Many of the hedge fund managers that have registered as investment advisers as a result of the new hedge fund adviser r gistration rule that became effective as of February 2006, are experiencing their first examination by the Securities and Exchange Commission (“SEC”), or soon will. The SEC’s Office of Compliance, Inspections, and Examinations has wasted little time gearing up to examine newly registered hedge fund managers and have made various public statements regarding the focus of these examinations. On the top of every SEC examination list for hedge fund managers is the onerous and opaque “conflicts of interest” review. But what does it mean for a hedge fund manager to have a conflict of interest with an advisory client, and how is the SEC likely to view practices that most hedge fund managers have taken for granted since they began managing their hedge funds?

At the heart of this discussion, is a basic conflict between the fiduciary duty owed by an investment adviser under Section 206 of the Investment Advisers Act of 1940 (the “Advisers Act”) and the ability of a limited partner of a Delaware limited partnership to contract away fiduciary duty under Section 15-103(f) of the Delaware Revised Uniform Partnership Act. Section 206 of the Advisers Act and the SEC rules, positions, and enforcement actions that have grown up around it, prohibits an investment adviser to engage in any conduct that is deceptive or would defraud a client or prospective client. The SEC has consistently stated, and various case law has reinforced, that an investment adviser owes the highest fiduciary duty to its client and may not use this position of trust to benefit at the expense of the client. Over the years, the SEC has brought numerous administrative and enforcement proceedings under Section 206 against investment advisers for violations of fiduciary duty.

However, under Delaware Law, a limited partner in a hedge fund is permitted to contract away the fiduciary duty otherwise owed to it by the general partner, other than the implied contractual covenant of good faith and fair dealing. In the U.S., most hedge funds are structured as Delaware limited partnerships in large part so that the general partner may avail itself of the protection against fiduciary liability Delaware offers general partners of hedge funds. In fact, the private placement memoranda (the “PPM””) of most hedge funds contain a section typically entitled “Conflicts of Interest” in which the hedge fund manager will describe any number of activities that could be construed as placing the interest of the general partner over that of the hedge fund and its investors. The partnership agreement indicates that the limited partner, by signing the partnership agreement, has read the PPM and agrees that none of the activities in which the general partner may engage will give rise to a cause of action by the limited partner. These activities often include the use of soft dollar arrangements that are outside the safe harbor of Section 28(e) of the Securities Exchange Act of 1934, engaging in principal transactions with the hedge fund, purchasing securities for the benefit of the general partner that are within the scope of permitted investments by the hedge fund, and managing other accounts or funds that may compete against the hedge fund. Thus, the disclosure to and approval by a hedge fund’s limited partner is generally thought sufficient to preclude future claims by the limited partners of a lack of good faith and fair dealing by the general partner with respect to this type of conduct. Unfortunately, this is exactly the type of conduct that is prohibited under the Advisers Act, and for which the SEC has brought enforcement action.

It is highly unlikely that the SEC will defer to Delaware law when it conducts an examination of a newly registered investment adviser that manages a hedge fund. To the extent the hedge fund manager has engaged in activities that would be considered to be a violation of the fiduciary duty standard, it is quite probable that the SEC would bring an administrative action to censure or fine the hedge fund manager or, depending on the perceived severity of the violation, recommend civil or even criminal enforcement action. It would not be out of character for the SEC to take the position that the mere inclusion of exculpatory language in the hedge fund documents is a violation of Section 206, because the hedge fund manager is attempting to obtain client approval for something the client is unable to waive. Because there is no private right of action under the Advisers Act, the SEC is more likely to view its role as the appropriate enforcer of the fiduciary duty standard, even if the perceived victims are sophisticated investors.

Where does this leave hedge fund managers? U.S. hedge fund managers should review their PPMs and their limited partnership agreements and conform these documents to the new standard to which they are now subject. Furthermore, because these managers are now registered advisers and subject to the Advisers Act compliance rule, they should also review and update their policies and procedures to make sure that the types of activities that may have once been permissible, are now flatly prohibited within the manager’s organization. The hedge fund manager’s systems should be revised and updated to enable the manager to detect violative behavior and correct any abuses that are found.

Non-U.S. hedge fund managers that have registered under the “registration lite” regime, must remember that the SEC has authority to examine all of the activities of the non-U.S. manager. Any activity that could be deemed to be a conflict of interest by the non-U.S. hedge fund manager, whether such activity was conducted with respect to its U.S. clients or otherwise, could give rise to an SEC enforcement action. Non-U.S. “lite” registrants that have been mis-advised that they may establish a Delaware limited partnership or limited liability company solely for the purpose of acting as the general partner to a U.S. hedge fund without full registration will have yet another surprise from the SEC. This failure to submit to full registration for activities conducted and advisory fees collected (including carried interest) in the U.S., will also likely be found to violate fiduciary principles.

Hedge fund managers must get out in front of this new regulatory scrutiny in order to avoid being the example that the SEC certainly seeks.

Note: Pillsbury Winthrop Shaw Pittman LLP represents hedge fund sponsors and advisers, prime brokers, and administrators through its 16 offices, located in global centers for capital markets, finance, energy, and technology.

For further information on the Pillsbury Winthrop Shaw Pittman LLP hedge fund practice, contact:

Jay B. Gould
San Francisco
+1.415.983.1226
jay.gould@pillsburylaw.com

Robert B. Robbins
Washington, DC
+1.202.663.8136
robert.robbins@pillsburylaw.com