Oct. 21, 2009

Specific Steps that Hedge Fund Managers Can Take to Increase the Likelihood of an Investment from a Sovereign Wealth Fund

Sovereign debt has been the historical repository of foreign exchange reserves.  In the old model, state enterprises would export goods (often commodities, such as oil) abroad, and the revenue from such sales would be used to purchase debt issued by other governments or their subdivisions, often the U.S. Treasury.  Alternatively, private firms would export goods produced with a state license, thereby generating tax revenue that the host country invested in sovereign debt.  With the bull run in commodities that began in the late 1990s, the foreign exchange coffers of various nations – especially the oil-rich – swelled, and the financial authorities in those nations took notice.  Rather than reflexively pouring growing foreign exchange reserves exclusively into sovereign debt, resource rich countries and other countries organized sovereign wealth funds (SWFs).  The goals of such funds included more concerted and disciplined management of reserves, and diversification among asset classes, industries and geographies.  For various countries, SWFs represented an effort to surmount the “resource curse” – the paradox in which development is often stunted in a nation rich in a single or a few natural resources.  Historically, SWFs have invested primarily in straightforward, liquid assets such as public equity and bonds, and allocated only a modest proportion of their net assets to hedge funds and other alternatives.  However, the credit crisis complicated the assumptions that undergirded that investment approach.  Among other things, the crisis demonstrated that investments in public equity – for example, in the stock of bank holding companies – could entail greater risk and exposure to more leveraged entities than investments in hedge funds.  Accordingly, SWFs are now looking to invest a greater proportion of their assets in hedge funds.  For example, in August of this year, the China Investment Corporation confirmed its plan to allocate approximately $6 billion to alternative investment strategies by the end of 2009.  For hedge funds managers still facing a difficult money-raising climate, the significant volume of assets in SWFs presents a compelling fund raising opportunity.  However, fund raising from SWFs is different in subtle but important ways from fund raising from the more traditional hedge fund investor base.  With the goal of assisting hedge fund managers in this unique but critical fund raising niche, this article explores: what SWFs are and how they are funded; the history and purpose of investments by SWFs in hedge funds; specific considerations for hedge fund managers when seeking to raise funds from SWFs; and potential concerns arising out of the receipt by hedge fund managers of SWF investments.

Billionaire Founder of Hedge Fund Manager Galleon Group, Raj Rajaratnam, Charged in Alleged Insider Trading Conspiracy

On October 16, 2009, the United States Attorney for the Southern District of New York and the Federal Bureau of Investigation announced the filing of criminal charges against several people involved with the Galleon Group family of hedge funds and New Castle Funds, LLC, for allegedly engaging in a massive insider trading scheme.  Specifically, the government accuses Raj Rajaratnam, founder and manager of Galleon, Mark Kurland, a top executive at New Castle, and Danielle Chiesi, a New Castle employee, of contacting a network of close business associates, including Rajiv Goel, a managing director at Intel Capital, Anil Kumar, a director at McKinsey & Company, Robert Moffat, an IBM senior executive, and one another to obtain confidential information about corporate earnings and takeover activity at several public companies.  The complaints also accuse Rajaratnam of using that non-public information to illegally trade on behalf of funds under his management to obtain more than $20 million in profits.  According to federal prosecutors, this criminal action, brought in two separate, but interconnected criminal complaints, is the largest ever against a hedge fund for insider trading, and it represents the first time that the government has used wiretaps to target “significant insider trading on Wall Street.”  In a related action, the Securities and Exchange Commission (SEC) also filed a civil injunctive action in the United States District Court for the Southern District of New York against Rajaratnam, Galleon Management L.P., and the aforementioned executives based on the same allegations.  Nonetheless, this case implicates far more than just the run-of-the-mill SEC civil complaint.  Instead, as the United States Attorney remarked, it “should be a wake up call” for the entire hedge fund community.  We detail the factual allegations and legal claims in the criminal and civil complaints.

Pursuit Partners, LLC v. UBS AG: Implications for Hedge Funds That Invested in Collateralized Debt Obligations and Other Structured Products

On September 8, 2009, the Connecticut Superior Court entered an order requiring two UBS entities to put aside more than $35 million to ensure that a hedge fund claiming fraud in its purchase of notes tied to UBS collateralized debt obligations (CDOs) would be adequately compensated in the event it was successful in its lawsuit against UBS.  The case, Pursuit Partners, LLC et al. v. UBS AG, et al., is notable for a number of reasons.  Chief among these is the rarity of lawsuits filed by purchasers of CDOs notwithstanding the anecdotal evidence indicating that most CDOs have suffered massive declines in value.  The lack of lawsuit filings by CDO purchasers has continued to puzzle industry experts who confidently predicted that the subprime mortgage crisis would result in an explosion of litigation by purchasers of securities and derivatives tied to subprime mortgages including CDOs.  There is no obvious explanation for why this expected litigation explosion did not occur beyond the general distaste that non-public institutional investors seem to have for lawsuits in general and the almost universally held assumption within the hedge fund industry that nobody could have anticipated the collapse of the subprime mortgage securities market.  The Pursuit case however, renders that assumption highly suspect.  As the limitations clock for filing suit continues to tick down for purchasers, hedge funds with significant losses in mortgage-backed securities, especially those headquartered in Connecticut, should examine closely the Pursuit court’s holding in evaluating any decision not to pursue litigation against sellers.  In a guest article, Darren Kaplan, a Partner at Chitwood Harley Harnes LLP, analyzes the factual background of the Pursuit case; the court’s legal analysis; and the lessons that hedge fund managers can draw from the case.

U.S. House of Representatives Holds Hearing on Hedge Fund Adviser Registration

On October 6, 2009, the U.S. House of Representatives, Financial Services Committee held a hearing on three legislative proposals regarding: (1) investor protection; (2) private fund adviser registration; and (3) insurance information.  The proposals, introduced by Rep. Paul Kanjorski (D-Pa.), Chairman of the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, are aimed at reforming the regulatory structure of the financial services industry and largely mirror proposals released by the Senate and the Obama administration.  See also “House Subcommittee Considers Bill Requiring U.S. Hedge Fund Advisers with Over $30 Million in Assets Under Management to Register with SEC,” Hedge Fund Law Report, Vol. 2, No. 41 (Oct. 15, 2009).  At the sparsely-attended hearing, regulators and industry advocates largely expressed support for the proposals.  Rep. Spencer Bachus (R-Al.), for example, called private funds, including hedge funds, “a valuable cog in our economy.”  (Notably, however, the hearings took place before charges against Raj Rajaratnam of the Galleon Group were made public.  See “Billionaire Founder of Hedge Fund Manager Galleon Group, Raj Rajaratnam, Charged in Alleged Insider Trading Conspiracy,” above, in this issue of the Hedge Fund Law Report.  While the charges against Rajaratnam and others have more to do with a group of allegedly bad actors, and less to do with hedge funds per se, press reports already have begun to conflate the hedge fund structure with the alleged insider trading.)  Despite the overall productive tone of the hearing, a major question remains: how quickly will Congress move with the proposed hedge fund adviser registration legislation?  This article summarizes the most relevant topics of discussion at the hearing, including commentary from members of Congress on the three bills, and concludes with a discussion of likely timing of legislative action.

How Will the New Cayman Islands Insolvency Regime Affect the Winding-Up of Cayman Islands Hedge Funds?

On March 1, 2009, the Cayman Islands Legislative Assembly implemented a new insolvency regime applicable to, among others, hedge funds organized there.  Market participants surveyed by the Hedge Fund Law Report agree that the new regime does not dramatically change the insolvency regime applicable to hedge funds, but may empower liquidators and courts to pursue claims by insolvent companies of fraudulent pre-petition trading.  This article reviews the mechanics of the new insolvency regime that are relevant to hedge funds (including providing statutory language); the new regime’s effect on the powers of liquidators and courts; whether the outcome in the case In the Matter of Strategic Turnaround Master Partnership Limited (12 December 2008) would have been different had the new regime been in effect in December 2008, when the case was decided; the “cash flow” definition of insolvency in the Cayman Islands; when a Cayman Islands hedge fund investor becomes a creditor of the hedge fund from which the investor has redeemed; the anticipated impact of the legal changes on the number of hedge funds domiciled in the Caymans; the effect of the law on in-kind redemptions; and the likelihood that the Caymans will impose an income or capital gains tax on hedge funds or their managers to make up a budget shortfall.

Hedge Fund Association Hosts Capitol Hill Symposium Focused on Hedge Fund Adviser Registration and Hedge Fund Industry Regulation

On October 5, 2009, the Hedge Fund Association (HFA) held its third annual Capitol Hill Symposium in Washington, DC.  This year’s symposium addressed many of the regulatory proposals pending before Congress that would affect the global hedge fund industry.  Although there are numerous bills currently pending, the symposium focused on two recent proposals in the House of Representatives: (1) the Investor Protection Act, which would hold broker-dealers that provide investment advice to the same fiduciary duty standard as investment advisers; and (2) the Private Fund Adviser Registration Act, which would require most hedge fund managers to register with the Securities Exchange Commission as investment advisers.  See “U.S. House of Representatives Holds Hearing on Hedge Fund Adviser Registration,” above, in this issue of the Hedge Fund Law Report.  See also “House Subcommittee Considers Bill Requiring U.S. Hedge Fund Advisers with Over $30 Million in Assets Under Management to Register with SEC,” Hedge Fund Law Report, Vol. 2, No. 41 (Oct. 15, 2009).  Rep. Paul Kanjorski (D-Penn.), the sponsor of the bills, spoke at the symposium, offering his thoughts on the need for and timing of the legislation.  We discuss the more noteworthy ideas raised at the symposium, including: The Hedge Fund Association’s position on hedge fund regulation and the rationale for its position; Rep. Kanjorski’s keynote address; credit ratings reform; international coordination of regulatory efforts; industry reactions to the Investor Protection Act and Private Fund Adviser Registration Act; and the practical risks inherent in increased regulation of the hedge fund industry.

BNY Mellon’s Pershing Unit Releases White Paper Detailing Best Practices for Hedge Fund Outsourcing Solutions

As the global economy struggles to find stability in today’s volatile marketplace, the hedge fund industry faces new challenges after years of unprecedented growth.  According to the white paper, “Fueling Growth: Outsourcing Solutions for Hedge Funds,” published by Pershing LLC, a BNY Mellon company, and Aite Group LLC, this growth has created an entire industry of service providers dedicated to fulfilling hedge funds’ “outsourcing” needs.  The industry includes service providers such as prime brokers, fund administrators and information technology companies.  However, at the same time, the recent increase in client redemption requests has threatened the viability of even the most well-managed hedge funds.  As a result, while hedge funds struggle to recover from heavy losses and fund managers reassess their overall investment strategies, the white paper predicts that the need for outsourcing support may increase within the hedge fund community.  In response, the white paper provides managers with a list of best practices for outsourcing and a systematic framework for helping them select and manage relationships effectively with third-party outsourcing solution providers.  This article summarizes the findings of the white paper, including the many factors hedge funds should consider when establishing an outsourced vendor relationship, such as cost, evaluating disparate information, balancing internal resources, prioritizing short and long-term business goals and establishing appropriate relationship metrics.

Broker-Dealer BTIG LLC Expands Capital Introduction Team with Appointments of Jennifer Bloom and Catherine Wagner

On October 21, 2009, BTIG LLC, a broker-dealer specializing in institutional trading and related brokerage services, announced that it had expanded its Capital Introduction team with the addition of Jennifer Bloom and Catherine Wagner as Vice Presidents to help drive the firm’s services to its Prime Brokerage and Outsource Trading clients.