The Hedge Fund Law Report

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

Recent Issue Headlines

Vol. 2, No. 33 (Aug. 19, 2009) Print IssuePrint This Issue

  • How Are Hedge Fund Managers with Funds Under their High Water Marks Renegotiating Performance Fees or Allocations?

    Despite solid year-to-date performance, many hedge funds remain below their prior net asset values (NAVs), in many cases achieved during the first half of 2007.  As a technical matter, the governing documents of most hedge funds contain so-called high water mark or loss carry-forward provisions stating that the manager cannot collect a performance fee or allocation until the NAV of the fund exceeds its highest prior level.  But as a practical matter, the performance fee is a critical part of the hedge fund business model.  Among other things, performance fees enable managers to offer the compensation packages required to attract and retain top investment and other talent; and such talent is necessary to offer the incremental advantages in terms of insight and analysis that distinguish one hedge fund from another – that enable one fund to yield alpha while others just deliver beta or losses.  And hedge fund investors recognize this: by and large, they are invested in hedge funds for uncorrelated, absolute returns.  They’re not in hedge funds – at least primarily – to save money on fees.  (Fee saving is what bond and stock index funds are for.)  Investors want their managers incentivized, and thus investors have generally been willing to negotiate alternative arrangements with respect to performance fees or allocations with managers whose funds are below their high water marks.  In a sense, the experience of the past year and a half has demonstrated that high water mark provisions in hedge fund documents do not provide a roadmap for how the relationship between hedge fund managers and investors actually operates.  Rather, such provisions provide a starting position for negotiations between hedge fund managers and investors with respect to performance fees or allocations so long as a manager’s best days remain, at least for the moment, behind him or her.  This article explores what performance fees and allocations are (including a discussion of the tax purpose and effect of mini-master funds); how high water mark provisions affect a manager’s ability to collect such compensation; specific ways in which managers and investors are renegotiating performance fees or allocations in the “shadow” of high water mark provisions; the rationale among managers for seeking, and among investors for consenting to, such revised performance fee or allocation arrangements; and the process for obtaining consent to such revised arrangements, and the circumstances in which negative consent may be viable.

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  • New Hedge Fund Transparency and Investors’ Rights – The Times They Are A Changin’

    So far in this century, hedge funds have raised and invested billions with minimal regulation and very little disclosure about their activities.  An investor turns over his money to the fund and goes along for the ride, usually without knowing what investments the fund manager has made, with little understanding of the strategies being employed and without access to information about where the fund is headed.  If an investor becomes dissatisfied, its only remedy is to withdraw from the fund.  Even that has strings attached to it.  Still, total hedge fund assets under management are estimated to have soared from approximately $450 billion in 1999 to over $2.5 trillion in June 2008, according to The Alternative Investment Management Association Limited.  During the fall of 2008, hedge fund returns plummeted, redemption requests poured in and many funds halted redemptions.  Several closed their doors; others sold their assets or have announced plans to do so.  Others are satisfying redemption requests with interests in newly formed pools of illiquid securities.  Add to this the fallout from Bernard Madoff and a few other high-profile hedge fund stories, and the stage is set for revisiting and rethinking the rights of investors in hedge funds.  The change has started even if, for the moment, it is still a trickle rather than a flood.  In a guest article, Robert L. Bodansky and E. Ann Gill, Partners at Seyfarth Shaw LLP, and Laura Zinanni, an Associate at the firm, discuss adopting private equity concepts in the hedge fund business model; advisory committees; charging performance fees only on realized gains; standards of conduct and fiduciary duty; most favored nations clauses and disclosure of side letters; investor reporting; indemnification carve outs; minimum levels of insurance; regulatory proposals in the United States and in Europe; pay to play regulation; due diligence; in-kind distribution issues; and more.

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  • For Hedge Funds and Their Managers, the SEC’s New Enforcement Initiatives May Increase the Likelihood, Speed and Vigor of Inspections and Examinations

    On August 5, 2009, Robert Khuzami, Director of the Division of Enforcement (Enforcement Division) of the Securities and Exchange Commission (SEC) delivered remarks before the New York City Bar entitled “My First 100 Days as Director of Enforcement.”  In those remarks, Khuzami announced changes and new initiatives for the Enforcement Division.  After a “rigorous self-assessment” of the Enforcement Division’s recent performance, Khuzami said, the new initiatives will refocus the Enforcement Division on speed and efficiency, less supervision and increased incentives for cooperation on the part of subjects of enforcement actions.  For hedge funds and their managers, the restructuring of the Enforcement Division can have various relevant consequences, including increased potential for investigations or examinations; increased speed with which examinations may proceed after they are announced (and hence less notice of examinations); and, in general, an Enforcement Division that is both more zealous and better educated with respect to many of the investment activities and operations of hedge funds.  We describe the new Enforcement Division units and discuss the Enforcement Division’s new priorities, focusing on hedge fund consultants and placement agents; streamlining of management of the Enforcement Division; the proposed Office of Market Intelligence; the likely effects of increased specialization; the anticipated increased scrutiny; and the likely impact on hedge funds and hedge fund managers of units other than the new Asset Management Unit.

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  • How Can Hedge Fund Managers Prevent Theft of Proprietary Trading Technology and Other Intellectual Property?

    Hedge fund managers who have made or are contemplating significant investments in proprietary technology, such as trading technology, face at least three major issues: (1) whether to develop such technology internally or buy or lease it from a third party; (2) whether to seek to patent it; and (3) how to prevent theft.  The relevance of these issues has been highlighted recently by at least two developments: the debate surrounding flash trading, and the implicit recognition in that debate that sophisticated trading technology has become central to the investment strategies of many hedge funds; and Citadel Investment Group’s recent lawsuit against three former employees and their new firm for alleged theft of Citadel’s trading technology.  On flash orders, see “What Are Flash Orders, and How Might Regulation Curtail the Ability of Hedge Funds Employing High-Frequency Trading Strategies to Profit from Such Orders?,” The Hedge Fund Law Report, Vol. 2, No. 32 (Aug. 12, 2009); and on the Citadel suit, see “Citadel Investment Group Sues Former Employees Alleging Violations of Non-Disclosure, Non-Solicitation and Non-Compete Agreements,” The Hedge Fund Law Report, Vol. 2, No. 28 (Jul. 16, 2009).  Based on interviews with specialists working at the intersection of technology and hedge fund investments and operations, the consensus answers to these questions appears to be: while every situation is unique and it is difficult to generalize with any reliability, more often than not, hedge funds would be better served by building their own technology than by licensing it, in cases where that technology is central to their trading strategy or operational infrastructure.  Among other things, building versus buying vests more control in the manager over its technology and changes and revisions thereto, and it increases the value of the advisory entity and the case for investors to invest with the manager as opposed to any other licensee of a third-party technology.  As for whether to seek patent protection, the answer, with exceptions, is often no because the process is long, the protection is uncertain, seeking patent protection may require disclosure of information that can undermine the proprietary value of the technology and most hedge fund technology is intended for use only by the manager; it is not intended to generate revenue via licensing.  And as for how to prevent theft, techniques involve confidentiality agreements and similar contractual protections, robust pre-employment (or pre-independent contracting) screening and security measures embedded in the technology itself.  Though as the Citadel case demonstrates, even with carefully thought-out protections, intellectual property (IP) remains uniquely susceptible to theft.  This article explores the three issues identified above – build versus buy; whether to seek to patent; and how to protect; includes an update on and analysis of the Citadel case; and discusses “soft” IP (copyright and trademark) in the hedge fund context.

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  • Second Circuit Reaffirms Flexible Standards Governing Section 363 Sales in Chrysler Decision

    On August 5, 2009, the United States Court of Appeals for the Second Circuit issued an opinion setting forth the reasoning behind its June 2009 approval of the $2 billion sale of substantially all assets of Chrysler LLC to a newly-formed entity, backed by the United States Treasury Department and managed by the automobile manufacturer Fiat, under Section 363 of the Bankruptcy Code.  This decision reaffirms precedent which established that a flexible standard which meets the needs of individual situations should govern Section 363 sale transactions.  We discuss the factual background of the case and the court’s legal analysis.

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  • In Interviews with The Hedge Fund Law Report, Reps. Scott Garrett (R-New Jersey) and Maxine Waters (D-California) Take Sharply Opposing Views on Derivatives Regulation

    Last week, the White House proposed comprehensive regulatory language for over-the-counter (OTC) derivatives markets.  The “Over the Counter Derivatives Markets Act of 2009” requires transparency for all OTC derivative transactions; strong prudential and business conduct regulation of all OTC derivative dealers and other major participants in the OTC derivative markets; and provides regulatory and enforcement tools to prevent manipulation, fraud, and other market abuses.  The Administration, according to a statement, “looks forward to working with Congress to pass a comprehensive regulatory reform bill by the end of the year.”  A main component of the reform will require central clearing and trading of standardized OTC derivatives to be regulated by the CFTC or a securities clearing agency regulated by the SEC.  The legislations’s higher capital requirements and higher margin requirements for non-standardized derivatives would presumably encourage greater use of standardized derivatives to facilitate substantial migration of OTC derivatives onto central clearinghouses and exchanges.  For transparancy, all relevant federal financial regulatory agencies will have access, on a confidential basis, to the OTC derivative transactions and related open positions of individual market participants.  In addition, the public will have access to aggregated data on open positions and trading volumes.  Before the legislative language was released, The Hedge Fund Law Report interviewed two members of Congress with opposing views on the appropriate degree of regulation of the OTC derivatives market.  On July 30, 2009, we interviewed Rep. Scott Garrett (R-New Jersey), and on June 28, 2009, we interviewed Rep. Maxine Waters (D-California).  Garrett espouses a strong laissez faire attitude with respect to OTC derivatives, while Waters would like to see them outlawed altogether.  The full transcripts of those interviews are included in this issue of The Hedge Fund Law Report in the conviction that insight from members of Congress will help hedge fund professionals predict how the Administration’s bill may change as it works its way through Congress.

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  • Madoff Feeder Funds Sue Casualty Insurers for Breach of Contract and Seek to Recoup Costs of Defending Against Liability Suits

    In the continuing fallout from the Bernard Madoff Ponzi scheme, certain funds affiliated with MassMutual Life Insurance Company (the Feeder Funds or the Funds) that invested client money with Madoff and his fraudulent investment management operation, are being sued by their clients for various alleged breaches of duty.  In response, the Feeder Funds decided to seek indemnity and defense from their insurers under their primary and excess fidelity bonds and director and officer liability insurance policies.  Because the primary fidelity bond carriers refused to contribute to the cost of defending some of the lawsuits, the Funds filed suit against the primary fidelity bond carriers for breach of contract in the Delaware Chancery Court.  Specifically, the Funds claim that the insurers that provided the Funds with surety bonds and executive and officers coverage have failed to meet their obligations to cover the legal cost of defending against the lawsuits.  The Funds are seeking an apportionment of defense costs among them and a declaration of their respective rights and obligations under the policies.  We discuss the factual background of the case, the court’s legal analysis and the implications for hedge fund D&O insurance arrangements.

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  • Third Circuit Holds that a Commodity “Feeder Fund” Must Register as a Commodity Pool Operator, Even Though the Feeder Fund Itself Does Not Trade in Commodities

    On July 13, 2009, the U.S. Court of Appeals for the Third Circuit affirmed a district court decision holding that Equity Financial Group – a “feeder fund” that invested in underlying funds that traded commodities, but that did not itself trade commodities – along with its president and sole shareholder and lawyer violated the Commodity Exchange Act (CEA) by failing to register as a commodity pool operator (CPO) and engaging in other fraudulent conduct.  The case, which appears to be one of first impression, confirms a view long held by the Commodity Futures Trading Commission (CFTC): that investors in commodity markets are exposed to the same risk whether they invest directly or indirectly, and thus direct and indirect investors are entitled to the same degree of regulatory protection.  See, e.g., “Michigan Couple Ordered to Pay More Than $3.1 Million for ‘Private Hedge Fund’ Fraud,” The Hedge Fund Law Report, Vol. 1, No. 9 (Apr. 29, 2008).  For hedge fund managers, the decision’s impact may be mitigated by various exceptions from CPO registration that may be available to them; those exceptions are discussed more fully below.  However, hedge funds that are required to register and elect not to take advantage of an exception or are not eligible for an exception are well advised to review the obligations that registration as a CPO entails.  These obligations include, among others, disclosure, record keeping and operating requirements.  See “Should Hedge Funds Register as Commodity Pool Operators?,” The Hedge Fund Law Report, Vol. 2, No. 26 (Jul. 2, 2009).  This article details the factual background and legal analysis in the Equity Financial Group case; discusses exclusions and exemptions from CPO registration that generally are available to hedge fund managers; addresses whether managed accounts are a viable means of structuring around the holding in the Equity Financial Group case; and highlights various consequences of CPO registration.

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  • Lehman Brothers Claims that Withholding of Payments under Swap Agreement Violates the Automatic Stay of Bankruptcy Code

    On June 24, 2009, Lehman Brothers Holdings Inc. (LBH) filed a motion in the United States Bankruptcy Court in the Southern District of New York requesting that the court compel Metavante Corporation to perform its obligations under a swap agreement it had entered with Lehman Brothers Special Financing Inc. (LBSF).  LBH claims that Metavante’s attempt to suspend its regularly scheduled contractual payments violates the automatic stay provisions of the Bankruptcy Code.  Metavante responds that the Bankruptcy Code does not dictate a specific timeframe in which a non-debtor party must terminate a swap contract to preserve the protections afforded by the Code’s safe harbor provisions.  Also, it asserts that their swap agreement specifically permits a swap counterparty to suspend its payment obligations under swap transactions if an “event of default,” such as a bankruptcy, has occurred and is continuing with respect to its counterparty.  We discuss the factual background of the case and the court’s legal analysis.  The case is particularly important in offering guidance to hedge funds about the law that will govern the increasingly important intersection of bankruptcy and derivatives laws.

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  • Dechert Announces Addition of Richard Horowitz to its Financial Services Group

    On August 18, 2009, Dechert LLP announced that Richard Horowitz joined the firm as a partner in the financial services group.  Horowitz, who will be resident in the firm’s New York office, was previously a partner at Clifford Chance LLP.

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  • Arnold & Porter Announces Addition of Cynthia D. Mann as a Tax Partner

    On August 13, 2009, Arnold & Porter LLP announced the addition of Cynthia D. Mann as a tax partner in the firm’s New York office.  It is anticipated that Ms. Mann will be doing a lot of work with the firm’s hedge fund practice in New York.

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  • Former General Counsel of Lehman Brothers Banking Entities Joins Alston & Bird

    On August 18, 2009, Alston & Bird LLP announced that Lloyd Winans will join its New York office as a partner in the Financial Services and Products group.  Mr. Winans brings more than 20 years of experience in banking and financial services, including expertise in federal and state bank regulatory regimes.

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  • Kinetic Partners Strengthens Cayman Team

    On August 17, 2009, Kinetic Partners announced that Steven Staatz had joined the firm’s Grand Cayman office as a consultant providing support with insolvency assignments.  Steven formerly worked for Queensland’s largest specialist insolvency firm, Knights Insolvency Administration, and a boutique firm focusing solely on corporate insolvency.

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