The Hedge Fund Law Report

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

Recent Issue Headlines

Vol. 3, No. 27 (Jul. 8, 2010) Print IssuePrint This Issue

  • Legal, Operational and Risk Considerations for Institutional Investors When Performing Due Diligence on Hedge Fund Service Providers

    The old paradigm of hedge fund due diligence focused on the hedge fund manager and the new paradigm focuses on hedge fund service providers.  That is, the purpose of hedge fund due diligence used to be (broadly, pre-2008) to ensure that the hedge fund manager itself had, internally, sufficient people, process and plant to maintain its return and risk profile.  However, the credit crisis that began in 2008, and the frauds it brought to the fore, highlighted the franchise risk posed by service providers to hedge funds and managers.  Consequently, post-crisis hedge fund due diligence has focused more squarely and thoroughly on service providers.  For example, in a June 2010 study, hedge fund operational due diligence consulting firm Corgentum Consulting analyzed data from over 200 hedge fund allocators and concluded that hedge fund “investors are focusing the bulk of their due diligence efforts on legal, compliance and regulatory risks.”  The primary reason for this shift in focus – from managers and performance (then), to service providers and operations (now) – relates to the estimated harm from adverse outcomes.  In relative terms, most investment losses are high probability, low magnitude events, while most operational failures are low probability, high magnitude events.  The chief goal of due diligence is to avoid low probability, high magnitude events; and, moreover, the credit crisis taught that the probability of some operational failures may not be so low after all.  Lehman Brothers provides the most sobering example.  Hedge funds that used Lehman’s U.S. or U.K. brokerage entities as their only prime brokers and that did not perform adequate due diligence on Lehman’s custody and cash management arrangements – or that did perform such diligence but did not incorporate its lessons – wound up with significant investor assets tied up for long periods in bankruptcy, SIPA or administration proceedings.  The purpose of service provider diligence is to identify operational issues that can have a material adverse effect on investment outcomes – issues such as the commingling of hedge fund customer assets by certain Lehman brokerage entities.  With the twin goals of providing guidance to investors conducting due diligence on hedge fund service providers, and to hedge fund managers and service providers anticipating such diligence, this article: identifies key hedge fund service providers; details ten specific areas on which investors should focus when conducting service provider diligence; highlights areas of diligence specific to certain service providers; discusses strategies for accessing the data necessary to perform adequate due diligence; and incorporates recommendations regarding the timing and frequency of service provider due diligence.

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  • Update: Are There Still Avenues for Recovery in United States Courts for Overseas Hedge Fund Losses After Morrison v. National Australia Bank Ltd.?

    Just over a year ago, Christopher F. Robertson and Erik W. Weibust, Partner and Associate, respectively, at Seyfarth Shaw LLP, published a guest article in The Hedge Fund Law Report focusing on the ability of U.S.-based hedge funds to sue foreign corporations in U.S. courts for violations of the antifraud provisions of the U.S. securities laws.  See “Are There Avenues for Recovery in United States Courts for Overseas Hedge Fund Losses?,” The Hedge Fund Law Report, Vol. 2, No. 29 (July 23, 2009).  In that article, they opined that, under existing precedents, U.S. federal courts would likely apply the antifraud provisions of the U.S. securities laws to a lawsuit involving the purchase or sale of shares of a foreign company on a foreign exchange, provided American investors were substantially affected by the foreign company’s wrongful acts – even if those acts were committed exclusively overseas.  They focused on a real life example in which numerous U.S. hedge funds lost a substantial amount of money in 2008 relying on public statements that Porsche Automobil Holding SE (Porsche) made regarding its ownership interest in Volkswagen AG (Volkswagen), which resulted in a massive short squeeze that by some accounts led to over $1 billion in hedge fund losses.  They ultimately concluded that the hedge funds could assert securities fraud claims against Porsche in a U.S. court, and that such claims would not be dismissed merely because Porsche is a foreign company whose shares trade solely on foreign exchanges.  (Porsche offers limited ADRs in the United States that are seldom traded.)  Since publication of that article, several of the aggrieved hedge funds have filed lawsuits in U.S. District Court in New York alleging that Porsche violated, among other things, Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 (the principal antifraud provisions of the U.S. securities laws) by making false and misleading statements and manipulating the market for Volkswagen’s shares.  How quickly things have changed.  Just last month, the United States Supreme Court ruled, in Morrison v. National Australia Bank Ltd. (Scalia, J.), Slip Op. No. 08-1191 (decided June 24, 2010), that the principal antifraud provisions of the U.S. securities laws do not have extraterritorial reach and thus do not apply to foreign companies whose shares trade solely on foreign exchanges.  While the Morrison decision is clearly a major victory for foreign companies faced with allegations that they violated the more investor-friendly antifraud provisions of the U.S. securities laws, the decision is not necessarily as damaging as it may seem for U.S. hedge funds that were harmed as a result of Porsche’s alleged fraud.  In this update to their July 23, 2009 article in The Hedge Fund Law Report, Robertson and Weibust discuss the implications of the Morrison decision for hedge funds generally, the implications of the decision for the Porsche case specifically and the likely market impact of the Morrison decision.

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  • After Bench Trial of First-Ever Credit Default Swap Insider Trading Action, U.S. District Court Rules that Swaps Referencing Bonds Are “Securities-Based Swap Agreements” Under Antifraud Provisions of Securities Exchange Act, but Holds that SEC Failed to Prove Insider Trading

    The Securities and Exchange Commission (SEC) has succeeded in bringing credit default swaps under its jurisdiction over insider trading, but has lost its securities fraud suit against Jon-Paul Rorech (Rorech), a Deutsche Bank bond and credit default swap salesman, and Renato Negrin (Negrin), a portfolio manager employed during the relevant period by hedge fund manager Millennium Partners, L.P.  The SEC had alleged that Rorech and Negrin engaged in insider trading of the credit default swaps of VNU N.V. (VNU), a Dutch media conglomerate.  Rorech allegedly revealed to Negrin non-public information about a proposed bond offering by VNU that would result in an immediate increase in the value of certain credit default swaps that referenced VNU bonds.  As a result of that disclosure, Negrin allegedly purchased VNU credit default swaps shortly before the bond offering was announced and made a substantial profit when the value of those swaps increased following the announcement of the proposed offering.  The District Court determined that, while the SEC did have the power to prosecute its insider trading claims arising out of trading in the VNU credit default swaps, the SEC failed to prove that Rorech revealed material non-public information to Negrin.  We offer a comprehensive summary of the factual findings and legal reasoning in the court’s 122-page opinion.

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  • Supreme Court Invalidates Patent on Hedging Risk But Leaves Door Open for Less “Abstract” Business Methods

    On June 28, 2010, the U.S. Supreme Court, in Bilski v. Kappos, held a patent directed to a series of steps for hedging risk in commodities trading invalid as not being drawn to statutory subject matter.  While the Supreme Court affirmed the Federal Circuit Court of Appeals’ decision that the patent was invalid, the Supreme Court did instruct the Federal Circuit to fashion additional tests for patentable subject matter based on the Supreme Court’s broad and somewhat antiquated principles.  In a guest article, Mark Scarsi and Blake Reese, Partner and Associate, respectively, in the Intellectual Property Litigation & Technology Department of Milbank, Tweed, Hadley & McCloy LLP, explain the facts, holding and legal analysis in Bilski.  The Bilski opinion is complex, but Scarsi and Reese convey the key legal and business points in a manner that is comprehensible to hedge fund industry participants who may not be intellectual property experts.  The case is particularly relevant to hedge fund managers that develop and use proprietary technology, such as managers with high-frequency or algorithm-driven strategies.

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  • North Carolina Supreme Court Rules that State Pension Fund May Have to Disclose Information about Pension Fund’s Hedge Fund Investments, Including Hedge Fund and Manager Names, Identity of Manager Principals, Positions, Returns and Fees

    In February 2007, Forbes magazine published an expose on the activities of Richard Moore, Treasurer for the State of North Carolina.  The article accused him, as the sole fiduciary over a State Retirement System containing $73 billion in assets, of engaging in a “pay-to-play” scheme or of accepting campaign contributions from dozens of financial firms that hoped to be selected as investment managers for the state pension fund.  See “Pensions, Pols, Payola,” Neil Weinberg, Forbes, Mar. 12, 2007.  (For more on the pay-to-play/pension fund kickback scandal in New York State and the Securities and Exchange Commission’s pay-to-play rule in its proposed form, see “What Do the Regulatory and Industry Responses to the New York Pension Fund ‘Pay to Play’ Scandal Mean for the Future of Hedge Fund Marketing?,” The Hedge Fund Law Report, Vol. 2, No. 30 (Jul. 29, 2009); “How Has the New York Pension Fund Kickback Scandal Changed the Landscape for Placement Agents, and for Hedge Fund Managers who Use Them?,” The Hedge Fund Law Report, Vol. 2, No. 17 (Apr. 30, 2009)).  The State Employees Association of North Carolina, Inc. (SEANC), a nonprofit corporation which protects the retirement interests of State employees, learned of the Forbes article, and requested all public records relating to these deals from the Treasurer under the North Carolina Public Records Act (the State equivalent of the Federal Freedom of Information Act).  After the Treasurer failed to fully comply with the request, SEANC filed a complaint that a state trial court dismissed.  On June 17, 2010, North Carolina’s highest court reinstated that complaint after finding that its allegations, if proven, would establish a prima facie case of a violation of the state Public Records Act.  We summarize the background of the action, the Court’s legal analysis and its implications for the types of hedge fund investment information that a third party can obtain from a public pension fund.

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  • Dechert Announces Addition of James Waddington as a Partner in its London Office Focusing on Hedge Fund and Private Equity Fund Clients

    On July 6, 2010, Dechert LLP announced that James Waddington has joined the law firm’s London office as a Partner.  Prior to joining Dechert, Waddington was a Partner at Orrick, Herrington & Sutcliffe LLP.  Waddington advises private equity and hedge fund clients, and commercial and investment bank clients, in connection with finance and derivative transactions, credit default swaps, lending and borrowing arrangements, debt and equity offerings, insolvency and restructuring matters as well as fund formation and fund investments.

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  • Deutsche Bank Hires Anita Nemes as Global Head of Capital Introduction

    On June 29, 2010, Deutsche Bank announced that Anita Nemes has been hired as Global Head of Capital Introduction, effective October 2010.  Based in London, she will spearhead the ongoing effort to provide Deutsche Bank’s hedge fund clients with access to institutional sources of capital, which has been one of the most significant growth areas for hedge funds since 2008.

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  • Ernst & Young Managing Partner Dan Scott to Chair Special Cayman Islands Legal Commission

    A special Cayman Islands legal commission, organized to advise the governor on the country’s top judicial jobs, will be chaired by Ernst & Young Managing Partner Dan Scott.

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