Jun. 17, 2009

A Pequot Postmortem: What is Headline Risk and How Can it be Avoided or Mitigated?

In the hedge fund context, “headline risk” may be defined as the potential for adverse publicity to undermine the business operations and investment strategy of a manager.  Headline risk is often invoked with a mixture of reverence and terror, one of the few trump cards that almost invariably will persuade a manager to make changes to a marketing presentation that otherwise appear ministerial.  The deterrent power of headline risk likely arises out of its vagueness: hedge fund managers generally are accustomed to modeling and quantifying the world, while headline risk remains inherently ambiguous – the stuff of rumor rather than reason – and thus difficult to measure or control once realized.  As demonstrated by the recent demise of Pequot Capital Management, headline risk can bring down an entire hedge fund management enterprise, even one with an admirable track record, and can tarnish otherwise sterling reputations.  However, managers are not without recourse – not defenseless against the fickle whims of the Fourth Estate.  There are specific precautions a manager can take to minimize both the likelihood of events that will result in headline risk, and the magnitude of the risk even if such events occur.  This article defines headline risk with more particularity, identifying its constituent elements and discussing the Pequot case as an example, then details the specific precautions managers can take to mitigate the likelihood and magnitude of headline risk.  It also discusses certain responses to headline risk that managers are encouraged to avoid.

AIFM Directive: Loosening the Regulatory Noose

On April 29, 2009, the European Commission published the text of its proposed Alternative Investment Fund Managers (AIFM) Directive as part of the Commission’s wider strategy to reduce systemic risk to the economy, and to strengthen transparency and harmonisation of applicable laws for hedge and private equity funds.  This is the first attempt in any jurisdiction to control the management of AIFs, the Directive’s definition of which also includes commodity, real estate and infrastructure funds.  The draft is now being considered by the European Parliament and Council and could be in force in Member States in 2012.  It is clear that certain aspects of the Directive, such as transparency for investors and some limits on leverage, are to be welcomed.  Indeed some provisions like increased disclosure are already UK industry practice.  Other provisions in the draft, however, are of genuine concern to the hedge fund industry.  In a guest article, Davina Garrod and Lawrence Grabau, Partner and Trainee Solicitor, respectively, in the London office of McDermott Will & Emery UK LLP, offer a detailed discussion of those more disquieting provisions, and provide a summary of the complex process for adoption of the Directive.

Update on the Federal Reserve Bank of New York Term Asset-Backed Securities Loan Facility

In November 2008, the Federal Reserve Board established the Term Asset-Backed Securities Loan Facility (TALF) to provide $200 billion in non-recourse financing by the Federal Reserve Bank of New York (FRBNY) to eligible borrowers owning eligible asset-backed securities (ABS).  On February 10, 2009, the Treasury announced that, under the Financial Stability Plan, the TALF would be expanded to provide up to $1 trillion in financing.  On May 1, 2009, the FRBNY announced that, beginning in June 2009, certain commercial mortgage-backed securities (CMBS) would be eligible for TALF funding; eligible CMBS will be highly-rated and of recent origin.  The FRBNY will cease making TALF loans on December 31, 2009, unless the program is extended by the Board of Governors.  In guest article, Alyson B. Stewart and Lawrence D. Bragg, III, Associate and Partner, respectively, at Ropes & Gray LLP, provide a comprehensive summary of terms of the TALF based on publications of the FRBNY and their experience representing borrowers in the TALF subscriptions to date.

Interview with Duff & Phelps Director Eric S. Lazear on Operational Risk Due Diligence

Amid the backdrop of recent high profile frauds, unprecedented market declines, poor hedge fund performance and resulting closures, hedge fund investors are placing heightened emphasis on due diligence.  In particular, investors are focusing in the course of due diligence on operational risks and business infrastructure.  Last month, independent financial advisory and investment banking firm Duff & Phelps Corporation created an Operational Risk Due Diligence (ORDD) practice to provide investors with an independent third-party assessment of their hedge fund managers’ operating policies and procedures.  The Hedge Fund Law Report spoke with Duff & Phelps Director Eric S. Lazear about the new ORDD practice; trends in operational risk due diligence; specific risks he has seen in the course of his practice (including risks relating to trading practices, valuation of illiquid assets, cash management, fund structuring and allocation of trades); and solutions recommended to institutional investor clients to address those risks.  The full text of the interview is available in this issue of the Hedge Fund Law Report.

New York Court Rules that Limited Partners of Collapsed Hedge Fund Cannot Sue Fund’s Outside Legal Counsel for Fraud and Breach of Fiduciary Duty

In the continuing saga over the 2005 collapse of Wood River Partners, L.P. (the Fund), which suffered huge losses by reason of its highly-concentrated bet on Endwave Corporation (Endwave), New York’s highest court affirmed the dismissal of a complaint filed by limited partners of the Fund against Seward & Kissel, LLP (S&K), which served as outside legal counsel to the Fund.  The Court of Appeals held that the limited partners failed to plead the alleged fraud by S&K with sufficient particularity.  It also ruled that outside counsel to a limited partnership owes a fiduciary duty only to the partnership itself, not to its individual limited partners.  We provide a detailed discussion of the facts of the case and the court’s legal analysis.  The case offers a rare statement on hedge fund law from the highest court of a U.S. state in which many hedge funds are domiciled, and in which the vast majority of hedge funds conduct business.  As such, the case includes important and widely-applicable insights on the scope of a hedge fund manager’s fiduciary duty, and the limits on the potential liability of service providers to hedge funds.

Transaction Terms Analysis: Hedge Fund Ramius Buys Investment Bank Cowen to Go Public Pursuant to Reverse Merger

On June 3, 2009, one of the nation’s largest private hedge fund managers, Ramius LLC, agreed to a “reverse merger” with public investment bank Cowen Group, Inc.  As a result of this reverse merger, the private hedge fund management company will merge with and obtain control of nearly 71 percent of the stock and operations of the publicly-traded investment bank.  This merger not only allows Ramius to go public without the formality and expense of an initial public offering, a major benefit of all reverse mergers, but also gives the firm an investment banking platform on which it can offer new services, including fixed-income sales, trading and origination and real-estate banking.  Ramius anticipates that its new platform may prove profitable as a source of high-margin revenues, especially as the hedge fund industry faces the imminent possibility of intensive regulation.  For more on hedge funds entering the investment banking business, see “Interview With Drinker Biddle Partner David Matteson on Citadel’s Entry Into the Investment Banking Business,” Hedge Fund Law Report, Vol. 2, No. 20 (May 20, 2009).  This article summarizes the material terms of the transaction, based on an analysis conducted by the Hedge Fund Law Report of the Transaction Agreement and Agreement and Plan of Merger and the Asset Exchange Agreement.  The article will be of particular interest to any hedge fund manager contemplating any sort of transaction with a public entity, and any manager considering entry into the investment banking business.

Regulatory Compliance Association Hosts Teleconference on “A New Era in Valuation”; Speakers Address Trans-Atlantic Convergence of Fair Value Accounting Principles, Indemnification of Hedge Fund Administrators and Due Diligence

On June 10, 2009, The Regulatory Compliance Association (RCA) hosted a teleconference titled “A New Era in Valuation,” as part of its CCO University Outreach Series.  The speakers discussed international accounting standards and the price and valuation committees charged with implementing them; the roles, responsibilities and indemnification of service providers, in particular administrators; and how due diligence has and will continue to evolve in a “new era” characterized, as RCA Chairman Walter Zebrowski said, by the convergence of “market losses, declining fund values and rising liabilities.”  In this new era, Zebrowski noted, the International Accounting Standards Board and its U.S. counterpart, the Financial Accounting Standards Board, will continue to work toward more effective accounting principles, but in the glare of a political spotlight that was turned on by Enron and brightened by the off-balance-sheet accounting for various of the vehicles at the heart of the current credit crisis.  See generally “Key Lessons from the Second Annual Hedge Fund Tax, Accounting & Administration Master Class: IFRS, Fair Value and SEC Examinations,” Hedge Fund Law Report, Vol. 2, No. 21 (May 27, 2009).  We summarize the key topics of discussion from the RCA teleconference.

Federal District Court Dismisses Suit Brought By Provider of Financial Services Software Against Two Officers of Hedge Fund Manager for Absence of Personal Jurisdiction

On May 19, 2009, the United States District Court for the District of Connecticut dismissed a breach of contract lawsuit brought by LucidRisk, LLC, a provider of financial services software, against Keith Ogden and Peter Gerhard, two officers of hedge fund management company East Avenue Capital Partners Management Company LLC (East Avenue), a Delaware company, for lack of personal jurisdiction.  The case offers insights relevant to the scope of personal jurisdiction in the hedge fund context, as well as legal claims that arise in connection with technology used by hedge fund managers to measure risk and similar software.

Offshore Law Firms Appleby and Dickinson Cruickshank to Merge

On June 15, 2009, global offshore legal, fiduciary and administration service provider Appleby announced a dramatic expansion of its international reach, merging with Dickinson Cruickshank, the largest law firm in the Isle of Man.  The firm will continue to be known as Appleby and the merger is to be effective, once all conditions are met, on 1st October, 2009.