Sep. 9, 2009

How Can Hedge Fund Managers Structure Their Compliance, Reporting and Disclosure Systems to Avoid Allegations of Principal Trading Rule Violations Such As Those Recently Alleged by the DOJ Against Former Bear Stearns Hedge Fund Manager Ralph Cioffi?

In a motion in limine filed in the insider trading case against Ralph Cioffi, the former head of failed Bear Stearns hedge funds, the U.S. Attorney’s Office for the Eastern District of New York alleged that Cioffi repeatedly violated the policies and procedures of Bear Stearns Asset Management, Inc. (BSAM) regarding principal trades.  Specifically, the motion alleges that despite repeated warnings from the BSAM compliance department, Cioffi repeatedly executed principal trades without making the disclosures or obtaining the consent required by Section 206 of the Investment Advisers Act of 1940 (Advisers Act).  Unlike the better-publicized allegations that Cioffi touted the glowing prospects of his funds while expressing serious misgivings about their prospects behind closed doors, or that he redeemed from his funds while in possession of material non-public information that, if public, would have severely diminished the value of the funds, the alleged principal trading rule violations are noteworthy for hedge fund managers for the same reasons that they are not front page news.  Saying X and doing Y is wrong for obvious reasons, as is redeeming when counseling investors not to redeem.  But precisely what constitutes a principal trade, when and how to obtain consent, what to disclose – these are subtler questions that may apply to any hedge fund manager with an interest in one of its own funds, whether or not the funds are on the brink of collapse.  Accordingly, the principal trading rule violations alleged against Cioffi offer a cautionary tale for hedge fund managers, and serve as an occasion to revisit the most pressing questions arising in the hedge fund context relating to principal trades, including: what precisely are the relevant principal trading rules and the statutory bases therefor?  At what threshold of ownership is a client or account of a hedge fund manager considered “owned” by that manager or its principals for purposes of the principal trading rules?  How is that ownership stake calculated?  In light of the allegations against Cioffi, what specific measures can hedge fund managers take to craft effective compliance, reporting and disclosure systems to avoid similar allegations?  What happens if a principal trade occurs without proper disclosure and consent?  This article explores these and related questions.

How Can Hedge Funds that Invest in Distressed Debt Keep Their Strategies and Positions Confidential in Light of the Disclosures Required by Federal Rule of Bankruptcy Procedure 2019(a)? (Part Two of Three)

An article in the August 27, 2009 issue of the Hedge Fund Law Report examined recent decisions that shed light on the scope of disclosure required under Federal Rule of Bankruptcy Procedure 2019(a) (Rule 2019(a)).  See “How Can Hedge Funds that Invest in Distressed Debt Keep Their Strategies and Positions Confidential in Light of the Disclosures Required by Federal Rule of Bankruptcy Procedure 2019(a)? (Part One of Three),” Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009).  This article further analyzes the issues that arise from those cases – issue that are currently under deliberation by the U.S. Bankruptcy Court for the District of Delaware in the matter of the reorganization of Washington Mutual Inc., the former holding company of failed Washington Mutual Bank.  This article draws on the views of leading practitioners in bankruptcy and other relevant legal areas to illustrate three points, among others: (1) relevant bankruptcy practice has not changed significantly since 2005, when the U.S. Bankruptcy Court for the Southern District of New York, in cases arising out of the bankruptcy of Northwest Airlines, required certain disclosures (e.g., the price and timing of securities purchases) by members of an ad hoc equity committee and refused to permit the disclosures to be made under seal; (2) the Northwest precedent has given litigants a new weapon that may be used against hedge funds that purchase distressed debt, though the effectiveness of that weapon remains to be determined; and (3) the hedge fund industry, and even some bankruptcy court judges, are looking to the Committee on Rules of Practice and Procedure of the Judicial Conference of the United States to resolve the uncertainty created by the Northwest decisions.

Do Collective Investment Management Schemes Offer a Means for Hedge Fund Managers to Access the Potentially Vast China Market?

For many hedge fund managers, China represents an enormous investment management opportunity.  However, China’s extensive capital controls have, to a degree, impeded entry into the potentially sizeable market.  To access the opportunity in a manner consistent with relevant capital controls, investment managers recently have been evaluating the potential use of collective investment management schemes (CIMs) as a means of managing assets in China.  Although hedge fund managers may not currently manage a Chinese CIM, the CIM industry in China is young and has been compared to the nascent hedge fund industry in the U.S. in the 1960s.  CIM industry observers predict that as time passes and the CIM industry matures, Chinese CIMs will increase in number and size.  As a result, hedge fund managers active in the China market or considering entering it may benefit from a thorough analysis of the relevant business and regulatory considerations raised by CIMs.  This article provides that analysis.

What Does the Comcast Victory in the Cable Market Share Limit Case Reveal About the Obama Administration’s Regulatory Approach?

Comcast Corp. scored a big legal victory when the U.S. Court of Appeals for the D.C. Circuit struck down a rule that restricted the percentage of all subscribers that any one cable operator may serve.  The Federal Communications Commission (FCC) had first imposed a 30% ownership cap in 1993 in an effort to limit the number of subscribers that large cable companies, such as Comcast, could serve.  Citing competition from satellite TV companies and the video services offered by phone companies, cable operators previously challenged the cap several times in court, but without success.  However, on August 28, 2009, Comcast, the only cable operator close to reaching the 30% limit, finally achieved a legal victory on this point.  The case, while very important to Comcast and other large cable operators, may do more than just permit cable operators to serve more than 30% of the market by number of subscribers: it may also provide insight into the regulatory philosophy of the Obama administration – in particular, how the administration approaches the definition of markets.  In a nutshell, the Comcast case suggests that in defining markets, the Obama administration may take technological innovation into account to a greater degree than its predecessor – which generally will result in a broader definition of markets.  How the Obama administration defines markets may have a fundamental impact on hedge funds that invest in regulated industries, including cable, telecom, pharma and energy.  For example, Harbinger Capital Partners reportedly is pursuing a multi-stage satellite phone venture that would require the purchase of significant amounts of radio spectrum, which in turn would require the acquisition of a satellite company or the merger of two smaller satellite companies.  These types of transactions would require FCC approval.  As a result, the regulatory approach taken by the Obama administration generally and by the FCC specifically can have a direct impact on how this venture, and others like it, proceed.  We detail the statutory and regulatory background of the Comcast case, as well as the court’s legal analysis, and discus the impact the case may have on the cable industry, and administrative law and enforcement under the Obama administration.

Jefferies Putnam Lovell Report Predicts “Winds of Change” in Asset Management M&A

In August 2009, Jefferies Putnam Lovell, the investment banking group of Jefferies & Company, Inc., published a strategic analysis of asset management industry activity entitled “Winds of Change: First-Half 2009 M&A Activity in the Global Asset Management, Broker/Dealer, and Financial Technology Industries.”  According to this report, strategic expansion purchases will overtake survival as the main catalyst of Wall Street’s merger and acquisition (M&A) business for asset management companies over the coming year as the economy resurges.  After describing the overall decrease in deal activity during the first half of 2009, the report projects that overall deal volumes will pick up over the coming year as confidence grows that the economic crisis has passed and as divestitures continue to drive deal activity.  The report foretells that sellers’ motivations over the coming year will be driven by factors other than just a need to raise capital, including product diversification and liquidity for retiring owners.  Most notably, the report also suggests that private equity buyers, including hedge funds, will return to the business of acquiring companies even in industries that have been hit hard by the recession.  This article summarizes the most salient findings of the report and its implications for the hedge fund community.

Federal Court Dismisses Investor’s Fraud Complaint against Apex Equity Funds, Effectively Holding that SEC Rule 10b-5 Applies to the Purchase of Private Hedge Fund Interests

Plaintiff Richard Kelter invested almost $4 million with the Apex Equity Options Fund, L.P. hedge fund (Apex or the Fund).  He alleged that virtually all of his investment evaporated when the Fund entered into a very large unhedged call contract.  Kelter sued, claiming that the Fund breached various representations about the Fund’s practices, including that his principal would be safe and that the Fund’s options transactions would all be hedged.  On August 24, 2009, the United States District Court for the Southern District of New York dismissed his complaint, holding that: (i) there were no misrepresentations made in the private placement memorandum (PPM) or prior to its issuance and, even if there were, the PPM precluded a claim based on those representations; and (ii) the alleged misrepresentations made after Kelter’s investment in the Fund could not form the basis of a claim because they were not made in connection with the purchase or sale of a security (being induced to continue to hold a security – as opposed to being induced to buy or sell a security – does not give rise to a claim).  Notably, the court did not question Kelter’s assertion that Rule 10b-5 of the Securities Exchange Act of 1934 (Exchange Act) applied to his investment in the Fund, a hedge fund.  We explain the factual background of the case, including details the PPM language, and the court’s legal analysis.

Junior Creditors Suffer Setback at the Carwash: U.K. High Court Approves IMO Carwash Group Scheme, Wiping Out IMO’s Senior Debt Without Junior Creditors’ Approval

On August 11, 2009, the United Kingdom High Court of Justice, Chancery Division, approved the terms of related restructuring schemes in which the bankrupt IMO (UK) Ltd. (IMO), the world’s largest dedicated carwash company, would release its senior debt, subject to a subsequent transfer of its assets to certain new companies.  Because a group of IMO’s junior creditors, the mezzanine lenders, did not join the schemes prior to their approval, the court’s ruling effectively granted control of IMO to senior lenders, the holders of the senior debt and, in the process, shut out the mezzanine lenders and any potential for them to challenge the fairness of the schemes.  The court also confirmed that a U.K. company has discretion to determine the creditors with whom it wishes to enter into a debt restructuring arrangement and need not include creditors whose economic interests will not be affected by that arrangement.  We discuss the factual background of the action, the mezzanine lenders’ argument and the High Court’s legal analysis.

In Conducting Background Checks of Hedge Fund Managers, What Specific Categories of Information Should Investors Check, and How Frequently Should Checks be Performed?

Background checks or investigations of managers of hedge funds, private equity funds and venture capital funds are in the spotlight with the recent frauds involving Bernard Madoff in New York and Stanford Financial in Houston.  For defrauded investors, the focus in the Madoff and Stanford contexts has shifted to litigation and asset recovery.  For those who still are invested in third-party managed funds or are considering investing in such vehicles, the Madoff, Stanford and other scandals have emphasized the importance of investigating the background of the individuals responsible for managing the funds.  No background investigation can prevent all fraud.  However, background investigations can indicate signs of a checkered past, which in turn can increase the risk profile of a potential investment.  In a guest article, Jack McCann and Daniel Weiss, both of investigation firm McCann Global, discuss the specific categories of information that investors should look into when conducting a background check on a hedge fund manager, the frequency with which background checks should be performed (and renewed) and the manner in which background checks should (and should not) be performed.

Ropes & Gray Announces that Michael J. Guilday has Joined the Firm’s Private Investment Fund Group

On September 2, 2009, Ropes & Gray LLP announced that Michael J. Guilday joined the firm’s Private Investment Fund Group in the firm’s Hong Kong office.  Throughout a career that involved practicing in London, Hong Kong and Australia, Guilday has led a range of complex international corporate transactions, including investment fund structuring and organization (either to U.S. or U.K. market standards), private and public capital raisings, and M&A transactions.  Guilday has also worked on many high-profile deals, including the first collateralized debt obligation and real estate fund to be listed on the London Stock Exchange.

3rd Annual Hedge Fund General Counsel Summit, October 1, 2009, Greenwich, CT

The troubled economy, recent industry scandals and a new administration calling for increased accountability and regulation is driving the hedge fund industry into a perfect storm.  Hedge fund executives must monitor the winds of change to protect their funds, their reputations and their investors.  The 3rd Annual Hedge Fund General Counsel Summit, taking place on October 1, 2009, in Greenwich, CT, will address these and other concerns by delivering cutting-edge information and facts essential to success in today’s climate.