On November 13, 2008, the U.S. House of Representatives Committee on Oversight and Government Reform (the “Committee”) held hearings with several industry academics and the five highest paid hedge fund managers regarding hedge fund operations and the future of hedge fund regulation.

The testimony from the industry academic panelists covered a wide range of topics, including:

Registration; Inspections and Disclosure. Some panelists suggested that hedge funds be required to register with the SEC; be subject to periodic inspections and be required to provide investors with more detailed information about their investment strategies, while another panelist argued that increased regulation could increase market instability and hurt investors;
Risk Measurement Reporting. Some panelists suggested that hedge funds, or their prime brokers, be required to provide risk measurements to regulators (and the public), including the size and nature of the fund’s risk positions and counterparties. One panelist suggested that the Federal Reserve may be the best regulator suited to monitor risk measurement reporting, while another panelist argued that such risk reporting and monitoring would create a false sense of security in the market that risk is being monitored and managed;
Treatment of Carried Interests as Regular Income. One panelist argued that the carried interest of hedge fund managers should no longer be treated as long-term capital gains and that such income be treated, for federal income tax purposes, as regular income;
Increased Hedge Fund Investment In Banks. A panelist recommended making it easier for hedge funds to invest in banks; and
Relaxing Mutual Fund Regulation. One panelist argued for decreasing investment restrictions for mutual funds to allow them to benefit from the same advantages as the hedge fund industry.
The testimony from the leading hedge fund manager panelists also covered a wide range of topics, including, among other topics:

Reasonable Regulation. Some panelists agreed that the regulation framework relating to hedge funds should be reviewed and that it may be appropriate to require hedge funds to register and to provide regulators with information to assess risk. Other panelists warned against over-regulation;
Ratings Agencies. A panelist gave testimony regarding the ratings agencies’ role in the current crisis, and proposed a new non-profit rating agency sponsored by bond buyers that would be funded by small transaction fees;
Treatment of Carried Interests as Regular Income. A panelist argued that if the tax treatment is changed for hedge funds' carried interest, the new requirements should apply to all partnerships; and
Performance Based Compensation. A panelist gave testimony regarding whether performance-based compensation is a positive incentive for fund managers because their success is tied to investors' success.

For more information, please see the Committee’s preliminary transcript of the hearing, available at:
http://oversight.house.gov/documents/20081114143312.pdf  

On October 22, 2008 the Delaware Court of Chancery ruled in Olson v Halvorsen, (C.A. No. 1884-VCL, 2008 WL 461831 (Del. Ch. Oct. 22, 2008), that although the Delaware Limited Liability Company Act expressly permits oral limited liability company operating agreements, the Delaware statute of frauds renders any provision within an oral operating agreement unenforceable if such provision can not be performed within one year.

The plaintiff in Olson v Halvorsen was one of several founders of a hedge fund and investment management firm. The plaintiff and the other founders established several limited liability companies through which they operated an investment manager and hedge funds. Although limited liability company operating agreements were drafted for each of the limited liability companies, all but one of the operating agreements remained unexecuted by the parties. The plaintiff was notified by the other founders that he was to leave the business. The unexecuted operating agreements provided that the plaintiff was entitled to a six year earn-out based on the profits of the limited liability companies. The other founders were not willing to honor such earn-out provision.

The Court considered the unexecuted operating agreements to be oral operating agreements, which are expressly permitted under the Delaware Limited Liability Company Act. Notwithstanding the Delaware Limited Liability Company Act’s allowance of oral operating agreements, the Court ruled that because the earn-out provisions in the unexecuted operating agreements could not be performed within one year, the Delaware statute of frauds renders such provisions unenforceable as oral contracts.

For more information please see: Olson v Halvorsen, (C.A. No. 1884-VCL, 2008 WL 461831 (Del. Ch. Oct. 22, 2008)

On November 20, 2008 FERC issued an order (the “Order”), which clarified FERC’s jurisdiction relating to certain investments in the securities of public utility companies. The Order is in response to a request by an investment adviser that FERC issue a “disclaimer of jurisdiction” with respect to investments in public utility companies by investment advisory accounts over which the investment adviser has investment discretion. In denying the investment adviser’s request for a “disclaimer of jurisdiction”, FERC found that: (1) the investment adviser is a public utility holding company under the Public Utility Holding Company Act (“PUHCA”) because the investment adviser has the power to vote more than 10% of the voting securities of a public utility company; and (2) the investment adviser was subject to Section 203(a)(2) of the Federal Power Act, which requires holding companies to receive prior authorization from FERC in order to acquire in excess of $10 million worth of the securities of certain public utilities and related companies.

However, although FERC found that the investment adviser fell under the pre-authorization requirements of Section 203(a)(2), FERC issued a blanket authorization to the investment adviser which would permit the investment adviser, and its advisory accounts, to acquire in excess of $10 million worth of the securities of certain public utilities, provided that: (a) each individual advisory account holds less than 10% of the voting securities of any public utility company or holding company; and (b) the investment adviser’s holdings together with all of its discretionary advisor accounts are less than 20%, cumulatively, of the voting securities of any public utility company or holding company.

FERC also reminded other entities in situations similar to that of the investment adviser that such entities must apply with FERC for authorization before February 23, 2009. After February 23, 2009, the failure to make a timely filing may result in potential civil penalties or other sanctions against such entity.

For more information please see:

FERC’s Press Release at: http://www.ferc.gov/news/news-releases/2008/2008-4/11-20-08-E-18.asp,
and the Order at: http://edocket.access.gpo.gov/2008/pdf/E8-27984.pdf  

On November 14, 2008 the Massachusetts Office of Consumer Affairs and Business Regulation announced that the compliance date for its new data privacy regulations (201 CMR 17.00) (the “Regulation”) has been extended from January 1, 2009 until:

May 1, 2009, with respect to:
Implementing contracts with third party service providers that comply with the Regulation’s requirements;
Encrypting laptop computers; and
All other requirements not otherwise extended to January 1, 2010.
January 1, 2010, with respect to:
Obtaining written certifications from third party service providers; and
Encrypting portable devices.

For more information please see the Commonwealth’s press release at:
http://www.mass.gov/?pageID=ocapressrelease&L=1&L0=Home&sid=Eoca&b=pressrelease&f=081114_IDTheftupdate&csid=Eoca

For more information on the regulations please see the WilmerHale Client Alert, “Protection of Personal Information: Massachusetts Requires Comprehensive Information Security Policy” at:
http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8529.

On November 17, 2008 the Treasury released a summary term sheet for the Capital Purchase Program (the “CIP”) for use by privately held and thinly traded financial institutions. The Treasury also released a “Frequently Asked Questions Sheet” that provides additional information for private banks. Any such eligible private institution seeking to participate in the CIP must submit an application by December 8, 2008. In order to participate in the CIP, an eligible institution must be approved by the applicable banking agency on or before January 15, 2009.

For more information please see:

The TARP Capital Purchase Program Summary Term Sheet at:
http://www.ustreas.gov/press/releases/reports/term%20sheet%20%20private%20c%20corporations.pdf 

The Private Bank Program Q&A at:
http://www.ustreas.gov/press/releases/reports/faq%20111708%20%20private.pdf 

The Application to participate in the CIP at: http://www.treasury.gov/initiatives/eesa/application-documents.shtml  

On November 20, 2008 the Treasury announced that it reached an agreement with a money market mutual fund to assist the fund with its liquidation. The fund was previously permitted to suspend redemptions as of September 17, 2008 in accordance with an order issued by the SEC. Under the agreement, the Treasury agreed to serve as a buyer of last resort for the fund’s securities, which consist of short-term government and government sponsored enterprise securities. The agreement grants the fund a 45-day period where it will continue to sell assets at or above their amortized cost. At the conclusion of this period, the Treasury's Exchange Stabilization Fund will purchase any remaining securities at amortized cost, up to an amount required to ensure that each of the fund’s shareholders receives $1 for every share they own. The agreement requires the fund's adviser and its trustees to waive their fees accrued after November 19, 2008 to the extent that fund shareholders do not receive distributions of $1 per share.

For more information, please see the Treasury Release available at:
http://www.treas.gov/press/releases/hp1286.htm; and

http://www.treas.gov/press/releases/reports/reservefundletteragreement.pdf  

On November 24, 2008 the Treasury announced an extension of the Temporary Guarantee Program for money market mutual funds (the “Program”) until April 30, 2009. Any funds that currently participate in the Program and meet the extension requirements are eligible to continue to participate. Funds that currently are not participating in the Program are not eligible to enter the Program. The Program will continue to provide coverage to shareholders up to amounts that they held in participating money market funds as of the close of business on September 19, 2008. Funds must make a Program extension payment and submit the extension notice by December 5, 2008.

The amount of the extension payment will be based on a fund's net asset value (“NAV”) as of September 19, 2008 as follows:

• for funds that had a market-based NAV greater than or equal to 99.75 % of their stable share price, the payment will be 0.015 %, 1.5 basis points, multiplied by the number of shares outstanding on September 19, 2008.
• for funds that had a market-based NAV less than 99.75 % of their stable share price but greater than or equal to 99.50 % of their stable share price, the payment will be 0.022 %, 2.2 basis points, multiplied by the number of shares outstanding on September 19, 2008.

For more information, please see the Treasury Release available at:

http://www.treas.gov/press/releases/hp1290.htm; and

http://www.treas.gov/press/releases/reports/moneymarketextension.pdf  

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) published a summary of its “Core Initial Request” for information during the routine examination of investment advisers that provide only “traditional money management services” to non-fund clients. Investment advisers that provide services to clients in addition to “traditional money management services” should expect to receive the Core Initial Request and an additional request for specific information that will allow the OCIE staff to evaluate compliance activities relating to the investment adviser’s additional services.

OCIE’s guidance contains a summary of information requested by the Core Initial Request, which includes:

• General Information. General information regarding the investment adviser’s business and investment activities, including organizational charts, demographic and other data regarding advisory clients, and a record of all trades placed for its clients.
• Compliance Risks. Information regarding the compliance risks identified by the investment adviser and the written policies and procedures established and implemented to address such risks.
• Internal Forensic and Quality Control Testing. Documents relating to the investment adviser’s quality control and periodic forensic testing, including the results of any compliance reviews or quality control analyses regarding the investment adviser’s client accounts, portfolio management procedures, brokerage arrangements, trade allocation procedures, insider trading policies and procedures and conflicts of interest.
• Remedial/Disciplinary Actions. Information regarding follow-up actions taken by the investment adviser to address shortfalls or breaches revealed by compliance reviews or quality control testing, including, warnings to or disciplinary action of employees, changes in policies or procedures, redress to affected clients, or other measures.
• Other Information. Compliance information regarding the investment adviser’s performance advertising and/or marketing, financial records and controls, custody arrangements and anti-money laundering policies and procedures.

OCIE’s summary also provides specific examples of the records and information that the Initial Core Request will cover.

For more information please see the SEC’s guidance, “Investment Adviser Examinations: Core Initial Request for Information” available at: http://www.sec.gov/info/cco/requestlistcore1108.htm  

For more information, please see the SEC Release available at:
http://www.sec.gov/news/press/2008/2008-275.htm  

On November 12, 2008, Treasury Secretary Henry Paulson held a press conference that included an update on the Troubled Asset Relief Program (“TARP”), the financial rescue package authorized by the Emergency Economic Stabilization Act of 2008. Secretary Paulson announced a major shift in the strategy behind the $700 billion financial-rescue program.

To date, $290 billion of TARP funds have already been committed to financial institutions. Instead of using the remaining TARP funds to buy up illiquid mortgage-related assets as originally envisioned, the Treasury now plans to use the funds in a broader campaign to bolster the financial markets to make credit more accessible for creditworthy businesses and consumers seeking loans.

Secretary Paulson also said that the Treasury is now considering making capital infusions into non-bank financial institutions, similar to the recent capital infusions made into eight banks. In addition, according to Secretary Paulson, the Treasury is considering a matching program in an attempt to leverage TARP’s impact by attracting investments of private capital in troubled financial institutions.

For more information on Secretary Paulson's remarks, please see:
http://www.treas.gov/press/releases/hp1265.htm  

On November 5, 2008, the Office of Foreign Assets Control (“OFAC”) of the U.S. Treasury Department (the “Treasury”) issued new guidance and revised existing guidance for the securities industry. The new guidance, "Opening Securities and Futures Accounts from an OFAC Perspective" (the “Account Guidance”) and revised guidance, "Risk Factors for OFAC Compliance in the Securities Industry" (the “Risk Matrix”) applicable to securities and futures firms clarifies OFAC’s compliance expectations regarding the administration and enforcement of list-based and country-based economic sanctions against targeted foreign countries and regimes, terrorists and terrorist organizations, and others (collectively, the “OFAC Sanctions”).

The Account Guidance aims to increase OFAC compliance by expressly stating that firms should develop risk-based OFAC compliance programs and sets forth factors to be considered in determining OFAC Sanctions risks. The Risk Matrix provides firms with details about the nature and scope of the due diligence process for each client/customer and intermediary and gives concrete examples of “high-risk” clients/customers and intermediaries.

In addition, the Account Guidance makes a clear link between OFAC’s rules and regulations and those of the Bank Secrecy Act (“BSA”), to which many securities and futures firms are also subject, and notes certain key distinctions between the OFAC Sanctions and BSA rules. The Account Guidance also provides guidance by recommending that firms screen the names and addresses of (i) new clients/customers and (ii) investments or transactions by or on behalf of such clients/customers, against the OFAC Sanctions.

For more information on the Account Guidance and Risk Matrix, please see the WilmerHale Regulatory Alert “OFAC Issues Compliance Guidance for Securities Industry” at: http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8541  

On November 4, 2008, the Securities and Exchange Commission Divisions of Investment Management and Corporation Finance (collectively, the “Staff”) granted no-action relief for liquidity providers who have agreed to purchase liquidity enhanced adjustable rate securities ("LEARS") from certain closed-end funds pursuant to a liquidity agreement. The closed-end funds plan to offer LEARS to address the systemic failures in the market for auction preferred shares. The closed-end funds will use the proceeds from the offerings to redeem their outstanding auction rate preferred shares.

The investment adviser to the closed-end funds requested that the Staff not recommend enforcement action pursuant to Section 16 of Securities Exchange Act of 1934 and Section 30(h) of the Investment Company Act of 1940 against the liquidity providers who will, after the consummation of the proposed transactions, own greater than a 10% beneficial interest in LEARS (“LP 10% Holders”) and therefore be subject to Section 16(a) reporting requirements. The Staff granted the requested relief for the following transactions under the liquidity agreement at prices equal to the liquidation preference plus accrued but unpaid dividends:

Purchases of LEARS in non-clearing remarketings;
Sales of LEARS in subsequent remarketings; and
Sales to the issuing fund of LEARS that have been continuously held by an LP 10% Holder for at least six months.
The no-action relief was granted based on the representations made to the Staff by the investment adviser. The adviser represented that LP 10% Holders will not have the opportunity to engage in the speculative abuse that Section 16 of the Exchange Act and Section 30(h) of the Investment Company Act were designed to deter because the liquidity agreement will contractually obligate them to engage in specified transactions at pre-determined times and based on a pre-determined pricing formula. The adviser further represented that the sale of LEARS provides liquidity which serves the same policy goal – to promote liquidity for an otherwise illiquid market – that was recognized by Congress in the enactment of Section 16(d) of the Exchange Act. Based on these representations, the adviser argued that to require Section 16(a) reporting by LP 10% Holders would impose an unnecessary burden.

For more information regarding this no-action letter, please see:
http://www.sec.gov/divisions/corpfin/cf-noaction/2008/blackrock110408-sec16.htm  

On November 11, 2008, Commodity Futures Trading Commission (“CFTC”) Chairman Walter Lukken, addressed a futures industry association and called for the replacement of the CFTC and the SEC with three new regulators to better regulate the increasingly complex U.S. financial system. Chairman Lukken proposed the creation of the following:

• A new systemic risk regulator, which would be responsible for policing the entire financial system and taking preventative actions with respect to risk;
• A new market integrity regulator, which would oversee the safety and soundness of key financial institutions, including exchanges, investment firms, and commercial banks; and
• A new investor protection regulator, which would be responsible for oversight of business conduct across all firms in the marketplace.

Chairman Lukken’s proposal is particularly noteworthy in light of recent public statements by SEC Chairman Christopher Cox, in which Chairman Cox called for a consolidation of the SEC and the CFTC into a single agency. According to Chairman Lukken, such a consolidation “is code for the larger SEC—along with its rules-based model and culture—taking over the principles-based CFTC.” Chairman Lukken further stated his view that such a consolidation would be ineffective and would reinforce the current outdated regulatory framework.

For more information regarding Chairman Lukken’s speech, please see: http://www.cftc.gov/stellent/groups/public/@newsroom/documents/speechandtestimony/opalukken-50.pdf  

On November 10, 2008, the Federal Reserve Bank of New York announced that on or about November 24, 2008, it would begin funding purchases of eligible money market instruments through the Money Market Investor Funding Facility (“MMIFF”). The MMIFF was created to support a private sector initiative designed to increase liquidity for U.S. money market investors. (See the October 28, 2008 edition of the WilmerHale Investment Management News Summary for further details on the MMIFF). In addition, the NY Fed announced that the frequently asked questions and terms and conditions documents regarding the MMIFF have been revised providing further details about the program, including information regarding enrollment for eligible investors.

For more information on the NY Fed's announcement, please see:
http://www.ny.frb.org/newsevents/news/markets/2008/an081110.html  

For more information please see: New York v. Samaritan Asset Management Services Inc., N.Y. Sup. Ct., No. 404969/06, October 29, 2008.

On October 16, 2008, the United States District Court for the Western District of Oklahoma, refused to dismiss a case against an insurance company alleging violations of the Investment Advisers Act of 1940 (the “Advisers Act”) related to the plaintiffs’ purchase of a variable life insurance product. The plaintiffs claim that the financial representatives of the insurance company violated fiduciary duties under the Advisers Act by failing to disclose the conflicts of interest created by the insurance company’s commission structure, fees, and other policies that gave the financial representatives incentive to put their own interests ahead of their clients.

The defendants argued that the insurance company’s financial representatives were not investment advisers within the meaning of the Advisers Act. The court assumed (for purposes of the motion) that plaintiffs’ insurance policy was a security and rejected the defendant’s arguments under the Advisers Act, concluding that:

• A sales representative of the insurance company could be an “investment adviser” under the Advisers Act simply by recommending the purchase of a proprietary life insurance policy instead of other products and by receiving a premium for that policy, regardless of whether investment advice was given, whether a specific fee was paid for the recommendation, and whether the agent had discretion over plaintiffs’ funds; and
• Rescission of the investment adviser’s contract is not the only available remedy under the Advisers Act. Rather, the plaintiffs could seek return of a portion of their insurance premiums they allegedly paid for investment advice.

The court noted that the Advisers Act would not be applicable at trial, if the insurance policy was not deemed a security or if it was determined that the policy was sold to the plaintiff on a “garden variety commission basis.”

For more information please see Robert L. Thomas, et al. v. Metropolitan Life Insurance Company, et al. (WD Okla.), CIV-07-0121-F.

After the announcement on September 16, 2008 that a major money market mutual fund’s NAV had fallen below $1.00, multiple lawsuits were brought against the money market fund, its adviser, and its officers and trustees. Currently, there are at least eleven cases pending in federal and state courts on various grounds, including negligence, violations of the federal securities law, breach of contract, breach of fiduciary duty and fraud. Two of the earliest cases were filed on September 19, 2008 and are discussed below.

In federal court in Minnesota a plaintiff alleges that the fund tipped off certain of its large investors regarding the impending decline in NAV below $1.00, permitting those investors to redeem in advance of the fund’s NAV decline. The plaintiff alleges that after the fund’s NAV fell below $1.00, representatives of the fund told the plaintiff about the alleged tip-offs and were surprised that the plaintiff had not also received the advance notice of the decline in NAV.

In federal court in New York shareholders brought a class action suit against the fund, its adviser, its officers and its trustees, based on investment and management decisions made in connection with the fund’s NAV falling below $1.00. The plaintiffs allege that the fund violated its stated investment objective by investing heavily in the commercial paper of Lehman Brothers Holdings Inc. in attempt to increase its yield by investing in the riskier commercial paper. The shareholders also allege that the fund violated its pricing policies by allowing certain investors to redeem their shares at $1.00 at 3:00 PM on September 16, 2008, rather than requiring all redemptions to be valued at the closing NAV of $0.97 at 5:00 PM on that date.

For more information please see: Ameriprise Financial Services, Inc. et al. v. The Reserve Fund, et al., No. 08-CV-5219, (Minn.) and George C. Dyer, et al. v. The Reserve Fund, et al., 08-CV-8139 (SDNY).  

On October 30, 2008 the U.S. Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) announced that it has withdrawn its proposed anti-money laundering (“AML”) program rules for investment advisers, hedge funds and commodity trading advisors. FinCEN stated that it will continue to contemplate whether to impose Bank Secrecy Act (the “BSA”) requirements on these entities, and if so, to what extent.

FinCEN noted that the activities of investment advisers, hedge funds and commodity trading advisors are not completely unregulated by the BSA scheme because financial transactions involving these entities and their clients are conducted through financial institutions that are subject to the BSA’s AML requirements.

For more information please see the FinCEN release at:
http://www.fincen.gov/news_room/nr/html/20081030.html  

On October 30, 2008 the SEC and the North American Securities Administrators Association announced that they will waive the initial filing and annual updating amendment fees paid by SEC-registered investment advisers, from November 1, 2008 through July 31, 2009.

For more information please see the SEC and NASAA Joint Press Release at:
http://www.sec.gov/news/press/2008/2008-259.htm  

On October 23, 2003 SEC Chairman Christopher Cox testified before the House Committee on Oversight and Government Reform regarding the role of the SEC in future regulatory reforms. In addition, on November 4, 2008, the Washington Post published an “Op-Ed” article by Chairman Cox discussing the role of the SEC in potential regulatory reforms and other related issues. The public statements called for the SEC to continue both its regulatory and enforcement functions.

After addressing some of the causes of the recent financial crisis, Chairman Cox recommended the following reforms to the financial regulatory system:

• The creation of a new overarching statutory scheme to increase coordination and communication among the SEC, the Commodities Futures Trading Commission (the “CFTC”), the Federal Reserve, the Department of Labor and other federal regulators so that regulators have a more comprehensive view of capital flows, liquidity, and systemic risk;
• The consolidation of the SEC and the CFTC into a single agency;
• Increased statutory authority to regulate investment bank holding companies;
• Immediate regulation of credit default swaps under the current regulatory system; and
• Increased transparency in the municipal securities markets.

For more information please see Chairman Cox’s complete testimony at:
http://www.sec.gov/news/testimony/2008/ts102308cc.htm and Chairman Cox’s “Op-Ed” article at:
http://www.sec.gov/news/speech/2008/spch110408cc.htm

On October 30, 2008 a privately held broker-dealer and several of its associated persons agreed to settle administrative charges brought by the Securities and Exchange Commission (“SEC”) for allegedly providing improper gifts and entertainment to an investment adviser’s trading personnel. The SEC alleged that the associated persons facilitated violations of securities laws by one of the traders involved by paying for high-end private entertainment and taking him on international trips. The SEC also charged the associated persons’ supervisor with failure to supervise by allowing the improper gifts and entertainment.

Without admitting or denying the SEC’s findings, the broker-dealer agreed to disgorgement of $1,817,629 plus prejudgment interest, a $600,000 penalty and censure. The associated persons also settled without admitting or denying the allegations, each agreeing to cease from committing any further violations, to pay a penalty, and to a suspension from associating with a broker-dealer or investment company for up to nine months.

For more information please see the SEC release at:
http://www.sec.gov/news/press/2008/2008-260.htm  

Investment advisers are required by the SEC to file applications and other documents with the Investment Adviser Registration Depository (“IARD”), a national Internet database for the collection and dissemination of information about participants in the investment advisory business. Last year’s waiver of the annual system fees paid by investment advisers to the IARD has been extended through October 31st, 2008. The initial set-up fees for new advisers filing on the IARD will also be waived, and system fees paid by investment adviser representatives will be reduced by one third.

SEC Press Release No. IA-2564/October 26, 2006, available at:

http://sec.gov/rules/other/2006/ia-2564.pdf. Investment Adviser Web site available at: http://www.iard.com/renewals.asp. 2007 IARD Renewal Calendar is available at: http://www.iard.com/pdf/renewal_calendar.pdf.