May 14, 2010

How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA's More Onerous Prohibited Transaction Provisions? (Part One of Three)

The hedge fund industry is at an interesting juncture.  Various studies suggest that assets under management (AUM) by hedge funds globally are poised to rebound dramatically from their 2009 nadir over the coming four years and beyond.  For example, an April 2010 survey by Credit Suisse's Prime Services business of institutional investors representing approximately $1 trillion projected that the hedge fund industry will grow from an estimated $1.64 trillion in AUM at the end of 2009 to $1.97 trillion by the end of 2010.  Similarly, an April 2009 survey by BNY Mellon and Casey Quirk forecast that global hedge fund AUM would reach $2.6 trillion by the end of 2013.  At the same time, we at the Hedge Fund Law Report have talked to an appreciable number of hedge fund managers − including startup managers and established managers with admirable track records − who have noted that the fundraising environment remains challenging.  In other words, a significant volume of assets is poised to move into (in some cases, back into) hedge funds, but that move has just begun.  Why this disjunction between survey results (suggesting large imminent inflows) and anecdotal evidence on the ground (suggesting that those inflows remain in the offing)?  One answer may be the nature of the new or returning investors.  According to the BNY Mellon-Casey Quirk study and other studies, a substantial portion of the near-term net inflows are expected to come, directly or via funds of funds, from corporate pension funds and other institutional investors subject to the Employee Retirement Income Security Act of 1974 (ERISA).  This is patient, judicious and sticky money: ERISA investors generally engage in lengthy and rigorous due diligence and take a relatively long time to make an investment decision.  But once they invest, they tend to stick around.  In short, the gulf between projected and actual inflows into hedge funds is consistent with survey findings suggesting that ERISA investors will comprise a growing proportion of an increasing hedge fund asset base, and it is consistent with the deliberate investment approach of many ERISA investors.  One key take-away for hedge fund managers who want a piece of the new asset pie: avoiding ERISA may no longer be a viable option.  However, the purpose of this article (and two companion articles to follow) is to illustrate why becoming subject to ERISA may no longer be such a bad outcome.  That is, heretofore, hedge fund managers generally have balanced the fee and long-term commitment benefits of accepting "substantial" ERISA investments, on the one hand, with the operational and investment restrictions and compliance and administrative burdens imposed by ERISA, on the other hand.  Many managers have concluded that the burdens outweigh the benefits, and thus have scrupulously kept investments by benefit plan investors below 25 percent of any class of equity interests issued by their hedge funds, thereby avoiding application of ERISA.  However, a robust list of "class exemptions" from the prohibited transaction provisions and other restrictions of ERISA offers to mitigate the operational and investment burdens imposed by ERISA on hedge fund and managers.  Notably, the Qualified Professional Asset Manager (QPAM) exemption and the service provider exemption permit hedge fund managers to engage in many transactions that otherwise would be prohibited by ERISA.  In short, the various class exemptions enable a hedge fund manager to exceed the 25 percent threshold while avoiding many of the more onerous provisions of ERISA.  If the Hedge Fund Law Report were inclined to use cute titles, we might have called this article series: "Class Exemptions or: How I Learned to Stop Worrying and Love ERISA."  As indicated, this article is the first in a three-part series.  This article discusses the general rules under ERISA, the plan asset regulations thereunder and relevant sections of the Internal Revenue Code (IRC) governing when a hedge fund may be deemed to hold plan assets thereby subjecting the fund and its manager to ERISA.  Importantly, this article also discusses the three exceptions to the general rule, focusing on the one exception typically relied upon by hedge funds to remain outside of the ambit of ERISA: the 25 percent test.  In particular, this article provides detail on the definition of "benefit plan investor," and how that definition was narrowed (and thus how hedge fund ERISA capacity was expanded) by the Pension Protection Act of 2006 (PPA); the treatment by a hedge fund of benefit plan investors in hedge funds of funds or insurance company general accounts that invest in the hedge fund; the formula for calculating the percentage ownership of benefit plan investors; the treatment of investments by manager personnel when calculating that formula; the potentially counterintuitive method of defining a "class" of equity interests for ERISA purposes, including discussions of the implications in this context of side pockets and side letters; when and how to recalculate the 25 percent test; the interaction of the 25 percent test and secondary market transfers of hedge fund interests; and disclosure and mandatory redemption considerations.  The second article in this series, to be published in next week's issue of the Hedge Fund Law Report, will discuss the most important consequences to a hedge fund manager of becoming subject to ERISA and the repercussions for a hedge fund manager of violating the fiduciary duty, prohibited transactions or other provisions of ERISA.  And the third article in this series will detail ten class exemptions and other exemptions that hedge fund managers may use to avoid the various operating and investment restrictions of ERISA, as well as potential changes to ERISA and the rules thereunder.

NICSA’s "Trends in Hedge Fund Operations" Seminar Focuses on Liquidity, Managed Accounts, Third-Party Administration, Due Diligence, GIPS Standards and Related Topics

On April 28, 2010, the National Investment Company Service Association, a not-for-profit trade association providing educational programming and information exchange within the operations sector of the worldwide investment industry, sponsored a webinar entitled "Trends in Hedge Fund Operations."  Speakers at the webinar focused on a range of issues of current relevance to hedge fund operations, including: fund-level and investor-level gates; side pockets; the frequency of use of managed accounts; the use of independent, third-party administrators; in-house administration; hybrid arrangements between third-party and in-house administration, including the use of agreed-upon procedures letters; investor due diligence and audit trends; GIPS standards; and the evolution of hedge fund technology.  This article summarizes the key points discussed during the webinar.

Second Circuit Upholds Dismissal of Suit by Investment Manager PIMCO Against Refco’s Attorneys, Holding that for Attorneys to be Liable for Securities Fraud as “Secondary Actors” Under Rule 10b-5, the Allegedly False Statements Must Actually Be Attributable to the Attorneys at the Time the Statements Are Made

The United States Court of Appeals for the Second Circuit has enunciated a “bright line” standard for imposing liability on so-called “secondary actors” under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.  Lead plaintiffs Pacific Investment Management Company LLC and RH Capital Associates LLC (the Funds) lost money in the 2005 collapse of brokerage Refco Inc. (Refco).  The Funds alleged that Refco engaged in a series of sham loan transactions in an effort to conceal a substantial amount of uncollectible debt.  The Funds sued Refco, along with certain of its affiliates, underwriters and outside counsel, including law firm Mayer Brown LLC (Mayer Brown) and former firm partner Joseph P. Collins (Collins), alleging securities fraud.  Mayer Brown and Collins were involved in negotiating and drafting the documents for many of the sham loan transactions.  They also prepared a private placement memorandum and registration statements for three Refco securities offerings.  Significantly, however, none of the allegedly false statements made in the memorandum or either of the registration statements was specifically attributed to either Mayer Brown or Collins.  Those defendants moved to dismiss the Funds’ claims against them for failure to state a cause of action.  The District Court and the Second Circuit agreed, holding that the mere act of helping to prepare the allegedly false statements did not give rise to liability under Rule 10b-5.  In order for liability to attach, the alleged false statements must be clearly attributed to the secondary actors.  In addition, the court held that, because the Funds admittedly had no idea that Mayer Brown and Collins were involved in negotiating and documenting the sham transactions, they could not have relied on any actions by those two defendants.  Consequently, the Funds’ claim of “scheme liability” also failed.  This article discusses the factual background, including a review of the mechanics of the Refco fraud, and the Second Circuit's legal analysis.

Singapore Monetary Authority Proposes New Rules to License Larger Hedge Fund Management Firms

On April 27, 2010, the Monetary Authority of Singapore (Authority), the Singapore central bank, set out its new plan to regulate fund managers, including hedge fund managers, with a framework governing fund management companies (FMCs).  Currently, Singapore represents the only developed jurisdiction other than the United States where hedge funds do not face regulation so long as they deal only with “accredited” or professional investors.  Pursuant to the Singapore Securities and Futures Act (SFA), in order to conduct fund management activities in Singapore, managers must either hold a Capital Markets Services (CMS) license, or fit within an exemption from the need to hold such a license.  Hedge fund managers in Singapore currently receive an exemption from holding a CMS license provided that they manage funds on behalf of 30 or fewer “qualified” investors (“qualified” investors refer to accredited investors, or funds whose underlying investors are all “accredited” investors).  The SFA refers to these managers as exempt fund managers (EFMs).  The new framework proposes the creation of three new categories of FMCs: (1) a “notified” category for smaller companies that manage fewer than S$250million (US$183 million) and serve no more than 30 qualified investors with no more than 15 funds; (2) a “licensed” category for those with assets under management (AUM) greater than S$250 million who serve only “accredited” and institutional investors; and (3) a “licensed” category for those who manage retail (non-accredited and non-institutional) investors.  Significantly, then, hedge fund management firms in Singapore that manage more than S$250 million and those that serve retail investors (the second and third categories) will require licenses.  These changes may potentially have a significant impact on many hedge fund managers who have established funds in Singapore in the last few years due to its light regulation.  Singapore now has 138 single-strategy hedge fund managers employing more than 800 professionals, according to a survey by the local chapter of the Alternative Investment Management Association (AIMA).  According to a survey by AIMA, this industry oversees at least $34.9 billion in assets under management, excluding assets managed by several of the large global firms, making it Asia’s second biggest market.  This article summarizes the proposed revisions to the Singapore regulatory regime, the proposed admission criteria for participation in the regime, the implications of the revisions for hedge fund managers in Singapore and the reaction from the AIMA.

“Confidence Game: How a Hedge Fund Manager Called Wall Street’s Bluff,” By Christine S. Richard; Wiley, 335 Pages

Bloomberg News reporter Christine S. Richard’s new book tells the story of hedge fund manager Bill Ackman’s six-year short-selling crusade against municipal bond insurer MBIA.  The tale is interesting on a purely personal level, as a study of Ackman’s remarkable character: his irrepressible outspokenness and obsessive tenacity in hounding his quarry.  But Richard’s book is most valuable for the new light it sheds on the credit crisis of 2008, illuminating the extent to which MBIA and its fellow “monoline” insurers were dangerous weak links in the financial system.  Having become dissatisfied with the profit margins from their traditional line of work, they ventured into the brave new world of “structured finance” and mortgage-backed collateralized debt obligations (CDOs), leading to a disaster that effectively killed off the bond insurance industry less than 40 years after its inception.  Of course, like many others burned by the subprime meltdown, MBIA’s management to this day insists that it could never have expected such an apocalyptic turn of events, and has brought lawsuits blaming banks and subprime lenders for its losses.  See “New York State Court Upholds 'Big Boy' Provisions and Dismisses Majority of MBIA’s Claims Against Merrill Lynch Relating to CDS Protection Sold by MBIA Referencing CDOs Issued by Merrill,” Hedge Fund Law Report, Vol. 3, No. 17 (Apr. 30, 2010).  Unfortunately for them, Bill Ackman gave ample forewarning of the dangers back in 2002, when his first hedge fund management firm, Gotham Partners, issued a research report entitled, “Is MBIA Triple-A? A Detailed Analysis of SPVs, CDOs, and Accounting and Reserving Policies at MBIA, Inc.”  That title in itself indicates how Ackman’s pursuit of MBIA spanned the two major crises of capitalism of the last decade, from the earlier era of corporate fraud prosecutions epitomized by Enron and its off-balance-sheet special purpose vehicles (SPVs), to the late credit debacle stemming from the collapse of the CDO house of cards.  In Ackman’s view, MBIA was both fraudulent and insolvent, and he spent years trying to persuade regulators and the credit rating agencies to see the truth as clearly as he did.

Simon Cullingworth Joins Kobre & Kim LLP in London

On May 10, 2010, Kobre & Kim LLP announced that Simon Cullingworth joined the firm in its London office as a Partner.  The firm focuses on litigation against banks, futures intermediaries, investment companies and professional firms on behalf of institutional clients.  Cullingworth will focus on the representation of foreign companies in the UK, with an emphasis on the banking, securities, commodities and hedge fund sectors.