Feb. 19, 2009

Climate in Washington Warms to Proposals to Tax Carried Interest as Ordinary Income, as Prospect for Material Revenue from Such Tax Wanes

In a series of exclusive interviews with members of both houses of Congress from both sides of the aisle, and members of their staffs, the Hedge Fund Law Report has determined that the appetite among Democratic legislators for taxing carried interest as ordinary income remains high, while opposition among Republicans to increasing taxation of carried interest remains equally vigorous.  In this climate of negative returns, the sizes of both management and performance fees are under pressure (primarily from hedge fund investors as opposed to regulators), and many managers will not earn a performance fee until they exceed their “high water mark” – the highest level their funds previously reached – which in many cases appears to be a far-away prospect.  Accordingly, for practical purposes, the level of taxation of hedge fund manager carried interest may be moot for the time being, since for the foreseeable future there will not be any carried interest to tax.  Nonetheless, in this dour economic environment, legislators may look to placate their Main Street constituents with actions targeting “executive compensation,” very broadly understood.  So, even though increasing taxation of carried interest may have only a minor near-term economic benefit, it may have a symbolic resonance.  That is, the setting may be ripe for finalizing a legislative item at precisely the time when it will yield the least revenue.  We bring you insight directly from Capitol Hill, including quotes from Rep. Charles Rangel (via a spokesman), Rep. Elijah Cummings, Senator Orrin Hatch and the office of Senator Mike Crapo.

As Prime Brokers Tighten Lending to Hedge Funds, the Federal Reserve Increases Hedge Fund Financing Capacity with Expansion of the TALF

The Federal Reserve Bank of New York and the United States Treasury have announced that financing available under the Term Asset-Backed Securities Loan Facility (TALF) program will be substantially increased, from a previously announced $200 billion up to $1 trillion, and that eligible collateral for loans under the TALF could be expanded (although such an expansion is not yet certain) to include newly and recently issued AAA-rated commercial mortgage-backed securities (MBS) and private-label residential MBS.  As originally envisaged, eligible collateral was limited to AAA-rated asset backed securities (ABS) backed by newly and recently originated auto loans, credit card loans, student loans and Small Business Administration-guaranteed small business loans.  The expansion of the TALF would be supported by a commitment from the Treasury of additional funds from the Troubled Asset Relief Program.  Hedge funds, who historically have not been eligible to borrow from the Fed, will become eligible to do so under the TALF with respect to investments in certain ABS.  We explain the background and mechanics of the revised TALF and the related Public-Private Investment Fund, and enumerate the benefits and burdens to hedge funds of participating in the program.

Representatives Castle and Capuano Propose Bill on Hedge Fund Adviser Registration, and Representative Castle Proposes Bills on Pension Investments in Hedge Funds and Study of the Hedge Fund Industry

On January 27, 2009, Representatives Michael Castle (R-Delaware) and Michael E. Capuano (D-Massachusetts) introduced the Hedge Fund Adviser Registration Act of 2009 (HFAR).  The same day, Rep. Castle also introduced the Pension Security Act of 2009 (PSA) as well as of the the Hedge Fund Study Act (HFS).  Generally, the HFAR would eliminate the exemption on which many hedge and other private fund managers rely to avoid registration as investment advisers; the PSA would require disclosure by pension funds of their investments in hedge funds; and the HFS would require the President’s Working Group on Financial Markets to conduct a study of the hedge fund industry.  We offer a detailed explanation of each bill, and include insight from an interview we conducted with Rep. Capuano.

“Oversight of Private Pools of Capital” Is Firmly on the Reform Agenda – What It Might Mean for U.S. Fund Managers

At Mary Schapiro’s January confirmation hearing for her nomination as Chair of the Securities and Exchange Commission, she called for registration of hedge funds.  Members of the Senate Banking Committee promptly pledged to help with legislation, and bills to that effect were put forward before the month was out.  At about the same time, the “Group of 30” – an international committee of current and former senior regulators and bankers – released 18 recommendations for reform of financial market oversight.  Recommendation #4 is titled “Oversight of Private Pools of Capital” and calls for registration and regulation of managers of leveraged investment pools.  With that background it should be clear that the consensus in Washington, DC is that regulation of hedge funds – and likely private equity funds as well – should be part of the overhaul of US financial markets.  In a guest article, Shearman & Sterling partner Nathan Greene fleshes out what that consensus might mean by outlining potential new obligations for fund managers.

House Bill Would Require Mandatory Settlement and Clearing of Over-The-Counter Derivatives, Authorize the CFTC to Suspend Trading in “Naked” Credit Default Swaps and Make Certain Other Changes to the Derivatives Regulatory Regime

On February 12, 2009, the Agriculture Committee of the US House of Representatives approved the Derivatives Markets Transparency and Accountability Act of 2009 (DMTA), a bill that would require, among other things, prospective over-the-counter (OTC) transactions in commodities excluded or exempt from the Commodities Exchange Act (CEA) to be settled and cleared through a designated clearing organization approved by the CFTC, or a clearing agency regulated by the SEC, or in some circumstances by a clearing agency with a foreign government regulator.  Other provisions of the bill would impose limits on the speculative positions in commodity derivatives, and authorize the CFTC and the President to suspend trading in “naked” credit default swaps when an SEC suspension order is in effect.  In short, the bill proposes a dramatic revision of the mechanics by which over-the-counter derivatives markets in the US (and to some extent, outside of the US) have operated since the 2000 amendments to the CEA.  If enacted in its current form, the bill would move the swaps market away from the bilateral, OTC model toward a model dominated by standardized contracts.  We provide a detailed analysis of how the bill would work and how it would change the regulatory landscape for OTC derivatives.

Delaware Bankruptcy Court Decision Precludes Triangular Setoff

A “setoff,” in the bankruptcy context, refers to the ability of entities that owe each other money to apply their debts against one another.  According to the United States Supreme Court, this avoids “the absurdity of making A pay B when B owes A.”  Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995).  Although the Bankruptcy Code does not create any setoff rights per se, it recognizes setoff rights if they otherwise exist under applicable non-bankruptcy law and satisfy the conditions set forth in section 553 of the Code. Section 553 limits setoffs to mutual obligations between a debtor and creditor.  It has four conditions; most significantly, it requires “mutuality,” meaning that the offsetting claim and debt must be owed between the same parties acting in the same capacity.  On January 9, 2009, in In re SemCrude, L.P., the United States Bankruptcy Court for the District of Delaware held that a creditor in bankruptcy cannot effect a “triangular” setoff of the amounts owed between it and three affiliated debtors, despite pre-petition contracts that expressly contemplated multiparty setoff.  We explain the facts and holding of a case that can have profound implications for hedge funds’ rights vis-à-vis bankrupt counterparties.