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    Jun. 18, 2010

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)

This is the third of three articles in a series intended to acquaint – or reacquaint – hedge fund managers, investors, service providers and others with the basic principles and prohibitions of, and exemptions from, the Employee Retirement Income Security Act of 1974 (ERISA).  The first article in this series explained how hedge fund managers can become – or avoid becoming – subject to ERISA.  That article focused primarily on the “25 percent test,” which generally provides that if benefit plan investors (e.g., corporate pension funds) own less than 25 percent of any class of equity interests issued by a hedge fund, the hedge fund manager will not be subject to ERISA.  See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part One of Three),” Hedge Fund Law Report, Vol. 3, No. 19 (May 14, 2010).  The second article in the series detailed the consequences to a hedge fund manager of becoming subject to ERISA, which can happen, for example, if a large non-ERISA investor redeems, causing the proportionate ownership of benefit plan investors to exceed 25 percent of a class of equity interests.  Those consequences most notably include the imposition of a heightened fiduciary duty and a prohibition on many transactions between the hedge fund and “parties in interest” to a benefit plan invested in the hedge fund.  See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part Two of Three),” Hedge Fund Law Report, Vol. 3, No. 20 (May 21, 2010).  As that second article noted, ERISA’s list of prohibited transactions is so long, and ERISA’s definition of “party in interest” (and the parallel definition of “disqualified person” under the Internal Revenue Code) so expansive, that strict compliance by investment managers with ERISA’s prohibited transaction provisions would undermine the basic purpose of ERISA; broadly, that purpose is to ensure the ethical, unconflicted and competent management of retiree money.  Accordingly, Congress (by statute) and the Department of Labor (by regulation and other action) have created a series of exemptions from the prohibited transaction provisions.  These exemptions enable a hedge fund to accept investments from benefit plan investors above the 25 percent threshold and to engage in many transactions that otherwise would be prohibited by ERISA.  That is, many hedge fund managers heretofore have taken the view that a fund can have significant ERISA money or a manager can have unfettered investment discretion, but not both.  But the prohibited transaction exemptions, properly understood and implemented, come close to reconciling that dichotomy.  To assist hedge fund managers in obtaining ERISA assets while retaining investment discretion, this article provides a comprehensive roadmap to the prohibited transaction exemptions most relevant to hedge fund managers.  Specifically, this article discusses: ERISA’s definition of “party in interest”; prohibited transactions under ERISA by category; typical hedge fund transactions that would (absent statutory and regulatory relief) be prohibited by ERISA; the conditions required to be satisfied for a hedge fund manager to qualify as a qualified professional asset manager (QPAM); the impact of the financial regulation overhaul bills on hedge fund managers’ eligibility for the QPAM exemption; the conditions required to be satisfied for a transaction to be eligible for the QPAM exemption; the impact of ERISA’s anti-self-dealing provisions on the timing of disposition of investments in private equity funds and hybrid funds; the service provider exemption; the eleven conditions that must be satisfied for performance compensation to comply with ERISA; the cross trading exemption; the foreign exchange transaction exemption; the electronic communication networks exemption; the block trading exemption; individual exemptions, including a discussion of a recent individual exemption granted to Ivy Asset Management Corporation in connection with a proposed sale of shares of offshore hedge funds owned by a hedge fund of funds; and a provocative provision included in the Restoring American Financial Stability Act of 2010, passed by the U.S. Senate on May 20, 2010, that threatens to undermine the ability of certain hedge funds to enter into swaps with prime brokers.

The Space between Alpha and Beta (and Why Hedge Fund Investors Should Care)

The concept of alpha vs. beta within the investment community is anything but new.  But too often the discussion is black and white as if some universal on/off switch can only be turned to the traditional definitions of alpha or beta, with nothing existing in between.  We are at a time in the evolution of the hedge fund landscape when this topic is particularly meaningful, especially given the various labels that have been put on the industry such as “absolute return,” “uncorrelated asset class,” and “alpha generators.”  There are a number of methods and products today – devised by investment banks, fund managers and even an occasional academic – that claim to replicate hedge fund returns or provide something called hedge fund beta.  In a guest article, Clint Stone, CFA, Principal Investment Analyst covering hedge fund strategies at the investment office at Cornell University, summarizes the differences between the various replication and hedge fund beta methods, frames why hedge fund investors should care about these concepts and discusses how institutional investors may want to implement them (or at least think about them) in their asset allocation and portfolio construction.

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

Hedge fund Basis Yield Alpha Fund (Master) (Fund) has commenced a civil securities fraud suit against Goldman Sachs (Goldman) in the Southern District of New York.  In March 2007, Goldman created a collateralized debt obligation (CDO) known as Timberwolf 2007-1, which was allegedly part of Goldman’s efforts to reduce its exposure to the subprime mortgage market.  The Fund agreed to purchase $100 million face value of interests in Timberwolf for about $80.8 million.  Within months of the purchase, Timberwolf had declined in value by more than 80 percent, resulting in the Fund’s collapse and subsequent liquidation.  The Fund alleges that, in selling Timberwolf interests to the Fund, Goldman failed to tell the Fund that it considered Timberwolf to be a bad deal, that Goldman expected the value of CDO’s based on the subprime mortgage market to decline in value, and that Goldman was short selling both the stock of companies involved in the subprime business and the underlying CDO’s owned by Timberwolf.  Despite that, the Fund alleges that Goldman assured the Fund that the price for the Timberwolf interest was “a good entry price” and that the subprime market had stabilized.  We summarize the allegations made by the Fund.

New York State Courts Side With Elm Ridge Hedge Funds and Founder Ronald Gutfleish in Fee Dispute With Former Manager Douglas DiPasquale

On May 18, 2010, the New York State Supreme Court, Appellate Division, First Department, affirmed a Manhattan trial court order entering partial summary judgment on behalf of the defendants, Ronald Gutfleish, Elm Ridge Capital Management, LLC (ERCM), Elm Ridge Value Advisors, LLC (ERVA), Elm Ridge Partners, LLC (ERP) and Elm Ridge Management, LLC (ERM), in a separation agreement fee dispute with a former manager, Douglas DiPasquale, the plaintiff.  DiPasquale had resigned as co-managing member of ERCM and ERVA, two firms that advised and managed three hedge funds controlled by Gutfleish, in exchange for a share of future profits from ERCM and ERVA.  Following DiPasquale’s resignation, Gutfleish created ERP and ERM to replace ERVA and ERCM, and ceased payments to DiPasquale.  The New York State courts dismissed DiPasquale’s complaint to the extent that he sought damages from the defendants because they found the separation agreement authorized Gutfleish’s actions.  We detail the background of the action and the courts’ legal analysis.

Hedge Fund Managers Anticipate Higher U.S. Equity Trading Volumes in 2010, TABB Group Report Finds

A recent report by financial markets research and strategic advisory firm TABB Group found that the hedge fund industry is poised for significant growth during the remainder of 2010 in terms of assets under management (AUM) and equity trading volumes.  The report, entitled “U.S. Hedge Fund Equity Trading 2010: Commissions, Volumes and Traders,” forecast that industry AUM will reach $1.8 trillion by the end of this year, and that equity trading volumes will rebound significantly from their credit crisis lull, augmented by an increased use of leverage.  In a recent webinar, Matt Simon, a TABB Group Analyst and author of the report, discussed the report and its findings.  This article summarizes those findings, which include: expected increases in hedge fund trading volumes; decreases in the number of execution traders on hedge fund trading desks; increases in use of dark pools, algorithms and direct market access (DMA) by hedge funds for equity trades; and anticipated increases in commissions for broker-dealers.

Jim McCarney, a Litigator with Extensive Hedge Fund Litigation Experience, Joins Sheppard Mullin

On June 15, 2010, Sheppard, Mullin, Richter & Hampton LLP announced that James G. McCarney has joined the firm’s Business Trial practice group in its New York office.  McCarney has extensive experience in representing hedge funds in litigation and related matters.  His clients have included the Irish hedge fund Structured Credit Company and Parametric Capital Management.

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