The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

Recent Issue Headlines

Vol. 3, No. 12 (Mar. 25, 2010) Print IssuePrint This Issue

  • IRS Directive and HIRE Act Undermine Tax Benefits of Total Return Equity Swaps for Offshore Hedge Funds

    As explained more fully below, total return equity swaps (TRSs) generally are contracts, often between a financial institution and a hedge fund, whereby the financial institution agrees to pay the hedge fund the total return of the reference equity during the swap term (including capital gains and dividends), and the hedge fund agrees to pay the financial institution the value of any decline in the price of the reference equity and interest on any debt embedded in the swap.  In other words, the financial institution pays the hedge fund any upside, and the hedge fund pays the financial institution any downside plus interest.  In this sense, the financial institution is the short party to the swap, and the hedge fund is the long party.  Traditionally, hedge funds have used TRSs for three principal purposes, among others.  First, hedge funds have used TRSs to gain economic exposure to companies without obtaining beneficial ownership of the stock of those companies, thereby avoiding the obligation to file a Schedule 13D and preserving the secrecy of incipient activist campaigns.  Second, offshore hedge funds have used TRSs to obtain economic exposure to dividend-paying U.S. stocks while avoiding the 30 percent withholding tax typically imposed on dividends paid by U.S. public companies to non-U.S. persons.  Offshore hedge funds have been able to use TRSs to avoid such withholding tax because, until recently, dividends were subject to withholding but “dividend equivalent payments” – the amount paid by a financial institution to a hedge fund under a swap by reference to the dividend paid by the relevant equity – were not.  Third, hedge funds have used TRSs to obtain leverage.  That is, the traditional way to get exposure to the total return of a stock was to buy it.  However, TRSs enable hedge funds to get exposure to the total return of a stock by entering into a contract with a financial institution and posting initial and variation margin (which, even taken together, often constitute only a fraction of the market price of the stock).  The first two of those purposes have been dramatically undermined by judicial and legislative action.  Specifically, with respect to the use of TRSs in activist campaigns, in June 2008, the U.S. District Court for the Southern District of New York held that two hedge funds that had accumulated substantial economic positions in publicly-traded railroad operator CSX Corporation, principally via cash-settled TRSs, were deemed to have beneficial ownership of the hedge shares held by their swap counterparties.  Accordingly, the court found that one of the hedge fund group defendants, The Children’s Investment Fund Management (UK) LLP and related hedge fund and advisory entities, violated Section 13(d) of the Securities Exchange Act of 1934 by failing to file a Schedule 13D within ten days of the date on which its beneficial ownership exceeded five percent.  See “District Court Holds that Long Party to Total Return Equity Swap May be Deemed to have Beneficial Ownership of Hedge Shares Held by Swap Counterparty,” The Hedge Fund Law Report, Vol. 1, No. 14 (Jun. 19, 2008).  With respect to the second purpose described above, in January of this year, the IRS issued an industry directive (Directive) outlining TRS structures that, in the agency’s view, may be used to improperly avoid withholding tax on dividends.  See “New IRS Audit Guidelines Target Equity Swaps with Non-U.S. Counterparties,” The Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010).  More recently, on March 18, 2010, President Obama signed into law the Hiring Incentives to Restore Employment (HIRE) Act (H.R. 2847), which contained provisions originally proposed as part of the Foreign Account Tax Compliance Act of 2009.  See “Bills in Congress Pose the Most Credible Threat to Date to the Continued to the Continued Tax Treatment of Hedge Fund Performance Allocations as Capital Gains,” The Hedge Fund Law Report, Vol. 2, No. 52 (Dec. 30, 2009).  Among other things, the HIRE Act will impose a 30 percent withholding tax on dividend-equivalent payments made to non-U.S. persons on or after September 14, 2010 on certain TRSs or pursuant to securities loans and “repo” transactions.  While there is significant overlap between the TRSs targeted in the Directive and those for which withholding will be required under the HIRE Act, the HIRE Act covers a broader range of TRSs.  While the third purpose of TRSs identified above – providing leverage – remains reasonably intact, the CSX case, the Directive and the HIRE Act collectively challenge the utility of TRSs for hedge funds, pose unique structuring challenges and change market dynamics that have existed for 20 years.  Yet the Directive and HIRE Act may also, like other facially adverse actions or events, offer opportunities.  With the goal of helping hedge fund managers navigate the changing tax consequences of TRSs, this article describes: the mechanics of TRSs in greater depth; the business benefits and burdens of TRSs; the Directive, including the specific scenarios identified by the IRS as meriting further attention from field agents; the relevant provisions of the HIRE Act; the likely market impact of the Directive and HIRE Act, including the specific impact on financial institutions, master-feeder hedge fund structures and TRSs written on a “basket” of equities; and potential structuring alternatives to avoid the adverse tax consequences of the Directive and HIRE Act.

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  • Hedge Fund VCG Special Opportunities Fund Loses CDS Dispute with Citigroup Unit

    As previously reported in the August 5, 2009 issue of The Hedge Fund Law Report, in Citigroup Global Markets Inc. v. VCG Special Opportunities Master Fund Ltd., No. 08-CV-5520 (BSJ), 2008 WL 4891229 (S.D.N.Y. Nov. 12, 2008), the U.S. District Court for the Southern District of New York granted a motion by Citigroup Global Markets Inc. (CGMI) to temporarily enjoin arbitration proceedings involving a credit default swap dispute between a British hedge fund, VCG Special Opportunities Master Fund Ltd., and CGMI affiliate Citibank, N.A. (Citibank).  In so ruling, the district court found that VCG, as the party seeking arbitration, had not proved facts sufficient to demonstrate that it was a “customer” of CGMI, a requirement under relevant Financial Industry Regulatory Authority (FINRA) rules for its members to unilaterally compel arbitration proceedings.  See “Growing Wave of Credit Default Swap Litigation: Judge Rules Citigroup Did Not Cheat VCG Hedge Fund on Swap and Trims Claims in VCG/Wachovia Litigation,” The Hedge Fund Law Report, Vol. 2, No. 31 (Aug. 5, 2009).  On March 10, 2010, the U.S. Court of Appeals for the Second Circuit affirmed the district court’s decision to grant CGMI a preliminary injunction.  It concluded that recent U.S. Supreme Court rulings had not invalidated the “venerable,” “long-standing” and flexible standard the Circuit has applied when considering motions for preliminary injunctions.  That standard requires the moving party to show “irreparable harm” absent injunctive relief, and either a “likelihood of success on the merits” or “sufficiently serious questions going to the merits to make them a fair ground for litigation and a balance of hardships tipping” in its favor.  It also rejected VCG’s alternative argument that the district court misapplied the “serious questions” standard by not construing FINRA arbitration rules in favor of arbitration absent “positive assurance” that its claim fell outside the scope of an arbitration agreement, because, it said, that standard was “inapposite.”  We summarize the background of the action and the court’s legal analysis.

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  • Katten Muchin Rosenman Hosts Program on “Infected Hedge Funds” Highlighting Rights and Remedies of Investors in Hedge Funds Whose Managers are Accused of Insider Trading or of Operating Ponzi Schemes

    The discovery, duration and depth of Ponzi schemes and insider trading rings uncovered during the last two years have altered, to a degree, the assumptions of institutional investors.  While investors do not presume that every hedge fund manager is engaged in illicit activity, they have expanded their due diligence checklists to include questions intended to identify and avoid bad actors.  Investors also realized that due diligence can never be perfect, and accordingly, have refocused on the legal rights and remedies available to parties invested with managers that are or are alleged to be operating Ponzi schemes or engaged in insider trading.  See “Hedge Funds in the Crosshairs: The Law of Insider Trading in an Active Enforcement Environment,” The Hedge Fund Law Report, Vol. 3, No. 7 (Feb. 17, 2010).  In recognition of these abiding concerns among institutional investors, and the concomitant interest among hedge fund managers in demonstrating their commitment to compliance, law firm Katten Muchin Rosenman LLP hosted a seminar on March 16, 2010 titled “Infected Hedge Funds: Rights and Remedies.”  The Katten Partners that served as panelists discussed various relevant topics, including the categories of claims and defenses available to investors in hedge funds whose managers are accused of Ponzi scheme operation or insider trading; differences in remedies available to direct and indirect investors; the SEC’s new enforcement initiatives and cooperation measures (including cooperation agreements, deferred prosecution agreements and non-prosecution agreements); and prophylactic measures hedge fund managers can take to prevent accusations of insider trading or running a Ponzi scheme.  This article describes in detail the most relevant topics discussed and points made at the Katten seminar.

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  • Federal District Court Finds that Affiliate of Hedge Fund D.B. Zwirn & Co. Failed to Prove Breach of Loan and Security Agreement by Borrower in that Agreement

    In 2006, the principals of defendant Traditions Management, LLC (Traditions), approached hedge fund D.B. Zwirn & Co. (Zwirn) for financing.  Zwirn, through plaintiff Bernard National Loan Investors, Ltd. (Bernard), made a $26.5 million non-recourse loan to Traditions.  The loan agreement imposed personal liability on Traditions’ principals only in the event a principal was responsible for a breach of certain representations and covenants made in that agreement.  In early 2008, as the credit crisis expanded, Bernard commenced a lawsuit against the defendants in U.S. District Court for the Southern District of New York.  Through several amendments of its original complaint, Bernard alleged that defendants were liable for fraud, conversion and various breaches of the loan agreement.  By the time of trial, in February 2010, Bernard’s claims had been whittled down essentially to breach of contract and determination of whether any of Traditions’ principals was personally liable under the loan agreement.  The Court denied all of Bernard’s claims and entered judgment in favor of defendants on all claims.  We summarize the relevant claims and the Court’s analysis of the evidence.

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  • Federal District Court Dismisses Lawsuit Brought by San Diego County Employees Retirement Association against Hedge Fund Manager Amaranth Advisors and Related Parties for Securities Fraud, Gross Negligence and Breach of Fiduciary Duty

    On March 29, 2007, the San Diego County Employees Retirement Association (SDCERA) filed a lawsuit against collapsed hedge fund manager Amaranth Advisors LLC (Amaranth) and several related individuals, including the fund manager’s one-time chief energy trader, Brian Hunter, in the U.S. District Court for the Southern District of New York, alleging securities fraud, common law fraud and several other causes of action.  In essence, the plaintiff alleged that the defendants fraudulently induced SDCERA into investing in funds managed by Amaranth, then dissuaded it from withdrawing that investment with a number of misrepresentations upon which SDCERA allegedly relied to its detriment.  The recurring theme in these allegations was that defendant Amaranth represented itself as managing a multi-strategy fund with sophisticated risk management controls when in reality it operated a single-strategy fund making essentially unhedged bets.  On March 15, 2010, District Court Judge Deborah A. Batts granted the defendants’ motions to dismiss each of the several counts of the complaint.  Judge Batts ruled that SDCERA’s claim under federal securities law – that it was fraudulently induced to purchase its interests in the Amaranth fund – was unreasonable as a matter of law; that choice-of-law principles dictated that the issue of common law fraud be decided according to the law of the state of Connecticut, where Amaranth was originally incorporated; that the claims of gross negligence and of breach of fiduciary duty are derivative, not subjects for a direct cause of action, and the plaintiffs failed to satisfy the requirements for a derivative action; and that Amaranth was not itself a party to the contract – which was between the plaintiff and the fund – so the management company was not liable on a breach of contract claim.  This article details the facts of the action and the issue of whether the court had personal jurisdiction over one of the defendants, Brian Hunter, who resides in Calgary, Canada, then analyzes the court’s rationale for its dismissal of each of the counts for failure to state a claim on which relief can be granted.

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  • Luxembourg Court Rejects Lawsuit Brought by Investors in Defunct Luxembourg Hedge Fund LuxAlpha SICAV Against UBS and Ernst & Young in Connection with Madoff Scandal; The Hedge Fund Law Report Offers Exclusive English-Language Translation of Court Opinion

    UBS Luxembourg was the primary custodian of Access International Advisors LLC’s LuxAlpha Sicav-American Selection fund (LuxAlpha SICAV), which was closed by the Luxembourg regulator, Commission de Surveillance du Secteur Financier (CSSF), because of investments in the Ponzi scheme operated by Bernard Madoff.  Investors seeking to recoup their losses in LuxAlpha SICAV, which once had assets of $1.4 billion, brought several lawsuits against UBS.  Most recently, on March 4, 2010, a Luxembourg court rejected efforts by certain investors in the now defunct LuxAlpha SICAV to pursue a direct cause of action against UBS AG and affiliated entities, and against auditor Ernst & Young, in connection with LuxAlpha SICAV’s Madoff-related losses.  Specifically, the court found that the investors have to pursue their claims through the liquidator of their fund.  This week’s issue of The Hedge Fund Law Report includes the only available English-language translation of that opinion.  Our translation is based on the official French-language opinion, which was made available to The Hedge Fund Law Report on Friday, March 5, 2010.

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