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    Dec. 30, 2009

Bills in Congress Pose the Most Credible Threat to Date to the Continued Tax Treatment of Hedge Fund Performance Allocations as Capital Gains

On December 9, 2009, the U.S. House of Representatives passed the Tax Extenders Act of 2009 (Extenders bill), H.R. 4213.  The bill, if it were to become law, would extend through the end of 2010 a package of tax relief provisions that otherwise would expire at the end of 2009.  Of particular interest to hedge fund managers are several provisions of the Extenders bill included with the goal of raising revenue to offset extended tax relief measures.  Specifically, the bill includes a provision that would tax as ordinary income any net income derived with respect to an “investment services partnership interest.”  The bill defines “investment services partnership interest” as a partnership interest held by a person where it is reasonably expected that the partner or a person related to the partner will provide substantial investment services to the partnership.  The result of this provision would be to change the tax treatment of the performance allocation that constitutes, in up years, the bulk of hedge fund manager revenue.  Currently, most managers structure performance allocations so that all or most of such compensation is taxed as long-term capital gains at a rate of 15 percent.  The Extenders bill would tax such compensation as ordinary income, generally for hedge fund managers at a marginal rate of approximately 35 percent.  In addition, as ordinary income, such compensation would be subject to any applicable self-employment taxes and state and local taxes.  See generally “IRS ‘Managed Funds Audit Team’ Steps Up Audits of Hedge Funds and Hedge Fund Managers, and Investigations of Hedge Fund Tax Compliance Issues,” Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009).  As discussed in more detail in this article, the Extenders bill also includes provisions that are similar to the reporting provisions in the proposed Foreign Account Tax Compliance Act of 2009 (FATCA), introduced in the Senate as S. 1934 and in the House (with the same name) as H.R. 3933.  With the support of President Obama and Treasury Secretary Geithner, FATCA was introduced on October 27, 2009 as a means of combating overseas tax havens.  FATCA would affect all foreign financial institutions (FFIs) that invest in U.S. stocks and securities.  Complying FFIs would be required to report financial account information of all U.S. persons to the Internal Revenue Service or subject all payments of U.S. source passive income and gross proceeds from the sale of U.S. securities to a 30 percent withholding tax.  This article details and analyzes the provisions of the Extenders bill and FATCA that are most relevant to hedge fund managers.  Where provisions of the two bills are similar, this article compares specific mechanics.  This article also highlights the differences between the two bills, and discusses, with the benefit of insight from leading practitioners, the implications of the bills for hedge fund manager compensation, tax planning, domicile, structuring, reporting, treatment of so-called “recalcitrant account holders” and more.

Why Are Most Hedge Fund Investors Reluctant to Sue Hedge Fund Managers, and What Are the Goals of Investors that Do Sue Managers? An Interview with Jason Papastavrou, Founder and Chief Investment Officer of Aris Capital Management, and Apostolos Peristeris, COO, CCO and GC of Aris

An article in last week’s issue of the Hedge Fund Law Report detailed a ruling by the New York State Supreme Court permitting a lawsuit by funds managed by Aris Capital Management (Aris) to proceed against hedge funds in which the Aris funds had invested and the managers of those investee funds.  See “New York Supreme Court Rules that Aris Multi-Strategy Funds’ Suit against Hedge Funds for Fraud May Proceed, but Negligence Claims are Preempted under Martin Act,” Hedge Fund Law Report, Vol. 2, No. 51 (Dec. 23, 2009).  That lawsuit is one of various suits brought by Aris and its managed funds against hedge funds or managers in which the Aris funds have invested.  The Aris suits allege a variety of claims in a variety of circumstances, but collectively are noteworthy for their mere existence.  In the hedge fund world, there has been a conspicuous absence during the past two years of legal actions by hedge fund investors against hedge fund managers, despite the coming-to-fruition of circumstances that industry participants thought, pre-credit crisis, would augur an uptick in litigation: the imposition of gates, suspensions of redemptions, mispricing of securities, large losses, etc.  Jason Papastavrou, Founder and Chief Investment Officer of Aris, appears to have broken ranks with what seems like an unspoken agreement in the hedge fund world to avoid the courthouse steps, and he has done so with a considerable degree of thoughtfulness, for specific reasons and with particularized goals.  In an interview with the Hedge Fund Law Report, Papastavrou and Apostolos Peristeris, COO, CCO and GC of Aris, discuss certain of their lawsuits, why they brought them, what they seek to gain from them and what the relevant managers might have done differently to have avoided the suits.  They also discuss: seven explanations for the reluctance on the part of most hedge fund investors to sue managers; the fund of funds redemption process; how their lawsuits have affected their due diligence process; in-house administration; background checks; the importance of face-to-face meetings; side letters; how Aris investors have reacted to the lawsuits; and Aris’ transition to a managed accounts model from a fund of funds model.

Affiliates of Hedge Fund Manager Fortress Investment Group Sue Dechert Over Opinion Letter Endorsing Marc Dreier

On December 21, 2009, Fortress Credit Corp. and FCOF UL Investments LLC (together, Fortress) sued law firm Dechert LLP in New York state court for malpractice.  Fortress accused Dechert of issuing a false opinion letter on behalf of Marc S. Dreier, without conducting any due diligence.  Fortress claims that as a result of the opinion letter, it entered into a purported $50 million loan agreement with Solow Realty & Development Company (Solow Realty) which, in reality, was a sham arranged by Dreier to misappropriate funds from Fortress for his personal use.  (Briefly, by way of background, on May 11, 2009, Dreier pleaded guilty to a complex scheme in which, among other things, he sold fraudulent notes to investors, including various hedge funds, who collectively lost at least $400 million.  On July 13, 2009, Dreier was sentenced to 20 years in prison.  See Bryan Burrough, “Marc Dreier’s Crime of Destiny,” Vanity Fair, Nov. 2009.)  We detail the allegations in the Fortress complaint – which have yet to be proven – and the relief requested by Fortress.  The parties and allegations in the Fortress complaint – the financing unit of a hedge fund manager suing a law firm in connection with a lending transaction – recall another complaint covered in last week’s issue of the Hedge Fund Law Report.  See “Cerberus Financing Unit Sues its Former Law Firm and Two of Its Partners for $55 Million for Allegedly Giving Bad Advice,” Hedge Fund Law Report, Vol. 2, No. 51 (Dec. 23, 2009).  The complaint also parallels other efforts by hedge fund managers (and in some cases hedge fund investors) – many of which have been unsuccessful – to seek redress from service providers for losses incurred during the credit crisis.  See “Appellate Division Upholds Dismissal of Complaint by Hedge Funds Holding More than $190 Million of Defaulted Loans Against Credit Suisse, as Arranger of Financing and Administrative and Collateral Agent, for Aiding and Abetting Fraud and Breach of Fiduciary Duty,” Hedge Fund Law Report, Vol. 2, No. 31 (Aug. 5, 2009); “New York Court Rules that Limited Partners of Collapsed Hedge Fund Cannot Sue Fund’s Outside Legal Counsel for Fraud and Breach of Fiduciary Duty,” Hedge Fund Law Report, Vol. 2, No. 24 (Jun. 17, 2009); “New York Supreme Court Dismisses Hedge Fund Investors’ Claims Against Prime Broker,” Hedge Fund Law Report, Vol. 1, No. 18 (Aug. 11, 2008); “Hedge Fund Service Professionals Do Not Owe Fiduciary Duty to Investors But May be Subject to Liability for Aider and Abettor Claims if Provided by State Statute,” Hedge Fund Law Report, Vol. 1, No. 6 (Apr. 7, 2009); “Madoff Feeder Funds Sue Casualty Insurers for Breach of Contract and Seek to Recoup Costs of Defending Against Liability Suits,” Hedge Fund Law Report, Vol. 2, No. 33 (Aug. 19, 2009); “New York Supreme Court orders separate trial on existence of attorney-client relationship between former hedge fund principal and outside lawyer and firm,” Hedge Fund Law Report, Vol. 1, No. 1 (Mar. 3, 2008).

SEC Accuses Former Associates at Global Financial Institutions of Tipping Friends in “Serial” Insider Trading Scheme

On December 16, 2009, the Securities and Exchange Commission (SEC) filed suit in the U.S. District Court for the Northern District of California against Vinayak Gowrish, a former associate at private equity firm TPG Capital L.P., formerly Texas Pacific Group.  The complaint accuses Gowrish of providing his friends with tips including confidential business information in a “serial insider trading scheme.”  The SEC alleges that the friends used the illegally communicated and obtained information to trade profitably in the stocks of companies engaged in mergers and acquisitions.  Gowrish’s friends – Adnan Zaman, a former vice president and investment banker at Lazard Freres & Co. LLC; Pascal S. Vaghar, who is currently unemployed; and Sameer N. Khoury, a mortgage broker – have settled with the SEC by collectively paying approximately $310,000 in disgorgement for their part in the purported scheme.  This article summarizes the SEC’s allegations in its civil suit against Gowrish, and details the terms of the SEC’s settlement with Zaman, Vaghar and Khoury.

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