Feb. 26, 2009

In Frozen Credit Markets, Enhanced Prime Brokerage Arrangements Offer a Rare Source of Hedge Fund Leverage, But Not Without Legal Risk

In the midst of a broad credit crisis, and in the wake of the demise of Lehman Brothers Inc., the primary broker-dealer entity in the Lehman group, major US prime brokers are scaling back dramatically on the range of services they provide to hedge funds, and the hedge funds to whom they are willing to provide such services.  Most notably, prime brokers are dialing back on their traditional role as lenders to hedge funds – making fewer loans, reducing the ranks of eligible borrowers, increasing fees and interest rates and expanding collateral requirements.  Prime brokers are also reigning in other categories of services that, just a short time ago, they competed to offer to hedge fund clients.  In response to the narrowing range of services and the diminishing group of US prime brokers providing those services, hedge funds are looking to non-US financial institutions to establish so-called “enhanced prime brokerage” arrangements.  Such arrangements are similar to traditional prime brokerage arrangements, in terms of the range of services they may entail, but usually involve two distinguishing factors: a non-US financial institution, as opposed to a US broker-dealer subsidiary of a major investment or commercial bank, and enhanced lending capacity available to the hedge fund.  We describe what enhanced prime brokerage arrangements are, how they differ from traditional prime brokerage arrangements, the risks and benefits of enhanced prime brokerage arrangements and how hedge funds can protect themselves against the risks while accessing the benefits.

Stimulus Bill Permits Deferral of Cancellation of Debt Income Arising out of Repurchases by Issuers of their Distressed Debt

On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Act of 2009, containing the American Recovery and Reinvestment Tax Act of 2009 (2009 Tax Act), which provides for, among other things, deferral of recognition of certain cancellation of indebtedness income (CODI).  That is, under tax law prior to the 2009 Tax Act, a taxpayer generally had to recognize income in the year in which it repurchased, cancelled or modified its debt, to the extent that the adjusted issue price of the old debt exceeded the amount of the new debt.  Under the 2009 Tax Act, taxpayers are allowed to defer recognition of CODI until a five year period starting, for calendar year taxpayers, in 2014; deferred CODI has to be included ratably in income during that five year period.  We explain the mechanics of the 2009 Tax Act, the effect on “deemed exchanges,” the consequences for deductibility of original issue discount in various circumstances and the applicable high yield debt obligation rules.  We also highlight the potential pitfalls for hedge funds, especially those employing a distressed debt strategy.

Investors in Hedge Fund Strategies Increasingly Demanding Separate Accounts to Avoid Gates and Other Consequences of Commingled Investment Vehicles

Faltering hedge fund performance, high profile frauds and prime broker and counterparty failures have combined to heighten the sensitivity of investors in hedge fund strategies to the type of vehicle in which their assets are invested.  In particular, recent events have highlighted the pitfalls to an investor of commingling its assets with those of other hedge fund investors.  One of the major concerns centers around the timing and quantity of redemptions: in a hedge fund, a substantial, simultaneous volume of redemptions can cause a manager to lower a gate or otherwise restrict withdrawals, or leave remaining investors with less liquid assets – and thus redemptions by one investor can decrease the liquidity of other investors.  Side letters are one way to address the concerns raised by commingled assets.  But regulators and even managers are looking increasingly askance on such arrangements.  Another method used to address these concerns involves investors investing in separate accounts, which often invest alongside or otherwise participate in the investment program of a related hedge fund.  We explain, among other things, the various forms a separate account may take, the potentially adverse Advisers Act consequences allowing investors to participate in a strategy via separate accounts and an alternative to separate accounts being used by managers with increasing frequency.

Ogier Discusses Potential Causes and Courses of Action Available to Investors in Madoff “Feeder Funds” Organized in the British Virgin Islands

On December 11, 2008, having admitted to masterminding what would appear to have been a $50 billion Ponzi scheme through his brokerage firm, Bernard L Madoff Investment Securities LLC (BMIS),  Bernard Madoff was arrested and charged with securities fraud.  On December 15, 2008, the Securities Investor Protection Corporation commenced liquidation proceedings against BMIS and a Bankruptcy Trustee was appointed over it.  Concerned that they are very unlikely to make any significant recoveries out of the liquidation of BMIS, investors in the Madoff “feeder funds” are now looking at possible ways of recovering their losses from the feeder funds and their third party service providers such as their administrators, custodians and investment managers.  In an exclusive contributed article, Robert Foote, Managing Associate and Barrister in the British Virgin Islands (BVI) office of leading offshore law firm Ogier, explores some of the causes and courses of action that might be open to such investors under BVI law.  The discussion has particular relevance for investors in Madoff feeder funds organized as BVI entities.

Suit by PayPal Founder and Macro Hedge Fund Manager Against Minority Investor in his Hedge Fund for Extortion Stayed Pending Arbitration of Related Fraud Suit Against the Hedge Fund

On November 12, 2008, a lawsuit filed by macro hedge fund management company Clarium Capital Management LLC, and its principle shareholder, PayPal founder Peter A. Thiel, in California state court against the agent of Amisil Holdings, Ltd., Amit Choudhury, was removed to the United States District Court for the Northern District of California.  In the state and now federal action, Clarium and Thiel complained that Choudhury committed acts of defamation, tortious interference with business advantage, fraud and negligent misrepresentation, and that he violated the California Business and Professions Code.  Choudhury moved for a Stay Action Pending Arbitration, because his firm, Amisil, had submitted to arbitration an outstanding and closely related lawsuit against Clarium and Thiel involving the same or similar claims.  The District Court agreed with Choudhury and imposed the stay.  Our discussion of the facts and legal analysis in the opinion shows, among other things, how courts may construe mandatory arbitration provisions in the operating agreements of hedge fund management companies.

MAXAM Fund Sues Auditors Over Madoff Losses

On Friday, January 30, 2009, MAXAM Absolute Return Fund L.P. (MAXAM) filed a lawsuit in Connecticut Superior Court against its auditors Goldstein Golub Kessler LLP (GGK) and McGladrey & Pullen LLP (M&P and, collectively, the Auditors) alleging professional negligence, with the goal of recovering losses in connection with MAXAM’s investments in Bernard L. Madoff Investment Securities LLC (BMIS).  Implicit in the suit is the recognition that investment funds that invested in Madoff’s purported investment management business are unlikely to see any material recovery from Madoff himself or the firm he controlled.  Accordingly, plaintiffs are looking to service providers – even those who, like the Auditors in this case, provided services to the investor rather than to BMIS or Madoff.  As a general matter, while the facts of each case are unique, courts have not been receptive to claims against service providers in connection with alleged investment frauds, in the absence of any privity of contract between the service provider and the bad actor, or any independent bad act on the part of the service provider.  We describe the allegations in the complaint, including the specific claims of failure to follow Generally Accepted Auditing Standards.