Jul. 2, 2009

Should Hedge Funds Purchase Unsecured Debt of Lehman Brothers Holdings Inc.? Key Legal Issues Impacting Returns

Before the ink was dry on the Chapter 11 bankruptcy filing of Lehman Brothers Holding Inc. (LBHI) last September 15, hedge funds – at least those with relatively strong stomachs – were  evaluating LBHI debt as an investment opportunity.  Many had in mind the Enron precedent, in which hedge funds and others bought the energy company’s debt for cents on the dollar, and in some cases enjoyed a par recovery based on lawsuits against the energy company’s banks.  (However, the Enron precedent is distinguishable in important ways, as discussed in this article.)  Others saw value in Lehman’s substantial derivatives book, in particular, in the opportunity to step into the shoes of Lehman’s derivatives counterparties.  Over the months since the filing, an active market has developed in LBHI’s unsecured debt.  Those on the long side of that market anticipate that value may reside in two primary sources: (1) recovery from JPMorgan Chase & Co. (JPMorgan) on the theory that the bank, acting as LBHI’s clearing bank with respect to repurchase agreements (repos) and as a significant derivatives counterparty, demanded and received more collateral than it was entitled to in the two weeks prior to the filing, thereby hastening or even causing the bankruptcy; and (2) that the Barclays PLC miscalculated the amount it should have paid for LBHI’s U.S. broker-dealer business, thus resulting in too little consideration being paid to the LBHI estate.  With unsecured LBHI debt currently trading at around 15 cents on the dollar, hedge funds are taking a close look at the merits of these claims.  To facilitate the evaluation by hedge funds of those claims, this article explores JPMorgan’s relationships with Lehman, the seizure by JPMorgan of LBHI collateral, potential remedies that may lead to recovery of some or all of that collateral, the relevance of the Enron precedent, the sale of the U.S. broker-dealer business to Barclays, the potential effects of various outcomes on the perception of finality of asset sales in bankruptcy and potential other sources of recovery for holders of unsecured debt of LBHI.

Should Hedge Funds Register as Commodity Pool Operators?

A common mistaken belief among many is that hedge funds are unregistered and unregulated investment vehicles.  While certain exemptions exist under the Investment Company Act of 1940 for registration, a hedge fund that trades in commodity options and futures contracts may be required to register as a commodity pool operator (CPO).  In a guest article, Ernest Edward Badway and Amit Shah, Partner and Associate, respectively, at Fox Rothschild LLP, discuss the questions that a hedge fund should consider in evaluating whether to register as a CPO, including what a commodity pool is, who must register as a CPO, registration exemptions, registration requirements, compliance requirements and more.

IRS Indicates that U.S. Persons May be Required to Report Interests in Offshore Hedge Funds in Reports of Foreign Bank and Financial Accounts

On June 12, 2009, in the course of a teleconference jointly sponsored by the American Bar Association and the American Institute of Certified Public Accountants, Internal Revenue Service (IRS) officials stated that a U.S. person’s equity interest in offshore hedge funds (as well as offshore mutual funds and similar pooled investment vehicles) constitutes a foreign financial account.  Under this view, U.S. persons with investments in offshore hedge funds would be required to file Treasury Form TD F 90-22.1, the Report of Foreign Bank and Financial Accounts (FBAR) with respect to such interests.  In recent guidance, the IRS clarified that certain U.S. persons will have until September 23, 2009 to file FBARs in respect of 2008 calendar year.  The IRS officials on the call framed the interpretation as a “clarification” of the existing filing regime, but the interpretation nonetheless took the hedge fund community by surprise: heretofore, U.S. persons with interests in offshore hedge funds generally had not filed FBARs based solely on those interests.  While the filing is not terribly onerous, the new interpretation may be understood as part of the federal government’s more general effort to obtain more information about hedge funds.  However, this move is different from recent hedge fund regulation bills in Congress or the Obama administration’s proposals in that while those efforts focus on obtaining information from hedge fund managers, this new and more expansive understanding of the range of required FBAR filers focuses on hedge fund investors.  The primary concern it raises – other than the surprise factor and the danger of accidentally tripping up an evolving rule that can result in liability – is that at the margin, the required disclosures will serve as a disincentive for required filers to invest in offshore hedge funds.  One of the historic attractions of investments in offshore hedge funds was the relative anonymity they offered to investors.  To a degree, the IRS’ new interpretation cuts back on the opportunity for anonymity.  We discuss the new IRS interpretation in detail, and offer, among other things, relevant excerpts from the transcript of the call in which the IRS espoused its new interpretation.

SEC Chairman Mary L. Schapiro and CFTC Chairman Gary Gensler Testify Before Congress On Addressing Gaps in Regulation of Securities-Related OTC Derivatives; Schapiro Suggests Imminent Beneficial Ownership Requirements for Equity Derivatives

The severe financial crisis that unfolded over the last two years revealed serious weaknesses in the structure of financial regulation, as well as the pressing need for a comprehensive regulatory framework.  Blame for the crisis has focused in part on the lack of regulation of the over-the-counter (OTC) derivatives markets. As a result, a critical component of President Obama’s financial plan involved regulating the markets for derivatives.  (For a more detailed analysis of the Obama Administration’s new proposal, see “The Obama Administration Outlines Major Financial Rules Overhaul, Announces Greater Scrutiny for Hedge Funds and Derivatives,”  Hedge Fund Law Report, Vol. 2, No. 25 (Jun. 24, 2009)).  On June 22, 2009, the chairmen of both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) testified before Congress regarding the regulation of these markets.  Specifically, SEC Chairman Mary L. Schapiro and CFTC Chairman Gary Gensler urged Congress to address existing gaps in regulatory oversight of securities-related OTC derivatives.  They proposed a new framework that would expand the regulatory authority of the CFTC and SEC to oversee the OTC derivatives markets.  We describe their testimony, and the four primary objectives they aim to achieve.

IOSCO Report Suggests Mandatory Registration for Hedge Fund Managers and Prime Brokers

On June 22, 2009, the Technical Committee of the International Organization of Securities Commissions (IOSCO) published a report endorsing mandatory registration for hedge funds and their managers/advisers and for the prime brokers and banks that financially support hedge funds.  The report called for hedge fund regulation based on six core principles.  We describe those principles, and detail what the IOSCO report had to say about them.

Consistent With International Trends, Cayman Islands Monetary Authority May Require More Transparency from Cayman-Registered Hedge Funds

The Cayman Islands Monetary Authority is planning to increase the transparency required of hedge funds registered in the popular offshore jurisdiction.  Specifically, it is contemplating extending the scope of information called for in Fund Annual Reports, and the range of uses to which such information may be put.  This article reviews the existing system of disclosure in the Caymans, and the most likely changes.  It also discusses the possible impact of such changes on the competitive position of the Cayman Islands vis-à-vis other offshore financial centers.

Second Circuit Revives Hedge Fund Fraud Claims Against Banc of America Securities

On June 9, 2009, the United States Court of Appeals for the Second Circuit reinstated hedge fund investors’ claims that Banc of America Securities LLC (BAS) aided and abetted the frauds and breaches of fiduciary duty committed by the manager of funds for which BAS served as prime broker.  It reasoned that the investors had adequately pleaded that BAS’ actions proximately caused their losses.  We detail the factual background and legal analysis of the most recent opinion in a case that the Hedge Fund Law Report has been tracking since last year.  See “Federal Court Permits Suit Concerning Collapsed Lancer Funds to Proceed in Part,” Hedge Fund Law Report, Vol. 2, No. 5 (Feb. 4, 2009); “Federal Court Bars Investors’ Claims Against Hedge Fund Administrator,” Hedge Fund Law Report, Vol. 1, No. 28 (Dec. 16, 2008).

Delaware Chancery Court Permits Hedge Fund Manager Steel Partners to Restructure Fund and Redeem Certain Limited Partnership Interests

After the 2008 market collapse, the Steel Partners II family of hedge funds (Steel Partners) was flooded with redemption requests.  Because the funds were locked into long-term investments, the funds’ manager proposed a restructuring plan under which the investors could receive a cash distribution and either (1) shares in a new publicly-traded entity that would hold the funds’ assets, or (2) a pro rata distribution of the funds’ securities holdings.  Certain limited partners sued to enjoin that plan and demanded an “orderly liquidation” of the funds.  Relying heavily on the fact that Steel Partners’ offering documents specifically contemplated temporary freezes on redemptions and permitted mandatory redemptions and distributions of assets in kind, the Delaware Chancery Court denied the plaintiffs’ demand for a preliminary injunction.  We explain the restructuring plan in detail, and explain the court’s analysis.

Offshore Law Firm Appleby Opens New Office in the Seychelles Focused on Emerging Markets in Africa, India and Asia

On June 29, 2009, Appleby, the global offshore legal, fiduciary and administration service provider, announced that it has opened an office in the Republic of Seychelles.  Appleby is the first international law firm to open in the country and the new office provides clients with greater access to the fast-growing emerging markets in Africa, Asia and India.  The office is located in the Seychelles’ capital, Victoria.