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    Apr. 23, 2009

Secondary Market Develops in Special Purpose Vehicle Interests as Use of SPVs to Effect Redemptions Becomes More Common

All redemptions from hedge funds holding liquid assets are alike; each redemption from a hedge fund holding illiquid assets is complex in its own way.  At bottom, that complexity arises out of a basic tension: monthly, quarterly or even annual liquidity is, in many cases, irreconcilable with the holding period required to realize value in currently illiquid assets.  Rather than selling illiquid assets at fire sale prices to satisfy redemptions, managers of funds that offer reasonably frequent liquidity have been using various tools to prevent or delay such sales – tools such as gates, lock-ups, suspensions and side pockets.  However, with increasing frequency, managers have also been employing special purpose vehicles (SPVs) in an effort to reconcile investor demands for liquidity with the illiquidity of portfolio assets.  In effect, SPVs offer redeeming investors what might be called a “qualified liquidity”: SPV interests are more liquid than a gate, suspension or hold back, but less liquid than cash.  However, many investors that have submitted redemption requests of late need more than qualified liquidity – they need actual liquidity.  Because of the ubiquity of the credit crisis, many investors are willing to accept – in fact, are demanding – cash today rather than a contingent payment tomorrow, even while recognizing that the cash they receive may be a small fraction of the ultimate realization value of the assets in an SPV.  But managers do not have the cash to give investors – that’s why they put the assets in the SPV in the first place.  What can investors do?  One answer is that they can access a developing secondary market in SPV interests.  We define SPVs and synthetic SPVs, then detail the mechanics of the secondary market in SPV interests, relevant legal considerations (including issues relating to restricted securities, ERISA, AML, KYC and the Bank Holding Company Act), treatment of confidential information, valuation issues, what types of funds would be interested in participating in secondary SPV transactions, the benefits to managers and the potential for use of Dutch auctions.

Addressing (and Resisting) Demands for Changes in Hedge Fund Manager Compensation

While the unprecedented market events of 2008 and 2009 have resulted in pressure upon fund liquidity terms and governance provisions, market forces have resulted in requests from some investors for changes to the manner in which hedge fund managers are compensated for their services.  Assuming that market demand will ensure the continued existence of the hedge fund industry, it may be safe also to assume that, in light of recent fund restructurings, as well as the imposition of gates/suspensions, and the use of true or “synthetic” side pockets, some forceful investors will begin to seek certain concessions from fund managers.  Over the past year or so, a small number of investors have indeed begun, in some cases very vocally and publicly, to criticize the incentive compensation structure for hedge fund managers that has developed to date.  In a guest article, Ira Kustin, a Partner at Akin Gump Strauss Hauer & Feld LLP, analyzes the demands for changes in hedge fund managers compensation, including discussions of: reasons why fund managers may resist calls for changes, separation of “new” and “old” funds, adjustments to management fees, adjustments to incentive compensation and complications arising from possible adjustments.

Key Players in Washington Agree that Increased Hedge Fund Regulation is Necessary, but Differ on the Shape that Regulation Should Take

A rift has developed between the chairmen of the main House and Senate committees dealing with hedge funds and their managers, according to conversations between the Hedge Fund Law Report and key congressional staff, reviews of numerous public statements by key figures and testimony before relevant committees in recent weeks.  While those committee chairmen – Senator Christopher Dodd of Connecticut, Chairman of the Senate Banking Committee, and Representative Barney Frank of Massachusetts, Chairman of the House Committee on Financial Services – broadly agree that some form of increased regulation of hedge funds and hedge fund managers would be an appropriate political (if not economic) response to recent economic events, they differ on the direction that increased regulation should take.  Judging by the flurry of recent bills, comments and other proposals on and around Capitol Hill, the drive to change or “reform” hedge regulation is well underway.  More than a dozen Senate and House hearings directly or indirectly focusing on hedge funds have been held so far, a slew of them coming in late March and early April.  We describe the current state of play on the Hill, including the Dodd-Frank face-off, recent testimony from Treasury Secretary Timothy Geithner, the status of the bill proposed in January by Senators Grassley and Levin to require registration of hedge funds, the views of Mary Shapiro of the SEC and Richard Baker of MFA and comments from Capitol Hill observers.

Will Hedge Fund Industry Self-Regulatory Codes, Such as the “Standards” Promulgated by The Hedge Fund Standards Board, Preempt Additional Hedge Fund Regulation or Complement It?

The increasingly frequent and occasionally shrill calls for government regulation of the hedge fund industry often ignore an important fact: the industry itself has promulgated various codes of conduct and best practices that are significantly more detailed, practicable and equitable to the various affected constituencies than any bill or rule thus far proposed in the U.S., U.K. or other jurisdiction.  In the U.S., the President’s Working Group on Financial Markets in January issued its final reports on hedge fund best practices; the practices, if adopted, are intended to reduce systemic risk and improve investor protection.  See “President’s Working Group Releases Final Best Practices Reports for Hedge Fund Managers and Investors,” Hedge Fund Law Report, Vol. 2, No. 5 (Feb. 4, 2009).  Along similar lines, the Hedge Fund Standards Board (HFSB) in the U.K. has adopted standards developed by the Hedge Fund Working Group, a predecessor organization, covering, among other things, disclosure, valuation, risk management, fund governance and shareholder conduct.  Like the PWG, the HFSB is a voluntary, market-led initiative.  For hedge funds, these various codes of conduct raise important issues, including: precisely how the codes operate; the pros and cons of signing on; similarities and differences between the different codes; and whether compliance with the codes will be required, either by law or the institutional investor market.  This article explores each of these issues.

District Court Dismisses Hedge Fund’s Fraud Suit Against Prime Broker for Lack of Reliance

On March 30, 2009, the U.S. District Court for the Southern District of New York dismissed a lawsuit brought by Walrus Master Fund Ltd. (WMF), a Cayman Island hedge fund, against its prime broker, Citigroup Global Markets, Inc., for its alleged violation of Section 4b of the Commodity Exchange Act, and violations under state law.  WMF, the court held, could not have acted in reliance upon the broker’s reports that WMF asserts were false given that the trading at issue occurred three days prior to WMF’s receipt of those reports.  We detail the background of the action and the court’s rationale for its dismissal of the fraud claim.

Investors in Hedge Fund Paramount Partners Sue Fund, General Partner and Fund Advisers for Securities Fraud and Violation of Minnesota Law

In a complaint dated April 13, 2009, Steven B. Cummings and a group of other investors who purchased almost $3 million of limited partnership interests in hedge fund Paramount Partners, LP (Paramount) accused Paramount, its general partner Crossroad Capital Management, LLC, investment adviser Capital Solutions Management, LP, sales agent Capital Solutions Distributors, LLC and their respective principals of securities fraud in connection with the purchase.  Plaintiffs alleged violations of various provisions of the federal securities laws and the Minnesota Securities Act, and various other common law claims.  Plaintiffs, who purchased their interests in Paramount between 2006 and 2008, brought this lawsuit after the SEC determined that, despite Paramount’s claim to have almost $17 million in assets at the end of 2008, it in fact had only about $1.3 million.  We detail the plaintiffs’ factual allegations and legal theories, and the related SEC action.

Delphi Drops Fraud Claim against Appaloosa Management in Adversary Proceeding Arising Out of Alleged Breach of Bankruptcy Exit Financing Agreement

On April 17, 2009, Judge Robert Drain of the U.S. Bankruptcy Court for the Southern District of New York ruled that Delphi Corporation (Delphi), the Troy, Michigan-based auto parts supplier that filed for chapter 11 bankruptcy protection in October 2005, may amend its complaint against Appaloosa Management LP (Appaloosa), a hedge fund manager that in April 2008 allegedly refused to participate in a funding that would have led to Delphi’s exit from bankruptcy.  As a result of that alleged refusal, Delphi sued Appaloosa, alleging, among other things, fraud.  Judge Drain’s decision will permit Delphi to remove fraud claims from its complaint while continuing with an adversary proceeding against Appaloosa.  On April 22, 2009, Appaloosa and affiliate A-D Acquisition Holdings LLC filed a Notice of Motion for Summary Judgment, asking for a hearing on that Motion on June 5, “or as soon thereafter as counsel can be heard.”  We offer a detailed review of the pleadings in the adversary proceeding – a cautionary tale for any hedge fund contemplating a DIP loan or other bankruptcy lending.

Hedge Fund Manager Ordered to Pay $2.78 Million for SEC Fraud Charges

On April 8, 2009, the U.S. District Court for the District of Massachusetts entered a final judgment on behalf of the SEC ordering United Kingdom citizen Glenn Manterfield, a principal of the Boston-based investment adviser Lydia Capital Management, to pay $2.35 million in disgorgement, almost $426,000 in pre-judgment interest and a penalty of $130,000 for securities fraud.  The order also permanently enjoins Manterfield from further violations of any of the federal securities laws.  We discuss the SEC action in the U.S., a related action in the U.K. and the court’s final judgment.

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