Oct. 15, 2009

Implications of Recent IRS Memorandum on Loan Origination Activities for Offshore Hedge Funds that Invest in U.S. Debt

On September 22, 2009, the Internal Revenue Service (IRS) Office of Chief Counsel issued a memorandum concluding that “interest income received by a foreign corporation with respect to loans that it originated to U.S. borrowers constitutes income effectively connected” with the conduct of a U.S. trade or business and is subject to net income tax in the U.S.  Some hedge fund managers – especially those with funds focused on credit or lending – are concerned that the memo presages more focused attention by the IRS on investments by offshore hedge funds in U.S.-based debt.  Other managers think the memo’s effect on hedge funds may be limited because it addresses a narrow fact pattern that differs in important ways from the typical approach taken by offshore funds to investments in U.S. debt.  However, even those that distinguish the memo on its facts concede that, at a broader level, the memo may indicate a disposition on the part of the IRS to take a harder look at lending activities by offshore entities in general.  The concern here is that even if this memo does not capture typical hedge fund investments within its purview, another memo that does may be in the offing.  This article details the fact pattern and legal conclusions of the memo, then analyzes the potential implications of the memo for offshore hedge funds.  In particular, the article explores: the extent to which the fact pattern in the memo resembles and departs from the typical structure of investments by offshore hedge funds in U.S. debt; efforts by offshore funds to structure debt investments to fit within the securities trading safe harbor; the components of lending activities that typically are and are not carried on by offshore hedge funds; secondary market purchases of U.S. debt by offshore hedge funds; whether the memo applies with greater or lesser force to the purchase by offshore hedge funds of loan portfolios; the leveling effect of the memo on the difference between independent and dependent agents; the effect of the memo on the tax concept of an “office” in the U.S.; and how the memo has already and is likely to, going forward, affect the structuring of offshore hedge funds.

Will the Proposed Out-of-Court Plan Help or Hinder Efforts of Hedge Fund Creditors to Recover Assets from Lehman Brothers International Europe?

The administrators of Lehman Brothers International Europe (LBIE), PricewaterhouseCoopers (PwC), continue to try to formulate a speedy and viable process for returning hedge fund client assets.  After a proposed scheme of arrangement (Scheme) was rejected by the High Court in London, PwC unveiled a contractual solution (Solution) as an alternative to the proposed Scheme.  PwC said in a statement that the Solution would allow them to distribute “a very significant portion” of the $8.9 billion in assets currently under their control directly to creditors.  According to PwC, the Solution offers substantially the same terms to investors as the Scheme.  The key difference is that the contracts by which the Solution would be effectuated do not need court approval.  LBIE is the U.K. broker-dealer affiliate of Lehman Brothers Holdings Inc., and served as a prime broker to various hedge funds.  On September 15, 2008, LBIE was placed into administration in the U.K.  The U.K. court appointed several PwC partners as joint administrators of the LBIE estate.  When LBIE collapsed, the assets of its hedge fund clients were frozen.  In the intervening year and change, those hedge funds clients have endured a long and tortuous process in an effort to retrieve their assets.  For more on the LBIE Scheme, see “How Can Hedge Funds Get Their Money Out of Lehman Brothers International Europe?,” Hedge Fund Law Report, Vol. 2, No. 31 (Aug. 5, 2009).  This article aims to help hedge fund managers with assets tied up in the LBIE administration determine whether or not to participate in the Solution.  To do so, the article examines: the mechanics of the Solution; the mechanics of the Scheme; how net equity claims would be computed and valued under both the Solution and the Scheme; recourse available to LBIE clients that participate in the Solution but disagree with valuations of claims; timing and mechanics of distribution of assets under the Solution; effect of the Solution on non-participating creditors; and the primary benefits and drawbacks to hedge funds of participating in the Solution.

Massachusetts’ Lawsuit Against Hedge Fund Manager Bulldog Investors and Its Principal, Phillip Goldstein, Survives Free Speech Challenge

On September 30, 2009, the Massachusetts Superior Court ruled that an administrative action by Massachusetts securities regulators against activist hedge fund manager Bulldog Investors, its principal Phillip Goldstein and its affiliated funds, for selling unregistered securities over an Internet website, did not violate the defendants’ First Amendment rights.  The court found that the regulations challenged by the defendants as an unconstitutional abridgement of their right to freedom of speech fulfilled the criteria for testing such a First Amendment challenge as set forth by the United States Supreme Court in Central Hudson Gas & Electric Corp. v. Public Serv. Comm’n, 447 U.S. 557, 561 (1980).  As required by that decision, the court found that the regulations advanced the state’s interest in protecting the capital markets and did not intrude on speech any more than necessary to achieve that objective.  This article summarizes the background of the action and details the court’s legal analysis.

Hedge Fund Bondholders Sue Aristocrat Leisure for Failure to Convert Bonds On Demand; Federal Court Limits Evidence to be Presented at Trial

In 2001, Aristocrat Leisure Limited (Aristocrat) issued $130 million of convertible bonds due in May 2006.  The bonds were purchased by a variety of financial institutions and hedge funds.  In December 2004, Aristocrat commenced a suit seeking a declaratory judgment to correct an alleged “scrivener’s error” in the exchange rate under the bonds.  After commencement of the suit, the bondholders sought to convert the bonds into shares of Aristocrat common stock.  Aristocrat refused and further litigation ensued.  The United States District Court for the Southern District of New York previously determined that an attempt by Aristocrat to call the bonds was ineffective and that Aristocrat had breached the bond indenture by failing to convert the bonds when demanded.  The court ruled that not only were the bondholders entitled to general damages equivalent to the value of Aristocrat stock on the date that conversion was demanded, but that they were also entitled to consequential damages stemming from the hedge funds’ need to cover short positions in Aristocrat stock that the funds had taken to hedge their bond purchases.  Aristocrat countered that consequential damages should be limited because the hedge funds kept open their short positions in Aristocrat stock long after Aristocrat refused to convert its bonds and thereby failed to mitigate their damages.  On September 28, 2009, the court issued a new ruling in the case.   We discuss the more recent ruling, and provide additional background on the prior ruling.  The case is of particular interest to hedge funds employing a convertible bond or convertible arbitrage strategy.

House Subcommittee Considers Bill Requiring U.S. Hedge Fund Advisers with Over $30 Million in Assets Under Management to Register with SEC

On October 1, 2009, in an effort to ensure that “everyone who swims in our capital markets has an annual pool pass,” Representative Paul E. Kanjorski (D-PA) released a “discussion draft” of a bill that would amend the Investment Advisers Act of 1940 (IAA) by requiring advisers to certain unregistered investment companies, including hedge funds, to register with and provide information to the Securities and Exchange Commission (SEC).  The proposed “Private Fund Investment Advisers Registration Act of 2009” (Draft) was released just prior to a House Financial Services Subcommittee on Capital Markets hearing held on October 6, 2009.  The bill generally would require U.S. hedge fund advisers with assets under management collectively across their funds of over $30 million to register with the SEC, even if the adviser has fewer than 15 “clients.”  Kanjorski’s draft essentially mirrors the U.S. Treasury Department’s bill by the same name which was released in July 2009 (Treasury Bill).  See “U.S. Treasury Department Proposes Legislation Requiring Registration of Hedge Fund Advisers,” Hedge Fund Law Report, Vol. 2, No. 29 (Jul. 23, 2009).  This article analyzes the Draft and the Treasury bill, detailing the mechanics of each and noting how they are similar and different on points such as the collection of systemic risk data, information required to be reported, a registration exemption for venture capital fund advisers and expansion of the SEC’s authority to obtain information on the identity, investments or affairs of any client of a hedge fund adviser.  This article also details industry reactions to the Draft as embodied in testimony by representative of the Managed Funds Association, the Private Equity Council, the Coalition of Private Investment Companies and the National Venture Capital Association at the October 6 hearing before the House Financial Services Subcommittee on Capital Markets.

Participants at Third Annual Hedge Fund General Counsel Summit Discuss Adviser Registration, Side Letters, SEC Audits and Enforcement, Fund Restructurings and More

On October 1, 2009, the Third Annual Hedge Fund General Counsel Summit convened in Old Greenwich, Connecticut, organized by Corporate Counsel and Incisive Media Events.  The one-day conference featured eight panel discussions focusing on topics including the following: changes in the regulatory and enforcement practices of the Securities and Exchange Commission (SEC); the “foregone conclusion” that the U.S. Congress will soon pass a bill requiring the registration of certain hedge fund advisers; how to prepare for an SEC audit; side letter terms and tracking; and hedge fund restructurings in the U.S., Cayman Islands and British Virgin Islands.  A recurring theme among the various panels was the newfound relevance of compliance and robust controls in the hedge fund business, and the concomitant growth in importance within hedge fund managers of the general counsel and chief compliance office (often the same person).  This article discusses the most salient points raised at the conference.

Paul, Weiss Announces Addition of Robert D. Goldbaum to the Firm’s Investment Management Group

On September 10, 2009, Paul, Weiss, Rifkind, Wharton & Garrison LLP announced that Robert D. Goldbaum joined the firm as a partner in its Corporate Department and Investment Management Group, focusing on merger and acquisition transactions in the investment management industry.