Jul. 29, 2009

What Do the Regulatory and Industry Responses to the New York Pension Fund “Pay to Play” Scandal Mean for the Future of Hedge Fund Marketing?

New York’s so-called “pay to play” scandal – in which state officials conditioned investments of state pension money in hedge and private equity funds on payments by the funds’ managers to the officials or their affiliates – has yielded a range of regulatory and industry responses, of varying degrees of severity.  At the most draconian is New York Attorney General Andrew Cuomo’s Code of Conduct (Code), to which three alternative investment managers have thus far agreed in settlement of pay to play charges.  The Code bans the use of placement agents altogether, but is not yet law and has not yet been adopted by any industry group as a best practice.  (However, it has been adopted by the New York State Teachers’ Retirement System.)  Somewhat less severe is a recently proposed SEC rule intended to curtail pay to play practices.  That rule generally provides that an investment adviser who makes a political contribution to an elected official in a position to influence the selection of the adviser to manage money for state or local governments would be barred for two years from providing advisory services for compensation, either directly or through a fund.  A yet more measured response to the pay to play scandal ­– and in the view of many on the hedge fund side, a more practicable one – has come from CalPERS and other pension funds.  These pension funds have required increased disclosure and transparency with respect to compensation arrangements between investment managers seeking to manage pension assets and any placement agents or third party marketers acting on behalf of such managers.  Finally, lurking in the background has been Investment Advisers Act Rule 206(4)-3, which generally requires disclosure of the compensation arrangement between a registered investment adviser and a placement agent, to any “client” of the adviser that was solicited by the placement agent.  The application of this rule in the pay to play scandal is subtle, as explained more comprehensively in this article.  The regulatory responses have changed the game of hedge fund marketing.  The difficult (though apparently improving) investment climate for hedge funds has made marketing more difficult as a practical matter, and the regulatory responses to the pay to play scandal have made marketing more treacherous as a legal matter.  Therefore, this article provides background on the scandal and the various settlements; offers details of Cuomo’s Code; addresses the likelihood that other states will follow New York’s lead; discusses actions by pension funds in response to the scandal, the SEC’s recently proposed anti-pay to play rule and Rule 206(4)-3; and, importantly, explores the future of hedge fund marketing without placement agents, or with harsh restrictions on their activities.

SEC’s Order in the Perry Case Effectively Creates a Presumption that Beneficial Ownership Acquired as Part of an Activist or Merger Arbitrage Strategy Is Not “In the Ordinary Course,” and thus May Require the Filing of a Schedule 13D

On July 21, 2009, the Securities and Exchange Commission (SEC) settled with New York-based hedge fund manager Perry Corp. over alleged securities law violations for failure to report that a fund it managed (Perry) had purchased a significant amount of stock in a public company.  The SEC Order found that Perry failed to disclose its acquisition of nearly 10 percent of the common stock of Mylan Laboratories Inc., a company that had just announced a proposed acquisition of King Pharmaceuticals Inc.  Perry was engaged in a merger arbitrage strategy and would have benefited from the Mylan-King merger.  The conclusions in the Order raise several questions about the obligation of a hedge fund to file a Schedule 13D, particularly if the fund is engaged in merger arbitrage or activist strategies.  Specifically, the Order appears to significantly narrow the circumstances in which beneficial ownership of the equity of a publicly traded company may be considered acquired “in the ordinary course” when acquired by a hedge fund following a merger arbitrage or activist strategy.  In fact, it may effectively create a presumption that such trading is not in the ordinary course, and thus any hedge fund following such a strategy that crosses the five percent threshold must file a Schedule 13D within 10 days of crossing the threshold, as explained more fully in this article.  In addition, the Perry Order highlights the ongoing tension between hedge funds and regulators over how much transparency hedge funds need to provide to the public.  We outline the filing requirements under Section 13(d)(1) of the Securities Exchange Act of 1934, provide a comprehensive summary of the Perry Order then describe the implications of the Perry Order for the obligations of hedge funds to file Schedule 13Ds (and 13Gs).  We also discuss the implications of the Perry Order for filing obligations based on beneficial ownership arising out of total return equity swap positions, and confidentiality concerns raised by the Order.

Investors Demand More Specificity in Hedge Fund Governing Documents Regarding Circumstances in which Liquidity Management Tools May Be Used

The credit crisis witnessed unprecedented deployment of liquidity management tools that, prior to the crisis, lay dormant in fund documents – tools such as fund-level gates, investor-level gates, hard and soft lock-ups, rolling redemption periods, holdbacks, redemption suspensions and side pockets.  The stigma previously attached to use of such tools faded as survival became the paramount imperative.  See “Stigma Fades as Use of Gates Becomes More Common,” Hedge Fund Law Report, Vol. 1, No. 29 (Dec. 24, 2008).  In addition, managers sought to stem the tide of outflows to ensure that remaining investors were not left with the least liquid assets, and to facilitate the execution of longer-term investment strategies.  See “Investors in Hedge Fund Strategies Increasingly Demanding Separate Accounts to Avoid Gates and Other Consequences of Commingled Investment Vehicles,” Hedge Fund Law Report, Vol. 2, No. 9 (Feb. 26, 2009).  The constituent documents of funds being launched today reflect the experience of the past year and a half.  At least for the time being, investors still have the upper hand in many cases in negotiating capacity with hedge fund managers, and many of those investors are demanding more specific liquidity provisions in fund documents.  In particular, investors are asking for – and in many cases getting – more specificity with respect to the circumstances in which liquidity management techniques may be employed, and the particular techniques that may be employed in specific circumstances.  The old approach was to vest essentially plenary discretion in the manager to lower a gate, suspend redemptions, etc. in a wide variety of circumstances.  The new drafting reflects an effort to enumerate the circumstances in which liquidity may be curtailed.  At the same time, investors and managers continue to recognize the impracticability of describing every circumstance in which liquidity restrictions may be prudent.  So while the drafting of liquidity management provisions is getting more precise, it still leaves room – albeit less room – for manager discretion.  We discuss relevant standards promulgated by the Hedge Fund Standards Board, and changes to those standards to reflect the trend toward more specific liquidity management disclosure, offer practitioner insight on the rationale for the trend and – importantly – provide actual language from the PPMs of two recently-launched hedge funds that reflect the new, more specific drafting.

How Will Changes to Proxy Access and Broker Voting Rules Impact Activist Hedge Fund Investors?

Recent decisions and proposals by the SEC may influence the actions and strategies employed by activist investors.  The activist’s world has long been shaped by a number of barriers, including the broker vote and the inability for shareholders to directly access the corporate ballot, that have made many corporate elections less than democratic.  These new regulatory changes may ultimately “level the playing field” and lead to more communication between boards and activists.  In a guest article, Steven Balet, Senior Managing Director at Okapi Partners LLC, a specialized strategic proxy solicitation and investor response firm, discusses the recent decisions and proposals, and some of their potential effects on activist investment strategies.  Among other things, Balet’s discussion includes a detailed analysis of changes to the broker voting and proxy access rules.

Former CFO of Highbridge/Zwirn Special Opportunity Fund Sues Ex-Partner Daniel B. Zwirn for Defamation and Breach of Contract

On July 20, 2009, Perry A. Gruss, the former chief financial officer of the hedge fund Highbridge/Zwirn Special Opportunity Fund, sued his ex-partner, Daniel B. Zwirn, in the United States District for the Southern District of New York for defamation and breach of contract.  Gruss accuses Zwirn of defamation for allegedly making him the “scapegoat” for Zwirn’s improprieties, including the purchase of a private jet with client capital, and asserts this defamation ruined his professional standing and diminished his employment opportunities.  Gruss also accuses Zwirn of breaching their partnership agreement because Zwirn allegedly failed to pay Gruss amounts due him in connection with his forced exit.  We detail the allegations underlying the defamation and breach of contract claims.

The Evolution of Offshore Investment Funds (Part One of Three): In Interview with the Hedge Fund Law Report, Ogier Partner Colin MacKay Discusses Drafting of Offshore Fund Documents; NAV Adjustments; Clawbacks; Managed Accounts; and Payment-in-Kind Provisions

During this past spring and summer, global law firm Ogier hosted its Second Annual Ogier Global Investment Funds Seminar, titled “The Evolution of Offshore Investment Funds,” for over 300 hedge fund professionals in New York, Boston, the Cayman Islands, Chicago and San Francisco.  Colin MacKay, one of the presenting partners at the seminar, spoke at length to the Hedge Fund Law Report about the most important issues addressed in the seminar, including: (1) How regulatory developments, recent economic events and caselaw in offshore financial centers is affecting drafting of specific provisions in fund documents (including net asset value adjustments, “clawbacks” of performance fees for subsequent underperformance); (2) Managed accounts, and the amount of assets required to be in a managed account for such an account to be economically viable, in light of the various administrative costs involved in creating and maintaining such an account; (3) Side letters; (4) Liquidity management tools (such as gates, redemption suspensions, payments in kind, etc.), and how the increasing use of such tools is affecting the drafting of payment-in-kind provisions in Cayman and BVI fund documents; (5) Indemnification of fund directors and the evolution of the “gross negligence” standard; (6) Caselaw developments in offshore financial centers (including cases addressing when a redeeming shareholder becomes a creditor of a fund and cases dealing with attempts by liquidators to adjust net asset value); (7) Clawback principles and mechanics; (8) Regulatory developments in offshore financial centers, and in other jurisdictions that may affect funds organized in offshore financial centers (such as the EU’s AIFM Directive); and (9) The relative advantages and disadvantages of various offshore financial centers.  This issue of the Hedge Fund Law Report includes the first of three parts of the full transcript of our interview with MacKay.

Second Circuit Holds that Recommendations by Hennessee Group that Clients Invest in Bayou Hedge Funds Did Not Violate Federal Securities Laws

On July 14, 2009, the Second Circuit affirmed the dismissal of South Cherry Street, LLC’s complaint which alleged that hedge fund consultant Hennessee Group LLC (i) violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder and (ii) breached an oral contract to conduct suitable due diligence by recommending that its clients invest in the “Bayou” group of funds, which turned out to be part of a Ponzi scheme.  The Second Circuit determined that the alleged oral contract was unenforceable by reason of the New York statute of frauds because it could not be fully performed within one year.  It also determined that South Cherry failed to allege sufficient facts to show that defendants acted with the requisite intent to sustain a claim for securities fraud under Section 10(b) of the Exchange Act.  We summarize the court’s findings and reasoning and its potential impact on hedge fund investors and the consultants who assist them in selecting hedge fund investments.

Celent Report Identifies Best Practices for Over-The-Counter Derivatives Collateral Management

When any entity, including a hedge fund, trades over-the-counter (OTC) derivatives, it assumes the risk that the counterparty – a bank, financial institution or another hedge fund – will fail to perform.  To mitigate that risk, OTC derivatives documents require each party to post collateral.  The amount of collateral adjusts based on: (1) the value of the derivative; and (2) the value of the collateral.  Both values fluctuate.  This practice, commonly referred to as OTC derivatives collateralization, has grown increasingly popular because of the recent credit crisis.  Celent, a Boston-based financial research and consulting firm, recently issued a report entitled: “OTC Derivatives Collateral Management: A Credit Risk Mitigation Technique Revisited,” regarding the status of and best practices for OTC derivatives collateralization.  The report found that collateralization of OTC derivatives has expanded due to greater hedge fund participation in these transactions.  The report identified the best practices for entities, including hedge funds, who participate in collateralized OTC transactions.  This article summarizes these best practices and the other major findings of the report, as they relate to hedge funds.

Reed Smith Adds Hedge Fund Guru Alexandra “Sandra” Poe to Financial Industry Group in Firm’s New York City Office

On July 28, 2009, law firm Reed Smith LLP announced the addition of Alexandra “Sandra” Poe as a partner in its Financial Industry Group.  Ms. Poe will be resident in the firm’s New York City office.  Ms. Poe was formerly a partner in the New York office of Wilmer Hale.  Her practice focuses on representing hedge funds and their advisers in fund formation, adviser registration, compliance and regulatory advice.