The Hedge Fund Law Report

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

Recent Issue Headlines

Vol. 3, No. 17 (Apr. 30, 2010) Print IssuePrint This Issue

  • Mandatory Redemptions Enable Hedge Fund Managers to Control Regulatory and Reputational Risks, Contain Costs and Accommodate Maturation of Investor Base

    Mandatory redemption provisions are provisions in hedge fund documents that generally permit a manager to eject an investor from the fund, in whole or in part, in the manager’s sole discretion, and against the investor’s will.  At first blush, such provisions would appear to have utility only in the best of times, when the demand for hedge fund capacity exceeds the supply.  But as discussed more fully below, a hedge fund manager has a continuous obligation, regardless of the marketing or investment climate, to control the composition of its investor base.  This is because the types of investors in the hedge fund – regardless of investment strategy or outcome – can have a material effect on the fund and the manager.  On the fund side, the types of investors in the fund can affect the fund’s regulatory status (in particular under the Employee Retirement Income Security Act of 1974 (ERISA) and the Investment Company Act) and costs.  And on the manager side, the types of investors in the fund can affect the manager’s time, reputation and flexibility in portfolio management.  A mandatory redemption provision provides a contractual basis for acting on the conclusion that the burdens to the fund or manager (regulatory, cost, reputational, etc.) of keeping an investor outweigh the benefits (fees, relationships, etc.) of keeping that investor.  In effect, mandatory redemption provisions are to a hedge fund investor base as a standard investment management agreement is to a hedge fund investment portfolio: both give a hedge fund manager considerable discretion to act in the best interests of the fund, even where those interests diverge from the interests of one investor.  We recognize that capital raising remains a paramount challenge and an urgent imperative for hedge fund managers – especially for startup managers, but even for established ones.  See “Why Does Capital Raising for Distressed Debt Hedge Funds Remain Particularly Challenging Despite the Recent and Anticipated Positive Performance of the Strategy?,” The Hedge Fund Law Report, Vol. 2, No. 39 (Oct. 1, 2009); “How Can Start-Up Hedge Fund Managers Use Past Performance Information to Market New Funds?,” The Hedge Fund Law Report, Vol. 2, No. 50 (Oct. 1, 2009); “How Should Hedge Fund Managers Adjust Their Marketing to Pension Funds in Light of Potential Downward Revisions to Pension Funds’ Projected Rates of Return?,” The Hedge Fund Law Report, Vol. 3, No. 11 (Mar. 18, 2010).  Nonetheless, just as you cannot buy insurance after a storm hits, so a hedge fund manager would have difficulty interpolating a mandatory redemption provision into fund documents once the rationale for such a redemption crystallizes.  Instead, the time to consider and draft provisions in hedge fund documents is before they become necessary.  Put another way, hedge fund documents – and they are not alone among legal documents in this regard – generally should be drafted to accommodate worst-case scenarios and low-probability events.  The advisability of this approach was borne out during the credit crisis, when gate and liquidating trust provisions – quiescent in fund documents for years before the crisis – were suddenly put into practice.  See “Steel Partners’ Restructuring and Redemption Plan: Precedent or Anomaly?,” The Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009).  Thus the timing of this discussion.  To assist hedge fund managers in appreciating the range of circumstances in which mandatory redemption provisions may be useful, this article first catalogues eleven distinct rationales for using such provisions.  Notably, all of these rationales can apply in good times or bad.  That is, the breadth of these rationales indicates that mandatory redemption provisions are not just tools to be used when investors are beating down the door.  The article then describes a practice that we call “reverse due diligence.”  While the use of this phrase in the hedge fund context may be novel, this practice it describes is not, and it should be an ongoing activity at hedge fund managers.  The article then discusses the mechanics of mandatory redemption provisions in hedge fund governing documents, including the drafting of such provisions, triggering events, notice requirements and fee considerations, including suggesting (for the benefit of institutional investors) the novel (as far as we have been able to determine) possibility of a “reverse redemption fee.”  Finally, the article examines the interaction of mandatory redemption provisions and side pockets, and discusses alternatives to mandatory redemptions that may effectuate similar goals.

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  • New York State Court Upholds “Big Boy” Provisions and Dismisses Majority of MBIA’s Claims Against Merrill Lynch Relating to CDS Protection Sold by MBIA Referencing CDOs Issued by Merrill

    On April 7, 2010, a New York State trial court dismissed most of the claims brought by MBIA Insurance Corporation (MBIA) and its affiliate against Merrill Lynch & Co. (now owned by Bank of America), over losses the bond insurer incurred guaranteeing credit default swaps (CDSs or swaps) referencing collateralized debt obligations (CDOs) issued by Merrill Lynch.  MBIA had brought the lawsuit just under one year ago, claiming that Merrill Lynch’s effort to market the CDOs was part of a deliberate scheme to “offload billions of dollars in deteriorating U.S. subprime mortgages and other collateral that [it] held on its books by packaging them into [ ] CDOs or hedging their exposure through swaps with insurers.”  Because MBIA and its affiliate contractually disclaimed reliance on any representations by Merrill Lynch as to the quality of those CDOs, the court dismissed their causes of action for fraud in the inducement, fraud by omission and negligent misrepresentation without regard to the truth of their accusations.  However, the court allowed MBIA to proceed with one cause of action, a claim for breach of contract on the theory that Merrill Lynch had promised to deliver securities of “AAA” credit rating quality, but had failed to do so when it delivered securities which had received but did not deserve such a rating.  This article summarizes the background of MBIA’s action and the court’s legal opinion.

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  • In a Significant Decision for Hedge Funds that Trade Bank Debt, Federal Court Holds that JPMorgan Breached the Implied Covenant of Good Faith and Fair Dealing it Owed to Cablevisión Pursuant to a Credit Agreement When JPMorgan Sold a Loan Participation in Cablevisión’s Debt to an Entity Affiliated With Cablevisión’s Primary Competitor

    Plaintiff Empresas Cablevisión, S.A.B. de C.V. (Cablevisión) is a Mexican telecommunications company.  In late 2007, it borrowed $225 million pursuant to a credit agreement with defendants JPMorgan Chase Bank, N.A. and J.P. Morgan Securities Inc. (together, JPMorgan) in order to fund the purchase of Empresas Bestel, which operated a large fiber optic network in Mexico.  Due to the tightening in the credit markets that preceded the 2008 credit crisis, JPMorgan was unable to syndicate the loan.  It eventually sought to assign 90% of the loan to Banco Inbursa, S.A. (Inbursa), a Mexican bank controlled by Carlos Slim Helu and his family, who also controlled a major Cablevisión competitor – Mexican telecommunications giant Telmex.  When Cablevisión refused to consent to the assignment, JPMorgan structured a loan participation agreement with Inbursa that gave Inbursa a 90% interest in the loan with many of the same benefits that it would have received through an outright assignment.  A critical aspect of this case is the distinction between an assignment of a loan, in which the assignee steps into the shoes of the original lender and has the right to deal directly with the borrower, and a loan participation, in which the purchaser of the participation shares only in the economic benefits of the loan, and the original lender continues to deal directly with the borrower.  Here, the credit agreement contained customary provisions requiring Cablevisión’s consent to any assignment of the loan, but permitted JPMorgan to sell participations in the loan without the Cablevisión’s consent.  Cablevisión sought to enjoin the JPMorgan-Inbursa participation agreement on the grounds that it was a de facto assignment masquerading as a participation in the loan and that the participation agreement violated the implied covenant of good faith and fair dealing embodied in the credit agreement.  Southern District Judge Jed S. Rakoff agreed, and issued a preliminary injunction prohibiting JPMorgan and Inbursa from proceeding with the participation agreement.  We review the facts of the case and the court’s analysis.

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  • Hedge Fund Operations and Technology Conference Focuses on SEC Reviews, Outsourcing of Operations, Operational Due Diligence, Multiple Prime Broker Relationships and More

    On April 21, 2010, Financial Technologies Forum LLC hosted its Third Annual Hedge Fund Operations & Technology conference in New York City.  The backdrop for the conference was a hedge fund industry coming out of two years of turmoil and refocused on hedge fund organizational structures, risk profiles, counterparties, trade processes, compliance policies, valuation approaches, information technology infrastructure and manager backgrounds.  The underlying question that the conference sought to address was how hedge fund operations and technology are evolving in light of the lessons learned during the crisis.  This article focuses on the more noteworthy points discussed during the conference, including potential new regulation and registration requirements; compliance policies and strategies (including use of a compliance calendar); anticipated increases in the frequency and depth of SEC reviews of hedge funds (including specific areas on which the SEC is expected to focus); demands from investors for increased transparency; outsourcing of operational functions (including appropriate service levels and due diligence to be performed on service providers); the specific components of operational due diligence, especially as it relates to service providers; and the rationale for and management of multiple prime brokerage relationships.

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  • Implications for Hedge Funds of Changes to the British Virgin Islands’ Securities and Investment Business Act

    The British Virgin Islands (BVI) is significantly changing the regime applicable to investment business and hedge funds by the enactment of the Securities and Investment Business Act (SIBA) and the accompanying Mutual Fund Regulations (MFR).  This will affect existing private and professional funds currently recognized under the Mutual Funds Act, 1996 (MFA), which includes most hedge funds organized in the BVI.  As a result of the implementation of SIBA, the MFA will cease to apply to hedge funds in the BVI.  In a guest article, Nadia Menezes, a Senior Associate at Ogier, discusses the implications for hedge funds of the changes to the BVI’s fund regulatory regime, including consequences relating to directors, authorized representatives, minimum investments, functionaries, submission of financial statements and written notice of changes.

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  • Private Equity Fund Manager Sues JPMorgan Private Asia for Specific Performance of SpinOut Agreement or Nearly $31 Million

    On April 19, 2010, Varun Kumar Bery, the former head of JPMorgan’s Private Capital Asia Corp., (JPM), a subsidiary of JPMorgan Chase & Co., filed suit against JPM, claiming that Bery had been terminated without cause and that JPM had breached a spinout agreement which would have allowed him to keep the private equity team and platform that he managed.  Bery is suing his former employer for injunctive relief, including specific performance of a spinout agreement, and damages “in the region of US$30.8 million” for breach of express and implied contract.  This article summarizes the background of Bery’s action, the allegations and the relief sought.

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  • Cadwalader Deepens Alternative Asset Management Bench with Addition of Drew G. L. Chapman as Partner

    On April 21, 2010, Cadwalader, Wickersham & Taft LLP announced that Drew G.L. Chapman, a prominent alternative investment, asset management and securities industry attorney, will join the firm as Partner in the Corporate Department in the firm’s New York office.  Chapman is a regular commentator on financial television networks including Fox Business News.  He is also a seasoned speaker and panelist on the topic of hedge funds and his commentary and insights have been included in The Hedge Fund Law Report.  See, e.g., “As Banks Close Prop Desks and Traders Move to Hedge Funds, Hedge Fund Managers Focus on Permissible Scope of Use of Confidential Information,” The Hedge Fund Law Report, Vol. 2, No. 18 (May 7, 2009); “Hedge Fund Managers Launching Mutual Funds in an Effort to Stay a Step Ahead of Regulatory Convergence,” The Hedge Fund Law Report, Vol. 2, No. 15 (Apr. 16, 2009); “For Managers Facing Strong Headwinds, Sales of the Advisory Business Offer a Means of Preserving the Franchise While Avoiding Fund Liquidations,” The Hedge Fund Law Report, Vol. 2, No. 11 (Mar. 18, 2009); “Gates Provide Safety Valves for Hedge Funds and Investors,” The Hedge Fund Law Report, Vol. 1, No. 7 (Apr. 15, 2008).

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  • ACI’s National Advanced Forum on Regulation and Enforcement of Hedge Funds & Investment Advisers Scheduled for June 24-25 in New York

    Financial reform is in full swing, and hedge funds in particular are under the microscope.  The SEC has stepped up its enforcement activity with respect to hedge funds.  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).  Furthermore, Congress is pushing to increase transparency and accountability within the industry, and mandatory registration of hedge fund advisers is likely.  See “Does the IOSCO Hedge Fund Disclosure Template Foreshadow the Content of Hedge Fund and Hedge Fund Adviser Disclosures to be Required by the SEC?,” The Hedge Fund Law Report, Vol. 3, No. 15 (Apr. 16, 2010).  These issues and others will be addressed at ACI’s National Advanced Forum on Regulation and Enforcement of Hedge Funds & Investment Advisers, scheduled for June 24-25, 2010 at the Carlton in New York, NY.

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