brainard recently delivered a speech at the Institute of International Bankers’ “Regulatory Dialogue with Government Officials” urging other nations to adopt the U.S. approach to hedge fund regulation:

It is also vital to have common agreement on the regulation of hedge funds, and to extend the perimeter of regulation to ensure stronger oversight of these funds. We have pursued international agreement on the same approach adopted by the United States: requiring all advisers to hedge funds, above a threshold, to register and report appropriate information so that regulators can assess whether any fund poses a threat to overall financial stability by virtue of its size, leverage, or interconnectedness. And to impose heightened supervisory and prudential standards on entities that do.

It is essential to ensure convergence of regulatory treatment for hedge funds to avoid a race to the bottom and promote a level playing field. Indeed, all the members of the G-20 committed to the same standards for oversight of hedge funds and to implementing these standards in a nondiscriminatory manner, and we are working hard to ensure these commitments are fulfilled.

The full text of the speech is available here.

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Hedge fund and private equity fund managers that use registered broker-dealers to raise capital on behalf of their funds should be aware of a recent report from the North American Securities Administrators Association (“NASAA”). The 2010 Broker-Dealer Coordinated Examination Report identifies the most prevalent compliance deficiencies by broker-dealers and offers a series of recommended best practices for broker-dealers to consider in order to improve their compliance practices and procedures.

Fund managers should conduct initial and ongoing due diligence on all of their agents and service providers, and no less so with third party marketers, which must be registered as broker-dealers.  Agreements between fund managers and their third party marketers should include representations from the marketer that no information will be given to potential fund investors that is not approved by the fund manager.  The agreement should include an indemnification by the third party marketer to the fund manager in the event a fund investor relies on information produced by the marketer that is not accurate and complete in all material respects.

A fund manager that understands the nature of past violations by a broker dealer/third party marketer will be in a better position to protect the reputation of his/her firm.  When conducting due diligence of third party marketers, fund managers should view the FINRA “Broker Check” tool and information provided by the SEC, as well as request information regarding past engagements of the third party marketer.  Fund managers should inquire about pending or ongoing regulatory investigations, customer complaints, and whether the third party marketer has implemented NASAA’s “10 Best Practices” for broker-dealers.

The NASAA Report took into account a total of 290 examinations conducted between January 1, 2010 and June 30, 2010, which found 567 deficiencies in five compliance areas.  The greatest number of deficiencies (33 percent or 185 deficiencies) involved books and records, followed by sales practices (29 percent or 164 deficiencies), supervision (20 percent or 115 deficiencies), registration and licensing (10 percent or 56 deficiencies), and operations (8 percent or 47 deficiencies).

The three most commonly found problem areas involved failure to follow written supervisory policies and procedures, advertising and sales literature, and variable product suitability. Half of the examinations involved one-person branch offices, 19 percent were home offices, 18 percent were branch offices with two to five agents, 10 percent were branch offices with more than five agents and 3 percent were non-branch offices.

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The Securities and Exchange Commission has proposed a new rule under the Dodd-Frank Wall Street Reform and Consumer Protection Act to define the term “family offices.” Advisers falling within this definition will be excluded from the definition of “investment adviser” under the Investment Advisers Act of 1940 and will therefore not be required to register with the SEC. Many family offices had previously relied on the “private adviser exemption” from registration, which exempted advisers with fewer than 15 clients from the registration requirement of the Advisers Act. As we have previously discussed, the Dodd-Frank Act removed the private adviser exemption from the Advisers Act.

Proposed Rule 202(a)(11)(G)-1 defines a family office as any firm satisfying the following three conditions:

  • Family Clients. Family offices may only provide investment advice to “family clients.” Family clients include family members, certain employees of the family office, charities established and funded exclusively by family members, trusts or estates existing for the sole benefit of family clients and entities wholly owned and controlled by family clients. Former family members may retain investments held through a family office but may not make new investments.
  • Ownership and Control. The family office must be wholly owned and controlled by family members.
  • Holding Out. The family office may not hold itself out to the public as an investment adviser.

The SEC noted that a family office that fails to meet the requirements of the new rule would still be able to seek an exemptive order from the SEC.

Comments on the proposed rule must be received by the SEC by Nov. 18, 2010.

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Written by Michael Wu and Judy Deng

Since 2007 there have been a number of circulars (i.e., ordinances issued by industrial regulators) and regulations pertaining to whether Chinese insurance companies are permitted to invest their assets in offshore (i.e., outside of China) private equity.  The following summarizes the relevant laws pertaining to this issue.

  • In 2007, the China Insurance Regulatory Commission (“CIRC”), jointly with China’s central bank (“People’s Bank of China”) and the State Administration of Foreign Exchange (“SAFE”), issued a circular to permit Chinese insurance companies to make certain types of offshore investments. Specifically, the circular stated that Chinese insurance companies were permitted to invest in offshore capital markets products, fixed income products, equity investments and public companies. Although the circular permitted offshore “equity investments,” which under applicable Chinese law includes private equity investments, so far there have not been any publicly reported investments by Chinese insurance companies in offshore private equity in reliance on the circular.
  • In August of 2010, the CIRC issued a circular to clarify certain investment policies applicable to insurance assets (“2010 Insurance Policies”). The 2010 Insurance Policies explicitly permit Chinese insurance companies to invest in offshore publicly issued bonds, investment funds and publicly traded stock; however, investment in offshore private equity was not explicitly listed as a permitted investment.  Accordingly, after the 2010 Insurance Policies were issued, it was not clear whether Chinese insurance companies could invest in offshore private equity.
  • In September of 2010, the CIRC issued a circular permitting Chinese insurance companies to invest in private companies and private equity located in China.  This circular suggests that Chinese insurance companies are not permitted to invest in offshore private equity.  Please refer to the blog titled China Permits Insurance Companies to Invest in Private Equity for additional information regarding the 2010 circular.
  • In addition, there is no consensus regarding whether a Qualified Domestic Institutional Investor (“QDII”) may make offshore private equity investments under the QDII regulations.  Under the QDII regulations, a QDII may apply for a quota to convert its RMB into foreign currency for purposes of making offshore investments. The QDII regulations enable Chinese investors to participate in offshore capital markets by investing in the products offered by QDIIs. The investment scope of QDIIs is strictly limited to banking products, bonds, public securities traded on specified stock exchanges, structured products and futures.

Unfortunately, the circulars and regulations above do not provide clear guidance regarding whether Chinese insurance companies may invest in offshore private equity.  Accordingly, non-Chinese private equity fund managers should contact us before accepting any investment from Chinese insurance companies to determine the risks of such investment and the extent to which such investment is permitted under applicable law in China.

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Written by Michael Wu and Judy Deng

A Chinese foreign-invested fund management company (“FIE FMC”) is a fund management company formed in China with at least one non-Chinese owner.  FIE FMCs are generally formed to manage foreign-invested PE/VC funds located in China (“Foreign-Invested RMB Fund”), such as Foreign-Invested Venture Capital Enterprises (“FIVCEs”) and Foreign-Invested Equity Investment Enterprises (“FIEIEs”).  A FIE FMC is subject to national regulations promulgated by China’s Ministry of Finance (“MOFCOM”), as well as applicable local regulations based on where the FIE FMC is registered.  The following highlights some of the key requirements and considerations for FIE FMCs.

  • Under the national regulations, in order to qualify as a FIE FMC, an entity must have at least three fund management professionals, each of which must have at least three years of venture capital or private equity fund management experience.  The applicable local regulations may have different, more rigorous standards.
  • Under the national regulations, a FIE FMC must have at least US$150,000 of net capital, also referred to as “registered capital,” which must be wired to the account of the FIE FMC generally within one to three years of registering as a FIE FMC with the appropriate regulatory authority.  The net capital requirements under the local regulations vary greatly from city to city and can be as high as US$2,000,000.
  • Retaining a FIE FMC may help a Foreign-Invested RMB Fund reduce its tax exposure in China.  For example, if a Foreign-Invested RMB Fund retains a FIE FMC to serve as its management company, the Foreign-Invested RMB Fund may be able to reduce the tax exposure that arises from being deemed a “permanent establishment” of its offshore investors.
  • Currently, there is no practical way for a FIE FMC to convert foreign currency into RMB to invest into a Foreign-Invested RMB Fund. Although some local authorities are attempting to address this issue, for the time being, a FIE FMC may only invest its foreign currency into a Foreign-Invested RMB Fund indirectly through an offshore affiliate.

Individuals who are thinking about forming a FIE FMC should contact us to determine what the local regulations are for FIE FMCs in the various jurisdictions and/or for any other advice regarding FIE FMCs or Foreign-Invested RMB Funds.

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Tagged: China and Private Equity
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On September 30, 2010, California Governor Arnold Schwarzenegger signed into law AB 1743, which regulates the activities of placement agents who solicit investments from public pensions on behalf of investment managers. The new law:

  • prohibits a person from acting as a placement agent in connection with any potential investment by a state public retirement system unless that person is registered as a lobbyist; and
  • requires placement agents acting in connection with any potential investment by a local public retirement system to file reports with a local government agency and comply with any applicable requirements imposed by such local government agency.

AB 1743 defines a “placement agent” as any person or entity hired, engaged, or retained by an external manager who acts or has acted for compensation as a finder, solicitor, marketer, consultant, broker, or other intermediary in connection with the offer or sale of the securities, assets, or services of an external manager to a California public pension. The definition excludes:

  • employees, officers, directors and equityholders of external managers who spend one-third or more of their time managing the securities or assets of the external manager; and
  • affiliates who manage assets of a California public retirement system if the external manager (i) is registered with the SEC or an appropriate state securities regulator, (ii) is selected by a competitive bidding process and (iii) agrees to a fiduciary standard of care.

AB 1743 is effective as of January 1, 2011.