Feb. 12, 2009

Hedge Fund Restructurings Becoming a Viable, and Variable, Alternative to Liquidation

Low or negative returns and high redemptions in 2008 seem to have effected a qualitative shift in the environment in which hedge funds exist and invest.  Alpha, long the coveted goal of managers, appears to have been replaced in many cases, at least for now, by a more mundane goal: survival. According to research by hedge fund investor consultant Hennessee Group, hedge funds suffered $382 billion in investment losses in 2008, coupled with $399 billion in net redemptions.  At the start of the year, the industry managed an estimated $2 trillion in assets.  That number has sunk to an estimated $1.2 trillion.  The industry, in short, has shrunk by almost half.  Hedge funds faced with significant redemption requests have a number of options; those options, of course, are constrained by the fund’s governing documents and side letters and the quantity of redemptions requested in a particular period.  At the most draconian, a fund can liquidate.  Another, slightly less extreme move is to suspend redemptions or impose gates.  Yet another approach being taken by some managers involves hedge fund “restructurings” – in effect, changing the basic deal with investors, of course, with whatever level of investor consent is required by the fund’s governing documents and jurisdiction of organization.  At bottom, a hedge fund reorganization serves as a mutual recognition by the manager and investors that the facts as they existed on the date of organization of the fund no longer obtain, and the changed circumstances warrant a revised investment structure.  We offer a comprehensive overview of the variety of approaches that hedge fund managers are taking in the context of fund restructurings.

IRS Releases Further Guidance Affecting Offshore Hedge Fund And Other Pooled Investment Vehicle Deferrals

On January 8, 2009, the Internal Revenue Service issued interim guidance (Notice 2009-8) under Internal Revenue Code Section 457A.  Enacted in October 2008, Section 457A largely eliminates compensation deferrals by nonqualified entities – in general, tax-indifferent non-U.S. corporations or partnerships (U.S. or non-U.S.) with tax-indifferent partners.  In a guest article, Jonathan M. Zorn, Brett A. Robbins and Lucas Rachuba describe the mechanics of the interim guidance – including a discussion of the treatment of deferrals attributable to periods before and after January 1, 2009 – and explain how the interim guidance may impact hedge funds and their managers.

Senate Banking Committee Grills Regulators on Missing Madoff, Discusses Possibility of Requiring Investment Advisers to Keep Assets at Independent Custodians

On January 27, 2009, the Senate Banking Committee held a hearing to examine Bernard L. Madoff’s alleged $50 billion Ponzi scheme, how it escaped detection for years and what regulatory changes would prevent similar future schemes.  At the hearing, lawmakers discussed the possibility of requiring investment advisers to maintain customers’ securities with independent custodians, rather than at their own brokerage affiliates.  They also urged senior SEC officials to re-evaluate how they prioritize complaints, examinations and inspections.  We describe the hearings in detail, with a particular focus on the discussion of the potential independent custodian requirement.

Hedge Funds Step into the Breach as Traditional Lenders Exit the Debtor-In-Possession Loan Market

Debtor-in-possession (DIP) financing long has served as a lifeline for companies during a Chapter 11 restructuring process.  Chapter 11 debtors use DIP loans to finance their operating expenses, including payments to bankruptcy lawyers and other advisors, and such financing generally is perceived as necessary for a debtor to restructure and avoid liquidation.  However, the market for DIP loans, like other types of credit, has all but frozen of late.  Notably, GE Capital, one of biggest players in the DIP lending market, with $1.75 billion of such loans made in 2007, pulled out of the business in the last quarter of 2008.  But just as the supply of DIP loans has constricted, the demand for such loans has grown dramatically.  GE executives reportedly predicted in September 2008 that the market for DIP loans could grow to $12 billion in 2009.  As traditional lenders such as GE pull out of the business, at least temporarily, Chapter 11 debtors are looking increasingly to hedge funds to step into the lending breach and preserve the viability of the restructuring process.  We explain the role hedge funds are assuming in the DIP loan market, common terms of hedge fund DIP loans, how hedge fund protect themselves when making such loans and borrower considerations.

U.K. FSA Proposes to Require Disclosure of Short Positions in All U.K. Listed Stocks

On February 6, 2009 the U.K. FSA issued Discussion Paper 09/01 proposing to require public disclosure of significant short positions in all U.K. listed stocks.  This proposed disclosure requirement follows a decision by the FSA on January 14, 2009 to extend to June 30, 2009 a requirement (originally imposed by the FSA on September 18, 2008) to publicly disclose significant short positions in U.K. financial sector companies.  Also on January 14, 2009, the FSA decided to let expire on January 16, 2009 a ban on the active creation or increase of net short positions in the stocks of U.K. financial sector companies.  We detail the background of the FSA’s recent activity with respect to disclosure of short positions, with special focus on the FSA’s evolving treatment of contracts for difference.

Ropes & Gray Hosts Teleconference on SEC Enforcement Actions Against Investment Managers, Potential Regulatory Changes in Response to Madoff and Private Plaintiff Claims Against Investment Managers

On February 4, 2009, global law firm Ropes & Gray LLP hosted a teleconference titled “The Sinking Markets’ Effect on Investment Funds: Litigation and Enforcement Issues Every Investment Fund Executive Should Know.”  The teleconference consisted of four presentations, each by one Ropes partner addressing an overarching question.  Those questions were as follows: (1) Under what theories is the SEC likely to bring claims against unsuccessful and “imprudent” managers?; (2) What impact is the alleged Madoff Ponzi scheme likely to have on future enforcement actions?; (3) What lessons may be learned from the problems at the Reserve Fund, a money-market mutual fund whose value tumbled and “broke the buck,” because of its over-reliance upon commercial paper issued by a Lehman Brothers entity?; and (4) More generally, what is the scope of private liability risk facing funds that have suffered substantial losses, and their managers?  We relate the material points from the various Ropes partners’ answers to these questions.

New York Trial Court Permits Action for Misappropriation of Hedge Fund Proprietary Software and Breach of Partnership Agreement To Proceed

On January 6, 2009, a New York County trial court denied a motion to dismiss a lawsuit brought by Kenneth L. Telljohann and his company, CoVision Capital Group, LLC, against defendants Lawrence Doyle, a hedge fund manager, and his business entity, Tower Capital, Inc. The plaintiffs alleged that Doyle breached their partnership agreement and his fiduciary duty to his partners, and misappropriated the plaintiffs’ hedge fund asset allocation and risk analysis software. Alternatively, the plaintiffs sought to recover the value of the work they had performed on behalf of defendants through claims of unjust enrichment and quantum meruit and to prevent the further misuse of their software through a claim of unfair competition.  We describe the factual background and the court’s legal analysis, and in the process provide insight into how hedge fund managers and their service providers can structure arrangements to avoid disputes over ownership of intellectual property, and the revenue streams from such ownership.