Mar. 24, 2008

Hedge Funds Stymied By Failing “Repo” Market

  • Repo market, reeling from subprime mortgage crisis, is no longer a cheap viable method of accessing short term capital.
  • Bear Stearns sells off, Carlyle Capital liquidates and KKR Financial Holdings restructures debt for a second time in four months.
  • New Fed “primary dealer” repo program loans nearly $30 billion - although unavailable to hedge funds, the resulting increased liquidity may stabilize industry and support hedge funds.

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.

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.

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.

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.