It’s back to school for hedge funds in the light of two new sets of strict rules introduced by the SEC. The big lesson funds need to learn is the difference between verification of information presented to them by investors and others, and real due diligence.BAD ACTOR DUE DILIGENCE.jpg

While fund managers and promoters are used to conducting due diligence on the companies they may invest in (and other funds they take on board in their funds of funds), this is different. Now funds have to investigate in some depth the backgrounds of people, some of whom are complete strangers.

The biggest changes come from new SEC regulations introduced last month following Dodd-Frank, and affect promoters of hedge funds and any other securities offered under Rule 506. Any issuer under the rule needs to know about a whole list of “bad acts” committed not only by directors and general partners, but by anyone who owns 20 percent of the entity, anyone who promotes it, anyone who manages it, and plenty of other categories. An SEC summary of the rules including look-back provisions is here.

Hedge funds that advertise need to make sure that their investors are all “accredited,” These rules under the JOBS Act put the responsibility on the funds to take reasonable steps to make sure that investors are worth enough to be investing in this kind of entity. If the SEC finds a single investor is not “accredited” and that the fund did not take reasonable steps to investigate the investor, that could pollute the entire fund offering. Those rules are here.

Funds therefore need to get up to speed on what we call Due Diligence 102. DD 101 was the due diligence that funds exercised on companies they were considering for an investment. Books, records, business plan, capability of leaders, and all the rest of the stuff they start you off with in business school and which you hone on the job.

DD 102 is the kind of thing we have been doing at our firm for years. It’s new to funds but not new to us, because dealmakers, litigators, divorce attorneys and others have for years been trying to figure out some of the following:

  • How much is someone worth, including liabilities they may not have disclosed? Do you know how to find an LLC associated with someone, or a personal guarantee exercised against your investor that potentially wipes out his net worth? If you don’t, you could be taking money from an unaccredited investor.
  • Has someone ever been subject to a court injunction or restraining order? Would you know how to look for one of these offline as well as on the internet? If not, a reportable bad act could go unreported.
  • How to do you know which state regulators to search as well as which relevant federal regulators to look at? “Bad actors” include people who have been bad at the state level too. If you don’t know, the SEC could decide that a bad act that was reasonably discoverable went undetected.

 Remember: due diligence is not the same as verification of information someone gives you. It’s doing an independent search for information that may confirm —  but may also contradict or supplement – the information submitted. Due diligence of someone’s resume isn’t just calling up the references given, it’s making sure that jobs haven’t been left off the resume to conceal firings, litigation, and other unsavory parts of someone’s past. If your due diligence service just checks representations made by someone, that’s not enough.

For instance: after verification, a person’s tax return from last year really turns out to state income of $1.3 million. Real due diligence means checking to see that this person doesn’t have tax liens that would wipe that income out, not to mention personal guarantees on unstated LLC’s that if exercised would cost him $7.5 million.

Or, a person says he has never been the subject of a criminal or civil action. Real due diligence involves on-site courthouse checks in that person’s relevant jurisdictions, to make sure he didn’t “forget” about an embarrassing matter. Knowing which courthouses to search and which are reasonable to skip is part of the process.

One final tip on anyone seeking to outsource the due diligence on accredited investors. One hedge fund was afraid that we would research an accredited investor, find nothing wrong and then sell that name to other hedge funds’ marketing departments.

We never re-sell information to third parties because everything we report is confidential, and we like to augment that protection by being retained by a lawyer so that everything is protected by the work-product privilege. If your proposed investigator can’t say the same, strike him off your list.