The Hedge Fund Law Report

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

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By Topic: Derivatives

  • From Vol. 11 No.44 (Nov. 8, 2018)

    ISDA 2018 U.S. Resolution Stay Protocol: Should Fund Managers Adhere or Not?

    Many fund managers have already received notices from their swap dealer counterparties regarding the implementation of “contractual stay rules” adopted by the U.S. federal banking authorities (QFC Rules). Swap dealers are now urging their counterparties to adhere to the ISDA 2018 U.S. Resolution Stay Protocol (Protocol). Fund managers that do not adhere to the Protocol or take other steps to bring their trading documentation into compliance may not be able to trade certain qualifying financial contracts with their counterparties after January 1, 2019. In this guest article, Michele Navazio, partner at Seward & Kissel, provides an overview of the Protocol and related QFC Rules, with an emphasis on issues that fund managers need to consider in assessing whether to adhere to the Protocol or opt for bilateral amendments to their trading documentation. The relative merits of the two approaches strongly suggest that fund managers should, in almost all cases, choose to adhere to the Protocol. For more on the QFC Rules and Protocol, see “Steps Fund Managers Should Take Now to Ensure Their Trading of Swap, Repo and Securities Lending Transactions Continues Uninterrupted After January 1, 2019” (Oct. 18, 2018). For additional commentary from Navazio, see “Private Funds Conference Addresses Recent Developments Relating to Fund Structuring and Terms; SEC Examinations and Enforcement Initiatives; Seeding Arrangements; Fund Mergers and Acquisitions; CPO Regulation; JOBS Act Implementation and Compliance; and Derivatives Reforms (Part Three of Three)” (Nov. 14, 2013).

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  • From Vol. 11 No.41 (Oct. 18, 2018)

    Steps Fund Managers Should Take Now to Ensure Their Trading of Swap, Repo and Securities Lending Transactions Continues Uninterrupted After January 1, 2019

    The regulatory fallout from the 2008 global financial crisis continues to affect derivatives and other instruments traded by private funds. Final rules issued in 2017 by three U.S. federal banking regulators (the U.S. Stay Regulations) alter how certain qualified financial contracts (QFCs) will be treated in U.S. bankruptcy proceedings. Although neither private funds nor their managers have direct obligations under the U.S. Stay Regulations, fund managers will nevertheless need to bring certain trading agreements into compliance with those regulations in order to continue trading QFCs with bank counterparties or their affiliates after January 1, 2019. In a recent interview with The Hedge Fund Law Report, Leigh Fraser, partner at Ropes & Gray and co-leader of the firm’s hedge fund group, discussed the U.S. Stay Regulations; the impact that these new regulations have on the trading and documentation of QFCs by private funds; and ways fund managers can ensure compliance with the new regulations, including a discussion of the recently released ISDA 2018 U.S. Resolution Stay Protocol. For additional insights from Fraser, see “Steps Hedge Fund Managers Should Take Now to Ensure Their Swap Trading Continues Uninterrupted When New Regulation Takes Effect March 1, 2017” (Feb. 9, 2017); and our three-part series on best practices in negotiating prime brokerage arrangements: “Preliminary Considerations When Selecting Firms and Brokerage Arrangements” (Dec. 1, 2016); “Structural Considerations of Multi-Prime and Split Custodian-Broker Arrangements” (Dec. 8. 2016); and “Legal Considerations When Negotiating Prime Brokerage Agreements” (Dec. 15, 2016).

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  • From Vol. 11 No.39 (Oct. 4, 2018)

    A Fund Manager’s Guide to the Initial Margin Rules for Uncleared Swaps (Part Two of Two)

    U.S. and E.U. regulators continue to phase in the application of initial margin (IM) requirements applicable to uncleared over-the-counter (OTC) derivatives transactions. September 1, 2020, is the date when most funds that are in scope of the IM rules in the U.S. and the E.U. (together, the IM Rules) will be required to post and collect IM to/from their dealer counterparties. Many swap dealers are currently contacting their clients to determine which of them will be in scope and when. All fund managers that trade uncleared OTC derivatives, therefore, will need to understand the IM Rules and how they affect the funds that they manage in order to engage in productive conversations with their dealer counterparties and amend their swaps trading documentation. In this guest article, the second in a two-part series, Sidley Austin partners Elizabeth Schubert and Leonard Ng, along with associate Kate Lashley, explore which funds will be in scope of the IM Rules and review the timing for the implementation of the IM Rules. The first article provided an overview of the IM Rules and discussed the IM threshold that affected parties may adopt; the requirement to segregate IM; the changes an affected fund will be required to implement to accommodate compliance; and the models and methodologies available to calculate IM. See our two-part series on how the final margin rules will affect hedge funds: “Increased Margin Requirements” (Feb. 18, 2016); and “Increased Trading Costs” (Feb. 26, 2016). For additional insight from Ng, see “Hedge Fund Legal Personnel May Fall Under U.K. Senior Managers Regime” (Feb. 4, 2016).

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  • From Vol. 11 No.38 (Sep. 27, 2018)

    A Fund Manager’s Guide to the Initial Margin Rules for Uncleared Swaps (Part One of Two)

    Regulators in the U.S., E.U. and other jurisdictions are in the process of implementing margin requirements for uncleared over-the-counter derivatives transactions, including rules regarding bilateral posting of initial margin (IM Rules). Although the IM Rules in the U.S. and the E.U. will not take effect until September 1, 2020, compliance with them requires advance planning, and many swap dealers are beginning to contact their clients to determine which of them will be in scope and when. Affected funds will be required to amend existing uncleared swap documentation (or enter into new documentation); establish custody relationships; determine the amount of initial margin (IM) they will be required to post and collect; and monitor threshold calculations. In this guest article, the first in a two-part series, Sidley Austin partners Elizabeth Schubert and Leonard Ng, along with associate Kate Lashley, provide an overview of the IM Rules and discuss the IM threshold that affected parties may adopt; the requirement to segregate IM; the changes an affected fund will be required to implement to accommodate compliance; and the models and methodologies available to calculate IM. The second article will explore which funds will be in scope of the IM Rules and review the timing for the implementation of the IM Rules. For a discussion of the variation margin requirement, see “Steps Hedge Fund Managers Should Take Now to Ensure Their Swap Trading Continues Uninterrupted When New Regulation Takes Effect March 1, 2017” (Feb. 9, 2017). For additional insight from Ng, see “What Are the Implications for Investment Managers of the Revised Prudential Framework for E.U. Investment Firms?” (Mar. 22, 2018); and “E.U. Market Abuse Scenarios Hedge Fund Managers Must Consider” (Dec. 17, 2015).

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  • From Vol. 11 No.37 (Sep. 20, 2018)

    NFA Mandates New Disclosures on Certain Virtual Currency Activities

    Citing a “variety of unique and potentially significant risks,” the NFA has issued an Interpretive Notice (Notice) to NFA-regulated firms that engage in certain derivatives and underlying or spot transactions involving virtual currencies. The Notice requires that regulated entities provide robust disclosures about the risks peculiar to virtual currency activities in their offering and disclosure documents and promotional materials, and provide customers with a specific notice expressing that the NFA does not have regulatory authority over spot or underlying virtual currency transactions. This article analyzes the key provisions of the Notice, along with several potential traps for unwary fund managers, with insight from a practitioner with expertise in this area. See our three-part series on blockchain and the financial services industry: “Basics of the Technology and How the Financial Sector Is Currently Employing It” (Jun. 1, 2017); “Potential Uses by Private Funds and Service Providers” (Jun. 8, 2017); and “Potential Impediments to Its Eventual Adoption” (Jun. 15, 2017).

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  • From Vol. 11 No.28 (Jul. 12, 2018)

    Women in Derivatives Event Features Address by CFTC Chair Giancarlo and Panel Discussion on the Intersection of Technology and Regulation

    A recent program presented by Women in Derivatives featured opening remarks by CFTC Chairman J. Christopher Giancarlo that focused on the CFTC’s use of market data to gauge the impact of algorithmic trading on market stability, as well as a panel discussion that discussed cutting edge business and regulatory issues concerning blockchain technology, cryptocurrencies and artificial intelligence. Petal Walker, special counsel at WilmerHale, moderated the panel, which featured Chris Brummer, professor at Georgetown Law; Isabelle S. Corbett, senior counsel and director of regulatory affairs at software firm R3; Amy Davine Kim, global policy director and general counsel at Chamber of Digital Commerce; and Sigrid Seibold, principal at KPMG US. This article summarizes the key takeaways from Giancarlo’s remarks, his responses to audience questions and the panelists’ insights. For more from Giancarlo, see “As Cryptocurrencies Advance, CFTC Commissioner Encourages Formation of an SRO to Oversee Customer Protection” (May 31, 2018); and Virtual Currencies Present Significant Risk and Opportunity, Demanding Focus From Regulators, According to CFTC Chair” (Feb. 8, 2018).

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  • From Vol. 11 No.26 (Jun. 28, 2018)

    HFLR Program Provides Overview of Five Financing Options Available to Private Funds (Part One of Two)

    Depending on the nature of their operations, strategies and investments, private fund managers have access to a number of different sources of financing. A recent webinar presented by The Hedge Fund Law Report provided an overview of the following types of financing arrangements used by private funds: total return swap (TRS) financing, structured repurchase agreements (repos), prime broker (PB) financing, special purpose vehicle (SPV) financing and subscription credit facilities. The program was moderated by Kara Bingham, Associate Editor of The Hedge Fund Law Report, and featured Fabien Carruzzo, partner at Kramer Levin; Matthew K. Kerfoot, partner at Dechert; and Jeff Johnston, managing director at Wells Fargo Securities, LLC. This article, the first in a two-part series, explores basic principles of financing arrangements and provides an overview of PB financing and TRS financing. The second article will provide an in-depth discussion of structured repos, SPV financing and subscription credit facilities. See “Types, Terms and Negotiation Points of Short- and Long-Term Financing Available to Hedge Fund Managers” (Mar. 16, 2017).

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  • From Vol. 11 No.15 (Apr. 12, 2018)

    U.S. District Court Rules That Virtual Currencies Are Commodities Under the Commodity Exchange Act

    Blockchain, virtual currencies and the businesses associated with them are developing in largely uncharted regulatory territory. This does not mean, however, that regulators are ignoring the technology and asset class. The U.S. District Court for the Eastern District of New York (EDNY) recently handed the CFTC a significant victory, ruling that virtual currencies are commodities under the Commodity Exchange Act, thereby giving the CFTC jurisdiction over fraudulent conduct involving them. See “What Fund Managers Investing in Virtual Currency Need to Know About NFA Reporting Requirements and the CFTC’s Proposed Interpretation of ‘Actual Delivery’” (Mar. 1, 2018); and “Virtual Currencies Present Significant Risk and Opportunity, Demanding Focus From Regulators, According to CFTC Chair” (Feb. 8, 2018). This article details the facts and circumstances leading up to the enforcement action and the EDNY’s reasoning. For more on blockchain, see “How Blockchain Will Continue to Revolutionize the Private Funds Sector in 2018” (Jan. 4, 2018); as well as our three-part series on blockchain and the financial services industry: “Basics of the Technology and How the Financial Sector Is Currently Employing It” (Jun. 1, 2017); “Potential Uses by Private Funds and Service Providers” (Jun. 8, 2017); and “Potential Impediments to Its Eventual Adoption” (Jun. 15, 2017).

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  • From Vol. 11 No.14 (Apr. 5, 2018)

    Three Asset-Based Financing Options for Private Funds: Total Return Swaps, Structured Repos and SPV Financing (Part One of Two)

    Traditional forms of financing – such as cash prime brokerage, securities lending and plain-vanilla repurchase agreements – continue to account for a large portion of the financing available to private funds and asset managers. These financing arrangements, however, tend to be available only for more liquid assets and are generally either callable on demand or committed for six months or less. As funds seek to use greater leverage; finance esoteric, illiquid assets; and obtain financing on a more committed and longer-term basis, bespoke financing arrangements have become increasingly popular, most of which can be categorized into three buckets: (1) total return swap (TRS) financing; (2) structured repo financing; and (3) special purpose vehicle/entity (SPV) financing. In this guest article, the first in a two-part series, Fabien Carruzzo and Daniel King, partner and associate, respectively, at Kramer Levin, review the main features of TRS financing, and highlight the comparative advantages and disadvantages to private funds of using this structure, taking into consideration the flexibility, the complexity of the legal documentation and the level of asset protection afforded by the structure. The second article will provide a comparative overview of structured repo financing and SPV financing transactions. For further discussion of financing available to private funds, see “Types, Terms and Negotiation Points of Short- and Long-Term Financing Available to Hedge Fund Managers” (Mar. 16, 2017); and “How Fund Managers Can Mitigate Prime Broker Risk: Preliminary Considerations When Selecting Firms and Brokerage Arrangements (Part One of Three)” (Dec. 1, 2016). For additional commentary from Carruzzo, see “OTC Derivatives Clearing: How Does It Work and What Will Change?” (Jul. 14, 2011).

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  • From Vol. 11 No.11 (Mar. 15, 2018)

    SEC’s Reg Flex Agenda Promotes Transparency While Adding Potential Compliance Burdens

    The SEC recently published its latest semi-annual Regulatory Flexibility Agenda (Agenda) setting forth rulemaking actions that Chair Jay Clayton and his staff intend to pursue over the next several months. Investment advisers and hedge funds will be directly affected by several of the Agenda items, such as the reporting of proxy votes on executive compensation. Likewise, the Agenda’s provisions relating to business continuity and transition plans will affect investment advisers, although those proposed rules may be difficult to apply, given the variance in hedge fund manager sizes, profiles and leadership structures. Despite implementation and other challenges, the Commission’s push to publicize its rulemaking priorities helps fund managers prepare for possible major regulatory developments and marks a step toward greater transparency and accountability. To that extent, the publication of the Agenda aligns with the Trump administration’s stated pro-business stance. To cast light on the above issues, this article analyzes the Agenda’s provisions that are most relevant to private fund managers and provides insights from legal professionals with experience in SEC enforcement matters. For coverage of recent SEC enforcement trends, see “SEC Enforcement Action Highlights Highly Specific Regulatory Focus on Conflicts of Interest” (Jan. 25, 2018); and “SEC Signals Aggressive Stance on Individual Responsibility, Including Potential CCO Liability, in FY 2017 Annual Report” (Dec. 14, 2017).

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  • From Vol. 11 No.9 (Mar. 1, 2018)

    What Fund Managers Investing in Virtual Currency Need to Know About NFA Reporting Requirements and the CFTC’s Proposed Interpretation of “Actual Delivery”

    Last December, the NFA adopted new reporting requirements for member commodity pool operators (CPOs) and commodity trading advisors (CTAs) related to virtual currency. Separately, the CFTC published a proposed interpretation of the term “actual delivery” in the context of retail commodity transactions in virtual currency. These actions reflect the enhanced regulatory oversight of virtual currency against the backdrop of spectacular volatility in these products and the recent launch of futures contracts involving virtual currency products. In a guest article, Lawrence B. Patent, of counsel at K&L Gates, reviews the new NFA reporting requirements for CPOs and CTAs; the CFTC’s proposed interpretation of the term “actual delivery”; considerations for hedge fund managers seeking to invest in virtual currency; and the outlook for further regulatory action in this area. See our three-part series on blockchain and the private funds industry: “Basics of the Technology and How the Financial Sector Is Currently Employing It” (Jun. 1, 2017); “Potential Uses by Private Funds and Service Providers” (Jun. 8, 2017); and “Potential Impediments to Its Eventual Adoption” (Jun. 15, 2017). For additional insights from Patent, see our three-part CPO compliance series: “Conducting Business with Non-NFA Members (Bylaw 1101)” (Sep. 6, 2012); “Marketing and Promotional Materials” (Oct. 4, 2012); and “Registration Obligations of Principals and Associated Persons” (Feb. 7, 2013).

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  • From Vol. 11 No.7 (Feb. 15, 2018)

    SEC Halts Registration of Cryptocurrency Mutual Funds, Calling for Dialogue Regarding Valuation, Liquidity, Custody, Arbitrage and Manipulation Risk

    Dalia Blass, Director of the SEC Division of Investment Management, has issued a staff letter to the Securities Industry and Financial Markets Association and the Investment Company Institute outlining her Division’s concerns about funds that invest in cryptocurrencies. The letter focuses on registered funds that desire to invest in cryptocurrencies and indicates that, for the time being, the SEC will not register funds that “intend to invest substantially in cryptocurrency and related products.” It also sheds light on the SEC’s general view of this evolving asset class, which may inform its perspective on private fund investments involving cryptocurrencies. This article summarizes the letter and its key takeaways for managers considering launching cryptocurrency funds, as well as any industry participant contemplating investing in cryptocurrencies. For more on investment in cryptocurrencies, see “Opportunities and Challenges Posed by Three Asset Classes on the Frontier of Alternative Investing: Blockchain, Cannabis and Litigation Finance” (Dec. 14, 2017). See also our three-part series on blockchain and the private funds industry: “Basics of the Technology and How the Financial Sector Is Currently Employing It” (Jun. 1, 2017); “Potential Uses by Private Funds and Service Providers” (Jun. 8, 2017); and “Potential Impediments to Its Eventual Adoption” (Jun. 15, 2017).

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  • From Vol. 11 No.6 (Feb. 8, 2018)

    Virtual Currencies Present Significant Risk and Opportunity, Demanding Focus From Regulators, According to CFTC Chair

    The meteoric rise of the value of cryptocurrencies like bitcoin demands a special focus from regulators, CFTC Chairman J. Christopher Giancarlo stated in recent remarks to the ABA Derivatives and Futures Section Conference in Naples, Florida. The Chairman noted that virtual currencies represent both significant risk and opportunity for investors, discussed the role of the CFTC and other regulators in overseeing virtual currencies and outlined the CFTC staff review checklist of virtual currency futures markets. In addition, Giancarlo examined the importance of mutual cross-border regulatory deference, using the E.U.’s and CFTC’s approach to margin rules to illustrate the benefits of global regulatory cooperation. This article summarizes the portions of the speech most relevant to fund managers. For more from Giancarlo, see “New CFTC Chair Outlines Enforcement Priorities and Approaches to FinTech, Cybersecurity and Swaps Reform” (Nov. 9, 2017).

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  • From Vol. 10 No.48 (Dec. 7, 2017)

    ACA Panel Reviews Effects of Impending MiFID II on U.S. Advisers

    A recent ACA Compliance Group (ACA) program examined the impact that the recast Markets in Financial Instruments Directive (MiFID II) will have on fund managers when it takes effect in January 2018, covering delegated portfolio management; market reforms; third-country managers; research payments; best execution; transaction reporting; marketing and product governance rules; recording of telephone conversations; algorithmic trading; and commodity derivatives. See also our two-part series “Simmons & Simmons and Advise Technologies Provide Comprehensive Overview of MiFID II”: Part One (Jun. 18, 2015); and Part Two (Jun. 25, 2015). The program featured Sally McCarthy and Martin Lovick, ACA director and senior principal consultant, respectively. This article summarizes the key takeaways from their presentation. For further insights from ACA, see “Challenges and Solutions in Managing Global Compliance Programs” (Oct. 5, 2017); and our coverage of its 2017 fund manager compliance survey: “Continued SEC Focus on Compliance, Conflicts of Interest and Fees, and Common Measures to Protect MNPI” (Jun. 1, 2017); and “Variety in Expense Allocation Practices and Business Continuity Measures” (Jun. 8, 2017).

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  • From Vol. 10 No.46 (Nov. 23, 2017)

    Best Practices for Fund Managers When Entering Into ISDAs

    In the world of hedge funds, trading over-the-counter (OTC) derivatives in the form of swaps has become ubiquitous. Funds trade swaps for a variety of reasons, including to hedge certain risks, take speculative positions, access difficult-to-trade assets or employ synthetic leverage. Some funds prefer to use swaps to gain exposure to the underlying asset class, even when it could be accessed directly, as in the context of equity investing. For swaps that are traded on a bilateral basis, as opposed to on an exchange, most dealers require a fund to execute a variety of complex documents prior to entering into swap transactions. This three-part series assists our readers with understanding the various trading agreements required for a fund to engage in the OTC trading of swaps, certain key negotiated provisions in swap agreements, common amendments requested by dealers and what are currently viewed as “market terms” for certain provisions. The first article provides background on the various agreements that govern swaps, explains how the Dodd-Frank Act has introduced additional complications to the documentation process and offers advice on best practices for negotiating with dealers. The second article reviews the most commonly negotiated events of default and termination events in the trading agreements and offers suggestions for negotiating these provisions. The third article analyzes the key considerations for funds with respect to the collateral arrangements – the delivery of margin to mitigate counterparty risk – between the two parties. For additional insights on swaps regulatory reform, see “How Hedge Fund Managers Can Prepare for the Anticipated ‘End’ of LIBOR” (Aug. 24, 2017); and “Steps Hedge Fund Managers Should Take Now to Ensure Their Swap Trading Continues Uninterrupted When New Regulation Takes Effect March 1, 2017” (Feb. 9, 2017).

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  • From Vol. 10 No.44 (Nov. 9, 2017)

    New CFTC Chair Outlines Enforcement Priorities and Approaches to FinTech, Cybersecurity and Swaps Reform

    In recent testimony before the House Committee on Agriculture, CFTC Chairman J. Christopher Giancarlo summarized the CFTC’s enforcement priorities and discussed ways to facilitate market-enhancing financial technology, cybersecurity and swaps reform. Giancarlo also outlined Project KISS, or “Keep it Simple Stupid” – an initiative meant to simplify and reduce the cost of CFTC regulations and practices – and the CFTC’s continued commitment to developing a position limits rule and the correct threshold for the de minimis exception. Giancarlo’s testimony provides valuable insight to fund managers into the regulator’s priorities and anticipated actions. This article reviews those portions of Giancarlo’s testimony most relevant to fund managers. For additional analysis of CFTC priorities and goals, see “WilmerHale Attorneys Detail 2016 CFTC Enforcement Actions and Potential Priorities Under Trump Administration” (Feb. 16, 2017).

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  • From Vol. 10 No.40 (Oct. 12, 2017)

    Two Recent Settlements Demonstrate CFTC’s Continued Focus on Spoofing

    Preventing and responding to market manipulation is one of the primary mandates of the SEC and CFTC, the latter of which recently entered into settlement orders with a bank and a day trader, alleging in each case that the respondents had engaged in spoofing – a manipulative practice by which a trader enters multiple orders for a given commodity or futures contract with no intention of executing them in order to move the price of that contract in a desired direction. This article analyzes the terms of the settlement orders, which were issued around the same time as the decision by the U.S. Court of Appeals for the Seventh Circuit in U.S. v. Coscia, which upheld the constitutionality of the anti-spoofing provision of the Commodity Exchange Act. See “Decision by U.S. Court of Appeals Sets Precedent for Emboldened Stance Toward Spoofing” (Sep. 7, 2017). For more on spoofing, see “WilmerHale Attorneys Detail 2016 CFTC Enforcement Actions and Potential Priorities Under Trump Administration” (Feb. 16, 2017); “Managing the Machine: How Hedge Fund Managers Can Examine and Document Their Automated Trading Strategies (Part One of Two)” (Jan. 7, 2016); and “E.U. Market Abuse Scenarios Hedge Fund Managers Must Consider” (Dec. 17, 2015).

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  • From Vol. 10 No.33 (Aug. 24, 2017)

    How Hedge Fund Managers Can Prepare for the Anticipated “End” of LIBOR

    The possibility of a significant change to, or discontinuation of, the London Interbank Offered Rate (LIBOR) has been discussed for some time. A recent speech by Andrew Bailey, Chief Executive of the U.K. Financial Conduct Authority, however, has crystallized the issue and made it appear almost certain that LIBOR will eventually cease to be published. Given LIBOR’s pervasive use by hedge funds and other market participants, the consequences of its permanent discontinuation will be felt – for better or worse – throughout the financial markets, and a misstep could affect investors worldwide. In a guest article, Anne E. Beaumont, partner at Friedman Kaplan Seiler & Adelman, discusses the possible consequences for derivatives transactions that involve USD LIBOR and are governed by ISDAs, while also suggesting five steps that advisers can take today to prepare for this impending change. For additional commentary from Beaumont on derivatives documentation, see “The 1992 ISDA Master Agreement Says Notice Can Be Given Using an ‘Electronic Messaging System’; If You Think That Means ‘Email,’ Think Again” (May 23, 2014); and “Five Steps for Proactively Managing OTC Derivatives Documentation Risk” (Apr. 25, 2014).

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  • From Vol. 10 No.13 (Mar. 30, 2017)

    New York Appellate Court Affirms Broad Rights of Parties in CDS Transactions to Pursue Their Economic Self-Interests, Despite Adverse Effect on Counterparties

    A New York appellate court recently ruled that two related hedge funds are entitled to receive a sum of approximately $22 million – plus prejudgment interest of approximately $68 million – from their counterparty, a large investment bank, in a credit default swap (CDS). The dispute between the parties arose out of a disagreement concerning the value of the reference assets, which in turn led to the bank refusing to return the collateral posted by the hedge funds. In its decision, the court held that the hedge funds’ arm’s-length transaction with the reference assets’ issuer, and their tendency to pursue their self-interest without regard for adverse effects on the counterparty, did not violate standards of good faith and commercial reasonableness. The court’s decision has far-reaching implications for the rights of parties entering into CDS transactions, particularly where some or all of the assets might be susceptible to valuation disputes in uncertain and rapidly fluctuating markets. To help readers understand the case and its impact on derivatives trading, The Hedge Fund Law Report has prepared a summary of the court’s decision and interviewed Fabien Carruzzo, a financial services partner at Kramer Levin Naftalis & Frankel, with expertise in the derivatives and CDS markets. For insights from Carruzzo, see our two-part series on minimum initial and variation margin requirements for over-the-counter derivatives: “Hedge Funds Face Increased Margin Requirements” (Feb. 18, 2016); and “Hedge Funds Face Increased Trading Costs” (Feb. 25, 2016). 

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  • From Vol. 10 No.11 (Mar. 16, 2017)

    ESMA Opinion Sets Forth Four Common Principles for UCITS Share Classes

    Following a lengthy consultation, the European Securities and Markets Authority (ESMA) published an opinion on 30 January 2017 concerning the use of share classes by E.U. Undertakings for Collective Investments in Transferable Securities (UCITS) structures. Specifically, ESMA outlined four key principles that all UCITS funds must follow when setting up different share classes and considering whether certain existing share class hedging techniques comply with such principles. The opinion particularly impacts share classes that use a derivative to hedge against a particular risk. In a guest article, Monica Gogna, a partner in Ropes & Gray’s London office, reviews and explains the expected impact of the four principles articulated by ESMA and discusses whether hedging techniques may continue to be executed in a share class as opposed to setting up a separate sub-fund. Gogna provides practical guidance on next steps, including whether the manager may continue to offer the share class to new investors after the transition period expires, as well as whether managers will need to provide updated disclosures to investors. For additional insights from Gogna, see “Leading Law Firms Debate Effect of Hard vs. Soft Brexit on Hedge Fund Managers (Part One of Two)” (Jul. 7, 2016). For commentary on other E.U. regulations from Ropes & Gray attorneys, see “A Fund Manager’s Guide to Calculating and Reporting Short Sales Under European Regulations” (Jan. 5, 2017); and “Ropes & Gray Attorneys Discuss Implications for U.S. Hedge Fund Managers of the European Market Infrastructure Regulation” (Jul. 18, 2014).

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  • From Vol. 10 No.7 (Feb. 16, 2017)

    WilmerHale Attorneys Detail 2016 CFTC Enforcement Actions and Potential Priorities Under Trump Administration

    Fund managers that trade futures, swaps and other derivatives may be subject to both CFTC and SEC supervision. A recent web briefing by regulatory and enforcement attorneys from WilmerHale provided a comprehensive review of significant enforcement and regulatory actions by the CFTC in 2016, considered pending CFTC legislation and regulation and offered insight into what CFTC operations and priorities may look like under the Trump administration. The briefing featured WilmerHale partners Paul M. Architzel, Dan M. Berkovitz and Anjan Sahni, along with special counsel Gail C. Bernstein. This article highlights the panelists’ key insights. For additional insight from WilmerHale attorneys, see “FCPA Concerns for Private Fund Managers (Part One of Two)” (May 28, 2015); “FCPA Risks Applicable to Private Fund Managers (Part Two of Two)” (Jun. 11, 2015); and “Best Legal and Accounting Practices for Hedge Fund Valuation, Fees and Expenses” (Jul. 18, 2013).

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  • From Vol. 10 No.6 (Feb. 9, 2017)

    Steps Hedge Fund Managers Should Take Now to Ensure Their Swap Trading Continues Uninterrupted When New Regulation Takes Effect March 1, 2017

    In the aftermath of the 2008 global financial crisis, the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions sought to reduce systemic risk and promote central clearing by recommending mandatory margin requirements on non-centrally cleared derivatives (i.e., derivatives that trade bilaterally). See “OTC Derivatives Clearing: How Does It Work and What Will Change?” (Jul. 14, 2011). In late 2015, five federal regulators adopted a joint rule that applies these requirements to swap dealers under their supervision; the CFTC adopted its own rule. The compliance date for the variation margin requirements under these rules is March 1, 2017. See Hedge Funds Face Increased Margin Requirements Under Final Swap Rules (Part One of Two)” (Feb. 18, 2016); and Hedge Funds Face Increased Trading Costs Under Final Swap Rules (Part Two of Two)” (Feb. 25, 2016). To better understand how the rules affect the private funds industry, The Hedge Fund Law Report recently interviewed Leigh Fraser, a partner at Ropes & Gray and co-leader of the firm’s hedge fund group, regarding the steps that funds should take to ensure that their swaps trading continues on an uninterrupted basis. For additional insights from Fraser, see our three-part series on best practices in negotiating prime brokerage arrangements: Preliminary Considerations When Selecting Firms and Brokerage Arrangements” (Dec. 1, 2016); Structural Considerations of Multi-Prime and Split Custodian-Broker Arrangements” (Dec. 8. 2016); and Legal Considerations When Negotiating Prime Brokerage Agreements” (Dec. 15, 2016).

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  • From Vol. 10 No.4 (Jan. 26, 2017)

    Best Practices for Fund Managers When Entering Into ISDAs: Negotiating Collateral Arrangements (Part Three of Three) 

    One of the primary goals when the Dodd-Frank Act introduced central clearing for certain standardized, liquid swaps was to reduce the credit risk between counterparties trading derivatives in the over-the-counter market. For cleared swaps, a regulated clearinghouse is interposed as a counterparty between the two original parties to the transaction, with each party posting margin directly with the clearinghouse. In contrast, uncleared swaps are traded bilaterally, with one party delivering collateral directly to the other party. To mitigate counterparty credit risk with uncleared swaps, parties enter into a credit support annex (CSA) setting forth the collateral arrangements between the parties, such as whether a party is required to deliver collateral and the type of collateral permitted. See “Celent Report Identifies Best Practices for Over-the-Counter Derivatives Collateral Management” (Jul. 29, 2009). In this final installment in our three-part series, we discuss the key considerations for funds when negotiating the CSA. The first article provided background on the various agreements that govern swaps and explained the impact the Dodd-Frank Act has had on trading these instruments. The second article reviewed the most highly negotiated events of default and termination events in swap trading agreements and offered suggestions for negotiating these provisions.

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  • From Vol. 10 No.3 (Jan. 19, 2017)

    Best Practices for Fund Managers When Entering Into ISDAs: Negotiating Event of Default and Termination Event Provisions (Part Two of Three) 

    One of the lessons learned by investment managers that previously traded swaps with Lehman Brothers was the importance of having robust legal documentation in place to govern these trades. For example, the bankruptcy filing by Lehman Brothers Holdings Inc. (LBH) generally triggered an event of default by LBH in its swap contracts that were traded under the International Swaps and Derivatives Association Master Agreement (Master Agreement), entitling LBH’s counterparties to certain remedies. See “Lehman Sues J.P. Morgan Over Allegedly ‘Inflated’ Claims Under Derivative Contracts and Improper Setoffs” (Oct. 25, 2012); and “The Lehman Bankruptcy and Swap Lessons Learned Negotiating an ISDA Master Agreement in Today’s Market” (Mar. 4, 2009). In this second article of a three-part series, we review commonly negotiated events of default in the Master Agreement and additional termination events in the schedule to the Master Agreement, in addition to suggesting tactics fund managers can employ when negotiating certain key provisions. The first article provided background on the various documents required to trade swaps and explained the impact the Dodd-Frank Act has had on trading these instruments. The third article will analyze the key considerations for funds when negotiating the collateral arrangements – the delivery of margin to mitigate counterparty risk – between two parties. 

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  • From Vol. 10 No.2 (Jan. 12, 2017)

    Best Practices for Fund Managers When Entering Into ISDAs: Negotiation Process and Tactics (Part One of Three) 

    In the world of hedge funds, trading of over-the-counter (OTC) derivatives in the form of swaps has become ubiquitous, as funds do so for many reasons, including to hedge certain risks, take speculative positions, access difficult-to-trade assets or employ synthetic leverage. See “What Is Synthetic Prime Brokerage and How Can Hedge Fund Managers Use It to Obtain Leverage?” (Apr. 2, 2010). Most dealers require a fund to execute a variety of complex documents prior to entering into swap transactions on a bilateral basis with the fund. The responsibility for reviewing and negotiating these documents can be a daunting task for a manager’s legal, compliance and operations professionals. In an effort to distill the complexities of these documents and the negotiation process, The Hedge Fund Law Report interviewed several experts that negotiate these agreements on a daily basis on behalf of their fund clients. In this three-part series, we review the various trading agreements required for a fund to engage in the OTC trading of swaps, explain certain key negotiated provisions in swap agreements, discuss common amendments requested by dealers and provide guidance on what are currently viewed as “market terms” for certain provisions. This first article provides background on the various agreements that govern swaps, explains how the Dodd-Frank Act has introduced additional complications to the documentation process and offers advice on best practices for negotiating with dealers. The second article will review the most commonly negotiated events of default and termination events in the trading agreements and offers suggestions for negotiating these provisions. The third article will analyze the key considerations for funds with respect to the collateral arrangements – the delivery of margin to mitigate counterparty risk – between the two parties. 

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  • From Vol. 9 No.36 (Sep. 15, 2016)

    ESMA Report Highlights Funds’ Rising Use – and Potential Impact on Market Stability – of Synthetic Leverage From Derivative Instruments

    Synthetic leverage – the use of derivative instruments, rather than direct borrowing, to gain exposure in financial markets – has grown in popularity with investment funds. The rising prominence of this practice has attracted a correspondingly greater level of attention from regulators, making it critically important for hedge fund managers to be aware of the risks it poses to financial stability and how regulators may respond to its use. See “European Central Bank Official Regards Hedge Fund Leverage As Risk to Financial System” (Mar. 24, 2016). A recent report published by the European Securities and Markets Authority contains a section devoted to analyzing these risks in a regulatory enforcement context. This article highlights the key takeaways most relevant to hedge fund managers deploying, or considering using, synthetic leverage. For more on alternative methods by which hedge funds obtain leverage, see our three-part series on subscription credit and other financing facilities: “Needed Liquidity and Advance Planning” (Jun. 2, 2016); “Greater Flexibility” (Jun. 9, 2016); and “Operational Challenges” (Jun. 16, 2016). 

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  • From Vol. 9 No.33 (Aug. 25, 2016)

    Perspectives From In-House and Private Practice: Cadwalader Special Counsel Garret Filler Discusses Family Offices, Broker-Dealer Registration Issues and Impact of Capital, Liquidity and Margin Requirements (Part Two of Two)

    The Hedge Fund Law Report recently interviewed Garret Filler in connection with his recent return to Cadwalader, Wickersham & Taft. As special counsel in the firm’s New York office, Filler represents both start-up and established hedge funds and private equity funds, as well as family offices, banks and broker-dealers. This article, the second in a two-part series, sets forth Filler’s thoughts on family offices transitioning to asset managers; broker-dealer registration issues for fund managers; considerations when negotiating counterparty agreements; the implications to hedge funds of increased capital and liquidity requirements for banks and broker-dealers; and the impact of new margin requirements for uncleared derivatives. In the first installment, Filler discussed the cultures of private fund managers; selection of outside counsel, including law firm relationships with regulators and their willingness to enter into alternative fee arrangements; and counterparty risk. For additional insight from Cadwalader partners, see “Practical Guidance for Hedge Fund Managers on Preparing for and Handling NFA Audits” (Oct. 17, 2014).

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  • From Vol. 9 No.33 (Aug. 25, 2016)

    A “Clear” Guide to Swaps and to Avoiding Collateral Damage in the World of ERISA and Employee Benefit Plans (Part Four of Four)

    This is the final installment in our four-part serialization of a treatise chapter by Steven W. Rabitz, partner at Stroock & Stroock & Lavan, and Andrew L. Oringer, partner at Dechert. The chapter describes the substantive considerations – as well as potential penalties for missteps – associated with employing swap transactions for employee benefit plans, certain other similar plans and “plan assets” entities subject to the fiduciary provisions of the Employee Retirement Income Security Act of 1974 (ERISA) or the corresponding provisions of Section 4975 of the Internal Revenue Code of 1986, and includes references to a wide range of relevant authority. This article examines issues relating to cleared swaps, collateral, rehypothecation and swap execution facilities. The third article in the serialization described implications of funds reaching the 25 percent threshold of plan investment; considerations for fund managers when facing governmental plans; and credit-related issues. The second article discussed exemptions that could keep swaps from being considered prohibited transactions and explored the extent to which swap counterparties and others would be considered fiduciaries under ERISA, as well as the potential implications of that consideration. The first article explored fiduciary responsibility and prohibited transactions generally.

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  • From Vol. 9 No.32 (Aug. 11, 2016)

    A “Clear” Guide to Swaps and to Avoiding Collateral Damage in the World of ERISA and Employee Benefit Plans (Part Three of Four)

    This is the third article in our four-part serialization of a treatise chapter by Steven W. Rabitz, partner at Stroock & Stroock & Lavan, and Andrew L. Oringer, partner at Dechert. The chapter describes the substantive considerations – as well as potential penalties for missteps – associated with employing swap transactions for employee benefit plans, certain other similar plans and “plan assets” entities subject to the fiduciary provisions of the Employee Retirement Income Security Act of 1974 (ERISA) or the corresponding provisions of Section 4975 of the Internal Revenue Code of 1986, and includes references to a wide range of relevant authority. This third article in the serialization describes implications of funds reaching the 25% threshold of plan investment; considerations for fund managers when facing governmental plans; and credit-related issues. The second article discussed exemptions that could keep swaps from being considered prohibited transactions and explored the extent to which swap counterparties and others would be considered fiduciaries under ERISA, as well as the potential implications of that consideration. The first article explored fiduciary responsibility and prohibited transactions generally.

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  • From Vol. 9 No.31 (Aug. 4, 2016)

    A “Clear” Guide to Swaps and to Avoiding Collateral Damage in the World of ERISA and Employee Benefit Plans (Part Two of Four)

    This is the second article in our four-part serialization of a treatise chapter by Steven W. Rabitz, partner at Stroock & Stroock & Lavan, and Andrew L. Oringer, partner at Dechert. The chapter describes – in considerable detail and with extensive references to relevant authority – the many substantive considerations associated with employing swap transactions for employee benefit plans, certain other similar plans and “plan assets” entities subject to the fiduciary provisions of the Employee Retirement Income Security Act of 1974 (ERISA) or the corresponding provisions of Section 4975 of the Internal Revenue Code of 1986 (Code), as well as potential penalties for missteps. This article discusses exemptions that could keep swaps from being considered prohibited transactions and explores the extent to which swap counterparties and others would be considered fiduciaries under ERISA, as well as the potential implications of that consideration. To read the first article in this serialization, click here

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  • From Vol. 9 No.30 (Jul. 28, 2016)

    Implications of Lehman Brothers Decision on Hedge Fund Managers Trading CDOs

    On June 28, 2016, Judge Shelley Chapman of the U.S. Bankruptcy Court for the Southern District of New York authored an opinion in the case of Lehman Brothers Special Financing Inc. v. Bank of America National Association. This decision, which holds that certain market-standard provisions in structured finance transactions are enforceable when the swap counterparty’s default is due to the bankruptcy of that counterparty, provides hedge fund managers and others trading collateralized debt obligations (CDOs) and other structured products with greater certainty than prior rulings relating to the collapse of Lehman Brothers. The Hedge Fund Law Report recently interviewed Schulte Roth & Zabel partner Paul Watterson about Judge Chapman’s decision and its ramifications for hedge fund managers. Specifically, Watterson addressed the significance of the decision in light of prior case law, the implications of the decisions for hedge fund managers trading CDOs and the specific provisions managers should include in CDO documentation to take advantage of this holding. For more on the Lehman Brothers collapse, see “Lesson From Lehman Brothers for Hedge Fund Managers: The Effect of a Bankruptcy Filing on the Value of the Debtor’s Derivative Book” (Jul. 12, 2012); and “How Can Hedge Funds Get Their Money Out of Lehman Brothers International Europe?” (Aug. 5, 2009).

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  • From Vol. 9 No.30 (Jul. 28, 2016)

    A “Clear” Guide to Swaps and to Avoiding Collateral Damage in the World of ERISA and Employee Benefit Plans (Part One of Four)

    Hedge fund managers and other investment professionals contemplating swap transactions for employee benefit plans, certain other similar plans and “plan assets” entities subject to the fiduciary provisions of the Employee Retirement Income Security Act of 1974 (ERISA) or the corresponding provisions of Section 4975 of the Internal Revenue Code of 1986 (Code) must consider numerous legal issues. To help clarify these complex issues, The Hedge Fund Law Report is serializing a treatise chapter by Steven W. Rabitz, partner at Stroock & Stroock & Lavan, and Andrew L. Oringer, partner at Dechert. The chapter describes – in considerable detail and with extensive references to relevant authority – the many substantive considerations associated with employing swaps on behalf of ERISA plan assets and the potential penalties for missteps. This article, the first in our four-part serialization, discusses fiduciary responsibility and prohibited transactions, including how swaps can constitute prohibited transactions. For more from Rabitz and Oringer, see “Is That Your (Interim) Final Answer? New Disclosure Rules Under ERISA to Impact Many Hedge Funds” (Aug. 20, 2010). For a prior serialization from Oringer, see our five-part series:“Happily Ever After? – Investment Funds that Live with ERISA, For Better and For Worse”: Part One (Sep. 4, 2014); Part Two (Sep. 11, 2014); Part Three (Sep. 18, 2014); Part Four (Sep. 25, 2014); and Part Five (Oct. 2, 2014).

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  • From Vol. 9 No.28 (Jul. 14, 2016)

    ESMA Chair Outlines Rulemaking Authority and Implementation of MiFID II 

    A recent speech by Steven Maijoor, chair of the European Securities and Markets Association (ESMA), at the Financial News 20th Anniversary Awards for Excellence, European Finance, 1996-2016, offered a recap of ESMA’s recent efforts to develop rules for E.U. member states with a view to minimizing risk. Maijoor described the processes and procedures through which ESMA and the European Commission (EC) have worked out the pending revisions of the E.U. Markets in Financial Instruments Directive (commonly referred to as “MiFID II”). Maijoor delivered a second speech to the Committee on Economic and Monetary Affairs of the European Parliament, in which he provided a more detailed and technical analysis of the status of MiFID II implementation. Maijoor’s remarks provide valuable insight to hedge fund managers about the relative authority of ESMA and the implementation and anticipated revisions to MiFID II, which affect transparency, position limits and derivatives trading. This article highlights the salient points from his two speeches. For coverage of Maijoor’s 2015 annual statement to the Committee on Economic and Monetary Affairs of the European Parliament, see “ESMA Chair Highlights Upcoming Focus on Supervisory Convergence” (Oct. 1, 2015). For analysis of a recent speech Maijoor delivered to the Asian Financial Forum, see “ESMA Chair Calls for Increased Transparency and Regulatory Convergence As Interest Rates Rise” (Jan. 28, 2016).

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  • From Vol. 9 No.22 (Jun. 2, 2016)

    OTC Options on Major Currencies May Be Marked-to-Market for Tax Purposes

    In Wright v. Commissioner, a recent court decision that came as a surprise to many, the Sixth Circuit held that over-the-counter (OTC) options on so-called “major” currencies should be marked-to-market for U.S. federal income tax purposes. This could have significant consequences for investment funds that take positions in options of this type. In a guest article, John Kaufmann of Greenberg Traurig discusses the Wright case; the applicable regulations and legislative history; and the decision’s potential implications for hedge fund managers who take positions in OTC options on major currencies. For additional insight from Kaufmann, see our two-part series on “The New Section 871(m) Regulations: Withholding Law Applicable to Non-U.S. Hedge Funds”: Part One (Jan. 21, 2016); and Part Two (Jan. 28, 2016). For more on mark-to-market accounting, see “Tax Practitioners Discuss Taxation of Options and Swaps and Impact of Proposed IRS Regulations” (Feb. 19, 2015).

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  • From Vol. 9 No.20 (May 19, 2016)

    MiFID II Will Affect Market Structure, Registration and Soft Dollars for Hedge Funds Trading in Europe

    Broker-dealers, asset managers and investment advisers all are affected by the E.U. Markets in Financial Instruments Directive (MiFID), which includes rules regarding authorization, business conduct, governance, market activities and reporting. Clifford Chance recently presented a program on how pending revisions to MiFID (commonly referred to as “MiFID II”) may affect U.S. hedge fund and other asset managers. The program – featuring partner Nick O’Neill and associate Sarah James – focused on implementation logistics and timing; market structure; product development and soft dollar rules; the third-country equivalency regime; and other relevant E.U. developments. This article summarizes their key insights. For more on MiFID II, see “ESMA Releases Final Report on MiFID II Technical Standards for Hedge Fund Management Firms” (Jul. 16, 2015); and “MiFID II Expands MiFID I and Imposes Reporting Requirements on Asset Managers, Including Non-E.U. Asset Managers” (May 28, 2015). For additional insight from Clifford Chance partners, see “Hedge Fund Managers Trading Distressed Debt Must Understand LMA Standard Form Documentation” (Feb. 25, 2016); and our series, “How Can Hedge Fund Managers Use Reinsurance Businesses to Raise and Retain Assets and Achieve Uncorrelated Returns?”: Part One (Jan. 10, 2013); and Part Two (Jan. 17, 2013).

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  • From Vol. 9 No.13 (Mar. 31, 2016)

    How Hedge Funds Can Mitigate FIN 48 Exposure in Australia and Mexico (Part Three of Three)

    Exposure to withholding taxes and exposure under FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48), are growing concerns for hedge funds investing in foreign securities. Australia and Mexico, along with other countries, have issued pronouncements on taxation of capital gains for non-residents. However, certain methods can be useful for funds to avoid or reduce exposure to withholding taxes. In this guest three-part series, Harold Adrion of EisnerAmper discusses hedge fund exposure to foreign withholding taxes and FIN 48. This third article explores developments in Australia and Mexico, as well as how hedge funds can minimize exposure to withholding taxes. The first article explained Fin 48 and considered E.U. developments regarding free movement of capital and its impact on funds. The second article addressed the limited exemption to capital gains taxation of non-residents announced by China and other issues for non-resident investors. For more on Australian tax issues, see “What Hedge Funds Need to Know About Tax Relief Under the New Australian Investment Manager Regime” (Jun. 11, 2015). For further insight from EisnerAmper professionals, see our two-part series on “How Can Hedge Fund Managers Structure, Negotiate and Implement Expense Caps to Amplify Capital Raising Efforts?”: Part One (Jun. 20, 2013); and Part Two (Jun. 27, 2013).

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  • From Vol. 9 No.13 (Mar. 31, 2016)

    Europe Approves Hedge Fund Use of CFTC-Authorized Central Counterparties Under EMIR

    The European Commission recently determined that the CFTC regime for regulating derivatives central counterparties (CCPs) is substantially equivalent to the regime established under the European Market Infrastructure Regulation (EMIR). Thus, a CFTC-authorized CCP, upon complying with certain initial margin and liquidity requirements, may clear derivatives with European counterparties without applying for E.U. authorization. As a result, hedge fund managers that use CFTC-authorized CCPs can continue using those CCPs and will not have to move to an E.U.-based CCP. Furthermore, because they will not need to comply with a second set of rules under EMIR, CFTC-authorized CCPs may be spared additional compliance costs, which costs would have likely been passed on to hedge funds in the form of higher clearing fees. This article discusses the basis for and the implications of the decision. For more on EMIR clearing obligations, see “Central Counterparty Liquidation Period May Be Shortened Under EMIR to Conform to U.S. Regime” (Sep. 10, 2015); and “Comparing and Contrasting EMIR and Dodd-Frank OTC Derivatives Reforms and Their Impact on Hedge Fund Managers” (Sep. 19, 2013). For more on EMIR generally, see “EMIR Offers Three Models of Asset Segregation to Fund Managers That Trade OTC Derivatives” (Apr. 16, 2015).

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  • From Vol. 9 No.10 (Mar. 10, 2016)

    Current and Former Directors of SEC Division of Investment Management Discuss Hot Topics Under the Investment Company Act

    The Practising Law Institute’s 2016 Investment Management Institute began with a keynote address by David Grim, the current Director of the SEC Division of Investment Management, followed by a panel discussion with two former Directors of that Division: Barry P. Barbash, now a partner at Willkie, and Paul F. Roye, currently a director of Capital Research and Management Company. Grim’s address focused on four important topics that had been discussed at the SEC program commemorating the 75th anniversary of the Investment Company Act and the Investment Advisers Act: exchange-traded funds; private fund advisers; disclosure and reporting; and the role of a fund’s board in oversight. The panel then focused on recent SEC rulemaking initiatives that affect mutual funds. This article encapsulates the key takeaways from their discussions. For more on exchange-traded funds, see “SEC Commissioner Calls for Increased Transparency and Accountability in Capital Markets” (Mar. 3, 2016).

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  • From Vol. 9 No.10 (Mar. 10, 2016)

    ESMA Provides Hedge Fund Managers With Plan for Supervisory Convergence

    The European Securities and Markets Authority (ESMA) recently published its Supervisory Convergence Work Programme for 2016 (2016 SCWP), which supplements its Annual Work Programme for 2016. See “ESMA Work Programme Provides Hedge Fund Managers With Key Guidance About E.U. Financial Services Legislation” (Oct. 15, 2015). Describing steps ESMA will take in 2016 to “promote sound, efficient and consistent supervision in the E.U.” and describing ESMA’s priorities in the context of the wider work programme and environment, the 2016 SCWP provides hedge fund managers and other industry participants with detailed insight into the regulator’s areas of focus for the coming year, along with planned activities and initiatives. This article highlights the fundamental points from the 2016 SCWP. For more about supervisory convergence, see “ESMA Chair Calls for Increased Transparency and Regulatory Convergence As Interest Rates Rise” (Jan. 28, 2016). See also “FCA Director Summarizes 2015 Regulatory Initiatives Applicable to Hedge Fund Managers and Financial Markets” (Jan. 7, 2016).

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  • From Vol. 9 No.8 (Feb. 25, 2016)

    Hedge Funds Face Increased Trading Costs Under Final Swap Rules (Part Two of Two)

    The new joint final rule adopted by the U.S. prudential regulators – establishing minimum initial and variation margin requirements for certain non-cleared swaps – likely means cost increases for hedge funds and other investment funds trading those swaps. Hedge funds face comparable issues under the substantially similar final rule adopted by the CFTC for margin requirements for non-cleared swaps entered into by registered swap dealers or major swap participants that are not regulated by a U.S. prudential regulator. In a guest two-part series, Fabien Carruzzo and Philip Powers, partner and associate, respectively, at Kramer Levin, discuss these final rules and their impact on hedge funds. This second article explores minimum transfer amounts; eligible collateral and haircuts; netting of exposure; documentation and industry initiatives; compliance obligations; and practical implications of the final rules on hedge funds. The first article focused on calculating a fund’s material swaps exposure, as well as the final rules’ requirements for collecting and posting initial and variation margin with respect to non-cleared swaps. For more from Kramer Levin practitioners, see “Risks Faced by Hedge Fund Managers That Access the Alternative Mutual Fund Market Via Turnkey Platforms” (Mar. 13, 2014); and “Kramer Levin Partner George Silfen Discusses Challenges Faced by Hedge Fund Managers in Operating and Distributing Alternative Mutual Funds” (Apr. 18, 2013).

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  • From Vol. 9 No.7 (Feb. 18, 2016)

    Hedge Funds Face Increased Margin Requirements Under Final Swap Rules (Part One of Two)

    The U.S. prudential regulators recently adopted a joint final rule establishing minimum initial and variation margin requirements for certain non-cleared swaps. The CFTC adopted a substantially similar final rule for swaps not regulated by a U.S. prudential regulator. Hedge funds and other investment funds trading non-cleared swaps with registered swap dealers supervised by either the U.S. prudential regulators or the CFTC will be impacted by these final rules and will likely face increased costs of trading non-cleared swaps. In a two-part guest series, Fabien Carruzzo and Philip Powers – partner and associate, respectively, at Kramer Levin – discuss these final rules and analyze their impact on hedge funds. This first article addresses the calculation of a fund’s material swaps exposure, as well as the requirements under the final rules for covered swap dealers to collect and post initial and variation margin with respect to non-cleared swaps with their counterparties. The second article will address minimum transfer amounts; eligible collateral and haircuts; netting of exposure; documentation and industry initiatives; compliance obligations under the final rules; and the practical implications of the final rules on hedge funds. For additional insight from Carruzzo, see “OTC Derivatives Clearing: How Does It Work and What Will Change?” (Jul. 14, 2011). For more from Kramer Levin practitioners, see “‘Interval Alts’ Combine Benefits of Alternative Mutual Funds and Traditional Hedge Funds” (Jul. 16, 2015).

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  • From Vol. 9 No.7 (Feb. 18, 2016)

    FCA Acting Chief Calls for Hedge Fund Managers to Take Greater Responsibility for Implementing MiFID II

    In a recent speech delivered at Bloomberg’s offices in the City of London, Tracey McDermott, Acting Chief Executive of the U.K. Financial Conduct Authority (FCA), discussed several critical developments and initiatives that involve the FCA and that may affect hedge fund managers; outlined the FCA’s approach to wholesale market policy; and detailed the benefits and challenges of implementing MiFID II. Throughout her speech, McDermott emphasized the need for financial services firms, such as hedge fund managers, to take greater responsibility for the overall functioning of the industry and implementation of MiFID II. This article provides an overview of the points raised by McDermott. For insight from McDermott’s colleagues, see “Hedge Fund Managers Must Prepare for Benchmark Regulation” (Feb. 11, 2016); “FCA Director Summarizes 2015 Regulatory Initiatives Applicable to Hedge Fund Managers and Financial Markets” (Jan. 7, 2016); and “FCA Urges Hedge Fund Managers to Prepare for MiFID II” (Oct. 29, 2015).

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  • From Vol. 9 No.4 (Jan. 28, 2016)

    The New Section 871(m) Regulations: Issues With the Expanding Scope of Withholding Law Applicable to Non-U.S. Hedge Funds (Part Two of Two)

    Most non-U.S. hedge funds take precautions to avoid engaging in a U.S. trade or business; otherwise, they are subject to U.S. federal income tax on net income that is effectively connected with that U.S. trade or business. However, all funds that invest in U.S. debt and equity – as well as in derivatives that reference U.S. debt and equity – may be subject to a 30% withholding tax on gross payments of U.S.-sourced fixed, determinable, annual or periodic income (FDAP). In this two-part series, John Kaufmann of Greenberg Traurig discusses certain ways in which final and temporary regulations recently promulgated under Internal Revenue Code Section 871(m) increase the scope of FDAP withholding, and lists traps for the unwary created by these regulations. This second article explains the scope of the new regulations and the potential complications that they have created. The first article discussed the current law and the issues that the new regulations are intended to address. For additional commentary from the firm, see our series on “Investment Opt-Out Rights for Hedge Fund Investors”: Part One (Nov. 8, 2013); Part Two (Nov. 14, 2013); and Part Three (Nov. 21, 2013).

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  • From Vol. 9 No.4 (Jan. 28, 2016)

    Adhering to Disclosed Fee and Valuation Methodologies Is Crucial for Hedge Fund Managers to Avert Enforcement Action

    The SEC continues to focus on the fee and valuation practices of investment advisers. See “Current and Former SEC, DOJ and NY State Attorney General Practitioners Discuss Regulatory and Enforcement Priorities” (Jan. 14, 2016). Although disclosure does not necessarily cure all potential issues, adherence to disclosed practices is essential. See “Explicit Disclosure of Changes in Hedge Fund Investment Strategy to Investors and Regulators Is Vital to Reduce Risk of Enforcement Action” (Oct. 29, 2015). The SEC recently took forceful action against an adviser that manages several publicly traded funds, alleging that the adviser disregarded fund disclosures regarding calculation of management fees and valuation of fund assets. In the press release announcing the settlement, Marshall S. Sprung, Co-Chief of the Asset Management Unit of the SEC Division of Enforcement, cautioned, “Fund managers can’t tell investors one thing and do another when assessing fees and valuing assets.” This article summarizes the adviser’s alleged misconduct and federal securities laws violations, as well as the outcome of the settlement. For more on enforcement actions involving fee disclosures and practices, see “Full Disclosure of Portfolio Company Fee and Payment Arrangements May Reduce Risk of Conflicts and Enforcement Action” (Nov. 12, 2015); “Blackstone Settles SEC Charges Over Undisclosed Fee Practices” (Oct. 22, 2015); and “SEC Enforcement Action Involving ‘Broken Deal’ Expenses Emphasizes the Importance of Proper Allocation and Disclosure” (Jul. 9, 2015). Management fees and valuation practices are inextricably intertwined. See “SEC Fraud Charges Against Lynn Tilton, So-Called ‘Diva of Distressed,’ Confirm the Agency’s Focus on Valuation and Conflicts of Interest” (Apr. 9, 2015).

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  • From Vol. 9 No.3 (Jan. 21, 2016)

    Hedge Funds and Others May Be Eligible to Collect Proceeds From $1.86 Billion CDS Antitrust Settlement

    On January 11, 2016, Quinn Emanuel announced the $1.86 billion settlement of a class action lawsuit alleging that, since 2008, major banks had conspired with the International Swaps and Derivatives Association and financial information services firm Markit Group to limit transparency and competition in the credit default swaps (CDS) market by thwarting attempts to create an exchange for trading CDS. The plaintiffs estimated that the defendants’ conduct inflated bid/ask spreads on CDS by 20% on average, amounting to damages between eight and twelve billion dollars. The U.S. District Court for the Southern District of New York has issued an order establishing a class of plaintiffs, identifying covered CDS transactions and preliminarily approving the settlement. Market participants covered by the class action plaintiffs – including hedge funds, pension funds, asset managers and other institutional investors that purchased certain CDS – have a limited time to opt out of the settlement class before final approval of the settlement. This article documents the history of the litigation and the plaintiffs’ claims, and summarizes the settlement terms. For coverage of another antitrust suit involving financial market participants, see “Federal Antitrust Suit Against Ten Prominent Private Equity Firms Based on Allegations of ‘Club Etiquette’ Not to Jump Announced Deals Survives Summary Judgment Motion” (Apr. 11, 2013).

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  • From Vol. 8 No.45 (Nov. 19, 2015)

    NFA Notice Provides Cybersecurity Guidance to Hedge Fund Managers Registered as CPOs and CTAs

    Cybersecurity in the futures and derivatives market is “perhaps the single most important new risk to market integrity and financial stability,” Commodity Futures Trading Commission (CFTC) Chairman Timothy Massad stated in a keynote address.  The National Futures Association (NFA) recently received CFTC approval of its Interpretive Notice to several existing NFA compliance rules related to supervision, titled “Information Systems Security Programs [ISSPs].”  The new guidance will provide more specific standards for supervisory procedures and will require hedge fund managers and other entities that are NFA members to adopt and enforce written policies and procedures to protect customer data and electronic systems.  “The approach of the Interpretive Notice is to tie cybersecurity best practices to a firm’s supervisory obligations,” Covington & Burling partner Stephen Humenik said.  This article summarizes the guidance.  See also “PLI ‘Hot Topics’ Panel Addresses Cybersecurity and Swaps Regulation,” The Hedge Fund Law Report, Vol. 8, No. 43 (Nov. 5, 2015).  For more on CFTC and NFA requirements applicable to hedge fund managers, see our three-part CPO Compliance Series: “Conducting Business with Non-NFA Members (NFA Bylaw 1101),” Vol. 5, No. 34 (Sep. 6, 2012); “Marketing and Promotional Materials,” Vol. 5, No. 38 (Oct. 4, 2012); and “Registration Obligations of Principals and Associated Persons,” Vol. 6, No. 6 (Feb. 7, 2013).

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  • From Vol. 8 No.43 (Nov. 5, 2015)

    PLI “Hot Topics” Panel Addresses Cybersecurity and Swaps Regulation

    A recent panel discussion at The Practising Law Institute’s Hedge Fund Management 2015 program, “Hot Topics for Hedge Fund Managers,” offered the perspective of an SEC counsel on cybersecurity and a summary of significant developments in swaps regulation, in addition to insight on current investor due diligence practices and a look at the challenges of starting a registered alternative fund.  Nora M. Jordan, a partner at Davis Polk & Wardwell, moderated the discussion, which featured Jessica A. Davis, chief operating officer and general counsel of investment adviser Lodge Hill Capital, LLC; Jennifer W. Han, associate general counsel at the Managed Funds Association; and Aaron Schlaphoff, an attorney fellow in the Rulemaking Office of the SEC Division of Investment Management.  This article summarizes the key takeaways from the program with respect to cybersecurity and swaps regulation.  For additional coverage of PLI’s Hedge Fund Management 2015 program, see “SEC’s Rozenblit Discusses Operations and Priorities of the Private Funds Unit,” The Hedge Fund Law Report, Vol. 8, No. 37 (Sep. 24, 2015).

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  • From Vol. 8 No.43 (Nov. 5, 2015)

    SEC Release of Private Fund Statistics Illuminates Key Trends in Hedge Fund Industry

    The Risk and Examinations Office of the SEC Division of Investment Management recently released a compilation of Private Fund Statistics (Report) that provides data from filers of Form PF and Form ADV in 2013 and 2014.  In a recent speech, SEC Chair Mary Jo White said of the Report, “The public availability of aggregated information should help to address persistent questions, and to some degree misconceptions, about the practices and size of the private fund industry.”  Accordingly, the data in the Report helps identify trends within the hedge fund industry, allowing hedge fund advisers to benchmark themselves against their peers and competitors, as well as providing investors with information to refine their due diligence processes.  This article examines the Report, focusing particularly on data relevant to hedge funds and hedge fund advisers, including leverage and liquidity practices.  The SEC also issues an annual report on how it uses such data.  See “Report Describes the SEC’s Use of Form PF for Hedge Fund Manager Examination Targeting and Risk Management,” The Hedge Fund Law Report, Vol. 7, No. 38 (Oct. 10, 2014); and “SEC’s First Report on Initial Form PF Filings Offers Insight into How the Agency Is Using the Collected Data for Examinations, Enforcement and Systemic Risk Monitoring,” The Hedge Fund Law Report, Vol. 6, No. 34 (Aug. 29, 2013).

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  • From Vol. 8 No.36 (Sep. 17, 2015)

    CFTC Requires Most Registered Commodity Pool Operators, Commodity Trading Advisors and Introducing Brokers to Join the NFA

    The Dodd-Frank Act requires hedge fund managers that engage in certain swap-related activities to register with the CFTC as either commodity pool operators (CPOs), commodity trading advisors (CTAs) or introducing brokers (IBs).  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).  Until now, such CFTC registrants have generally only been required to join the National Futures Association (NFA) if they were also engaged in commodities futures transactions.  To ensure that registrants engaging only in swap-related activities join the NFA – and thereby become “subject to the same level of comprehensive NFA oversight” – the CFTC recently adopted Final Rule 170.17 (Rule), which requires all registered CPOs and IBs, as well as many registered CTAs, to join the NFA.  This article summarizes the Rule, the relevant regulatory background and the CFTC’s rationale for adopting it.  For more on the impact of Dodd-Frank on hedge fund managers, see “How Have Dodd-Frank and European Union Derivatives Trading Reforms Impacted Hedge Fund Managers That Trade Swaps?,” The Hedge Fund Law Report, Vol. 6, No. 40 (Oct. 17, 2013).

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  • From Vol. 8 No.35 (Sep. 10, 2015)

    Central Counterparty Liquidation Period May Be Shortened Under EMIR to Conform to U.S. Regime

    The European Securities and Markets Authority (ESMA) recently proposed changes to liquidation time horizons that central counterparties (CCPs) use for certain financial instruments under the European Market Infrastructures Regulation (EMIR).  Citing the possibility of regulatory arbitrage arising from differences with the U.S. CCP regime, ESMA seeks to shorten the liquidation period for non-OTC financial instruments.  This article discusses the legislative background and rationale for ESMA’s review and summarizes ESMA’s considerations, queries and proposals.  ESMA is seeking comments from CCPs, their clearing members and clients, including hedge funds.  For more on EMIR clearing obligations, see “E.U. Commission Publishes Regulations Setting Forth Clearing Obligations for Hedge Funds and Other Counterparties,” The Hedge Fund Law Report, Vol. 8, No. 32 (Aug. 13, 2015); and “Comparing and Contrasting EMIR and Dodd-Frank OTC Derivatives Reforms and Their Impact on Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 6, No. 36 (Sep. 19, 2013).  For more on EMIR generally, see “EMIR Offers Three Models of Asset Segregation to Fund Managers That Trade OTC Derivatives,” The Hedge Fund Law Report, Vol. 8, No. 15 (Apr. 16, 2015).

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  • From Vol. 8 No.32 (Aug. 13, 2015)

    ISDA Guidance Helps Hedge Fund Managers Determine EMIR Classifications

    Hedge fund managers trading derivatives with an E.U. counterparty are subject to the European Market Infrastructure Regulation (EMIR).  However, the classification of the hedge fund may affect the clearing, reporting and/or risk mitigation provisions of EMIR to which the trade is subject.  See “Comparing and Contrasting EMIR and Dodd-Frank OTC Derivatives Reforms and Their Impact on Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 6, No. 36 (Sep. 19, 2013).  Thus, it is important for hedge fund managers and other asset managers to understand how their funds are classified under EMIR, as well as to communicate that status to counterparties.  The International Swaps and Derivatives Association, Inc. (ISDA) recently issued a sample form of classification letter that a party to an OTC derivative subject to EMIR may use to advise counterparties of the party’s classification under EMIR.  In addition, ISDA issued an explanatory memorandum that provides line-by-line guidance for completing the classification letter.  This article summarizes the essential requirements of the classification letter and the key provisions of the memorandum.  For more on EMIR, see “EMIR Offers Three Models of Asset Segregation to Fund Managers That Trade OTC Derivatives,” The Hedge Fund Law Report, Vol. 8, No. 15 (Apr. 16, 2015).

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  • From Vol. 8 No.32 (Aug. 13, 2015)

    E.U. Commission Publishes Regulations Setting Forth Clearing Obligations for Hedge Funds and Other Counterparties

    The European Commission has published a draft Delegated Regulation (Regulation) setting out regulatory technical standards to supplement the clearing obligations imposed by European regulations relating to market infrastructure.  The draft Regulation specifies the classes of over-the-counter derivatives that should be subject to clearing; the dates from which the obligations will take effect for various types of counterparties, including clearing members, alternative investment funds and other financial counterparties; the minimum remaining maturities for the purposes of regulatory “frontloading” requirements; and the dates on which frontloading should start.  This article provides a summary of the Regulation.  For more on European regulatory obligations with respect to derivatives, see “Ropes & Gray Attorneys Discuss Implications for U.S. Hedge Fund Managers of the European Market Infrastructure Regulation,” The Hedge Fund Law Report, Vol. 7, No. 27 (Jul. 18, 2014); and “How Have Dodd-Frank and European Union Derivatives Trading Reforms Impacted Hedge Fund Managers That Trade Swaps?,” The Hedge Fund Law Report, Vol. 6, No. 40 (Oct. 17, 2013).

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  • From Vol. 8 No.31 (Aug. 6, 2015)

    Hedge Funds Are Required to Disclose Basket Option Contracts and Basket Contracts

    The IRS has recently set its sights on “basket option contracts” and “basket contracts,” suspecting that certain hedge funds and other taxpayers have improperly used those structures to defer recognition of ordinary income and short-term gains on assets within the basket, and to claim long-term capital gains treatment on exercise of the option or termination of the contract.  IRS Notice 2015-47 deems basket option contracts to be “listed transactions.”  IRS Notice 2015-48 deems basket contracts to be “transactions of interest.”  The Notices apply to transactions in effect on or after January 1, 2011; taxpayers who were parties to basket option contracts or basket contracts on or after that date will have to report them retroactively, even for years for which they have already filed returns.  This article summarizes the key provisions of each Notice.  For more on taxation of options, see “Tax Practitioners Discuss Taxation of Options and Swaps and Impact of Proposed IRS Regulations,” The Hedge Fund Law Report, Vol. 8, No. 7 (Feb. 19, 2015).  For a discussion of other strategies that investors have used to seek long-term gains treatment on investments, see “Tax Practitioners Discuss Taxation of Swaps, Wash Sales, Constructive Sales, Short Sales and Straddles at FRA/HFBOA Seminar (Part Four of Four),” The Hedge Fund Law Report, Vol. 7, No. 5 (Feb. 6, 2014).  The IRS has previously targeted certain swaps.  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).

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  • From Vol. 8 No.24 (Jun. 18, 2015)

    NFA Conference Addresses Examination Focus Areas, Investigation Processes and Reporting Requirements for Swap Dealers and Major Swap Participants (Part Two of Two)

    As members of the NFA, registered swap dealers (SDs) and major swap participants (MSPs) are subject to examination and investigation by the NFA – an involved process that can lead to disciplinary action.  In addition to compliance with NFA and CFTC regulations, the NFA examines SDs and MSPs for compliance with multiple substantive regulatory requirements (Section 4s Implementing Regulations).  While most hedge fund managers likely do not themselves qualify as SDs or MSPs, counterparties with which they do business may be so registered, and non-compliance issues with, or disciplinary action against, those counterparties may affect the managers’ hedge funds.  During the recent NFA Member Regulatory Conference held in New York City, members of the NFA and other industry experts discussed best practices in compliance training, testing and monitoring and SD and MSP reporting requirements.  This article, the second in a two-part series, discusses upcoming examination focus areas; NFA investigations; the Section 4s Implementing Regulation review process; and filings required from SDs and MSPs.  The first article highlighted the main points regarding the NFA’s examination process and NFA expectations concerning member training programs, compliance monitoring and testing.  For more on SDs and MSPs, see “Katten Partner Raymond Mouhadeb Discusses the Purpose, Applicability and Implications of the August 2012 ISDA Dodd-Frank Protocol for Hedge Fund Managers, Focusing on Whether Hedge Funds Should Adhere to the Protocol,” The Hedge Fund Law Report, Vol. 6, No. 4 (Jan. 24, 2013).

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  • From Vol. 8 No.24 (Jun. 18, 2015)

    CFTC Extends Reporting Relief for Registered Swap Dealers and Major Swap Participants

    In December 2012, the Division of Market Oversight of the Commodity Futures Trading Commission (CFTC) granted swap dealers (SDs) and major swap participants (MSPs) acting as reporting counterparties for swap transactions time-limited no-action relief from certain reporting requirements of Section 45.4 of the CFTC Regulations.  Consequently, SDs and MSPs were spared the significant burden – in time and resources – of complying with the above requirements, which otherwise could have had follow-on effects for hedge fund managers using such SDs and MSPs as counterparties.  Initially set to expire on June 30, 2013, the no-action relief was extended twice for successive one-year periods.  This article summarizes last week’s further extension of the no-action relief to June 30, 2016.  For other recent CFTC no-action relief with respect to SDs and MSPs, see “CFTC Extends Annual Report Deadline for Futures Commission Merchants, Registered Swap Dealers and Major Swap Participants,” The Hedge Fund Law Report, Vol. 8, No. 14 (Apr. 9, 2015).

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  • From Vol. 8 No.22 (Jun. 4, 2015)

    NFA Conference Addresses Examination Processes, Training and Compliance Best Practices for Swap Dealers and Major Swap Participants (Part One of Two)

    Under Dodd-Frank, registered swap dealers (SDs) and major swap participants (MSPs) are required to become members of a registered futures association, such as the NFA or the CFTC.  In addition, Section 4s of the Commodity Exchange Act requires registered SDs and MSPs to meet specific requirements with regard to, among other things, capital and margin; reporting and recordkeeping; daily trading records; business conduct standards; documentation standards; trading duties; and designation of a chief compliance officer.  Registered member firms will be examined by the NFA for compliance with multiple substantive regulatory requirements (Section 4s Implementing Regulations).  During the recent NFA Member Regulatory Conference held in New York City, members of the NFA and other industry experts discussed best practices in compliance training, testing and monitoring, and SD and MSP reporting requirements.  This article, the first in a two-part series, highlights the main points regarding the NFA’s examination process and NFA expectations concerning member training programs, compliance monitoring and testing.  The second article will review upcoming examination focus areas; NFA investigations; the Section 4s Implementing Regulation review process; and filings required from SDs and MSPs.  For more on SDs and MSPs, see “CFTC Extends Annual Report Deadline for Futures Commission Merchants, Registered Swap Dealers and Major Swap Participants,” The Hedge Fund Law Report, Vol. 8, No. 14 (Apr. 9, 2015).

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  • From Vol. 8 No.15 (Apr. 16, 2015)

    EMIR Offers Three Models of Asset Segregation to Fund Managers That Trade OTC Derivatives

    In August 2012, the European Commission adopted the Regulation on OTC Derivatives, Central Counterparties and Trade Repositories, also known as the European Market Infrastructure Regulation (EMIR).  One of its key risk mitigation measures is a central clearing regime for derivatives similar to that adopted in the U.S. under the Dodd-Frank Act.  See “Comparing and Contrasting EMIR and Dodd-Frank OTC Derivatives Reforms and Their Impact on Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 6, No. 36 (Sep. 19, 2013).  To protect counterparties in the event of the failure or default of a clearing member or central clearing party, EMIR requires a client’s collateral to be segregated, which can be achieved in a number of ways.  A recent program explored the three basic models of asset segregation, the risks and costs of each and how an asset manager’s own structure may affect the choice of segregation model.  The program was hosted by Julia Schieffer, founder of DerivSource Limited, and featured Jaki Walsh, a buy-side consultant at Derivati Consulting Limited.  This article summarizes the key points discussed during the program.  See also “Interest Rate Swap Compression for Hedge Fund Managers: Mechanics, Fee Savings, Risk Consequences and Regulatory Context,” The Hedge Fund Law Report, Vol. 8, No. 8 (Feb. 26, 2015).

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  • From Vol. 8 No.14 (Apr. 9, 2015)

    CFTC Extends Annual Report Deadline for Futures Commission Merchants, Registered Swap Dealers and Major Swap Participants

    Commodity Futures Trading Commission (CFTC) Regulation 3.3(f)(2), promulgated under the Commodity Exchange Act, requires the chief compliance officer of a futures commission merchant, swap dealer or major swap participant to furnish an annual report to the CFTC not more than 60 days after the end of the applicable registrant’s fiscal year, simultaneously with the submission of Form 1-FR-FCM or the Financial and Operational Combined Uniform Single Report.  See “CFTC Issues Guidance for Completing Annual CCO Reports of Swaps and Futures Firms,” The Hedge Fund Law Report, Vol. 8, No. 1 (Jan. 8, 2015).  However, in response to a joint request from the Futures Industry Association and the International Swaps and Derivatives Association, the Division of Swap Dealer and Intermediary Oversight of the CFTC issued no-action relief from those timing requirements.  Consequently, the deadline for those entities to file the required annual report has been extended.  This article explains the mechanics and impact of the extension.

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  • From Vol. 8 No.11 (Mar. 19, 2015)

    BDC Finance v. Barclays: Derivatives Collateral Calls in a Chaotic Market

    A series of decisions by all three levels of the New York State court system in BDC Finance L.L.C. v. Barclays Bank PLC, which culminated recently in a Court of Appeals decision remanding the case to the Supreme Court for trial, provides a window into the normally opaque world of collateral calls for over-the-counter derivatives transactions and offers some important lessons for hedge funds and other market participants.  In a guest article, Anne E. Beaumont, a partner at Friedman Kaplan Seiler & Adelman LLP, describes the factual background of the decisions, in particular, the relevant series of collateral calls; applicable law, contract language and market practice; the courts’ legal analyses in the relevant decisions; and three important lessons for hedge funds and other derivatives users.  For related analysis by Beaumont, see “Eighteen Major Banks Agree to Adopt FSB/ISDA Resolution Stay Protocol that Postpones Exercise of Right to Terminate Derivatives on Bank Counterparty Failure,” The Hedge Fund Law Report, Vol. 7, No. 44 (Nov. 20, 2014); “The 1992 ISDA Master Agreement Says Notice Can Be Given Using an ‘Electronic Messaging System’; If You Think That Means ‘E-Mail,’ Think Again,” The Hedge Fund Law Report, Vol. 7, No. 20 (May 23, 2014); and “Five Steps for Proactively Managing OTC Derivatives Documentation Risk,” The Hedge Fund Law Report, Vol. 7, No. 16 (Apr. 25, 2014).

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  • From Vol. 8 No.8 (Feb. 26, 2015)

    Interest Rate Swap Compression for Hedge Fund Managers: Mechanics, Fee Savings, Risk Consequences and Regulatory Context

    Hedge funds with exposure to interest rate swaps and other derivatives pay considerable fees to clearing brokers and futures commission merchants to clear such derivatives.  Further, changes in the relevant regulatory environment – including Basel III, MiFID 2 and the U.S. and U.K. clearing mandates – may result in significant fee increases.  In an effort to minimize such fees, hedge funds are exploring strategies such as netting and compression of interest rate swaps.  The Hedge Fund Law Report recently interviewed Tom Lodge, Partner at London-based Catalyst Development Ltd., on the impact of regulatory changes on clearing broker and futures commission merchant fees and the benefits and costs of netting and compression strategies.  See also “CFTC Issues Guidance for Completing Annual CCO Reports of Swaps and Futures Firms,” The Hedge Fund Law Report, Vol. 8, No. 1 (Jan. 8, 2015).

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  • From Vol. 8 No.7 (Feb. 19, 2015)

    Tax Practitioners Discuss Taxation of Options and Swaps and Impact of Proposed IRS Regulations

    The IRS is nudging hedge funds and other market participants toward mark-to-market accounting for many swaps and other derivatives.  Some rules, such as those for Section 1256 contracts, are already in place, while other regulations are in the works.  At a recent presentation, leading tax practitioners offered an overview of the current regime of taxation of swaps and options and insights into how proposed IRS regulations may affect that regime.  See also “Tax Practitioners Discuss Taxation of Swaps, Wash Sales, Constructive Sales, Short Sales and Straddles at FRA/HFBOA Seminar (Part Four of Four),” The Hedge Fund Law Report, Vol. 7, No. 5 (Feb. 6, 2014).

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  • From Vol. 7 No.44 (Nov. 20, 2014)

    Eighteen Major Banks Agree to Adopt FSB/ISDA Resolution Stay Protocol that Postpones Exercise of Right to Terminate Derivatives on Bank Counterparty Failure

    Normally, the bankruptcy of a party to a derivative contract gives the counterparty the right to terminate the contract or exercise certain rights with regard to collateral.  In an effort to reduce systemic risk upon failure of a systemically-important bank or other financial institution, the Financial Stability Board (FSB), in conjunction with the International Swaps and Derivatives Association, Inc. (ISDA), recently announced that 18 major banks have agreed to adopt a protocol that amends the ISDA Master Agreement to suspend early termination rights for two days upon the insolvency of a counterparty.  In theory, this two-day window will allow the distressed counterparty to deal with its derivatives book in an orderly fashion.  Many of those 18 banks (or subsidiaries) serve as prime brokers for private funds; the protocol could put those funds at a disadvantage if their prime broker were to fail.  See “Prime Brokerage Arrangements from the Hedge Fund Manager Perspective: Financing Structures; Trends in Services; Counterparty Risk; and Negotiating Agreements,” The Hedge Fund Law Report, Vol. 6, No. 2 (Jan. 10, 2013).  Not surprisingly, hedge funds and other interested trade organizations are pushing back, arguing that the protocol falls short on both substantive and procedural grounds.  In a letter to the FSB, a consortium of buy-side and other trade organizations have argued that the protocol will not work in practice and that it constitutes an improper end run on the legislative process.  This article summarizes the new protocol, the rationale behind its adoption, the buy-side pushback, and insights from Anne E. Beaumont, a partner in Friedman Kaplan Seiler & Adelman LLP.

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  • From Vol. 7 No.42 (Nov. 6, 2014)

    The First Steps to Take When Joining the Rush to Offer Registered Liquid Alternative Funds

    The registered liquid alt rush continues unabated.  Since 2008, there has been a 116% increase in the number of registered liquid alternative funds (Alt Funds) and a 360% increase in Alt Fund assets.  Sponsors have now created 468 Alt Funds with $172 billion of assets.  Before stepping on the gas to join this rush, you should start by answering a simple question – is it viable for my organization to offer an Alt Fund?  In a guest article, Bibb L. Strench, Counsel in the Washington, D.C. office of Seward & Kissel LLP, addresses the chief legal and practical factors that hedge fund managers should consider in answering that question.  In particular, Strench discusses strategic eligibility, liquidity, leverage, derivatives, valuation, tax, “strategy engineering” (e.g., via use of commodity mutual funds), closed-end funds, ETFs, entry points into the registered alternative fund business (including umbrella alternative funds), registered alternative fund fees and expenses, advertising and marketing possibilities, and operational and compliance considerations.  See also “Five Key Compliance Challenges for Alternative Mutual Funds: Valuation, Liquidity, Leverage, Disclosure and Director Oversight,” The Hedge Fund Law Report, Vol. 7, No. 28 (Jul. 24, 2014).

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  • From Vol. 7 No.42 (Nov. 6, 2014)

    Rules Against “Spoofing” and Other Disruptive Trading in Futures, Swaps and Options

    The Dodd-Frank Act resulted in new rules on disruptive trading in futures, options and swaps.  Following Dodd-Frank, both the Commodity Futures Trading Commission (CFTC) and the CME Group Exchanges implemented their own rules to address disruptive trading.  These new rules have significant implications for pooled investment vehicles, such as hedge funds and commodity pools.  This guest article outlines new disruptive trading rules and recent cases that the CFTC, futures exchanges and U.S. Attorneys’ Offices have brought under these new rules.  The authors of this article are Thomas K. Cauley, Jr. and Courtney A. Rosen, both litigation partners in the Investment Funds, Advisers and Derivatives and Securities and Derivatives Enforcement and Regulatory practices in the Chicago office of Sidley Austin LLP, and Lisa A. Dunsky, a counsel in those practices.  For additional insight from the authors, see “Contractual Provisions That Matter in Litigation between a Fund Manager and an Investor,” The Hedge Fund Law Report, Vol. 7, No. 37 (Oct. 2, 2014); and “Derivative Actions and Books and Records Demands Involving Hedge Funds,” The Hedge Fund Law Report, Vol. 7, No. 39 (Oct. 17, 2014).

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  • From Vol. 7 No.35 (Sep. 18, 2014)

    Three Reasons Why Hedge Fund Managers That Trade Commodities or Derivatives Should Care about Insider Trading in Securities

    For insider trading liability to attach, there must be, among other things, a purchase or sale of a security.  See “Perils Across the Pond: Understanding the Differences Between U.S. and U.K. Insider Trading Regulation,” The Hedge Fund Law Report, Vol. 5, No. 42 (Nov. 9, 2012) (subsection entitled “Summary of the Elements Under U.S. Law”).  Therefore, one might conclude that the manager of a hedge fund that invests exclusively in commodities and derivatives might fall outside the ambit of insider trading laws.  Similarly, one might conclude that the manager of one or more hedge funds that invest in commodities, derivatives and securities might only have to concern itself with insider trading laws to the extent of its securities trading.  This line of thinking is wrong – and hedge fund managers focused on commodities and derivatives do have to concern themselves with insider trading – for at least three reasons.

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  • From Vol. 7 No.27 (Jul. 18, 2014)

    Ropes & Gray Attorneys Discuss Implications for U.S. Hedge Fund Managers of the European Market Infrastructure Regulation

    In response to the 2008 global financial crisis, the U.S., the EU and other developed economies implemented reforms to mitigate the systemic risks posed by derivatives.  In the U.S., those reforms were embodied in the 2010 Dodd-Frank Act.  See “How Have Dodd-Frank and European Union Derivatives Trading Reforms Impacted Hedge Fund Managers That Trade Swaps?,” The Hedge Fund Law Report, Vol. 6, No. 40 (Oct. 17, 2013).  In August 2012, the European Commission adopted the Regulation on OTC Derivatives, Central Counterparties and Trade Repositories, also known as the European Market Infrastructure Regulation (EMIR), which imposed a central clearing regime for derivatives and other risk mitigation measures, including reporting and valuation requirements.  See “Comparing and Contrasting EMIR and Dodd-Frank OTC Derivatives Reforms and Their Impact on Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 6, No. 36 (Sep. 19, 2013).  Non-EU fund managers that trade derivatives with EU counterparties will be subject to certain of those provisions.  A recent program sponsored by Ropes & Gray LLP discussed the status of EMIR implementation and the impact of EMIR on U.S. fund managers.  This article highlights the main points from the program.

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  • From Vol. 7 No.27 (Jul. 18, 2014)

    RCA PracticeEdge Session Highlights the Key Points of Intersection between ERISA and Hedge Fund Investments and Operations

    Pension funds are a potentially huge source of capital for hedge fund managers.  However, accepting investments from pension plans governed by the Employee Retirement Income Security Act of 1974 (ERISA) is not without significant risks and drawbacks.  Of greatest concern to a hedge fund manager is that a fund will be deemed a “plan asset fund,” thereby making the manager an ERISA fiduciary and subjecting the fund to ERISA’s strict regulatory regime.  A recent PracticeEdge Session presented by the Regulatory Compliance Association provided an overview of the ERISA regime, with emphasis on when investment funds become subject to the ERISA regime, the consequences of being subject to that regime, the duties of ERISA fiduciaries and certain proposed or pending regulatory changes.  This article summarizes that session.  See also “What Should Hedge Fund Managers Expect When ERISA Plans Conduct Due Diligence on and Negotiate for Investments in Their Funds?,” The Hedge Fund Law Report, Vol. 6, No. 25 (Jun. 20, 2013); “How Can Hedge Fund Managers Managing Plan Asset Funds Comply with the QPAM and INHAM Exemption Requirements?,” The Hedge Fund Law Report, Vol. 6, No. 38 (Oct. 3, 2013).

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  • From Vol. 7 No.25 (Jun. 27, 2014)

    Can a Hedge Fund That Holds Senior Subordinated Notes Issued by a Credit Default Swap Seller Sue the Issuer Despite a “No-Action” Clause in the Indenture Governing the Notes?

    The New York Court of Appeals, the state’s highest court, recently ruled on the scope of a “no-action” clause in a bond indenture.  This article analyzes the ruling.  For a discussion of a dispute involving bond redemption rights, see “Recent Decision Highlights the Perils for Hedge Fund Managers of Failing to Understand Early Redemption Provisions in Bond Indentures,” The Hedge Fund Law Report, Vol. 6, No. 30 (Aug. 1, 2013).  For a discussion of a dispute involving an indenture’s impact on bankruptcy claims, see “Tribune Bankruptcy Highlights the Importance of Close Reading of Indenture Agreements by Hedge Funds That Trade Bankruptcy Claims or Distressed Debt,” The Hedge Fund Law Report, Vol. 5, No. 43 (Nov. 15, 2012).

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  • From Vol. 7 No.25 (Jun. 27, 2014)

    Key Investment and Operational Restrictions Imposed on Alternative Mutual Funds by the Investment Company Act of 1940 (Part Two of Two)

    This is the second article in a two-part series covering a recent program on alternative mutual funds.  Speakers at the program – including K&L Gates partners and Cordium executives – discussed the benefits and limitations of alternative mutual funds, outlined ways to enter the alternative mutual fund market and provided a thorough overview of some of the investment and operational restrictions imposed on alternative mutual funds by the Investment Company Act of 1940.  This article summarizes the investment and operational restrictions identified by the speakers, including issues relating to leverage, custody, prime brokerage, valuation, liquidity, portfolio management, CFTC jurisdiction and compliance policies and procedures.  The first article in this series addressed the potential advantages of alternative mutual funds over hedge funds, mutual fund laws and rules that are typically foreign to hedge fund managers, hedge fund strategies that “fit” within the mutual fund model and the pros and cons of three structures for entry by hedge fund managers into the alternative mutual fund business.  See “K&L Gates and Cordium Detail the Structuring, Investment and Operational Mechanics of Entry by Hedge Fund Managers Into the Alternative Mutual Fund Business (Part One of Two),” The Hedge Fund Law Report, Vol. 7, No. 24 (Jun. 19, 2014).

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  • From Vol. 7 No.22 (Jun. 6, 2014)

    Greenwich Associates Report Argues That Hedge Fund Managers Can Use the Cloud to Obtain Greater Computing Power at Lower Cost with Acceptable Risk

    A recent Greenwich Associates (GA) report discussed, in connection with the use of cloud computing by hedge fund managers: what hedge fund managers use cloud computing for, security, compliance and culture.  The report concludes with a four-part argument in favor of the ability of hedge fund managers – especially those that use derivatives or structured products – to obtain more computing power at lower cost via the cloud.  This article summarizes the GA report.  See also “Key Considerations for Hedge Fund Managers in Evaluating the Use of Cloud Computing Solutions (Part Two of Two),” The Hedge Fund Law Report, Vol. 5, No. 41 (Oct. 25, 2012).

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  • From Vol. 7 No.20 (May 23, 2014)

    The 1992 ISDA Master Agreement Says Notice Can Be Given Using an “Electronic Messaging System”; If You Think That Means “E-Mail,” Think Again

    That was the conclusion in a case decided last month by the High Court of England and Wales.  In a guest article, Anne E. Beaumont, a partner at Friedman Kaplan Seiler & Adelman LLP, discusses the court’s decision, the definition of an “electronic messaging system” under the 1992 ISDA Master Agreement, the significance of the decision for users of New York-law ISDA Master Agreements and how to provide for e-mail notice.  For related analysis by Beaumont, see “Five Steps for Proactively Managing OTC Derivatives Documentation Risk,” The Hedge Fund Law Report, Vol. 7, No. 16 (Apr. 25, 2014).

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  • From Vol. 7 No.16 (Apr. 25, 2014)

    Five Steps for Proactively Managing OTC Derivatives Documentation Risk

    Lehman Brothers’ filing of a Chapter 11 petition in September 2008 sent both Lehman and its derivatives counterparties scrambling to find and make sense of the reams of documentation that governed their rights and obligations in the wake of that cataclysm.  The bewildering challenge of terminating and valuing thousands of transactions was compounded by the fact that some counterparties could not promptly locate all of their documentation, and many of those that could were surprised – both negatively and positively – by what it contained when they read it.  The consequences of the Lehman bankruptcy are now in the rear-view mirror for most counterparties, but the market now faces other serious challenges.  In particular, the OTC derivatives market is hurtling toward the brave new world of clearing, which will simplify some aspects of derivatives transactions, but not all of them.  Not only are non-cleared transactions going to persist on a substantial scale, but many users likely will have a mix of both cleared and non-cleared transactions in their portfolios.  This compounds the complexity of documentation of OTC derivatives, making it critical that market participants stay on top of their documentation.  Unfortunately, there are signs – including two recent reports – that many market participants may not be keeping pace in monitoring and managing all of the necessary details of their OTC derivatives portfolios.  As so many counterparties learned from Lehman’s bankruptcy, such disarray is a recipe for disaster.  Only by keeping a close eye on documentation – both on the trading floor and in the legal and compliance functions – can problems be minimized or avoided, and opportunities exploited.  In a guest article, Anne E. Beaumont, a partner at Friedman Kaplan Seiler & Adelman LLP, identifies five best practices that OTC derivatives users of all sizes should adopt to manage the risks and to take best advantage of the opportunities presented by their documentation – and be well-prepared for any crisis, whether it is another major counterparty collapse like Lehman, or something more modest.  See also “How Have Dodd-Frank and European Union Derivatives Trading Reforms Impacted Hedge Fund Managers That Trade Swaps?,” The Hedge Fund Law Report, Vol. 6, No. 40 (Oct. 17, 2013).

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  • From Vol. 7 No.16 (Apr. 25, 2014)

    How Can a Hedge Fund Manager Craft an Effective Program for Foreign Exchange Trading Surveillance, Compliance and Monitoring?

    Foreign exchange (FX) trading is a multi-trillion dollar market in which hedge funds are regular participants.  As in other financial markets, there is always the potential for manipulation and other abuses.  A recent program sponsored by NICE Actimize gave an overview of the FX markets, discussed regulation of those markets and provided valuable insights into how hedge funds and others that engage in FX trading may develop effective compliance and monitoring programs.  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. 7 No.5 (Feb. 6, 2014)

    Tax Practitioners Discuss Taxation of Swaps, Wash Sales, Constructive Sales, Short Sales and Straddles at FRA/HFBOA Seminar (Part Four of Four)

    As a general matter, investors prefer long-term capital gains over ordinary income and, when faced with losses, short-term losses over long-term capital losses.  Investors and tax professionals are constantly seeking to optimize their tax results, in part by seeking to assure the most favorable tax treatment available when trading.  In some circumstances, such as those involving total return swaps, the IRS has simplified matters by predetermining a fixed percentage of gains and losses that are entitled to short-term or long-term treatment.  The IRS has also adopted several rules in response to trades that generated tax benefits but that did not result in a change of economic position for the investor.  In that regard, two presentations given as part of the 15th Annual Effective Hedge Fund Tax Practices seminar, co-hosted by Financial Research Associates and the Hedge Fund Business Operations Association, covered the fundamentals of the taxation of swaps and the tax treatment of wash sales, constructive sales, short sales and straddles.  This article, the last in our four-part series covering the seminar, summarizes the key takeaways from those presentations.  The first article in this series covered three sessions addressing contribution and distribution of property to fund investors, allocation of investment gains and losses to fund investors and preparation of Forms K-1.  See “Hedge Fund Tax Experts Discuss Allocations of Gains and Losses, Contributions to and Distributions of Property from a Fund, Expense Pass-Throughs and K-1 Preparation at FRA/HFBOA Seminar (Part One of Four),” The Hedge Fund Law Report, Vol. 7, No. 2 (Jan. 16, 2014).  The second article discussed issues impacting foreign investors in foreign funds, including basics of withholding with respect to fixed or determinable annual or periodic gains, profits, or income (FDAPI); the portfolio interest exemption from FDAPI withholding; the pitfalls of effectively connected income (ECI) for offshore hedge funds; and the sources of ECI.  See “Tax Experts Discuss Provisions Impacting Foreign Investors in Foreign Hedge Funds During FRA/HFBOA Seminar (Part Two of Four),” The Hedge Fund Law Report, Vol. 7, No. 3 (Jan. 23, 2014).  The third article addressed taxation of foreign investments, including withholding at the source, rules regarding controlled foreign corporations and issues concerning taxation of distressed debt investments.  See “Tax Practitioners Discuss Taxation of Foreign Investments and Distressed Debt Investments at FRA/HFBOA Seminar (Part Three of Four),” The Hedge Fund Law Report, Vol. 7, No. 4 (Jan. 30, 2014).

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  • From Vol. 7 No.4 (Jan. 30, 2014)

    Ropes & Gray Partners Share Experience and Best Practices Regarding the JOBS Act, the Volcker Rule, Broker Registration, Information Barriers, Examination Priorities, Multi-Year Incentive Fees and Swap Execution Facilities

    On February 4, 2014 – this coming Tuesday – the New York office of Ropes & Gray will host GAIM Regulation 2014.  The event will feature an all-star speaking faculty including general counsels and chief compliance officers from leading hedge fund managers, top partners from Ropes and other law firms and officials from the SEC, CFTC, FINRA and other U.S. and global regulators.  The intent of the event is to share best practices in a private setting, and to hear directly from relevant regulators.  For a fuller description of the event, click here.  To register, click here.  The Hedge Fund Law Report recently interviewed three Ropes partners on some of the more noteworthy topics expected to be discussed at GAIM Regulation 2014.  Generally, we discussed SEC and regulatory issues with Laurel FitzPatrick, co-leader of Ropes’ hedge funds practice and co-managing partner of its New York office; CFTC and derivatives issues with Deborah A. Monson, a partner in Ropes’ Chicago office; and enforcement issues with Zachary S. Brez, co-chair of Ropes’ securities and futures enforcement practice.  Specifically, our long form interview with these partners included detailed discussions of the future of hedge fund advertising following the JOBS Act; the impact of the Volcker rule on hedge fund hiring and trading; fund manager responses to the SEC’s focus on broker registration of in-house marketing personnel; best practices for preparing for and navigating SEC examinations; structuring multi-year incentive fees; the impact of swap execution facilities on hedge fund manager obligations and cleared derivatives execution agreements; recent National Futures Association developments relevant to hedge fund managers; design and enforcement of robust information barriers; measures that managers can take to preserve the firm before and after initiation of an enforcement action; government enforcement priorities for hedge fund managers; and specific financial products likely to face government scrutiny in the next two years.

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  • From Vol. 7 No.4 (Jan. 30, 2014)

    K&L Gates Investment Management Seminar Addresses Compliance Obligations for Registered CPOs and CTAs, OTC Derivatives Trading, SEC Examinations of Private Fund Managers and the JOBS Act (Part One of Two)

    K&L Gates partners and in-house counsel gathered on December 10, 2013 at the firm’s annual investment management seminar to provide updates on some of the most pertinent topics impacting the private fund industry.  This two-part series summarizes salient points from various sessions at the seminar.  This first installment summarizes a session covering CFTC and NFA regulations impacting registered commodity pool operators and commodity trading advisors as well as U.S. and European regulations governing transactions in swaps and other over-the-counter derivatives, including discussions of swap execution facilities and the European Market Infrastructure Regulation.  The second installment will discuss two sessions, one addressing the newest approaches and strategies used by the SEC to examine investment managers and bring enforcement actions where necessary, and another tackling the implications of the JOBS Act for fund managers.

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  • From Vol. 7 No.2 (Jan. 16, 2014)

    Aksia’s 2014 Hedge Fund Manager Survey Reveals Manager Perspectives on Economic Conditions, Derivatives Trading, Counterparty Risk, Financing Trends, Capital Raising, Performance, Transparency and Fees

    Aksia LLC (Aksia), a specialist hedge fund research and portfolio advisory firm, recently released the results of its 2014 Hedge Fund Manager Survey (Survey).  This third annual survey solicited hedge fund managers’ views on topics in three principal areas: The state of the economy and the broader market; the state of the hedge fund industry (particularly with respect to counterparty risk and central clearing, fund financing and capital raising); and hedge fund investor concerns with regard to performance, transparency and fees.  The Survey also drew insights on trends by comparing this year’s responses to those from Aksia’s first two surveys.  See “Aksia Survey Reveals Hedge Fund Managers’ Perspectives on AUM Composition, Fees, Liquidity, Advertising Practices, Transparency, Reporting and High-Frequency Trading,” The Hedge Fund Law Report, Vol. 6, No. 3 (Jan. 17, 2013); and “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,” The Hedge Fund Law Report, Vol. 5, No. 2 (Jan. 12, 2012).

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  • From Vol. 6 No.46 (Dec. 5, 2013)

    ALM’s 7th Annual Hedge Fund General Counsel Summit Addresses Strategies for Handling Government Investigations, Challenges for CCOs, Distressed Debt Investing, OTC Derivatives Reforms, Insider Trading Best Practices, the JOBS Act, AIFMD and Activist Investing (Part Two of Three)

    Hedge fund industry thought leaders recently shared their insights on legal, operational and other issues impacting hedge fund managers during the 7th Annual Hedge Fund General Counsel Summit hosted by ALM Events.  This second installment in our three-part series covering the summit discusses topics including the impact of over-the-counter derivatives reforms on fund managers (including a discussion of new mandatory trade reporting, clearing and execution requirements as well as CFTC cross border rules); opportunities and challenges associated with distressed debt investing (including a discussion of opportunities to participate in Chapter 11 proceedings, considerations in claims trading and risks of distressed debt investing); and best practices to address insider trading risks.  The first installment discussed strategies for handling government investigations and challenges facing chief compliance officers, including dual-hatting and potential supervisory liability.  The third installment will provide regulatory updates on the JOBS Act, the Alternative Investment Fund Managers Directive and new Canadian and U.S. initiatives that will impact activist investing strategies.

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  • From Vol. 6 No.44 (Nov. 14, 2013)

    Sidley Austin Private Funds Conference Addresses Recent Developments Relating to Fund Structuring and Terms; SEC Examinations and Enforcement Initiatives; Seeding Arrangements; Fund Mergers and Acquisitions; CPO Regulation; JOBS Act Implementation and Compliance; and Derivatives Reforms (Part Three of Three)

    This is the third installment in The Hedge Fund Law Report’s three-part series covering the recent Sidley Austin LLP conference entitled “Private Funds 2013: Developments and Opportunities.”  This article summarizes the key points made by presenting Sidley partners on relevant regulatory developments, including commodity pool operator registration and regulation, over-the-counter derivatives reforms and implementation and compliance with the JOBS Act.  The first article summarized conference segments on fund structuring, single-investor funds, first loss capital arrangements, side letter terms, hard wiring of feeder funds for ERISA purposes, liquidity terms, fee terms, founder share classes and expense allocations and caps.  And the second article addressed SEC examinations and enforcement, the SEC’s new policy requiring admissions of wrongdoing and best practices for compliance, seeding arrangements and fund mergers and acquisitions.

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  • From Vol. 6 No.43 (Nov. 8, 2013)

    In a Total Return Swap to Which a Hedge Fund Is a Party, Which Governs: The ISDA Master Confirmation or the Credit Support Annex?

    The New York State Supreme Court, Appellate Division, First Department (Court), recently awarded a hedge fund an important victory in its suit to unwind a total return swap with a counterparty and to recover collateral being held by the counterparty.  The Court ruled that the counterparty had defaulted on the swap when it failed to pay in full a $40 million collateral call by the hedge fund pursuant to the ISDA documents governing the swap.  See “How Have Dodd-Frank and European Union Derivatives Trading Reforms Impacted Hedge Fund Managers That Trade Swaps?,” The Hedge Fund Law Report, Vol. 6, No. 40 (Oct. 17, 2013).  A critical issue in the suit was whether language contained in the ISDA Master Confirmation negotiated by the parties modified and trumped the mechanism for disputing a collateral call contained in the credit support annex.  For a discussion of another action involving swap counterparty risk, see “British High Court Interprets ISDA Master Agreement to Suspend Non-Defaulting Party’s Payment Obligations Until Defaulting Party Has Cured the Default,” The Hedge Fund Law Report, Vol. 5, No. 20 (May 17, 2013).

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  • From Vol. 6 No.40 (Oct. 17, 2013)

    How Have Dodd-Frank and European Union Derivatives Trading Reforms Impacted Hedge Fund Managers That Trade Swaps?

    The Practising Law Institute recently sponsored a panel highlighting the impact of derivatives reforms on managers of hedge funds that trade swaps.  Among other things, the panel addressed key product definitions, including whether certain instruments are considered “swaps”; CPO registration obligations, exemptions and other administrative relief; ongoing compliance requirements applicable to registered CPOs, including the Series 3 exam requirement; and amendments to swap trading documentation triggered by Dodd-Frank and European Union derivatives regulatory reforms.  See “Dechert Webinar Highlights Key Deal Points and Tactics in Negotiations between Hedge Fund Managers and Futures Commission Merchants regarding Cleared Derivative Agreements,” The Hedge Fund Law Report, Vol. 6, No. 16 (Apr. 18, 2013); and “A Practical Guide to the Implications of Derivatives Reforms for Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 6, No. 29 (Jul. 25, 2013).  This article summarizes the key insights from the discussion.  The speakers were Michael J. Drayo, Senior Counsel at investment adviser The Vanguard Group, Inc., and Susan C. Ervin, a partner in the Financial Institutions group at Davis Polk & Wardwell LLP.  See “Do You Need to Be a Registered CPO Now and What Does It Mean If You Do? (Part Two of Two),” The Hedge Fund Law Report, Vol. 5, No. 19 (May 10, 2012).

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  • From Vol. 6 No.36 (Sep. 19, 2013)

    Comparing and Contrasting EMIR and Dodd-Frank OTC Derivatives Reforms and Their Impact on Hedge Fund Managers

    In response to the role played by over-the-counter (OTC) derivatives in the 2008 financial crisis, the U.S. and the EU each took steps to mitigate risks associated with OTC derivatives trading.  The U.S. reforms were embodied in the Dodd-Frank Act.  See “Dechert Webinar Highlights Key Deal Points and Tactics in Negotiations between Hedge Fund Managers and Futures Commission Merchants regarding Cleared Derivative Agreements,” The Hedge Fund Law Report, Vol. 6, No. 16 (Apr. 18, 2013).  Similarly, in 2012, the EU adopted its own OTC Derivatives reforms, known as the European Market Infrastructure Regulation (EMIR).  Implementation of Dodd-Frank’s OTC derivatives regulations and the EMIR regulations continues to take shape, with several important compliance and effective dates on the horizon.  With this in mind, a recent webinar presented by Dechert LLP provided a timely and detailed discussion of: the current state of implementation of EMIR; certain newly-effective EMIR risk mitigation requirements; implementation of Dodd-Frank’s central clearing and trade execution mandates and their extraterritorial application; and the significant similarities and differences between the U.S. and EU derivatives reforms.  This article summarizes the key insights from that webinar.  The speakers were Dechert partners Abigail Bell, Richard Frase and M. Holland West.

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  • From Vol. 6 No.29 (Jul. 25, 2013)

    A Practical Guide to the Implications of Derivatives Reforms for Hedge Fund Managers 

    Under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, a new world of cleared derivatives products is being developed, and hedge funds that employ derivatives will be required to use such cleared products.  To paraphrase the law, what is available for clearing must be cleared (subject to few exemptions that generally do not apply to funds).  This new world has created significant consternation for the hedge fund industry, which must engage new service providers, enter into new trading agreements and enter into new collateral arrangements.  These and other changes will create additional risks for hedge fund managers; likely increase the cost of doing business; and increase the complexity of trading relationships.  However, hedge fund managers that proactively address these concerns and challenges can mitigate some of the impact from these new regulations.  In a guest article, Matthew A. Magidson, Chair of Lowenstein Sandler’s Derivatives Practice Group and a Partner in the firm’s Investment Management Group, provides a roadmap for hedge fund managers on how to identify and address relevant challenges.

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  • From Vol. 6 No.16 (Apr. 18, 2013)

    Dechert Webinar Highlights Key Deal Points and Tactics in Negotiations between Hedge Fund Managers and Futures Commission Merchants Regarding Cleared Derivative Agreements

    The Dodd-Frank Act eliminated bilateral trading for most over-the-counter derivatives and will require most derivatives to be cleared through a clearinghouse, or central counterparty (CCP), which will hold collateral (i.e., margin) from both counterparties.  The principal goal of central clearing is to reduce counterparty risk associated with swaps and other derivatives transactions.  Hedge funds that trade swaps, futures and options on futures will likely need to clear those derivative transactions through a registered “futures commission merchant” (FCM) which will, in turn, face the CCP as counterparty with respect to such transactions.  As a result of these regulatory changes, hedge fund managers must understand cleared derivatives agreements entered into with FCMs and the key points to negotiate with respect to such agreements.  A recent webinar hosted by Dechert LLP provided an overview of the new rules governing margin held by FCMs on behalf of their customers and a roadmap for negotiating cleared derivative agreements with FCMs.  This article summarizes the key takeaways from the webinar.  For a general discussion of central clearing, see “Don Muller and Joshua Satten of Northern Trust Hedge Fund Services Discuss the Impact of OTC Derivatives Reforms on Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 6, No. 6 (Feb. 7, 2013).

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  • From Vol. 6 No.12 (Mar. 21, 2013)

    SEC Provides Guidance in Frequently Asked Questions on Form PF Concerning Reporting of Related Persons; Disregarded Entities; Derivatives Positions and Volumes; Master-Feeder Structures; and Calculation of Gross Asset Value and Regulatory Assets Under Management

    As filers continue to confront challenges in providing accurate and complete reporting on Form PF, the SEC has at various times during the past year provided answers to its Form PF Frequently Asked Questions (FAQs).  The most recent of these updates were provided on March 8, 2013 and November 20, 2012, and addressed issues such as how to report various related persons; report certain disregarded investments; calculate derivatives position exposures and trading volumes; report private funds that are part of a master-feeder structure; and calculate the gross asset value and regulatory assets under management of a reporting fund.  This article summarizes highlights from these most recent updates to the SEC’s Form PF FAQs.  For coverage of previous updates to the FAQs, see “SEC Staff Publishes Answers to Frequently Asked Questions Concerning Form PF,” The Hedge Fund Law Report, Vol. 5, No. 26 (Jun. 28, 2012).

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  • From Vol. 6 No.9 (Feb. 28, 2013)

    Department of Labor Advisory Opinion Facilitates Continued Access to the Swaps Market by Plan Asset Hedge Funds

    The Dodd-Frank Act established a comprehensive new regime of central clearing and trade execution requirements for certain over the counter swap transactions.  In anticipation of the effectiveness of that new regime, the Securities Industry and Financial Markets Association (SIFMA) requested an advisory opinion from the U.S. Department of Labor (DOL) on the applicability of the Employee Retirement Income Security Act of 1974 (ERISA) to certain elements of the central clearing of swaps entered into by pension plans and other entities deemed to hold “plan assets,” including hedge funds deemed to be “plan asset funds” (ERISA plans).  SIFMA was concerned that margin held by clearing members might be considered “plan assets” and that clearing members might be deemed ERISA fiduciaries or “parties in interest” to an ERISA plan subject to ERISA’s prohibited transaction rules.  In response, the DOL recently issued an advisory opinion (Opinion) addressing these issues.  The Opinion impacts plan asset hedge funds, which are subject to ERISA’s substantive provisions.  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).  This article summarizes the Opinion and its implications for ERISA plans, including plan asset hedge funds.

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  • From Vol. 6 No.6 (Feb. 7, 2013)

    Don Muller and Joshua Satten of Northern Trust Hedge Fund Services Discuss the Impact of OTC Derivatives Reforms on Hedge Fund Managers

    In an attempt to reduce systemic risk from over-the-counter (OTC) derivatives trading, the Dodd-Frank Act fundamentally changed the mechanics of the execution, clearing, settlement and recording of OTC derivatives trades.  Among other things, the Dodd-Frank Act mandates central clearing and exchange trading for many OTC derivatives.  These reforms will have financial, legal, compliance and operational implications for hedge fund managers.  Among other things, hedge fund managers will need to determine whether they wish to adhere to the August 2012 International Swaps and Derivatives Association, Inc. (ISDA) Dodd-Frank Protocol, which is a supplement that will amend their ISDA agreements with swap dealers and major swap participants.  See “Katten Partner Raymond Mouhadeb Discusses the Purpose, Applicability and Implications of the August 2012 ISDA Dodd-Frank Protocol for Hedge Fund Managers, Focusing on Whether Hedge Funds Should Adhere to the Protocol,” The Hedge Fund Law Report, Vol. 6, No. 4 (Jan. 24, 2013).  To explain some of the impact of these reforms on hedge fund managers, The Hedge Fund Law Report recently interviewed Don Muller, the Global Head of Middle Office Services at Northern Trust Hedge Fund Services, and Joshua Q. Satten, the Global Head of OTC Structured Products at Northern Trust Hedge Fund Services.  Specifically, our interview covered topics including: historical OTC derivatives trading practices; the impact of central clearing and exchange trading of OTC derivatives transactions; the Dodd-Frank Act OTC derivatives reporting requirements; posting of margin on OTC derivatives trades; changes in collateral practices for OTC derivatives trades; the financial impact of such reforms on hedge fund managers; solutions available to facilitate OTC derivatives trading post-reforms; and the impact of OTC derivatives reforms on hedge fund service providers.

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  • From Vol. 6 No.4 (Jan. 24, 2013)

    Katten Partner Raymond Mouhadeb Discusses the Purpose, Applicability and Implications of the August 2012 ISDA Dodd-Frank Protocol for Hedge Fund Managers, Focusing on Whether Hedge Funds Should Adhere to the Protocol

    The Dodd-Frank Act’s overhaul of over-the-counter derivatives trading will fundamentally change the trading relationship between swap dealers and major swap participants (MSPs) and hedge funds and other counterparties.  Among other things, the Dodd-Frank Act and related CFTC rules will impose significant new obligations on swap dealers and MSPs that will necessitate the amendment of bilateral swap documentation entered into with hedge funds.  To standardize this process, the International Swaps and Derivatives Association, Inc. (ISDA) introduced the August 2012 ISDA Dodd-Frank Protocol (Protocol).  The Protocol is a non-negotiable supplement designed to amend existing swap documentation with the goal of facilitating the exchange of information between swap dealers/MSPs and their counterparties.  While adherence to the Protocol is not mandatory for counterparties, non-adherence is likely to have consequences for their swap trading activities.  To help hedge fund managers understand the Protocol and evaluate whether their funds should adhere to it, The Hedge Fund Law Report recently interviewed Raymond Mouhadeb, a Partner at Katten Muchin Rosenman LLP.  Mouhadeb advises investment managers and sponsors of hedge funds, funds of funds and other investment vehicles on structuring and legal issues, including the applicability of the Dodd-Frank Act and regulations related to derivative transactions.  Our interview with Mouhadeb covered various topics, including: the purpose of the Protocol; understanding the hedge funds to which the Protocol applies; the specific entity that should consider Protocol adherence; consequences of non-adherence; principal concerns related to Protocol adherence; whether onshore funds should consider moving their swap relationships offshore; important compliance dates; the process for signing on to the Protocol; how adherence will lead to disclosure of information about the hedge fund; the types of representations that must be made in adhering to the Protocol; concerns relating to the DF Terms Agreement and the ISDA August DF Supplement; whether parties have entered into arrangements to amend the Protocol; continuing compliance obligations arising out of Protocol adherence; and whether the Protocol will change the procedures for entering into new ISDA agreements.

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  • From Vol. 5 No.48 (Dec. 20, 2012)

    CFTC Grants Additional Relief from CPO Regulation for Operators of Certain Securitization Vehicles

    On December 7, 2012, the CFTC’s Division of Swap Intermediary Oversight issued a letter expanding the scope of relief from commodity pool regulation for certain securitization and structured finance vehicles and their operators.  This article summarizes the guidance and relief granted in the letter.  See also “NFA Workshop Details the Registration and Regulatory Obligations of Hedge Fund Managers That Trade Commodity Interests,” The Hedge Fund Law Report, Vol. 5, No. 47 (Dec. 13, 2012).

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  • From Vol. 5 No.46 (Dec. 6, 2012)

    United Nations White Paper Explains How Hedge Fund Investors Can Layer Environmental, Social and Governance Factors into Manager Selection

    There has been a surge of recent interest in “responsible investment” in and by hedge funds.  However, the meaning of “responsible investment” is still being developed.  The term broadly refers to the integration of environmental, social and governance (ESG) investment criteria; and hedge fund managers are increasingly incorporating ESG factors into their investment strategies.  See “More Hedge Funds Are Employing Environmental, Social and Governance Investment Criteria,” The Hedge Fund Law Report, Vol. 4, No. 39 (Nov. 3, 2011).  However, there is little consensus on the impact of incorporating ESG criteria into hedge fund investments and strategies, or how to do so most efficiently and effectively.  In 2006, the United Nations (U.N.) Secretary-General launched the Principles for Responsible Investment (PRI), a set of aspirational standards designed to guide investors towards creating a sustainable global financial system that fosters good governance, transparency, integrity and accountability.  Hedge funds are important investment vehicles for many signatories to the PRI initiative.  To assist its signatories in their hedge fund investments, PRI recently issued a white paper discussing how hedge funds can incorporate ESG criteria into their investment strategies and how hedge fund investors can incorporate ESG factors into manager selection.  This article provides (1) an overview of PRI’s paper, including its assessment of the advantages and risks of various hedge fund investment techniques and strategies for ESG investors, and (2) a roadmap for responsible investment in and by hedge funds.

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  • From Vol. 5 No.45 (Nov. 29, 2012)

    Practising Law Institute Panel Discusses Sweeping Regulatory Changes for Hedge Fund Managers That Trade Swaps

    The Practising Law Institute recently hosted its “Hedge Funds 2012: Strategies and Structures for an Evolving Marketplace” program, which included a panel entitled “Trading Issues Relating to Swaps Under Dodd-Frank: The CFTC’s Expanded Registration Requirements for Commodity Pool Operators.”  This panel provided a comprehensive overview of the business consequences for buy-side swaps market participants (such as hedge fund managers that trade swaps) of the regulatory changes caused by the Dodd-Frank Act.  This article summarizes the notable insights from the panel discussion, including coverage of which entities must register as commodity pool operators (CPOs) or commodity trading advisors (CTAs) based on their swaps trading activity; the registration exemptions available to such CPOs and CTAs; certain regulations governing CPOs and CTAs that are required to register; and the regulations governing trading and clearing of swaps.  See also “Do You Need to Be a Registered Commodity Pool Operator Now and What Does It Mean If You Do?  (Part Two of Two),” The Hedge Fund Law Report, Vol. 5, No. 19 (May 10, 2012).

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  • From Vol. 5 No.43 (Nov. 15, 2012)

    Lessons Learned by Hedge Fund Managers from the August 2012 Initial Form PF Filing

    Form PF has presented, and continues to present, daunting challenges for hedge fund managers required to file the form.  Very large hedge fund advisers – those with $5 billion in regulatory assets under management – were required to file their initial Forms PF by August 29, 2012.  The initial filing highlighted some best practices as well as some pitfalls associated with the Form PF process.  On October 11, 2012, at the Princeton Club in Manhattan, Global Risk Management Advisors, Inc., Citi Prime Finance, Imagine Software, Sidley Austin LLP and The Hedge Fund Law Report hosted a seminar entitled, “Lessons Learned and Not Learned From the August 2012 Initial Form PF Filing.”  The seminar participants all had direct experience with the initial round of Form PF filings, and the seminar offered an occasion to reflect on that experience and extract lessons from it.  In particular, participants at the seminar discussed specific lessons learned from the initial filing process; some common mistakes made by first filers; how to craft assumptions used in Form PF; the treatment of derivative positions in Form PF; how regulators will use the information in Form PF in connection with enforcement actions against hedge fund managers; how to handle investor requests for Form PF or the data in it; allocation of costs of preparing Form PF; and other challenges presented by the form.  This article summarizes the key takeaways from the seminar.

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  • From Vol. 5 No.41 (Oct. 25, 2012)

    CFTC Grants Temporary Relief from CPO and CTA Registration to Certain Hedge Fund Managers that Trade Swaps

    The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) established a comprehensive new regulatory framework for swaps and security-based swaps which would bring many market participants within the ambit of CFTC regulation, including requiring numerous entities to register with the CFTC.  See “Do You Need to Be a Registered Commodity Pool Operator Now and What Does It Mean If You Do?  (Part Two of Two),” The Hedge Fund Law Report, Vol. 5, No. 19 (May 10, 2012).  Hedge fund managers were principally concerned that the inclusion of swaps as “commodity interests” would cause their hedge funds to be treated as “commodity pools,” which in turn could subject the hedge fund manager to compliance and registration obligations as a commodity pool operator (CPO) or a commodity trading advisor (CTA).  This concern was amplified when the CFTC and SEC jointly adopted rules refining the definition of the term “swap” and related terms, on August 13, 2012.  Specifically, the August 13 rules required hedge fund managers to determine whether their swaps-related activities would subject them to CFTC regulation and require them to register as a CPO or CTA by October 12, 2012, the effective date of the rules.  In light of the complexity of the definitions and the business arrangements to which the definitions applied, many hedge fund managers struggled to arrive at a conclusive determination.  See “CFTC Issues Responses to Frequently Asked Questions Concerning Registration Exemption Eligibility and Compliance Obligations for Commodity Pool Operators and Commodity Trading Advisors,” The Hedge Fund Law Report, Vol. 5, No. 32 (Aug. 16, 2012).  Fortunately for managers grappling with this issue, on October 11 and 12, 2012, the CFTC issued two no-action letters relevant to the registration obligations of hedge fund managers that trade swaps.  This article summarizes the key practical points arising out of the two no-action letters for hedge fund managers that trade foreign exchange and other swaps and foreign exchange forwards.

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  • From Vol. 5 No.41 (Oct. 25, 2012)

    Lehman Sues J.P. Morgan over Allegedly “Inflated” Claims under Derivative Contracts and Improper Setoffs

    Lehman Brothers Holdings Inc. and three of its subsidiaries (together, Lehman) have commenced an adversary proceeding in the Lehman bankruptcy against JPMorgan Chase & Co. and several of its subsidiaries (together, J.P. Morgan) that were counterparties to various derivative contracts with Lehman.  Lehman’s bankruptcy constituted a default under those derivative contracts, allowing the J.P. Morgan counterparties to terminate the contracts early and submit claims for amounts allegedly owed by Lehman.  The Lehman entities are now challenging the claims filed by J.P. Morgan in the bankruptcy, attacking them in two ways.  This article summarizes Lehman’s complaint and includes insight from Solomon J. Noh, a partner in the Bankruptcy & Reorganization Group at Shearman & Sterling LLP, on valuing terminated derivatives, cross affiliate setoff and related matters.

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  • From Vol. 5 No.41 (Oct. 25, 2012)

    CFTC Interpretive Guidance Takes the View That Certain Securitization Vehicles Are Not Commodity Pools, Even Though They Use Swaps

    Prior to the Dodd-Frank Act, few considered securitization vehicles commodity pools.  But after the Dodd-Frank Act – and, in particular, after passage of various CFTC rules governing swaps trading – a question has arisen in the structured finance world as to whether certain securitization vehicles that use swaps are commodity pools.  The answer matters because if such securitization vehicles are commodity pools, the vehicles would be subject to CFTC regulation and their operators would be subject to CFTC registration (unless an exemption is available).  In turn, CFTC regulation is complicated and CFTC registration can be onerous.  See, e.g., “So You Don’t Want to Take the Series 3 Exam?  Alternatives to the General Proficiency Requirement for Associated Persons of Commodity Pool Operators and Commodity Trading Advisors,” The Hedge Fund Law Report, Vol. 5, No. 37 (Sep. 27, 2012).  Accordingly, the American Securitization Forum (ASF) and The Securities Industry and Financial Markets Association (SIFMA and, together with ASF, Applicants) recently requested guidance from the CFTC’s Division of Swap Dealers and Intermediary Oversight concerning these issues.  This article summarizes the interpretive guidance provided by the CFTC in response to the Applicants’ request.  Also, this article includes insight from Sidley Austin partner Jonathan Miller on the guidance and its implications for the registration and filing obligations (including potential Form PF filing obligations) of operators of securitization vehicles.

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  • From Vol. 5 No.27 (Jul. 12, 2012)

    Lesson from Lehman Brothers for Hedge Fund Managers: The Effect of a Bankruptcy Filing on the Value of the Debtor’s Derivative Book

    Prior to its bankruptcy filing, Lehman Brothers (Lehman) was a global broker-dealer/investment bank that conducted trades and made investments on behalf of itself as well as its clients, including many hedge fund managers.  As part of this business, Lehman entered into a large number of “derivatives” transactions – such as credit default swaps, interest rate swaps and currency swaps – both for speculative and hedging purposes.  As of August 2008, Lehman held over 900,000 derivatives positions worldwide, in each case through one of its operating subsidiaries.  In many instances, Lehman’s ultimate parent entity, Lehman Brothers Holdings Inc. (LBHI), guaranteed the obligations arising out of these derivatives positions.  As of August 31, 2008, Lehman internally estimated that, on an aggregate basis, its derivatives positions had a positive net value of approximately $22.2 billion, representing a significant asset of the company.  This substantial “in the money” position abruptly turned “out of the money” as the result of LBHI’s bankruptcy filing in the early morning of September 15, 2008.  The commencement of LBHI’s bankruptcy case – the largest by far in U.S. history, with claims well exceeding $300 billion – provided a contractual basis for a large majority of Lehman’s derivatives counterparties to terminate their transactions with Lehman.  As a result, more than 80 percent of Lehman’s derivatives positions terminated as of, or soon after, the date of the bankruptcy filing.  Alvarez & Marsal, Lehman’s restructuring advisors, concluded in a three-month internal study that the losses from terminated derivatives trades cost the bankruptcy estate “at least” $50 billion.  In a guest article, Solomon J. Noh, a partner in the Global Restructuring Group at Shearman & Sterling LLP, examines what may be one of the principal reasons why Lehman’s bankruptcy filing resulted in such an extraordinary loss in value for the Lehman estate and how Congress has proposed to address this problem in any future failure of a major financial institution.  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. 5 No.27 (Jul. 12, 2012)

    U.K. High Court of Justice Finds Magnus Peterson Liable for Fraud in Collapse of Hedge Fund Manager Weavering Capital and Weavering Macro Fixed Income Fund

    In 1998, defendant Magnus Peterson formed hedge fund manager Weavering Capital (UK) Limited (WCUK).  He served as a director, chief executive officer and investment manager.  One fund managed by WCUK, the open-end Weavering Macro Fixed Income Fund Limited (Fund), collapsed in the midst of the 2008 financial crisis.  Peterson was accused of disguising the Fund’s massive losses by entering into bogus forward rate agreements and interest rate swaps with another fund that he controlled.  In March 2009, the Fund suspended redemptions and went into liquidation when it could not meet investor redemption requests.  At that time, WCUK went into administration (bankruptcy).  WCUK’s official liquidators, on behalf of WCUK, brought suit against Peterson, his wife, certain WCUK employees and directors and others, seeking to recover damages for fraud, negligence and breach of fiduciary duty and seeking to recover certain allegedly improper transfers of funds by Peterson.  After a lengthy hearing, the U.K. High Court of Justice, Chancery Division (Court), has allowed virtually all of those claims, ruling that Peterson did indeed engage in fraud.  In a separate action, the Fund’s official liquidators recovered damages from Peterson’s brother, Stefan Peterson, and their stepfather, Hans Ekstrom, who served as Fund directors, based on their willful failure to perform their supervisory functions as directors.  See “Cayman Grand Court Holds Independent Directors of Failed Hedge Fund Weavering Macro Fixed Income Fund Personally Liable for Losses Due to their Willful Failure to Supervise Fund Operations,” The Hedge Fund Law Report, Vol. 4, No. 31 (Sep. 8, 2011).  This article summarizes the factual background and the Court’s legal analysis in the liquidators’ action against Peterson and others.

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  • From Vol. 5 No.21 (May 24, 2012)

    CFTC and SEC Adopt Long-Awaited Rules Excluding Most Hedge Funds from Swap Dealer Registration Requirements

    The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) recently adopted final rules defining the types of entities that will be required to register as swap dealers, security-based swap dealers, major swap participants (MSPs) and major security-based swap participants (MSSPs) under the Dodd-Frank Wall Street Reform and Consumer Protection Act.  These entities will be required to register with the CFTC or the SEC and adhere to a wide variety of new requirements with respect to their derivatives trading, including capital, margin, reporting and business conduct requirements.  The CFTC and the SEC defined “swap dealer” and “security-based swap dealer” narrowly, thereby including for the most part only traditional dealers in the over-the-counter derivatives market and excluding most hedge funds and other buy-side participants who are not undertaking traditional dealing activities.  The final rules also set a high bar for the MSP and MSSP categories, excluding most hedge funds and hedge fund advisers from the requirement to register as an MSP or an MSSP.  The CFTC also adopted a revised definition of “eligible contract participant” (ECP).  The final rule exempts most hedge funds from the requirement that each investor in the fund be an ECP in order for the fund to be able to enter into off-exchange foreign currency transactions without satisfying certain requirements under the CFTC’s retail foreign exchange rules.  In a guest article, Leigh Fraser and Molly Moore, Partner and Associate, respectively, in the Hedge Funds group of Ropes & Gray LLP, provide a detailed analysis of the final rules and their application to hedge funds and hedge fund managers.

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  • 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.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.15 (Apr. 12, 2012)

    Recent New York Court Decision Suggests That Hedge Funds Have a Due Diligence Obligation When Entering into Credit Default Swaps

    Domestic and foreign regulators have historically afforded differing levels of protection to retail investors as opposed to sophisticated investors, such as hedge funds, based on their presumptively differing levels of financial knowledge and abilities to conduct due diligence on prospective investments.  Sophisticated investors have been permitted to invest in more complicated financial products based on their presumed ability to understand and conduct due diligence on such investments.  However, the flip side of enhanced access is diminished investor protection, as evidenced by a recent court decision holding that sophisticated investors have a duty to investigate publicly available information in arms-length transactions.

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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.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.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.20 (Jun. 17, 2011)

    Insider Trading and Debt Securities: Practical Tips for Hedge Funds in Coping with Regulatory Enforcement

    Recent events have brought increased regulatory and judicial focus on the world of debt instruments.  The stock market crash of the fall of 2008 was largely precipitated by the implosion of debt instruments linked to sub-prime mortgages loans.  These market crises put into relief the relative size and power of the bond markets.  The equity markets were, at least as of mid-2009, less than half the size of the debt markets, $14 trillion versus $32 trillion in the U.S. and $44 trillion versus $82 trillion globally.  Perhaps understanding this, since 2008, the SEC has begun new, unprecedented investigations of insider trading in the realm of debt instruments.  In a guest article, Mark S. Cohen, Co-Founder and Partner at Cohen & Gresser LLP, and Lawrence J. Lee, an Associate at Cohen & Gresser, discuss: hedge funds and the debt markets; the law of insider trading; potential sources of inside information; relationships that are likely to give rise to duties of confidentiality in connection with a debt trading strategy; types of insider trading cases concerning debt securities and credit, including discussions of specific cases involving derivatives, bankruptcy, distressed debt, government bonds and bank loans; and practical steps that hedge fund managers can take to avoid insider trading violations when trading various types of debt and debt-related instruments.

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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)

    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

    On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), heralded as the most significant new financial regulation since the Great Depression.  Title II of the Dodd-Frank Act creates a framework to prevent the potential meltdown of systemically important U.S. financial businesses.  This framework includes a new federal receivership procedure, the so-called orderly liquidation authority (“OLA”), for significant, interconnected non-bank financial companies whose unmanaged collapse could jeopardize the national economy.  The OLA will form part of a new regulatory framework intended to improve economic stability, mitigate systemic risk, and end the practice of taxpayer-financed “bailouts.”  The OLA generally is modeled on the Federal Deposit Insurance Act (“FDIA”), which deals with insured bank insolvencies, and also borrows from the Bankruptcy Code.  Notwithstanding the enactment of Title II, there will be a heavy presumption that companies that otherwise qualify for protection under the Bankruptcy Code will be reorganized or liquidated through a traditional bankruptcy case.  If, however, an institution is deemed to warrant the special procedures under the OLA, Title II will apply, even if a bankruptcy case is then pending for such institution.  As discussed in this article, the decision of whether to invoke Title II will be made outside the public view.  As a result, hedge funds that have claims and other exposures to financial companies may find the playing field shifting overnight from the relatively predictable confines of the Bankruptcy Code to the novel and untested framework of the OLA.  In a guest article, Solomon J. Noh, a Senior Associate in the Bankruptcy & Reorganization Group at Shearman & Sterling LLP, provides a high-level discussion of how the following types of claims and exposures would be handled in a receivership governed by Title II based on the regulatory rules currently proposed or in effect: (i) secured claims; (ii) general unsecured claims (such as a claim arising out of unsecured bond debt); (iii) contingent claims (such as a claim relating to a guaranty); (iv) revolving lines of credit and other open commitments to fund; and (v) “qualified financial contracts” (i.e., swap agreements, forward contracts, commodity contracts, securities contracts and repurchase agreements).  Hedge funds employing a variety of strategies – notably, but not exclusively, distressed debt – routinely acquire the foregoing categories of claims and exposures.  For situations in which those claims or exposures face a firm that may be designated as systemically important, this article highlights the principal legal considerations that will inform any investment decision.

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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. 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 ERISA 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.15 (Apr. 16, 2010)

    White & Case Hosts Program on “Financial Regulatory Reform: Current Status and Developments,” Highlighting Key Legislative Proposals Impacting Hedge Fund Managers, Broker-Dealers and Derivatives Industry Participants

    As previously reported in the Hedge Fund Law Report, on March 26, 2009, the U.S. Department of the Treasury outlined a new framework for financial regulatory reform, including a proposal to require advisers to hedge funds (and other private pools of capital) with assets under management above a certain threshold to register with the SEC, along with certain other regulatory reforms.  See “Treasury Calls for Registration of Hedge Fund Managers with Assets Under Management Above a Certain Threshold and Outlines Framework for Other Regulatory Reforms Aimed at Limiting Systemic Risk,” The Hedge Fund Law Report, Vol. 2, No. 13 (Apr. 2, 2009).  Some of these reforms have been incorporated into current and pending legislation, including, most notably, the Private Fund Investment Advisers Registration Act of 2009, which was incorporated into Title V of the Wall Street Reform and Consumer Protection Act of 2009 and was passed by the House of Representatives on December 11, 2009 (House bill), and the Restoring American Financial Stability Act of 2009, which was introduced by Banking Committee Chairman Senator Christopher Dodd on November 10, 2009 (Dodd bill).  For more on the Dodd bill, see “Does the IOSCO Hedge Fund Disclosure Template Foreshadow the Content of Hedge Fund and Hedge Fund Adviser Disclosures to be Required by the SEC?,” above, in this issue of the Hedge Fund Law Report.  Also on March 26, 2009, the Obama Administration issued details on proposed legislation for a “resolution authority” that would give the President sweeping powers to dismantle or reorganize failing companies that pose a threat to the country’s financial system.  On April 8, 2010, White & Case LLP held a seminar entitled “Financial Regulatory Reform: Current Status and Developments,” with the goal of outlining and analyzing some of the more significant pieces of the pending financial regulatory reform legislation referenced above, and the ways in which various market participants may be impacted by such reforms.  This article outlines the most relevant topics discussed at the seminar, including: legislation relating to creation of a “resolution authority” to deal with pending failures of large, interconnected financial companies; ipso facto clauses in derivatives contracts; proposed central clearing requirements for derivatives; comparisons of the relevant provisions of the House and Dodd bills with respect to hedge fund manager registration; the issue of self-custody by hedge fund managers in light of the recent amendments to the custody rule; the proposed fiduciary standard for broker-dealers providing investment advice incidental to their brokerage activities; and the treatment of proprietary trading activities of broker-dealers under the Volcker Rule.

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  • From Vol. 3 No.12 (Mar. 25, 2010)

    IRS Directive and HIRE Act Undermine Tax Benefits of Total Return Equity Swaps for Offshore Hedge Funds

    As explained more fully below, total return equity swaps (TRSs) generally are contracts, often between a financial institution and a hedge fund, whereby the financial institution agrees to pay the hedge fund the total return of the reference equity during the swap term (including capital gains and dividends), and the hedge fund agrees to pay the financial institution the value of any decline in the price of the reference equity and interest on any debt embedded in the swap.  In other words, the financial institution pays the hedge fund any upside, and the hedge fund pays the financial institution any downside plus interest.  In this sense, the financial institution is the short party to the swap, and the hedge fund is the long party.  Traditionally, hedge funds have used TRSs for three principal purposes, among others.  First, hedge funds have used TRSs to gain economic exposure to companies without obtaining beneficial ownership of the stock of those companies, thereby avoiding the obligation to file a Schedule 13D and preserving the secrecy of incipient activist campaigns.  Second, offshore hedge funds have used TRSs to obtain economic exposure to dividend-paying U.S. stocks while avoiding the 30 percent withholding tax typically imposed on dividends paid by U.S. public companies to non-U.S. persons.  Offshore hedge funds have been able to use TRSs to avoid such withholding tax because, until recently, dividends were subject to withholding but “dividend equivalent payments” – the amount paid by a financial institution to a hedge fund under a swap by reference to the dividend paid by the relevant equity – were not.  Third, hedge funds have used TRSs to obtain leverage.  That is, the traditional way to get exposure to the total return of a stock was to buy it.  However, TRSs enable hedge funds to get exposure to the total return of a stock by entering into a contract with a financial institution and posting initial and variation margin (which, even taken together, often constitute only a fraction of the market price of the stock).  The first two of those purposes have been dramatically undermined by judicial and legislative action.  Specifically, with respect to the use of TRSs in activist campaigns, in June 2008, the U.S. District Court for the Southern District of New York held that two hedge funds that had accumulated substantial economic positions in publicly-traded railroad operator CSX Corporation, principally via cash-settled TRSs, were deemed to have beneficial ownership of the hedge shares held by their swap counterparties.  Accordingly, the court found that one of the hedge fund group defendants, The Children’s Investment Fund Management (UK) LLP and related hedge fund and advisory entities, violated Section 13(d) of the Securities Exchange Act of 1934 by failing to file a Schedule 13D within ten days of the date on which its beneficial ownership exceeded five percent.  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).  With respect to the second purpose described above, in January of this year, the IRS issued an industry directive (Directive) outlining TRS structures that, in the agency’s view, may be used to improperly avoid withholding tax on dividends.  See “New IRS Audit Guidelines Target Equity Swaps with Non-U.S. Counterparties,” The Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010).  More recently, on March 18, 2010, President Obama signed into law the Hiring Incentives to Restore Employment (HIRE) Act (H.R. 2847), which contained provisions originally proposed as part of the Foreign Account Tax Compliance Act of 2009.  See “Bills in Congress Pose the Most Credible Threat to Date to the Continued to the Continued Tax Treatment of Hedge Fund Performance Allocations as Capital Gains,” The Hedge Fund Law Report, Vol. 2, No. 52 (Dec. 30, 2009).  Among other things, the HIRE Act will impose a 30 percent withholding tax on dividend-equivalent payments made to non-U.S. persons on or after September 14, 2010 on certain TRSs or pursuant to securities loans and “repo” transactions.  While there is significant overlap between the TRSs targeted in the Directive and those for which withholding will be required under the HIRE Act, the HIRE Act covers a broader range of TRSs.  While the third purpose of TRSs identified above – providing leverage – remains reasonably intact, the CSX case, the Directive and the HIRE Act collectively challenge the utility of TRSs for hedge funds, pose unique structuring challenges and change market dynamics that have existed for 20 years.  Yet the Directive and HIRE Act may also, like other facially adverse actions or events, offer opportunities.  With the goal of helping hedge fund managers navigate the changing tax consequences of TRSs, this article describes: the mechanics of TRSs in greater depth; the business benefits and burdens of TRSs; the Directive, including the specific scenarios identified by the IRS as meriting further attention from field agents; the relevant provisions of the HIRE Act; the likely market impact of the Directive and HIRE Act, including the specific impact on financial institutions, master-feeder hedge fund structures and TRSs written on a “basket” of equities; and potential structuring alternatives to avoid the adverse tax consequences of the Directive and HIRE Act.

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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.10 (Mar. 11, 2010)

    Should Hedge Funds Include Automatic Termination as a Term of Bank Debt Trades on the New Loan Market Association Forms?

    On January 25, 2010, the Loan Market Association (LMA) – the European trade association for the syndicated loan market – launched a combined set of standard terms and conditions for par and distressed trading documentation (Combined Terms and Conditions).  One of the key additions to the form loan documentation is a termination upon insolvency provision.  Specifically, the new provision creates a default rule whereby the non-insolvent party to a bank debt trade may terminate the trade upon notice to the insolvent party.  The parties may also revise the default rule to provide for automatic termination upon the insolvency of either party.  In addition, the provision provides a mechanism for calculating damages upon a termination occasioned by insolvency of one of the parties.  The inclusion of the termination upon insolvency provision is widely perceived as a direct response to the experience of loan market participants in the Lehman Brothers bankruptcy.  In that case, absent a termination right on the part of Lehman’s non-insolvent bank debt trade counterparties (many of whom were hedge funds), Lehman generally had the right to (and in many cases did) keep open trades for which it was in the money, and cancel trades for which it was out of the money.  In short, the rules as they existed at the end of 2008 and through 2009 permitted Lehman entities to “cherry pick” favorable trades.  Part of the policy behind the new provision is to prevent parties trading in bank debt from using bankruptcy (or, in the U.K., administration) to obtain a trading advantage.  For hedge funds, one of the key questions raised by the new provision is whether to include automatic termination provisions in bank debt trade documentation.  This article explores that question, and in doing so discusses: the details of the new LMA Combined Terms and Conditions; the specifics of the termination on insolvency provision (including the default rule requiring notice of termination and permitted alterations to the default rule); the mechanism for calculating early termination payments; the disadvantages of providing for automatic termination, highlighting the different relevant bankruptcy rules in the U.K. and the U.S.; the advantages of providing for automatic termination, also highlighting the variations in analysis between the U.K. and the U.S.; the extent to which automatic termination can harmonize bank debt and derivatives documentation, at least in the U.K.; the effect of automatic termination on bank debt trade pricing; and relevant differences between LMA and LSTA documentation.

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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.51 (Dec. 23, 2009)

    SEC’s First-Ever Credit Default Swap Insider Trading Case Survives Motion to Dismiss

    On May 5, 2009, the Securities and Exchange Commission (SEC) commenced an insider trading enforcement action against Jon-Paul Rorech, a Deutsche Bank bond and credit default swap salesman during the relevant period, and Renato Negrin, a portfolio manager employed during the relevant period by hedge fund adviser Millennium Partners, L.P.  This case is the first insider trading case the SEC has brought with respect to credit default swaps, which are not registered securities.  The SEC alleged that Rorech and Negrin engaged in insider trading of the credit default swaps of VNU N.V., a Dutch media conglomerate.  The defendants moved to dismiss the complaint primarily on the basis that credit default swaps were not “securities based swap agreements” for purposes of insider trading law.  Rorech also argued that the relevant information was not confidential and that the SEC lacked jurisdiction over foreign bonds.  The court rejected their contentions and allowed the SEC’s case to proceed.  We review the arguments made and the court’s rationale for its decision.  See also “SEC Brings First-Ever Credit Default Swaps Insider Trading Case,” The Hedge Fund Law Report, Vol. 2, No. 19 (May 13, 2009).

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  • From Vol. 2 No.47 (Nov. 25, 2009)

    “The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History,” By Gregory Zuckerman; Broadway Books, 295 pages

    In 2006, hedge fund manager John Paulson realized something few others suspected – that the housing market and the value of subprime mortgages were grossly inflated and headed for a fall.  Paulson, who knew mergers and acquisitions, knew little about real estate or how to wager against housing.  But Paulson saw an opportunity to bet against the market in complicated derivative investments.  Colleagues at investment banks scoffed at him and investors dismissed him.  Even professionals skeptical about the housing market shied away from him.  But Paulson, obstinate, bet heavily against risky mortgages and precarious financial companies anyway.  Of course, timing is everything.  And, although Paulson lost tens of millions of dollars as real estate and stocks continued to soar, he redoubled his bet, putting his hedge fund on the line.  Then, the markets imploded in the summer of 2007, and Paulson saw profits.  By year’s end, Paulson had pulled off “The Greatest Trade Ever” in financial history, earning more than $15 billion (gross of fees) for funds managed by his firm, Paulson & Co.  In “The Greatest Trade Ever,” Gregory Zuckerman chronicles the unparalleled and unprecedented trade executed by John Paulson, with the help of analyst Paulo Pellegrini and others at Paulson’s firm.  The book provides insider insight into how Paulson and others profited from the subprime market’s demise.  In doing so, it details not only Paulson’s experience, but the experience of other individuals pursuing the same historic trade: Jeffrey Greene, an investor who emulated Paulson; Michael Burry, an investor who read the same problems in the market correctly but had poor timing; and Andrew Lahde, the hedge fund manager who succeeded like Paulson, but on a smaller scale, and then infamously penned a colorful goodbye letter to Wall Street.  None of these players, however, had quite the “smarts, good timing and a touch of the . . . renegade” of Paulson, according to Zuckerman.  This review examines Zuckerman’s remarkably insightful analysis of Paulson’s character, how Paulson was able to foresee the credit crisis based on a single chart, and how Paulson formulated, pursued and completed the “Greatest Trade Ever.”

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  • From Vol. 2 No.42 (Oct. 21, 2009)

    Pursuit Partners, LLC v. UBS AG: Implications for Hedge Funds That Invested in Collateralized Debt Obligations and Other Structured Products

    On September 8, 2009, the Connecticut Superior Court entered an order requiring two UBS entities to put aside more than $35 million to ensure that a hedge fund claiming fraud in its purchase of notes tied to UBS collateralized debt obligations (CDOs) would be adequately compensated in the event it was successful in its lawsuit against UBS.  The case, Pursuit Partners, LLC et al. v. UBS AG, et al., is notable for a number of reasons.  Chief among these is the rarity of lawsuits filed by purchasers of CDOs notwithstanding the anecdotal evidence indicating that most CDOs have suffered massive declines in value.  The lack of lawsuit filings by CDO purchasers has continued to puzzle industry experts who confidently predicted that the subprime mortgage crisis would result in an explosion of litigation by purchasers of securities and derivatives tied to subprime mortgages including CDOs.  There is no obvious explanation for why this expected litigation explosion did not occur beyond the general distaste that non-public institutional investors seem to have for lawsuits in general and the almost universally held assumption within the hedge fund industry that nobody could have anticipated the collapse of the subprime mortgage securities market.  The Pursuit case however, renders that assumption highly suspect.  As the limitations clock for filing suit continues to tick down for purchasers, hedge funds with significant losses in mortgage-backed securities, especially those headquartered in Connecticut, should examine closely the Pursuit court’s holding in evaluating any decision not to pursue litigation against sellers.  In a guest article, Darren Kaplan, a Partner at Chitwood Harley Harnes LLP, analyzes the factual background of the Pursuit case; the court’s legal analysis; and the lessons that hedge fund managers can draw from the case.

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  • From Vol. 2 No.39 (Oct. 1, 2009)

    Would the Expanded Disclosures Required by Proposed Amendments to Federal Rule of Bankruptcy Procedure 2019 Deter Hedge Funds from Investing in Distressed Debt? (Part Three of Three)

    On August 12, 2009, the Advisory Committee on the Federal Rules of Bankruptcy Procedure (Advisory Committee) proposed a significant revision of Federal Rule of Bankruptcy Procedure 2019 (Rule 2019), the rule that in its current form requires disclosure by an “entity or committee representing more than one creditor” of the identity of each creditor involved, the nature and amount of its interest, the times when the entity’s interests were acquired and the amounts paid for them.  The proposed amendment would clarify that every entity that plays an active part in a bankruptcy proceeding is at least potentially subject to a requirement to disclose a wide range of information of the sort that distressed debt hedge funds and other bankruptcy investors have long sought to keep proprietary.  Comments on the proposed revision are due by February 16, 2010.  The proposed rule revision would change the bankruptcy investing game in three principal ways: (1) it would widen the scope of who must disclose under Rule 2019; (2) it would widen the scope of what must be disclosed; and (3) it would give bankruptcy courts wider discretion to relieve or abridge disclosure obligations, especially disclosure regarding the prices of assets purchased in secondary market trading.  This article discusses the proposed revision in depth, focusing on the potential consequences for hedge funds that invest in and around bankruptcies.  This article is the third in a three-part series on Rule 2019, and its impact on hedge fund strategies.  For the two previous installments in the series, see “How Can Hedge Funds that Invest in Distressed Debt Keep their Strategies and Positions Confidential in Light of the Disclosures Required by Federal Rule of Bankruptcy Procedure 2019(a)?,” The Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009); and “How Can Hedge Funds that Invest in Distressed Debt Keep Their Strategies and Positions Confidential in Light of the Disclosures Required by Federal Rule of Bankruptcy Procedure 2019(a)? (Part Two of Three),” The Hedge Fund Law Report, Vol. 2, No. 36 (Sep. 9, 2009).

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  • From Vol. 2 No.36 (Sep. 9, 2009)

    How Can Hedge Funds that Invest in Distressed Debt Keep Their Strategies and Positions Confidential in Light of the Disclosures Required by Federal Rule of Bankruptcy Procedure 2019(a)? (Part Two of Three)

    An article in the August 7, 2009 issue of The Hedge Fund Law Report examined recent decisions that shed light on the scope of disclosure required under Federal Rule of Bankruptcy Procedure 2019(a) (Rule 2019(a)).  See “How Can Hedge Funds that Invest in Distressed Debt Keep Their Strategies and Positions Confidential in Light of the Disclosures Required by Federal Rule of Bankruptcy Procedure 2019(a)?,” The Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009).  This article further analyzes the issues that arise from those cases – issue that are currently under deliberation by the U.S. Bankruptcy Court for the District of Delaware in the matter of the reorganization of Washington Mutual Inc., the former holding company of failed Washington Mutual Bank.  This article draws on the views of leading practitioners in bankruptcy and other relevant legal areas to illustrate three points, among others: (1) relevant bankruptcy practice has not changed significantly since 2005, when the U.S. Bankruptcy Court for the Southern District of New York, in cases arising out of the bankruptcy of Northwest Airlines, required certain disclosures (e.g., the price and timing of securities purchases) by members of an ad hoc equity committee and refused to permit the disclosures to be made under seal; (2) the Northwest precedent has given litigants a new weapon that may be used against hedge funds that purchase distressed debt, though the effectiveness of that weapon remains to be determined; and (3) the hedge fund industry, and even some bankruptcy court judges, are looking to the Committee on Rules of Practice and Procedure of the Judicial Conference of the United States to resolve the uncertainty created by the Northwest decisions.

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  • From Vol. 2 No.34 (Aug. 27, 2009)

    Greenwich Associates Issues Report Finding that Private Sector Signals Strong, Albeit Cautious, Support for Financial Regulatory Reform

    According to an August 2009 report issued by Greenwich Associates, corporations and financial institutions around the world have expressed strong levels of support for many of the key components of financial regulation reform proposed by governments in the United States and Europe.  Greenwich Associates surveyed 458 large corporations and financial institutions in North America, Europe and Asia about their opinions on various reform proposals and their assessments of how governments and regulators have performed since the start of the global financial crisis.  The results reveal strong support for regulatory proposals including: the establishment of systemic risk regulators, the mandatory separation of investment banking and commercial banking activities, the tightening of hedge fund regulations and derivatives markets reform.  Still, many survey participants pointed out that they are cautiously watching the progress of regulatory reform, even as they broadly support the specific regulatory proposals in question.  We offer a detailed review of the report.

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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.31 (Aug. 5, 2009)

    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

    In a pair of recent lawsuits in the United States District Court for the Southern District of New York, VCG Special Opportunities Master Fund, Ltd. (VCG or CDO Plus), an Isle of Jersey, U.K.-registered hedge fund of approximately $50 million in assets and a credit default swaps (CDS) seller previously known as “CDO Plus Master Fund Ltd.,” sued Citibank, N.A. and Wachovia Bank, N.A., both CDS buyers, raising similar claims against each bank.  VCG alleged that both banks had purchased CDS contracts from VCG, each covering a different credit default obligation for the amount of $10 million, and that each had made unwarranted and bad faith demands for additional credit support, i.e., margin calls.  These lawsuits are part of a growing wave of credit default swap litigation and highlight the need for caution in this area.

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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.28 (Jul. 16, 2009)

    In FINRA’s First Action Involving Credit Default Swaps, FINRA Fines ICAP $2.8 Million to Settle Price Fixing Claims

    ICAP Corporates LLC (ICAP), a unit of ICAP Plc, one of the largest brokers of inter-bank transactions, has settled with the Financial Industry Regulatory Authority (FINRA) over allegations that a former broker improperly influenced fees on credit-default swaps (CDS).  Specifically, FINRA accused a former broker and manager of the ICAP CDS desk, Jennifer Joan James, of “improper communications” with competing firms about customers’ proposed brokerage rate reductions in the wholesale credit default swap market.  We detail FINRA’s allegations and the specifics of the settlement.

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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.25 (Jun. 24, 2009)

    The Obama Administration Outlines Major Financial Rules Overhaul, Announces Greater Scrutiny for Hedge Funds and Derivatives

    On June 17, 2009, the Obama administration released its proposed “rules of the road” for the nation’s regulation of the financial industry.  The proposal aims to restore confidence in the nation’s financial system after last year’s collapses of The Bear Stearns Cos. and Lehman Brothers Holdings Inc., which caused a credit-market seizure, froze bank lending and paralyzed consumer spending.  The proposal generally tightens regulations on many existing institutions already subject to government scrutiny, and brings many products and companies that had operated outside of the banking system under federal control.  The proposed reforms target almost every facet of the financial system, including hedge funds and derivatives.  We provide a comprehensive summary of the proposals, focusing especially on those sections that are most relevant to hedge funds and hedge fund managers.

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  • From Vol. 2 No.23 (Jun. 10, 2009)

    FTI Consulting Inc. Hosts Conference on Structured Finance Securities Litigation

    On June 2, 2009, FTI Consulting Inc. hosted the FTI Securities Matters Conference: Structured Finance Securities Litigation.  The four panelists sought to identify themes and trends in the welter of litigation, enforcement actions and arbitration proceedings that have flowed from the credit crisis and its impact upon the securitization process.  We outline the key take-aways from the conference.

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  • From Vol. 2 No.22 (Jun. 3, 2009)

    Proposed Model Act Would Severely Undermine Participation by Hedge Funds as Sellers of Protection Under Credit Default Swaps

    The National Conference of Insurance Legislators is circulating a draft of a model act (Model Act) that would have the adopting states regulate credit default swaps under provisions patterned on New York State’s current regulation of financial guaranty insurance.  The Model Act would provide that “credit default insurance may be transacted in this state only by a corporation licensed for such a purpose,” and it imposes a variety of requirements upon the licensees.  This article reviews the draft, analyzes how it would operate and then discusses the conflict between an approach to regulation that would empower the insurance departments of 50 states and one that would employ a single regulatory policy.

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  • From Vol. 2 No.22 (Jun. 3, 2009)

    Committee on Capital Markets Regulation Releases Report on How to Reduce Systemic Risk in the American Financial System

    On May 26, 2009, the Committee on Capital Markets Regulation, an independent and nonpartisan research organization made up of 25 industry leaders, released a report entitled, “The Global Financial Crisis: A Plan for Regulatory Reform.”  The report outlines the committee’s plans for creating a more effective and more investor-friendly American financial regulatory structure.  The Committee posits that the most effective system of regulation must achieve four critical objectives: (1) reduced systemic risk; (2) increased investor protection through greater transparency; (3) a unified financial regulatory system with greater accountability; and (4) a coordinated international approach based on globally coordinated rules.  We offered a detailed synopsis of the report.

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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.19 (May 13, 2009)

    SEC Brings First-Ever Credit Default Swaps Insider Trading Case

    On May 5, 2009, the Securities and Exchange Commission (SEC) charged Jon-Paul Rorech, a salesman at Deutsche Bank Securities, and Renato Negrin, a former Millennium Partners, L.P. hedge fund portfolio manager with insider trading in credit default swaps of VNU N.V., a Dutch media conglomerate (VNU).  According to the SEC, this case is the first insider trading enforcement action it has brought with respect to credit default swaps (CDSs).  Rorech allegedly learned information from Deutsche Bank investment bankers about a change to a proposed VNU bond offering that was expected to increase the price of CDSs on VNU bonds.  Rorech then purportedly illegally tipped Negrin about the contemplated change.  Negrin then purchased CDSs (which are not registered securities, and are used to insure against the default of debt and certain related credit events) on VNU for a Millennium hedge fund.  According to the SEC, when news of the restructured bond offering became public in late July 2006, the price of VNY credit default swaps increased, and Negrin closed Millennium’s VNU credit default position at a profit of about $1.2 million.  The SEC seeks an injunction barring further securities laws violations, disgorgement of profits and civil penalties.  We detail the SEC’s factual allegations and legal claims.

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  • From Vol. 2 No.13 (Apr. 2, 2009)

    Treasury Calls for Registration of Hedge Fund Managers with Assets Under Management Above a Certain Threshold and Outlines Framework for Other Regulatory Reforms Aimed at Limiting Systemic Risk

    On March 26, 2009, the U.S. Department of the Treasury outlined a new framework for regulatory reform, including a proposal to require advisers to hedge funds (and other private pools of capital) with assets under management above a certain threshold to register with the SEC, along with certain other regulatory reforms.  As Secretary Geithner observed in written testimony before the House Financial Services Committee that day, addressing “critical gaps and weaknesses” exposed in our financial regulatory system over the past 18 months “will require comprehensive reform – not modest repairs at the margin, but new rules of the road.”  The Treasury framework for regulatory reform includes four broad components: (1) addressing systemic risk; (2) protecting investors and consumers; (3) eliminating gaps in the regulatory structure; and (4) fostering international coordination.  To address the first category – systemic risk – the Treasury proposes, among other things: (1) registration of all hedge fund advisers with assets under management above a certain threshold; (2) formation of a comprehensive oversight framework for the Over-The-Counter (OTC) derivatives market; (3) creation of a single independent regulator responsible for “systemically important firms” and critical payment and settlement systems; and (4) imposition of higher standards on capital and risk management for “systemically important firms.”  We provide a detailed summary of the proposed framework.

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  • From Vol. 2 No.13 (Apr. 2, 2009)

    FINRA Proposes Interim Pilot Program for Margining Credit Default Swaps

    On March 18, 2009, the Financial Industry Regulatory Authority (FINRA) announced its proposal to the Securities and Exchange Commission for a pilot program to impose margin rules for credit default swaps transactions executed by a FINRA-registered broker-dealer and cleared by the Chicago Mercantile Exchange (CME) or other central counterparty platforms.  The new rule would apply to transactions executed by a member, regardless of the type of account in which the transaction is booked, and include transactions in which the member cleared offsetting matching hedging transactions through the central counterparty clearing services of the CME.  We offer a comprehensive summary of FINRA’s proposal.

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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.11 (Mar. 18, 2009)

    SEC Fines Investment Advisers for Taking Warrants from Hedge Funds

    The SEC has announced that registered investment adviser M.A.G. Capital LLC, and its president and sole owner, David F. Firestone, have settled allegations that they took warrants from three hedge funds M.A.G. advises, without compensating those funds.  M.A.G. and Firestone agreed to an order, issued on March 2, 2009, by the SEC, in which they neither admitted nor denied the allegations, but agreed to a censure, to cease and desist from future violations and to pay civil monetary penalties of $100,000 and $50,000, respectively.  The SEC has reported that this settlement reflects the return of all warrants and the proceeds of all warrants sold.  We discuss the facts and allegations in the SEC’s order.

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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. 2 No.6 (Feb. 12, 2009)

    U.K. FSA Proposes to Require Disclosure of Short Positions in All U.K. Listed Stocks

    On February 6, 2009 the U.K. FSA issued Discussion Paper 09/01 proposing to require public disclosure of significant short positions in all U.K. listed stocks.  This proposed disclosure requirement follows a decision by the FSA on January 14, 2009 to extend to June 30, 2009 a requirement (originally imposed by the FSA on September 18, 2008) to publicly disclose significant short positions in U.K. financial sector companies.  Also on January 14, 2009, the FSA decided to let expire on January 16, 2009 a ban on the active creation or increase of net short positions in the stocks of U.K. financial sector companies.  We detail the background of the FSA’s recent activity with respect to disclosure of short positions, with special focus on the FSA’s evolving treatment of contracts for difference.

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  • From Vol. 2 No.1 (Jan. 8, 2009)

    Provisional Settlement in Short-Swing Profits Lawsuit Brought by CSX Shareholder Against Hedge Funds TCI and 3G: The 8% Solution

    Based in large part on Judge Lewis A. Kaplan’s June 11, 2008 opinion in the case of CSX v. TCI and 3G (which was detailed in the June 19, 2008 Hedge Fund Law Report), a CSX shareholder recently filed a lawsuit against TCI and 3G alleging violations of Section 16(b) of the Securities Exchange Act of 1934, the provision prohibiting short-swing profits.  The parties have settled the suit, pending court approval – but, as always, the settlement occurred in the “shadow” of relevant law and legal uncertainty.  We detail the legal backdrop before which the case has provisionally settled, and we show how legal uncertainty can translate into a dollars-and-cents reduction of claimed damages in the context of settlement of securities claims.

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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.27 (Dec. 9, 2008)

    Regulating Credit Default Swaps as Insurance: Gone, But Not Forgotten

    Although New York State Insurance Superintendent Eric R. Dinallo decided to “delay indefinitely” his plan to regulate an important chunk of the credit default swaps (CDS) market as insurance contracts, the agency’s original policy proposal may well be used as a blueprint in wider efforts by federal regulators to reform the CDS market.  We explain the mechanics of the proposal and detail provisions that may reappear in future legislation or regulation.

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  • From Vol. 1 No.26 (Dec. 3, 2008)

    Lehman Debtors Propose Procedures to Unlock Value in “In The Money” Derivative Contracts

    Bankruptcy Court Judge James Peck will preside over a hearing in Manhattan today, December 3, in the consolidated bankruptcy cases of Lehman Brothers Holdings Inc. and certain of its subsidiaries (collectively, Debtors), concerning procedures proposed by the Debtors for the settlement or assumption and assignment of derivatives contracts that are, from the Debtors’ perspective, in-the-money (that is, contracts on which the Debtors are owed money) and that have not been terminated by the relevant counterparties.  We explain the operation of and law relevant to derivatives contracts in this context, and the mechanics of the proposed procedures.

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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.24 (Nov. 12, 2008)

    FASB’s Proposed Changes to Hedge and Derivative Accounting Rules Draw Strong Criticism

    The Financial Accounting Standards Board’s ambitious initiative to introduce changes to hedge and derivative accounting rules has met with widespread skepticism and bewilderment from market players.  We analyze the status and likely future course of the initiative, based on a review of all comments received by the FASB on its June 6, 2008 Exposure Draft and interviews with affected market participants.

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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)

    Lehman Brothers Bankruptcy: ISDA Issues

    The recent bankruptcy filing by Lehman Brothers Holdings Inc. has generated pressing and complicated questions for hedge funds. Among the most salient topics on the minds of many hedge fund lawyers and managers is how the Lehman filing will affect hedge funds who entered into trades with Lehman or an affiliate under the ISDA Master Agreement. More generally, even for hedge funds that do not have direct Lehman exposure, the filing raises questions about what happens when your counterparty to a trade documented on the ISDA Master goes into liquidation. Leading derivatives attorneys from law firm Sutherland have contributed an article to The Hedge Fund Law Report that addresses these timely issues.

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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.19 (Aug. 21, 2008)

    Quick, Easy and Wrong: Congress Considers Legislation to Curtail Energy Trading and the Use of Off-shore Blockers

    On August 1, 2008, Senators Ron Wyden (D-Ore.) and Charles Grassley (R-Iowa) proposed legislation that would make the tax code even more complicated and obtuse and would curtail the use of so-called “foreign blockers” by tax-exempt investors.  The one sentence take-away on the Wyden-Grassley bill is that it would eliminate long-term capital gains treatment, as well as preferential treatment for tax-exempt entities, on profits from investments in the oil and gas markets, beginning in 2008.  In this article, guest contributors Mark Leeds and Rita Cameron, shareholder and associate, respectively, at Greenberg Traurig, provide a lucid, informed and critical analysis of the proposal.  In their view, the proposal could have a profound and adverse effect on tax-exempt US investors in offshore hedge funds.  In the worst case scenario, it could even trigger provisions sometimes found in offshore feeder documents that allow tax-exempt investors to redeem if there is a change in law (or in some cases even a proposed change in law) that would adversely affect the tax treatment of their investments.  On the positive side, the proposal has only a slim chance of becoming law, at least in its current form.

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  • From Vol. 1 No.15 (Jul. 8, 2008)

    IRS Rules that Long Position in a Swap Referencing a Broad-Based U..S Real Property Index Is Not a U.S. Real Property Interest for FIRPTA Purposes

    On June 12, 2008, the IRS published Revenue Ruling 2008-31, holding that a long interest in a swap referencing a broad-based index of U.S. real property is not a U.S. real property interest within the meaning of the Foreign Investment in Real Property Tax Act of 1980. Good news for offshore hedge funds looking for broad-based exposure to U.S. real property; even better news for index publishers.

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  • From Vol. 1 No.15 (Jul. 8, 2008)

    FASB Proposes Changes to Hedge and Derivative Accounting Rules

    In an effort to simplify one of the most complex and criticized financial reporting regimes, the Financial Accounting Standards Board (FASB) is proposing changes to hedge and derivative accounting rules that, if approved, would (1) (according to FASB) greatly improve comparability of financial results for entities that apply hedge accounting, and (2) require application of the fair-value measurement approach to all transactions, a mark-to-market accounting method long favored by the Board.

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  • From Vol. 1 No.14 (Jun. 19, 2008)

    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

    In a case of first impression, with potentially important consequences for activist hedge funds, the US District Court for the Southern District of New York ruled on June 11, 2008 that two hedge funds that had accumulated substantial economic positions in publicly-traded railroad operator CSX Corporation, principally via cash-settled total return equity swaps, were deemed to have beneficial ownership of the hedge shares held by their swap counterparties.

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  • From Vol. 1 No.14 (Jun. 19, 2008)

    Federal District Court Invalidates Purported Terminations of Credit Default Swaps by Bond Insurer

    On June 11, 2008, in a one-page order, the US District Court for the Southern District of New York ruled that Merrill Lynch International did not repudiate its obligations under seven credit default swaps with affiliates of bond insurer XL Capital Assurance Inc. with a notional value of $3.1 billion, and that XL’s purported terminations of those credit default swaps were without effect.

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  • From Vol. 1 No.12 (May 20, 2008)

    District Court Denies Motions by Amaranth and Brain Hunter to Dismiss CFTC’s Claims of Attempted Market Manipulation and Attempted Cover Up

    • District Court found that the CFTC had alleged sufficient facts regarding Amaranth’s attempted manipulation of natural gas futures markets – including two sets of “marking the close” trades in early 2006 – to survive motions to dismiss.
    • Court also found that the CFTC had adequately pleaded its cover up case, based on allegations of misrepresentations in a letter from Amaranth to the NYMEX Compliance Department.
    • Court held that it had personal jurisdiction over Hunter based on NYMEX orders he placed from Canada through a broker in New York.
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  • From Vol. 1 No.11 (May 13, 2008)

    New York Insurance Regulator Suggests that “Core” Credit Default Swaps Might be Ripe for Regulation as Insurance Contracts

    Eric Dinallo, the New York insurance superintendent, indicated in an interview that credit default swaps in which the protection buyer owns the underlying asset may constitute insurance arrangements, under statutory definitions, and perhaps should be regulated as such.

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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

    • 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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  • From Vol. 1 No.4 (Mar. 24, 2008)

    Counterparty Risk in Credit Default Swaps: What Happens when a Broker-dealer Goes Bust?

    • Barclays predicts $80 billion in losses from counterparty CDS defaults in 2008.
    • Bankruptcy code exempts swaps and repos from the automatic stay, giving hedge funds accelerated right to terminate under swap agreements.
    • When selling CDS to a broker-dealer, hedge funds must post up-front collateral and supply additional payments if the reference asset declines in value.
    • Amount and timing of recoverable collateral depends whether broker-dealer liquidates under Chapter 7 or under SIPA.
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  • From Vol. 1 No.4 (Mar. 24, 2008)

    SEC Publishes Text of “Naked” Short Sales Anti-fraud Rule

    • SEC calls for public comment on proposed new rule 10b-21.
    • New rule concerns liability for deception in share ownership, intent, ability or failures to deliver securities in time for settlement.
    • SEC received over 400 investor complaints regarding naked short selling last year.
    • Comments sought on how the proposed rule may affect legitimate short sales and broker-dealer policies and procedures, and whether the rule would cause naked short sellers to move offshore.
    • SEC Chairman Cox claims new rulewill bring “teeth” and needed enforcement to Regulation SHO - stemming abuses such as intentional failure to deliver in order to manipulate price or avoid borrowing costs.
    • Significant intent or knowledge of wrongdoing required for enforcement of the rule.
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  • From Vol. 1 No.4 (Mar. 24, 2008)

    Prepaid Forward Contracts - Debt, Equity or a Hybrid?

    • Treasury Tax Legislative Counsel Michael Desmond testified before a Subcommittee of the House Ways and Means Committee.
    • Noted current regulatory ambiguity as to whether prepaid forward contracts should be taxed as debt, equity or a hybrid.
    • As more such instruments migrate into retail investors’ portfolios, the Treasury Department has increased its scrutiny of tax ramifications.
    • Desmond illustrated inconsistencies in alternative tax treatment based on structure of prepaid forward contracts.
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  • From Vol. 1 No.4 (Mar. 24, 2008)

    CSX Sues Hedge Funds TCI and 3G for Violating Federal Securities Laws

    • Complaint alleges that funds attempted to change CSX’s corporate structure by withholding information on percentage of CSX shares controlled.
    • CSX claims that the funds used swap agreements to evade federal securities filing requirements and acquired more than 5% of its common stock without making required disclosures.
    • formed a Section 13(d)(3) group with beneficial ownership of over 5% of outstanding CSX common stock, yet allegedly failed to timely file legally required schedules - according to the complaint, to secretly accumulate CSX stock.
    • Allegedly TCI’s disclosures of its CSX share swap position were materially misleading, failing to disclose that swap counterparties intend to vote CSX shares in accordance with TCI’s wishes.
    • CSX seeks to divest funds of shares acquired and to terminate all CSX-referenced swaps from the time they should have been disclosed.
    • CSX requests that the funds be prohibited from (or seeks to limit) voting those shares at the 2008 annual meeting.
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