While much ado has been made of flash orders in the news lately, little focus has been placed on the mechanics of flash orders, the legal and regulatory basis for flash orders, who is trading based on flash orders, and the benefits and downsides of flash orders for both investors and the market.  Because of the likelihood that the Securities and Exchange Commission (SEC) will take action to regulate or eliminate the use of flash orders, the debate over these issues is particularly relevant.  There is some question as to whether the SEC will amend current regulations to eliminate flash orders altogether, or whether additional requirements could be imposed on flash orders that would satisfy regulators’ needs for transparency while still leaving flash orders in place.  In addition, because hedge funds and other firms may have already invested in the technology necessary to execute flash orders or planned to invest in such technology, understanding the debate and the potential outcome of SEC regulation may enable hedge funds to allocate resources in light of likely regulatory outcomes.  This article offers a comprehensive overview and analysis of issues raised by flash orders, including: a description of what flash orders are; the legal basis for flash orders; recent challenges to flash orders from Senator Charles Schumer and the SEC’s response; the upside to hedge funds and others of flash orders; the downside; the likelihood of regulation and the shape such regulation may take; and the implications of the foregoing for hedge funds and their managers. Read full article …

On July 31, 2009, the U.S. House of Representatives passed the Corporate and Financial Institution Compensation Fairness Act of 2009 (Act).  The Act consists of two components.  The first component is a “say-on-pay” provision that would, among other things, provide for a separate, non-binding shareholder vote on executive compensation and “golden parachutes” at public companies.  The second component – and the more interesting (and potentially game changing) one for hedge fund managers – provides for “enhanced compensation structure reporting” requirements that would apply to “covered financial institutions” (CFIs), a term that would include, among others, hedge fund managers.  The enhanced compensation structure reporting requirements would require “appropriate Federal regulators” jointly to prescribe, no later than nine months after the date of enactment of the Act, regulations requiring disclosures that would enable the regulators to determine whether a CFI’s incentive compensation (1) “is aligned with sound risk management,” (2) “is structured to account for the time horizon of risk” and (3) meets such other criteria as the regulators may determine to be appropriate to reduce unreasonable incentives for employees of CFIs to take undue risks that could threaten the safety and soundness of the CFI or could have serious adverse effects on economic conditions or financial stability.  The Act also contains a “rule of construction” providing that nothing in the Act shall be construed as requiring the reporting of actual compensation of individuals, and exempts CFIs “with assets of less than” $1 billion.  The hedge fund community has been taken aback by the capacious and ambiguous drafting, and the profound ramifications that the Act, if passed in its current form, could have for hedge fund compensation arrangements.  Read literally, the Act would give regulators unprecedented discretion to substantively regulate the performance-based fees charged by hedge fund managers – one of the bedrocks of the hedge fund business model (albeit a bedrock that is shifting in its precise shape and scope).  The Act still remains to be passed by the Senate, and presented to the President, and even if it becomes law in something like its current form, the undefined terms in the Act likely would assume some specificity through implementing regulations.  As it stands, however, the Act represents a significant government intervention into an area heretofore considered the exclusive province of private agreements.  We discuss the likely effect of the Act on performance fees, base salaries and assets under management; application of the $1 billion exclusion; likely construction of the phrase “sound risk management” and who will construe it; whether the Act will require calculation of performance fees based on performance over a number of years; and what may constitute “inappropriate risks.” Read full article …

On July 31, 2009, the Federal Deposit Insurance Corporation (FDIC) issued a press release announcing the first test of the funding mechanism for its Legacy Loans Program (LLP), part of the Public-Private Investment Program (PPIP).  Specifically, the FDIC announced that it has created a limited liability company (LLC) to receive troubled assets, and that by the end of this summer it plans to have the receiver of a defunct bank transfer loans and other assets into the LLC “on a servicing released basis . . . in exchange for an ownership interest in the LLC.”  On June 3, 2009, the FDIC had put the earlier incarnation of the LLP on indefinite hold.  See “Treasury, Fed and FDIC Officials Discuss Suspension of Legacy Loans Program, Status of Legacy Securities Program and Future of the TALF at SIFMA and PREA’s Public-Private Investment Program Summit,” Hedge Fund Law Report, Vol. 2, No. 23 (Jun. 10, 2009).  The June 3 announcement cancelled a previously planned pilot sale of assets.  In its more recent press release, the FDIC said that it would instead “test the funding mechanism contemplated by the LLP in a sale of receivership assets this summer,” drawing on the experience of the Resolution Trust Corporation (RTC) in the late 1980s and early 1990s.  The RTC used a number of distinct models of “equity partnership,” but in essence there is one major difference between the goals of the RTC and the LLP: the RTC was charged with distributing the assets of closed institutions, whereas the goal of the LLP is to reinforce the solvency of open banks and jumpstart their lending activities.  We examine the restructured LLP from the hedge fund perspective, and in the course of our examination discuss: the RTC precedent; the mechanics of the test program; the background of the LLP; valuation issues; concerns with participation (including tax and “headline risk” concerns); cash and leverage options; and the policy behind the PPIP. Read full article …

When a hedge fund manager manages concurrent funds with different investor bases, investors are reasonably concerned about how investment opportunities that fall within the mandate of both funds may be allocated.  For example, investors in one fund may be concerned that the other fund is “front running” the fund in which they are invested.  On “front running,” see “Hedge Fund Manager Kenneth Pasternak Cleared of Securities Fraud,” Hedge Fund Law Report, Vol. 1, No. 15 (Jul. 8, 2008).  Even short of that, managers must address concerns about the fair and transparent allocation of investment opportunities and managerial efforts.  As Gregory Nowak, Partner at Pepper Hamilton LLP, told the Hedge Fund Law Report in an interview, investors want to know that managers are “eating their own cooking.”  The potential conflicts inherent in simultaneous management of multiple funds can be especially pronounced when one of the funds is a proprietary fund, owned by employees of the management firm, and another fund includes outside investors.  If the employee-owned fund gains and the outside-investor fund gains less, does not gain at all or loses, there will be questions from the outside investors, as happened earlier this year to Renaissance Technologies.  Renaissance’s Medallion Fund, a hedge fund whose investors consisted of Renaissance principals and employees, gained 12 percent in the first four months of 2009, while Renaissance Institutional Equities Fund, with outside investors, lost 17 percent in the same period.  In a conference call with fund management, the outside investors demanded explanations for the divergent performance – even though the funds had significantly different investment mandates.  Against this backdrop, this article addresses the following questions: how common is the practice of operating an employee-owned fund alongside an outside-investor fund?  What are the benefits of such an arrangement?  Who constitutes a “knowledgeable employee” for purposes of beneficial ownership of an employee-owned fund?  And, what are the drawbacks of such an arrangement, and how can they best be managed? Read full article …

On August 3, 2009, the Securities and Exchange Commission (SEC) published the full text of its proposed rule regarding “Political Contributions by Investment Advisers,” Investment Advisers Act Rule 206(4)-5.  Its intended purpose is to curtail so-called “pay to play” practices involving investment advisers.  The phrase “pay to play” refers to arrangements whereby investment advisers make political contributions or related payments to governmental officials in order to be rewarded with, or afforded the opportunity to compete for, contracts to manage the assets of public pension plans and other government accounts.  On July 22, 2009, the SEC unanimously voted to approve the proposed rule, which remains subject to a 60-day public comment period after its publication in the Federal Register.  We provide a detailed description of the proposed rule. Read full article …

After a year that saw $155 billion in hedge fund withdrawals, two investors who had invested about $1.6 million with AJW Qualified Partners, LLC (the Fund), a hedge fund managed by N.I.R. Group (N.I.R. or the Manager), filed a lawsuit in a dispute over the Fund’s redemption provisions.  In September 2008, plaintiff Steven Mizel and his limited partnership, Palmetto Partners (Palmetto) sought to redeem their approximately $1.68 million investment in the Fund.  Instead, in October 2008, the Fund allegedly froze all redemption requests and sought to reorganize into a new fund that had a different management compensation structure and more restrictive withdrawal rights.  The Fund also allegedly refused to supply plaintiffs with certain information about the Fund, particularly a list of its members.  Plaintiffs then brought suit in New York State Supreme Court, alleging anticipatory breach of contract by the Fund and breaches of fiduciary duty by the Manager and its principal, Corey S. Ribotsky.  The Hedge Fund Law Report analyzed the relevant pleadings in the case and a related case involving similar allegations brought against Ribtosky by Gerald Tucci.  This article summarizes our analysis. Read full article …

Delaware has a history of vigorous enforcement of indemnification rights for directors and officers of corporations.  On July 14, 2009, the Delaware Chancery Court applied the principles developed in the corporate context on behalf of principals in a partnership when it ruled in favor of two former officers of Collins & Aikman Corp. (C&A), David Stockman and J. Michael Stepp.  The officers had sued for advancement of legal fees and indemnification from C&A’s majority investor, Heartland Industrial Partners LP (Heartland), for expenses arising from civil and criminal proceedings against them stemming from their C&A service.  The Chancery Court held: (1) ambiguous agreements must be construed against the entity, be it a partnership or corporation, and not the individual; and (2) a director is entitled to indemnification for proceedings that the director won without the need to wait until all proceedings against that director have concluded.  The case is likely to have important implications for officers and directors of hedge funds or hedge fund managers that are organized as Delaware limited partnerships.  We discuss the factual background of the case and the court’s legal analysis. Read full article …