The recent proposal to amend the Custody Rule has occasioned a flurry of comment letters from hedge fund industry participants, lawyers and other interested parties.  The amendments to the Custody Rule were proposed in part in response to recent fraudulent activities involving investment advisers and affiliated custodians.  While the amendments as a whole are intended to make it more difficult for registered investment advisers to misuse funds for which they serve as custodian, some portions of the amendments, according to various comment letters, would present difficulties in practice.  In particular, one aspect of the proposed amendments about which hedge fund managers have significant questions is the proposed requirement that hedge fund managers relying on the so-called audit approach that liquidate a hedge fund prior to the fund’s fiscal year end prepare audited financial statements upon liquidation.  The Securities and Exchange Commission (SEC) alleges that this “at liquidation” audit requirement is simply a “clarification” of standard practice, but practitioners interviewed by the Hedge Fund Law Report did not uniformly agree.  Further, there are questions regarding the timing of the liquidation audit and whether an audit upon liquidation should be required if it would occur close in time to when the hedge fund’s annual audit would be performed.  Finally, the liquidation audit requirement begs the question of what, in this context, constitutes a liquidation, and whether a hedge fund that is merged into another hedge fund will be considered to have liquidated and thus need to perform a liquidation audit.  This article addresses these and related issues. Read full article …

Despite accounting rules that generally permit banks to carry residential mortgages at cost and thus serve as a disincentive to sell, banks have begun unloading residential mortgages for two primary reasons: pressure from regulators (especially the Federal Deposit Insurance Corporation (FDIC)) and improvements in other operating or investment areas that can offset loan losses.  Hedge funds have been buyers, to a degree, but hedge funds’ appetite for whole residential mortgages (as opposed to mortgage-backed securities) is limited by a dearth of servicers who are willing or able to modify mortgages in a manner that will serve the hedge funds’ investment goals.  Since a significant amount of value in mortgage investing may be captured via modification, the limited field and ability of existing servicers has constrained purchases by hedge funds from banks of residential mortgages.  In response, various hedge fund managers are launching or buying servicers.  As noted by Paul Watterson, a Partner at Schulte Roth & Zabel LLP: “Some institutional investors feel like they are not getting enough attention from these mortgage servicers, particularly for scratch and dent loans, and so they are launching or buying servicers so the loans get the attention they seemingly deserve.”  (“Scratch and dent loans” generally refers to non-performing, or sub-performing mortgages.  The phrase can also apply to re-performing mortgages – mortgages that have been modified so they are performing again but still may fall back into default.)  Owning a servicer offers the opportunity to create value in mortgages, but it also can expose a hedge fund manager to liability for, to name just a few items, predatory lending claims or misrepresentation, to the extent the manager is involved in or controls modification decisions.  At worst, the manager may be exposed to a buy back obligation.  However, hedge funds that purchase or start servicers can structure transactions to mitigate liability concerns.  As a practical matter, managers contemplating ownership of servicers also face a “buy or build” question, and have to contend with various barriers to entry (practical and regulatory) into a non-core business.  We analyze these and other issues involved in ownership by hedge fund managers of mortgage servicers. Read full article …

Loan-to-own strategies are becoming increasingly popular among hedge funds, especially those with a credit orientation.  Generally in such strategies, a hedge fund purchases debt of a company with the goal of converting that debt into a control equity position though a triggering event, such as a bankruptcy, other restructuring or recapitalization.  In many such circumstances, the pre-event equity is wiped out.  Not surprisingly, the popularity and prevalence of such strategies increases as economic conditions worsen – and thus as the distressed opportunity set widens.  Moreover, as a route to equity ownership, a loan-to-own strategy offers a certain degree of safety relative to an outright acquisition of the equity or assets of a company: even if the loan-to-own strategy is aborted in media res, the hedge fund investor still may sell the acquired debt at a profit.  But for credit-focused hedge funds, a loan-to-own strategy that actually ripens into ownership raises a ticklish question: what to do once you own?  That is, credit hedge funds generally are in the business of purchasing passive stakes in the debt of companies, then selling those stakes, ideally at a price above the price at which they were purchased.  But majority equity ownership is a very different ballgame from passive debt investment: majority equity ownership requires different managerial competencies, personnel, fund structures and time horizons.  It also exposes a fund and its manager to different categories of liability.  So how can traditional credit hedge funds see a loan-to-own strategy through to its conclusion?  That is, how can they own?  Or what can they do in anticipation of ownership to mitigate the legal and practical difficulties of owning equity in a fund organized to invest in debt?  We address these questions, and in the course of our analysis discuss distressed debt funds, dedicated loan-to-own funds, cross trading concerns and lender liability issues. Read full article …

The Federal Deposit Insurance Corporation (FDIC) has recently faced the daunting task of salvaging an ever-increasing number of failed depository institutions.  Indeed, 45 insured institution closings occurred in the first two quarters of 2009, nearly double the total for all of 2008.  Concomitantly, the FDIC recognized the increased interest from private equity capital in acquiring or investing in the assets and assuming the deposit liabilities of failed depository-insured banks or thrift institutions.  In response, on August 26, 2009, the FDIC released a Final Statement of Policy on Qualifications for Failed Bank Acquisitions (the Final Statement) to provide guidance to these interested private capital investors.  The Final Statement offers guidance to private investors, including hedge funds, on the terms and conditions the FDIC will require to obtain bidding eligibility of a failed bank.  It does not establish civil or criminal penalties, but rather offers guidance to investors that agree to its terms.  The FDIC issued the statement to attract private investment capital for the purpose of purchasing deposit liabilities, or both the liabilities and assets of a failed insured depository institution.  The Final Statement reflects changes made in response to public comments on the Proposed Statement of Policy on Qualifications for Failed Bank Acquisitions released by the FDIC on July 2, 2009 (the Proposed Statement).  This article summarizes both the most salient terms of the Final Statement and the key differences between the Final Statement and the Proposed Statement. Read full article …

London is one of the world’s premier centers of hedge fund management.  A recent ranking of the world’s 11 most successful hedge fund managers listed two headquartered in London: Winton Capital Management and Brevan Howard Asset Management.  But there has been, for months now, a good deal of talk about an exodus of hedge fund managers from the U.K.  That talk has been fueled by two factors: recent tax law changes and the European Commission’s proposed Alternative Investment Fund Managers Directive (Draft Directive).  We detail the tax law changes, and analyze whether they and the Draft Directive really have the potential to engender the much-discussed flight, or whether such flight constitutes an exaggerated threat. Read full article …

Crushing litigation has plagued the seemingly indestructible Terminator franchise in recent months.  On August 17, 2009, the Halcyon Company, which had purchased the rights to the Terminator franchise, and its wholly owned subsidiary, Halcyon Games, LLC (together, Halcyon), filed for bankruptcy.  On that day, Halcyon also filed a lawsuit in Los Angeles Superior Court accusing Kurt Benjamin of fraudulent dealings in setting up financing for Halcyon’s purchase of the Terminator franchise from Pacificor, LLC, a hedge fund.  In yet another lawsuit filed August 17, 2009, Dominion Group, LLC, a company that possessed common ownership with Halcyon, asked the same court to expunge a lien Pacificor had filed against it.  Dominion claimed Pacificor filed the lien to prevent Dominion from raising capital on behalf of Halcyon, which caused Halcyon to default on its payments to Pacificor.  This article summarizes the factual allegations contained in both complaints. Read full article …

The New Jersey Superior Court has thrown out claims that hedge fund manager S.A.C. Capital Advisors (SAC) conspired with other firms, including the independent research firm Gradient Analytics, Inc. (formerly known as Camelback Research Alliance, Inc.) (Gradient) to drive down the stock price of Canada’s largest publicly-traded pharmaceutical company, Biovail Corporation (Biovail).  The court dismissed the suit after it determined that Biovail failed to prove it was entitled to damages and that, in any event, the court lacked jurisdiction over all but one of the defendants.  Most notably, the court stated that it did not evaluate the merits of Biovail’s claims against SAC or Gradient.  We describe the court’s reasoning as to why the research company’s reports did not give rise to a viable claim and why the court lacked jurisdiction over the parties. Read full article …

On September 1, 2009, multi-jurisdictional law firm Conyers Dill & Pearman announced the appointment of Craig Fulton as head of its Mauritius office. Read full article …