May 2010
SEC Scrutinizing Hedge Fund “Side Pockets”
BY KENNETH M. BREEN, DOUGLAS KOFF, KEITH MILLER, BARRY SHER, SEAN T. HARAN,
AND KEVIN BROUGHEL
In late 2009, the Director of the SEC’s Division of Enforcement, Robert Khuzami, singled out the
hedge fund industry as one that would be the focus of increased enforcement scrutiny, stating: “We at
the SEC are committed to pulling back the curtain on hedge fund operations and taking a closer look
at their activity.”1 In January 2010, the SEC formally announced the creation of various specialized
enforcement units to combat financial fraud and other illegal conduct in certain high priority areas.2
One such unit is the Asset Management Unit, a group comprised of roughly 60 SEC enforcement
attorneys spread across nine offices, tasked with focusing on investment companies, investment
advisers, mutual funds, hedge funds and private equity funds. The Asset Management Unit met for the
first time last week and reportedly focused on certain topics currently under investigation. Of
particular interest, the SEC is reportedly investigating the use of “side pockets” by hedge fund
managers, and whether hedge funds are properly assigning fair values to side pocket assets while
accurately disclosing information to investors.3 The investigations reportedly target hedge fund
managers, but it appears that the conduct of directors, administrators, and auditors will be under
scrutiny as well.
Generally, a side pocket is an account that is established by a hedge fund to segregate certain assets
or investments from the fund’s general portfolio. Often, side pockets are used to hold less liquid
securities. Fund documents may specifically permit the use of side pockets, and this mechanism has
been used by fund managers to isolate investments until market conditions improve and the assets
can be sold at prices that better reflect their intrinsic value, thereby limiting losses to the fund and
protecting fund investors in the process. In 2008, as the world experienced the credit and liquidity
crisis, many of the assets held by hedge funds became difficult or impossible to sell for anything
resembling a reasonable price. During this same time period, many hedge funds experienced an
onslaught of redemptions – demands by investors for the return of their money. To avoid selling
investments at extremely distressed prices, some managers transferred these hard to sell or price
assets to side pocket accounts. Thereafter, some investors complained to the SEC . It looks like the
SEC is taking these complaints seriously by making side pockets a priority investigative issue for the
Asset Management Unit.
The Asset Management Unit appears to be broadly scrutinizing the use and implementation of side
pockets. In particular, the Asset Management Unit will likely focus on how fund offering documents
authorized and disclosed the use of side pockets, and how managers implemented side pocket
arrangements: what assets were put in the side pocket, when, and why? The Asset Management Unit
will also likely review how fund management and fund service providers accounted for the side pocket
assets, and whether the manager charged fees associated with those assets.4 Did the manager receive
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a fee on the value of the securities in the side pocket, and if so, how were those securities valued?
While the focus of the investigation appears to center on hedge fund managers, others have
speculated that the SEC may look at whether fund directors, administrators or auditors somehow
shirked their valuation or disclosure responsibilities.5 The Asset Management Unit currently has at
least two ongoing investigations into the use of side pockets that it hopes to bring to the Commission
for approval of enforcement action within the next six months.6
In light of these developments, hedge fund managers would be wise to reexamine any side pocket
arrangements they currently have and evaluate whether additional disclosure to investors concerning
those arrangements is warranted. Additionally, managers should be prepared to justify the
methodology used to value side pocketed assets, especially if those assets are eventually sold at a
substantially lower price. Similarly, administrators and fund directors should review situations in which
their funds implemented side pockets and be prepared to justify the associated valuations. Finally, as
hedge fund investments begin to rebound, new funds should carefully consider how to adequately
disclose information about side pockets to investors and the rules that will govern their use so as to
avoid disputes down the road.
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If you have any questions concerning these developing issues, please do not hesitate to contact any of
the following Paul Hastings lawyers:
San Francisco
Los Angeles
Thomas P. O'Brien
213-683-6146
thomasobrien@paulhastings.com
Douglas Koff
212-318-6772
douglaskoff@paulhastings.com
Grace Carter
415-856-7015
gracecarter@paulhastings.com
William F. Sullivan
213-683-6252
williamsullivan@paulhastings.com
Keith Miller
212-318-6005
keithmiller@paulhastings.com
Mitchell E. Nichter
415-856-7009
mitchellnichter@paulhastings.com
Thomas A. Zaccaro
213-683-6285
thomaszaccaro@paulhastings.com
John A. Reding
Pugliese, Domenick
415-856-7004
212-318-6295
domenickpugliese@paulhastings.com jackreding@paulhastings.com
Art Zwickel
213-683-616
artzwickel@paulhastings.com
Barry Sher
212-318-6085
barrysher@paulhastings.com
New York
Palo Alto
Morgan J. Miller
202-551-1700
morganmiller@paulhastings.com
Kenneth M. Breen
212-318-6344
kennethbreen@paulhastings.com
Peter M. Stone
650-320-1843
peterstone@paulhastings.com
James D. Wareham
202-551-1728
jameswareham@paulhastings.com
Sean T. Haran
212-318-6094
seanharan@paulhastings.com
San Diego
Washington, D.C.
Christopher H. McGrath
858-458-3027
chrismcgrath@paulhastings.com
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1 See Robert Khuzami, Director, SEC Enforcement Division, “Remarks at Press Conference,” Oct. 16, 2009, New York, NY.
2 See Robert Khuzami, Director, SEC Enforcement Division, “Remarks at News Conference Announcing Enforcement
Cooperation Initiative and New Senior Leaders,” Jan. 13, 2010, Washington, D.C.
3 See Jenny Strasburg, SEC Probes ‘Side Pocket’ Arrangements, The Wall Street Journal, April 28, 2010.
4 Id. Such fees may not in and of themselves be improper, but the SEC will likely focus on whether fund documents
provided adequate authority and disclosure to support the charging of fees under the circumstances.
5 Id.
6 Id.
18 Offices Worldwide
Paul, Hastings, Janofsky & Walker LLP
www.paulhastings.com
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