Section 363 of the Bankruptcy Code (the Code) provides a mechanism whereby distressed debt investors can purchase unencumbered assets out of bankruptcy.  Specifically, Code Section 363(b)(1) authorizes a “trustee” (in a Chapter 11 cases, this usually refers to the debtor itself) to sell “property of the estate” other than in the ordinary course of business after notice and a hearing.  Section 363(f) provides that, subject to satisfying certain conditions, the trustee may sell property under Section 363(b) “free and clear of any interest in such property” that a third party may claim.  The ability to purchase assets “free and clear” can be a tremendous benefit to distressed debt investors.  Among other things, it permits greater certainty of ownership and valuation of assets, and easier resale, versus a purchase outside of bankruptcy.  On the downside, however, 363 sales can take a significant amount of time.  Moreover, 363 sales generally proceed as auctions, meaning that the first bidder – known colloquially as the “stalking horse” – can be outbid.  To address this possibility, the stalking horse can provide in the purchase agreement relating to its bid for expense reimbursement, and/or a break-up fee and/or so-called “overbid protection”  Yet the inclusion of such protections in purchase agreements typically provoke challenges from trustees or creditors’ committees, and the law governing such challenges remains unsettled.  The core principle emerging from the relevant cases is that the bankruptcy court (or any appellate court) will only uphold the validity of a break-up fee to the extent the fee benefits the bankruptcy estate.  This article examines the potential pitfalls of participating in 363 sales – an important topic for hedge funds, especially those with a strategy that involves investing in and around bankruptcies, as more and more interesting assets wind up on the bankruptcy auction block. Read full article …

In recent years, proprietary trading desks (prop desks) have contributed a growing proportion of revenue at the major Wall Street investment banks.  As the credit crisis has persisted, however, the idea of a proprietary trading operation housed within a major investment bank has become less and less viable.  The freezing of credit markets has severely curtailed leverage, which once enhanced returns.  Growing risk aversion has diminished the tolerance among risk management departments for the sorts of trades that generated outsized returns (and that occasionally resulted in large losses).  And limits on executive compensation – imposed either by statute or the prospect of public condemnation – have undermined the ability of investment banks, especially those with affiliated commercial banks, to retain trading talent.  The result has been a well-publicized wave of closures of prop desks across the Street (and, in the UK, across the City).  For hedge funds, this wave of closures has had two primary effects.  First, it has decreased competition in certain investment strategies.  Second, it had created a surfeit of unemployed trading talent.  However, while the closure of prop desks has created a market for talent that is very favorable to hedge fund managers looking to hire, it has also created a scenario rife with legal and compliance pitfalls.  Specifically, for the very reasons that a trader would be attractive to a hedge fund manager as a new hire – specific relevant experience; knowledge of specific companies, assets or strategies; relationships with investment target company executives and board members, etc. – the hiring of that trader also creates the opportunity for personnel of the manager to use information possessed by that trader in an unauthorized and potentially illegal manner.  In short, while experienced traders often possess valuable information, they do not, as a contractual matter, own that information.  Rather, their former employer generally owns that information.  That is, much of the information constitutes an asset of the former employer, which subsequent employers are contractually and legally prohibited from using.  Think of it as hiring a race car driver: you (the manager) are getting his ability to drive the car, but not the car itself.  We detail the confidentiality, non-compete and non-solicitation agreements generally entered into by traders at the inception of employment with investment banks and hedge funds, standard provisions of severance arrangements that bear on confidentiality of information, compliance precautions that hedge fund managers can take, consequences for ongoing confidentiality obligations of closures of prop desks and repercussions of violations of confidentiality obligations. Read full article …

The new world order for private funds is beginning to take shape, from a regulatory perspective at least.  We now have legislative proposals to apply additional regulation to private funds – hedge funds and private equity funds – on both sides of the Atlantic: legislation introduced in the U.S. Congress and, last week, a draft EU Directive on Alternative Investment Fund Managers.  Both sets of proposals will potentially add significant additional regulatory obligations and cost.  However, as the proposals stand to date, the changes seem likely to add greater additional burden for those managing private funds from an EU jurisdiction than their U.S. competitors.  Some of the proposed changes on both sides of the Atlantic are welcome – but some, particularly in the EU proposals, are of doubtful benefit and have the potential to add significant additional cost for the industry.  In a guest article, Richard Horowitz, a Partner at Clifford Chance US LLP, compares the likely shape of future regulation of private funds in the U.S. and the EU. Read full article …

One of the primary reasons why troubled loans do not receive meaningful modifications is that the loan servicers fear lawsuits from the investors who own securities backed by the loans.  As a result, the government effort so far to address the problem of troubled mortgages has focused on creating incentives to get loan servicers to begin workouts.  President Obama gained their favor in his housing rescue plan by promising up to $9 billion in TARP funds to cover the fees associated with modification and proposing as part of the comprehensive Housing Act a legal “safe harbor” from litigation that might arise in reworking a deal.  The bill is intended to give loan servicers, including big banks like Bank of America and Citi, breathing room to modify loans more easily without having to worry about investor lawsuits.  But recent reports, including one by the Amherst Security Group, found that many of the supposed loan modifications are simple repayment plans that actually increase the balance of the mortgage and result in bigger fees payable to the loan servicers.  Now, there is another major stumbling block as investors holding mortgage-backed securities realize just how big a threat a servicer safe harbor poses to them.  We provide a comprehensive discussion of the legislative background, the mechanics of the proposed servicer safe harbor, a discussion of the necessity of such a safe harbor and a summary of the Amherst Security Group report. Read full article …

In an effort to reduce the likelihood of fails in the repurchase agreement (repo) market, the Treasury Market Practices Group (TMPG), an industry body sponsored by the Federal Reserve Bank of New York, has imposed a three percentage point fee on investors in the repo market who fail to deliver borrowed Treasuries on time.  The TMPG action is designed to increase market efficiency.  According to a statement issued by the TMPG, “[s]ince November, short-term interest rates have declined to unprecedented levels, increasing the urgency to implement new practices to enhance liquidity and improve functioning of the U.S. Treasury market.  Accordingly, the TMPG focused on the fails charge recommendation as the most immediate and meaningful way to improve Treasury market functioning and liquidity.”  However, while the charge is meant to increase market liquidity, it could ultimately have the reverse effect: the fee is likely to make Treasuries scarce as the owners of these securities become reluctant to lend and instead opt to hold onto them.  We define a repo transaction and discuss the TMPG action, hedge funds’ participation in the repo market, the reasons for and frequency of repo fails, whether the fee is high enough to deter fails and the impact of the TMPG action on the current market. Read full article …

On March 30, 2009, the Securities and Exchange Commission issued two identical no-action letters to Icahn Associates Corp. and Eastbourne Capital, L.L.C., two unaffiliated dissident shareholders of Amylin Pharmaceuticals, Inc., concerning the election of directors to the Amylin Board where each shareholder had submitted separate “short slates” of director nominees at the annual meeting.  “Short slates” refer to a dissident slate for less than a majority of the company’s board of directors.  In the no-action letters, the SEC took the view that each of the two unaffiliated dissident shareholders could “round out” its short slate of directors with the nominees from the slate of the other dissident shareholders, under an expansive interpretation of the “bona fide nominee” rule in Exchange Act Rule 14a-4(d).  This stance represents a significant change from the SEC’s prior position that authorized a soliciting shareholder to “round out” its short slate with company nominees only.  We detail the SEC’s analysis in the two no-action letters. Read full article …

The activist strategy employed by various hedge funds typically involves a fund taking minority equity positions in publicly owned companies, then pressuring the boards of directors or managements of those companies into making key governance changes such as stock buybacks, sales of non-core assets or even sales of the whole enterprise.  Some of the rules governing shareholder activism are federal, generally provided by the SEC or FTC, while others are set by self-regulatory organizations such as the New York Stock Exchange LLC (NYSE), subject to approval by regulators.  A recent proposal by the NYSE to amend NYSE Rule 452 to prohibit discretionary voting by brokers in uncontested board elections could have a powerful impact on the legal regime in which activist shareholders operate.  We discuss the mechanics of the proposed rule change, its potential impact and the market reaction. Read full article …

On May 6, 2009, international law firm Norton Rose LLP announced that Michael Newell has joined the investment funds team as a partner.  He joins from DLA Piper where he was a partner in the investment funds group. Read full article …