May 7, 2010

Delaware Supreme Court Endorses Third-Party Vote Buying in an Opinion with Important Implications for Activist and Merger Arbitrage Hedge Fund Strategies

On April 21, 2010, the Delaware Supreme Court issued an opinion approving the practice of third-party vote buying where economic and voting rights are transferred together, even if bare legal title remains with the seller.  See Crown EMAK Partners, LLC v. Kurz, -- A.2d --, 2010 WL 1610487 (Del. Supr. Apr. 21, 2010).  Although the court found that the specific transaction at issue violated the terms of a Restricted Stock Grant Agreement, and the court thus disallowed voting of the purchased shares, the court’s approval of the vote buying transaction, and its emphasis on the importance of maintaining the link between economic and voting rights, may have important implications for hedge funds pursuing activist or merger arbitrage strategies.  In particular, the case may further erode the utility of total return equity swaps as a tool for activists and arbitrageurs; as we have reported in previous issues of the Hedge Fund Law Report, the range of circumstances in which total return equity swaps may be used as an effective and tax efficient tool has been narrowed by court cases, IRS action, congressional action and rulemaking by the U.K. FSA.  See “District Court Holds that Long Party to Total Return Equity Swap May be Deemed to have Beneficial Ownership of Hedge Shares Held by Swap Counterparty,” Hedge Fund Law Report, Vol. 1, No. 14 (Jun. 19, 2008); “SEC’s Order in the Perry Case Effectively Creates a Presumption that Beneficial Ownership Acquired as Part of an Activist or Merger Arbitrage Strategy Is Not ‘In the Ordinary Course,’ and thus May Require the Filing of a Schedule 13D,” Hedge Fund Law Report, Vol. 2, No. 30 (Jul. 29, 2009); “IRS Directive and HIRE Act Undermine Tax Benefits of Total Return Equity Swaps for Offshore Hedge Funds,” Hedge Fund Law Report, Vol. 3, No. 12 (Mar. 25, 2010); “FSA Publishes Revised Disclosure Rules for Contracts for Difference,” Hedge Fund Law Report, Vol. 2, No. 12 (Mar. 25, 2009).  To illustrate the implications of the EMAK case for hedge funds, this article discusses: the relevant factual background of the case; the Delaware Court of Chancery decision; the Delaware Supreme Court decision and opinion; and the way the case may affect hedge funds in four specific circumstances: (1) third-party vote buying; (2) the purchase of voting rights without economic interests, for example, in connection with a merger arbitrage strategy; (3) the purchase of economic interests without voting rights, for example, in connection with an activist strategy; and (4) international coordination of activist campaigns.  In connection with the discussion of merger arbitrage, this article reviews the June 2009 settlement between Perry Corp. and the SEC relating to trading by a Perry fund in shares of Mylan Laboratories Inc. and swaps referencing the shares.  And in connection with the discussion of activism, this article refers back to the June 2008 decision of the U.S. District Court for the Southern District of New York in the case in which railroad operator CSX Corporation sued hedge fund managers The Children’s Investment Fund Management (UK) LLP and 3G Capital Partners Ltd. alleging violations of Section 13(d) of the Securities Exchange Act of 1934.

N.Y. Appeals Court Rules that Securities Clearance Broker Cannot Compel Arbitration Against Hedge Fund 3V Capital Master Fund Ltd. Over Bankruptcy Trade Claims Litigation

On April 22, 2010, the New York State Supreme Court, Appellate Division, First Department, unanimously affirmed a trial court order dismissing a motion to compel arbitration by broker Imperial Capital LLC against distressed debt hedge fund 3V Capital Master Fund Ltd.  3V Capital faced a lawsuit by Deephaven Distressed Opportunities Trading, Ltd. and its affiliates for its alleged breach of a contract requiring it to purchase claims held by Deephaven against a bankruptcy estate.  3V Capital dragged Imperial, its securities clearance broker, and another hedge fund, Post Distressed Master Fund, L.P., which had promised but then failed to purchase those same claims from 3V Capital, into the lawsuit as third-party defendants.  Since the litigation at issue involved Imperial’s actions as broker for an uncompleted sale of bankruptcy claims, the Appellate Division agreed with the trial court that the sale fell outside the narrow terms of the securities clearance brokerage arbitration agreement between 3V Capital and Imperial.  This article details the background of the action and the court’s legal analysis.

Colorado District Court Asserts Personal Jurisdiction in Cascade Fund, LLLP’s Action Against Offshore Hedge Fund Absolute Capital Management Holdings Limited, but Dismisses the Complaint for Failure to Plead Securities Fraud Claims with Sufficient Particularity

Plaintiff Cascade Fund, LLLP (Cascade) invested in three Cayman Islands hedge funds managed by defendant Absolute Capital Management Holdings Limited (ACM).  Florian Homm was ACM’s chief investment officer.  He also owned 50 percent of a California brokerage that dealt in penny stocks.  Homm allegedly invested substantial portions of the funds’ assets in those penny stocks.  The funds apparently carried those stocks on their books at inflated values.  In 2007, certain funds lost about 30 percent of their values when the net asset values were recalculated using the stocks’ actual market values.  Cascade sued ACM, along with the funds’ general partner, Homm, and certain fund directors, alleging that they had violated Rule 10b-5 of the Securities Exchange Act of 1934 by failing to disclose Homm’s relationship with the California brokerage and by misrepresenting the extent to which the funds would invest in unlisted securities and the method the funds would use for reporting the values of those securities.  The defendants moved to dismiss the complaint for lack of standing, absence of personal jurisdiction over the defendants and failure to state a claim.  The court dismissed Cascade’s entire action.  Significantly, it ruled that ACM had sufficient contacts with the United States to warrant the exercise of personal jurisdiction over ACM, but not over the other defendants.  Nevertheless, it dismissed Cascade’s claims against ACM because Cascade failed to plead fraud with the degree of specificity required by the Private Securities Litigation Reform Act of 1995.  It also determined that Cascade had standing to assert fraud claims only with respect to those funds in which it had actually invested.  We outline the facts and the court’s rationale in deciding the motion to dismiss.  Among other things, the decision serves as an excellent primer on the exercise of personal jurisdiction by U.S. courts over offshore entities, such as offshore hedge funds, and non-resident individuals, such as directors of offshore hedge funds.

Massachusetts Courts Approve of Accounting Firm Rothstein Kass’ Role as Award Arbiter in Hedge Fund Management Fee Dispute

On April 21, 2010, the Appeals Court of Massachusetts affirmed the decision of the Suffolk County Superior Court of Massachusetts denying a hedge fund’s motion to remove Rothstein Kass & Company, P.C., as independent accountant and deemed arbiter in a management fee dispute.  The dispute, between Rajesh and Neelam Idnani (Plaintiffs) and Vikas Mehrotra and his hedge funds Venus Capital Management (VCM), Venus Investment Partners, LLC and Venus Series Trust (together Defendants) had landed in arbitration.  There, an arbitration panel had ordered Defendants to pay Plaintiffs either quarterly fees based on Defendants own internal financial report, or, if Plaintiffs’ rejected that report, based on an accounting by an independent third party.  As a result, the report of the third-party accountant became the arbitration award, and that firm effectively became the arbitrator for all future disputes.  Defendants challenged Plaintiffs’ decision to use Rothstein Kass as the third-party accountant because of perceived bias.  The Superior Court rejected this claim.  Also, the Appeals Court affirmed because Defendants failed to previously challenge the selection of Rothstein Kass in earlier litigation, and because the firm’s performance was free of “evident partiality,” as required to vacate an arbitrator’s award under the Massachusetts Uniform Arbitration Act.  This article summarizes the background and legal analysis of the courts below.