The Hedge Fund Law Report

Articles By Topic

By Topic: Derivatives

• From Vol. 5 No.20 (May 17, 2012)

  British High Court Interprets ISDA Master Agreement to Suspend Non-Defaulting Party’s Payment Obligations Until Defaulting Party Has Cured the Default

  Counterparty risk has garnered significant attention among hedge fund industry participants in the aftermath of the collapse of Lehman Brothers in 2008.  Evaluating counterparty risk requires hedge fund managers to evaluate their counterparty agreements to understand, among other things, the scope of their obligations in the event that one of their trade counterparties defaults or becomes insolvent.  A decision recently handed down by the Court of Appeals of England and Wales interpreted a contractual provision contained in the International Swaps and Derivatives Association, Inc. Master Agreement (Master Agreement) that governs such obligations in relation to swaps and other derivatives effected between trade counterparties.  A central component of the case involved the interpretation of Section 2(a)(iii) of the Master Agreement, which provides that a party to a derivative contract is not obligated to make payments to the counterparty while an “event of default” is occurring with respect to the counterparty.

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• From Vol. 5 No.19 (May 10, 2012)

  Do You Need to Be a Registered Commodity Pool Operator Now and What Does It Mean If You Do?  (Part Two of Two)

  On February 9, 2012, the Commodity Futures Trading Commission (CFTC) amended the CFTC Rules to rescind an exemption from commodity pool operator (CPO) registration heavily relied upon by hedge fund managers.  This development, in combination with statutory changes to the Commodity Exchange Act enacted by the Dodd-Frank Wall Street Reform and Consumer Protection Act, will require many hedge fund managers to register as CPOs.  This article is the second part of a two-part series by Stephen A. McShea, General Counsel and Chief Compliance Officer of Larch Lane Advisors LLC, providing an overview of the current regulatory landscape of CFTC regulations impacting CPOs.  Part one of this series focused on the managers of private funds and their CPO registration and compliance obligations.  In particular, part one discussed: the regulatory framework governing commodity pools and CPOs and the remaining exemption from CPO registration for managers who operate or control a private fund; the compliance obligations of a registered CPO; and the enforcement mechanisms and penalties for non-compliance.  See “Do You Need to Be a Registered Commodity Pool Operator Now and What Does It Mean If You Do?  (Part One of Two),” The Hedge Fund Law Report, Vol. 5, No. 8 (Feb. 23, 2012).  This part two focuses on the funds (i.e., commodity pools) operated or controlled by registered CPOs.  Specifically, this article discusses: general fund disclosure and reporting obligations applicable to CPOs; the exemptions from certain of those disclosure and reporting obligations available under CFTC Rules 4.7 and 4.12; and the reporting obligations applicable to funds operating under those exemptions.

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• From Vol. 5 No.17 (Apr. 26, 2012)

  Federal Reserve Credit Officer Survey Identifies Trends in Prime Broker Credit Terms, Hedge Fund Leverage and Counterparty Risk

  One of the fundamental premises of the Dodd-Frank Act is that leverage in the financial system – if inadequately monitored, insufficiently understood and too voluminous – can create systemic risk.  Accordingly, many of the provisions in the Dodd-Frank Act are intended to reduce leverage or increase monitoring of leverage.  In the same vein, regulators have been collecting information about leverage via interaction with market participants.  In the U.K., for example, the FSA conducts a periodic study of potential systemic risk engendered by hedge funds.  See “U.K.’s FSA Issues Latest Biannual Report Assessing Possible Sources of Systemic Risk from Hedge Funds,” The Hedge Fund Law Report, Vol. 5, No. 11 (Mar. 16, 2012).  In the U.S., since 2010, the Federal Reserve has been conducting a quarterly Senior Credit Officer Opinion Survey on Dealer Financing Terms.  The survey generally asks dealers about the availability and terms of credit, securities financing and over-the counter (OTC) derivatives markets.  On March 29, 2012, the Federal Reserve published the results of its most recent survey (Survey).  The Survey polled the senior credit officers of the twenty largest dealers in dollar-denominated securities financing and the most active intermediaries in OTC derivatives markets.  The purposes of the Survey were to: (1) obtain a consolidated perspective on changes in the management of credit risk between December 2011 and February 2012; and (2) identify trends in financing terms between dealers (including prime brokers and other counterparties with whom hedge fund managers effect trades) and their customers (including hedge funds).  This article summarizes the Survey’s findings with respect to trends in: credit terms offered by dealer-respondents, including prime brokers; demands by hedge funds for better credit terms from prime brokers; overall use of leverage by hedge funds; credit terms with respect to OTC derivatives; and demand for and credit terms relating to securities financing.

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• From Vol. 5 No.9 (Mar. 1, 2012)

  National Futures Association COO Dan Driscoll Discusses Registration, Reporting and Related Challenges Facing Hedge Fund Managers with Strategies Involving Commodities or Derivatives

  Hedge fund managers with strategies that involve commodities or derivatives are facing complicated new registration and reporting requirements.  On the registration side, on February 9, 2012, the Commodity Futures Trading Commission (CFTC) adopted final rules that rescinded the CFTC Rule 4.13(a)(4) exemption from commodity pool operator (CPO) registration that has been heavily relied upon by many hedge fund managers and their affiliates.  See “CFTC Adopts Final Rules That Are Likely to Require Many Hedge Fund Managers to Register as Commodity Pool Operators,” The Hedge Fund Law Report, Vol. 5, No. 7 (Feb. 16, 2012).  As a result, many hedge fund managers will either have to qualify for another exemption from CPO registration (most likely the Rule 4.13(a)(3) exemption for de minimis commodity interest trading activity), or register as a CPO.  See “Do You Need to Be a Registered Commodity Pool Operator Now and What Does It Mean If You Do? (Part One of Two),” The Hedge Fund Law Report, Vol. 5, No. 8 (Feb. 23, 2012).  On the reporting side, with the adoption of new CFTC Rule 4.27(d), CPOs that manage private funds and that are dually registered with the SEC as investment advisers and with the CFTC as CPOs will need to complete Form PF, which requires detailed information about the private funds managed by the adviser/CPO.  See “Form PF: Operational Challenges and Strategic, Regulatory and Investor-Related Implications for Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 5, No. 4 (Jan. 26, 2012).  With these registration, reporting and related challenges in mind, a session at the Regulatory Compliance Association’s Spring 2012 Regulation & Risk Thought Leadership Symposium will identify and address critical issues and pitfalls with respect to Form PF.  That Symposium will be held on April 16, 2012 at the Pierre Hotel in New York.  For more information, click here.  To register, click here.  (Subscribers to The Hedge Fund Law Report are eligible for discounted registration.)  One of the anticipated speaking faculty members for the Form PF session at the RCA Symposium is Dan Driscoll, the Chief Operating Officer of the National Futures Association (NFA).  We recently interviewed Driscoll, who spoke with The Hedge Fund Law Report about Form PF and other issues related to CFTC and NFA regulation of hedge fund managers.  Specifically, our interview covered topics including: interpretational and operational issues related to qualification for the Rule 4.13(a)(3) de minimis exemption from CPO registration; the applicability of the relief granted under Rule 4.7 to hedge fund managers; the NFA examination and enforcement paradigm, including questions about how registrants are targeted for examination, what are the focus areas for NFA audits and how audits can lead to NFA enforcement activity; prospective NFA regulation of swap dealers and major swap participants; and Form PF, including issues related to the use of Form PF data for NFA enforcement activity, interpretation and confidentiality.

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• From Vol. 5 No.8 (Feb. 23, 2012)

  Do You Need to Be a Registered Commodity Pool Operator Now and What Does It Mean If You Do?  (Part One of Two)

  In light of recent CFTC rule amendments repealing the exemption from CPO registration most commonly relied upon by managers of private funds (Rule 4.13(a)(4)), now, more than ever before, it is critical for managers who operate or control private funds to understand: (1) if they must become a registered CPO; and (2) what it means for the operation of their firms and their funds if they do.  See “CFTC Adopts Final Rules That Are Likely to Require Many Hedge Fund Managers to Register as Commodity Pool Operators,” The Hedge Fund Law Report, Vol. 5, No. 7 (Feb. 16, 2012).  In this article – the first of a two-part series – Stephen A. McShea, General Counsel and Chief Compliance Officer of Larch Lane Advisors LLC, provides an overview of the current regulatory landscape of Commodity Futures Trading Commission (CFTC) regulation of commodity pool operators (CPOs).  Specifically, McShea discusses: the regulatory framework governing commodity pools and CPOs, and the remaining exemption from CPO registration for managers who operate or control a private fund; the compliance obligations of a registered CPO; and the enforcement mechanisms and penalties for non-compliance.  This article also provides a quick-reference compliance checklist for registered CPOs.  Part two of this series will discuss exemptions available to the funds (i.e., commodity pools) operated by registered CPOs that provide relief from some of the disclosure and periodic reporting obligations to which the funds would otherwise be subject.  For additional insight from McShea, see “What Do Hedge Fund Managers Need to Know to Prepare For, Handle and Survive SEC Examinations?  (Part Two of Three),” The Hedge Fund Law Report, Vol. 4, No. 5 (Feb. 10, 2011).

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• From Vol. 5 No.7 (Feb. 16, 2012)

  CFTC Adopts Final Rules That Are Likely to Require Many Hedge Fund Managers to Register as Commodity Pool Operators

  On February 9, 2012, the Commodity Futures Trading Commission (CFTC) adopted final rules (Final Rules) amending Part 4 of its regulations promulgated under the Commodity Exchange Act governing commodity pool operators (CPOs) and commodity trading advisers (CTAs).  Notably for hedge funds, the Final Rules, among other things, rescind the exemption from CPO registration contained in Rule 4.13(a)(4), which is relied on substantially in the hedge fund industry.  Notably for hedge funds, the Final Rules differ from the rule amendments proposed by the CFTC (Proposed Rules) on January 26, 2011, in that the Final Rules do not rescind the exemption from CPO registration under Rule 4.13(a)(3) for hedge funds that conduct a de minimis amount of trading in futures, commodity options and other commodity interests.  For an in-depth discussion of the Proposed Rules, see “CFTC Proposes New Reporting and Compliance Obligations for Commodity Pool Operators and Commodity Trading Advisers and Jointly Proposes with the SEC Reporting Requirements for Dually-Registered CPO and CTA Investment Advisers to Private Funds,” The Hedge Fund Law Report, Vol. 4, No. 5 (Feb. 10, 2011).  As a result, unless an exemption is otherwise available, the Final Rules will require a CPO to register with the National Futures Association if the managed commodity pool (i.e., hedge fund) conducts more than a de minimis amount of speculative trading in futures, commodity options and other commodity interests; and CPO registration imposes significant obligations on registrants.  This article provides a detailed summary of the CFTC’s Final Rules and highlights relevant changes from the Proposed Rules.  The article focuses on the provisions of the Final Rules with most direct application to hedge fund managers following commodities-focused investment strategies.

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• From Vol. 5 No.5 (Feb. 2, 2012)

  Second Circuit Rules Hedge Fund VCG Is Not Entitled to Arbitration in CDS Litigation Because It Was Not a Customer of Wachovia Bank

  On October 28, 2011, the U.S. Court of Appeals for the Second Circuit ruled the investment banking unit of Wachovia NA (Wachovia), Wachovia Capital Markets LLC (WCM), did not have to submit to binding arbitration with VCG Special Opportunities Master Fund Ltd. (VCG).  It reasoned that VCG, the hedge fund suing Wachovia over a $9 million credit default swap (CDS), did not constitute a “customer” of the unit.  For additional background, see “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,” The Hedge Fund Law Report, Vol. 3, No. 34 (Aug. 27, 2010), “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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• From Vol. 5 No.2 (Jan. 12, 2012)

  Aksia’s 2012 Hedge Fund Manager Survey Reveals Managers’ 2012 Predictions Regarding Tail Risk Hedges, Portfolio Transparency, Movement of Balances Away from Counterparties and More

  In November 2011, Aksia LLC (Aksia), an independent hedge fund research and advisory firm, published its 2012 Hedge Fund Manager Survey (Survey) in which it solicited predictions for 2012 from 125 hedge fund managers managing approximately $800 billion in assets and employing various investment strategies.  Thirty-eight percent of the respondents employ long-short equity strategies, 26% employ event-driven strategies, 18% employ relative value strategies and 18% employ tactical trading strategies.  Among other things, the respondents made predictions about market and investment strategy performance, economic growth projections and various scenarios with respect to the European financial crisis.  The respondents also shared their views on policymakers’ handling of the global financial crisis as well as the impact of market correlation and new financial regulations on their investment strategies.  Notably, respondents opined on hedge fund industry specific practices, such as the use of hedges for tail risk, portfolio transparency, movement of balances away from counterparties and the availability of financing in 2011.  This article summarizes the Survey’s findings.

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• From Vol. 4 No.45 (Dec. 15, 2011)

  CFTC Position Limit Rules Challenged in Lawsuit by ISDA and SIFMA

  On Friday, December 2, 2011, the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (SIFMA) jointly filed a complaint in the U.S. District Court for the District of Columbia against the Commodity Futures Trading Commission (CFTC).  Their complaint challenges the final rules adopted by the CFTC at its October 18, 2011 meeting establishing speculative position limits on 28 commodity futures, option contracts and economically equivalent commodity swaps (the Position Limit Rules).  This article summarizes the Position Limit Rules and the lawsuit challenging them.  For hedge fund managers that trade covered commodities or derivatives based on them, the Position Limit Rules and the lawsuit can directly affect trading volumes and strategies.  See also “Recent CFTC Settlement with Former Moore Capital Trader Illustrates a Number of Best Compliance Practices for Hedge Fund Managers that Trade Commodity Futures Contracts,” The Hedge Fund Law Report, Vol. 4, No. 30 (Sep. 1, 2011).

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• From Vol. 4 No.37 (Oct. 21, 2011)

  Lehman Brothers Court Holds Triangular Setoff Provisions Unenforceable in Bankruptcy

  On October 4, 2011, the United States Bankruptcy Court for the Southern District of New York held that Section 553(a) of the Bankruptcy Code renders unenforceable cross-affiliate netting or “triangular” (non-mutual) setoff provisions to the extent they cover non-mutual debts between the debtor and entities affiliated with the creditor.

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• From Vol. 4 No.36 (Oct. 13, 2011)

  Hedge Fund Healey Alternative Investment Partnership’s Complaint Against Royal Bank of Canada for Failure to Pay Full Cash Settlement Value of Equity Barrier Call Option Agreement Survives Bank’s Motion to Dismiss

  Plaintiff Hedge Fund Healey Alternative Investment Partnership (Fund) purchased a cash-settled equity barrier call option from defendants Royal Bank of Canada and RBC Dominion Securities Corporation (together, Bank).  The option agreement referenced a basket of financial assets, including interests in hedge funds.  However, the Bank was not obligated to own those assets.  In September 2008, the Bank’s monthly report on the option agreement showed its value to be almost $22 million.  The Fund formally terminated the option agreement as of June 30, 2009.  The Bank paid about $9.16 million to the Fund, but refused to pay any further amounts, claiming that it was unable to value certain hedge fund interests, particularly hedge fund investments held in side pockets.  The Fund sued the bank, claiming breach of contract, breach of fiduciary duty and breach of the covenant of good faith and fair dealing.  The Bank moved to dismiss for failure to state a cause of action.  This article provides a comprehensive summary of the factual background and the District Court’s legal analysis.

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• From Vol. 4 No.35 (Oct. 6, 2011)

  South Korea Permits Domestic Hedge Funds to Use More Leverage and to Increase Investments in Derivatives

  On July 27, 2011, the Financial Services Commission (FSC) of South Korea – South Korea’s SEC – made legislative notice of its proposal to revise the Enforcement Decree of the Financial Investment Services and Capital Markets Act (FSCMA).  The intent of the proposal is to enhance the speed and depth of development of South Korea’s domestic hedge fund market.  To do so, the proposal generally relaxes South Korean securities regulation with respect to who may invest in hedge funds, leverage and asset restrictions, who may manage hedge funds and the activities that prime brokers may undertake.  At the same time, the proposal also contemplates enhanced supervision and surveillance of South Korean hedge fund managers by the FSC, and enhanced reporting to the FSC by hedge fund managers.  On September 27, 2011, South Korea’s cabinet approved the proposal.  This article outlines the proposed revisions of the FSCMA based on available documents and correspondence between the South Korea FSC and The Hedge Fund Law Report.

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• From Vol. 4 No.32 (Sep. 16, 2011)

  In Second Lawsuit Arising Out of Failed CDO Deal, UBS Is Not Permitted to Pursue Claims Against Hedge Fund Manager Highland Capital Management to the Extent those Claims Could Have Been Brought in its Original Suit

  In 2007, UBS Securities LLC and two affiliates (UBS) agreed to finance and serve as placement agents for certain collateralized debt obligations (CDO) that hedge fund manager Highland Capital Management, L.P. (Highland) proposed to issue.  As a result of the 2008 financial crisis, the CDO deal collapsed in December 2008.  UBS then sued Highland in New York State Supreme Court under the indemnification provisions of the CDO deal to recover the losses it allegedly sustained.

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• From Vol. 4 No.31 (Sep. 8, 2011)

  Gold Investment Alternatives for Hedge Fund Managers

  Many hedge fund managers have a view with respect to gold, but few know how to put such a view into practice.  In a guest article, David A. Gulley, a Senior Managing Director at Mesirow Financial Consulting, LLC, and veteran gold banker Ian C. MacDonald, detail the benefits, burdens and mechanics of six distinct methods of investing in gold, the price of gold or gold-related trends.  In addition, Gulley and MacDonald provide a comprehensive discussion of historical, cultural and practical issues relating to gold.

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• From Vol. 4 No.30 (Sep. 1, 2011)

  Recent CFTC Settlement with Former Moore Capital Trader Illustrates a Number of Best Compliance Practices for Hedge Fund Managers that Trade Commodity Futures Contracts

  The Commodity Futures Trading Commission (CFTC) recently entered an order (Order) settling charges that former Moore Capital trader Christopher Louis Pia attempted to manipulate the settlement prices of palladium and platinum futures contracts by “banging the close.”  Specifically, the CFTC alleged that Pia caused market-on-close (MOC) buy orders to be entered in the last ten seconds of the closing periods for both types of contracts in an effort to exert upward pressure on the settlement prices for the contracts.  The Order has attracted considerable attention for various reasons, including the prominence of Moore Capital, the obscure allure of the metals at issue and the Wall Street Journal’s report that Pia “tooled around town in an orange Lamborghini.”  But less attention has been paid to the more important implications of the Order for the hedge fund industry.  Those implications fall into two general categories, one of which focuses on best compliance practices for hedge fund managers that trade commodity futures contracts.  This article discusses the factual allegations and legal analysis in the Order, then outlines some of the more noteworthy implications of the Order for hedge fund managers focused on commodities.  See also “CFTC and SEC Propose Rules to Further Define the Term ‘Eligible Contract Participant’:  Why Should Commodity Pool and Hedge Fund Managers Care?,” The Hedge Fund Law Report, Vol. 4, No. 21 (Jun. 23, 2011).

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• From Vol. 4 No.27 (Aug. 12, 2011)

  U.K. Supreme Court Rules That Change in Priority over Dante CDO Collateral Triggered by Lehman Bankruptcy Does Not Violate Britain’s Anti-Deprivation Bankruptcy Rule

  Belmont Park Investments PTY Limited was one of several Australian institutional investors (Noteholders) that purchased notes under the “Dante” collateralized debt obligation (CDO) program sponsored by Lehman Brothers Special Financing Inc. (Lehman).  The proceeds of the Dante notes were used by a Lehman special purpose vehicle to purchase AAA rated debt instruments that were held by BNY Corporate Trustee Services Limited as collateral to secure the parties’ obligations under the CDO and a related credit default swap.  Central to this dispute were CDO and swap provisions that shifted priority to the collateral from Lehman to the Noteholders in the event of Lehman’s bankruptcy.  In related cases involving Lehman, U.S. Bankruptcy Courts had previously ruled that the priority-shifting provision was a prohibited ipso facto clause, and ruled that Lehman retained first priority to the collateral.  In contrast, the U.K. Supreme Court has now ruled that the provision does not violate the United Kingdom’s anti-deprivation rule.  We summarize the Supreme Court’s decision.  For a discussion of two related U.S. Bankruptcy Court decisions, see “Bankruptcy Court Holds That a Provision in a Derivative Contract Subordinating Payments to a Bankrupt Counterparty May Be an Unenforceable Ipso Facto Clause,” The Hedge Fund Law Report, Vol. 4, No. 18 (June 1, 2011); “Bankruptcy Court Finds Unenforceable CDO Provisions Subordinating Swap Termination Payments to Swap Counterparty Lehman Brothers as a Result of Its Bankruptcy,” The Hedge Fund Law Report, Vol. 3, No. 5 (Feb. 4, 2010).  See also “Treatment of a Hedge Fund’s Claims Against and Other Exposures To a Covered Financial Company Under the Orderly Liquidation Authority Created by the Dodd-Frank Act,” The Hedge Fund Law Report, Vol. 4, No. 15 (May 6, 2011).

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• From Vol. 4 No.25 (Jul. 27, 2011)

  Second Circuit Decision Sends CSX and Hedge Fund Suitors TCI and 3G Back to District Court to Examine When Funds Formed a “Group” to Acquire CSX Stock, Leaving Unresolved the Issue of Beneficial Ownership of Shares Referenced in Cash-Settled Total-Return Equity Swaps

  In 2006, hedge funds sponsored by The Children’s Investment Fund Management and 3G Capital Management (respectively, TCI and 3G, or the Funds) believed shares of railroad giant CSX Corporation (CSX) were undervalued and sought to “unlock” that value by influencing CSX management.  The Funds acquired positions in CSX both directly and through cash-settled total-return equity swaps that referenced CSX stock.  See “IRS Directive and HIRE Act Undermine Tax Benefits of Total Return Equity Swaps for Offshore Hedge Funds,” The Hedge Fund Law Report, Vol. 3, No. 12 (Mar. 25, 2010).  Unable to persuade CSX management to change its policies, in January 2008, the Funds commenced a proxy fight.  In response, CSX sued the Funds for violating the disclosure requirements of Section 13(d) of the Securities and Exchange Act of 1934.  CSX argued that the Funds were the beneficial owners of the CSX shares that the Funds' counterparties had acquired to hedge the swap contracts and that the Funds had been operating as an undisclosed “group.”  The District Court agreed and enjoined the Funds against future violations of Section 13(d) but refused to prohibit the Funds from voting their shares at the CSX meeting.  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).  Each of the parties appealed different parts of the District Court’s decision, and on July 18, 2011 – almost three years after the appeal was argued – the Second Circuit issued its long-awaited decision in the matter.  This article summarizes the Second Circuit’s decision.  For a summary of the original complaint in this matter, see “CSX Sues Hedge Funds TCI and 3G for Violating Federal Securities Laws,” The Hedge Fund Law Report, Vol. 1, No. 4 (Mar. 24, 2008).

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• From Vol. 4 No.24 (Jul. 14, 2011)

  OTC Derivatives Clearing: How Does It Work and What Will Change?

  New over-the-counter (OTC) derivatives regulations have been proposed in both the U.S. and the E.U., which once finalized will affect how market participants trade, provide margin with respect to and settle OTC derivatives.  The new regulations will have an impact on the liquidity, transparency and pricing for these products and a key component of both regimes will be the central clearing of certain standardized swaps.  If a market participant wishes to engage in a swap that is of a type that the applicable regulator has determined must be cleared, the swap must be submitted to a clearinghouse for clearing unless an exception applies.  While certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act passed by the U.S. Congress last year will become effective on July 16, 2011, most key provisions are expected to be finalized by the end of 2011.  In Europe, the new derivatives regulations proposed by the European Commission are still pending.  OTC derivatives clearing will therefore soon become a reality for most market participants in the U.S. – including many hedge funds – as well as foreign market players trading these products with U.S. counterparties.  In a guest article, Fabien Carruzzo and Joshua Little, Senior Associate and Associate, respectively, at Kramer Levin Naftalis & Frankel LLP, describe the clearing process, how hedge funds and other market participants will trade and access clearing and what will change from the current bilateral trading model.  Carruzzo and Little also address margin requirements and how trades and margin are protected in the event of default by a dealer (clearing member).  Finally, the authors provide a general overview of the documentation governing contractual relationships among market participants.

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• From Vol. 4 No.21 (Jun. 23, 2011)

  CFTC and SEC Propose Rules to Further Define the Term “Eligible Contract Participant”:  Why Should Commodity Pool and Hedge Fund Managers Care?

  On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act” or “Dodd-Frank”) into law.  Section 721(c) of Title VII of the Dodd-Frank Act made certain changes to the definition of the term “eligible contract participant” (“ECP”).  Subsequently, as part of their efforts to implement Dodd-Frank, the Commodity Futures Trading Commission (the “CFTC”) and the Securities and Exchange Commission (the “SEC” and, together with the CFTC, the “Commissions”) proposed rules to further refine the definition of ECP under the Commodity Exchange Act (“CEA”) (the “Proposed Rules”).  Unless the Commissions withdraw or revise the Proposed Rules before they become effective, the definitional change will negatively affect many commodity pools that engage in over-the-counter (“OTC”) foreign currency (“FX”) transactions.  In a guest article, Steven M. Felsenthal, General Counsel and Chief Compliance Officer of Millburn Ridgefield Corporation, The Millburn Corporation and Millburn International, LLC, and Stephanie T. Green, a legal and compliance intern at The Millburn Corporation: (1) introduce the Proposed Rules as applied to commodity pools engaged in OTC FX transactions; (2) highlight the adverse result of the Proposed Rules; and (3) discuss revisions or alternatives to the Proposed Rules that could help to avoid such adverse results.  While the focus of this article is the adverse results on commodity pools, the same adverse results would apply to any pooled investment vehicle that seeks to trade OTC FX forward contracts, including hedge funds that trade such instruments, because they would likely fall within the definition of commodity pool under Dodd-Frank.

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• From Vol. 4 No.18 (Jun. 1, 2011)

  Bankruptcy Court Holds That a Provision in a Derivative Contract Subordinating Payments to a Bankrupt Counterparty May Be an Unenforceable Ipso Facto Clause

  On May 12, 2011, the United States Bankruptcy Court for the Southern District of New York, in its oversight of the jointly administered chapter 11 bankruptcy cases of Lehman Brothers Holding, Inc. (LBHI) and Lehman Brothers Special Financing, Inc. (LBSF), found that a provision in a derivative contract that would subordinate payments to a counterparty in the event of its bankruptcy or insolvency may constitute an unenforceable ipso facto clause, and that the termination payments provision of the relevant contract was not eligible for the Bankruptcy Code safe harbor for qualified financial contracts.  This decision reaffirmed the holding in a prior decision in the LBHI bankruptcy.  See “Bankruptcy Court Finds Unenforceable CDO Provisions Subordinating Swap Termination Payments to Swap Counterparty Lehman Brothers as a Result of Its Bankruptcy,” The Hedge Fund Law Report, Vol. 3, No. 5 (Feb. 4, 2010).  Although this decision largely follows the legal analysis in the prior decision rather than breaking new legal ground, this decision is likely to increase the negotiating leverage of the LBHI estate vis-à-vis swap and other counterparties.  More generally, the decision sheds additional light on the treatment of bankruptcy/insolvency-based termination provisions in derivatives contracts.  This article details the background of the adversary proceeding and the Court’s legal analysis.  For more on the operation of bankruptcy/insolvency-based termination provisions in qualified financial contracts under the Bankruptcy Code and Title II of the Dodd-Frank Act, see “Treatment of a Hedge Fund’s Claims Against and Other Exposures To a Covered Financial Company Under the Orderly Liquidation Authority Created by the Dodd-Frank Act,” The Hedge Fund Law Report, Vol. 4, No. 15 (May 6, 2011).

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• From Vol. 4 No.15 (May 6, 2011)

  Federal Energy Regulatory Commission Upholds Administrative Law Judge Ruling that Imposes $30 Million Penalty on Former Amaranth Trader Brian Hunter for Natural Gas Market Manipulation During 2006

  Defendant Brian Hunter (Hunter) was an executive and head natural gas trader at hedge fund manager Amaranth Advisors, LLC (Amaranth).  The Federal Energy Regulatory Commission (FERC), which has jurisdiction over interstate sales of natural gas and electricity, has upheld in all respects the findings of a FERC administrative law judge who found Hunter guilty of manipulation of the natural gas market and imposed a $30 million penalty on him.  At the end of February, March and April 2006, Hunter sold large volumes of natural gas futures contracts on their expiration dates in order to drive down the settlement prices of those contracts.  Gas futures contracts trade on the New York Mercantile Exchange (NYMEX).  FERC argued that, unbeknownst to traders on the NYMEX, Hunter had amassed short positions in natural gas swap agreements that referenced the settlement prices of the gas futures contracts.  Consequently, he stood to profit from the drop in the settlement price of gas futures contracts that occurred when Amaranth dumped those contracts on their expiration dates.  Amaranth collapsed in late 2006, in large part because of the bets it had made on the natural gas market.  FERC determined that Hunter’s trading was intended to manipulate the price of natural gas futures contracts, was done knowingly and had an effect on the market for natural gas.  FERC bills this case as the “first fully litigated proceeding involving FERC’s enhanced enforcement authority under section 4A of the Natural Gas Act, which prohibits manipulation in connection with transactions subject to FERC jurisdiction.”  The trading at issue occurred only in the futures market, rather than in the physical gas market.  We summarize FERC’s decision.  See also “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,” The Hedge Fund Law Report, Vol. 3, No. 12 (Mar. 25, 2010).

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• From Vol. 4 No.15 (May 6, 2011)

  European Asset Manager Seeks Recovery from LIBOR Panel Banks for Hedge Funds That Lost Income on LIBOR-Based Derivative Contracts

  In a putative class action complaint filed in the U.S. District Court for the Southern District of New York on April 15, 2011, a European asset manager, FTC Capital GMBH, and two of its futures funds, FTC Futures Fund SICAV and FTC Futures Fund PCC Ltd., accused twelve banks of colluding to manipulate the London interbank offered rate (LIBOR) from 2006 to June 2009.  LIBOR generally is the published average of rates at which selected banks (including the defendants) lend to one another in the London wholesale money market.  LIBOR is a global benchmark lenders use to set short-term and adjustable interest rates for almost $350 trillion in financial contracts.  These contracts include those heavily utilized by hedge funds, such as “fixed income futures, options, swaps and other derivative products” traded on the Chicago Mercantile Exchange (CME) and over-the-counter (OTC).  If understated, as alleged in the complaint, LIBOR provides a discount to borrowers, and can cause significant losses to hedge funds that utilize LIBOR-related financial instruments.  This article explains what LIBOR is and how it is used in derivatives contracts, summarizes the material allegations in the complaint and discusses relevant reports in the business press about potential manipulation of LIBOR.

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• From Vol. 4 No.5 (Feb. 10, 2011)

  CFTC Proposes New Reporting and Compliance Obligations for Commodity Pool Operators and Commodity Trading Advisers and Jointly Proposes with the SEC Reporting Requirements for Dually-Registered CPO and CTA Investment Advisers to Private Funds

  On January 26, 2011, the U.S. Commodity Futures Trading Commission (CFTC) proposed amendments to Part 4 of its regulations promulgated under the Commodity Exchange Act (CEA) governing Commodity Pool Operators (CPOs) and Commodity Trading Advisers (CTAs).  The CFTC announced a joint effort with the U.S. Securities and Exchange Commission (SEC) proposing the adoption of a new rule on reporting for investment advisers required to register with the SEC that advise one or more private funds and that are also CPOs or CTAs required to register with the CFTC (dual registrants).  This joint endeavor, mandated by Section 406 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), would obligate dual registrants to file newly-created Form PF with the SEC in order to satisfy both Commissions’ filing requirements.  In an effort to harmonize its rules with this regulatory scheme, the CFTC separately announced a proposed amendment requiring all registered CPOs and CTAs to electronically file newly-created Forms CPO-PQR and CTA-PR with the National Futures Association (NFA) pursuant to § 4.27 of the CFTC regulations, forms substantively identical to Form PF.  The CFTC has also proposed further changes to its regulations that it deemed necessary in the wake of recent economic turmoil and the new regulatory environment engendered by the Dodd-Frank Act.  These proposed amendments would: (1) rescind the exemption from registration for CPOs provided in §§ 4.13(a)(3) and (a)(4) of its regulations; (2) revise § 4.7 so that CPOs may no longer claim an exemption from certifying certain annual reports; (3) incorporate the definition of “accredited investor” promulgated by the SEC in Regulation D into § 4.7; (4) reinstate the criteria for claiming an exclusion from the definition of CPO provided in § 4.5; (5) require any CPO or CTA seeking exemptive relief pursuant to §§ 4.5, 4.13 and 4.14 to annually renew their request with the NFA; and (6) require an additional risk disclosure statement under §§ 4.24 and 4.34 for any CPO or CTA engaged in swap transaction.  The CFTC intends to promulgate these new rules in an effort to provide effective oversight of the commodity futures and derivatives markets and to manage the risks, especially systemic risks, posed by any pooled investment vehicles under its jurisdiction.  This article provides a detailed summary of the CFTC’s proposed amendments.

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• From Vol. 3 No.34 (Aug. 27, 2010)

  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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• From Vol. 3 No.32 (Aug. 13, 2010)

  Dodd-Frank May Impose New Obligations on Managers of Large Hedge Funds and Plan Asset Hedge Funds that Enter into Swaps

  Placement agents, in-house marketers, data providers and others interviewed by The Hedge Fund Law Report have identified two salient trends in the current hedge fund capital raising environment: the “race to the top” and the growing importance of ERISA money.  As discussed below, both trends highlight the importance to the hedge fund industry of a provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank or the Act), enacted on July 21, 2010, relating to swaps with “special entities.”  On the first trend: The race to the top refers to the fact – good for larger managers, not so good for smaller and start-up managers – that the lion’s share of recent inflows have gone to the largest hedge funds.  According to data provider Hedge Fund Research, Inc., 93 percent of the $9.5 billion of net inflows into hedge funds in the second quarter of 2010 went to funds managed by managers with more than $5 billion in assets under management (AUM).  And that capital raising advantage is only enhancing the current distribution of assets in favor of larger managers.  According to HFR, as of June 30, 2010, managers with $5 billion or more in AUM managed approximately 60 percent of total industry assets of $1.6 trillion.  Moreover, HFR data as of June 30 showed that while 342 hedge funds with $1 billion or more in AUM comprised just 4.9 percent of the total number of hedge funds globally, they accounted for 76.1 percent of total industry AUM.  While a full analysis of the reasons for this race to the top is beyond the scope of this article, a few of the reasons are discussed herein.  However, investors racing to the top may miss many of the more interesting hedge fund investment opportunities.  According to research published by PerTrac Financial Solutions in February 2007 and updated to incorporate 2009 data, smaller, younger hedge funds appear to perform better, over longer periods, than larger, older funds.  And on the second trend: The Hedge Fund Law Report has and continues to analyze the growing importance of ERISA investors in hedge funds.  See, for example, The Hedge Fund Law Report’s three-part series on ERSIA considerations for hedge fund managers and investors.  The story here is essentially as follows: private sector pension funds are the most important category of ERISA investor.  According to data provider Preqin, as of late 2009, private sector pension funds represented 14 percent of institutional investors in hedge funds and constituted the largest group of investors actively considering their first investment in hedge funds in 2010.  Moreover, survey data released by Preqin on August 10, 2010 indicates that 29 percent of institutional investors plan to allocate more capital to hedge funds in the next 12 months while just 15 percent are looking to redeem, meaning the balance of inflows into hedge funds over the next year is expected to be positive.  Preqin also found that 37 percent of institutional investors are planning to invest in new hedge funds in the next 12 months.  Many of those new investments, often with new managers, will come from private sector pension funds and other ERISA investors.  Accordingly, more hedge fund managers (by number and AUM) will become subject to ERISA in the near term.  In anticipation of that trend, we have provided managers with a roadmap for accepting ERISA money without materially undermining their investment and operational discretion.  See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part Three of Three),” The Hedge Fund Law Report, Vol. 3, No. 24 (Jun. 18, 2010).  In light of the importance of the race to the top and ERISA money to hedge fund capital raising, any legal provision that directly impacts larger hedge funds and hedge funds subject to ERISA (Plan Asset Hedge Funds) is of central importance to the industry.  Dodd-Frank contains precisely such a provision.  Specifically, Dodd-Frank will require a “swap dealer” or “major swap participant” that enters into a swap with a “special entity” to: (1) have a reasonable basis to believe that the special entity has an independent representative that, among other things, has sufficient knowledge to evaluate the transaction and risks; and (2) comply with certain business conduct standards.  As explained more fully below, the definition of “major swap participant” in Dodd-Frank may include large hedge funds, and the definition of “special entity” in Dodd-Frank may include Plan Asset Hedge Funds.  See “Hedge Fund Industry Practice for Defining ‘Class of Equity Interests’ for Purposes of the 25 Percent Test under ERISA,” The Hedge Fund Law Report, Vol. 3, No. 29 (Jul. 23, 2010).  To help explain the application of this “swaps and special entities” provision of Dodd-Frank to hedge fund managers, swap dealers and others, this article: defines the relevant terms, including a discussion of the extent to which those definitions may include hedge funds and hedge fund managers; offers examples of applications of the special entities provision in the hedge fund context; explains the mechanics of the “reasonable basis test” included in the statute; describes the business conduct standards; then analyzes the elements of the statutory reasonable basis test, including a potential “de facto best execution” standard included in the test.

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• From Vol. 3 No.26 (Jul. 1, 2010)

  Video Interview with Roger Liddell, CEO of LCH.Clearnet, Regarding Mechanics of OTC Derivatives Clearing and Implications for Hedge Funds

  The Hedge Fund Law Report recently interviewed Roger Liddell, CEO of LCH.Clearnet, one of the largest independent clearinghouses.  Our interview focused on the mechanics and goals of clearing, especially as it relates to over-the-counter derivatives, and the relationship between clearinghouses and hedge funds, either as derivatives market participants or clearinghouse members.  (One important point from the interview is that broker-dealers and futures commission merchants generally are more natural fits for clearinghouse membership than most hedge funds.)  A video recording of the interview is available in this issue of The Hedge Fund Law Report, and we would like to thank the following attorneys for providing insight, context and derivatives expertise that informed the questions in this interview: Leigh Fraser, Partner at Ropes & Gray, LLP; Marilyn Selby Okoshi, Partner at Katten Muchin Rosenman LLP; Richard Chen, Counsel at Arnold & Porter LLP; and Fabien Carruzzo, Associate at Kramer Levin Naftalis & Frankel LLP.

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• From Vol. 3 No.26 (Jul. 1, 2010)

  In Enforcement Action Against Investment Adviser ICP Asset Management, LLC, SEC Alleges More than $1 Billion of Improper Trades, Trades at Inflated Prices and Other Fraudulent Conduct in Connection with ICP’s Management of Triaxx CDOs

  The SEC has commenced an enforcement action against investment adviser ICP Asset Management, LLC (ICP), its broker-dealer affiliate ICP Securities, LLC, holding company Institutional Credit Partners, LLC, and their principal, Thomas C. Priore.  ICP was the collateral manager of four Triaxx collateralized debt obligations (CDOs) that invested primarily in mortgage-backed securities.  The SEC claims that ICP engaged in a variety of prohibited and fraudulent conduct, including self-dealing, breach of its fiduciary duties to the Triaxx CDOs, engaging in fraudulent transactions among those CDOs, trading to benefit one CDO at the expense of the others, and making trades that benefited another ICP client at the expense of the Triaxx CDOs.  The SEC alleges violations of the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 and seeks an injunction against future violations, disgorgement of profits and civil penalties.  We summarize the SEC’s complaint.  See also “Defunct Hedge Fund Basis Yield Alpha Fund (Master) Sues Goldman Sachs for Securities Fraud Arising Out of the Fund’s Investment in Goldman’s Timberwolf CDO,” The Hedge Fund Law Report, Vol. 3, No. 24 (Jun. 18, 2010).

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• From Vol. 3 No.23 (Jun. 11, 2010)

  Bankruptcy Court Finds Swedbank AB Violated Automatic Stay in Lehman Brothers’ Bankruptcy; Rules Safe Harbor Provisions Do Not Override Setoff Mutuality Requirement

  In bankruptcy parlance, a “setoff” refers to the ability of a creditor and a debtor that owe each other money to apply their claims against one another, if called for under non-bankruptcy law.  As a prerequisite to exercising setoff rights, Section 553(a) of the Bankruptcy Code (the Code) requires “mutuality” between debtor and creditor and debt and credit.  Mutuality exists when “the debts and credits are in the same right and are between the same parties, standing in the same capacity.”  In the absence of mutuality, a creditor’s refusal to pay amounts due to a bankrupt estate may violate various sections of the Code, including Section 362, the automatic stay, even if the estate also owes the creditor money.  Exceptions exist, however.  For instance, in 2005, Congress amended Section 560 and enacted Section 561 of the Code, to provide safe harbors for, inter alia, any pre-existing contractual right of a swap participant to offset or net termination values from the swap agreements in another participant’s bankruptcy.  On May 5, 2010, Judge James Peck of the United States Bankruptcy Court for the Southern District of New York, presiding over the Chapter 11 Bankruptcy of Lehman Brothers Holdings Inc. (LBHI) and its affiliates (collectively, Lehman), squarely addressed whether these Code amendments erased the requirement of “mutuality” for a party to a swap agreement to engage in a “setoff” under Section 553(a).  The Court held that “A contractual right to setoff under derivative contracts does not change well established law that conditions such a right on the existence of mutual obligations.”

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• From Vol. 3 No.16 (Apr. 23, 2010)

  SEC Accuses Goldman, Sachs & Co. and a Goldman V.P. of Securities Fraud

  On April 16, 2010, the U.S. Securities & Exchange Commission charged Goldman, Sachs & Co. and Fabrice Tourre, a vice president on leave from Goldman, with committing fraud in the structuring and marketing of a synthetic collateralized debt obligation (CDO) linked to subprime mortgages.  See “SEC Charges Goldman, Sachs & Co. and a Goldman V.P. with Securities Fraud; Hedge Fund Manager Paulson & Co. Named in Complaint, But Not Charged with Any Violation of Law or Regulation,” The Hedge Fund Law Report, Vol. 3, No. 15 (Apr. 16, 2010).  The SEC alleges that one of the world’s largest hedge fund managers, Paulson & Co., paid Goldman to create the CDO, participated in the process of selecting subprime residential mortgage-backed securities (RMBS) to be referenced by the instruments in the CDO and then entered into a credit default swap transaction with Goldman to buy protection from credit events on specific layers of the CDO.  According to the SEC, Paulson did not violate federal securities law in its actions, but Goldman did when it thereafter failed to disclose to investors that Paulson had played a key role in developing the financial product when Paulson also had an investment that would increase in value if the CDO decreased in value.  The case represents the latest in a series of SEC enforcement actions seeking to hold firms accountable for their alleged roles in the financial crisis.  As the SEC alleged in its complaint filed in U.S. District Court for the Southern District of New York, Goldman’s actions “contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.”  This article provides a detailed recitation of the key factual and legal allegations in the SEC’s complaint, and outlines Goldman’s preliminary response.

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• From Vol. 3 No.12 (Mar. 25, 2010)

  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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• From Vol. 3 No.5 (Feb. 4, 2010)

  Bankruptcy Court Finds Unenforceable CDO Provisions Subordinating Swap Termination Payments to Swap Counterparty Lehman Brothers as a Result of Its Bankruptcy

  On January 25, 2010, the United States Bankruptcy Court for the Southern District of New York ruled that the automatic stay and ipso facto clauses of the Bankruptcy Code forbid enforcement of structured finance provisions which alter the priority in bankruptcy of swap termination payments upon a default.  The court’s decision – a declaratory judgment on behalf of Lehman Brothers Special Financing, Inc. (LBSF) that these swap payment alteration provisions were unenforceable against it – casts doubt upon the enforceability of these market-standard provisions in other structured finance transactions in which hedge funds may engage.  We detail the background of the action, the court’s intricate legal analysis and the practical implications of the decision.

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• From Vol. 3 No.3 (Jan. 20, 2010)

  New IRS Audit Guidelines Target Equity Swaps with Non-U.S. Counterparties

  On January 14, 2010, the Large and Mid-Scale Business division of the IRS issued its “Industry Directive on Total Return Swaps Used to Avoid Dividend Withholding Tax” (Swap Audit Guidelines).  In addition to providing audit guidance to IRS field agents auditing U.S. financial institutions and U.S. branches of foreign financial institutions, the Swap Audit Guidelines contain six Information Document Requests for agents to use to solicit information from financial institutions that have equity swap operations.  The new guidance is substantially more detailed than the previous guidance.  As a result, IRS audits of financial institutions undertaken in accordance with the Swap Audit Guidelines are likely to impose a significant compliance burden on affected companies.  The purpose of the Swap Audit Guidelines is to assist IRS agents in “uncovering and developing cases related to total return swap transactions that may have been executed in order to avoid tax with respect to U.S. source dividend income” paid to non-U.S. persons.  The Swap Audit Guidelines posit four different transaction structures involving equity swaps.  If an IRS agent uncovers one of these fact patterns, he is encouraged to “develop facts supporting a legal conclusion that the Foreign Person retained ownership of the reference securities.”  In a guest article, Greenberg Traurig, LLP Shareholder Mark Leeds examines those four transaction structures in depth, and discusses the implications of the Swap Audit Guidelines for over-the-counter derivatives markets participants.

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• From Vol. 3 No.3 (Jan. 20, 2010)

  CFTC Proposes Position Limits for Four Energy Contracts in the Energy Futures and Options Markets to Curb Volatility

  On January 14, 2010, the Commodity Futures Trading Commission (CFTC) proposed limits for certain futures and option contracts in the major energy markets that may curtail the investments of large banks and swaps dealers in the markets for oil, natural gas, heating oil and gasoline.  The proposal aims to curb some of the significant price volatility that occurred in 2007 and 2008.  Under the proposal, speculators in the futures markets will no longer be grouped together with commodity-linked businesses like airlines and oil companies that may exceed limits on the number of energy futures one trader can hold.  In addition, the proposal establishes consistent, uniform exemptions for certain swap dealer risk management transactions while maintaining exemptions for bona fide hedging.  This article outlines the proposed rule, the exemptions and the rule’s implications for hedge fund participants in the futures markets.

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• From Vol. 3 No.2 (Jan. 13, 2010)

  New York Federal Court Rules that Investors Can Sue Derivatives Issuer Ambac Financial Group

  On December 23, 2009, the United States District Court for the Southern District of New York refused to dismiss a derivative securities fraud putative class action against defendant Ambac Financial Group Inc. (Tolin v. Ambac Financial Group Inc., 08 Civ. 11241 (S.D.N.Y., filed Dec. 24, 2008)).  In so doing, the court answered a question of first impression: whether investors in mortgage-related derivatives had standing to pursue their claims where they had not purchased these securities directly from the issuer-defendant.  The court ruled that the holding in Ontario Pub. Serv. Employees Union Pension Trust Fund v. Nortel Networks Corp., 369 F.3d 27 (2d Cir. 2004), which stated that a shareholder has to purchase or sell the securities of the defendant company to have standing under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, did not prevent purchasers of a derivative securities products from bringing a Rule 10(b)(5) fraud action against an issuer of securities where an intermediary issuer had bundled those securities to create the derivative.  We detail the allegations in the complaint and the court’s legal analysis.

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• From Vol. 2 No.48 (Dec. 3, 2009)

  ISDA Announces Appointment of Conrad P. Voldstad as Chief Executive Officer

  On November 19, 2009, The International Swaps and Derivatives Association, Inc. announced that its Board of Directors had appointed Conrad P. Voldstad as Chief Executive Officer.

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• From Vol. 2 No.33 (Aug. 19, 2009)

  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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• From Vol. 2 No.33 (Aug. 19, 2009)

  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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• From Vol. 2 No.30 (Jul. 29, 2009)

  Celent Report Identifies Best Practices for Over-The-Counter Derivatives Collateral Management

  When any entity, including a hedge fund, trades over-the-counter (OTC) derivatives, it assumes the risk that the counterparty – a bank, financial institution or another hedge fund – will fail to perform.  To mitigate that risk, OTC derivatives documents require each party to post collateral.  The amount of collateral adjusts based on: (1) the value of the derivative; and (2) the value of the collateral.  Both values fluctuate.  This practice, commonly referred to as OTC derivatives collateralization, has grown increasingly popular because of the recent credit crisis.  Celent, a Boston-based financial research and consulting firm, recently issued a report entitled: “OTC Derivatives Collateral Management: A Credit Risk Mitigation Technique Revisited,” regarding the status of and best practices for OTC derivatives collateralization.  The report found that collateralization of OTC derivatives has expanded due to greater hedge fund participation in these transactions.  The report identified the best practices for entities, including hedge funds, who participate in collateralized OTC transactions.  This article summarizes these best practices and the other major findings of the report, as they relate to hedge funds.

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• From Vol. 2 No.26 (Jul. 2, 2009)

  SEC Chairman Mary L. Schapiro and CFTC Chairman Gary Gensler Testify Before Congress On Addressing Gaps in Regulation of Securities-Related OTC Derivatives; Schapiro Suggests Imminent Beneficial Ownership Requirements for Equity Derivatives

  The severe financial crisis that unfolded over the last two years revealed serious weaknesses in the structure of financial regulation, as well as the pressing need for a comprehensive regulatory framework.  Blame for the crisis has focused in part on the lack of regulation of the over-the-counter (OTC) derivatives markets. As a result, a critical component of President Obama’s financial plan involved regulating the markets for derivatives.  (For a more detailed analysis of the Obama Administration’s new proposal, see “The Obama Administration Outlines Major Financial Rules Overhaul, Announces Greater Scrutiny for Hedge Funds and Derivatives,”  The Hedge Fund Law Report, Vol. 2, No. 25 (Jun. 24, 2009)).  On June 22, 2009, the chairmen of both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) testified before Congress regarding the regulation of these markets.  Specifically, SEC Chairman Mary L. Schapiro and CFTC Chairman Gary Gensler urged Congress to address existing gaps in regulatory oversight of securities-related OTC derivatives.  They proposed a new framework that would expand the regulatory authority of the CFTC and SEC to oversee the OTC derivatives markets.  We describe their testimony, and the four primary objectives they aim to achieve.

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• From Vol. 2 No.20 (May 20, 2009)

  Treasury, SEC and CFTC Jointly Propose Mandatory Central Clearing of Standardized Over-The-Counter Derivatives

  On May 13, 2009, the Secretary of the Treasury, Timothy Geithner, along with the chairman of the Securities and Exchange Commission (SEC), Mary Schapiro, and the acting chairman of the Commodity Futures Trading Commission (CFTC), Michael Dunn, jointly announced a plan for reforming the regulation of over-the-counter (OTC) derivatives.  Secretary Geithner elaborated on the plan in a letter dated the same day to House and Senate leaders.  At the heart of the proposed reform is legislation that would require centralized clearing – through “central counterparties” or CCPs – of all standardized OTC derivatives.  To prevent circumvention of the legislation, Geithner has cautioned that the customization of derivatives must not be “used solely as a means to avoid using a CCP.”  Such practices might be headed off, Geithner suggested, by the creation of a legal presumption: the acceptance for clearing by one or more regulated CCPs of an OTC derivative would create a presumption that the accepted contract is standard, and thus within the mandatory clearing requirement.  We provide a detailed discussion of the proposed reforms as well as the Authorizing the Regulation of Swaps Act, proposed by Senators Carl Levin (D-MI) and Susan Collins (R-ME) on May 4, 2009.

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• From Vol. 2 No.12 (Mar. 25, 2009)

  FSA Publishes Revised Disclosure Rules for Contracts for Difference

  The United Kingdom Financial Services Authority (FSA) recently published a Policy Statement (PS09/3), which expands its regime for the disclosure of major shareholdings to include contracts for difference (CfD) and similar financial instruments.  The Policy Statement responds to comments received by the FSA in response to its Consultation Paper (08/17) and includes final rules for the new disclosure regime for CfDs and other similar financial instruments.  We explore the material terms of the new Policy Statement, and discuss similar developments with respect to the disclosure regime applicable to total return equity swaps under United States law.

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• From Vol. 2 No.10 (Mar. 11, 2009)

  ISDA Announces Various Changes to the Legal and Operational Infrastructure of Credit Default Swaps with a View Towards Fungibility of Trades

  In recent weeks, the International Swaps and Derivatives Association (ISDA) announced and published various actions designed to substantially revamp the legal and operational framework of the derivatives markets generally, and the credit default swaps (CDS) market specifically.  ISDA’s various efforts all appear aimed at the same objectives: (1) to advance the standardization and fungibility of CDS trades in response to calls from politicians and some industry participants for central clearing of CDS, and (2) to enhance the overall transparency and predictability in the CDS markets.  The changes initiated by ISDA include the following: (1) “hardwiring” Auction Settlement into new CDS trades by adding a supplement to the 2003 ISDA Credit Derivatives Definitions; (2) establishing Credit Derivatives Determinations Committees (CDDCs) to, at the request of a CDS market participant, oversee the settlement auctions and make certain determinations with respect to CDS trades; (3) facilitating the amendment of outstanding CDS trades to incorporate the provisions for Auction Settlement and CDDCs – the so-called “Big Bang Protocol”; (4) proposing certain market practice changes with respect to North American CDS; and (5) publishing, on February 27, 2009, its Close-Out Amount Protocol, which generally enables parties to amend the 1992 ISDA Master Agreement to provide for determination of termination payments according to the “Close-Out Amount Method” used in the 2002 ISDA Master Agreement rather than the 1992 ISDA Master Agreement’s “Market Quotation” or “Loss” methods.  We discuss each of these actions in detail, and outline considerations for hedge funds in connection with the Close-Out Amount Protocol.

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• From Vol. 2 No.9 (Mar. 4, 2009)

  The Lehman Bankruptcy and Swap Lessons Learned Negotiating an ISDA Master Agreement in Today’s Market

  Recent market events have caused many entities to examine their agreements regarding a variety of relationships they have with brokers and other trading counterparties.  Many over-the-counter derivative trades are documented using the form of Master Agreement of the International Swaps and Derivatives Association Inc. (ISDA), and therefore many entities have been paying particular attention to these ISDA Master Agreements and their related schedules and confirmations.  In a guest article, Thomas H. French and Jack I. Habert, Partner and Special Counsel, respectively, at Willkie Farr & Gallagher LLP, highlight certain provisions of the ISDA Master Agreement that have generated significant interest for counterparties as market conditions have changed in the wake of the Lehman bankruptcy.

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• From Vol. 2 No.7 (Feb. 19, 2009)

  House Bill Would Require Mandatory Settlement and Clearing of Over-The-Counter Derivatives, Authorize the CFTC to Suspend Trading in “Naked” Credit Default Swaps and Make Certain Other Changes to the Derivatives Regulatory Regime

  On February 12, 2009, the Agriculture Committee of the US House of Representatives approved the Derivatives Markets Transparency and Accountability Act of 2009 (DMTA), a bill that would require, among other things, prospective over-the-counter (OTC) transactions in commodities excluded or exempt from the Commodities Exchange Act (CEA) to be settled and cleared through a designated clearing organization approved by the CFTC, or a clearing agency regulated by the SEC, or in some circumstances by a clearing agency with a foreign government regulator.  Other provisions of the bill would impose limits on the speculative positions in commodity derivatives, and authorize the CFTC and the President to suspend trading in “naked” credit default swaps when an SEC suspension order is in effect.  In short, the bill proposes a dramatic revision of the mechanics by which over-the-counter derivatives markets in the US (and to some extent, outside of the US) have operated since the 2000 amendments to the CEA.  If enacted in its current form, the bill would move the swaps market away from the bilateral, OTC model toward a model dominated by standardized contracts.  We provide a detailed analysis of how the bill would work and how it would change the regulatory landscape for OTC derivatives.

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• From Vol. 1 No.29 (Dec. 24, 2008)

  Proposed Senate Bill on Credit Derivatives Would Put CDS under the Umbrella of the CFTC, Running Counter to SEC Plans

  In a move that could radically alter the DNA of the over-the-counter credit derivatives business, Senator Tom Harkin (Democrat, Iowa), chairman of the Senate Agriculture, Nutrition and Forestry Committee, introduced a bill on November 20 that would force all over the counter (OTC) financial instruments, including credit default swaps, onto regulated futures exchanges.  Harkin’s bill, named the Derivatives Trading Integrity Act 2008, would require derivatives to be traded as futures contracts, thus falling under the sole supervision of the Commodity Futures Trading Commission (CFTC).  We detail the substance of the bill and its potential implications for CDS and other OTC derivatives.

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• From Vol. 1 No.25 (Nov. 26, 2008)

  ISDA Master Agreement and Credit Support Annex at Heart of Hedge Fund Collateral Dispute

  BDC Finance LLC has filed a lawsuit against Barclays Bank Plc, its counterparty in a derivatives facility that involved both total return swap and credit default swap index transactions.  The suit – like the recent Lehman Brothers bankruptcy and SIPA filings – highlights the importance of close attention to the terms of ISDAs and related swap documentation, especially the identity of the valuation agent in various circumstances and the parties’ obligations with respect to posting and return of collateral.

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• From Vol. 1 No.23 (Oct. 28, 2008)

  Fannie Mae and Freddie Mac’s Credit Default Swaps Auction May Buttress Case Against Regulation of Derivatives

  Amid renewed pressures from policy makers to increase regulatory oversight of the $55 trillion over-the-counter credit default swaps market, on Monday, October 6, buyers and sellers of Fannie Mae and Freddie Mac’s debt obligations successfully settled their counterparty exposure in an auction administered by Creditex and Markit in partnership with 13 major credit derivatives dealers.  Auctions have emerged as one of the most efficient methods of settling rights and obligations of parties in the CDS market upon the occurrence of major credit events.  According to market observers, the Fannie and Freddie auction, as well as the low-priced Lehman auction, are a clear sign that CDS markets can operate in an orderly fashion in the midst of the most pervasive financial crisis in decades.  “The process has been very orderly and the CDS market continues to function and provide liquidity,” an ISDA official told The Hedge Fund Law Report.

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• From Vol. 1 No.23 (Oct. 28, 2008)

  Ongoing Credit Crisis is Significantly Impacting Trading of OTC Derivatives, TABB Group Study Reveals

  In the face of the current credit crisis, a growing range of investment firms are trading equity derivatives.  According to a new study published by the TABB Group, a research and advisory firm, entitled “Equity Swaps and OTC Options 2008: A Buy-side Perspective,” nearly two-thirds of the 32 asset managers interviewed at buy-side firms in the U.S. trading an aggregate of $6.35 trillion dollars of assets under management say that the continuing credit crisis is having a significant impact on their trading of over-the-counter derivatives.  Moreover, more than half of U.S. asset managers have tightened their risk management processes in the aftermath of the credit crunch to guard against the counterparty failures in the equity derivatives markets.  The Study reports that as many as 57% of the buy-side firms surveyed said that the main impact of the credit crisis is an increased focus on counterparty risk.

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• From Vol. 1 No.21 (Sep. 22, 2008)

  Pushed by Regulators, Industry Sets Ambitious Goals to Modernize OTC Derivatives Infrastructure

  Major dealers and industry associations have agreed with international regulators to actively pursue ambitious infrastructure improvements in the over-the-counter derivatives market. The goal of the improvements is to reduce systemic risk and enhance transparency in the $450 trillion (notional) market for instruments that Warren Buffett has famously called “financial weapons of mass destruction.” At the core of the infrastructure improvement proposal is a dramatic expansion of the use of electronic platforms. The goal is to achieve automated matching on trade date, known in the industry as T+0, thereby “creating an environment that will mirror performance in mature markets and eliminate material confirmations backlogs.”

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• From Vol. 1 No.20 (Sep. 4, 2008)

  UK Imposes Strict Rules on Derivatives Disclosure, Perhaps Setting the Stage for More Hedge Fund Regulation in the US

  In a policy statement due later this month, the FSA is expected to propose that so-called contracts for difference (CFDs) must be disclosed as if they were common shares. CFDs are equity derivatives that enable traders to obtain exposure to the price performance of a wide variety of assets – including equity shares, indices and commodities – without directly owning the underlying assets. The new UK disclosure regime would be consistent with the recent decision in the US case of CSX v. TCI & 3G (which was covered in the June 19, 2008 issue of The Hedge Fund Law Report). According to the FSA, such a general disclosure regime for long CFD positions will be “the most effective way of addressing concerns in relation to voting rights and corporate influence.” However, hedge fund industry participants have criticized the move as “heavy-handed” and unnecessary. Also, hedge fund professionals have expressed a concern that the new disclosure regime could reduce trading volumes and increase the cost of capital.

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• From Vol. 1 No.6 (Apr. 7, 2008)

  Operations Management Group Sends Letter to New York Fed Regarding Industry Efforts to Increase Transparency in OTC Derivatives Market Operations Manageme

  • OMG Letter outlined goals for derivatives dealers and trade associations for 2008, including:
  • Expanded use of electronic confirmation platforms.
  • Development of trade associations’ goal implementation plans.
  • Major dealers and buy-side institutions to meet submission, matching and accuracy targets.
  • Having most major dealers live for central settlement.
  • Submission of novation requests via electronic platforms rather than email.

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