Mar. 11, 2010

Implications of the Volcker Rule – Managing Hedge Fund Affiliations with Banks

On January 21, 2010, President Obama proposed to limit the size and scope of banking institutions.  The proposal, named the “Volcker Rule” after its key proponent, Chairman of the President’s Economic Recovery Advisory Board and former Federal Reserve Chairman Paul Volcker, would prohibit depository institutions and their bank holding companies (collectively referred to herein as “BHCs”) from owning, investing in, or sponsoring hedge funds, private equity funds or proprietary trading operations.  If enacted into law, the Volcker Rule would require BHCs to divest their investments in hedge funds and would restrict BHC affiliations and transactions with hedge funds.  Accordingly, hedge fund managers could be faced with managing investor divestitures, including their own investments in the funds they manage, as well as managing limitations on their funds affiliating with BHC service providers going forward.  In a guest article, Genna N. Garver, an Associate at Bracewell & Giuliani LLP; Sanford M. Brown, Managing Partner of Bracewell & Giuliani’s Dallas office; Robert L. Clarke, a Senior Partner at Bracewell & Giuliani and former United States Comptroller of the Currency; and Cheri L. Hoff, a Partner at Bracewell & Giuliani, offer a comprehensive analysis of the implications of the Volcker Rule for hedge fund affiliations with banks.  In particular, the authors provide detailed discussions of: fiduciary duties, the withdrawal process and investor relations issues as they relate to withdrawals by BHC investors in hedge funds; the mechanics of and legal considerations involved in divestitures of hedge fund sponsorship interests; and limitations in the proposed Volcker Rule on the ability of hedge funds to affiliate with BHC service providers, such as BHCs providing prime brokerage services.

Identifying and Resolving Conflicts Arising out of Simultaneous Management of Debt and Equity Hedge Funds

Many hedge fund managers, especially larger ones, manage multiple hedge funds.  Oftentimes, those multiple hedge funds follow different investment strategies.  While management by a single manager of multiple hedge funds offers certain operational economies of scale (e.g., shared office space, personnel and technology), diversification of the manager’s revenue sources and potentially greater overall revenue, it also creates the potential for conflicts between the interests of the funds.  In particular, simultaneous management by a single manager of both debt and equity funds can create a variety of information and business conflicts that challenge the manager’s ability to satisfy its fiduciary duties to both funds and both sets of investors.  This issue is particularly acute now, at a time when many hedge fund managers that previously focused on equity-related strategies have launched distressed debt funds in an effort to make silk purses out of the many sow’s ears left over from the credit crisis.  In effort to assist hedge fund managers in avoiding or navigating these conflicts, this article: discusses fiduciary duty as it relates to the relevant conflicts, both under Delaware law and the Investment Advisers Act; identifies specific examples of the potential conflicts, including five investment issues (e.g., consequences to both the equity and debt funds when a reorganization would benefit the debt but wipe out the equity) and two information issues (e.g., consequences to the equity fund when its manager receives material, non-public information in the course of also managing a debt fund); and evaluates the pros and cons of specific ex ante and ex post remedies for both the information issues and investment issues.

Should Hedge Funds Include Automatic Termination as a Term of Bank Debt Trades on the New Loan Market Association Forms?

On January 25, 2010, the Loan Market Association (LMA) – the European trade association for the syndicated loan market – launched a combined set of standard terms and conditions for par and distressed trading documentation (Combined Terms and Conditions).  One of the key additions to the form loan documentation is a termination upon insolvency provision.  Specifically, the new provision creates a default rule whereby the non-insolvent party to a bank debt trade may terminate the trade upon notice to the insolvent party.  The parties may also revise the default rule to provide for automatic termination upon the insolvency of either party.  In addition, the provision provides a mechanism for calculating damages upon a termination occasioned by insolvency of one of the parties.  The inclusion of the termination upon insolvency provision is widely perceived as a direct response to the experience of loan market participants in the Lehman Brothers bankruptcy.  In that case, absent a termination right on the part of Lehman’s non-insolvent bank debt trade counterparties (many of whom were hedge funds), Lehman generally had the right to (and in many cases did) keep open trades for which it was in the money, and cancel trades for which it was out of the money.  In short, the rules as they existed at the end of 2008 and through 2009 permitted Lehman entities to “cherry pick” favorable trades.  Part of the policy behind the new provision is to prevent parties trading in bank debt from using bankruptcy (or, in the U.K., administration) to obtain a trading advantage.  For hedge funds, one of the key questions raised by the new provision is whether to include automatic termination provisions in bank debt trade documentation.  This article explores that question, and in doing so discusses: the details of the new LMA Combined Terms and Conditions; the specifics of the termination on insolvency provision (including the default rule requiring notice of termination and permitted alterations to the default rule); the mechanism for calculating early termination payments; the disadvantages of providing for automatic termination, highlighting the different relevant bankruptcy rules in the U.K. and the U.S.; the advantages of providing for automatic termination, also highlighting the variations in analysis between the U.K. and the U.S.; the extent to which automatic termination can harmonize bank debt and derivatives documentation, at least in the U.K.; the effect of automatic termination on bank debt trade pricing; and relevant differences between LMA and LSTA documentation.

Florida District Court Dismisses Class Action Suit Against Hedge Fund Palm Beach Capital Because Forum Selection Clause in Subscription Agreement Called For Jurisdiction in Cayman Islands, Even Though the Fund Did Not Sign the Subscription Agreement

Plaintiffs were investors in hedge fund Palm Beach Offshore (Fund), which was organized in the Cayman Islands.  The Fund became insolvent when the Tom Petters multi-billion dollar Ponzi scheme, in which the Fund had made a substantial investment, collapsed in 2008.  See “Update on the Petters Fraud: Polaroid Bankruptcy Trustee Sues to Void Hedge Fund’s Pre-Bankruptcy Receipt of Polaroid Assets,” Hedge Fund Law Report, Vol. 2, No. 9 (Mar. 4, 2009).  Plaintiffs commenced a class action lawsuit against the Fund’s manager, its principals, its auditors and an outside administrator, alleging breach of fiduciary duty, negligence, unjust enrichment, fraud, negligent misrepresentation and conversion.  The Fund manager and principals moved to dismiss on the grounds that a forum selection clause contained in the subscription agreement required suit to be brought only in the Cayman Islands.  Plaintiffs argued that the forum selection clause was unenforceable because (i) the Fund had not signed the subscription agreement that contained the clause, (ii) the forum selection clause was obtained through fraud and (iii) enforcement was against public policy.  The court rejected all three of plaintiffs’ arguments and dismissed the suit as against the manager and its principals, holding that the clause was enforceable.  We summarize the facts of the case and the Court’s reasoning.

Obama Administration Releases Text of “Volcker Rule” Legislation to Restrict Size and Risky Activities of Financial Firms

On March 3, 2010, the United States Department of the Treasury delivered proposed legislative text to Capitol Hill to implement the “Volcker Rule” as previously announced by the Obama Administration on January 21, 2010.  See “What Is Proprietary Trading, and Why Does Its Definition Matter to Hedge Fund Managers?,” Hedge Fund Law Report, Vol. 3, No. 8 (Feb. 25, 2010).  As discussed in this and previous issues of the Hedge Fund Law Report, the Volcker Rule is part of a comprehensive package of reforms intended to create a safer, more resilient financial system.  See “Implications of the Volcker Rule – Managing Hedge Fund Affiliations with Banks,” above, in this issue of the Hedge Fund Law Report.  The rule aims to limit the size and scope of banks and other financial institutions with the goals of “rein[ing] in excessive risk-taking and protect[ing] taxpayers.  See “Senate Banking Committee Hears Testimony from Hedge Fund Industry Experts and Academics on ‘Volcker Rule,’” Hedge Fund Law Report, Vol. 3, No. 6 (Feb. 10, 2010); “Senate Banking Committee Holds Hearings on ‘Volcker Rule’ Designed to Limit Banks’ Ability to Own, Invest In or Sponsor Hedge or Private Equity Funds,” Hedge Fund Law Report, Vol. 3, No. 5 (Feb. 4, 2010).  This new legislative language would add to existing activity restrictions applicable to banking firms by prohibiting the firms from engaging in proprietary trading and investing in or sponsoring hedge funds or private equity funds.  The text also supplements and strengthens existing financial sector concentration limits.  This article summarizes the most salient provisions of the Treasury Department’s proposal, which, if enacted, will take the form of new Sections 13 and 13a of the Bank Holding Company Act of 1956.

Bingham Adds Structured Transactions Lawyer in its Washington, D.C. Office

On March 8, 2010, Bingham McCutchen LLP announced that it had added Martin Teckler to its Structured Transactions Practice Group as a Washington-based Of Counsel.  Teckler plans to work with Bingham’s Investment Management Practice Group to serve his clients, particularly those focused on venture capital and private equity.