In the scramble for liquidity starting in summer 2007 and persisting, in varying degrees, through today, the perception and use of redemption requests has evolved.  Traditionally, hedge fund managers and investors understood redemption requests as irrevocable; and the constituent documents of most hedge funds reflect that understanding, requiring the manager to process any redemption request properly received from an investor.  However, fund documents also generally grant the manager – in its discretion and consistent with its fiduciary duty to the fund and all of its investors – discretion to grant a request by an investor to revoke its redemption request.  During the credit crisis, some investors have been taking advantage of such provisions in fund documents by submitting “preemptive” redemption requests.  That is, they have been submitting requests for full or partial redemptions for each redemption period, then withdrawing those redemption requests before the redemption is effectuated.  The specific purpose of such preemptive redemption requests is to avoid getting caught in a gate, or to submit redemption requests before the manager suspends redemptions.  The general goal of such requests is to maximize a claim on liquidity in a time of illiquidity and market dislocation.  However, while the ability to submit such requests is good for the investor that reserves the right to redeem, it is bad for the manager and other investors.  In effect, the ability to submit preemptive redemption requests gives the requester an option on redemption.  But like any option, this one has a cost.  In this case, the cost is borne not by requester, but by the other fund investors.  And that cost has at least three components: (1) reduced liquidity for other investors (who may be caught by a gate if total redemption requests in any period exceed a certain threshold of net asset value, usually around 15 percent); (2) costs in connection with preparing to meet the redemption, such as administrative and valuation fees, brokerage commissions, etc.; and (3) opportunity costs, which consist of the manager selling at inopportune times to raise the cash required to pay redemptions, or missing good investment opportunities while sitting on that cash.  In economic parlance, investors submitting preemptive redemption requests are internalizing the liquidity benefits of such requests while externalizing the various costs of such requests to other fund investors.  Since fund managers have a legal fiduciary duty to act in the best interests of the fund and all of its investors, and a practical duty to avoid, to the extent possible, operational structures that inhibit their ability to manage their funds, managers have been looking for credible ways to prevent or mitigate revocations of redemption requests.  We detail four specific strategies that managers are using to discourage revocation of redemption requests, and another approach to redemptions that may render all of those techniques unnecessary. Read full article …

On May 20, 2009, the Securities and Exchange Commission (SEC) published its proposed amendments to Rule 206(4)-2 of the Investment Advisers Act of 1940, as amended (the Advisers Act), relating to “Custody of Funds or Securities of Clients by Investment Advisers.”  The suggested amendments: substantially increase protections for investors who allow investment advisers to retain custody over their assets; promote independent custody; enable independent public accountants to act as third-party monitors; and provide the SEC with better information about the custodial practices of registered investment advisers.  The rules would impose surprise accounting examinations on investment advisers who have custody of client assets, and additional reporting requirements by independent accountants.  We describe the proposed amendments in detail. Read full article …

Following a spate of alleged Ponzi schemes and two dozen recent enforcement actions involving the misuse of client funds, the SEC has proposed amendments to custody rules to increase scrutiny and accountability of money managers.  The most significant of the proposed changes would require all registered investment advisers who have any kind of custody of client assets to undergo a surprise examination by an independent public accountant once per year to verify the existence and proper treatment of the funds.  The rigor and reporting requirements would differ depending on whether investment advisers place client funds with affiliated or unaffiliated custodians.  As a companion piece to our article describing the proposed amendments to the custody rules (above, in this issue of the Hedge Fund Law Report), we offer reactions from industry participants to the proposed amendments, and discuss the potential impact of the amendments on unregistered hedge fund managers. Read full article …

From May 18th through May 20th, 2009, Financial Research Associates LLC and The Hedge Fund Business Operations Association presented the Second Annual Hedge Fund Tax, Accounting & Administration Master Class in New York City.  During the three-day conference, leading industry participants discussed the latest developments in hedge fund taxation, regulation, accounting and administration.  A key theme among the participants was that valuation will receive greater regulatory focus going forward, and hedge fund managers will need to keep up to date on relevant changes in accounting standards in order to prevent (or survive) investigations from the SEC and other regulators.  We summarize some of the key take-aways from the conference, and we include a lengthy discussion of how to approach and survive an SEC examination based on comments at the conference from Thomas Biolsi, Associate Regional Director of the SEC, and Thomas Verderber, Staff Accountant at the SEC. Read full article …

Purchasers (including hedge funds and other investment funds) of residential mortgage loans will have affirmative disclosure obligations to consumers under The Helping Families Save Their Homes Act of 2009 (Act), which Congress passed last week and sent to President Obama for his signature.  While most have focused attention on the Act’s “safe harbor” for servicers and amendments to the FHA Hope for Homeowners Program, this new statutory obligation will subject purchasers of mortgage loans to civil liability if they fail to make the required disclosures.  This provision does not require regulations first to be promulgated and is effective upon the President’s signature.  In a guest article, Laurence E. Platt and Kerri M. Smith, Partner and Associate, respectively, at K&L Gates LLP, discuss this underappreciated provision in the Act – which can have a powerful impact on the returns (and reputations) of hedge funds involved in buying and selling residential mortgage loans. Read full article …

On May 12, 2009, the Treasury Department released President Obama’s fiscal 2010 tax and revenue proposals in a lengthy book with a green cover.  Accordingly, everyone is calling the list of proposals, the “Green Book.”  President Obama did not desire to raise taxes during the worst recession in the last 80 years.  As a result, most of the revenue proposals would not be effective until 2011, when the current economic crisis is expected to abate.  The Green Book proposals have yet to be introduced as formal legislation.  The current political climate and President Obama’s extraordinary popularity make the introduction and passage of the bulk of the proposals extremely likely.  In a guest article, Mark Leeds and Diana Davis, Shareholder and Counsel, respectively, at Greenberg Traurig LLP, discuss in detail the Green Book, and its potential implications for hedge funds and their managers. Read full article …

What happens under the Bankruptcy Code if the recipient of a voidable transfer has transferred the property received from a bankrupt debtor to a third party?  Specifically, can the bankruptcy trustee, or the trustee in a proceeding under the Securities Investor Protection Act of 1970, seek the property in question from the third party, or would the trustee be limited to seeking its value from the original transferee?  The short answer is that trustees generally may have the statutory authority to bring recovery actions against remote transferees with respect to such property, but such remote transferees may have robust defenses that render it legally and practically difficult to collect from them.  Recent actions brought by Irving Picard, the Madoff trustee, against the Fairfield Greenwich Group and Jeffrey Picower and his foundation and related entities exemplify the disconnect between available legal remedies and the low likelihood of collection.  This article examines the statutory landscape and the factual context of Picard’s recent actions. Read full article …

A strategy employed by certain hedge funds involves the purchase of heavily discounted, sometimes defaulted, sovereign debt, followed by legal action seeking the face value of that debt.  The present political climate is not perceived as favorable for hedge funds that employ this strategy, as evidenced by the epithet “vulture funds” often used to describe them.  According to sources interviewed by the Hedge Fund Law Report, legislation restricting investment activities relating to sovereign debt may be passed in the U.K in the coming months.  On May 6, 2009, Sally Keeble, a Labour Party Member of the U.K. Parliament, introduced a bill that would severely limit the recovery, within the courts of the U.K., on the defaulted sovereign debt of developing countries.  We discuss the legal considerations in connection with a sovereign debt strategy generally, and Keeble’s bill specifically. Read full article …

On May 1, 2009, the Securities and Exchange Commission’s Office of Economic Analysis (OEA) published a summary of a study indicating that a pre-borrow requirement on naked short selling effectively curbs abuses, but also has the unintended effect of significantly increasing the costs of legitimate transactions.  We provide a detailed synopsis of the OEA’s summary of its study. Read full article …