Dec. 10, 2009

To What Extent Is a Hedge Fund Bound, Legally and Practically, by Its Strategy as Stated in Its Governing Documents and at Marketing Meetings?

In the hedge fund context, strategy drift (also known as style drift) broadly may be defined as a material deviation from the investment strategy represented to an investor – in the fund’s governing documents as well as orally, for example, in marketing meetings – prior to and during the investor’s investment in the fund.  Implicit in this definition is the notion that a hedge fund investor purchases a product.  But there is a competing, often more apt, view of the hedge fund investment process which holds that sophisticated investors do not invest “in a fund,” but rather “with a manager.”  While this distinction may be more theoretical than practical – manager selection matters profoundly even for less customized products like hedge fund replication ETFs, and even the most gifted managers have to articulate the layout of their product waterfront with reasonable clarity – it has important legal and drafting implications.  Investors with a product-purchase view of hedge fund investing will demand more specificity in governing documents with respect to strategy, which will narrow manager discretion and expand the range of potential strategy drift claims.  On the other hand, investors with a manager-commitment view of hedge fund investing will, other things being equal, require less granularity on strategy, and may compensate with deeper and longer manager due diligence.  For this latter category of investors, once they have satisfied themselves as to the manager’s investment competence, talent bench, infrastructure quality, risk controls and related matters, they are apt to confer a wider discretion, and less inclined to bring strategy drift claims.  But even managers who have earned the full faith and credit of their investors cannot offer apples and deliver oranges.  Strategy drift claims tend to increase in frequency during and immediately following major market dislocations.  There are two reasons for this.  First, funds launched prior to such turbulence often do not include mechanisms adequate to deal with it, especially if the nature of the dislocation is relatively unprecedented.  For example, many hedge funds launched prior to 2007 lacked mechanisms to deal with the illiquidity of 2008 in a manner satisfactory to investors.  Second, managers – rightly and consistent with their fiduciary duties – want to stem losses or seize opportunities in times of dislocation.  When such defensive or offensive moves work, investors applaud.  (We have yet to find a strategy drift claim that follows a period of positive performance.)  But when such moves fail, strategy drift claims often follow.  In light of our current posture at what appears to be the tail end of a major market dislocation, this article focuses on strategy drift in the hedge fund context and in particular covers: two recent examples of strategy drift claims; what hedge fund “strategies” are and where they are stated; what strategy drift is and the types of legal claims it may give rise to; the relevance of materiality in assessing whether an alleged departure from a stated strategy may give rise to a legal claim; the legal consequences of strategy drift; and – probably most importantly – concrete steps that hedge fund managers can take to avoid allegations of strategy drift.  One of the more heartening takeaways from this article is that, under appropriate circumstances, a manager need not be a “hostage to its documents.”

Stars in Transition: A New Generation of Private Fund Managers

The economic events of 2008 and 2009 resulted in significant displacement of star talent from market-leading investment banks and similar financial institutions, some of which have ceased to exist.  Some of those stars have moved on to their own ventures, and are launching their own investment management firms to raise hedge or private equity funds.  For most of their careers, some of these individuals, or entire teams of talent, may have thrived in larger institutional environments; however, now many are facing new challenges with practical issues they never had to address, or be bothered with, in the past.  Basic questions can range from something as fundamental and potentially complicated as “do I need to register with the SEC and what rules apply to me?” to something much more basic like “are the terms of this office lease a good deal for me?”  Any manager starting a hedge fund or private equity fund advisory business, whether an experienced veteran or first-timer, will need to think about many issues that could be broadly grouped within the following five categories: (1) seed investors/compensation arrangements; (2) registration requirements for the investment manager and its funds; (3) other regulatory issues impacting private funds; (4) the fund’s offering and operating documents; and (5) the investment manager’s business operations and service providers.  In a guest article, Ira P. Kustin, a Partner in the investment funds practice group at Akin Gump Strauss Hauer & Feld LLP, details the relevant considerations for start-up managers in each of these five categories.

Can Mutual Funds Rely on the Recent T. Rowe Price No-Action Letter to Invest in Hedge Funds?

On October 7, 2009, T. Rowe Price Associates, Inc., a registered investment adviser to, primarily, registered investment companies (i.e., mutual funds), received a no-action letter (NAL) from the SEC.  The NAL stated that the SEC would not take enforcement action under Section 17(a) or 17(c) of the Investment Company Act of 1940, as amended (the 1940 Act), or Rule 17d-1 thereunder, against T. Rowe Price, the T. Rowe Price Funds (Price Funds) or certain accounts managed by T. Rowe Price (Accounts) if: (1) T. Rowe Price caused certain mutual funds that it advises to contribute cash or securities to a newly created private fund (that is, a fund excepted from the definition of “investment company” under either Section 3(c)(1) or 3(c)(7) of the 1940 Act); (2) the private fund in turn used the cash or securities as collateral for a loan under the U.S. Treasury Department’s Term Asset-Backed Securities Loan Facility (TALF); and (3) the private fund used its own assets and the TALF loan to purchase eligible securities (including various asset-backed securities).  T. Rowe Price sought no-action relief with respect to this arrangement for two reasons.  First, it perceived an interesting and comparatively low-risk investment opportunity in asset-backed securities purchased in part with TALF loan proceeds.  Second, none of its mutual funds individually had or could acquire eligible securities (as defined by the TALF) with a value sufficient to collateralize a TALF loan (such loans have a minimum denomination of $10 million), but collectively the mutual funds had or could acquire a sufficient value of eligible securities.  For hedge fund managers, the T. Rowe Price NAL is potentially quite interesting because, at a certain level of generality, it offers no-action relief to a registered investment adviser seeking to cause its advised mutual funds to invest in a private fund.  However, the language of the NAL and the fact pattern with respect to which the SEC granted no-action relief may be too specific to have any viable precedential value for mutual fund managers considering investing in hedge funds.  In light of the importance of any authority even suggesting the possibility that mutual funds may surmount the various obstacles traditionally understood to stand in the way of investments in hedge funds, this article examines: the mechanics of the TALF program; the structure of the proposed investment outlined by T. Rowe Price in its incoming letter; the legal issues raised by the proposed structure; the primary obstacles faced by mutual funds contemplating investments in hedge funds, including valuation and affiliated transaction issues; and the likely impact of the NAL on the mutual fund and hedge fund industries, and the interaction between the two industries.

Morgan Stanley Finds Hedge Fund Assets May Rise to $1.75 Trillion by the End of 2010

According to a new report from Morgan Stanley, entitled “Hedge funds: where next (II)?,” 2010 appears likely to be a pivotal and beneficial year for hedge funds due to a rise in demand for better risk adjusted returns, the migration of talent from investment banks and the trading off of a successful 2009.  The report addresses five issues: (1) the growth outlook for the hedge fund industry; (2) the hedge fund strategies that will prosper in the foreseeable market environment; (3) the viability of the hedge fund of funds model; (4) the reality of fee compression; and (5) the risk to hedge funds from regulatory change.  Most notably, the report suggests that hedge funds provided as much as 40 percent of the money raised this year by United States and European banks as they sought to offset losses and meet government capital requirements.  Of equal note, it also suggests that hedge fund assets may rise to $1.75 trillion by the end of 2010.  This article details the report’s most salient findings and its implications for the hedge fund industry.

As Debate over Amendment of Bankruptcy Rule 2019 Continues, Delaware Bankruptcy Court Finds that Current Rule 2019(a) Mandates Disclosure of Economic Interests of “Loose Affiliation” of Washington Mutual Creditors

Following a run on Washington Mutual Bank (WaMu), WaMu was seized by the Office of Thrift Supervision.  The Federal Deposit Insurance Company, acting as receiver, sold “substantially all” of WaMu’s assets to JPMorgan Chase, Inc. (JPMC).  Simultaneously, WaMu’s holding company, Washington Mutual, Inc. (WMI), filed for bankruptcy protection.  As we have previously reported, certain entities, including several hedge fund managers, that held WMI debt (WMI Noteholders Group) intervened in the WMI bankruptcy proceeding to argue for a narrow construction of what assets had actually been sold to JPMC (which would have the effect of increasing the value of the WMI bankruptcy estate and, by extension, the value of the WMI Noteholders Group interests in WMI).  JPMC sought full disclosure of all information called for by Bankruptcy Rule 2019(a), not just the names of the members of the WMI Noteholders Group and the aggregate value of their interests.  Following the 2005 decision of the United States District Court for the Southern District of New York in In Re Northwest Airlines Corp., the court granted JPMC’s motion and ordered full compliance.  We discuss the court’s reasoning and the implications for investors in distressed debt.

FINRA Fines Terra Nova $400,000 for Making Over $1 Million in Improper Soft Dollar Payments to Hedge Fund Managers

On November 23, the Financial Industry Regulatory Authority (FINRA) fined Terra Nova Financial, LLC, of Chicago, $400,000 for making more than $1 million in improper “soft dollar” payments to or on behalf of five hedge fund managers.  The broker-dealer did not follow its own policies to ensure the payments were proper, according to FINRA.  We detail the factual background and legal basis for the fine imposed by FINRA.

Carl B. McCarthy, Internationally-Focused Corporate, Securities and Hedge Fund Attorney, Joins Herzfeld & Rubin, P.C.

On December 8, 2009, Herzfeld & Rubin, P.C. announced that Carl B. McCarthy joined the firm as a member.

Former SEC Deputy Director of Enforcement George Curtis Returns to Gibson Dunn

On December 7, 2009, Gibson Dunn & Crutcher LLP announced that George Curtis, former Deputy Director of the Division of Enforcement of the U.S. Securities and Exchange Commission, has returned to the firm as a partner.