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    Oct. 7, 2009

How Can Hedge Fund of Funds Managers Manage a “Liquidity Mismatch” Between Their Funds and Underlying Hedge Funds?

The growing trend toward retailization of hedge funds of funds (FOFs) faces a considerable practical hurdle: retail investors demand frequent liquidity, while many of the more interesting opportunities for underlying hedge funds remain in less liquid investments.  See, e.g., “Why Does Capital Raising for Distressed Debt Hedge Funds Remain Particularly Challenging Despite the Recent and Anticipated Positive Performance of the Strategy?,” Hedge Fund Law Report, Vol. 2, No. 39 (Oct. 1, 2009).  For example, Alexandre Poisson, managing director of FOF HDF Switzerland recently stated that a well-structured FOF portfolio can give investors “monthly access to their money rather than quarterly, without any mismatch.”  But he added an important caveat: to accomplish this, the FOF must avoid illiquid strategies among its underlying funds.  At best, such avoidance restricts investment decision making.  At worst, it renders FOFs ineligible for some of the best opportunities, and thereby constrains alpha.  Are there better ways to reconcile liquidity and investment discretion?  To address this question – and hopefully to expand the range of options available to FOF managers looking to maintain their strategic approach while accessing a broader retail market – this article discusses the practical and legal bases for the obligation on the part of FOF managers to conduct thorough due diligence, especially with respect to the match between the liquidity of the FOF and the hedge funds in which it invests; the so-called “FOF regulatory loophole”; structural changes in the FOF market; the benefits and burdens of investments by FOFs in only liquid underlying funds; the early notification approach; FOF disclosure matters; side letters; and fee deferrals.  In addition, in mid-September 2009, the International Association of Securities Commissions (IOSCO) published a report titled “Elements of International Regulatory Standards of Funds of Hedge Funds Related Issues Based on Best Market Practices.”  The report broadly focuses on liquidity management and due diligence, and is both descriptive and prescriptive.  That is, it purports to describe how the market is, and how it should be.  We detail the salient points from the IOSCO report, and relay insights from industry participants on the extent to which the report reflects current market practice, and the extent to which the prescriptive sections may change market practice (to the extent they differ from it).

Key Tax Considerations for Hedge Funds When Investing in Life Settlements

As discussed in an article last week’s issue of the Hedge Fund Law Report, life settlements offer hedge funds an uncorrelated investment category in an era when even assets heretofore considered uncorrelated have fallen in unison.  That article, the first in a three-part series, provided a detailed overview of the primary legal and business considerations applicable to hedge funds when investing in life settlements.  See “Hedge Funds Turning to Life Settlements for Absolute, Uncorrelated Returns,” Hedge Fund Law Report, Vol. 2, No. 39 (Oct. 1, 2009).  As in any investment, tax can have a profound effect on the economic return of life settlement investments.  Accordingly, this article, the second in the three-part series, focuses on the tax considerations relevant to hedge funds, hedge fund managers and hedge fund investors in connection with investments in life settlements, including: taxation of life settlements (including income versus capital gains treatment of the “gain” on life settlements); varying tax consequences for domestic and offshore hedge funds and hedge fund investors; the impact of recent Internal Revenue Service (IRS) Revenue Rulings on the tax consequences of life settlement investments; relevant tax rules for offshore hedge funds (including “limitation of benefits” provisions, treaties, “effectively connected income” considerations, relevance of the jurisdictions of investors and “anti-avoidance” rules); the special cases of Ireland and Luxembourg, and the “double taxation” treaties between those jurisdictions, on the one hand, and the U.S., on the other hand (and the absence of such treaties between the U.S. and other jurisdictions, notably the Cayman Islands); the utility of the UCITS structure for investing in life settlements; tax consequences of premium financing arrangements; and the future of life settlement taxation in light of certain items in President Obama’s proposed budget.  Part three in this series will focus in more depth on securitization of life settlements.

How Can Hedge Fund Managers Minimize Tax on Deferred Compensation from Offshore Hedge Funds?

Hedge fund managers are painfully aware of the U.S. government’s efforts to eliminate the tax benefits associated with their foreign deferred compensation plans.  In 2004, Congress amended the Internal Revenue Code by adding Section 409A, which prohibited the use of foreign trusts in connection with deferred compensation plans.  More recently, in 2008, Congress enacted IRC § 457A, which makes foreign deferred compensation plans fully income taxable as of January 1, 2017.  As a result, the tax bar has been working overtime to develop tax compliant strategies that would mitigate the disastrous effects of Congress’ campaign to increase taxes on hedge fund managers’ income.  Tax attorneys’ efforts have, however, been largely unsuccessful – until now.  In a guest article, Kenneth Rubinstein, Senior Partner at Rubinstein & Rubinstein, LLP, details one strategy that has been developed that will significantly minimize the income tax payable on foreign deferred compensation and blunt the effect of IRC § 457A in a tax compliant manner.  Based on the use of a “hybrid” trust that avoids the prohibitions of IRC § 409A and utilizing the long-standing tax advantages that Congress and the Internal Revenue Code bestow upon life insurance, this strategy will allow early access to the majority of deferred compensation assets on a tax-free basis and eliminate estate tax on plan assets upon the death of the manager.

Second Circuit Rules that Contract Dispute between Hedge Fund Manager and its Placement Agent Over Proper Arbitration Venue Does Not Permit Federal Intervention

As previously reported in the Hedge Fund Law Report, placement agents in the hedge fund industry face an uncertain future after the New York pension fund kickback scandal and the Securities and Exchange Commission’s new proposed pay to play rules.  See, e.g., “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?,” Hedge Fund Law Report, Vol. 2, No. 30 (Jul. 29, 2009); “How Has the New York Pension Fund Kickback Scandal Changed the Landscape for Placement Agents, and for Hedge Fund Managers who Use Them?,” Hedge Fund Law Report, Vol. 2, No. 17 (Apr. 30, 2009).  As a result, new court decisions interpreting the interaction of placement agents and hedge fund managers, including their contractual rights, have increased significance for hedge fund industry participants.  This article describes the facts and legal analysis of one such notable decision, issued September 22, 2009 by United States Court of Appeals for the Second Circuit.

What Can Hedge Fund Managers Learn From the SEC’s Failure to Catch Madoff? An Interview with Charles Lundelius, Senior Managing Director at FTI Consulting, Inc.

FTI Consulting Inc. (FTI), a global business advisory firm, substantially assisted the Securities and Exchange Commission’s (SEC) Office of Inspector General (OIG) in preparation of its report on the agency’s responses – or failures to respond – to a series of “red flags” regarding Bernard Madoff and Bernard Madoff Investment Securities LLC (BMIS).  For more on that report, see “SEC Recommends More Hedge Fund Oversight in Audit on Its Failure to Uncover Madoff Fraud; House Oversight and Government Reform Committee Chairman Questions SEC Competence,” Hedge Fund Law Report, Vol. 2, No. 38 (Sep. 24, 2009).  Charles Lundelius, a Senior Managing Director in the FTI Forensic and Litigation Consulting Practice, led the FTI engagement team, and thus has a uniquely clear perspective on the OIG’s review, the omissions in the SEC’s approach as determined by the OIG, structural flaws at the SEC as identified by the OIG and the OIG’s suggestions for remedying those flaws.  The Hedge Fund Law Report recently interviewed Lundelius, focusing on his experience assisting the OIG in preparation of its report.  The full transcript of that interview is included in this issue of the Hedge Fund Law Report, and touches on topics including: what FTI is and what they do; the most salient red flags that were missed by the SEC in the Madoff context; structural problems that may exist at the SEC and OCIE; the tendency of investigators to view new evidence in light of old experience; how the SEC – and for that matter, hedge funds and funds of funds – can use news and information services to discover information that may lead to red flags and ultimately to decisions against investments or in favor of redemptions; how the OIG’s report can offer tips to hedge funds of funds on how to conduct effective due diligence and how to detect fraud; and the role of hedge fund manager Renaissance Technologies in the Madoff investigation.

New York State Appellate Court Reinstates Investors’ Claims Against CSAM Capital, General Partner of High-Risk Exchange Fund

In New York, the statute of limitations for fraud is the longer of six years from the wrongful conduct or two years from when the party knew, or should have discovered, the fraud.  This particular statute of limitations was at issue in a case filed by investors against CSAM Capital, Inc., the general partner of a high-risk exchange fund, and allegedly related entities (collectively referred to as CSAM), alleging, among other things, fraud in connection with the loss of their investments in the fund.  In this action, billionaire Ronald Lauder and other investors in the exchange fund brought an arbitration claim against the fund’s general partner, CSAM Capital Inc., alleging that CSAM had fraudulently misrepresented the qualifications of the fund employees who were responsible for the fund’s hedging strategy.  We describe the allegations in the case, the factual background, the trial court decision and the First Department’s decision and legal analysis.

Northern Trust to Provide Custody and Administration Services for Hedge Fund Managers that use Merlin Securities as a Prime Broker

In an article in our September 24, 2009 issue, we discussed the emergence of smaller prime brokers to fill the services void left by the focus of larger prime brokers on their larger hedge fund clients.  See “Boutique Prime Brokers are Emerging to Provide Services to Small and Mid-Size Hedge Funds Marginalized by Larger Prime Brokers,” Hedge Fund Law Report, Vol. 2, No. 38 (Sep. 24, 2009).  One of the points made in that article is that certain smaller prime brokers are partnering with trust companies to offer segregated, safer custody of hedge fund customer assets, as well as administration services.  See also “Hedge Funds Turning to Prime Brokerage Trust Affiliates For Added Protection Against Prime Broker Insolvencies,” Hedge Fund Law Report, Vol. 2, No. 25 (Jun. 24, 2009).  Consistent with this trend, on September 29, 2009, Northern Trust and Merlin Securities announced an agreement whereby Northern Trust will provide Merlin prime brokerage clients with fully integrated access to Northern Trust’s global custody and administration services.

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