Jan. 27, 2010

Delaware Bankruptcy Court Disagrees with WaMu Decision, Finding that Rule 2019 Does Not Apply to Ad Hoc Committees in Six Flags Chapter 11 Proceeding

As increasing numbers of hedge funds compete for investment opportunities, it has become even more critical for fund managers to keep their holdings and investment strategies close to the vest.  For instance, many hedge funds that focus on distressed investments more actively participate in bankruptcy proceedings, but remain loath to disclose sensitive information about the precise nature of their holdings.  As a result, Federal Rule of Bankruptcy Procedure 2019 – a seemingly ministerial rule mandating disclosures by creditors in specified circumstances – has become a source of hotly-contested litigation for these funds.  According to Rule 2019, “every entity or committee representing more than one creditor” must file a verified statement disclosing certain information about its claims.  That information includes, among other things, (i) the nature and amount of its claims or interests, (ii) the date of acquisition of its claims or interests acquired in the year before filing of the bankruptcy cases, (iii) the amount paid, and (iv) any subsequent sales of claims or interests.  For more background on Rule 2019, see “Would the Expanded Disclosures Required by Proposed Amendments to Federal Rule of Bankruptcy Procedure 2019 Deter Hedge Funds from Investing in Distressed Debt? (Part Three of Three),” Vol. 2, No. 39 (Oct. 1, 2009); “How Can Hedge Funds that Invest in Distressed Debt Keep their Strategies and Positions Confidential in Light of the Disclosures Required by Federal Rule of Bankruptcy Procedure 2019(a)?,” Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009); and “How Can Hedge Funds that Invest in Distressed Debt Keep Their Strategies and Positions Confidential in Light of the Disclosures Required by Federal Rule of Bankruptcy Procedure 2019(a)? (Part Two of Three),” Hedge Fund Law Report, Vol. 2, No. 36 (Sep. 9, 2009).  In an abrupt change of course from the December 2, 2009 Washington Mutual decision, on January 9, 2010, the Delaware Bankruptcy Court held that the members of an ad hoc committee of noteholders did not have to comply with the disclosure requirements of Bankruptcy Rule 2019.  See In re Premier International Holdings, Inc. Case No. 09-12019 (Bankr. D. Del. Jan. 9, 2010); see also “As Debate over Amendment of Bankruptcy Rule 2019 Continues, Delaware Bankruptcy Court Finds that Current Rule 2019(a) Mandates Disclosure of Economic Interest of ‘Loose Affiliation’ of Washington Mutual Creditors,” Hedge Fund Law Report, Vol. 2, No. 49 (Dec. 10, 2009).  Judge Christopher S. Sontchi reasoned that the plain meaning and legislative history of Rule 2019 does not contemplate ad hoc committees.  This article details the background of the action, the court’s legal analysis and its potential implications for the hedge fund community.

How Does the Amended Custody Rule Change the Balance of Power Between Hedge Fund Managers and Accountants?

The bad news about the amended custody rule is the surprise examination requirement.  The good news, at least for many hedge fund managers, is the annual audit exception.  (That is, the amended custody rule contains an exception from the surprise examination requirement for advisers to pooled investment vehicles that are annually audited by a PCAOB-registered accountant and that distribute audited financial statements prepared in accordance with GAAP to fund investors within 120 days (180 days for funds of funds) of the fund’s fiscal year end.)  See “SEC Adopts Investment Adviser Custody Rule Amendments,” Hedge Fund Law Report, Vol. 3, No. 1 (Jan. 6, 2010).  The qualified news is that while many hedge fund managers may avail themselves of the annual audit exception, an appreciable number may not.  For example, managers whose funds are audited by non-PCAOB-registered accountants, or that do not (or cannot) distribute audited financial statements to fund investors within 120 days of the fund’s fiscal year end, would not be eligible for the annual audit exception.  See “How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures in Light of Amendments to the Custody Rule?,” Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010).  For such “ineligible” hedge fund managers, the surprise examination requirement may complicate operations for at least two reasons.  First, it creates a de facto annual audit requirement.  The substance of a surprise examination – explained in the SEC’s adopting release and a related interpretive release providing specific guidance for accountants – closely resembles the substance of an annual audit.  (The substance of a surprise examination is discussed in more detail in this article.)  Moreover, as the SEC pointed out in the adopting release accompanying the custody rule amendments, a hedge fund manager’s inability to predict which transactions an auditor will test in the course of an annual audit is analogous to the “surprise” element of the examination requirement.  Second – and perhaps more controversially – the surprise examination requirement may complicate operations for hedge fund managers that are not eligible for the annual audit exception because of various SEC reporting requirements imposed on accountants that conduct surprise examinations.  Those reporting requirements are described in more detail in this article, but in pertinent part would require an accountant to file with the SEC, within four business days of resignation, dismissal or other termination from an engagement to provide surprise examinations, Form ADV-E, along with an explanation of any problems that contributed to such resignation, dismissal or other termination.  Importantly, Form ADV-E, along with the accompanying explanation, would be publicly available.  According to the adopting release, the policy rationale for such public availability is to enable current and potential clients of an adviser to assess for themselves the importance of the explanation provided by the accountant for its resignation, dismissal or other termination.  The concern haunting the subset of hedge fund managers that are (or are concerned about becoming) subject to the annual surprise examination requirement is that the Form ADV-E filing requirement may – in cases where reasonable minds can differ on close accounting and valuation calls – further enhance the leverage of accountants over managers.  In other words, the concern is that revised Form ADV-E may increase the volume and specificity of an accountant’s “noisy withdrawal,” and in recognition of that, may increase risk aversion on the part of hedge fund managers in dealings with accountants.  The rejoinder to this argument is that accountants already have considerable leverage over hedge fund managers, as evidenced most starkly by the consequences flowing from withholding of an unqualified audit opinion letter.  See, e.g., “Former CFO of Highbridge/Zwirn Special Opportunity Fund Sues Ex-Partner Daniel B. Zwirn for Defamation and Breach of Contract,” Hedge Fund Law Report, Vol. 2, No. 30 (Jul. 29, 2009).  In an effort to assess the extent to which the custody rule amendments may alter the balance of power between accountants and hedge fund managers, this article examines: how custody is defined in the amended custody rules (because custody is a condition precedent for application of the surprise examination requirement); the substance of the surprise examination requirement; the three exceptions from the surprise examination requirement; relevant SEC reporting requirements (on Form ADV-E); expert insight on whether and how the SEC reporting requirements may increase the leverage of accountants vis-à-vis hedge fund managers; existing accountant leverage (including a discussion of audit representation letters); who bears the cost of a surprise examination; and PCAOB resource limits.

What Effect Will the Carried Interest Provision in the Tax Extenders Act Have on Hedge Fund Managers that Are or May Become Publicly Traded Partnerships?

On December 9, 2009, the U.S. House of Representatives passed legislation that includes a provision that would tax as ordinary income any net income derived with respect to an “investment services partnership interest.”  This carried interest provision in the Tax Extenders Act of 2009, H.R. 4213, would change the tax treatment of the performance allocation that, in years in which a hedge fund has positive investment performance, constitutes the bulk of a hedge fund manager’s revenue.  Currently, most managers structure performance allocations so that all or most of such compensation is taxed as long-term capital gains at a rate of 15 percent.  The carried interest provision would subject such compensation to tax at ordinary income rates, which for hedge fund managers generally would be at a marginal rate of approximately 35 percent.  For more discussion of the Tax Extenders Act, see “Bills in Congress Pose the Most Credible Threat to Date to the Continued Tax Treatment of Hedge Fund Performance Allocations as Capital Gains,” Hedge Fund Law Report, Vol. 2, No. 52 (Dec. 30, 2009).  The Extenders Act also contains a provision that would effectively cause any publicly traded partnership (PTP) that derives significant income from investment advisory or asset management services to be treated, for tax purposes, as a corporation.  This is because the provision would treat carried interest income as non-qualifying income for purposes of determining whether a PTP meets the 90 percent “good income” test.  That test specifies that partnerships that (1) satisfy the 90 percent good income test (described in more detail in this article) and (2) are not registered under the Investment Company Act of 1940 will, in general, continue to be treated as partnerships and not as Subchapter C corporations for federal income tax purposes.  This article examines the federal tax treatment of the carried interest received by hedge fund managers, as well as the tax treatment of PTPs.  The article also outlines the likely effects of the Extenders Act on the tax treatment of both, and explains tax planning steps that hedge fund managers may take to avoid some of the adverse tax consequences of the bill.

Co-Founder of Hedge Fund Manager Camulos Partners Sues Other Co-Founder for $67 Million in “Unlawfully Seized” Bonuses and Investments

On December 30, 2009, William Seibold, an investor in hedge fund Camulos Partners LP, and an equity interest holder in hedge fund manager Camulos Capital LP and fund general partner Camulos Partners GP LLC, sued the Camulos entities and their controlling individuals for over $67 million in the Delaware Chancery Court.  His complaint alleges that the defendants, through a “calculated scheme and brazen abuse of power,” forced him out of the management partnership and “deprived him of millions of dollars of his investments, compensation and equity.”  His sixteen-count complaint includes claims for statutory theft, conversion, unjust enrichment, breach of contract, tortious interference with contract, breach of fiduciary duty and civil conspiracy.  This article summarizes the primary factual and legal allegations in the complaint.

Assessing Board of Director Vulnerability, Protecting Against Activist Campaigns and Good Corporate Governance Are Themes at Activist Investor Conference

On January 21 and 22, 2010, DealFlow Media hosted The Activist Investor Conference 2010 in New York City.  Among the key topics discussed during the conference were: what attracts activist investors to certain target companies; how a company can defend itself against an activist campaign; how activist investors assess the vulnerability of a board of directors; defining good corporate governance; and what might cause a passive investor to become – without intending to do so – an activist investor.  This article offers a comprehensive summary of the key points raised and discussed at the conference.

Hedge Fund Research and Advisory Firm Aksia LLC Sues Two Former Employees for Misappropriation and Destruction of Confidential Business Information

Aksia LLC is a hedge fund advisory business that provides strategy and portfolio-level research and advisory services to institutional investors that invest in hedge funds.  Defendants Sarah Cole and Corissa Mastropieri worked for Aksia’s “Americas advisory services team” servicing institutional clients and developing new business.  Aksia’s complaint alleges that, in connection with the defendants’ move to work for an Aksia competitor in London, the defendants solicited each other to leave Aksia, stole confidential business information and other company property, tampered with company records and interfered with Aksia’s relations with its clients.  The complaint illustrates how Aksia used forensic investigations of the defendants’ computers to document the defendants’ alleged preparation for their move to an Aksia competitor.  In addition to money damages, Aksia seeks, among other things, to enjoin the defendants from using the confidential information they allegedly took and from working for that competitor.  This article summarizes Aksia’s allegations and the relief it is seeking.

Dealing with Mr. Big: Recent Developments in Transactions Involving Controlling Shareholders

Controlling shareholders of public companies contemplating a sale of the company to a third party sometimes favor private equity bidders over their strategic competitors.  This is because private equity sponsors typically can be more flexible than strategic buyers in structuring transactions that allow the controlling shareholder to retain an equity stake in the surviving entity or to receive other financial benefits that are not shared with the minority shareholders, such as continuing employment with the surviving entity, stock options and other arrangements.  The Delaware Chancery Court’s recent decision in In re John Q. Hammons Hotels Inc. Shareholder Litigation, No. 758-CC (Oct. 2, 2009) provides a road map for parties to structure controlling shareholder sale transactions so that they will be subject to the protections of the business judgment rule, rather than the more rigorous “entire fairness” standard of review.  However, the Chancery Court held in Hammons that a merger between a controlled company and a third party unaffiliated with the controlling shareholder was subject to the entire fairness test because the controlling shareholder received consideration different from that received by the minority shareholders and because the transaction did not include sufficient procedural protections to protect the minority: namely, in addition to the special committee process typically used in going private transactions, there be a condition to the merger that it be approved by holders of a majority of the outstanding shares held by the minority shareholders.  In a guest article, William D. Regner and Dmitriy A. Tartakovskiy, Partner and Associate, respectively, at Debevoise & Plimpton LLP, explore the implications of the Hammons decision on the structuring of controlling shareholder sale transactions.

Delaware Bankruptcy Court Bars Ad Hoc Noteholder Group from Participating in Accuride Chapter 11 Proceedings Until the Group Complies with Rule 2019

On January 22, 2010, Judge Brendan L. Shannon, hearing In re Accuride Corporation, No. 09-13449 (Bankr. D. Del. January 22, 2010), issued an order compelling the Ad Hoc Noteholder Group in that matter to comply with Rule 2019(a).  Judge Shannon also prohibited further participation in these cases by the Ad Hoc Noteholder Group pending compliance, and directed the debtors in that case to withhold further payments to or on behalf of such group pending compliance.  Though Judge Shannon has not yet issued a memorandum explaining this decision, it would seem that he sides with Judge Mary F. Walrath, also of the Delaware Bankruptcy Court, who issued an opinion in the Washington Mutual Inc. Chapter 11 reorganization on December 2, 2009, likewise holding that Rule 2019 applies to the “ad hoc committees” of which hedge funds are often members.  See “As Debate over Amendment of Bankruptcy Rule 2019 Continues, Delaware Bankruptcy Court Finds that Current Rule 2019(a) Mandates Disclosure of Economic Interest of ‘Loose Affiliation’ of Washington Mutual Creditors,” Hedge Fund Law Report, Vol. 2, No. 49 (Dec. 10, 2009).  This article details the factual background of and the court’s legal analysis in the Accuride decision.

Aladdin Capital Holdings LLC Appoints General Counsel and Global Risk Officer

On January 26, 2010, Aladdin Capital Holdings LLC (Aladdin) announced the appointment of Sharad Samy as its General Counsel and Thomas Donahoe as its Global Risk Officer.  These appointments, the firm said, are “indicative of Aladdin’s continued strategic development and further strengthening of the firm’s operational efficiency and corporate governance.”

Survey Suggests that Institutional Investors in Hedge Funds Favor Online Investor Reporting Systems

On January 25, 2010, Netage Solutions, Inc. – a CRM software and online reporting systems provider for the alternative investment industry – announced the results of a survey covering 31 institutional investors, family offices and advisers.  The survey, conducted in the fourth quarter of 2009, concluded that “limited partners and their advisers overwhelmingly agree that online reporting systems help increase transparency.”