Mar. 18, 2009

For Managers Facing Strong Headwinds, Sales of the Advisory Business Offer a Means of Preserving the Franchise While Avoiding Fund Liquidations

Many hedge fund managers, especially those with relatively lower levels of assets under management, find themselves between the Scylla and Charybdis of declining revenues and rising costs.  On the revenue front, performance declined an average of 18 percent across hedge fund strategies during 2008, meaning that many managers did not collect performance fees last year, and are unlikely to collect such fees until they regain their high water marks – which can take years.  Also, declining performance during 2008 and substantial redemptions shrunk assets under management, which reduced management fees.  At the same time, the exposure of various investment frauds, combined with widespread losses, increased scrutiny by major investors of hedge fund manager operations, compliance, risk management and reporting.  In short, as revenue has dwindled, the cost of doing business as a hedge fund manager has increased.  Managers faced with this daunting set of circumstances generally have the option (subject to the language of fund documents) of liquidating their funds and returning the proceeds to investors.  But many managers have invested a significant amount of time, effort and personal reputation in building a hedge fund management company; recreating that complex web of relationships among employees, investors, counterparties, creditors and others following a liquidation can be a herculean task.  Accordingly, instead of liquidation, various managers have evaluated and in some cases consummated sales of the management company to other, generally larger hedge fund managers or others in complimentary lines of business.  We explore in detail various aspects of sales of hedge fund advisory businesses, including: recent precedents, the scope and focus of due diligence, deal structures and consideration (including the increasing prevalence of earnouts), investor consent issues and key personnel retention mechanisms.

Proposed Tax Legislation Affecting Hedge Funds

Bills introduced this month in both the House and the Senate contain two provisions that are of particular significance to hedge funds.  One provision would materially alter the tax treatment of offshore hedge funds with U.S.-based managers, and the other provision would change the tax treatment of “dividend equivalent” payments made on notional principal contracts (or “swaps”) that reference U.S. stocks.  The proposed legislation, which was introduced by Senator Carl Levin (D-Michigan) and Representative Lloyd Doggett (D-Texas), contains various other provisions, including the addition of certain reporting requirements, as well as certain presumptions to be applied in judicial and administrative proceedings, with respect to amounts derived by U.S. persons from offshore entities.  In a guest article, Mary Conway, Lucy W. Farr and Rachel D. Kleinberg, all partners of Davis Polk & Wardwell’s Tax Department, explain the two provisions and the implications of the provisions for hedge funds.

Aurelius Capital and Fir Tree Funds Commence Class Action to Challenge MBIA Insurance Restructuring

On March 11, 2009, five holders of securities and other financial instruments for which MBIA Insurance Corporation (MBIA Insurance) issued financial guarantee insurance filed a lawsuit in the United States District Court for the Southern District of New York against MBIA Inc. (MBIA), MBIA Insurance and MBIA Insurance Corporation of Illinois (MBIA Illinois).  The class action suit alleges that the February spinoff of MBIA Insurance’s municipal bond insurance business into a separate entity owned entirely by MBIA constituted a “massive fraudulent conveyance transaction” that damaged the holders of securities and financial instruments covered by financial guarantee policies issued by MBIA Insurance by transferring assets out of MBIA Insurance without adequate consideration and weakening the ability of MBIA Insurance to pay potential claims on those policies.  We detail the factual allegations and legal theories advanced in the complaint, and the relief requested by the hedge fund plaintiffs.

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.

“Hedge Funds – The Regulatory Wagons are Circling,” a Webinar Hosted by SEI Knowledge Partnership

On February 12, 2009, SEI Knowledge Partnership hosted a webinar titled “Hedge Funds – The Regulatory Wagons are Circling,” in which panelists discussed recent proposed legislation relating to hedge funds and their managers, and the potential impact of those proposals on the hedge fund industry.  We detail the relevant insights from that conference, and in the process review various of the bills currently pending in Congress to regulate hedge funds and their managers.

IRS Guidance and Two House Bills Offer Tax Relief for Investors in Ponzi Schemes

On March 17, 2009, the Internal Revenue Service issued Revenue Ruling 2009-9 (Revenue Ruling) and Revenue Procedure 2009-20 (Revenue Procedure) which together provide additional guidance for taxpayers who have lost money in the Ponzi scheme orchestrated by Bernard Madoff and other Ponzi-type investment frauds.  The Revenue Ruling generally provides that losses from Ponzi schemes are theft losses, and not capital losses; that such losses are not subject to the $3,000 annual limitation on capital loss deductions or the limitations on personal casualty and theft losses; and that the amount of loss can include “phantom income” received by the investor from the scheme, not just the principal invested by the investor.  The Revenue Procedure provides a uniform approach for determining the proper time and amount of the theft loss.  Generally, the Revenue Procedure deems a loss to be the result of theft if the promoter was charged with fraud or similar crimes; it does not require a conviction.  Also, the Revenue Procedure generally permits taxpayers to deduct in the year of discovery up to 95 percent of their net investment, less certain actual and expected recoveries.  We describe in detail both items of guidance, as well as two related House bills.

Cadwalader Strengthens Financial Services Offerings with Bank Regulatory Expertise; Julius “Jerry” Loeser Joins Busy Practice as Special Counsel

On March 12, 2009, law firm Cadwalader, Wickersham & Taft LLP announced that Julius L. (“Jerry”) Loeser has joined the firm as special counsel in the Financial Services Department of the New York office.