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    Apr. 2, 2009

Should Hedge Funds Participate in the Public-Private Investment Program?

On March 23, 2009, the Treasury Department announced the Public-Private Investment Program (PPIP), a collaborative initiative among the Treasury Department, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC), on the one hand, and private investors, on the other hand, to create $500 billion to $1 trillion in buying power for the purchase from financial institutions of “legacy” (formerly known as “toxic”) loans and securities.  Loans eligible for purchase likely will include primarily residential and commercial mortgages and leveraged loans used to fund buyouts, and eligible securities are likely to include securities backed by eligible loans and certain consumer loans.  The goals of the PIPP include (1) creating a market for currently illiquid assets, thus enabling financial institutions to value and sell those assets, which in turn will enable the institutions to make new loans, raise new capital and repay TARP loans; and (2) reopening the securitization markets, which, at least prior to the credit crisis, generally expanded (some would argue over-expanded) the availability of consumer credit and reduced its cost.  Many of the details of the PPIP remain to be provided.  In the meantime, prior to the provision by the Treasury, Federal Reserve Board or FDIC of further guidance and clarification, hedge and other private fund managers are evaluating the advisability of participation based on the announced parameters of the PPIP.  In particular, hedge fund managers are analyzing the following issues, among others:

  1. The scope of the FDIC’s oversight of various aspects of the PPIP, and the role of the Treasury as an equity co-investor and, in the case of the Legacy Securities Program, a lender.
  2. With respect to the Legacy Loans Program, the design of the auctions in which assets will be sold, and the timing of the FDIC’s leverage determinations (i.e., the extent to which the FDIC can, as a practical matter, provide clarity with respect to the amount of leverage it can offer prior to commencement of an auction).
  3. Any limits that may be imposed on hedge fund manager compensation as a result of participation.
  4. How participation may be structured, i.e., whether current funds can invest or whether new dedicated funds have to be organized.
  5. Tax issues, including the structures that will be permitted or required for PPIFs, the ability of tax-exempt or non-U.S. investors to invest in PPIFs via offshore feeder funds (likely structured as non-U.S. corporations) and the characterization of income from PPIFs as ordinary income or capital gain.
  6. Adverse selection issues, i.e., whether banks will only seek to sell their worst assets under the program (and if so whether appropriate pricing can mitigate the gravity of this concern).

Our article addresses each of these issues in detail.

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.

Can a Hedge Fund Make Redemption Payments “In Kind” by way of the Issue of “Participation Interests” in its own Illiquid Assets, and What is the Status of a Redeeming Investor who has not Received any Payment at All?

Hedge funds incorporated in Bermuda, the Cayman Islands, and the British Virgin Islands face substantial legal challenges in 2009, especially in meeting liquidity needs for redeeming investors.  Many hedge fund assets and investments have declined both in value and in liquidity.  Some assets are hard to value.  Other investments are illiquid.  Many investors have been seeking to withdraw their investments in hedge funds and to have their shares redeemed for value.  There is unlikely, however, to be enough cash or liquid assets available to pay all of them, at the same time.  There are a variety of defensive strategies potentially available to hedge funds holding illiquid assets when faced with a rush of redemption requests and requests for payment.  In a guest article, Alex Potts of Conyers Dill & Pearman details various of those strategies, and offer a comprehensive discussion of the evolving caselaw regarding redemptions from hedge funds organized in the British Virgin Islands and the Cayman Islands.

IOSCO Report Scrutinizes Hedge Fund Manager Compensation as Group of 20 Prepares to Weigh in on Hedge Fund Regulation

In March 2009, the International Organization of Securities Commissions (IOSCO) issued its Hedge Funds Oversight Consultation Report (Consultation Report), outlining ideas for enhanced oversight of various aspects of hedge fund investments and hedge fund manager operations.  In particular, the Consultation Report discusses hedge fund manager compensation, identifying what IOSCO deems to be shortcomings in the current compensation structure that could exacerbate various risks to investors and the broader financial system.  IOSCO is an international group of securities regulators organized to promote high and unified standards of market integrity, exchange information among members and provide mutual assistance.  IOSCO itself is not regulator and does not have binding regulatory or legal authority; its authority is limited to its ability to persuade and build consensus.  Nonetheless, the recommendations in the Consultation Report are timely, coming as they do on the heels of requests from pension funds and other institutional investors to renegotiate fees with hedge fund managers and otherwise restructure their relationships.  We discuss the problems identified by IOSCO with respect to hedge fund manager compensation, as well as its proposed principles-based remedies.  We also offer practitioner insight into how hedge fund manager compensation might be regulated, and whether it should be.

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.

Three Bills Before Congress Presage a Return of the Uptick Rule, Potentially Undermining Hedge Fund Strategies that Involve Short Sales of Equities

On March 16, 2009, Senator Edward Kaufman (D-Delaware) introduced a bill in the Senate that, if enacted, would direct the SEC to take several actions aimed at (1) restoring the uptick rule that was in effect until July 5, 2007, and (2) addressing delivery and settlement issues that can arise in connection with short sales.  Two bills with similar goals have also been introduced into the House of Representatives in the 111th Congress; each has been referred to the Financial Services Committee.  We explain the mechanics of the three bills, the history of the uptick rule (including its implementation in 1938 and its withdrawal in 2007) and hedge fund industry responses to the latest legislative efforts regarding short selling.

The Weavering Blow-Up and What It May Mean for Boards of Directors of Cayman Islands Hedge Funds

The collapse of Weavering Capital (UK) Limited came quickly over an eleven-day period in March 2009.  Multiple investigations are underway, and it may be some time before a full account is available.  Meanwhile, the institutional funds that invested with Weavering are taking their write-downs, and in at least some cases are congratulating themselves on their diversification and the limited nature of the damage.  We tell the lurid story of Weavering’s collapse and its impact on various investors, some of them domiciled in Sweden.  We also highlight the potential impact of the Weavering story for the composition of boards of directors of hedge funds organized in the Caymans.

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