Mar. 11, 2009

Hedge Fund Managers and Investors Turning to Dutch Auctions as an Alternative to Secondary Markets for Hedge Fund Interests

On the heels of dismal performance by hedge funds as a group during 2008, the discovery of frauds unprecedented in their pervasiveness and audacity and generally frozen credit markets, hedge funds have paid record amounts in redemptions and received record levels of redemption requests.  In response to the daunting level of redemptions and requests, hedge fund managers have deployed tools that, until recently, were widely considered available but, from an investor relations points of view, impracticable – tools like redemption suspensions, gates, side pockets and redemptions in kind.  As a means of reconciling investors’ demands for liquidity with managers’ goal of keeping capital invested in their funds, a growing number of investors have been turning to secondary markets for hedge fund interests.  However, secondary markets for hedge fund interests suffer from various flaws.  Most notably, in light of the confidentiality of information provided to hedge fund investors, selling investors are prohibited, absent manager consent, from providing potential purchasers with information relevant to an informed valuation – information such as fund liquidity and fee terms, performance data and portfolio composition.  To preserve the intent of secondary market transactions while addressing some of the flaws in such markets, hedge fund managers and investors are increasingly working with banks to conduct so-called Dutch auctions of hedge fund interests.  We explain the mechanics of Dutch auctions in the hedge fund context, compare the benefits and burdens of Dutch auctions versus secondary market trades, discuss two recent examples of hedge funds that have conducted Dutch auctions and conclude by highlighting practical and legal considerations.

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.

AIMA Announces New Policy Platform Calling for Increased Transparency, Aggregated Short Position Disclosure, Reduction of Settlement Failures, Manager Supervision Template and Unified Global Standards

On February 24, 2009, the Alternative Investment Management Association (AIMA) announced its new policy platform, consisting of five new policies: (1) regular reporting and increased transparency of systemically significant positions and risk exposures by managers of large hedge funds to their national regulators (the regulator of the jurisdiction in which the manager is authorized and registered to operate); (2) an aggregated short position disclosure regime to national regulators; (3) support for new policies to reduce settlement failure (including in the area of naked short selling); (4) support for a global manager-authorization and supervision template based on the model of the UK Financial Services Authority (FSA); and (5) a call for unified global standards for the industry based on the convergence of existing industry standards work, such as that authored by AIMA, the Hedge Fund Standards Board, the International Organization of Securities Commissions, the President’s Working Group on Financial Markets and Managed Funds Association (MFA).  In an extensive interview with the Hedge Fund Law Report, Andrew Baker, CEO of AIMA, offered additional detail on each of these policies.  We offer salient points from that interview, and in addition discuss recent testimony by MFA head Richard Baker supporting the establishment of a systemic risk regulator.

Delaware Chancery Court Potentially Opens Door to Limit Activist Stockholder Rights

The Delaware Chancery Court may have opened the door to allow companies to raise the stakes when activist investors attempt to nominate members of a company’s board of directors.  In the case of TravelCenters of America LLC v. Brog et al. (Del. Ch. Dec. 5, 2008), TravelCenters argued that by failing correctly to follow the detailed notice requirements in the company’s limited liability agreement when nominating a director for election, the Investors were liable to the company for all of its costs incurred in defending against the invalid nomination.  In a guest article on the TravelCenters case, Joseph J. Basile and Joseph F. Bernardi, Jr., partner and associate, respectively, at Weil, Gotshal & Manges LLP, discuss how the Delaware Chancery Court may have created the potential for a limited liability agreement or bylaws of a company to be drafted in such a manner that a procedurally improper attempt to elect a director could subject a member or stockholder to personal liability.

Can Hedge Funds Make DIP Loans to Bankrupt Companies in which they Also Own or Acquire Equity Interests?

Given the high number and size of bankruptcies predicted to occur during 2009, hedge fund managers see an interesting opportunity in distressed investing generally, and in particular in providing debtor-in-possession (DIP) financing to companies reorganizing under chapter 11 of the Bankruptcy Code.  Extending or continuing DIP loans may give rise to legal obligations, in particular when the lender has or during the term of the DIP loan acquires an equity interest in the bankrupt borrower.  While the law does not prohibit ownership of both equity and debt of bankrupt company, investment in various levels of the capital structure of a chapter 11 debtor may require certain disclosures, special precautions with respect to information acquired as a lender and special care with respect to actions taken as an equity owner (especially a majority owner).  We discuss certain legal considerations for hedge funds in connection with simultaneous investments in equity of a chapter 11 debtor and participation in a DIP loan to the same debtor.

Implications for Hedge Funds of New Whistleblower Initiatives by FINRA and the SEC: An Interview with Kenneth Springer of Corporate Resolutions Inc.

On March 5, 2009, the Financial Industry Regulatory Authority (FINRA) announced that it had established a new Office of the Whistleblower to expedite the review of high-risk tips by FINRA senior staff and ensure a rapid response for tips believed to have merit.  On the same day, the SEC announced that it had enlisted the services of the Center for Enterprise Modernization, a federally funded research and development center operated by The MITRE Corporation, to begin immediately working with the agency to conduct a comprehensive review of internal procedures used to evaluate tips, complaints and referrals.  The Hedge Fund Law Report discussed these developments in an interview with Kenneth Springer, President of Corporate Resolutions Inc., a worldwide business investigations and consulting firm based in New York City.  We offer the full text of that interview.

SEC Seeks Custodial Safeguard and Stock Price Manipulation Data from Registered and Unregistered Investment Advisers

On February 10, 2009, the SEC sent a so-called “sweep letter” to registered investment advisers requesting information about the advisers’ compliance and supervisory practices regarding the allegedly malicious creation, spread and use of false or misleading rumors with the intent to manipulate securities prices.  On February 13, 2009, the SEC sent an additional sweep letter to an undisclosed list of investment advisers and broker-dealers seeking information through interviews about client asset custodial practices.  These letters appear to be part of the SEC’s stated objective to pursue enforcement issues more seriously.  We discuss both letters in detail.

UK Financial Services Authority Report Reveals that Hedge Fund Leverage Declined in 2008

Hedge funds around the world have become more cautious, reducing the amount of debt they acquired to buy assets in response to the global economic turmoil, according to a study released on February 5, 2009 conducted by Megan Butler at the Financial Services Authority in the United Kingdom.  We provide details of the study.

Sarah Dobbyn Joins Harneys’ Cayman Islands Office as Head of Firm’s Cayman Islands Litigation and Insolvency Practice

On March 5, 2009, international offshore law firm Harney Westwood & Riegels announced the appointment of Sarah Dobbyn as head of the firm’s Cayman Islands litigation and insolvency practice.  Sarah has more than 20 years of experience in cross-border insolvencies, restructurings and international commercial litigation in both onshore and offshore settings.