Hedge Fund Report - Summary Of Key Developments - Fall 2012

This continues to be a time of rapid change for the hedge fund industry, as the Securities and Exchange Commission (the "SEC"), the Commodity Futures Trading Commission (the "CFTC"), and various other regulatory agencies, including the Federal Reserve Board (the "Federal Reserve") and the Department of the Treasury (the "Treasury"), continue to propose and finalize rules to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). There have also been a number of significant developments in the hedge fund tax area, and the SEC and private plaintiffs have continued to bring enforcement actions and litigation involving hedge funds and other types of private investment funds and fund managers.

This Report provides an update since our last Hedge Fund Report in Spring 2012 and highlights recent regulatory and tax developments, as well as recent civil litigation and enforcement actions as they relate to the hedge fund industry. Paul Hastings attorneys are available to answer your questions on these and any other developments affecting hedge funds and their investors and advisers.

1. SECURITIES-RELATED LEGISLATION AND REGULATION

   1. Dodd-Frank Rulemaking

      The following is the status of various proposed and final rules and regulations implementing the Dodd-Frank Act that are most relevant to the hedge fund industry.

      1. Federal Reserve Clarifies Volcker Rule Conformance Period

         On April 19, 2012, the Federal Reserve issued a statement clarifying the duration of the conformance period for Section 619 of the Dodd-Frank Act, also known as the "Volcker Rule." The Volcker Rule generally prohibits a banking entity from (i) engaging in short-term proprietary trading of any security, derivative and certain other financial instruments for the banking entity's own account; or (ii) owning, sponsoring or having certain relationships with a hedge fund or private equity fund. The Dodd-Frank Act requires the Federal Reserve to adopt rules regarding the conformance periods for activities and investments covered by the Volcker Rule, which it did in a final rule dated February 9, 2011 (the "Conformance Rule"). The Federal Reserve's statement confirms that the Conformance Rule grants entities covered by the Volcker Rule the full two-year period after the Volcker Rule's July 21, 2012 statutory effective date (i.e., until July 21, 2014) fully to conform their activities and investments to the Volcker Rule, unless the period is further extended by the Federal Reserve. Additional information on the Federal Reserve's statement is available here. A final rule implementing the Volcker Rule is still pending, despite increased pressure from legislators to finalize the implementing regulations.1

      2. SEC and CFTC Adopt Joint Final Rules Defining "Swap," "Security-Based Swap" and "Security-Based Swap Agreement"

         On August 13, 2012 the SEC and the CFTC (collectively, the "Agencies") issued joint final rules clarifying the definitions of "swaps" and "security-based swaps" under Title VII of the Dodd-Frank Act ("Title VII"). Title VII established a new regulatory framework for oversight by the CFTC of swaps, by the SEC of security-based swaps, and jointly, by the Agencies, of mixed swaps. Title VII defined "swaps," "security-based swaps" and "security-based swap agreements" for the purposes of the Dodd-Frank Act and mandated that the Agencies issue rules to define further the terms.

         The Agencies, through the joint final rules, further clarified the treatment under these definitions of certain types of agreements, contracts and transactions. Under the joint final rules, certain foreign exchange products, foreign exchange forwards, foreign exchange swaps and forward rate agreements are defined as swaps, while certain insurance products, commercial agreements, contracts and transactions involving customary business arrangements are excluded from the definition of swaps. The joint final rules became effective on October 12, 2012.

         As discussed in our last Report, effective December 31, 2012, the CFTC rescinded the exemption from registration as commodity pool operators ("CPOs") under CFTC Rule 4.13(a)(4), commonly relied upon by certain private fund advisers. Private fund advisers should review the definitions in the joint final rules to determine their eligibility for the exemption from CPO registration under CFTC Rule 4.13(a)(3) (the de minimis exemption), and will have until December 31, 2012 to file a notice of exemption or to register with the CFTC as CPOs. On August 14, 2012 the CFTC Division of Swap Dealer and Intermediary Oversight released responses to frequently asked questions ("FAQs") regarding CPO compliance obligations. Additional information on the Agencies' joint final rules is available here and the FAQs are available here.

      3. SEC's Proposed Rules for Security-Based Swap Dealers and Major Security-Based Swap Participants

         On October 17, 2012 the SEC voted unanimously to propose rules creating capital, margin and segregation requirements for security-based swap dealers ("SBSDs") and major security-based swap participants ("MSBSPs") subject to SEC jurisdiction, as required by Title VII of the Dodd-Frank Act. The proposed rules (i) set minimum capital requirements for SBSDs (proposed Rule 18a-1 and Rule 15c3-1 amendments) and MSBSPs (proposed Rule 18a-2) (the "Minimum Capital Rule"); (ii) establish margin requirements for SBSDs and MSBSPs with respect to non-cleared security-based swaps (proposed Rule 18a-3) (the "Margin Rule"); and (iii) establish segregation requirements for SBSDs and notification requirements with respect to segregation for SBSDs and MSBSPs (proposed Rule 18a-4) (the "Segregation Rule").

         The Minimum Capital Rule would subject all SBSDs to a fixed dollar capital minimum (generally, $20 million) plus an additional amount equal to eight percent (8%) of the margin required for cleared and non-cleared security-based swaps. The Margin Rule would require SBSDs, in the absence of an applicable exception, to collect margin collateral from counterparties to non-cleared security-based swaps transactions to cover current exposure and potential future exposure. The Segregation Rule would require SBSDs that maintain custody of customer securities and cash to (i) maintain physical possession or control over all excess securities collateral that has been provided by such customers to the SBSD and (ii) maintain a reserve of funds or qualified securities in an account at a bank that is equal in value to the net cash owed to customers.

         In addition to the Margin Rule, Minimum Capital Rule and Segregation Rule, the proposed rules impose certain risk management standards on SBSDs and MSBSPs. The comment period for the proposed rules will close sixty (60) days after publication of the proposed rules in the Federal Register. Additional information on the SEC's proposed rules for SBSDs and MSBSPs is available here.

      4. SEC's Three-Part Supervisory Strategy for Newly Registered Private Fund Advisers

         On October 9, 2012, in an open letter from Drew Bowden, Acting National Associate Director of the SEC's Office of Compliance Inspections and Examinations ("OCIE"), to senior management of newly registered investment advisers (i.e., those that registered with the SEC after July 21, 2011) the SEC announced the launch of its initiative to conduct focused, risk-based examinations of investment advisers to newly registered private funds (the "Presence Exam Initiative"). These examinations will be conducted through OCIE's National Exam Program ("NEP"). The Presence Exam Initiative, which was also described by OCIE's Deputy Director Norm Champ in a May 11, 2012 speech before the New York City Bar Association, has three distinct phases: an "engagement phase", an "examination phase" and a "reporting phase."

         The "engagement phase" is an educational phase that features speeches, staff letters, risk alerts and various other compliance outreach materials, available on the SEC's website. Its purpose is to inform newly registered firms of their obligations under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), describe the Presence Exam Initiative and explain OCIE's examination practices. In the examination phase, OCIE staff will review one or more identified "higher-risk" areas of the business of advisers selected for on-site examination, including but not limited to the advisers' marketing, portfolio management, conflict of interest controls, client asset protection measures and valuation policies. OCIE expects these examinations to occur over a two year period, after which, in the "reporting phase," OCIE intends to report its observations to the SEC and to the public.

         NEP staff will contact newly registered investment advisers separately if they have been selected for an examination. Mr. Bowden's open letter to senior management of newly registered investment advisers is available here, and the full text of Mr. Champ's speech is available here.

      5. SEC Offers Additional Guidance on Form PF

         On June 28, 2012 and July 19, 2012 the staff of the SEC's Division of Investment Management updated its Frequently Asked Questions on Form PF (the "FAQs"). The updated FAQs address, among other topics, general filing information for private fund advisers and provide interpretive guidance relating to hedge funds, liquidity funds, private equity funds and fund of funds. The FAQs also clarify certain key definitions in Form PF, including but not limited to "gross notional exposure," "net asset value," "borrowings" and "listed equity derivatives." The FAQs are available here.

   2. Other New and Proposed Securities-Related Legislation and Regulation

      1. Stop Trading on Congressional Knowledge (STOCK) Act Subjects Private Fund Advisers to Potential Insider Trading Liability

         On April 4, 2012, President Obama signed into law the Stop Trading on Congressional Knowledge Act (the "STOCK Act"). The STOCK Act, which...