The Hedge Fund Law Report

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

Recent Issue Headlines

Vol. 3, No. 34 (Aug. 27, 2010) Print IssuePrint This Issue

  • SEC Adopts Final Rules Expanding Access to Public Company Proxy Statements for Activist Hedge Funds and Other Major Shareholders

    On August 25, 2010, the SEC adopted, by a 3-to-2 vote, final rules granting significant shareholders mandatory access to the proxy statements of public companies.  Under new Rule 14a-11, any shareholder or group of shareholders collectively holding an investment and voting interest of at least three percent of a public company’s total voting power continuously for at least three years may include nominees for director on the company’s ballot and describe the nominees (in up to 500 words per nominee) in the company’s proxy statement.  Rule 14a-11 will be effective 60 days from publication in the Federal Register, in time for the 2011 proxy season.  On the same day, the SEC adopted new Rule 14a-8(i)(8), which requires companies to include in their proxy materials shareholder proposals to broaden proxy access, for example, by lowering ownership thresholds, reducing holding periods or increasing the number of permitted nominees.  Although Rule 14a-11 limits the ability of major shareholders to use the proxy access regime to effect a change of control of the company, the new rules likely will make it easier, faster and cheaper for activist hedge funds to engage in proxy contests and to nominate at least some of a company’s directors.  This article details: the range of companies covered by Rule 14a-11; the three percent ownership and holding period requirements; the intent of the use of a “voting power” concept in the rule; the rule’s definition of “ownership” (including discussions of the exclusion of private share classes, the definitions of “investment power” and “voting power,” and treatment under the rule of borrowed securities and securities sold short); required disclosures; the purpose and limits of the required “no change in control intent” certification; timing of required disclosures and the interaction of stated periods with advance notice bylaws; number of permitted nominees; the rule’s limited independence requirements; the process for companies wishing to exclude shareholder nominees; the narrowed “election exclusion” and what it may portend for alliances between large and small shareholders in contests for “influence”; and analogous Delaware law – and why, in the SEC’s view, such state law is insufficient to effectuate the policy goals of Rule 14a-11.

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  • Manhattan District Court Writes Final Chapter in Litigation Between Internet Law Library and Hedge Fund Adviser Southridge Capital Management; Orders Tech Firm to Pay Adviser Almost $1.2 Million in Attorney’s Fees on Top of Damages

    On August 9, 2010, the United States District Court for the Southern District of New York (Southern District) effectively ended the decade-long litigation between Internet Law Library, Inc. (INL), its executives and several of its shareholders, and Southridge Capital Management, LLC (Southridge), its principals and affiliates, including hedge fund Cootes Drive, LLC, and its broker, Thomson Kernaghan & Co., Ltd. (TK & Co.).  The litigation arose out of a “floorless” or “toxic” convertible securities purchase agreement between INL and Cootes Drive.  The agreement allowed Cootes Drive to demand conversion of its INL preferred stock into common stock based on a floating conversion ratio tied to the common stock’s market price, and obligated Cootes Drive to float a $25 million line of equity, so long as INL common stock remained priced above a certain level.  This arrangement arguably provided Cootes Drive and its affiliates with an incentive to aggressively short-sell INL common stock, because the further they decreased its price, the more common stock Cootes Drive could obtain on conversion (which it could use to cover its short positions and profit from the difference), and because that decrease would eliminate its obligation to provide a line of equity.  The agreement proved disastrous for INL, just as it has for many other companies with similar financing arrangements.  Its common stock price fell precipitously after it signed the agreement, allegedly due to Cootes Drive and its broker, TK & Co., short selling its common stock.  INL filed a lawsuit against Southridge and its affiliates in a Texas district court for fraud and market manipulation.  Cootes Drive filed a countersuit for breach in the Southern District after INL refused to redeem its preferred shares and to honor a promissory note.  The Southern District accused INL of forum shopping, consolidated the actions, found INL’s complaint legally sufficient to survive a motion to dismiss, but then dismissed that complaint as a sanction for its flagrant disregard of court orders and discovery abuses.  It then granted summary judgment to Cootes Drive, because INL had failed to provide evidence that Cootes Drive committed a material breach that would excuse INL from redeeming its preferred shares or honoring the note.  It emphasized that Cootes Drive’s short-selling of a “small amount of” INL shares was only “a technical violation” of their agreement and that INL had failed to supply evidence showing that TK & Co. had shorted significant quantities of common stock at the behest of Cootes Drive.  It also refused INL’s request for additional discovery to establish that connection, due in large part to its prior discovery abuses.  The Court then awarded over $1.1 million in damages to Cootes Drive, and required INL to pay Cootes Drive over $1.2 million in attorney’s fees.  This article surveys many of the opinions in the litigation to provide a detailed analysis of the factual background and legal analyses of various courts.  The article also identifies and discusses the legal principles established by the litigation that have broad, ongoing application to private investments by hedge funds in private or public companies.

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  • Poll: Will the Whistleblower Bounty Program Under Dodd-Frank Increase or Decrease the Use by Hedge Fund Management Company Employees of Internal Whistleblower Hotlines?

    Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act states that where a whistleblower provides “original information” to the SEC that leads to an enforcement action in which the SEC obtains a monetary sanction totaling at least $1 million, the SEC “shall pay an award” to the whistleblower of between 10 and 30 percent of the monetary sanctions imposed in the SEC enforcement action and certain related actions.  The whistleblower bounty provision has started to affect the hedge fund industry.  On July 23, 2010, two days after passage of Dodd-Frank, the SEC paid $1 million to whistleblowers that provided documents that assisted the SEC in its insider trading case against the principal and a former employee of Pequot Capital Management.  See “The SEC’s New Focus on Insider Trading by Hedge Funds,” The Hedge Fund Law Report, Vol. 3, No. 22 (Jun. 3, 2010); “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).  And earlier this month, an anonymous whistleblower complaint relating to valuation of portfolio assets by Plainfield Asset Management reportedly was filed with the SEC.  For more on Plainfield, see “Hedge Fund Managers Using Special Purpose Vehicles to Minimize Adverse Effects of Redemptions on Long-Term Investors,” The Hedge Fund Law Report, Vol. 2, No. 15 (Apr. 16, 2009).  However, the real impact of the whistleblower bounty provision on the hedge fund industry remains to be seen.  The Pequot payment was for assistance provided pre-Dodd-Frank, and presumably was made in part to demonstrate that the SEC will actually cough up some money for whistleblowers – in the interest of causing more whistleblowers to come forward.  And the Plainfield whistleblower complaint may or may not lead to a successful enforcement action and payment to the whistleblower.  Hedge fund managers have started setting up whistleblower hotlines to enable employees and service providers to anonymously report wrongdoing.  The intent of such hotlines is to enable management to identify and promptly address wrongdoing, ideally before it ripens into a legal or regulatory violation.  See “Can Hedge Fund Managers Use Whistleblower Hotlines to Help Create and Demonstrate a Culture of Compliance?,” The Hedge Fund Law Report, Vol. 3, No. 29 (Jul. 23, 2010).  However, the use by hedge fund managers of whistleblower hotlines is in its infancy, and there are essentially two views on how the whistleblower bounty provision of Dodd-Frank will impact the use of such hotlines going forward.  One view holds that the considerable bounties theoretically available to whistleblowers that provide “original information” to the SEC will diminish the use by employees of hedge fund managers and service providers of internal whistleblower hotlines established by the hedge fund manager.  Why give whistleblower information away for free, this line of reasoning goes, when you can sell it for a considerable amount?  The other view holds that the whistleblower bounty program is one of various ways in which Dodd-Frank strengthens the SEC’s investigation, data-collection and enforcement powers, and that in recognition of this newly empowered SEC, hedge fund managers will, on their own, redouble their compliance efforts.  In other words, under the first view, there is a fixed supply of bad acts and whistleblowers, as rational actors, will report those bad acts to the highest bidder; under the second view, the mere existence of the whistleblower bounty program will change behavior at hedge fund managers – will frighten managers into increased compliance.  The first view is classical economics, the second view, behavioral economics.  We want to hear from you on which view you find more plausible.  Specifically, we want to hear your thoughts on the following questions: (1) Do you think the Dodd-Frank whistleblower bounty provision will increase or decrease the use by hedge fund management company and service provider personnel of internal whistleblower hotlines (where hedge fund managers have such hotlines)?  (2) What incentives can hedge fund managers offer to employees to cause them to report wrongdoing through internal channels rather than to the SEC?  (3) Do you think hedge fund managers should have employee whistleblower hotlines, and if so, why?  Please send your thoughts on these questions to Mike Pereira, Publisher of The Hedge Fund Law Report, at: mpereira@hflawreport.com.  If we receive a critical mass of responses, we will publish those responses in edited version.  (Even if we do not receive a critical mass of responses, we will continue to explore this topic and will report on it as appropriate.)  We will not disclose your name or affiliation unless you affirmatively ask us to.  Thank you in advance for your thoughts.

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  • Foundation for Accounting Education’s “2010 Hedge Funds and Alternative Investments” Conference Focuses on Taxation of Hedge Funds and Hedge Fund Managers, Structuring, Valuation, Risk Management, Due Diligence, Insurance and Regulatory Developments

    On July 29, 2010, the Foundation for Accounting Education (FAE) presented its 2010 Hedge Funds and Alternative Investments Conference in New York City.  Speakers at the one-day event focused on a range of issues impacting the hedge fund industry, including: FIN 48 (which relates to accounting for uncertain tax liabilities); ASU 2010-10 (which amends Statement of Financial Accounting Standards No. 167, which in turn requires nonpublic companies to publicly disclose their interests in variable interest entities in a similar manner to the disclosure provided by public entities); carried interest taxation developments; state and local tax developments relevant to hedge fund managers; tax implications of globalization of the hedge fund industry; special purpose vehicles; blockers; unrelated business taxable income and effectively connected income; mini-master funds; master-feeder and side-by-side structures; International Financial Reporting Standards; valuation trends; risk management; due diligence; insurance; and regulatory developments.  This article details the key points discussed during the conference.

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  • S.D.N.Y. Dismisses Jersey Hedge Fund VCG’s Claim against Wachovia Alleging Improper Demands for Collateral under a Credit Default Swap and Orders VCG to Pay Wachovia Balance of Demanded Collateral and Attorney's Fees

    On August 16, 2010, Wachovia Bank, N.A. won dismissal of the final count of a multiple-count lawsuit brought against it by a Jersey hedge fund that accused the bank of breaching its covenant of good faith and fair dealing by demanding more collateral than the $10 million value of a credit default swap entered into between the hedge fund and bank.  In addition to dismissing the case against Wachovia, the U.S. District Court for the Southern District of New York ordered the hedge fund to pay the bank the outstanding balance owed plus legal fees, in an amount to be determined.  This article discusses the factual background of the case and the court’s legal analysis.  For additional background, see “Hedge Fund VCG Special Opportunities Fund Loses CDS Dispute with Citigroup Unit,” The Hedge Fund Law Report, Vol. 3, No. 12 (Mar. 25, 2010); “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).

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  • The Hedge Fund Law Report Will Not Publish an Issue Next Week and Will Resume Regular Publication Schedule the Following Week

    Please note that The Hedge Fund Law Report will not publish an issue next week, the week starting August 30, 2010, and will resume its regular publication schedule the following week, the week starting September 6, 2010.  However, we will remain available next week, as we customarily are, for private discussions with our subscribers regarding any of the issues specifically discussed in any of our articles, or about legal and regulatory developments relevant to hedge funds and hedge fund managers generally.

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  • Fried Frank Names Lisa Schneider as Hedge Fund Partner

    On August 13, 2010, Fried, Frank, Harris, Shriver & Jacobson LLP announced that Lisa Schneider has been elected to the Firm’s partnership effective September 1, 2010.  Schneider’s practice is focused primarily on the structuring and representation of hedge funds and other alternative investment products.  She joined the Firm’s New York office in 2002.

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  • Alyssa A. Grikscheit Named Partner in Sidley Austin LLP’s Latin America and Investment Funds Practices in New York

    On August 26, 2010, Sidley Austin LLP announced that Alyssa A. Grikscheit has joined the firm as a Partner in the Latin America and investment funds, advisers and derivatives practices.  She will be based in the New York office and will focus on cross-border transactions and alternative investment funds.

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  • Man Group Hires Former FRM Executive Luke Ellis to Lead Multi-Manager Business

    On August 24, 2010, Man Group announced that Luke Ellis is to become Head of its Multi-Manager business.  See “Transaction Analysis: Hedge Fund Managers Man Group and GLG Partners Announce Plans to Merge,” The Hedge Fund Law Report, Vol. 3, No. 21 (May 28, 2010).

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