Jan. 8, 2009

From Bayou to Madoff: Feeder Funds, Claw-Backs, Make-Wholes and More

On December 16, 2008, the Securities Investor Protection Corporation initiated liquidation proceedings with respect to Bernard L. Madoff Investment Securities LLC.  In some respects, the events surrounding that filing recall, though with larger numbers, the fall of the Bayou hedge funds in the summer of 2005.  Bayou too was a complex, multi-year pyramid scheme that deceived even sophisticated investors with falsified books approved by obscure (or in Bayou’s case, nonexistent) auditors.  We discuss the implications (and limits) of the analogy between the Bayou and Madoff cases, and lawsuits and the likelihood of future suits against Madoff feeders.  Also, we explore the question: is it possible that Madoff feeders will make investors whole for Madoff-related losses, as some major banks have done for their clients in other contexts?

Side Pockets: Operation, Valuation, Practical Considerations

A side pocket is a segregated account created by a hedge fund manager in accordance with provisions in the fund’s governing documents to hold portfolio assets that the manager deems illiquid or less liquid.  Generally, the values of side pocketed assets are excluded from the periodic calculation of net asset value of the liquid portfolio, the theory being that including valuation of such illiquid or less liquid assets in NAV calculations could distort NAV in a way that does not accurately reflect the current realizable value of all portfolio assets, which could unfairly help or hurt new or redeeming investors.  We explore the mechanics of side pockets, their utility in an environment of heavy redemptions, valuation and ERISA considerations and the interaction of side pockets and fees.

Hedge Funds Gain Access to Government Loans as Fed Expands the TALF

Hedge funds find themselves in new territory under a plan by the Federal Reserve to boost lender liquidity.  The Fed created a new $200 billion lending facility, called the Term Asset-Backed Securities Loan Facility (TALF), which offers low-cost, three-year financing to a wide range of US banks and investors for the purchase of securities backed by consumer loans, beginning in February 2009.  Notably, domestic (though probably not offshore) hedge funds would be eligible to participate in the program, allowing them to borrow from the Federal Reserve, something hedge funds have not been able to do in the past.  We describe the mechanics of the program and how hedge funds may be able to participate, and explore the benefits and burdens of participation.

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 the 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.

Mark-to-Market Accounting in the Absence of Marks

Recent statements from the SEC and the Financial Accounting Standards Board suggest that hedge fund managers and auditors will have significantly more leeway in establishing the fair value of financial assets, a move that has been welcomed by the hedge fund community, but that at the same time has raised issues of interpretation and application.  Many hedge funds are concerned that the lack of clear regulatory guidance might open the door to valuation inconsistencies.  At the heart of this matter are recent clarifications regarding Financial Accounting Standard (FAS) 157, which outlines the basic rules that apply to mark-to-market accounting.  We detail those clarifications, and analyze regulatory guidance – such as it is – on applying those clarifications, especially in today’s environment, where marks are often hard to come by.

“Hedge Fund Operational Due Diligence: Understanding the Risks,” by Jason A. Scharfman; Wiley Finance, 320 pages

Until not too long ago, operational or non-investment-related risk was given short shift vis-à-vis its more directly bottom-line related cousins: market, credit and liquidity risk.  In the current marketplace, however, the impact of operational due diligence on the profit and loss of investments in and by hedge funds is being starkly illustrated every day, most notably in the unfolding Madoff scandal.  Hedge funds and investors in hedge funds need to understand many new issues, including counterparty risk, the impact of new accounting pronouncements and how to deal with fraudulent schemes and funds which suspend redemptions or restructure.  In his book, “Hedge Fund Operational Due Diligence: Understanding the Risks,” Jason Scharfman, a director with Graystone Research at Morgan Stanley identifies these operational risks and recommends a strong and innovative “operational” due diligence review program as the best defense against them.  Our review of Scharfman’s new book offers a thorough overview of the book and its lessons.

The Hedge Fund Law Report Adds Innovative Features to its Regulatory & Legislative Chart

Recently, we added innovative new features to our Regulatory & Legislative Chart to enhance its utility and relevance for subscribers.  Those new features include the following: